The regular bouts of volatility which have dogged sharemarkets in 2023 may dissipate if the interest rate cycle turns and Australia, in particular, is able to avoid a recession.

That’s the view of Sandstone Insights analysts who believe rate hikes are now done in the US, whilst just one further rate hike locally.

Similar sentiment is already reflected in the performance of global indices as equity investors, who are forward-thinking by nature, aim to position their portfolios for anticipated market conditions in 2024 and 2025. So far this calendar year, the technology-heavy NASDAQ Composite Index was up by more than 20% in the second last week of June and the Euro Stoxx 50 had risen by close to 15%. 

Australia’s benchmark S&P/ASX 200 Index was up by 4% in the same period. Sandstone Insights forecasts that a similar gain in the second half will take annual returns from local equities to potentially high single digits by year end, notwithstanding the potential for volatility in individual stocks and sectors.

“Real interest rates – or nominal rates adjusted for inflation, will be the key factor up to Christmas. As equity strategists, we focus on real rates as it gives you a sense of how tight monetary policy really is,” says Head of Investment Strategy at Sandstone Insights, John Lockton.

“Our view is that interest rates are in the peaking phase and that central bank policy, in conjunction with slowing inflation, will mean real rates will not keep rising in the US. Economic growth will slow, but there’s unlikely to be a recession and perhaps in Australia, not at all,” Lockton says.

It’s also apparent that corporate earnings in both the US and Australia remained resilient in the face of a rate cycle, which proved dramatic in terms of both speed and quantum. 

“There are real differences between this cycle and others. Leverage really hurts economies and there is less debt among US corporates today than during the Global Financial Crisis. The same applies in Australia,” says Lockton.

“US consumers don’t have significant leverage either and if you adjust Australian investors’ leverage for total assets, including superannuation, they may not have the same leverage as some bears suggest,” he says.

The implication is there may be a very modest downturn in earnings if the economy slows. 

So given this environment, what is the outlook for the most commonly held stocks by Australian investors? Below are Sandstone Insights’ current ratings and its team’s rationale for the recommendations.

CSL (ASX:CSL) – Buy

The share price performance of the global biotech has been volatile over the past three years and it recently surprised the market by downgrading its FY24 earnings guidance. That said, the company has been in a good upgrade cycle over the past three months driven by a recovery in margins from the Behring plasma business after a COVID-induced contraction. The recovery is set to play out over three to five years and has reset the earnings base under the company’s new chief executive officer. The company is trading at price/earnings to growth (PEG) ratio of 1.6 versus its long-term average of 2.2, which suggests it’s quite good value at current prices, says Ryan McCaugherty, Research Analyst at Sandstone Insights.

Telstra (ASX: TLS) – Buy

Over the last two to three years, the telco has simplified its mobile pricing and now has just a handful of plans versus its previous multitude of legacy plans. This means it can instantly move 12-month rolling contracts into inflation-linked price increases as part of an industry trend. Its earnings will therefore be much more resilient and lead to margin upside, which will enable dividends to be increased. Sandstone Insights is forecasting a fully franked yield of 4% that is likely to grow moving forward, according to McCaugherty. He also says the looming sale of the Telstra InfraCo business could unlock significant capital and allow capital management initiatives such as share buybacks. 

Westpac (ASX:WBC) – Buy

Reserve Bank of Australia tightening cycles tend to push earnings-per-share higher for banks but drive price-earnings multiples lower. Most banks thus won’t outperform the market until the hiking cycle is over and it’s clearer that bad debts won’t rise significantly in an economic slowdown, according to Lockton. Nonetheless, Sandstone Insights believes there is value in Westpac as its response to the Royal Commission catches up with industry peers and it’s able to refocus on its core business. Westpac’s potential for earnings improvement is simply better relative than competitors, Lockton says. Sandstone Insights has “hold” recommendations on the other three major banks.

Macquarie (ASX: MQG) – Buy

Sandstone Insights has a conversative 12-month view on Macquarie as its earnings are likely to go backwards next year. This is not because of expected underperformance per se, but due to the fact FY23 performance was so strong as a result of the gains delivered by parts of the bank (such as its commodities business). The four key trends which Macquarie can leverage – commodities, technology, infrastructure and energy transition – are structural drivers of growth and a competitive advantage, according to Lockton. As a result, on a two- to three-year basis Sandstone has a “comfortable buy” rating on the stock.

Woolworths (ASX: WOW) – Hold

A recent downgrade from “buy” was driven by a number of factors. For example, Woolworths price earnings multiple has been above competitors at around 25 times for relatively modest earnings growth, according to McCaugherty. Food inflation has peaked as a result of the return to dining out following COVID-19 lockdowns and belt-tightening is also apparent as others adjust to cost-of-living pressures. “There has been a shift towards home brand products and instead of buying avocado, some people are making do with butter,” he says. Falling inflation is also likely to affect like-for-like sales growth, with Big W, in particular, at threat of the pressures affecting other retailers.

Wesfarmers (ASX: WES) – Sell

Bunnings now accounts for 60% of Wesfarmers’ earnings before interest and tax. However, its sales are declining as the DIY boom of COVID-19 subsides and cost-of-living pressures restrict the spending power of consumers. Even though Bunnings has a resilient trade hardware business, it’s likely the retail component will come under pressure in terms of both sales and margins, according to McCaugherty. K-Mart and Target will be in a similar position as apparel sales drop from their peak. Further, Wesfarmers’ chemicals business is facing headwinds driven by a 70% drop in the price of ammonia. A lithium project which will offset that issue isn’t due to come online until mid-2024. Finally, the online Catch marketplace hasn’t so far delivered expected outcomes.

BHP (ASX: BHP) – Hold

China’s recent efforts to stimulate its economy as it reopens from COVID-19 should flow through to iron ore, which accounts for 60% of BHP’s business and other commodities such as copper too. Sandstone Insights estimates there is a 25% earnings upside for all the commodities in the business at current spot prices. If the prices remain higher for an extended period, there will be higher free cash flow and higher dividends as a result. A falling US dollar if interest rates decline is another potential tailwind for resource stocks. Given these factors, there could be scope for Sandstone Insight’s “hold” recommendation to be reviewed, according to McCaugherty.

Woodside (ASX: WDS) – Hold

“There is a potential opportunity for people who are long Woodside to bank some of the outperformance relative to Santos, and switch into Santos,” says Lockton. The issues that held back Santos are likely to impact Woodside more, such as questions about how to fund growth. The big theme for energy companies is free cashflow generation and Woodside is having to drive a tricky balance between keeping dividends and free cashflow high, while still managing to grow its production base. “We’re in that period of time where the risks to its capex profile are to the upside, not the downside,” he says. There is a risk the dividend payout ratio will fall to the bottom of a 50%-75% range, whereas previously it was close to 100%.

Santos (ASX: STO) – Buy

The energy company has had a chequered performance history over the past few years. Some of the factors that weighed on its share price are alleviating and Sandstone Insights believes there is at least 30% upside to a relatively modest valuation assumption. This is based on LNG multiples from global energy majors such as Chevron and Exxon Mobil. In time, the market should recognise Santos is going to have production volumes in the latter part of this decade three times higher than at the start of the decade, says Lockton. “That’s not being rewarded in the share price – at some point the market will realise and it should be re-rated.”

The information has been prepared without taking account of your objectives, financial situation or needs. For this reason, before acting on the information you should consider whether it is appropriate to you, having regards to your objectives, financial situation and needs and, if necessary, seek appropriate financial advice.