Rudi's View | Mar 10 2022
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In this week's Weekly Insights:
-Risk Is Tangible, And On The Rise
-Conviction Calls & Post-Reporting Season Notes
By Rudi Filapek-Vandyck, Editor FNArena
Risk Is Tangible, And On The Rise
2022 is not 2008, but there are a number of similarities that deserve to be highlighted, in particular since so many financial market reports this month include observations like "highest price/first time since 2008".
Fourteen years ago the world had a problem inside the financial sector but few knew exactly what was going on, and even fewer people had somewhat of an idea about how things might develop. Equity markets started the new calendar year by selling off, and continued falling for weeks.
In similar fashion to Quality and Growth companies today, nobody wanted to touch banks and other financials back then; after all, we didn't know how bad this problem could become. But resources were considered okay as the Supercycle and stronger-for-longer narratives dominated investors' perception and outlooks.
Energy in particular quickly became too hot to ignore with the price of a barrel of crude doubling in a matter of months, ultimately peaking at US$147/bbl amidst forecasts and projections that oil soon would be priced at US$180/bbl and beyond.
What is different today, and what seemed completely forgotten about back then, is that today investors know full well that if the price of oil rises too far, it will kill off the global economy.
So how high is too far?
Weeks ago, economists and sector analysts had been debating the issue and, on my observation, some kind of a consensus, sort of, had been agreed upon that were oil to rise above US$110-120/bbl, and stay at that level, this would before long start translating into demand destruction and loss of global economic momentum.
But now Ukraine has happened and democracies in Europe and North America are placing sanctions on the Russian aggressor and futures for both WTI and Brent have quickly surged above that range (on Monday, as I am writing this update).
Another way to approach this issue is through the old rule that whenever the price of crude oil doubles in a relatively short time span, the next economic recession will follow. Back in 2008, oil futures took off from circa US$70/bbl and they didn't stop rising until someone had paid US$147.
Two things happened next.
The bubble in investors' exuberance in energy futures and related equities came back to earth relatively quickly. And then, of course, the global recession did arrive but not before China came unstuck and Lehman Bros was allowed to go bankrupt, so nobody made the connection to oil until much, much later.
To add a little extra colour to the situation in mid-2008: shares in Woodside Petroleum ((WPL)) peaked above $70. At no point since have they ever managed to trade even in the vicinity of that price level ever again over the subsequent 14 years.
Today, Brent seems to be closing in on US$130/bbl and Woodside shares, about to fully consume a transformational merger with BHP Petroleum, have barely crossed the $30 mark.
Mind you, there is a bear market gripping global equities and energy stocks, year-to-date, are the only sector in the US trading in the positive in 2022, while in Australia we can also add iron ore, lithium, coal and various base materials for a positive performance.
This time around, oil prices have taken off from a dip towards US$65 in November and they have already traded above US$120/bbl.
I only have to casually watch my Twitter feed for evidence that just about everyone's attention has quickly shifted to energy, gold and industrial materials; because that's where the money is being made this year. However, if there's one lesson to heed from the experience from 14 years ago it is that, ultimately, investor exuberance in commodities digs its own grave.
As they say in Wall Street parlance: the best cure for high commodity prices are… high commodity prices (though not necessarily immediately).
So don't get sucked in by the narratives about buying resources companies as protection against inflation or war-time supply disruptions. Those strategies only work for so long. If the recent February reporting season showed one thing, it was that commodity producers are struggling with higher input prices too.
Ultimately, higher prices for oil, iron, steel, aluminium, plastics, grains, etc will result in demand destruction and lower economic activity. This is why few companies only on the ASX can draw out an enthusiastic bid from investors this month. Higher prices for materials, be they energy-related, agricultural, or otherwise, pretty much affect everyone and every company listed on the ASX.
As they like to say on Wall Street, in good old fashioned sexist prose: Don't get married to those stocks, they're for dating only.
Ultimately, the best protection against inflation are capital-light businesses with a healthy balance sheet, supported by pricing power and plenty of operational cash, just ask Warren Buffett and Charlie Munger, but those businesses are currently being sold as little else appeals outside of commodities.
Many Impacts From Higher Commodity Prices
As far as the many and varied impacts go for what is happening at the macro-economic level in 2022, below are a few snippets from the Economist Intelligence Unit:
-Agricultural commodity prices have been rising through 2021; the war in Ukraine will worsen matters and result in sustained high prices of food commodities. High food prices will bode well for some commodity exporting countries as well as grain traders, but curtail consumer spending power, particularly in poorer countries where food occupies a larger share of the consumption basket.
-Consumer packaged goods companies will face prolonged profitability challenges. The risk of price wars eroding margins will be particularly significant in more fragmented and competitive markets—online sellers will have to shift away from their discount-led strategies faster than expected. We had for some time expected the middle-market segments being squeezed (while premium as well as budget segments do better), as companies compress product lines and focus on high margin brands. Overall, businesses are likely to face increased financial volatility, which might impact investment earmarked for digitalisation or supply chain modernisations. The need to cut costs will result in the closure of stores performing poorly as well as staff layoffs in case of a prolonged conflict in Ukraine.
-Alcoholic beverage makers’ recovery from the pandemic-induced slump in 2022 will be arrested by persistently high input costs, especially for barley and aluminium. In 2021 alcoholic beverage makers had to contend with the demand shocks created by covid-19 variants, while also battling input and logistics prices. Barley, a key ingredient in malted drink, and aluminium, which is essential for making beer cans, have seen their prices shoot up in 2020-21. The current geopolitical turmoil will worsen matters: Russia is the second-largest aluminium producer and the third largest barley exporter in the world; Ukraine is the second-largest barley exporter. The pain will be felt shared across other parts of the beverage industry, beyond brewers. In western markets, soft drink giants have been launching malted drinks and hard seltzers to diversify their offerings beyond sugary drinks. Such efforts may become less rewarding amid sky-high input costs.
All of the above yet again highlights the predicament decision makers at the Federal Reserve are facing this year. It is their intention to start winding down the balance sheet (thus tightening liquidity) and lifting interest rates, potentially in accelerated fashion, at a time when economic momentum is most likely to slow down on the back of war and high energy and commodity prices alone.
Volcker Equals (Deep) Recession
What most concerns me is how Jerome -'Turncoat Jay'- Powell is now presenting himself as a modern day Volcker, the central bankers' hero who killed (high) inflation in the 1980s. What investors should realise is that Volcker stood up to the politicians of his time to inflict a deep economic recession upon America, or two recessions if one wants to be exact about it; 1980 and 1981-82.
As per always, the devil is in the detail with economists projecting the next US rate hike will be 25 basis points, as indicated by Powell last week, but as soon as geopolitical tension subsides, that 50bp hike comes back in focus, together with a rather robust pace in further tightening. What can possibly go wrong, right?
Irrespective of one's strategy or view, we'd rather prefer not to be 100% invested if the Volcker scenario is to be repeated this year or next. And the same applies for the next blow-off top in oil and commodities a la 2008.
Investors should not be blind to the fact the world might well be changing right now in front of our eyes, and negative consequences could be lurking at the next bend in the road. Risks are rising. Worst case scenarios are not the only outcome, but they should be given a higher probability for happening.
I expect the next surveys among institutional investors to reveal average cash levels are rising and I think retail investors should equally direct their focus to capital preservation and limiting losses.
As per always, don't do anything you might come to regret. But equally: don't not do something you will end up regretting later. Money lost is just that: gone. Make sure you can still sleep at night.
Crude Oil Becomes The Global Referee
As far as crude oil goes, we shall all be hoping China buys lots of oil and gas from Russia so that supply is merely re-directed, which should also feed into lower prices over time.
Nevertheless, a change in overall market dynamics seems upon us, and they are longer-lasting, if not permanent from here onwards:
-Western countries, especially Europe, will be biding time in order to sever ties with Russia, which is not possible in the here and now
-Countries will accelerate investments in energy security and the push into EVs and renewables;
-Short-term, this likely translates into a revival for coal
-Accelerated investments are likely on the cards for the oil and gas industry, see first two points above
-Assuming Putin remains in power and Russia a pariah state, Western countries are equally likely to turn their focus to securing other vital minerals and metals, like cobalt, rare earths, lithium, etc
Some experts are suggesting Putin has clearly over-stretched himself and the chances of an internal power-switch in Russia -with Putin either assassinated or overthrown- have risen significantly. Such a solution would be the best outcome possible for everyone who values law and order, and freedom under democratic rules, but how much of this is wishful thinking?
I remember visiting Zimbabwe, twice, and meeting investors who had sunk their capital in the country in anticipation of the old dictator's passing, but he simply wouldn't die and finally was deposed in November 2017. Not sure whether it was worth the wait, to be honest. I'll have to ask them upon my next visit, if they're still in the country.
Charts below: Crude Oil – sharp rallies, sharp reversals (also thanks to Macrotrends) and below that: equity bear market periods are more common than commonly assumed.
Conviction Calls & Post-Reporting Season Notes
Analysts at JP Morgan found February 2022 an uncharacteristically positive reporting season, with "beats" surging to an all-time high on their assessment (FNArena's assessment is slightly different, but we share the positive undercurrent – see also https://www.fnarena.com/index.php/2022/03/07/february-2022-result-season-the-wrap/).
JP Morgan believes staples and REITs crowned themselves local champions in February, generating the most "beats". Nominated as stand-out performers: Coles ((COL)), Woolworths ((WOW)), Charter Hall ((CHC)), Goodman Group ((GMG)), and Dexus ((DXS)).
EPS growth for FY22 has now risen to 13.6%.
The main disappointment, on JP Morgan's numbers, came through via revisions to dividend guidance and projections.
Ironically, when it comes to operational performances, the energy sector was the stand-out underperformer. Luckily, the sector continues to be carried by rising oil and gas prices.
Small and medium cap analysts at Goldman Sachs have revised their forecasts and preferences, including a general assessment of how rising inflation is having an impact across the broker's research universe.
The exercise has led Goldman Sachs to yet again express its preference for long-term structural growth opportunities, while equally directing focus towards strong balance sheets and valuation support.
A few points made by the team:
-food suppliers and discount retailers with long-term fixed price contracts will face margin pressure as they are limited into how much input-inflation can be passed on
-land-lease and retail-e-commerce businesses with strong end market demand should have the greatest ability to pass on cost increases
Preferred businesses thus include: Lifestyle Communities ((LIC)), Temple & Webster ((TPW)), Hipages Group ((HPG)), Omni Bridgeway ((OBL)), APM Human Services International ((APM)), Super Retail ((SUL)), Elders ((ELD)) while other Buy-rated stocks get a mentioning too: Redbubble ((RBL)), Adairs ((ADH)), Costa Group ((CGC)), IDP Education ((IEL)), and Johns Lyng Group ((JLG)).
Macquarie spotted plenty of positives from media, telecom and technology companies throughout the February reporting season. Traditional media operators now have a strong balance sheet, observes the broker, with M&A or share buybacks expected to become positive catalysts for share prices for both Nine Entertainment ((NEC)) and Seven West Media ((SWM)).
A few observations published following a deep dive into the local technology sector by analysts at Wilsons:
-Companies where share prices are arguably not properly reflecting their meaningful organic growth profiles (though there may be company-specific reasons for this, the broker adds): Whispir ((WSP)), Xero ((XRO)), Elmo Software ((ELO)), and Nitro Software ((NTO)).
Analysts at Credit Suisse have used the February performances to reiterate their diversified financials number one preference for Computershare ((CPU)). Potentially even more eyebrow raising is the fact Credit Suisse has become universally positive on local owners and operators of financial platforms with all of Insignia Financial ((IFL)), Hub24 ((HUB)) and Netwealth ((NWL)) now rated Outperform.
Despite asset managers looking "cheap" and trading at deep discounts to their intrinsic valuations, Credit Suisse simply cannot get excited about this sector at this point in time. Credit Suisse foresees further outflows and mark-to-market downgrades. Only two asset managers are currently Outperform-rated; Perpetual ((PPT)) and Pendal Group ((PDL)).
Strategists at stockbroker Morgans found the February reporting season "frustrating"; despite excellent stats and results, most share prices could not muster a sustainable gain.
The broker does believe investors will continue to be rewarded for investing in quality, "which includes mid-to-small cap stocks caught up in macro volatility". Best Ideas from the reporting season include Santos ((STO)), Treasury Wine Estates ((TWE)), Cochlear ((COH)), Lovisa Holdings ((LOV)), Seek, Corporate Travel Management ((CTD)), NextDC, Baby Bunting ((BBY)), Hub24, and GQG Partners ((GQG)).
Morgans' list of Best Ideas among Aussie stocks has now accumulated to 52 inclusions with Challenger ((CGF)), Cochlear, GQG Partners, Healius ((HLS)), Baby Bunting, Ramelius Resources ((RMS)), Dexus Industrial REIT ((DXI)), and IDP Education now added to the list.
US strategists at Citi believe bond yields have done their dough for now, implying the brisk de-rating for Growth stocks in 2022 ends here and now.
Macquarie has returned from the February reporting season with a renewed focus on the re-opening trade, nominating the likes of Qantas ((QAN)), Transurban ((TCL)), Star Entertainment ((SGR)), Dexus ((DXS)), and CSL ((CSL)).
Companies that in February were able to raise guidance and are seen as well-positioned for the months ahead include Charter Hall, Seek, James Hardie ((JHX)), Steadfast Group ((SDF)), NextDC, and Computershare.
As reported previously, the prospect of economies slowing and the Fed set for rate hikes keeps Macquarie more defensive in portfolio allocations. (Think Coles ((COL)) and CSL).
Macquarie's more defensive bias also rules its preferences among engineers and contractors making Ventia Services Group ((VNT)) its current sector favourite.
Retail analysts at Jarden are more positive on companies with pricing power, such as Metcash ((MTS)), Woolworths, Coles, Treasury Wine Estates and Costa Group, category killers (Super Retail) and beneficiaries of a global reopening (Treasury Wine, Super Retail, Accent Group ((AX1)) and Universal Store Holdings ((UNI)).
Healthcare analysts at Macquarie believe the sector mostly reported in-line throughout February, while showcasing it is in good health (pun intended).
Positive surprises were noted from CSL and Cochlear, while Ramsay Health Care ((RHC)) upped costs guidance (negative).
Healthcare analysts at Credit Suisse believe the sector managed to surprise on the upside, with the key exception of Ansell ((ANN)).
Credit Suisse's sector picks are ResMed, Cochlear, Ebos Group ((EBO)), and APM Human Services International.
(This story was written on Tuesday 7th March, 2022. 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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