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Rudi’s View: How To Protect Against Inflation

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Always an independent thinker, Rudi has not shied away from making big out-of-consensus predictions that proved accurate later on. When Rio Tinto shares surged above $120 he wrote investors should sell. In mid-2008 he warned investors not to hold on to equities in oil producers. In August 2008 he predicted the largest sell-off in commodities stocks was about to follow. In 2009 he suggested Australian banks were an excellent buy. Between 2011 and 2015 Rudi consistently maintained investors were better off avoiding exposure to commodities and to commodities stocks. Post GFC, he dedicated his research to finding All-Weather Performers. See also "All-Weather Performers" on this website, as well as the Special Reports section.

Rudi's View | Jun 03 2021

This story features CHALLENGER LIMITED, and other companies. For more info SHARE ANALYSIS: CGF

In this week's Weekly Insights:

-How To Protect Against Inflation
-Tech Might Require More Patience
-S&P June Index Rebalancing
-Conviction Calls
-Research To Download
-Morgans Strategy: Catalyst Stocks

By Rudi Filapek-Vandyck, Editor FNArena

How To Protect Against Inflation

It is a question that has regularly landed in my inbox this year: I am worried about inflation. How do I protect my investment portfolio?

Let me start with the observation that, on my assessment, still less than half of all investment experts is predicting a fundamental change in the outlook for inflation, and many of those expert voices have an agenda, a built-in bias or a history of proclaiming the end is nigh or the system is approaching its ultimate day of reckoning.

Think: the always-buy-gold bugs (alongside silver). Today's true believers in crypto. Your old fashioned, true blue cheap-value-is-everything investor, many of whom also believe risk assets are in a bubble and the Fed's QE policy alone is responsible for the outperformance of growth stocks pre-November last year.

Having said so, it cannot be denied many more expert voices and market participants are paying attention this year, if only because most portfolios and strategies were not prepared for potentially higher inflation, plus one can never be 100% certain about these matters; it's thus best to hedge and to re-align so that one unforeseen event doesn't destroy all the good work done previously.

As one prescient expert put it recently: inflation might prove transitory, but a lot of damage can be done in the meantime.

Judging from the emails and messages I have received since the beginning of the year, I am certain many an investor agrees with that assessment. Share prices for some of last year's share market champions are down by -50% and more. This whole market re-set has been nothing but brutal for particular pockets and corners, impacting on portfolios, returns and strategies.

Ironically, it is also my observation a new stream of expert voices seems to be rising to the surface; one that is looking beyond the current supply-chain bottlenecks and production shortages, questioning the sustainability and the severity of this year's economic recovery. What if next year brings disinflation, if not deflation, rather than run-away inflation?

Needless to say, this year's Grand Debate among experts and investors worldwide is to remain inconclusive for a while longer. My take on it from two weeks ago: https://www.fnarena.com/index.php/2021/05/20/rudis-view-collins-foods-rio-tinto-and-aurizon/

Irrespective of one's own views, bias or portfolio positioning, it does make sense to re-align portfolios and strategies, even after the adjustments that have occurred already since November last year. Because if inflation does decide to stick around for much longer, global re-positioning in financial assets will have a lot longer and farther to run still.

Basic rules of inflation

Let's not make this subject too complicated. Higher inflation weighs on asset valuations, hence why investors have been selling equities trading on high PE multiples (in a general sense) and buying into laggards and lower priced equities instead. This has been factor number one underpinning the switch from Growth and Quality into Value and Cyclicals.

Another factor is that if higher inflation translates into higher bond yields, in particular at the longer end (further out) then most financials stand to benefit.

Hence why Australian banks have made such a forceful comeback. However, all else remaining equal, this should equally have benefited insurance companies and other financials, but we only have to look briefly at share prices for the likes of Challenger ((CGF)) and Insurance Australia Group ((IAG)) to find out that other factors still have a say as well.

Inflation and bond yields are but one factor. They are not the only driver for share prices.

Inflation also favours real assets above financial assets. Think bricks and mortar properties, but also so-called "hard" assets like oil, gold, metals, and even agricultural products, not just timber and wood chips.

Again, since January the share price of Woodside Petroleum ((WPL)) has gone from $27-plus to below $22 today. Santos' ((STO)) share price shows a much flatter trajectory, while Senex Energy ((SXY)) has simply continued trending upwards.

A highly simplified way of looking at inflation is that most industrial companies buy in commodities and other input materials, meaning their margins are coming under pressure unless they have strong pricing power.

In a simplified set-up, this pits the likes of Amcor ((AMC)), Ansell ((ANN)) and Incitec Pivot ((IPL)) against the producers of basic materials, such as BlueScope Steel ((BSL)), Oil Search ((OSH)) and BHP Group ((BHP)). Yet again, if inflation really takes off, those producers will start feeling the squeeze themselves from rising inputs and slowing demand.

As an investor, one should always be careful what to wish for. We might just get it in spades, and not fully realising the potential consequences. Today's doom and gloom scenarios, or at least one, of them involves persistently higher inflation which forces central banks to turn less accommodative, with devastating impact on assets, economies and government finances.

Inflation and bond yields are one factor, but seldom the sole defining driver. Which is why formulating an answer to what appears a simple and straightforward question is more complicated than one might think, especially now that bond yields have calmed down and a large re-adjustment between opposing parts of the share market has already occurred.

The case for real assets

Wilsons last week explained the case for increased exposure to real assets during times of inflation outbreak uncertainty. Such hard assets tend to preserve real value in an inflationary environment, in addition to truly acting as a portfolio diversifier and often offering lower correlation with equities and bond markets.

Wilsons also suggests hard assets reduce portfolio volatility, but that would be the topic of fierce debate. Just like gold doesn't always retain its momentum in the face of inflation, and iron ore prices will sink if China stops buying, regardless.

Wilsons also advocates investors looking to diversify because of inflation concerns should broaden their spectrum and include real estate and infrastructure. Most infrastructure assets have an explicit link to inflation through regulation, concession agreements or customer contracts, explain the analysts. This means they can increase prices at least in line with inflation, and without impacting on demand.

Gold has a history of generating strong returns during times of high run-away inflation, while Wilsons also includes exposure to farmland.

UBS's and JPMorgan's global macro strategies

Making matters a little more complicated, there is a difference between nominal bond yields moving higher and the direction in real bond yields -adjusted for inflation- global strategists at UBS once again explained last week. Nominal bond yields did surge earlier in the year, but real, inflation adjusted yields are still near an all-time low in the US.

UBS predicts real bond yields will start trending upwards later in 2021. This eventually turns into a negative as rising real yields slow down economic activity. However, this should not become an issue anytime soon, and central banks are keeping an eye out as well (insofar they can retain control).

Assuming UBS's scenario plays out, Value stocks should outperform, as well as US small cap stocks vis a vis the large and Megacaps.

Strategists at JP Morgan have started advocating for a more nuanced approach in the Value versus Growth debate. In their view, certain segments in the Value basket no longer automatically represent opportunity, while the trend among Growth stocks is turning favourably towards GARP – Growth at a Reasonable Valuation.

Maybe JP Morgan's assessment is the most valuable among all now that market momentum has turned, and that initial, large re-adjustment between Winners and Laggards has taken place.

Find those companies that are able to grow profits and create shareholder value next year and in subsequent periods. Don't own them at too high a valuation.

Tech Might Require More Patience

Investors must be scratching their heads after several Australian tech stocks tumbled in 2021, comment analysts at Wilsons in their latest review of the sector. After such a remarkable run in 2020, what could have changed in such a short space of time?

The relative underperformance of the domestic technology sector over the first five months of 2021 has exceeded -20% and this applies both against the ASX200 as well as vis a vis the Nasdaq. Time for an explanation.

Wilsons points out the overall performance of Australian tech stocks in 2020 had been exceptionally strong, and this has to be taken into account when measuring this year's relative performance, which has been poor on everybody's assessment.

A few additional points to include in this year's sector performance assessment:

-Australian technology companies often have no profits but do trade on elevated multiples which makes them ultra-vulnerable to rising bond yields and an increase in inflation forecasts. Wilsons makes the observation this was in particular apparent during February and March, the most intense phase of bond markets adjusting to the changing inflation outlook this year;

-because of the exceptional performance in 2020, the starting point of highly elevated valuations left the sector extremely vulnerable to any market switch out of last year's winners and into the market laggards. This switch accelerated in the opening months of 2021;

-the global cyclical recovery unfolding is much stronger than expected and favours cyclicals and cheaper alternatives with higher economic leverage instead of growth stocks, even if they are merely trading on reasonable multiples;

-earnings momentum for Australian technology companies has been trending negatively since January in direct opposition to the firm positive trend for financials and commodity producers in Australia. In contrast, Wilsons points out, US Tech has been in upgrade mode since July 2020

For the sector to resume its prior outperformance, Wilsons suggests two things need to change:

-earnings momentum for the sector needs to revert back to a positive trend – investors should watch trading updates pre-August and financial results and guidances in August, Wilsons suggests;
-investors need to feel more comfortable with the level and direction of bond yields

Regarding the second factor, it is Wilsons' view that bond yields can still rise to a higher level and who could possibly argue with that?

None of the above has stopped Wilsons from retaining a few technology stocks in its selected list of High Conviction Buys; see further below.

For my own take on the local technology and growth stocks, see last week's Weekly Insights:

https://www.fnarena.com/index.php/2021/05/27/rudis-view-investing-in-quality-growth-a-journey/

S&P June Index Rebalancing

As Standard and Poor's is expected to announce the next batch of index inclusions and exclusions in Australia on Friday June 11th, analysts at Wilsons expect no changes for the ASX20 or ASX100, but the ASX50 and ASX200 are unlikely to retain their current compositions.

Two weeks ago I explained the potential short-term importance of index changes, and forecasts made by Morgan Stanley in this regard:

https://www.fnarena.com/index.php/2021/05/20/rudis-view-collins-foods-rio-tinto-and-aurizon/

Wilsons is anticipating a whole lot fewer changes will be announced on the above-mentioned Friday morning. Appen ((APX)) might lose its ASX100 spot to Harvey Norman ((HVN)), but this scenario might depend on respective trading volumes this week, say the analysts.

More probable are fresh ASX200 inclusions for Orocobre ((ORE)), Chalice Mining ((CHN)) and Uniti Group ((UWL)), respectively replacing Resolute Mining ((RSG)), Austal ((ASB)) and Perenti Global ((PRN)).

Wilsons also thinks Orica ((ORI)) is likely to lose its ASX50 inclusion to Northern Star Resources ((NST)).

All shall be revealed on June 11 with announced index changes put in practice after the market's close on June 18th, the following Friday.

Conviction Calls

Investors still looking for exposure to oil and gas companies might take some guidance from RBC Capital's initiation of coverage of Senex Energy ((SXY)).

Generally speaking, the share price has gradually made its way to $3 from $2 around the release of FY20 financials in August last year, but most stockbroking analysts covering the sector still regard the share price as too low, and certainly RBC Capital backs up that assessment.

Monday's initiation contains a maiden Outperform rating alongside a price target of $4, which beats all other targets in the FNArena database with exception of the $4.20 set by stockbroker Morgans.

The reason as to why RBC Capital and others remain positive on Senex's outlook is related to the company's substantial reserves that are located near its existing operations and which underpin the potential to double current production level in the years ahead, which -if successful- should translate into strong revenue growth and a tasty dividend yield (think more like 4% instead of the current 2%-plus).

It is RBC Capital's assessment that delivering future production growth is relatively low risk and low cost for Senex management, also because the GLNG Project is to become increasingly reliant on third party gas supply volumes, which is seen as de-risking Senex's expansion plans.

Meanwhile, Senex's Atlas project delivers gas to high quality customers including Alinta, Origin Energy, Orora, CleanCo and CSR via fixed-price, CPI linked contracts.

Outside of RBC Capital, five of the six stockbrokers monitored daily by FNArena rate the shares a Buy (or equivalent) with a consensus target of $3.77. Loyal shareholders received an interim dividend of 1c in March, but there should be a lot more to follow in the years ahead, as also indicated by the fresh research update by RBC Capital.

****

JPMorgan's mid-year sector updates have generated a Top Pick nominattion for NextDC ((NXT)) in the local technology sector, while platform operator Hub24 ((HUB)) is now Least Preferred.

On observation the NextDC share price has found the going a lot tougher thus far in 2021, JP Morgan suspects short-termism is to blame for the relative underperformance of Australia's leading cloud centres operator. There still is a large pipeline of large developments and the company remains well-funded.

As far as Hub24 is concerned; JP Morgan is worried margin pressure is to reveal itself over the near-term due to increased commodification of the local financial platforms industry. This would make current growth momentum unsustainable with potentially serious consequences for Hub24's valuation.

Elsewhere, the same mid-yearly sector revision for the oil and gas industry has elevated Beach Energy ((BPT)) as JPMorgan's Top Pick for the sector, with Worley ((WOR)) now Least Preferred.

A similar exercise by analysts at the REITs desk has triggered a forecast that strong operational momentum for Goodman Group ((GMG)) is likely to persist for the next 3-4 years.

Moreover, JPMorgan sees little risk to Goodman's earnings growth being delivered over the period ahead. More positive commentary refers to Stockland Group ((SGP)), while Waypoint REIT ((WPR)) is expected to announce capital management initiatives with the release of interim financials in August.

***

Analysts at Wilsons have conducted a deeper-dive into this year's misfortunes for local technology stocks, as mentioned earlier, and their conviction in the ongoing growth potential for Afterpay ((APT)) and Xero ((XRO)) has remained intact.

Both remain on Wilsons' Focus List and in both cases "the long-term growth outlook continues to look bright, driven by the global opportunity set, transformative customer proposition, and network effect that both businesses have".

EML Payments ((EML)) is also one of the analysts' favourites among local technology stocks. Wilsons is of the opinion the share price has fallen way too much in response to an investigation by the central bank of Ireland into EML's Irish subsidiary.

****

Property analysts at Moelis highlighted while large shopping centres are battling with declining rents and assets under valuation pressure, sector peers owning smaller formats are currently seen offering an attractive investment alternative.

On Moelis' assessment, rents and yields have been relatively consistent through the pandemic, while retail sales remain elevated, and long term structural risk remains relatively low.

Hence, for yield/income investors looking for an alternative for your traditional Unibail-Rodamco-Westfield or Scentre Group, Moelis recommends Shopping Centres Australasia ((SCP)) and Charter Hall Retail REIT ((CQR)) instead.

Both are Buy rated (of course) with price targets of $2.64 and $3.87, respectively, with respective forecast dividend yields of 6.1% and 6.9%.

Research To Download

RaaS on that (potentially) transformational deal for Betmakers Technology Group ((BET)):

https://www.fnarena.com/downloadfile.php?p=w&n=87C22027-C0C6-DE79-525E43A93DF4AD71

Morgans Strategy: Catalyst Stocks

It remains the view of stockbroker Morgans that current investor fears about a sustainable outbreak in inflation will -ultimately- prove unfounded. In the meantime, of course, this won't stop share market volatility spiking higher whenever economic data suggest otherwise.

One of the strategies to deal with this environment, suggests Morgans, is to concentrate on positive catalysts. Share prices tend to respond favourably to positive catalysts, irrespective of the overall risk climate.

Within this framework, Morgans prefers Sonic Healthcare ((SHL)), Sydney Airport ((SYD)), APA Group ((APA)), Tyro Payments ((TYR)), Eagers Automotive ((APE)), Lovisa Holdings ((LOV)), Acrow Formwork and Construction Services ((ACF)), and Alliance Aviation ((AQZ)).

Identified catalysts range from anticipated positive trading updates, to new contract wins, expected acquisitions and a strong forward pipeline of projects.

Other companies mentioned include Link Administration ((LNK)), Afterpay, Atlas Arteria ((ALX)), DBI Infrastructure ((DBI)), Micro-X ((MX1)), ImpediMed ((IPD)), and Antisense Therapeutics ((ANP)).

Morgans has identified five companies potentially awaiting negative catalysts, mostly related to anticipation of disappointing company guidances in August: AGL Energy ((AGL)), Origin Energy ((ORG)), CSL ((CSL)), Cochlear ((COH)), and Ramsay Health Care ((RHC)).

The latter has by now announced a large acquisition in the UK.

(This story was written on Monday 31st May, 2021. 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: info@fnarena.com or via the direct messaging system on the website).

****

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