Morgan Stanley’s Chris Nicol on equity strategy, rates, the Aussie dollar, and capital management

Note: This interview was taped on Monday 14 October 2024.

At any given time, there are a handful of dominant factors that could have an outsized impact on the future direction of markets.

And while investors might be aware of these factors and their ability to impact markets, formulating a view on them can be a challenge.

Fortunately for Livewire readers, I recently sat down with Chris Nicol, who is the Head of Australian Strategy and Macro at Morgan Stanley.

Given the wide-ranging nature of the conversation, the topics covered have been broken down into manageable sections below, focusing on the highlights from each. Alternatively, you can watch the full interview above.

Time Codes

0:00 - Intro
0:24 - Chris' background
1:33 - Views on the RBA and interest rates
3:50 - The Aussie dollar
5:13 - Australian equity strategy
6:58 - The Great Rotation
7: 39 - The state of the consumer
9:01 - The model portfolio: banks and miners
10:57 - China stimulus
12:38 - Overweight defensive industrials
13:54 - The model portfolio: tech and healthcare
16:14 - Franking credit war chests
19:17 - Yield, yield where are you?
20:38 - Chris' View from the Top

The RBA and the path for rates

To the dismay of those hoping for interest rate cuts, Nicol believes the RBA is not in a position to ease policy soon, noting that the central bank lagged behind other central banks in raising rates and will likely do the same on the way down.

When cuts eventually come, Nicol expects a shallow to normal cutting cycle. He cites Australia’s persistent inflation, particularly in rents and wages, as a factor that will challenge any aggressive easing moves by the RBA.

Nicol also expresses caution around the risk of global re-acceleration and the desire to avoid repeating historical cycles of excessive inflation and easing.

"They [central banks] don't want to repeat of the Volcker years. So I think every central bank is on notice for that. Our RBA wouldn't be on its own in that view", says Nicol. 

Aussie dollar outlook

Nicol is on record as predicting that the Australian dollar could strengthen to around 70 cents against the US dollar by the end of the year.

This projection is based on two factors: one is the RBA’s lag in easing monetary policy, which would typically put upward pressure on the currency, and the other is the global economic outlook. Potential soft landings and Chinese stimulus could boost Australian growth expectations together.

As for the potential impacts, Nicol believes a stronger Australian dollar could help mitigate inflation by reducing the risk of imported inflation. He suggests this may align with the RBA’s goals, as a higher currency would naturally contribute to price stability and take away any risk of inflation stalling.

Australian equity market and strategic positioning

Discussing the Australian equity market, Nicol notes the concentration and bifurcation within the market, particularly between large-cap stocks and other sectors. He explains that risk aversion and the need for liquidity have driven investors toward large-cap stocks, particularly banks, which have offered a compressed yield and a sense of safety.

Highlighting the concentration at the top end of the market, Nicol recounts the following observation:

“Over a period of time, if you'd just bought the best-performing, most-expensive stock in every sector over a 12-month view, you would've done okay, and that explains some of the narrative”.

However, Nicol also sees potential for a broader rotation into resources, contingent on factors like improved commodity prices and further Chinese stimulus. He notes that a recent period of underperformance in the resources sector relative to banks might signal opportunities for strategic rotation as global conditions improve.

What about the consumer?

Nicol hasn’t called this one perfectly over the journey and is self-aware when looking back.

“People that follow our work will say that I've probably been called the ‘boy who cried consumer’, just seeing interest rate rises, expecting that to bite into the economy.

When I try to back solve that over-caution that we had in terms of actual delivery of earnings for those sectors, it really came down to [the fact] that people kept their jobs and we saw a very strong jobs market", says Nicol. 

As for the current consumer environment, Nicol characterises it as one of “thrifting”, with consumers increasingly choosing cheaper options and reducing discretionary spending due to interest rate pressures.

He is cautious about expecting a cyclical recovery in consumer-driven sectors, as he anticipates this thrifting behaviour will persist and potentially dampen retail sales during the upcoming holiday season.

Strategies in mining and defensive industrials

Morgan Stanley’s model portfolio maintains an overweight position in mining stocks, despite a challenging year for this trade.

Nicol argues that the lack of investment in new resource supply has created favourable conditions for resource stocks, provided demand holds steady. As China eases monetary and fiscal policy, he sees potential for recovery in commodity prices, which would benefit mining stocks.

“You start to bring softer landing scenarios back into the equation, that's important because that allows the commodity signal to start to bounce and we've definitely seen that in iron ore”, says Nicol.

In addition, Morgan Stanley is overweight defensive industrial stocks, like telecommunications, infrastructure, and utilities names. Nicol believes these sectors offer some protection against volatility and benefit from lower long-term interest rates. He underscores the importance of having a defensive overlay to navigate the potentially choppy market outlook.

Quality growth: tech and healthcare

Tech has outperformed in recent months, while healthcare has lagged. Nicol attributes the relative underperformance of healthcare to earnings disruptions and sector-specific challenges.

Meanwhile, the Australian tech sector, though smaller than its US counterpart, has attracted institutional attention due to liquidity and structural tailwinds. Nicol believes investors looking for quality growth should consider blending healthcare and tech stocks, along with global growth-oriented companies, rather than seeing these sectors as exclusive options.

“When a broker comes to you and says you need more quality in your portfolio, you're probably needing to add healthcare and tech together," says Nicol.

Franking credit war chests

Many Australian companies have large reserves of franking credits, which have traditionally been distributed through buybacks. With recent regulatory changes limiting off-market buybacks, Nicol expects companies to explore alternative ways to return cash to shareholders, such as through special dividends.

He notes that repeated special dividend payments could signal to the market a company’s strong cash position, potentially leading to a re-rating of its stock.

“The expectation is starting to build that [consecutive special dividend payments] could feature, because if you just pay them once it's a sugar hit, it doesn't get reflected in long-term rerating.

“But if the market starts to think that a company has multiple periods of optionality to pay over and above your ordinary distribution schedule, that could actually be a rerating event for certain stocks”.

The hunt for yield

With the ASX 200’s forward yield of 3.6% at its lowest in years, Nicol acknowledges that yield compression is a challenge for yield-focused investors.

While current payout ratios remain aligned with historical averages, he suggests that a recovery in earnings coupled with potential increases in payout ratios could enhance yield. However, he emphasises that earnings growth is essential for a meaningful recovery in yield.

“The reality is an earnings recovery is going to be critical, with the payout ratio being maintained, with a little bit of flex in payout ratios should conditions really start to improve on an easing cycle basis”, says Nicol

View From the Top

As noted at the start of this wire, there is always plenty going on in markets and it’s not always easy to figure out what matters and what doesn’t.

In closing, Nicol shares the character traits he believes are required to stay ahead. 

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