Company Interview / Small caps: "the trade of the decade..."

Key topics:

Market weak, expensive, limited earnings growth; positive consumer outlook, rising costs due to inflationConsumer confidence vital for RBA policy; no rate cuts expected this year or nextPromising outlook for resources excluding iron ore; Aussie dollar expected to rise, supported by global interest rate shifts

Tim Rocks of Evans and Partners shares insights on the current reporting season, noting that the overall market remains weak, expensive, and with limited earnings growth. He highlights that the consumer outlook is encouraging, though results vary, with banks showing positive earnings. However, cost increases continue to impact many industries due to inflation.

Tim discusses the importance of consumer confidence for the Aussie economy and RBA policy. He mentions that better consumer spending, aided by tax cuts and recovery from the cost-of-living crisis, could support the economy and shift sentiment positively. Despite a tight labour market and high wages, no rate cuts are expected from the RBA this year or potentially next.

Tim evaluates the resources sector and the Aussie dollar, emphasising that while iron ore's outlook is concerning due to China's economic conditions, other resources like copper show promise. He forecasts the Aussie dollar rising above 70 cents, driven by changing interest rate differentials with the US, which could see capital flows rerouting globally, benefiting markets including Australia.

Full unedited transcript:

0:11

So we're pretty close to the end of the reporting season now. Our next guest said the overall market is weak, expensive and little earnings growth. Are there any positives? Let's find out. Tim Ross is the chief investment officer at Evans and Partners. He joins us now. Tim welcome. That sounded very negative. Well the positive it's over 8000. Yeah. Um and of course reporting season reporting season's been really two buckets I would say consumer outlook has been encouraging. Maybe not so much the results but the outlook has been encouraging. Banks have surprised the upside on the earnings front. Uh so that's positive. But everything else has been generally pretty weak. There is an undercurrent of cost increases that have still filtering through the economy. That's the tail end of the whole inflation story, because the other side of inflation is, of course costs rising. And those industries that have limited Did earnings, limited revenue growth and limited pricing power have really suffered from that. So by the time we get to the end of today,

1:11

which is the big reporting day, I think we're going to find that the reporting season was a disappointment. We're probably down about 2%, I think, on initial expectations. But as I said, it has been a tale of consumer and banks on one side and everything else on the other.

1:27

What are you seeing then in terms of the guidance that we're getting and how that's projecting, really where the Aussie economy is tracking at this point? Yeah, yeah. Consumer really important. So a broad range of companies have said that the trading days of this financial year, so from July, July and August have been good. And that's really really important important for the RBA. RBA has said consistently that consumer is the swing factor for the economy, which is pretty obvious anyway. Right? I think there's there's always been a compelling case for a better consumer in this financial year. You starts with the tax cuts, but also the cost of living crisis is mostly over. Unless you're a renter, it's mostly over. Uh, so there are. And of course, we're sitting on wealth gains from stock market, from housing. So there is a good reason for people to start more broadly spending again, if this is the start of it, I think it's very important

2:27

for the overall economy. It's important for RBA policy. Um, is a general support for the market and earnings. Uh, so this potentially ushers in, um, sort of better commentary about the economy. Like everyone's been so negative. You know, the economy has actually been okay. But there's a broad range of negativity out there. But I think if you've got the consumer back just a little bit, then that'll change that sentiment. So how is the RBA likely to interpret that then do you think? I mean the RBA has been very clear. Uh, a lot of people clearly haven't been listening. Uh, but they don't want to listen. Perhaps perhaps don't want to listen. I've never known it very different. Such a different commentary from the RBA compared with everybody else out there in the market. They've been very consistent. They are that they remain concerned that what wages growth is too high, the unemployment rate is effectively too low, labor market

3:27

just generally too tight. And that the but the economy is generally okay and they'll be comfortable with a little bit more weakness. So that is a scenario where there's no RBA cuts this year. There's potentially no RBA cuts next year or well into next year. Um, yet you've still got people out there just calling it down so, so negatively. Um so and why do you say potentially no cuts next year. Do you see that resilience remaining with the economy that particularly jobs is going to be a focus whether you can maintain that employment? Uh, yeah. Well if if the consumer is stronger. So clearly the consumer has been the weak part of the economy for two years now. Uh, as many people have said, is consumption going down in real terms. If that recovers, that's what is it, 60% of the economy doing okay. You have other things that are doing reasonably well as well. It's a reasonably good environment for business

4:26

investment. Uh, governments are spending a bit of money that creates an environment where you've got actually pretty good overall GDP growth. Uh, and so then you have settings where, uh, the interest rates are above normal, but not by too much. Um, and if you've still got a relatively tight labor market, you've still got wages that are bubbling around too high. The RBA is going to be in no rush to, to to cut rates, I think in that environment. Tim, how do you view the resources sector at the moment? So much of this, of course, is hinges on what we're seeing out of China. Yeah. You've got more results today South that determine raise. Yeah. Looking pretty negative. Look I think there's there's two resources markets. There is iron ore which is very much about China. And that is potentially concerning. But I think the rest is outstanding. If it was easier to isolate industrial metals, particularly copper, uh, and by some, um, some, you know,

5:26

very focused copper companies, you buy them all day because our view is the global economy, um, is actually looking better that there are a broad range of demand, uh, and supply challenges. That means that a broad range of industrial metals will be out of whack in terms of their their supply demand balance for a long time. So I think that's a very compelling story. The problem is for Australia, of course, is iron ore is the one thing that matters. And the iron ore outlook is concerning. Uh, it's potentially even more concerning than the headlines suggests, because what you've seen is that you've had to bring forward of construction, uh, of of apartments in China and now quite a potentially quite a big hole. So that is a worry. But the rest of the resources, I think, will look pretty good.

6:20

What did you make of BP's result then, particularly in terms of its guidance and very much a focus there on those future facing commodities such as copper?

6:33

I mean, they're talking them up, but but the pure maths of the breakdown of their business means that it's all about iron ore. So, so so that's the challenge. I mean, at some point you obviously, you know, the those big resource companies have had big falls and you'd kind of prefer to, to, to buy them when expectations are low rather than they're high. So I think you've got to keep a watching brief on when that potentially sort of turns around. But you just can't fight the iron ore market for now. I think that's very, very, very challenging.

7:05

How has your view on the Aussie dollar at the moment? Once again, this comes back to, I guess, that closing differential between Aussie rates and US rates, given the US is obviously about to start cutting, whereas as you've just pointed out, we may not cut here until well into next year. Yeah, I mean, we've had a view for a long time that the Aussie is going above 70 and potentially to 75 over the next 12 months. And just all that recent run of data confirms that. I think it is about the interest rate differential. Commodity prices have a matter. It's all been about the interest rate differential. And at the moment the interest rate differential with the US is 1.2. So US rates 1.2% above Aussie rates. And there in US rates chances are going to be will be below Aussie rates in 12 months time. So that's a massive, massive change in interest rate differential. And that means you're just going to get this broad based realignment of currencies, which is really interesting by the way has a broad range of other consequences. But for the Aussie dollar it means we're going north

8:05

of 70 I think, and perhaps B quickly. So if we do reach that point, we're also seeing above US rates. What sort of inflows are we going to see do you think?

8:13

Uh, I think we will see inflows. Um, I think it'll be more important for other markets. One possibility is that it feeds into this whole global rotation trade, which I think is underway, perhaps given more legs last night with Nvidia's result, where the last 3 or 5 years has all been about flows into the US, flows into the US, US dollar stronger. Once that turns around and it feels like it is, US dollars have been very weak now for for a month. Uh, the capital flows start to turn on the back of that too. So suddenly you have, uh, money exiting the US looking for somewhere else. I think some of that will go to Europe. I think a lot of it will go to emerging markets. Some of it will go to Japan. And chances are some of it will go to us too. And Tim, you talk about that rotation of course, that that rotation is small caps sort of got underway about a month ago and then stalled again. It's coming, it's coming. Okay. So are you looking in the smaller end of the market then? Uh, in the US

9:13

not not in Australia so much the the Aussie small cap market is pretty unexciting. I mean, you've had very few IPOs for, for years now. So it's it's all feeling a bit stale in Oz. But us I think it's a fantastic story. It's the trade of a decade is buying us small caps given that valuation gap, given that the macro is now coming towards them in terms of interest rate cuts really matter for small caps because they're more indebted. Uh, but also because just US rate cuts just kind of give people more confidence in the, in the economic cycle. And they're sitting there at, what is it a 40% discount to to the large cap index. And historically that'll that'll close to to nothing. So I think that's, that's you're setting up for as I said it depends on how long, how quickly it shuts. But it's a 5 or 10 year pretty spectacular trait of the decade. Any particular sectors then?

10:07

Uh, I mean, we're just buying them as a group, really. You know, the small cap index has a different composition to the large cap index. It's less tech focused, it's more domestic focus, you know, small financials, consumer stocks. But that's where you'll see it. And it probably is financials like non Australian financials. You know not buying banks at 20 times earnings as you have to do in Australia. But for the rest of the world um the financials are probably another big trade as well.