Rudi’s View: Australia’s Share Market Sweet Spot

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 | Oct 28 2021

In this week's Weekly Insights:

-We Are All Worried
-Australia's Share Market Sweet Spot
-Conviction Calls
-What Works In Australia?

By Rudi Filapek-Vandyck, Editor FNArena

We Are All Worried

Confused? Well, you should be.

Investors, central bankers, business leaders, economists, politicians, and consumers, not to forget the many experts and market commentators on Twitter and elsewhere across social media; all are struggling to see what is really going on in a world full of contrasts and contradictions.

At its core lives a global economy that is far from 'normal' given the extraordinary context of a global pandemic and the re-opening of societies and country borders but still supported by extraordinary central bank largesse. Yet, central bankers are once again looking at winding down their accommodative policies at a time when global economic momentum is deflating.

Add share markets near all-time peak valuations and this process by definition will be a tricky one to pull off without triggering market anxiety, or worse; the threat of a good old fashioned asset market meltdown.

We've had a few of such moments in the recent past. September-December 2018 is most comparable to today's situation. In case anyone needs reminding: US indices tanked by -20% over those four months and only stopped falling once the Federal Reserve declared it understood the market's message, and stopped tightening through higher interest rates.

Today's central bankers' dilemma looks slightly different, because the focus is on 'inflation' -sticky or transitory- but other factors are eerily similar; asset valuations are high, economic growth is decelerating and central banks want to migrate to a less accommodative policy-setting.

The valuation gap inside equity markets is similar too. Growth and Quality are trading at a sizeable premium to cyclicals/Value, even as banks and energy stocks have performed strongly. Back in 2018, as the likes of Altium ((ALU)), CSL ((CSL)) and Afterpay ((APT)) started to sell off, the schadenfreude among your typical value-investors didn't last long with banks, miners and other laggards soon following suit.

The set-up three years later is equally as confusing: historically, when global growth slows noticeably markets are usually quick in pricing in the commensurate decline in demand for energy and commodities. This time around, however, inflation and higher bond yields are in focus and thus the general expectation is that energy producers and banks should take the lead in guiding indices higher.

At least widespread concerns about disappointing market updates from listed businesses, both domestically and in the USA, have thus far proved unfounded, or at the very least premature.

But earnings estimates are still falling, both in Australia and on Wall Street, providing an additional headwind for markets looking for answers and direction. Providing offset is the true avalanche in M&A deals that has descended upon the ASX (though, equally, this also involves a large number of failed attempts and aborted agreements).

Inflation Is The Concern

After more than a decade of subdued, benign inflation the possibility of a reversal in trend is now increasingly on investors' mind, and it scares many.

Look no further than this month's Global Fund Manager survey by Bank of America as back-up for that observation with the survey suggesting the overall mood among large institutional investors has not been this cautious since October last year, with average cash held jumping to the highest level in twelve months.

Portfolios have been rotating into energy and bank stocks in defiance of reduced optimism about growth next year, as general discomfort about the potential outlook for inflation has grown, and is probably still growing. Hence, overall allocation to bonds has slumped to an all-time low, while exposure to equities, US equities in particular, remains high by historical standards.

Banks are now the number one sector owned globally, followed by healthcare, with energy stocks third.

Observe The Gap

There are plenty of doom and gloom forecasters out there, alongside many (hyper)inflation fashionistas, but it's still worth pointing out this debate is far from settled (and it won't be for many more months). Of even more importance, I suggest, is the fact that implications from current market moves seem yet another case of too eager, too quick, too aggressive, and too soon.

Take the current situation in Australia, where government bonds have moved a lot quicker, and farther than comparables in the US (some say because of the first rate hike delivered by the RBNZ across the Tasman). This has now resulted in the local bond market essentially being priced for the first RBA rate hike by May next year, or approximately seven months from today.

In contrast, RBA messaging to markets has remained undeterred: no rate hikes before 2024.

Of course, markets will always try to test central bankers' confidence and speculate on a change in outlook, possibly forced by inflation deflating much slower than expected, but May next year, seriously?

The teams of economists producing forecasts at the Big Four banks in Australia are currently divided on the issue. ANZ Bank and National Australia Bank are still on par with the RBA's official forecast (2024, not sooner) while CBA and Westpac are projecting the first hike in the first half of 2023.

Most other forecasters sit somewhere in between. Citi, for example, sees the RBA in action from the third quarter of 2023 onwards. Virtually no one is on par with the local bond market. The situation is not that dissimilar in the US.

One should never try to be too clever in making predictions that are too far out still to be vindicated or proven inaccurate, but I think the current set-up once again smacks of fear and discomfort guiding market moves; government bonds most likely are priced too aggressively for what will plausibly unfold over the year(s) ahead.

As a matter of fact, I could easily string a story together that firmly suggests inflation already is losing strength as the impact from re-openings is evaporating against a downward trend in global economic momentum. All I would have to do is cherry-pick market signals and pieces of data, similar to what most inflation advocates are doing today.

My worry today is different from the media headlines and the many opinions and declarations on social media: my concern is this global fixation on never-ending inflation might be seducing central bankers into tightening prematurely, only to discover the economy is not half as healthy as projected.

Such an outcome, I believe, would be quite devastating for equities and commodities.

Meanwhile, the market is trying to figure out what scenarios are possible and which ones are the most viable. I know this sounds like the ultimate platitude but I think the sole certainty for the time being is there is none, and this usually means a lot more volatility is on the horizon.

Australia's Share Market Sweet Spot

The problem with an international best-seller such as James O'Shaughnessy's What Works On Wall Street is a reader in Australia can wrestle his/her way through the nearly 700 pages of fine print, charts and tables and still be left with that one crucial question: how much of all this actually works on the ASX?

Hence why my online presentation to members of the Ballarat chapter of the Australian Shareholders Association (ASA) last week was titled: What Works In Australia?

As per usual, slides of the presentation are available via the Special Reports section on the website, while the video is available via the website (FNArena Talks) and on YouTube (see also further below).

One of the key observations I highlighted is there is a sweet spot on the Australian share market, and it is situated in the second half of the ASX100; in other words: the group of stocks numbered 51-100 has traditionally crowned itself as the basket of outperformers on the ASX.

The presentation also made me realise it had been a long while since I reminded readers of Weekly Insights about this -research based- point of local knowledge, hereby corrected!

So which stocks are responsible for this segment to crown itself the best performing in Australia post-GFC?

My first suggestion would be ResMed ((RMD)). The stock has recently been elevated into the ASX50, but its steady climb through the ranks of Australia's sub-top in terms of market capitalisation automatically implies ResMed's relative outperformance has been a major contributor.

I remain of the view ResMed's longer-term growth story is far from finished, but, alas, further outperformance from here onwards will no longer be contributing to the overall performance of the ASX's sweet spot. There are, of course, fifty other stocks that still make up the best hunting ground on the stock exchange, and among these one finds plenty of growth and potential:

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