Australian equity markets advanced modestly in May, with the S&P/ASX 200 Accumulation Index returning 1.1% for the month.

The recovery that began in April continued, although the domestic market lagged a broadly stronger global backdrop. The US S&P 500 rose around 5%, led heavily by the technology sector and artificial intelligence (AI) semiconductors, as offshore investors continued to reward the data-centre and compute build-out. In my view, the defining feature of the month was the narrowness of leadership: gains were concentrated in a small number of sectors rather than broadly distributed across the market.

The dominant domestic event was the Federal Budget for 2026-2027, which the Government delivered in May.

I regard it as the most significant change to the tax system since the introduction of the GST. The headline measures affecting individuals are material: investors will now pay their full marginal tax rate on all real capital gains, subject to a minimum applied rate of 30%; from 1 July 2027 negative gearing on residential property will be limited to new builds; and from 1 July 2028 discretionary trusts will attract a 30% minimum tax paid by the trustee.

The Government framed these reforms around housing affordability and inequality, coupled with a $2bn Local Infrastructure Fund and build-to-rent measures, alongside a $14.5bn package to strengthen fuel and fertiliser reserves. In my opinion the second-round effects of these changes have not been fully assessed, and they introduce a layer of uncertainty into the consumer, banking, and property outlook that the market is still digesting.

On monetary policy, the RBA raised the cash rate by a further 25 basis points to 4.35%, continuing to lean against inflation that remains above target.

The market has been pricing a further move to 4.60% later in the year, though I expect the Board to pause and assess the combined impact of the Budget and prior tightening before acting again (which they have done in June).

The inflation picture is genuinely mixed.

April headline CPI eased to 4.2%, the lowest reading of the current cycle, while core inflation ticked up to 3.4% from 3.3%, a reminder that the last leg of disinflation is likely to be the most difficult. Q1 GDP slowed sharply to 0.3% quarter-on-quarter, household consumption is softening, and unemployment rose to 4.5%, the first meaningful increase in some time.

Sector dispersion was wide. Materials was the standout, rising more than 10% as base metals rallied, with copper extending its structural advance on AI data-centre and energy-transition demand. Consumer Discretionary also gained, supported by softer data and the prospect that the rate-hiking cycle is nearing its end.

At the other extreme, Health Care was again the weakest sector, falling close to 9%, driven by a further earnings downgrade from CSL and an ongoing struggle with both the valuation and growth outlook for the sector.

Energy was weaker as oil softened on hopes of a Middle East resolution, alongside the defensive Consumer Staples and Utilities sectors.

Small Caps and Mid Caps both edged ahead of Large Caps, with the S&P/ASX Small Ordinaries Accumulation Index rising 2.03%.

We have written in past letters that we expect Quality to reassert itself as markets place greater value on strong balance sheets, predictable earnings, and durable cash flow, particularly in uncertain conditions.

May continued that trend, with the highest-quality names within our long books performing well. We do not draw firm conclusions from a single month, but the dispersion now evident across sectors and factors is precisely the environment in which I believe: disciplined, bottom-up active management can add value.