Record-breaking ASX rally faces key earnings test

Strategists make the case for a pause in the ASX 200 ‘melt-up’ as companies prepare to report another year of declining profits, despite the market’s record run.

Traders work on the floor of the New York Stock Exchange. Picture: Michael M. Santiago/Getty Images/AFP

Australian shares have rebounded impressively since April, but the real test will be the upcoming earnings season.

The ASX 200 hit a record high last week, more than 22 per cent above its April low.

For now, the market is mostly holding its ground and on Tuesday closed flat at 8677.2 points. Major banks including Commonwealth Bank and National Australia Bank fell sharply again, but their falls this week have been largely offset by gains in the big miners, Rio Tinto, BHP, Fortescue and Newmont, plus biotechnology giant CSL.

However, strategists warn of a sobering reality that could soon catch up with investors.

For a third year running, corporate Australia is on track to deliver declining profits.

The mining and energy sectors continue to drag on overall earnings.

Resources profits are expected to be down almost 20 per cent for the 2025 financial year.

“The economy is slowing, rate cuts have thus far been relatively unimpactful, and earnings are declining,” UBS strategist Richard Schellbach warned.

“The downbeat tones we expect to come from August results may not be enough to halt the markets ‘melt-up’, but they should cause it to pause.”

The Reserve Bank, led by Michele Bullock, is under pressure to cut rates in August. Picture: Christian Gilles/NewsWire

The disconnection between soaring share prices and falling corporate profits – particularly among the big four banks – has stretched valuations to a dangerous degree. The ASX 200 now trades on about 19 times the consensus estimate for the next 12-month earnings per share – two standard deviations above its long-term average and 18 per cent above its 10-year average of 16.1 times.

Morgan Stanley equity strategist Chris Nicol sees a challenging set-up for the August reporting season. “Earnings growth remains hard to find with broadbased negative revisions for FY25,” he said.

“Consensus expects a rebound, but there remains plenty of risk around the timing and trajectory of a market earnings trough, particularly given stretched valuations.”

ASX 200 companies in aggregate are expected to report a 1.7 per cent drop in profits for the current financial year, down 18 per cent from peak estimates.

While the resources sector bears much of the blame, the weakness has spread across most sectors. Only technology and communications services companies continue to show robust earnings growth, providing some bright spots in an otherwise lacklustre landscape.

So far the Reserve Bank’s interest rate cuts have not moved the dial on the economy and profits.

The lags involved are notoriously long and variable, and consumer sentiment has been depressed by years of cost-of-living hikes, which is causing doubt about the effectiveness of rate cuts.

“Rate cuts were meant to boost the economy (and earnings) this year, but so far this hasn’t materialised,” Mr Schellbach said.

Across a range of measures, including retail sales, confidence and investment, the macro landscape remains tough. The bright spot had been the strength in the jobs market, but last week’s jobs numbers showed that even there a slowdown is now being seen.

“A concern of ours is the possibility that monetary policy may have lost its ability to stimulate the economy in the way it once did,” Mr Schellbach said.

“This structural change stems from the consumers’ higher share of wealth and assets.

“Although we would not describe the economy as an outright headwind to earnings, it remains muted. We expect through August results both CEOs and analysts will point to this sluggishness.”

The economy has slowed as Australians continue to refrain from spending amid uncertainty. Picture: NCA NewsWire/Tertius Pickard

Looking ahead to reporting season, strategists expect company executives to focus on several tariff impacts from global trade tensions and the return on artificial intelligence investments, while calls for economic reform are likely to feature prominently in management commentary.

Healthcare emerges as one sector where the earnings downgrade cycle may be ready to turn, prompting UBS to recently upgrade the sector to overweight. Technology-related stocks are also expected to maintain their momentum with continued earnings upgrades.

Despite the earnings headwinds, Mr Schellbach acknowledges the powerful momentum driving equity markets higher. On Monday, he raised his year-end target for the ASX 200 from 8150 points to 8650 points, even as he warned that fundamentals alone do not justify current levels.

“Sentiment and momentum in equities is a powerful force to fight in the post-pandemic world,” he conceded, highlighting the challenge facing investors trying to time market corrections based on fundamental analysis.

While the market’s “melt-up” has delivered spectacular returns, the underlying earnings picture remains challenging. With valuations stretched and corporate profits declining, the sustainability of the current rally increasingly depends on a swift turnaround in earnings growth.

“The spark needs to come from earnings, in our view, which still face some challenges for the remainder of this calendar year,” Mr Nicol said.

Investors may soon discover whether corporate reality can support the market’s lofty valuations.