Markets were too optimistic ahead of the ASX earnings season, industry experts say, with around half of companies missing earnings expectations.
Margin squeeze was a key theme, and while the full impact of higher interest rates is yet to flow through, cost inflation is already starting to bite.
Investors should think small
Hudson is a portfolio manager and director at Yarra Capital and manages the gold-rated UBS Australian Small Companies fund.
“On balance, about 50% of companies missed earnings expectations and then their numbers were downgraded,” Hudson says.
“But clearly it's going to be a challenging environment. What reporting season really told us was that volume growth has been okay, price growth has been strong - largely as people have passed through cost inflation - but margins have been coming under pressure.”
That will create significant headwinds for earnings through 2023, she says, and the winners will be companies that can grow their earnings and generate real cashflow.
So, where should investors be looking in the small cap space, I asked, which was heavily sold off in 2022.
“The sector ended down 18% [in 2022], and that's meant there's been a big valuation gap that's opened up between small caps and large caps. From that perspective, we think the small cap sector looks really interesting,” Hudson says.
She says quality growth and technology companies caught up in the wider sector sell-off now present good opportunities.
“There’s some really interesting companies within those cohorts that we think have maybe had some short term missteps, maybe have been overvalued, but the retracement has created some really good opportunities, particularly in that sort of growth and technology part of the market in the back end reporting season.”
The impact of higher interest rates
The RBA this week raised the cash rate for the tenth time in a row, taking it to a 13-year high of 3.6%.
However, the full impact of these increases will take time to wash through the economy.
While Hudson says earnings expectations have returned to more realistic levels, Warnes is less optimistic and says further downgrades will be forthcoming.
“While inflation may have peaked, there is still a pipeline of higher costs yet to filter through, particularly in the services space. Price increases of 14% in Brambles pallets are just an example,” Warnes says.
On average, there is a three-month lag between each rate hike the time it takes to hit a borrower’s mortgage repayments.
Interest rate changes can take between one and two years for their maximum effect to unfold on economic activity and inflation. Even assuming a lag effect of only twelve months, the already implemented RBA hikes won’t fully reflect in our economy before early 2024, as shown in the chart below.
So far, household spending remains surprisingly robust, although the household savings ratio has fallen back below pre-pandemic levels.
As for home loan risks, data from Australia’s largest lender - the Commonwealth Bank (CBA) – suggests mortgage stress remains relatively low.
The bank has identified 5% of home loan balances as being high-risk, but within this group, 65% have a loan-to-value ratio below 80%.
