We came into 2023 with a positive, non-consensus view on Australian shares.

We maintain this view, and think the outlook is not as bad as forecast by many in the market; Australia is likely to avoid the deep downgrades that are now beginning to unfold elsewhere in the world, most notably in the US.

There will, of course, be some near-term weaknesses as tighter monetary policy eventually slows activity, and we expect earnings downgrade momentum to increase over coming months as companies, especially those in the retail sector, look to notify the market that activity has dampened.

But overall, we see a shallow peak-to-trough earnings decline with the Australian economy likely to hold up relatively well versus other developed market peers.

While market volatility is likely to linger, more realistic earnings expectations, alongside peak policy rates and ongoing progress in bringing inflation down, should provide a good starting point for a strong equity rally into the second half of the year.

Low risk of bank contagion

The US banking crises in early March have created some concern about potential contagion to Australian banks. However, we would argue that our banks are very different when compared to those of the US.

The US has a significant number of regional banks, and not many of them are well-capitalised, which has created problems in a rising interest rate environment that has seen intense competition for deposits. In comparison, our banks are very well-capitalised, profitable and mark to market regularly. We believe the risk of contagion is low.

In addition, if our banks are getting sold off on the back of the US banking weaknesses, then that’s actually a very good opportunity to buy the Australian banking sector at a discount, and get access to extremely attractive dividend yields.

Opportunities

Like the banking sector, other opportunities in these kinds of markets lie in those companies that are being sold off on weakening near-term outlooks. One such company we like is a2 Milk.

Its share price has underperformed on the weakness of the Daigou channel (Chinese students and tourists coming into Australia and buying the product to send home), as well as strong sales by a China label in China.

Our view is that Chinese students and tourists will return to Australia, they’re just taking a little longer than the market anticipated.

We are optimistic this company will deliver some of the best earnings growth compared to the rest of the Australian market, with attractive earnings multiples in the low-20s.

We continue to be very bullish on the China reopening thematic and A2M is well positioned within that theme, as are many Australian companies in the travel, education and resources sectors.

Another ugly duckling company we like is Xero, which has recovered somewhat from its lows. This is a high growth tech company, that is transitioning from growth at any cost to profitability, and has made very good inroads.

We expect a good result in its upcoming reporting announcement, and is the kind of company investors should look to buy at a discount in a volatile market.

Resources sector gems

The market has become very pessimistic about resources companies, but we see good buying opportunities in this sector as well.

We may be three months early, but we have found that by being the first investor in a thematic, we are often in the best position to benefit from forecast rallies.

This is another sector that will do well from the Chinese reopening that, as outlined above, may be late but is definitely gathering momentum.

Data we have analysed on credit growth and consumer spending in China certainly points to very strong economic growth over the next six months, and recently announced GDP estimates in the provinces have also been much better than expected.

We are confident that despite the current weakness, the strong China thematic will play out, and current prices offer investors a good bargain on some quality companies in this sector.

Light at the end of the tunnel

We remain positive on the Australian equity market, particularly heading into the second half of the year when corporate earnings are likely to stabilise, and markets will rebound as they focus on a bottom in economic and earnings momentum.

Investors would do well to look for good quality companies at cheaper prices in the volatility that may continue for the next few months before a better second half.

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This article was originally posted by The Australian Financial Review here.

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