International | Jul 14 2021
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As equity markets continue to rise, investment managers scan the world for opportunity with an eye on inflation and the commencement of tapering by the US Federal Reserve.
-Front-loaded US fiscal policy may drag on second half growth
-Fund managers offer preferences by sector and style
-The shift towards ESG strategies looks structural
-Citi expects the ASX200 to reach 7,700 by mid-2022
-Preferred Australian stocks
By Mark Woodruff
The reopening trade can be dated from the first week of November 2020, when the first successful covid-19 vaccine was announced. Since then, the best performing asset classes have been small-cap and non-US equities, global real estate investment trusts and commodities, while the Value style of investing has outperformed.
More recently, US equity markets have continued to rally with the S&P500 rising 0.5% in May and 2.2% in June.
In June, that strength was driven primarily by a strong move in the stocks making up the latest acronym, namely FAAMG (Facebook, Apple, Amazon, Microsoft and Google). These stocks account for over 20% of the S&P500’s market capitalisation.
Other markets have fared less well, as the strength/momentum of the uptrend in global equity markets has diminished. For example, Chinese equities are largely unchanged since the start of 2021, German equities have continued to edge modestly higher, while Japanese and Korean equity markets have been trending lower since February this year.
In Australia, the stock market is currently around 4.8% above its pre-covid peak, lagging behind other global markets with the MSCI AC World index 28.5% above the peak.
Globally, many assets have increased more than normal in the acceleration phase of the economic cycle. Cyclicals and growth stocks are 46% and 26% above their ten-year trend, respectively, which suggests they are vulnerable to negative surprises.
Where to from here? Naturally, the topic du jour remains the likely timing and magnitude of interest rate rises across the globe.
In the US, speculation continues as to when the Federal Reserve will start to taper the asset purchasing program. Some fund managers believe the situation is in hand, and trust the Fed is cognisant of how tapering impacted markets in 2013, and will proceed in such a way this time so as to avoid too much turbulence.
While risk assets could become volatile temporarily on the announcement of tapering, it’s thought this may not have a long-lasting impact.
Of course this looks easy in print, but at the time markets will have to assess the Fed’s average inflation-targeting framework, which by design looks past initial price increases.
Back in Australia, the Reserve Bank recently reiterated its commitment to "highly supportive monetary conditions” and suggests the target cash rate is unlikely to increase from its current level of 0.10% until 2024 at the earliest.
Before looking at how portfolio managers worldwide are adjusting their asset class exposures, let’s first examine the dynamics of this current cycle and how that may affect expectations for growth and inflation.
Dynamics of the current cycle
The current cycle has been driven by pandemic effects and explains why the manufacturing recovery was underestimated, explains Dankse Bank. As consumers could not buy services, they bought a lot more goods.
However, the easing of the pandemic leaves a lot of uncertainty about what will drive the economy. As the market underestimated the increase in goods consumption, there is a risk the market will also underestimate the reversal and see a bigger decline in goods demand than expected.
Such reversals are currently evident in the US housing market, where pandemic effects have previously dominated. There is now a sharp cooling in activity, despite rising consumer confidence and a strengthening jobs market.
Going forward, a driver for overall growth may be the higher-than-normal savings, along with the reduction in consumer debt during the pandemic.
Additionally, stronger services should underpin overall growth, as the sector has been lagging with lots of pent-up demand. Normally the manufacturing and service sectors move in accord, explains Danske B, but this time there has been quite a big divergence.
However, fiscal policy has been front-loaded in the US, which will turn into a drag on growth in the second half as the temporary income spike from stimulus cheques and enhanced benefits fades.
Inflation and tapering
After upgrades to all major regions over the last few months, Citi economists expect global real GDP to grow by an impressive 6% in 2021 and 4.2% in 2022, following the -3.5% contraction in 2020.
Rising energy prices in 2021 are expected to keep headline inflation running well above 2% in many economies, but should unwind into 2022.
However, a couple of factors will help put a lid on inflation expectations going forward, according to Dankse Bank. Firstly, we are approaching the peak in the economic cycle, which has historically mostly led to lower inflation expectations. Secondly, this peak now coincides with an expected decline in headline inflation in both the US and Germany over the next year. Finally, a more hawkish Fed during the second half should help anchor inflation expectations.
On the flipside, an upside risk is that US wage growth moves up more than expected due to labour shortages, and that the Fed falls behind the curve. However, while a tapering of bond purchases should contribute to higher yields, Dankse Bank does not expect a new "taper tantrum".
Morgan Stanley also believes the rate of change in terms of year-on-year inflation is peaking. While inflation should remain above the Fed's 2% personal consumption expenditure (PCE) target in the next two years, it should normalise from current levels.
Inflation in Europe and Japan is less pronounced, and will undershoot targets for longer, suggesting to the investment bank that any tightening from the European Central Bank and Bank of Japan will be well behind the Fed.
Sectors and styles
Dankse Bank believes we will face ‘twin peaks’ in both inflation and the manufacturing cycle over the coming quarters. This has important implications for performance across assets and within asset classes.
The bank believes this will occur when we move from the current acceleration phase of the business cycle (easy liquidity and lagging job gains, leading to muted wage pressure) to a more mature late cycle phase (central banks start a path of withdrawing liquidity, job markets gain strength and wage pressure builds).
In this latter phase, corporates also face lower growth in revenue. Nonetheless, equities should continue to rise after the peak, assures Danske.
More interestingly, it will likely be a matter of tilting the equity exposure to benefit from the (average) shift in markets, as borne out by a historical analysis performed by the bank. That is, the curve flattens and commodities pause or outright decline. Inflation expectations then co-move with commodities, the US dollar strengthens and liquidity tightens.
Largely, such cross asset moves would be consistent with a tilt to Quality and Technology in styles and sectors. The Value factor would probably underperform jointly with the commodity space.
Russell Investments, on the other hand, still likes the pandemic-recovery trade that favours equities over bonds, Value over the Growth and non-US over US stocks.
The investment advisor believes the inflation spike is mostly transitory, a combination of base effect (from when the Consumer Price Index fell during the initial lockdown last year), and temporary supply bottlenecks. It’s thought it will take until the middle of 2022 for the US economy to recover the lost output from the lockdowns and longer in other economies. Broad-based inflation pressures are unlikely until then.
Alternatively, Citi strategists think the recent pull-back in bond yields will prove temporary and they still expect the ten-year US Treasury yield to hit 2.0% into 2022, as the economic recovery gathers momentum and markets contemplate Fed tightening.
Rising yields are usually accompanied by cyclical sector outperformance, especially Financials. Technology-related stocks are also expected to hold their own if real yields stay low.
Finally, Morgan Stanley recommends investors begin to blend Value with Quality, particularly in the US and Europe, as this blended approach tends to outperform in the mid-cycle phase.
In particular, there’s a preference for Quality stocks with relatively more stable earnings along with reasonably priced Growth stocks. These both offer dependable performance in mid-cycle transitions.
In this regard, the investment bank prefers international (and Australian) healthcare stocks as opposed to technology stocks for which valuations remain rich.
Timing of tapering
Morgan Stanley expects the Fed to wait until the September FOMC meeting to signal its intention to taper asset purchases, whilst formally announcing tapering in March 2022.
The investment bank forecasts tapering to then start from April 2022 and rate hikes are likely to begin in the third quarter of 2023. This will occur after the inflation rate has been sustained at or above 2% for some time and the labour market has reached maximum employment. These moves to normalise policy are expected to come at a later stage in the recovery compared to previous cycles.
As long as the Fed retains balance sheet expansion, technical corrections in the market (not related to a downgrade in the macro outlook) will likely be bought as investors believe the “Fed put option” remains. This term encapsulates the widespread belief that the Fed will always rescue the economy and financial markets.
Morgan Stanley believes the Fed is very cognisant of how tapering impacted markets in 2013, and will do so in such a way as to avoid too much turbulence. Risk assets could become volatile temporarily on the announcement of tapering, but it's not seen as having a long-lasting impact. The Fed is only expected to proceed once inflation and growth have sufficient momentum to allow a change in policy.
Citi expects an announcement this September of -$15bn/month worth of tapering (from US$120bn/m), to start in December this year, five months earlier than the April date envisaged by Morgan Stanley. The first US rate hike is expected by Citi in December 2022.
While Morgan Stanley’s base case remains a moderate overshoot of inflation, their economists see a very real risk that inflation could enter the acceleration phase, (i.e. threaten to breach 2.5%, the Fed’s implicit tolerance threshold, from the second half of 2022).
This would likely be driven by higher wage costs. This could play out either from a faster-than-expected job market improvement or uncertainty around the natural rate of unemployment. It’s conceivable that the natural rate of unemployment has risen and sits higher than commonly perceived.
A shorter timeline of the current labour market recovery may not give workers enough time to be re-skilled and reallocated across industries. This is especially the case if the structural shifts in the labour market persist due to the pandemic. This would mean that a lower decline in unemployment would be needed to start generating noticeable wage inflation.
The combination of a neutral short-term/positive long-term view leads Morgan Stanley to continue to recommend a mild overweight to risk assets. The style preference shifts somewhat towards Quality as the cycle matures but a preference remains for Value over Growth, and overweight sectors and countries most levered to reflation on a longer-term view.
Earnings growth is expected to continue, but at a much slower pace. Valuations will also remain elevated, particularly in the US. However, risk premiums (the amount by which the return of a risky asset is expected to outperform the known return on a risk-free asset) remains relatively appealing. This is even more so now that the investment bank expects a limited rise in bond yields moving forward and cash rates are expected to remain steady for a sustained period.
Morgan Stanley considers tapering in US monetary policy as the key trigger for a correction in the short term, particularly given current elevated valuations and artificially low bond yields.
Nevertheless, with substantial cash sitting on the sidelines and a positive macro outlook, it’s believed this could potentially create a good opportunity for investors to add to equities in the medium to longer term.
Russell Investments believes global equities remain expensive, with the very expensive US market offsetting better value elsewhere. While sentiment is close to overbought, it is not near dangerous levels of euphoria. The strong cycle delivers a preference for equities over bonds for at least the next 12 months, despite expensive valuations.
Financial stocks are the largest sector in the MSCI World Value Index, and these should benefit from further yield-curve steepening, which boosts the profitability of banks. Russell expects long-term interest rates will have modest upside over the next few months as global growth continues to improve.
In terms of regions, Morgan Stanley believes the US market will likely lag in the second half of the year. The 'strong winds' of the economic recovery will create risks to margins, tax policy and high valuations.
Europe and Japan are expected to perform better, with still-strong earnings growth, less extreme valuations and less risk associated with a “hotter economy”.
Emerging markets (EM) equities sit somewhere in the middle of Morgan Stanley’s scenarios for the US (earnings growth, but at a slower pace) and Europe and Japan (still-strong earnings growth with less extreme valuations than the US).
EM equities have been laggards so far this year and Russell Investments believes they have been held back by the high weighting toward technology stocks in the emerging markets benchmark.
Additionally, there have been concerns about slowing credit growth in China and the slow rollout of covid-19 vaccines across some regions has contributed. It’s believed this should start to reverse later in the year as Chinese credit growth stabilises and vaccines become more available across emerging markets.
Citi suggests the shift towards ESG strategies is structural, and this favours Growth over Value and Europe over EM equities.
ESG inputs are becoming increasingly important for equity fund managers. Flows into ESG-focused funds are increasing and right now it is the most important theme for European equities, and becoming more important elsewhere.
Australian economy and the sharemarket
Morningstar notes the Australian economy continues to exhibit solid growth, and there are now more people employed than before the covid-19 outbreak. The slow vaccine rollout is expected to ramp up, and early signs of this are more evident following the recent lockdowns.
The RBA has maintained its accommodative stance and the investment management firm believes it will continue the quantitative easing program until the Fed begins to taper. Hence, a rise in the cash rate is still considered some way away.
The Australian economic recovery is reflected in the rapidly improving unemployment rate. It fell to 5.1% in May, its lowest level since December 2019. This is despite the federal government’s JobKeeper scheme ending in March. Unemployment is already below the Federal Budget forecasts, released in May, which envisaged an unemployment rate of 5.5% for the June 2021 quarter.
The equity market as a whole currently looks overvalued, according to Morningstar, and investors should be particularly selective when investing new capital. Nonetheless, Morningstar makes several sector and individual stock suggestions (below).
Australian equities also look fairly expensive to Citi though the ASX200 is expected to reach 7,700 by mid-2022, 4.6% above current levels.
Economists at the investment bank have upgraded their GDP growth forecasts for Australia by 1.3 percentage points (ppt) to 5.6% in 2021 and by 0.7ppt to 3.2% in 2022. The upgrades reflect strong growth in domestic demand, which has offset weaker net-exports.
With less than 6% of the population fully vaccinated, Australia lags other advanced economies and remains vulnerable to future outbreaks. Notwithstanding these risks, fundamental factors are considered supportive of continued domestic growth, particularly from household and housing-exposed sectors. The investment bank also likes the Resources sector, which should be supported by commodity prices remaining higher.
With limited upside for the ASX200, Morgan Stanley feels there is more value in rotation. Similar to international equities, this means retaining leverage to mid-cycle expansion whilst embracing Quality as a hedge to later cycle risks that attach to rising inflation and higher yields.
Australian sectors and stocks
Longer-term, as the cash rate increases, Morningstar expects the banks to reprice loan books and generate attractive returns on equity. Westpac ((WBC)) is the only major bank still estimated to be trading below fair value. While the earnings outlook is more volatile, general insurers such as Suncorp Group ((SUN)) and Insurance Australia Group ((IAG)) still appear undervalued despite being strong performers in the June quarter. Magellan Financial Group ((MFG)) and Challenger ((CGF)) also are considered to look attractive at current prices.
Pure-play BNPL firms will cede share as the banks fight back. Most could see slimmer margins and higher bad debts in time, having to boost marketing, loosen lending standards, and trim fees. Consensus is ignoring their capital intensity and cost demands, which will likely result in a de-rating if these hefty expectations aren’t met, explains Morningstar.
Chemical firms, including Incitec Pivot ((IPL)), Nufarm ((NUF)) and Orica ((ORI)) are considered -21% undervalued on average. For Orica and Incitec Pivot, global mining volumes are expected to improve as the covid-19-related restrictions on supply ease. For Nufarm, margins are expected to improve as headwinds from raw materials costs, weather effects and covid-19-related restrictions ease.
In what is an overvalued sector generally, Newcrest Mining ((NCM)) remains one of the better-value picks, trading at just over a -10% discount to Morningstar’s fair value estimate. This is considered to reflect market concerns around the outlook for gold as the world recovers from covid, which has the potential to reduce gold’s appeal as a safe haven asset. In addition, the spectre of inflation could increase the opportunity cost to hold gold and lessen its relative appeal. The company has also faced production challenges at Lihir and imminent grade decline at Cadia. However, the assets are considered to remain much better than average.
The investment manager continues to see limited buying opportunities in Healthcare, with approximately 70% of stocks under coverage seen as overvalued. Avita Medical ((AVH)) remains one of the favoured picks in the sector.
The June quarter technology stock rebound only made the overvalued sector even more expensive, in Morningstar’s view. Computershare ((CPU)) rose 15% on no news yet remains relatively cheap. Link Administration ((LNK)) tracked sideways during the quarter, despite positive pricing for the Pexa Group ((PXA)) IPO and remains the cheapest stock in the sector.
Technology One ((TNE)), with a long track record of profitability and franked dividends, is the new Morningstar top pick for the sector. The company is often unfairly perceived as "old tech". Its share price tends to be inversely correlated with movements in "new tech" names, despite its rapid transition to a "new tech" SaaS business model.
The ongoing Chinese intervention to curb commodity prices is expected to have only a temporary effect and Citi is bullish on commodity demand as the global recovery pushes on.
All-time high free cash flow, de-geared balance sheets and ever-increasing ESG pressures against growth have meant very high shareholder returns in the sector. We are reminded that most of the metals are enablers of the energy transition and will benefit from it.
However, JP Morgan is much less constructive on the price outlook for industrial metals. China accounts for 55-60% of base metals end-use demand, and the country’s credit cycle has peaked, supporting a bearish bias for base metals over the course of 2021.
The Agricultural outlook remains bright, according to Citi, supported by rising grain prices and higher fertiliser pricing compared to last season.
Morgan Stanley’s strategists believe current commodity share prices are overshooting fair value, though is looking for a better opportunity to sell, focusing instead on relative value. Here, aluminium and copper are favoured over nickel and zinc.
The commodities team forecasts a lower iron ore price through the second half of 2021 as market tightness recedes, due to slowing property and infrastructure demand in China. Also, it’s expected that monetary tightening will likely start weighing on prices in the months ahead.
A neutral view on oil is maintained, with Brent to remain in the US$65-70/bbl range as demand recovery accelerates while OPEC supply remains constrained. JP Morgan, on the other hand, predicts oil prices are set to break US$80/bbl in the second half on strong demand.
Morgan Stanley remains negative on gold, with prices likely to drift lower as real yields are expected to bottom out, with the risk of a sharper sell-off in 2022 as the trend accelerates.
Meanwhile, Dankse Bank is forecasting that metal prices will be broadly stable over the next six months, as the decline in manufacturing momentum will ease demand for metals, in line with historical patterns. This time around, the cooling of the Chinese business cycle is set to underpin these patterns, as the slowdown is driven mostly by commodity-intensive sectors such as construction and infrastructure.
Credit and government bonds
As long as recession risks are low, Dankse Bank sees a rather benign environment for credit, as the low-yield environment drives a hunt for yield.
For government bonds, the bank expects a catch-up in US jobs growth and looks for US ten-year treasury yields to rise to 2% by year-end.
Government bonds are expensive in Russell Investments’ view, and yields should come under upward pressure as output gaps close and central banks look to taper back asset purchases.
The global investments solutions firm expects the US ten-year Treasury yield to trade in a range of 1.5%-2.0% range over the second half of the year.
High yield and investment grade credit are considered expensive on a spread basis yet benefit from a positive cycle view that supports corporate profits growth and keeps default rates low.
Credit as an asset class has had an outstanding run to date, and Morgan Stanley sees limited value left. While moving to underweight on investment grade credit, the investment manager still likes the sub-investment grade segment (loans in particular) given the lower duration, higher yield and low default rates.
As a general statement Russell Investments thinks Australian government bond rates will largely track the US, given the RBA’s quantitative easing program and focus on the exchange rate.
Morgan Stanley expects a modest yet fairly broad-based US dollar strength over the next 12 months, bringing the US dollar index (DXY) from the bottom to the top of the around 5% range it's been trading in since mid-2020.
As Fed normalisation is signalled and US policy divergence is underscored versus the rest of the world, the US dollar should gradually move higher, with the DXY potentially reaching 93 by mid-2022.
JP Morgan agrees and suggests staying long the US dollar versus other reserve currencies, as the Fed’s hawkish pivot is seen as bullish.
The Australian dollar will be around US$0.75 by mid-2022, according to Morgan Stanley, as RBA dovishness will increasingly contrast with other central banks that will have begun to normalise.
The normalisation in iron ore prices will be a headwind as well, though the interest rate differential will likely play a greater role in the currency price.
Russell Investments notes the US dollar typically gains during global downturns and declines in the recovery phase, and hence takes the opposite stance to Morgan Stanley on the currency’s trajectory. The main beneficiary is likely to be the euro, which is still undervalued. British sterling and the economically sensitive commodity currencies (the Australian dollar, New Zealand dollar and the Canadian dollar) are expected to climb further, although these currencies are no longer considered undervalued from a longer-term perspective.
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