Rudi’s View: Bonds Versus Earnings

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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 | Nov 04 2021

In this week's Weekly Insights:

-Bonds Versus Earnings
-Signal Says Sell, But Don't Sell
-Autumn Has Arrived For Sydney Properties
-Covid Is Changing The World
-Copper: Supercycle With A Twist
-Conviction Calls


By Rudi Filapek-Vandyck, Editor FNArena

Bonds Versus Earnings

As far as historical battles between financial markets and central banks are concerned, the past two weeks have generated a lot of excitement for bond traders locally who had chosen to challenge the RBA's resolve in a global context that saw inflation worries spike, including among the mighty central bankers in countries like Canada, the UK and the USA.

In case readers are not quite familiar with events or with the finer details behind the October bond market massacre (for the many on the wrong side of the trend), the RBA has maintained it won't be raising the official cash rate until 2024. On occasion the central bank puts money where its official target lays through buying Australian government bonds so that the forward yield on those bonds that expire in 2024 remains around the current cash rate of 0.10%.

But local bond traders had been testing the RBA by selling bonds and pushing up the yield. Then all it took was one CPI release that surprised on the upside, pushing core inflation to 2.1% and the central bank's defense of that 0.10% level got pretty much smashed into smithereens.

At one stage the yield on those 3-year government bonds rose to 0.80%, or seven times above the level the central bank had been defending as accurate and appropriate.

Admittedly, it's not quite up there with George Soros breaking the Bank of England's defense of the British Pound back in 1992, a victory that earned Soros' fund a cool $1bn at the time, but the achievement should nevertheless not be underestimated either: the local bond market has forced the RBA explicitly into a change in official monetary policy.

That change has not yet been communicated, but it is tangible and real because the RBA can no longer defend a target of 0.10% when local bonds are suggesting otherwise. This is why the message from Governor Philip Lowe and Co on Melbourne Cup day this year carries a lot more weight than usual.

The real question is, however, whether the RBA's (yet to be communicated) confirmation that plans to lift Australia's cash rate to a more "normal" level on the back of a stronger economy and stronger-for-longer price inflation also signals a change in overall dynamics for the local share market.

Here I can only repeat the view I have been expressing for weeks: the local bond market has overshot, its implied pricing now appears well over the top, way too aggressive.

To put it bluntly: either equities are too sanguine about the way forward for inflation and bond yields, or the bond market will have to calm down and retreat from its newfound trend/momentum.

My allegiance still lays with the second scenario. Plus the recovery for the share market throughout October, including for stocks like Goodman Group ((GMG)), CSL ((CSL)) and TechnologyOne ((TNE)) suggests I am not too far off the mark with my assessment as to how exactly this ongoing battle between the bond market and the RBA will most likely unfold.

As I suggested last week: I'd be flabbergasted if Philip Lowe stands ready to start lifting the official cash rate from mid next year onwards, and then in quick succession proceeds with a series of follow-up hikes by late 2022. More realistic, I think, is assuming the RBA has accepted defeat and might suggest sometime in 2023 looks "plausible", if not "possible".

But let's wait and see, shall we?



The second most important issue at the moment, one that is receiving a lot less attention, is that global economic momentum is slowing. Were this to go on for longer, companies locally and in the USA might find it increasingly difficult to beat or meet expectations. I hope we all realise that equity markets are where they are in 2021 -at or near top-notch valuations- because corporate performances have been nothing but extraordinary, on average, and broadly speaking.

Financial results in Australia post-August have been a lot less supportive, as also proven by Westpac ((WBC)) on Monday, but the AGM season has generated more positive than negative momentum. Plus, it has to be pointed out, strong and solid businesses are still showcasing their nouse and positive operational momentum, including by Home Consortium ((HMC)), Aristocrat Leisure ((ALL)), Charter Hall ((CHC)), Macquarie Group ((MQG)) and yes, even ResMed ((RMD)), though the latter's cautious outlook for the coming two quarters has triggered a reversal in share price momentum.

While investors, and market commentators, tend to be worried about elevated valuations, I think the biggest risk between now and February lays with companies that cannot meet guidance or expectations, especially among smaller cap companies. Last week, Codan ((CDA)) shares fell -18% on weak forward guidance. Control Bionomics ((CBL)) quickly went from 70c to 47c. Shares in Damstra Holdings ((DTC)) closed at 71c on Monday. Two months ago, these were trading at $1.20. One year ago, they were priced above $2.

a2 Milk ((A2M)) shares have fallen, again, and Woolworths ((WOW)) disappointed too. Today, Westpac shares lost more than -7%.

These are but a few examples, but they show investors where true and tangible risk lays. Regime change has arrived. Those shenanigans in the bond market are only part of the story and in my view not even the most important part.


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