ASX large cap resources the new home for quality earnings, says Morgan Stanley

While it is true that the Australian economy is going through some very different challenges to our global counterparts, it (and therefore, our markets) is not immune to the key issues of sticky inflation, higher interest rates, and volatile commodity prices. In fact, Morgan Stanley believes that the full effects of Australia's monetary tightening cycle may still be as long as six to nine months away. The first sign of this thesis was the Q1 GDP print, in which growth came in at just 0.1% over the first three months of 2024. 

"Our cash rates have ultimately a much bigger impact and immediate impact on the economy because of the variable nature of most people's mortgages. We're finally starting to see that flow through," Chris Nicol, Head of Australian Strategy & Economics at Morgan Stanley, told the Morgan Stanley Australia Summit last week. 

But the good news is that Nicol's team is forecasting that we are near the growth trough - and that means that any downturn in specific stocks or sectors may be near its end as well.

"From an equity market standpoint, we are seeing maybe some of the final phase impacts on earnings. Earnings still will be a risk in the market this upcoming results season but the economy is probably finding a trough," Nicol said. 

Nicol shared his views alongside his wealth management colleague Alexandre Ventelon recently. This wire summarises their take on where Australian assets and the Australian economy are likely to head.

Watch the company updates this August

It may feel like an eternity away but August's full-year reporting season is not all that far away. Nicol and his team will be watching the commentary in company updates particularly closely this time.

"We are watching the slowdown in company updates that we've seen in the last couple of months. That could be an indicator that there is a bit of earnings risk at the moment in some particular sectors," Nicol said. 

"If corporates come to us in August in their reporting season and suggest to us that things are going to stay pretty sluggish for some time. They start taking costs out and that may reflect in jobs," he added. 

Nicol's last comment on jobs is particularly important as the RBA's dual mandate includes maintaining relatively full employment - and of course, a low unemployment rate is a key ingredient in the soft landing scenario that markets are pricing in. 

The math adds up to a stronger ASX 200

The good news for investors is that Nicol's team has a 12-month price target of 8100 for the ASX 200 - which implies 10% earnings growth through 2025 and 2026 and is also a big upgrade from the team's previous price target of 7300-7400.

"We started to frame that conversation around the equity market's direction of travel as a base to bull case kind of market," Nicol said. Here is his math, as he described it:

"As it sits today, that [target] is predicated on some form of earnings rebound as well in 2025/2026. So this time next year, the market should be looking at maybe 10% earnings growth as a potential for the market."

"Valuations are a little bit stretched at the moment at 16+, but you can look through time and say that we probably can hold, with monetary stimulus ultimately coming with fiscal stimulus there already, we can probably hold a 10-year average multiple of 15.8. If you put that on the earnings forecast that we have next year, that gets you to 8100," Nicol added.

Why healthcare stocks were not the quality buffer they once were

All through this cycle, the professional investors who speak to us have been emphasising the importance of quality. You know the refrain: Pick quality stocks in quality sectors that have high-quality earnings with high-quality management teams. 

"It's a lofty pursuit," Nicol quipped.

If you followed this thesis at the start of 2023, chances are you would have bought ASX healthcare stocks - and been burned in the process.

"That has been the one sector that's massively underperformed since that period of time because of disruption, the domestic healthcare sector not having the pricing power and dealing with inflation and disruptive elements creates a lot of volatility," Nicol noted. 

"So at the moment, if you just put the quantitative lens on healthcare, it doesn't sit within quality," he said but added one important caveat - especially for the healthcare companies with international earnings.

"If they can prove their compounding credentials again, and the market regains confidence that there is low double-digit compounding growth potential, then they could easily move back into the quality factor," Nicol said. Ironically, healthcare is one of the main overweight positions by sector in the Morgan Stanley model portfolio.

...and resources stocks are now where quality investors should be

While this may sound counterintuitive, Nicol argued that large-cap resource stocks are where a lot of the quality earnings are found today.

"And that's because the commodity earnings of those companies have been fairly stable. One of the things that we've been talking to clients about is that we're quite comfortable having some big cap resources exposure within portfolios because when I look across the commodity space, I've never seen price signals like this and not trigger the investment that usually comes. We're just not seeing companies invest behind the pricing," Nicol said. 

He went on to say:

"What you have is a unique environment where you're not going to get swamped with supply that crushes the price and therefore crushes the earnings and creates a huge amount of volatility. We're actually getting much more stable earnings in that sector.

As of the most recent Morgan Stanley Model Portfolio update provided to clients at the start of June, the main resources exposures are in BHP (ASX: BHP), Newmont (ASX: NEM), Rio Tinto (ASX: RIO), South32 (ASX: S32), Paladin Energy (ASX: PDN), Woodside Energy (ASX: WDS), and Santos (ASX: STO).

Quality outside of resources

Outside of resources, Nicol says the market has been focusing on quality in compounders within the ASX tech sector - where companies such as REA Group (ASX: REA) and WiseTech Global (ASX: WTC) have been strong performers this year. As he put it, you need to find stocks with "growth that you can trust".

Finally, he also sees a scenario where companies that benefit from a rising Australian Dollar may also see a flow-through effect on their earnings.

"Our official forecasts out of New York are for 67/68 cents. But I can see a scenario next year that we could be living in the 70s again," Nicol said and added, "I'd say that the central bank would be very comfortable with a higher level of AUD because that takes away the risk of re-inflation from imported currency next year, which is something I think that they would see to be great."

At least 35% of the ASX 200 gets at least 30% of their earnings from offshore - meaning currency moves will matter.

A rising Australian dollar is generally better for cyclical stocks, companies that import goods and services into Australia, and by extension of its effect on interest rates, can also be good for small caps. It's also good for your overseas holiday because a stronger dollar means you get more bang for your buck.  

Information is everywhere; true insight is rare.

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