Beware of the rotation coming in ASX large cap companies

2024 recap - Strong amidst uncertainty

Amidst a sea of geopolitical, election and macroeconomic uncertainty, the ASX 200 broke through its record high in January 2024 and has not looked back with another year of strong returns.

The key themes that drove the Australian market higher in 2024:

• Global decline in inflation as supply chains normalised and demand for goods eased, coupled with interest rate hikes having their intended effect.
• Initiation of interest rate cuts by central banks in major economies, with the US commencing its rate reduction journey in September.
• Resilient global growth, with robust performance in the US offsetting slower growth in China, and Europe and Japan flirting with recession.
• Commodity prices, whilst mixed, overall strength was observed, particularly with record highs in gold and copper, and solid performance in iron ore and coal throughout most of the year.

2025 outlook

We believe investors should always pay heed to valuation, so let's address this first.

As I put pen to paper at the end of November, the Australian market is valued at levels that have only been surpassed during the COVID period- which does warrant some caution.

However, we believe the structural re-rating can be justified to some extent as we see improvements in the quality of the market due to changes in its composition. Furthermore, it's not unexpected for the market to be highly valued at this stage of the cycle - it often rallies at the beginning of rate-cutting cycles in anticipation of future earnings upgrades. But, for the market to maintain its current rally, earnings will need to demonstrate growth.

The earnings cycle

ASX 200 earnings estimates have been in a downgrade cycle since June 2023, but there are tentative signs that the cycle has reached its nadir.

Australia is a relatively small, open, export-oriented economy heavily reliant on commodities, so it is not surprising that the market is significantly influenced by global growth. In previous cycles, the Global Purchasing Managers' Index (PMI), a key indicator of global growth, has reached its lowest point between two and ten months before the decline in earnings.

In this current cycle, the Global PMI potentially reached its lowest point in July 2023 and is showing signs of recovery, albeit in a volatile pattern. Breaking the Global PMI down further into the Manufacturing and Services components, it is clear that manufacturing has been weak and services strong. A sustained recovery requires the Manufacturing component to recover whilst the Services component maintains it strength, particularly in the US. The encouraging news is that the necessary conditions for this recovery are in place.

Soft landing

Focusing on the US Manufacturing PMI, which has hovered in mild contractionary territory for much of the year, we see a clear relationship with interest rates. In previous cycles, the US Manufacturing PMI reached its lowest point around the halfway mark of an interest rate cutting cycle.

Current market expectations point to an approximately 200 basis points (bps) cut in US interest rates, aligning closely with the median of the US Federal Reserve (Fed)'s own projections by the end of 2025. With the Fed having already implemented a 75bps cut, we are nearing the halfway mark. In fact, current market pricing indicates that this point could be reached early in 2025.

Whilst the risk of a recession is abating, it is difficult to completely rule it out considering the trigger of recession indicators such as the inverted yield curve and the ‘Sahm Rule’.

The Sahm Rule, a concept developed by Fed economist Claudia Sahm, poses that the economy is in a recession when the three-month average unemployment rate rises 50bps from the prior 12-month low - a condition met in July 2024. However, when comparing a range of cyclical indicators for the US economy at the time the Sahm Rule was triggered, it is evident that by all the key indicators economic conditions are notably stronger than in previous cycles.

Overall, it appears that the elusive soft landing remains on track. This is positive signal for the potential earnings recovery and equity market returns.

China: Tariffs and stimulus

China has the potential to be either a headwind or a tailwind to Australian and global growth, depending on a few key factors. These include how aggressive the new Trump administration is in implementing planned tariffs and how China responds with domestic stimulus and potential currency depreciation. Some optimism can be garnered from the noticeable pro-growth pivot in Chinese policymakers’ stance over the second half of 2024 and the significant savings Chinese consumers have built up over the last few years.

Elections: Fiscal stimulus

Elections are another key swing factor with Australians set to go to the polls by May 2025. If we look at overseas elections in 2024 as a guide, there is potential for a notable swing in votes away from the incumbent government due to cost-of-living pressures. With opinion polls now finely balanced, there is a possibility of fiscal stimulus in the form of more spending, tax cuts and more job creation, which is likely to provide support for economic growth. 

It is reassuring to note that Australia can implement such measures, thanks to the windfall from higher-than-budgeted commodity prices over the last few years. However, there is a downside risk that a minority government could potentially impose limits on the amount of stimulus, leading to a reduction in growth.

Sector rotation

It is important for investors to be aware of potential sector rotation in the market, as historical evidence shows that top-performing sectors can become poor performers in subsequent years. In the Australian market in 2024, there was a notable divergence between the banks and resources sectors. If sentiment towards China improves or domestic conditions deteriorate, it could lead to a rotation in these sectors. Therefore, we believe investors should be vigilant and keep an eye on these potential changes in the market moving forward.

Attractive opportunities amidst volatility

In summary, the Australian market presents an attractive investment opportunity in 2025 with improving fundamentals. Sectors that could benefit from the revival in global growth include Resources and Industrials sectors, whilst the Technology sector is likely to continue to exhibit robust growth.

Conversely, the Banks and Consumer sectors, which have been the winners of 2024, are now highly valued and could see some pressure from rotation. However, it is essential to be mindful of the that volatility will likely remain a consistent feature in an uncertain world. So, it is important to invest for the long term and take advantage of any short-term dislocations on the journey to building wealth.