In many countries, including Australia, inflation remains stubbornly high. If central banks, including our own Reserve Bank, remain steadfast in their quest to bring inflation down – even at the risk of causing a recession – interest rates may well have further to rise and stocks prices further to fall.    

Apart from interest rates and inflation, there’s also the risk of an escalation in the Russia-Ukraine war. China remains at risk as it deals with both a property bubble and intermittent lockdowns to contain COVID-19. 

Climate change is also becoming increasingly evident and problematic – with persistent droughts in some parts of the world and persistent flooding in others. 

But as history demonstrates, equity markets often climb a “wall of worry”. It’s precisely when stocks are in the doldrums and few can see anything positive ahead that markets are often prone to turning the corner. 

If all or at least most of the negative fears referred to above ease somewhat, stocks are potentially poised to rebound, in BetaShares’ opinion.

For starters, equity market weakness to date has at least improved equity valuations. At the time of writing, Australia’s S&P/ASX 200 Index was trading at 14 times forward Price Earnings multiple – or modestly below its long-run average of around 15, according to BetaShares research.

Thanks to strong global commodity prices and a V-shaped post-COVID-19 recovery in the economy, the corporate sector appears in good health. 

According to (unpublished) Refinitiv estimates, corporate earnings of S&P/ASX 200 listed companies rose by just over 20% last financial year. If global commodity prices rise further, Australia’s market could potentially outperform global peers thanks to its higher exposure to mining and energy companies. 

In BetaShares’ view, there’s also a reasonable chance that global inflation soon begins to surprise on the downside in much the same way it surprised on the upside over the past year. Global supply chain bottlenecks are easing, as is the initial surge in demand for goods and services following the removal of COVID-19-related restrictions. Ample fiscal and monetary support during the depth of the COVID crisis is also being wound back. 

Importantly, long-term inflation expectations remain fairly contained in most countries, and heightened global competition should lessen the risk of a repeat of the 1970s wage-price spiral, in BetaShares’ view. As and when inflation eases, central banks will also likely stop raising interest rates and may even cut them to support economic growth.  

As regards Russia, there must be some risk that President Putin is overthrown if the war drags on and the Russian economy worsens. Provided it remains well-armed, the steely resolve of the Ukrainians might also see them ultimately prevail. 

China, meanwhile, has so far at least always managed to prove the doomsayers wrong. Indeed, the Communist Party’s political survival critically depends on the Chinese economy avoiding disaster. As such, officials can and potentially will unleash even more stimulus measures - if only to keep kicking its can of problems a little further down the road.

For Australia’s part, despite low unemployment, nation-wide wages growth remains modest – meaning the RBA should not need to push the economy into recession to get inflation under control, in BetaShares’ view. 

Indeed, due to high debt levels and the sensitivity of the economy to interest rates, the RBA may not need to raise rates all that much further to get the slowdown in economic growth and inflation pressures that it desires, in BetaShares’ view.

All up, while some dark clouds continue to hang over the market outlook, there's still a reasonable chance the skies could clear in coming months, in BetaShares’ view. And at worst, hopefully all Australian shares might face is a passing shower.

The bear case for Australian stocks is best understood by analysing the market’s biggest sectors. The iron ore majors constitute more than 20% of the index (based on S&P data of the S&P/ASX 200 index). The iron ore price has been falling as China’s property market struggles. 

At least in terms of productivity, China has reached the end of its “bridges to nowhere” and “ghost city” phase. That is, racking up more debt to build uneconomic property assets to maximise employment.

This strategy has consumed unimaginable amounts of steel produced from high-quality Australian iron ore, which means the “salad days” of historically high iron ore prices are likely behind us. Particularly if Brazilian miner Vale can eventually restore its output or China eventually succeeds developing a “Pilbara killer” iron ore mine in Africa.

Australia’s largest iron-ore stocks will continue to pay attractive dividends, according to Intelligent Investor research. But with some companies flagging major new investments, dividends could fall, in the Intelligent Investor’s view. Particularly if a global recession hurts commodity prices.

Depending on your definition, Australia’s banks and other finance companies constitute roughly another 20% of the major indexes. Typically, higher interest rates increase bank profit margins, as they increase borrowing rates immediately but slowly increase savings rates.

This cycle could be different, however. Bank profit margins are under more pressure while technology and staff costs are increasing. 

The banks haven’t been the dream cocktail of capital gains and increasing dividends for nearly a decade now. Returns from some banks are below long-term averages despite a house price and lending boom, according to Intelligent Investor research.

Should bad debts increasing during a recession as credit demand falls, Australian banks could potentially suffer share price falls, as they are amongst the highest valued banks in the world, according to Intelligent Investor research. Australian banks are also highly leveraged to Australia’s residential property market, which reacts to higher interest rates like it’s kryptonite.

The same applies for property stocks, which are also around 20% of the S&P/ ASX 200 Index. In Intelligent Investor’s view, Australian Real Estate Investment Trusts (A-REITs) have typically been amongst the more reliable stocks on the Australian sharemarket over time. However, trends such as working from home and online shopping are exposing surplus property space and pressuring rents.

Again, despite a host of tailwinds, unit prices for some of these stocks are currently trading at the same level they were two decades ago.

Moreover, new environmentally improved office buildings in areas like Barangaroo in Sydney are also pressuring rents and increasing the costs of owning older buildings. Tenants increasingly need less but more flexible office space, modern floor plans and amenities that older buildings can’t deliver.

In the Intelligent Investor’s view, the current discounts to net tangible assets in many A-REITs won’t offer sufficient protection if higher interest rates trigger falling property valuations and rents, after the expiry of many long-term leases struck at high lease rates.

The reality is, many companies in the S&P/ASX 200 index are much larger than they used to be, so we can’t expect them to grow as fast anymore, particularly when their costs are under attack, in the Intelligent Investor’s view.

In summary, the Intelligent Investor believes valuations across the Australian share market are still factoring in strong growth and are far from depressed. Be patient and choose wisely.