It’s not surprising that with Australia’s appetite for Australian equities, this asset class remains probably the most discussed part of a client’s portfolio. John Guadagnuolo (Antares Equities), Melinda White (Longwave Capital), and Martin Crabb (Shaw and Partners) share their thoughts on Australian equities in a sticky inflationary environment.

Against a backdrop where the U.S. is looking at possibly 10 interest rate cuts of 25bps each over the next 18 months, there is widespread expectation locally that the RBA will finally be satisfied that inflation has been tamed and begin reducing interest rates.

John Guadagnuolo — Head of Fundamentals/Portfolio Manager at Antares Equities — believes the current market environment is favourable for Australian equities. He points to global financial conditions not being particularly tight, Australian employment remaining reasonably high, and stocks in consumer sectors performing well. Under such conditions, John expects the biggest impact of interest rate cuts to be via lower discount rates, which favours stocks with longer duration growth.

Speaking on Australian equities at the 2024 IMAP Independent Thought Conference, John believes that although long duration growth is shaping up as a definite thematic moving forward, he stresses the importance of accurately forecasting the earnings of a company and what actually drives that company — more so than what might impact the valuation of the company — when looking to invest in a stock.

As a bottom-up manager with a focus on small caps, Longwave Capital has a very different investment process to most small cap managers. It combines systematic stock selection and portfolio construction methodologies, with fundamental investing methodologies, to run a more diversified portfolio across the small caps space.

This approach means Longwave doesn’t embed any interest rate forecasts into its stock picking or portfolio construction process, however, it does take a view of where rates might be over the medium-term when conducting its fundamental overlay and investment analysis.

“What really matters in small caps is to select a basket of stocks that will survive in all market conditions, which we embed in our stock picking process,” says Melinda White — Equity Portfolio Manager at Longwave Capital. “The survival of small cap stocks is dependent on how their balance sheets look, so we search for companies with strong balance sheets.”

Longwave runs a diversified portfolio of 115 stocks. This allows it to hold buckets of core, value, and growth stocks, which provides the manager with stock coverage across various market conditions and potential outcomes.

“Our mission is to help clients stay allocated to a part of the market that is a source of non-redundant alpha over the long-term,” says Melinda. “Looking over a five-year period, which is mid-cycle, we’re focused on areas like: a company’s ability to continue to grow its earnings across all market environments; how the market has priced that in; and whether the price is reasonable.”

Shaw and Partners is currently running a neutral view on interest rates. Martin Crabb — Chief Investment Officer at Shaw and Partners — says this neutral view is based on the most probable outcome that’s being priced in the market, which is for a soft-landing.

“For the first time, central banks have managed to get inflation down without killing the economy. So, effectively, the market is betting on an outcome that has never happened before,” he says.

“Therefore, from an asset allocation perspective, particularly with equities, I think you need to be nimble and perhaps not have a view on interest rates, or if you have a view, at least have it hedged, just in case you’re wrong. I think that’s probably the best way to play interest rates.”  

Martin adds that when the macro environment is as uncertain as it is today, the key to portfolio construction is diversification.

“Don’t have all your eggs in the one basket,” he says. “Whether that’s taking a bottom-up approach by adding high quality companies that do well regardless of the market environment — the Warren Buffet approach — or whether you decide not to take too many big macro bets within the portfolio. Either of those approaches is probably appropriate at the moment.”

Globally, we’re at the start of a rate cutting cycle, with many foreign central banks already moving to cut their rates. Domestically, there is also an expectation the RBA will move to begin cutting rates. However, when this will happen is still unclear. But what if the market is wrong and inflation in Australia remains sticky? How should investors adjust their portfolios under such a scenario? 

“It’s an interesting question,” says Melinda. “If inflation remains sticky, you want to be invested in companies that can execute and survive in all types of market conditions. That means you need to be invested in quality companies and focus on balance sheets. A sticky inflationary environment will benefit gold stocks, which are currently cheap.”

She concedes that small caps are 26 months into a relative drawdown versus large caps, but are looking “very interesting” compared to large caps in Australia. “The median active manager in Australia has outperformed both their benchmark and the ASX 300 over 30 years, so small caps is a space that investors should be looking at.”

Martin believes what could possibly cause another inflation outbreak are situations in the Middle East and Ukraine worsening at the same time.

“The risk is we get another supply-side event or a massive commodity/energy spike, which caused the last outbreak in inflation,” he says. “And then there’s the risk of it getting stuck in the system with the likes of wages and prices. That’s why gold stocks are a geopolitical risk hedge, as well as an inflation hedge.

“In terms of the Australian market, we believe there are companies that have pricing power (a company’s ability to raise prices and maintain profit margins amidst increasing costs and/or competition). Typically, these types of companies have high return on equity, a sustainable business model, high recurring cashflows, and the ability to pass on higher costs to their customers. The ultimate pricing power stock is Transurban, because its tolls are linked to inflation.”