Rudi's View | Jun 06 2019
In this week's Weekly Insights:
-The One That Got Away From Morgan Stanley
-No Weekly Insights Next Week
-High PE Stocks Versus Hyper PE Contenders
-Rudi On Tour
By Rudi Filapek-Vandyck, Editor FNArena
The One That Got Away From Morgan Stanley
Part Two of last week's Weekly Insights carried a chart by Morgan Stanley illustrating how, adjusted for QE and QT by the Federal Reserve, the US bond market had been in inverted yield curve mode since November last year.
For those who are less familiar with what this actually means: "inverted yield curve" refers to the rather unusual situation whereby US government bonds with an expiry date in ten years from today are offering a lower yield than shorter duration bond yields, like three months for example.
As everybody will understand, this instinctively doesn't make much sense as longer dated loans (which is what a bond effectively is) should offer higher yield than a short term loan.
In financial parlance this then translates into the US bond market is predicting an economic recession lies ahead, which is why all the talk is about recession this month.
In practical terms it means the Federal Reserve tightened at least one time too much late last year. The bond market is now signalling to the Fed thou shalt need to be loosening monetary policy, and sooner rather than later.
When looking at the raw economic data, this can get confusing because recent data might be signalling a slowing down for the US economy, but a recession? As per always, recessions don't show up in data until after they are in place, and financial markets are forward looking.
US investors are most likely to take further guidance from proprietary downturn indicators, such as Morgan Stanley's (below). When I had to make a decision which chart to include in Weekly Insights last week, I chose the inverted yield curve chart. So this week I am adding the US Cycle Indicator by Morgan Stanley.
As the asset strategists who oversee this modeling pointed out, for the first time in over a decade, the Cycle Indicator is now pointing towards a downturn taking shape for the US economy. And this downturn, on Morgan Stanley's assessment, started before trade talks between the Trump administration and China broke down and turned nasty.
No Weekly Insights Next Week
Next week starts with a public holiday across Australia (Queen's birthday) and I will be in Adelaide to present to the local chapter of the Australian Investors Association (AIA) the next day, so there will be no Weekly Insights for that week.
Weekly Insights will resume in the week Monday June 17 – Friday June 21.
Inverted bond yield curves are a rather rare phenomenon. They occur more often in Australia than in the US, where they are widely considered a fairly reliable signal for much tougher times ahead for the US economy and by extension US and global equities.
History shows extended inversions have only happened just seven times over the past 50 years and on every occasion the occurrence was followed up by an economic recession. Not necessarily because bond markets never fail when making forecasts, but because banks stop providing loans as the dynamic between long and short bonds, which is their key source for funding, no longer works in their favour.
Taking guidance from history, Wilsons' head of asset allocation, Tracey McNaughton points out some of the statistics that come with an inverted US bond curve. On average, it takes about eight months after the inversion takes place before the Federal Reserve delivers its first rate cut.
Regardless, an economic recession usually follows between 5 and 16 months after the bond market signal. The big unknown is that the impact/consequences for equities are not as clear cut, though it remains an indisputable fact that deeper recessions correspond with sharper declines, in particular when equity valuations were on the more expensive side to begin with.
As such, five of the last seven inversions have been associated with US recessions; 1969, 1973, 1981, 2001 and 2007.
"This", concludes McNaughton, "makes the inversion of the yield curve a valuable early warning signal and suggest a more defensive investment state of mind is required."
Wilsons' own positioning is Overweight cash and bonds and underweight equities, in particular the US and Europe.
See also Part Two of last week's Weekly Insights, published on the FNArena website as "Rudi’s View: Citadel, Stockland & Expert Warnings".
This week's update on Wilsons' selective list of Conviction Calls revealed two deletions and one new inclusion with Arq Group ((ARQ)) and Citadel Group ((CGL)) no longer included and ReadyTech ((RDY)) as the newcomer.
Wilsons Conviction Calls have a long history of outperforming both the Small Ordinaries and the Small Industrials indices, but the past six months have proven much harder than usual with both indices mostly performing better. May in particular has not been kind to Wilsons' Conviction Calls, probably exacerbated by the profit warning cum sell-down in Citadel Group shares.
Remainers on the Conviction recommendations list are Bravura Solutions ((BVS)), EML Payments ((EML)), Collins Foods ((CKF)), ImpediMed ((IPD)), EQT Holdings ((EQT)), Pinnacle Investment ((PNI)), Noni B ((NBL)), Ausdrill ((ASL)), Mastermyne ((MYE)), and Whitehaven Coal ((WHC)).
Macquarie market strategists continue to advocate investors' portfolios to have exposure to Australian housing related stocks. Macquarie's own model portfolio owns shares in REA Group ((REA)), Nine Entertainment ((NEC)), National Australia Bank ((NAB)), Westpac ((WBC)), James Hardie ((JHX)), CSR ((CSR)), and Stockland ((SGP)).
Macquarie's portfolio is underweighted bond proxies (yield stocks that move in accordance with bond yields) as the strategists believe the downward move in bonds looks overdone and the months ahead will likely see higher instead of lower bond yields. Thus far, this forecast has proved horribly wrong.
Assuming improving dynamics for housing in Australia continue to manifest themselves, Macquarie continues to highlight the improving outlook for domestic cyclicals in Australia. Macquarie thinks house prices could be up by 5% at least by end 2020 and banks and construction materials stocks should be among the main beneficiaries.
The RBA well and truly delivered on Tuesday when Phillip Lowe & Co announced the widely anticipated -25bp cash rate cut but the more cautious wordings in the accompanying statement is now attracting increased expectations for one additional cut in August, if not a third cut later this year. Earlier, JPMorgan had built a case for a total of four rate cuts spread over this year and next.
Here's the response from BIS Oxford Economics shortly after the rate cut announcement:
"The statement also suggests that more cuts will materialise in the near term, with the Board noting that they will adjust monetary policy in order to hit the inflation target over time. Given the shift in stance we now expect to see a second 25bps cut in August. And with global conditions deteriorating markedly and the US heading for a sharper than anticipated slowdown as a result of disruption caused by the tariffs imposed on China and Mexico (which will feed through to services exports and business confidence), we think it’s likely that they will cut for a third time this year in November, taking the cash rate to 0.75%."
Over at stockbroker Morgans, the strategists have removed Reliance Worldwide ((RWC)) from their High Conviction Calls. Reliance Worldwide issued a profit warning in May and was subsequently downgraded by the stockbroker to Hold. Morgans remains concerned about the potential impact from the downturn in multi-res buildings in Australia, as well as the increase in US tariffs on imports from China.
In its place comes OZ Minerals ((OZL)), sold down heavily since early April and now worth buying with conviction, according to Morgans. Prime minister-related troubles in PNG have not deterred the broker and Oil Search ((OSH)) remains on the High Conviction list, alongside ResMed ((RMD)), Sonic Healthcare ((SHL)), Westpac, Kina Securities ((KSL)), Senex Energy ((SXY)), and Australian Finance Group ((AFG)).
High PE Stocks Versus Hyper PE Contenders
A most interesting share market observation was released by JPMorgan/Ord Minnett in the week past, with the analysts observing there has been a notable switch in market momentum inside the group of companies broadly defined as High PE Stocks.
Whereas most of the traditional High PE names such as CSL ((CSL)), REA Group ((REA)), Blackmores ((BKL)) and Domino's Pizza ((DMP)) have found the going a lot tougher in 2019, with only a small number managing to continue to outperform the broader share market, no such loss in momentum has shown up for what the analysts label the "Hyper PE Technology Sector Contenders".
The analysis identifies twelve names that fit under this label, and only Hub24 ((HUB)) and TechnologyOne ((TNE)) did not significantly outperform year-to-date. Other members are Afterpay Touch ((APT)), Altium ((ALU)), Bravura Solutions ((BVS)), IDP Education ((IEL)), Netwealth ((NWL)), WiseTech Global ((WTC)) and Xero ((XRO)) for an average return of 54% over five months.
The suggestion made is whether the traditional group of High PE companies has become too mature to continue trading on an elevated market premium, with growth hiccups triggering a de-rating for companies including Blackmores, Cochlear and Domino's Pizza. The analysts do point out the February reporting season proved disappointing for most of these companies, hence it may yet be too early to draw a definitive conclusion.
The analysis offers an interesting fresh insight, but it doesn't cover enough ground, in my opinion, to answer all questions that should be asked by astute investors, including where does this leave non-technology related newcomers such as Bubs Australia ((BUB)) and a very much technology-related NextDC ((NXT)) whose stock equally has found significant outperformance elusive in 2019.
There is no denying companies like Blackmores, Domino's Pizza and Bellamy's ((BAL)) have run into strong headwinds, but whether this means the end of the High PE road is also near for champion stocks including CSL, ResMed, and others remains yet to be seen.
Five months including a disappointing reporting season seems a bit short to draw such far-reaching conclusions. In particular given the likes of Aristocrat Leisure ((ALL)) and Iress Technologies ((IRE)), to name but two examples from the old version High PE stocks, continue to exhibit strong growth and the ability to find new ways to improve the path forward.
To be continued.
Recent audio interview about investing in high quality stocks in the Australian share market:
Rudi On Tour In 2019
-AIA Adelaide, SA, June 11
-AIA National Conference, Gold Coast, Qld, 28-31 July
-AIA and ASA, Perth, WA, October 1
(This story was written on Tuesday 4th June 2019. It was published on the day in the form of an email to paying subscribers, and again on Thursday as a story on the website).
(Do note that, in line with all my analyses, appearances and presentations, all of the above names and calculations are provided for educational purposes only. Investors should always consult with their licensed investment advisor first, before making any decisions. All views are mine and not by association FNArena's – see disclaimer on the website.
In addition, since FNArena runs a Model Portfolio based upon my research on All-Weather Performers it is more than likely that stocks mentioned are included in this Model Portfolio. For all questions about this: email@example.com or via the direct messaging system on the website).
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(Do note that, in line with all my analyses, appearances and presentations, all of the above names and calculations are provided for educational purposes only. Investors should always consult with their licensed investment advisor first, before making any decisions.)