Inflation data in focus before US interest rate decision

The ASX 200 record masks troubling signs. The chasm between earnings performance and share price gains helps explain why Australian equities now trade almost 10 per cent above fair value estimates – a premium not seen since the 2021 technology bubble.

Ongoing uncertainty about US economic policy and potential trade disruptions under the Trump administration add layers of complexity to the investment outlook. Picture: Getty Images

Inflation numbers this week may determine how comfortable markets are with an expected interest rate cut by the United States Federal Reserve, almost a sure bet on account of new evidence that hiring is stalling in the world’s biggest economy.

America added just 22,000 new jobs in August, and official labour data released last Friday revised the June result to a net loss of 13,000 jobs that month, the first decline since December 2020. Unemployment rose to 4.3 per cent from 4.2 per cent.

US consumer price index data on Thursday is expected to show headline inflation rose to 2.9 per cent, while ex-food and energy inflation remained stubbornly high at 3.1 per cent.

High inflation remains a challenge for the Fed given its 2 per cent target, but a weakening labour market is widely expected to lead the US central bank to restart rate cuts next week.

But in the short-term, Australian stocks need sustained upward momentum in the US market.

On the surface, August’s reporting season delivered some of the best returns in two decades, with the ASX 200 grinding almost 3 per cent higher to hit a record 9054.5 points last month.

But beneath that veneer a more troubling picture emerges.

Stretched valuations, anaemic earnings growth and a heavy reliance on just two sectors have left local shares looking dangerously exposed. A subsequent 3.6 per cent fall in the ASX 200 by early September – including a 1.8 per cent drop last Wednesday – offered a sobering reminder of what can happen when valuations are stretched and earnings momentum is weak.

ASX warning signs

The warning signs are flashing bright red across multiple metrics. The ASX 200 now trades on a forward price-to-earnings multiple of 19.5 times – well above its long-term average of 14.8 times.

Meanwhile, the dividend yield has shrunk to 3.2 per cent, down from a historical average of 4.3 per cent. These numbers point to a market that has become increasingly expensive relative to the underlying fundamentals.

More concerning still is the earnings backdrop. For the ASX’s largest 20 companies, earnings have fallen for three consecutive years, declining a cumulative 18 per cent over that time.

Yet over the same period, the ASX 20 has surged more than 30 per cent.

This chasm between earnings performance and share price gains helps explain why Australian equities now trade almost 10 per cent above fair value estimates – a premium not seen since the 2021 technology bubble.

Concentration risks mount

Australia’s heavy weighting towards banks and miners creates additional vulnerabilities that passive investors cannot easily escape.

Apostle Funds Management investments director Harrison Lane.

Apostle Funds Management’s Harrison Lane warns this concentration leaves local investors “hostage to a narrow set of drivers” compared with more diversified overseas markets.

The contrast with the US is particularly stark.

While 80 per cent of S&P 500 companies outperformed earnings expectations in the recent reporting season, only a quarter of ASX 200 companies managed the same feat.

Financials comprise about 34 per cent of the local market, while materials account for just under 20 per cent. Both sectors are mature businesses well past their growth heyday, unlike the US technology giants that continue to deliver strong earnings expansion.

Global headwinds gathering

The local market also faces headwinds from shifting global dynamics, particularly around US monetary policy and currency movements.

With the US administration pushing for even bigger rate cuts, the US dollar may weaken, potentially benefiting Australian commodity producers like BHP in the near term.

However, ongoing uncertainty about US economic policy and potential trade disruptions under the Trump administration add layers of complexity to the investment outlook.

Not all the news is gloomy. Australia’s economic outlook shows signs of gradual improvement as inflation continues to ease and interest rates decline.

Betashares chief economist David Bassanese expects annual GDP growth to reach 2.1 per cent by December 2025, supported by recovering consumer spending and continued public investment.

The Reserve Bank is likely to deliver three more rate cuts through to May 2026, bringing the cash rate down to 2.85 per cent. This should provide some support for domestic-focused companies and sectors sensitive to borrowing costs.

Selective opportunities emerge

And reporting season did create some selective opportunities for discerning investors.

Morningstar’s Lochland Halloway says the sharp sell-offs in quality companies like CSL, James Hardie and Woolworths have created value for long-term buyers. And in his view, WiseTech’s AI-driven transformation story looks compelling despite recent weakness.

Morningstar analysts upgraded fair values for 44 per cent of reporting companies during August – a higher proportion than recent cycles – suggesting the underlying business quality remains sound even if share prices have run well ahead of earnings.

The path ahead requires careful navigation. A major correction isn’t inevitable, but the combination of stretched valuations and modest earnings growth leaves little margin for disappointment.

Investors would be wise to remain selective, focusing on quality companies trading at reasonable prices rather than chasing momentum in an increasingly expensive market.

The Australian sharemarket’s resilience during reporting season was impressive, but sustainability will ultimately depend on whether fundamentals can catch up with prices.

For now, caution should temper any excessive optimism.

Originally published as Inflation data in focus before US interest rate decision