Casey McLean - Finding Earnings Resilience in Australian Equities

In this episode of the Exchange podcast, we sat down with Casey McLean to discuss all things Australian Equities. Casey is the portfolio manager for the Fidelity Australian Opportunities Fund and has worked with Fidelity since 2015. Prior to commanding the Australian strategy, he was the director of equities in Hong Kong where he specialised in Chinese equities and energy. With more than 19 years of asset management experience, his unique insights make for a very interesting conversation about what lies ahead for markets and the relative value of Australian equities.With rates likely to remain elevated for longer, McLean highlights the potential risk of re-inflation throughout 2024. Despite this, he talks at length about how Australia's strong track record during periods of moderating global growth, coupled with China's re-opening and demand for commodities, is expected to drive counter-cyclical growth opportunities. As a higher cost of capital widens the divergence of winners and losers, Casey provides context to how investors should be thinking to capitalise on market dislocations.

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Please see the transcript of the show below:

Casey McLean (Fidelity)

Ryan: [00:00:00] Welcome to The Exchange Podcast by E W L as advisors to some of the most successful families in the country. Craig Emmanuel, Tim Whybourne and I, Ryan Loehr, draw upon some of the best minds in the country. We believe that by exchanging ideas, we can deliver better advice and better outcomes for the families we work for.

Ryan: Now, we're inviting you on this journey. In this podcast, we interview some of the country's best investment managers, business advisors, bankers, and founders, to share their valuable insights. And our hope is that with better information comes better decisions, helping you to achieve more.

Ryan: Alright, Casey, thanks so much for being here today. It's a pleasure to have you [00:01:00] in the EWL offices in Brisbane. 

Casey McLean: Thanks very much having me. 

Ryan: You've actually come on quite a an opportune day. We're waiting for the Reserve Bank decision later this afternoon. We won't ask you to forecast what they'll do today, but we'd love to get your view on what you think you will see from the Reserve Bank over the coming months.

Casey McLean: Yeah, it's, I mean, today's decision's very much a line ball, I think, whether they'll ra, whether they'll raise or pause. And yeah, market's definitely pricing in a pause at this point. But I think we're definitely close to the peak in interest rates. But I think what Is the outlook is that we're probably not gonna see a cut for longer than most people expect.

Casey McLean: I think inflation, at least at the core level is much stickier than a lot of people expect. And that's really because the sort of services element, which is much more. Non-discretionary spend is still rising. And I think that will sustain with, you know, the wages, demands that a lot of industries and workers are making now.

Casey McLean: So, yeah I'm not looking for any cuts this year, but yeah, I think I'm more worried about a re [00:02:00] inflationary period. Coming into next year. So we're, this month in April, we're cycling, you know, $130 oil prices from the Ukraine War. So naturally there's some disinflation that comes out of that, and I think that can continue for this year.

Casey McLean: But as we get into next year I think given that those underlying services, parts of the economy are pretty sticky, I think we could be talking about reinflation in 2024 and you know, higher rates of inflation sustaining for a longer period. 

Ryan: And do you have any catalysts in mind that'll be key to that reinflation?

Casey McLean: Yeah, I mean it's like partly it's just cycling the high base effect from last year and that's, you know, mathematically why inflation is slowing as well. And so I think the opposite will be happening in, in 2024. We coming for low base as well. That's part of it. But I think it's just that ongoing wage inflation that starts at the minimum wage and escalates up like even post-election in New South Wales, we see now that they're targeting a 7% increase in the minimum wage.

Casey McLean: Which [00:03:00] is much higher than expected, at least pre-election as well. And I think it's warranted because if you look at wages across the economy they have been growing slower than inflation. Definitely slower than the headline inflation and even slower than core inflation. So real wages have been declining and there is a need for a catch up, particularly in, you know, blue collar and minimum wage workers.

Casey McLean: I think. 

Ryan: And with that wage inflation, do you see Australia as having a relatively higher problem compared to global peers? Or do you view us broadly in line with say the US and Europe there as well? 

Casey McLean: Yeah, I think Compared to the us. I mean, unemployment rates are similar in both economies.

Casey McLean: I think the key difference between the two is the level of labor mobility. US labor is far more mobile. People change. Cities change jobs much quicker. In Australia it's much harder to do that. So, you know, I think that will have an impact on wages. And I could see Australia sort of sustaining at a [00:04:00] higher rate potentially than the US I think as well with the, you know, the government now every go.

Casey McLean: In Mainland Australia's labor as well. And we have seen a more, a unionization of the workforce that's also gonna play into wage growth in Australia. But I think they're gonna be broadly similar. But if I was picking, I think Australia would be at a slightly higher rate. 

Ryan: And then similarly how do you feel about Australia's recessionary outlook compared to those global peers as well?

Casey McLean: Yeah, I think on that front, Australia is definitely in a better position. You know, Australia has obviously a very long trap record of growth and beating recessionary periods in the us. And I think this period, Similar because, you know, firstly I'd think we have the, one of the best benefits from the only countercyclical growth driver that's available in the market at the moment, and that's China.

Casey McLean: Whether it's, you know, on the commodity side or even on like the consumer side with a lot of Australian exports, be it, you know, vitamins or infant milk formula or educational tourism. Yeah, China really is, [00:05:00] Our key source of export demand and I think will benefit on that side. But secondly, I think, you know, balance sheets are in pretty good shape across the economy, whether you're looking at corporates where you're looking at the households as well.

Casey McLean: I think they're in pretty good shape. They still have excess savings in the system. They're probably gonna wind down. As you know, inflection of pressures rise, but it does give them a bit of a buffer. And then I think, you know, in terms of financial stability, banking stability Australia is probably one of, if not the sort, most Banking systems in the world especially post Silicon Valley Bank and credit Swiss in, in the US and Europe.

Casey McLean: So I think Australia's on good footing from an economy point of view. I guess the key source of concern is probably around the consumer side that there could be a consumer recession coming. But I, I think across the whole economy, we are looking pretty good. 

Casey McLean: And just on bank balance sheet, For our listeners, can you point out the key distinctions between Australian banks and US banks?[00:06:00] 

Casey McLean: Sure. Yeah. Yeah. Well maybe step back and look at Silicon Valley Bank and, you know, what went wrong there and why I don't think that'll happen in Australia. Well the first reason is Silicon Valley Bank they were the banker for tech startups in, in Silicon Valley. And during this sort of low interest rate period, there was, the market was just a wash with venture capital funds and most of those venture capital funds went into deposits with Silicon Valley Bank, but by nature, these companies didn't need any loans on the other side.

Casey McLean: So Silicon Valley Bank needed somewhere to put the funds and they thought either safest. The best place to put 'em is in long. Government bonds. And that was fine when interest rates weren't rising. But when interest rates rise, the value of those bonds came down. And in, in the US for small regional banks, they don't have to mark to market those bonds.

Casey McLean: So when the source of deposits started to slow and dry up as venture capital funds going into these tech [00:07:00] companies, slowed. There, there was demands on those deposits. And another key thing was that the amount of deposits that they had insured was very low. Only about 10% of the deposits were insured by the federal government.

Casey McLean: Given they were over the $250,000. Limit. So, you know, the deposits of caught wind of this. And it led to a run on those bank deposits. So in the space of one day they saw 42 billion in deposits go out the door. And if you look back at in, in past history, The second biggest bank run in, in the US was Washington Mutual.

Casey McLean: During the G ffc they had 16 billion be withdrawn, but over the space of 10 days. So it was a huge rush for the doors and it created liquidity concerns. So, you know, what did S V B do to plug the gap? They said, oh, we'll have to sell some of those bonds, which have now gone down in value. And the rules are if you sell one single bond you need to mark to market your whole [00:08:00] portfolio.

Casey McLean: They did that and they had a 16 billion negative mark to market, which wiped out all of their 11 billion in capital. And they had a plan to plug that hole with an equity issue, but, That failed. I mean, who would provide equity to a bank where deposits are walking out the door and they don't have the capital to sustain.

Casey McLean: So yeah, it all imploded because of basically, I think was mismanagement. Too much concentration in one type of customer, not market to market their bond holdings. Whereas you, if you look at Australia, I think it's a very different mix. You know, first. The balance sheet is quite sound in the, about 50% or more of deposits are coming from households and banks have no shortage of place to lend that money out, so they don't have to put me much into, to bonds.

Casey McLean: Only about 10% of their liquid assets are in bonds and under Australian regulations, they have to mark to market those bonds as well. And on top of that, they have to hedge the interest rate risk. And again, mark to market the [00:09:00] hedges as well. So I think the regulatory requirement in Australia is much higher.

Casey McLean: And then if you think about how much of those deposits are insured in Australia, it's again, about 50% belong to households. Most of those are under that that $250,000 cap in Australia as well. So much more of the balance sheet is is insured as well. So I think, yeah, Australian banks with their AA rating, some highest capital ratios in the world, I think they're looking like a safe haven amongst the banking assets globally.

Casey McLean: And in 

Casey McLean: Australia, our property is for first and foremost in terms of, you know, personal investing and general day-to-day discussions. How do you see the interest rate cliff impacting bank stability and just general deterioration in and potential residential housing 

Casey McLean: prices? Yeah, I think In, there's two sides to that.

Casey McLean: I think in terms of bank stability I don't have any concerns in the Australian banks. Their capital position is very strong, but as house [00:10:00] prices come down, borrowing capacity comes down. This fixed rate cliff approaches, there can be a bad debt cycle. But the impact of that is lower earnings as opposed to any concern around their financial stability.

Casey McLean: So at the moment, you know, bad debts are at basically record lows. They have to go up, they will go up, as you know, a huge portion of these customers coming off the fixed rate cliff in the next one to two quarters. Ha see the repayments gap up by 40 or 50%. There will be more stress in the system.

Casey McLean: But the banks have been provisioning for this ahead of time. And in fact, during covid they put in a covid overlay, so put even more aside to provide for bad deaths during covid, which didn't eventuate. And now they have that additional buffer in, in provisions as well. So yeah, I think there could be an earnings impact, but I don't think in terms of stability there's anything to worry with.

Casey McLean: What is should be a normal cycle in terms of bad. And talking to 

Casey McLean: bank earnings you know, [00:11:00] if you're an Australian resident you can't get away from the topic of property discussion, but if you're an Australian equity investor, you can't really. The topic of investing in, you know, our banks, particularly our big four banks, with earnings coming under pressure how do you see Australian investors diversifying their exposure to Australian equities?

Casey McLean: Yeah I think you, you're exactly right. I think banks earnings are gonna come under pressure, not only because of the bad debts that we talked about, which have to go. But secondly, I think the net interest margin has likely peaked and C b A called that out at their most recent results. And that's really coming from two fronts.

Casey McLean: One is the amount of mortgage competition that there is in the market. And a lot of that is related to that thick fixed rate cliff, as the banks are desperate to retain the customers, and some of they're even offering up to $10,000 cash back. Which, you know, according to cba means that some banks are riding loans at below their cost of capital.

Casey McLean: So as this fixed rate Cliff intensifies mortgage competition is unlikely to. [00:12:00] And then on the other side of the coin is deposits and deposit costs, funding costs and deposit costs have been rising with in line with interest rates, at least on the term deposit side. But more so is the mix effect.

Casey McLean: So if you think back during the zero interest rate period that we had, Term deposits were almost were negligible in terms of the amount of deposits the banks held. Now they're approaching 20% and above, and you know, long-term averages are over 30%. So it's that mix shift within deposit. That's creating pressure on margins as well.

Casey McLean: And then the final element of deposit funding is the repayment that they need to do for the T F, the term funding facility, which was a backstop that the government provided during covid at very low rates, only 10 basis points. And the first trench expires in June this year, the second in, in June 24.

Casey McLean: And they need to replace that funding with higher cost funding. So yeah the NIM is gonna be under. I think, [00:13:00] and then at the same time, you have slowing loan growth as people's borrowing capacity declines, and also they're not immune from the wage cost pressure that we're seeing across the economy as well.

Casey McLean: But I think in terms of diversification Especially within the financial sector I think insurance is a much better way to play the sort of inflationary and interest rate regime. And that's largely because insurance companies are being able to put through premium rate increases at quite a high rate sort of low, high single digits or even low double digits across some lines.

Casey McLean: And that's really coming from firstly, the amount of natural disasters that we've had in recent. Not only in Australia, but you know, also overseas. US had Hurricane Ian, which was the second biggest hurricane after Katrina. And you know, that coupled with the supply chain issues, shortage of trade is that's really pushed up claims inflation.

Casey McLean: So the amount that insurance companies have to pay out on claims and then, you know, the [00:14:00] reinsurance companies haven't been immune to any of these pressures as well. So general insurers use reinsurers to offset some of their risk in their insurance book. And the reinsurers have just up their rates by a large amount up to 30% in January.

Casey McLean: So the insurers either need to pay that higher cost or take more. Onto their own book, and either way it means premiums are gonna go up. So you can see that cycle sustaining over the medium term. That's one side of their earnings equation. The other is on the investment earnings where they put their, those policies that you pay, and generally they invest those into bonds into fixed income.

Casey McLean: And obviously in, in years gone by, they're earning almost zero on those now, with interest rates rising, they're getting a much better return. And even if interest rates do peak and start to come down, they're locking in those rates. They have an average duration of about 2.1 years, so their earnings outlook looks far better, I think, than the banks, and [00:15:00] definitely prefer insurance over banks at the moment.

Casey McLean: And when we think about the Australian Index, lots of our iconic companies, we often think of banks and financials, mining and resources. Can you talk to us a little bit about some of the opportunities you're seeing outside those big categories and tell us where Fidelity's positioned there. Yeah, sure. I mean, one, one theme I think that does look quite attractive at the moment is on Chinese consumption, which I think is quite different to Australian or US or Western consumption.

Casey McLean: In that China has built up a big pool of excess savings just like they had in Australia or the us. The difference is that these are real savings. They haven't come from government handouts. They've come from a reduction in spending, and China's consumption is well below. The trend line, they haven't pulled forward consumption, whereas US and Australia spending is well above trend and should correct.

Casey McLean: So I think being exposed to Chinese consumption is a good place to be. And I would sort [00:16:00] of counter that with being exposed to China, construction is actually a dangerous place to be because you know, the government is, their policy direction is really focused. Domestic demand and consumption as the key growth driver in the market.

Casey McLean: And at the same time Xi Jinping's core philosophy is that of common prosperity. And in, in order to achieve that prosperity the middle class needs to overcome three big mountains in education, healthcare, and property, and education. And healthcare is largely done. But property is still work in progress and she's core mantra is that property is for living and not speculating.

Casey McLean: So don't expect much in the way of stimulus for the property market. That's gonna drive a very strong cycle. You have seen some measures come in, but their support measures don't confuse 'em with stimulus. They're designed to ensure that the bottom in the Chinese property market doesn't fall out and creates a systemic risk for the hair economy.

Casey McLean: [00:17:00] When some investors think about China, they often think about regulatory risk as going hand in hand with investment in the Chinese economy and in Chinese markets. Can you give us your view on that at the moment? Yeah that's a very common view and in recent times, you know, some people have.

Casey McLean: Called China Uninvestible because of that regulatory risk. Yeah. And to me personally, I saw that those calls as uninvestible as a great time to, to be buying. And it's actually proven to be the case. But yeah, I think China, like every economy really goes through regulatory cycles. You see periods where, The pressure from new regulations really ramps up and then other times it eases.

Casey McLean: And over the last two or three years you've had, you've seen a very strong regulatory cycle where they've clamped down on numerous industries in China. I think what you're seeing now is the opposite. And easy policy is not directed at at clamping down on some key industries. It's about promoting.

Casey McLean: And I think that [00:18:00] growth and stability is their key focus for the coming periods. So I think, we'll, for at least for the medium term the regulatory environment is much more conducive to investing in China and 

Casey McLean: prior to commanding the for Fidelity Australian strategy, you've spent some time focusing on a China innovation fund.

Casey McLean: So you're probably very qualified to speak on relative opportunities coming outta China and those that you can chase in Australia to, to capture those tower winds. Are there any investments you've made recently in the Australian portfolio that you expect to benefit from the China reopening trade?

Casey McLean: Yeah there there's one key position in the portfolio that does focus on trying to reopening, and that is IDP education who a a student. Business where they place international students into universities in Australia, Canada, and the uk in the main yeah. As economies across the world reopen they've had a great tailwind and seen really strong volume growth.

Casey McLean: There's a few. Hiccups along the way, bottlenecks in terms of visa [00:19:00] approvals, but these are being worked out long term and yeah, really the sort of the second tailwind that's is coming from them is from the Chinese economy. The government there said that overseas students needed to get back to their place of study or else they wouldn't recognize their university degrees.

Casey McLean: So you have seen that travel recommend and they're the key to beneficiary of that as well. I think other areas long term that attracted to is Is it a lot of the sort of future facing materials as P H P calls them? These are the materials that are, you know, gonna decarbonize the world through electric vehicles or solar or wind.

Casey McLean: And you know, I think in the short term, perhaps commodity prices in those segments are. Pretty extended, although they are correcting. But I see this is a sort of long-term structural growth driver. And I think when there's better entry points, that's a long-term theme that I think will perform very well.

And 

Ryan: In addition to covering China you, you covered energy too. 2022 is unique in a sense that [00:20:00] almost every asset. Was in the red the exception of commodities, which was in the black. You talked to, you know, those prices correcting, but the long term opportunities, what sort of minerals do you think offer the most attractive every point 

Casey McLean: at this point in time, commodities in general look relatively attractive because of the long period of underinvestment that we've seen over, you know, the last decade or more.

Casey McLean: And that's, you know, created supply constraints in many commodities. And then on top of that, you're getting this decarbonization tailwind, a new source of demand coming in for various commodities. So I think generally speaking, the outlook looks pretty good, but I wouldn't say it's sort of blanket statement across all commodities.

Casey McLean: I think one way to judge the relative attractiveness is looking at swap prices compared to the marginal cost of production. And some commodities are very extended. They're trading well above what is the marginal cost of capital? Yeah, sure. They might be in shortage now, but there is [00:21:00] supply coming online and I think you have to be wary of some of those commodities, even if you do have sort of long-term structural growth in some of them as well.

Casey McLean: But then there's. Yeah. And and oil was one of them where they're into the cost curve where, you know, the spot price was trading below the cost curve, at least for a short time period. Thereafter the Silicon Valley Bank and Credit Swiss debacle in March. And yeah, I think oil is pretty well placed, particularly on sort of a medium term view that, you know, Europe needs to replace Russian energy oil and gas.

Casey McLean: And they got lucky last year in that it was a warmer. An average winter, the third in a row, that was one with an average. And also that China demand wasn't in the market given, you know, they were in lockdown. This year could be different. You know, China is back in the market. Who knows what's gonna happen with the weather, but at some point it's likely to sort of mean revert there as well.

Casey McLean: And just even in recent days, you've seen. OPEC has very strong control over the market.[00:22:00] Probably the Saudis have probably the best control they've had in many years. And yeah, I think their sort of objectives are for higher prices. Yeah, I don't think they wanna see the $130 that we saw last year.

Casey McLean: Because that does create demand destruction. And I think you can see that when you look at the US IRA Inflation Reduction Act, which is really about promoting electric vehicle battery production in the US as a new source of energy supply for the US economy. But I think there is a happy medium in between, you know, Under a hundred dollars 80 to 80 to a hundred dollars, where OPEC is happy with prices as well.

Casey McLean: So I think that's one commodity I'm attracted to. And I think if there's corrections in the other commodities like lithium, copper, where the structural growth is evident I think that they'll be attractive opportunities to enter at some point as well. 

Ryan: I guess it's fair to say then that you know, commodities have been relative strength for the Australian index, especially when you look at the drawdowns overseas in the US particularly.

Ryan: Looking forward, what do you think is [00:23:00] going to be the cushion for the Australian index? We have sort of declining commodity prices. Banks coming under pressure, and if you look at our index, the last 10 years, it's been heavily supported by income rather than the capital. What do you see the, you know, the next set of opportunities are or the relative value in our 

Casey McLean: market?

Casey McLean: Yeah, I mean, just taking a step back, I guess, a lot of people probably wouldn't realize, but I, if you look back as far as 1900 so over a hundred years, Australia has been the second best performing market globally actually after South Africa. But when you take into account the risk, the standard deviation of those returns on a risk adjusted basis, it's been the.

Casey McLean: Performing market long term better than the US. And you know, th these stuff come from the global investment Review handbook book published annually by the London Business School. And they've said that, you know, the key drivers for the countries that perform the best ones that are resource rich.

Casey McLean: Have strong dividends and strong real growth [00:24:00] in dividends. And the keys to drivers of those two things really are, you know, firstly good corporate governance, but second of all, population growth. Which, you know, makes a lot of sense, right? I think there's a lot of concerns that. In the past that when there's migration to Australia, you know, people are gonna lose their jobs.

Casey McLean: People are gonna have their jobs stolen. You know, same as there was post World War II when women entered the workforce. But the reality is it grows supply and everyone benefits. And on the corporate governance side, I think it's a very important point for long-term returns. In the, you know, if you do have strong corporate governance, generally that means you do pay out high dividend.

Casey McLean: Because you can't do that if you're a fraud and you don't have the cash flow. But secondly as well, if you pay out dividends a high amount of dividends, it reduces the risk of investing in poor returning projects. So it instills, it forces capital discipline and that's why returns in co in countries with strong corporate governance do very well.

Casey McLean: So, you know, as Australia sits today, I think all [00:25:00] those factors are still the case. Population. Has rebounded after covid and immigration has started. We're back above pre covid levels now, and yeah, admittedly a lot of it is temporary visas, but I think over time that mix will shift to permanent as well.

Casey McLean: And you know, also I think the valuation starting point of Australia is attractive. The index is trading. It's long-term average price earnings multiple, which, you know, you can't say of other markets like the US as well. So I think Australia is really well placed in the upcoming period with so much of our index being made up by resource companies.

Casey McLean: And there being a continual shift towards greener technologies, do you view that as a net opportunity for the Australian resource companies or a net headwind for them? Yeah, I think I think longer term it's definitely more of a tailwind. Australia has. You know, some of the best resources in the future facing materials, particularly lithium and particularly hydro rock, lithium, [00:26:00] germine which should be the lowest on the cost curve longer term.

Casey McLean: There's also quite strong sort of endowments in rare earth, which are critical to electric vehicles, but also wind turbines as well and copper as. Pretty well endowed. And I think that is, you know, three of the best place commodities from a long-term perspective. But, you know, at the same time, the commodity companies need to decarbonize as well.

Casey McLean: And it's not a particularly easy task when you run lots of. Diesel trucks. Yeah. In some cases run steel seal mills or aluminum smelters. It's not an easy thing to do but they are, it's now starting to do that. They have, you know, big decarbonization budgets and they're really looking for, you know, projects with good returns that can decarbonize.

Casey McLean: So I think it's a sort of medium term, short to medium term sort of headwind. Nothing that they can't overcome. And then after that period, I think there's some great opportunities. There is longer term as well. There's opportunities for [00:27:00] green commodities as well. Green aluminum I think is one that's quite an attractive opportunity that if you can have.

Casey McLean: Low carbon aluminum, or even zero carbon aluminum. There is a path to zero carbon in aluminum that those products are gonna command a premium in the market. And you know, so decarbonization in some industries is not just a cost, it's a value driver for these companies as well. And do you feel that there are a number of Australian companies that are well placed to move towards those green commodities?

Casey McLean: Yeah, so I think in terms of aluminum Rio is really well placed with their Canadian operations where they do have, you know, hydro as a power source. It's already a low carbon opportunity, but they have a a proprietary technology that they're. Is still in early stages, but does give them that path to zero carbon.

Casey McLean: Aluminum their Australian operations in Queensland are a bit a bit harder to decarbonize. But those Canadian ones are pretty good as, as actually do their their iron ore in Canada where it [00:28:00] is actually lower grade, but they, you know, concentrate, they pelletize the iron. Which ends up being higher grade and that's what the steel mills are gonna have in demand longer term.

Casey McLean: So yeah, I think there's, that's a couple of projects. Yeah. Mid Italy, a small part of Rio's overall portfolio, but it is is something that does have real long-term benefits as well. 

Ryan: And Talking to the headwinds and tailwinds, I think it'd be important to cover risk Premier and just the value of equities more broadly.

Ryan: If you look at the Australian index and headwinds to, to earnings for an index that's heavily supported by income. And then you look at potentially elevated risk-free rate, cash being set higher for longer. The case for active management becomes, you know, pretty clear. How do you think active management will favor?

Ryan: I. Yeah, in the short term, medium term over, over buying the index. Cause I do think that given that risk premium and the risk free rate of return being where it's at potentially for longer rather bit attractive of the index and particularly the largest constituents of that index that favor [00:29:00] income.

Ryan: How do you see that influencing. You know, where you 

Casey McLean: positioned the portfolio. Yeah, no I totally agree. I think, you know, the coming periods are gonna be a really great opportunity for active management. You know, the starting point is, you know, Australian market valuations are below historic averages, but I think what you're gonna see is much more dispersion in valuations that are coming up because of that higher interest rate, higher risk free rate, which feeds into higher cost of equity.

Casey McLean: So the higher returning business. That have good growth are gonna be able to sustain or even rerate. Whereas companies that aren't able to maintain their cost of capital, which has just increased they're gonna see d ratings going forward. So yeah, I mean, buying the market, you might be getting the market at a reasonably attractive level, but there is gonna be a big divergence in who the winners and losers are as well.

Casey McLean: Income, you know, is still critical to your total return in Australia. We'll, you know, hopefully always will be as long as the Franken credit system stays in place. [00:30:00] And should definitely not be ignored as I think long term. It's, you know, over a third of your total return in Australia. So yeah, again it's focusing on those companies.

Casey McLean: That have strong cash flow generation across cycles and are able to sustain high dividend payouts as well. That's gonna be a key part of your returns over the longer term. So, Casey, you mentioned that the Australian Index is trading relatively inexpensively to where it has in the past. Do you think investors have sufficiently priced in what could be a downgrade in the upcoming corporate earnings cycle and.

Casey McLean: Possibly a little bit of degradation in the economic conditions, or do you think there's more to do there? Yeah, I think there definitely is in some sectors within the market. The key ones apart from banking that we've talked about is probably in the consumer sector consumer discretionary sector.

Casey McLean: That is I think there is still elevated. I. Across some of the companies in in that space. And we have seen that impact earnings and outlook statements in the past [00:31:00] reporting season. So there's one area of definitely concerned about, especially as yeah, household budgets do get co bit constrained by rising interest rates and costs.

Casey McLean: But I think broadly, Speaking the Australian economy is gonna be relatively resilient and although earnings growth may slow that, you know, we still have a better, pretty good positive outlook overall. Particularly I think, you know, when I think about Countercyclical opportunities that they still do exist in the market even within that consumer discretionary space that we talked about.

Casey McLean: And you know, one holding we have is in B Babcock. We're a aftermarket auto parts supplier. And yeah, the theory being that in tough economic times you don't sell your car and buy a new one. You hold onto it for longer, and if something breaks, you have to fix it. So that's a stock where I think there is reasonable earnings visibility.

Casey McLean: They might be cycling relatively tough comps from last year, but they should still be able to grow their earnings and as well have, you know, cost our programs there and [00:32:00] trade on pretty attractive multiples as well. But I guess part, a big part of the focus of the portfolios also is on sort of idiosyncratic growth opportunities, which you can find in the smaller end of town particularly in areas like biotech.

Casey McLean: And we do have. Position in the portfolio called poly Novo, who have a product called B T M, which is a a polymer based scaffolding that's used for severe burns. And they've this product's been approved for a while and they're rolling it out in the us and gaining really strong traction with burns surgeons in the us.

Casey McLean: They've penetrated most of the major burns hospitals now and are really. Their sales quite strongly. And what is really attractive about this company is that some of the doctors are using the product off-label, so for different indications than what it's already approved for. And that's giving them, you know, new ideas, new markets to target.

Casey McLean: So they're adapting the product [00:33:00] to, you know, do, to have new functions so that they're talking about your hernia. Hernia surgery breast reconstruction and, you know, acutes of traumas as well. So seeing as a company with, you know, this product that forms a basis of a suite of products and, you know, they've just done capital rays, which sees them through to break even, hopefully.

Casey McLean: And also allows 'em to expand their production capacity by a long way as well. So this is a company I think, Become the standard of care and burns and has a really great long track long-term track record and and growth outlooks as well. And there's 

Ryan: been a relative flight from risk two to companies in the index, both domestically and abroad.

Ryan: And that's left companies outside of the index in the smaller market cut end of the spectrum. With less liquidity trading at, you know, significant discounts. Do you think outside of that stock there's other opportunities in the market that you would 

Casey McLean: consider? Yeah, definitely. Like we, we invest across the full [00:34:00] range of market cap.

Casey McLean: All the way down to some micro caps. And liquidity is definitely something that we monitor and make sure we have enough liquidity across the whole portfolio. But you're right, there has been a dislocation in the smaller end of town particularly in, in recent times. And that is creating some opportunities.

Casey McLean: That we're seeing as pretty attractive. So we're always looking at those and generally have, you know, a handful of these smaller cap companies in the portfolio because, you know, we see them, you know, like poly novo that have idiosyncratic growth drivers that are not dependent on, you know, sort of economic or macro conditions and you know, in many cases the trading on now pretty cheap multiples as well.

Casey McLean: Thanks 

Ryan: for your time today, Casey. Really appreciate it. 

Casey McLean: Thanks very much. It's been a pleasure. 

Ryan: I hope you enjoyed listening to this episode of the Exchange Podcast with Casey McLean. Here's my four minute recap and key takeaways on the topic of inflation and I v a policy. We [00:35:00] finally appear to be approaching terminal rates in Australia.

Ryan: Whether or not we see another 25 basis points on the table at the next meeting is inconsequential, and we can expect rates to remain elevated for longer with the rest of the outlook being periods of reinflation throughout 2024 as services. Inflation remains persistent in the wake of Central Bank tighten.

Ryan: Markets are looking towards the question of recession. Australia's track record throughout periods of moderating global growth, particularly in the US, is strong, and this time it looks no different. Our economy will be driven by the only countercyclical growth trade available that is the outcome of China.

Ryan: Reopening most obvious is the result of demand for our key export of commodities. And whilst global energy shocks have driven some commodities to the peak of their owning cycle with several trading our prices above the cost of capital. Opportunities are in abundance. Following years of underinvestment in the sector, select opportunities will be favorable driven by the tailwinds of the green energy transition.

Ryan: We stand to not only benefit from China's demand for our commodities, but their [00:36:00] consumption of consumer exports. Like Australia. Household savings are at record highs driven by actual saving rates and no government stimulus. If the only real risk of recession in Australia is a consumer recession, we can expect this demand to provide some insulation for corporate earnings in the consumer discretionary sector.

Ryan: Adding to these tailwinds is the expectation of a softer regulatory regime. As a Chinese government looks to prioritize growth and stability following a period of strong regulatory intervention In the context of risk Premier and the sustained elevation of our cash rate, investors should look for relative value in our income supported index.

Ryan: At an elementary level, the staples of our index comprised of. Farms and mines, and it's time to diversify away from banks. As net interest margins come under pressure to do a variety of factors such as slower loan growth and the higher cost of funding, at this stage in the cycle, investors will do better to preference insurance companies who stand a benefit from rising premiums as they reinsure.

Ryan: And elevated investment earnings on collective premiums. Whilst our big banks may face earnings pressures, they don't face [00:37:00] solvency or liquidity issues like those recently publicized abroad, they remain well capitalized and is subject to tie to regulatory scrutiny requiring them to both hedge their interest rate risk, and mark the value of their bonds to market.

Ryan: The impending 350 billion interest rate cliff as fixed rate loans go to variable is unlikely to create balance sheet stress, but it is more likely to force a contractionary period in the credit cycle. So what's the case for Australia's continued economic resilience? Our country is resource rich as strong will growth and offers attractive dividend returns.

Ryan: Our robust corporate governance will continue to encourage capital discipline and investor. Moreover, Australia's accelerating population growth, which is now back above pre pandemic levels, will add propellant to economic growth. Adding to all list from an equities perspective is an index trading below long-term historical averages on a price to earnings basis.

Ryan: However, a, his historically cheap index isn't a simple answer for investors. A higher risk-free rate feeds into a higher cost of [00:38:00] equity, and the result is significant valuation dispersion as traditional index heavyweights come under. Credit conditions, contract, and the relative value of equities become scara.

Ryan: There will be a big divergence of winners and losers fortune favors. The bold and the bold will actively pursue opportunities born from dislocations in the market today.

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