Why a sharemarket market ‘melt-up’ is possible: UBS

Sticky inflation has delayed and limited the amount of rate cuts expected in the US and Australia, but that won’t not stop the local sharemarket hitting fresh highs if the US keeps rising.

Conditions are ripe for the local sharemarket to hit the accelerator. Picture: NCA NewsWire/ Gaye Gerard

Sticky inflation has delayed and limited the amount of rate cuts expected in the US and Australia, but that won’t stop the sharemarket from surging to fresh record highs led by the US.

Before the release of FOMC minutes and results from Nvidia early on Thursday, both of which could cause volatility in global financial markets, UBS called a “melt-up” in Australian shares.

The somewhat bullish view was rolled out by the Swiss bank’s Australian equity strategist, Richard Schellbach this week as the S&P/ASX 200 neared its early April peak of 7910 points.

It comes after a 5 per cent dip in the S&P/ASX 200 last month as interest rate expectations were recalibrated to a “high-for-longer” outlook, although central banks subsequently hosed down speculation that further interest rate hikes were needed.

Of course melt-ups, characterised by rapid and sustained rises in share prices that aren’t backed by fundamental economic conditions, are usually followed by meltdowns.

Schellbach has sympathy for those who are “frustrated and confused” by the sustained strength of the local sharemarket this year. It has pushed the 12-month forward price-to-earnings ratio of the S&P/ASX 200 up to 16.5 times versus its long-term average of about 14.8 times.

“Many fundamental analysts are understandably frustrated and confused,” he said.

“Despite already rich valuations and tepid growth outlooks, equities keep grinding higher.”

While he doesn’t see the kind of euphoria that would signal that a “full blown melt-up scenario” is already underway, Schellbach does think there are signs that a “mini melt-up” could occur.

USB equity strategist Richard Schellbach. Picture: Emma Murray

His “market melt-up checklist” notes that the sharemarket is rising despite already high valuations, a weak earnings per share outlook, and a subdued macroeconomic outlook.

There’s still hope of interest rates cuts that could warrant above average valuations, plenty of “dry powder” or money that can be deployed in the market, and potential for some “FOMO” – fear of missing out – causing “speculative euphoria” in terms of market sentiment.

There’s also a belief that “this time could be different” for the longer-term earnings outlook as artificial intelligence is expected to boost productivity; retiring “baby boomers” could underpin spending; and policy makers may be looking to “do whatever it takes” to avoid a recession.

The current unusual equity market rally is perhaps best illustrated by the divergence between equity market leadership and macroeconomic readings. Since mid-2022, cyclical stocks have outperformed defensives, even as purchasing manager index readings have mostly been in “contraction” territory.

Schellbach argues that a market melt-up is taking shape despite the starting point on stock valuations being “undeniably rich”. In recent months he’s warned that Australian stocks have never been so expensive, excluding the Covid years that were supported by unprecedented stimulus.

“History tells us that during a melt-up, equities choose to remain largely agnostic to valuations,” he said. “Despite Australia’s economic and equity earnings outlook being softer than what is expected in the US, the two stockmarkets have long been highly connected.”

If US stocks keep grinding up, it would be highly unusual for Aussie stocks not to participate.

Another factor is simply the amount of money that could flood into the sharemarket if it takes off.

At the end of 2023, Australian self-managed super funds – a proxy for the retail investor community – held $170bn in liquid cash holdings. With interest rates having already peaked, this dry powder could be deployed into chasing stocks, which in turn could further fuel a melt-up.

Current strength in the US sharemarkets is being driven by the belief that the Fed will be cutting rates in the second half of 2024, and that a soft landing will play out.

Schellbach says eventual Fed rate cuts could accelerate a melt-up in shares and in the meantime a secular force has emerged in the form of AI technologies.

Investors becoming enamoured with a new wave of technological innovation has precedence in prior market melt-up periods, as seen in the late 1990s during the dotcom era.

“Local stocks have also been attaching themselves to this revolution, with AI mentions rapidly spreading across Australian companies,” Schellbach said. “To an extent this breeds an investor mentality which errs on the side of ‘this time is different’ mentality, over fundamentals.”

But investing through a melt-up raises challenging questions. Should investors stick with the stocks that have run up, despite stretched valuations; buy the laggards; or just sit it out?

“We find many of the laggard trades interesting, given if rates are headed down, and economies engineer a Goldilocks outcome, then surely at some point these names will begin participating,” the analyst said. One area of notable underperformance has been value stocks.

Domestic cyclicals like banks could fuel a melt-up, even though they are overvalued.

A neutralisation of these positions could see their share prices drift even higher.

UBS finds that investors are still “crowded short” Australian bank and retail stocks.

But “value stocks” and small-cap equities may be a better bet in a melt-up.

UBS’s “catch-up” candidates are: Brambles, Computershare, Dexus, GPT Group, GQG, HMC Capital, Hansen Technologies, Metcash, National Storage, Pinnacle, Reliance Worldwide, and Worley.