Brace for lower growth, earnings as interest rates go up

T. Rowe Price’s head of Australian equities remains cautious about the outlook for growth and corporate earnings amid uncomfortably high inflation and rising interest rates.

Federal Reserve chairman Jerome Powell. Picture: AFP

T. Rowe Price’s head of Australian equities, Randal Jenneke, remains cautious about the outlook for growth and corporate earnings amid uncomfortably high inflation and rising interest rates.

As the local sharemarket boomed last year — with the S&P/ASX 200 Total Return index up 17.2 per cent ­— Mr Jenneke went defensive, underweighting banks, retailers and property trusts, while beefing up on healthcare, utilities and consumer staples. He was also underweight iron ore miners before flipping to overweight at the start of the year.

Now he warns that “basically all of the pandemic bubble that was created will be given back”.

“So I’m fairly cautious that we will have a slowdown and or recession in Australia, much like we’re going to see in the US and most of the world, and that’s going to be sort of giving back the gains that we got during the pandemic,” Mr Jenneke told The Australian. “That’s to bring inflation under control. It’s unsustainably high and that’s why central banks are raising rates.”

Hope of a “pause and assess” after a few rapid-fire hikes in the US gained traction this week after Atlanta Fed president Raphael Bostic floated the idea as the S&P 500 flirted with a “bear market”.

A few days earlier, St Louis Fed president James Bullard, until recently seen as an “uber-hawk”, said he didn’t see a recession this year or next and that if the Fed “frontloads” hikes, it could be cutting rates in 2023 and 2024 because inflation was under control.

But Fed Reserve chairman Jerome Powell said recently that “the process of getting inflation down to 2 per cent will also include some pain, but ultimately the most painful thing would be if we were to fail to deal with it and inflation were to get entrenched” — words that make more sense to T. Rowe’s Jenneke.

“Think about the situation now … the market is down about 20 per cent on the S&P 500 and 30 per cent on the Nasdaq, but they don’t seem particularly perturbed by that,” he said.

While sharemarket falls are “orderly”, he doesn’t see the Fed being upset by another 10 or 20 per cent of downside, falls which would push the S&P 500 well past the bear market marker of minus 20 per cent from a peak. Last Wednesday’s 4 per cent fall might have rung some alarms though.

T. Rowe Price is one of the world’s biggest purely active managers of funds with about $US1.42 trillion ($2 trillion) under management as of April 30. “US household wealth increased massively over the pandemic on a combination of what happened in financial markets and house prices,” Mr Jenneke argues.

“Part of the transmission mechanism (of tighter monetary policy) is that wealth needs to be destroyed to actually curb consumer behaviour and we’ve really only just started that process.”

Meanwhile “ignorance is bliss” in Australia as the nation faces a similar shock from inflation and central bank rate hikes, although it doesn’t yet have a smoking gun on wages growth.

“I don’t think people fully understand the kind of slowdown that is required to get inflation back to that 2 to 3 per cent band,” Mr Jenneke said.

He hasn’t made any portfolio changes as a result of the federal election but is keeping a close eye on wages policy and the Fair Work Commission’s decision on the minimum wage next month.

“If Labor’s advocates a 5 per cent wage increase, that’s more than what employers expect,” he says. He sees it as a first test of the Labor government’s ability to work with business.

“If we get a high minimum wage judgment from the Fair Work Commission, that would be negative for costs, margins and earnings of Australian companies,” he said. But the T. Rowe Price Australian Equities Fund will be relatively well insulated from a spike in wages.

“When you think about the industries that would be most affected, it’s the big employer businesses like the banks, supermarkets and retail sectors where we don’t have much exposure,” Mr Jenneke said. “Our fund has been shifting more defensive over the last six plus months.”

Labour-intensive companies like the banks, retailers and supermarkets will be in the firing line.

In his mind, recent inflation jitters in the sharemarket will morph to stagflation, then recession fears. “So you move from a derating of the market and stocks, based on higher inflation driving interest rates higher and price-to-earnings multiples lower, then you get the bad news around earnings,” Mr Jenneke said. “That’s what we have started to see in the US and it’s going to broaden.

“If you look at what’s happened to Walmart, Target and the US retailers, that’s kind of the next phase — earnings coming under pressure — and that will happen everywhere.”

Whereas rising bond yields were initially correlated with concern about falling valuations this year, he now sees bond yields cooling on recession fears, which also hit the earnings outlook.

“We may have seen the peak in US 10-year bond yields around 3.2 per cent – if inflation can be brought under control and back to target levels and the markets believe that,” Mr Jenneke said.

“But we are now seeing US 10- year yields closer to 2.7 per cent and that’s because people are worried about economic growth and corporate earnings.”

The 12-month forward PE ratio of the Australian market has fallen back to about 14 times versus a decade average around 16 times, but Mr Jenneke says that emerging signs of value in the broader market could prove somewhat illusionary and earnings estimates are likely to be revised down.

“Part of what’s happened in Australia this year is that commodity prices have buoyed the overall earnings numbers, but the more important thing to be worried about is that the cash rate by the end of this year is probably going to be 1.75 per cent, rising to 2.5 per cent by the middle of next year.” “That’s going to slow the economy. I think what people forget is the whole point of raising rates is to slow demand. Demand is too hot and that’s part of the reason why we are having inflation.”

“It’s not just supply issues. We have to slow demand. That means unemployment needs to go up.”

“I just don’t think people are thinking through the logic of what should happen here, and the RBA doesn’t help. I saw their updated forecasts and I was just thinking ‘you’re living in La-La Land.’”

“You’ve got the forecasts horribly wrong so far and you’re going to get it wrong again.

“I think the growth slowdown is going to be bigger, the unemployment rate is going to be higher, and they’re just horribly wrong on their forecasts.”

Mr Jenneke remains positive on iron ore miners but says for commodities outside of iron ore, the demand outlook is increasingly looking challenged.

“Demand destruction is the thing you want to worry about for commodity prices, but iron ore is a bit different because it does depend on what China is doing and that comes back to the Covid-zero policy and how they try to pump up domestic demand as much as they can.”

In recent months the fund has added exposures to “beaten-up (growth at a reasonable price)”, including Aristocrat, Caresales.com.au and Domino’s Pizza.

“Some of those beaten up growth names where we think the market has gone too far, we’ve been adding to those, because I think the way this will play out is that growth stocks get hit first, with rising rates and PE ratios contracting, but then the (earnings) gets hit, and when that happens, it’s a lot of the cyclical and value stocks that underperform.

“I’m positioning ourselves for that environment where the earnings come under pressure, which I think is going to be in the second half of this year.”