Schroders head of Australian equities, Martin Conlon, has warned against paying too much for assets given an underlying disconnect between share prices and the real economy and says equity prices will remain vulnerable next year as the cost-of-living climbs in Australia.
The Australian equity market is currently witnessing divergent trajectories between the financial economy and the real economy. While asset prices continued to rise in 2024, this growth is not reflected in the real economy, leading to concerns about the sustainability of this trend, according to Mr Conlon.
"Equity markets continue to ride the wave of money which is supporting asset prices but not living standards. The difference between fundamentals and multiples mean company valuations are like corks on the ocean, driven by sentiment and news. Whether and when we revert to fundamentals is impossible to predict, but waves do tend to break eventually," Mr Conlon said.
One of the main drivers of this disconnect is the Australian housing market. “The housing market continues to be a central issue, with rising costs contributing to inflation and cost of living pressures. The high demand for housing has led to a surge in prices, which is not sustainable in the long run. As interest rates rise and affordability decline, there is a risk that the housing bubble could burst,” Mr Conlon said.
Adding to risks for equities is that the strong run over the past year in Australia has been driven by an expansion in earnings multiples rather than earnings growth. While share prices have increased and earnings multiples expanded, they may not be supported by corresponding increases in company profits, leading to concerns about overvaluation.
“Underlying this multiple expansion were substantial gains in the very large financials sector and enormous gains in the smaller, but increasingly large technology sector. While the property sector also saw multiples elevate, one could substitute data centres, as the heavy lifting was done by Goodman Group.
“Multiples for materials, energy and consumer staples remained fairly moribund, with materials and energy retaining the mantle as the cheapest sectors. While ‘average’ price-earnings (P/E) ratios are now substantially above long-term averages, these averages are flattered by the high benchmark weightings and earnings dominance of materials and financials,” he said.
Another risk factor to consider, Mr Conlon said, is Australia’s reliance on China. If the Chinese economy slows, there is a risk that demand for Australian exports could decline. This could have a negative impact on the Australian equity market.
“Subdued sentiment on China and poor affordability and economics in housing construction are creating the preconditions for depressed multiples for Australian shares and jeopardising future returns. In an environment in which investors become ever more attuned to chasing popular themes at incredibly rich valuations, it is perhaps understandable that most investors are happier running with the crowd than feeling lonely,” Mr Conlon said.
“However, there can be no hiding from China’s importance as a demand source for Australia’s exports, but as a production rather than consumption-led economy, economic weakness is usually met through stimulating additional production. Without incremental domestic demand to absorb this production, China is increasingly becoming an intermediary between raw materials and export markets.
Mr Conlon also sees problems for Australian lithium producers.
“Lithium spodumene prices are languishing at not much above US$700/t and lithium carbonate around US$10,000/t, well below what investors, including Rio Tinto in its Arcadium Lithium acquisition, expect as the long-term price. While wanting to be more optimistic on the prospects for the lithium sector, our enthusiasm is tempered by valuations which still reflect long run pricing well above the costs of most players.”
Despite these challenges, there are also opportunities for investors in the Australian equity market, Mr Conlon said.
“There are plenty of companies available for sale at sensible multiples if one is prepared to see attraction in the more mundane characteristics of durability and profitability rather than alluring growth prospects and a large Total Addressable Market.”
“Many of the most appealing investments from our perspective are centred in real economy businesses across the materials and energy sectors,” adds Conlon.
“Subdued sentiment on China and poor affordability and economics in housing construction are creating the preconditions for depressed multiples and attractive future returns.”
Schroders' outlook also delves into the private equity landscape, where it is anticipating a more favourable environment in 2025.
Claire Smith, head of private assets sales with Schroders, predicts that 2025 will be a year of opportunity.
“While 2024 has been a subdued year for dealmaking, we are beginning to see promising green shoots that presage brighter times ahead in 2025.”
“Private equity, especially that in which Schroders invests, shows signs of resilience and growth. The interplay between falling interest rates and easing inflation sets the stage for improved multiples. Exit values in the global market seem to be stabilising, too, with a recent uptick in sponsor-to-sponsor exits.”
"As we look to the year ahead, many of the dynamics that have put downward pressure on multiples should subside or reverse. Namely, falling rates and cost pressures should promote higher multiples as borrowing costs go down and cashflows improve," said Ms Smith.
Ms Smith said Schroders prefers the small and middle markets where valuations are attractive.
“There remains a significant valuation discount for small to mid-sized buyouts when compared to their larger peers, suggesting a difference in perceived value within the market,” she said.
“These markets are diversifying, tend to perform well during volatility, and the law of large numbers makes it inherently easier to generate meaningful multiples on small companies than on large companies.
“Importantly, too, operating in the small and middle markets means we’re not reliant on a still frozen IPO market for exits. Rather, our exits tend to be into the larger part of the market where a large pile of dry powder remains,” she said.
Smith also flagged Schroders’ preference for investment in “GP-led secondary” funds, a segment of the private equity market where existing investments are rolled into a new fund under the direction of a general partner.
“Sponsors engage in GP-led transactions to enhance the value of a portfolio company by allowing additional time and/or capital for further strategic development. By executing a GP-led transaction, sponsors can adopt a longer-term perspective on a company, effectively extending the holding period of an asset beyond the conventional four to six years.”
“More and more dedicated strategies are beginning to focus on GP led secondaries, and the main issue most will encounter is that the majority of GP-led secondary deal flow is in the small to mid-cap market. Additionally access to these prized assets will often be restricted to existing investors and structured and executed on a proprietary basis.”
And while the election of Donald Trump has stoked volatility, Ms Smith believes Private Equity could stand to benefit.
“Finally with the new Trump administration, there could be more volatility in the market, and our research shows that private equity delivers most of its long term outperformance during more volatile periods. Private equity has historically outperformed listed markets by 4% per annum, but when you look at times of higher volatility this outperformance increases to 8 per annum%. If we are indeed in for more turbulent times, private equity could be a nice place to hide.”
