From the desk of the CIO: Squeeze the lemon dry
Valuation discipline helps avoid overpriced assets and manage downside risk in volatile markets.
Key takeaways
- Lower interest rates making cash less attractive than bonds
- Strong emerging market performance
- Knowing when to hold or to fold
- European luxury sector is undervalued
Away from the glare of tariffs, one thing is very clear about 2025: interest rates are coming down, including here in Australia.
Across most of the developed economies, central banks are making money cheaper and decreasing the return available from cash. Interest rates remain above inflation rates in most countries such as Australia, and the pace of rate cuts might have been faster but for the uncertainty about tariff effects. But inflation is not the only potential outcome of tariffs. Weaker economic growth and subdued household spending are likely to give central banks a greater sense of urgency for further rate cuts as we move through 2025.
Source: Reserve Bank of Australia, Federal Bank of St.Louis, Morningstar
Since the beginning of this year, the Australian treasury yield curve has steepened, driven by a decline in short-end yields while the long-end has remained elevated. Long term Australian government bonds offer a decent extra return vs cash and inflation, supporting income seeking investors and those transitioning to retirement seeking shock absorbers to deal with bumpy markets.
After the tariff-induced hiccup in early April, equities have resumed and continued their rally, with 2024 superscalar stars back in the spotlight. The easing of inflation fears and bond yields not rising further has no doubt supported these more highly valued companies and perhaps reduced fears of large inflation/growth shocks from tariffs. At current share prices, the valuation of US equities in aggregate are less attractive than other regions, and we continue to favour opportunities elsewhere that offers better reward for risk.
What’s been notable this year is the outperformance of emerging market equities, such as Korea and China tech. For example, the Morningstar China Index was up 35% for the last 12 months to 30 June. The stimulus measures announced in September last year may not have been a ‘bazooka’ one, but they signaled a shift towards more forceful monetary and fiscal support aimed at lifting the Chinese economy out of its slump. Earlier this year the market was surprised by the ‘DeepSeek moment’ for the pace and capabilities of China’s AI development, leading investors to recognise the relatively cheap valuations of Chinese tech companies versus their US peers. We have held higher quality China technology companies, such as Alibaba and Tencent, in Morningstar multi-asset portfolios for the compelling valuations they were offered prior to the rally.
Getting the most out of investment opportunities is a key element of successful investing, knowing what to invest in, when to buy and when to sell. Overstaying your welcome can lead to large losses but cashing out too early can be just as impactful in terms of missing out on extra gains.
Looking back over the past 40 years, the classic signs it’s time to sell include asset prices rising a lot over an extended time frame to levels that are very high vs metrics like cashflows, dividends and asset values, universally bullish investors with outsized exposures and unsustainably high sales and profits. Examples include telco, media and technology companies in late 1999, emerging market and financial service firms in 2007 and mining companies in the early 2010s during the commodity boom.
Conversely, it’s been better to hold or even add to exposures, when investors are fixated on the downside, fundamentals are improving from a low base, asset price gains are small over longer horizons and prices reflect low rather than high expectations of future profits. Here examples include oil and gas companies in 2020 and IT companies in 2003.
Consumer companies have been facing investor skepticism, with negative sentiment due to noisy macro backdrops and bearish expectations. Over the past two and a half years, the Morningstar Developed Markets Europe Luxury Goods Index has notably underperformed the broader Morningstar Global Markets Index. This underperformance reflects multiple headwinds, including persistent cost-of-living pressures in developed markets, a muted recovery in Chinese consumption, and growing uncertainty surrounding tariffs.
At Morningstar, we believe the luxury sector presents compelling long-term investment opportunities. Valuations of the industry have become increasingly attractive, with certain companies trading at discounts that we view as overly punitive relative to their fundamentals. While near-term demand remains subdued, we do not expect this softness to persist indefinitely. Long term investors should look through the current cyclical weakness and focus on the sector’s enduring fundamentals. Most luxury companies possess strong branding intangibles and pricing power, although under the current macro environment, their high fixed cost structures create near term pressure on profit margins. In our view, disciplined cost control, and the eventual demand normalisation, should support margin recovery over time.
Along with China tech, European luxury is an example of the potential for gains from specialised research and contrarian risk taking. Getting the most out of opportunities while staying diversified remains key to navigating this period of rapid change.
