Australian Equities running into earnings headwinds

Historical data shows a reasonable (albeit imperfect) link between earnings growth and equity market performance. The local market has periodically demonstrated the capacity to push higher against a backdrop of sluggish earnings growth, however, the market has typically struggled amidst significant declines in aggregate earnings, or multi-year periods of stagnant earnings. Multi-year bull runs are generally reliant on periods of solid earnings growth.

Figure 1: The Australian market is struggling to make decisive headway as aggregate earnings flatten out

Figure 2: The market typically struggles in earnings downswings. Are earnings just pausing or rolling over?

Figure 3: Australian market EPS growth by financial year

Banks and big miners weighing on market earnings

The current flat earnings backdrop for the local market is being driven by the outsized influence of the heavyweight banking and materials (mostly mining) sectors on the ASX 200.

Banks are set to round off a strong year of earnings growth in FY23, but the sector has underperformed for several quarters now on the prospect of a lack-luster year for earnings in FY24, as well as concerns over the sector’s longer-term growth potential.

The earnings profile for the materials sector has retraced after the significant earnings rebound witnessed in FY21 and FY22, as commodity prices recovered sharply from their 2020 Covid slumps. Aggregate mining sector earnings growth is expected to be negative in both FY23 and FY24, with downgrades holding sway in recent months.

Sentiment towards the mining sector has brightened somewhat in recent weeks, as the market looks to stimulus in China to buoy commodity demand over the coming year. Last week’s Politburo policy statement has been supportive of market sentiment, helping extend the recent rally, though policy stimulus specifics are yet to be released.

Outside of banking and materials, a number of key sectors hold out the prospect of decent earnings growth in FY24. Healthcare has been a disappointing performer over the past year, although growth is expected to rebound in FY24 and beyond, led by heavyweight CSL Limited. Other sectors expected to deliver decent growth in FY24 include information technology and communication services.

From a heavyweight stock perspective, there is growth on offer in selected large cap stocks, but it is fairly sparse. Only 8 of the top 20 large caps are expected to deliver better than 5% earnings per share (EPS) growth in FY24.

Looking at consensus earnings expectations more broadly, median expectations for FY24 across the large cap ASX100 universe are for 10% EPS growth in FY24 (excluding banks and resources). This follows 5% growth in FY23.

Given the slowing economic backdrop, we view the risks to FY24 earnings forecasts as skewed to the downside. While the macro picture will likely create some headwinds, it will not be sufficiently dire to rule out some decent earnings growth across a reasonable number of large cap stocks, in our view.

Figure 4: Australian market key sector EPS growth metrics

Figure 5: Large cap Australian company consensus earnings growth estimates

A cyclical or structural earnings problem?

In summary, the Australian market is going through a tougher period for earnings, in part due to its inherent skew towards the cyclical banking and materials (mining) sectors.

The mining sector earnings cycle is notoriously volatile and could surprise to the upside if Chinese growth is better than feared. As such, we are watching China stimulus developments closely, alongside the general global growth pulse, which has been better than feared lately.

For the banking sector, the fate of the domestic economy will be an important driver of top-line growth and bad debt outcomes. The sector has struggled against rising competition for both mortgages and deposits with net interest margins disappointing in recent results. The backdrop still looks relatively benign from a bad debt perspective, but with provisions at low levels and the economy slowing, a rise in bad debt provisions remains an earnings risk to monitor.

On the positive side, a lower than expected peak in rates and/or an earlier than expected easing cycle could see renewed positive sentiment around earning prospects, although we feel it is premature to position for a bank earnings upswing.

Beyond the banks and miners, our general view is to stay with quality, resilient earnings at this relatively early stage of the economic slowdown. Reasonably buoyant global equity market conditions are supporting Australian equities, although Australia has underperformed since early February given our banking and mining sector skew on the local index.

The US market earnings outlook does look to have more near-term recovery potential, even if relatively buoyant CY24 earnings expectations (12% growth) and high valuations are tempering the size of our overweight global call relative to the domestic market.

We will continue to monitor key cyclical factors such as the local interest rate outlook, and the outlook for global and Chinese growth, in respect to their influence on the domestic earnings cycle. At this stage, we see the domestic earnings picture as transitioning through an (extended) cyclical slowdown that should rebound again in FY25. However, we are pondering the structural challenges that the big 4 banks and large cap miners are likely facing when thinking about the multi-year prospects for the local index.

Certainly, we continue to emphasise the importance of both active management and global diversification, given the elevated uncertainty surrounding both the cyclical and structural outlook for domestic market earnings.

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