ASX investors are "embracing the possibility" of an earnings rebound - but Morgan Stanley is sceptical

Markets may be forward looking but a lacklustre February (so far) has the consensus downgrading FY24 earnings growth.
Hans Lee

Livewire Markets

Markets are forward looking beasts - and nowhere is this more apparent every day than in equity markets. February may have seen more earnings beats than misses so far, but as UBS' Australia-based equity strategist Richard Schellbach has already explained, the bar is lower than it has ever been.

"Through this period ASX200 FY24 earnings growth has slipped by 0.6%, and now sits at -5.5% y/y. A similar negative skew has been seen in the guidance and outlook statements, which have come from company management teams," Schellbach wrote in a client note today.

But are investors already looking past February even before it has ended? This chart from Wilsons Advisory would argue the answer is yes:

Source: Refinitiv, Wilsons Advisory
Source: Refinitiv, Wilsons Advisory

But in this wire, I'll explain why Schellbach and Morgan Stanley's team of ASX analysts are expressing caution on this otherwise Goldilocks outlook.

Good from far, but far from good

Schellbach's eloquently titled research note essentially argues that the numbers look worse than what is being reported. While the beats look good and margins are improving at most publicly-listed companies, there are still three key issues for companies (and by extension, investors in stocks) to deal with:

  1. Cost cutting is the key theme - but at least the worst looks over: "The peak rate of upward momentum in cost growth may be over, with one-third of reporting companies saying cost pressures have now passed peak intensity."
  2. Top-line growth is slowing, and that's down to the consumer - "Very few companies had anything positive to say about the top-line growth environment ... Management teams painted a picture of a customer base that is battling against cost of living pressure and higher rates and thus has little scope to up their spending."
  3. Monetary policy works with long and variable lags - and firms are still getting caught out: "Although the RBA's rate hiking cycle started almost two years ago, it seems that many are still getting caught out by this. Companies at results were overwhelmingly hawkish on the topic of rates, pointing to rising interest expenses.

The fourth key issue - jobs, jobs, jobs

While the above three issues are worth talking about, there is a fourth issue that both Schellbach and Morgan Stanley's team of Australian market analysts agree on as a key headwind for equities: How will the Australian job market conundrum end?

"In our view, the labour market remains central to the crystallisation of both of these risks - a tight labour market sustains labour costs and corporate pricing power, while sharper job losses would be a key driver of a more cautious consumer," Morgan Stanley analysts wrote.

And as they add, your answer to the question of which economic scenario you believe could have big implications for which stocks you buy. 

"The recent outperformance of both Discretionary and Banks sectors suggest investors are reading a playbook of an imminent pro-cyclical easing path – a longer hold with possible hikes are not written into that story," strategists wrote.
Domestic cyclical exposures have outperformed the broader equity market. (Source: Bloomberg, Morgan Stanley)
Domestic cyclical exposures have outperformed the broader equity market. (Source: Bloomberg, Morgan Stanley)

In short, Morgan Stanley argues that investors are discounting the risk that the jobs data will force the Reserve Bank to keep rates both higher for longer and delay any forecast rate cuts. 

"To us, it is clear that investors have jumped over any gaps that may still present in FY24e and are now embracing the possibility of a broader pro-cyclical domestic earnings outlook that could present in FY25e and beyond," analysts wrote. 

For what it's worth, Morgan Stanley's Model Portfolio demonstrates a strong UNDERWEIGHT in ASX-listed financials (especially the Big Four banks) as well as the cyclical industrials space. Its most notable underweight position here is Wesfarmers (ASX: WES)

The good news on this front, at least from the reports of the last few weeks, is that costs are still there - but it's becoming less of a headache. 

"Signs of normalisation are emerging, however, with Downer (ASX: DOW) pointing to a stabilisation in labour costs, and Cleanaway (ASX: CWY) noting a fall in its vacancies. Relief was also noted in white-collar fields, with CSL (ASX: CSL) reporting that its labour costs have reduced," Schellbach noted. 

UBS is NEUTRAL-rated on Downer and Cleanaway while CSL is rated a BUY. CSL is also in Morgan Stanley's "Focus List" - a list of stocks that they eye as representing the best opportunities in the market right now.

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4 stocks mentioned

Hans Lee
Senior Editor
Livewire Markets

Hans is one of Livewire's senior editors. He is the creator and moderator of Livewire's economics series "Signal or Noise". Since joining Livewire in April 2022, his interview record includes such names as Fidelity International Global CIO Andrew...

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