Rudi's View | Jul 07 2022
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-Are We There Yet?
-Asset Classes Over The Decades
By Rudi Filapek-Vandyck, Editor FNArena
Are We There Yet?
Bank of America Securities Chief Investment Strategist Michael Hartnett put it as follows when the June results of the global fund manager survey were released mid last month:
"…history is no guide to future performance but if it were, today's bear market would end on Oct 19th 2022 with the S&P 500 at 3000".
On Friday, the S&P500 closed at 3825.33 – 21.5% above the suggested bottom.
Of course, history is not a perfect guide and sometimes it is no useful guide at all. Besides, when it comes to humans, patience is not our biggest virtue, especially not when share prices already are down -35%, -50%, -75%, and more!
May was a pretty lousy month for Australian equities, but June was simply heart wrenching, making sure the average portfolio is now down compared with twelve months ago. So surely, markets must be approaching The Bottom, yes? (Let's ignore BofA and history for a moment).
For what it's worth, it is my observation the more defensive, Quality stalwarts on the ASX are showing early signals of what might well turn out to be an embryonic bottoming trajectory on price charts; look up CSL ((CSL)), for example, or ResMed ((RMD)), but this doesn't tell us anything about where inflation is heading, or bond yields, or corporate margins and profits in general.
And those items, rather than today's share prices, will determine the low and the future of local and global equities.
There are multiple signs that inflation might soon stop rising. Look at the price of copper, for example. And bond yields are retreating as the focus shifts to the rising probability for a US and even a global recession, possibly ex-Australia, over the year ahead. But central banks are still tightening.
The latter is important. History shows, the Wall Street Journal reported two weeks ago, markets don't find a bottom until there's no more tightening and central bankers start preparing for rate cuts instead.
Within this context, I find the latest change of heart by strategists at stockbroker Morgans quite telling.
"We think the rises in global government bond yields and falls in equity prices have further to run", strategists Andrew Tang and Tom Sartor revealed in their latest update, "Government bond yields have typically peaked shortly before the end of central bank tightening cycles and we expect most major central banks to continue hiking rates over the next 12 months."
Unsurprisingly, both strategists see more downside potential over the months ahead -quite the opposite of The Bottom- as the combination of high inflation, high bond yields, still tightening central banks and slowing economic growth firmly keeps risks to the downside.
The good news is that as this scenario plays out, the end of tightening might ultimately not be that far off. At some point over the coming months, financial markets will sniff out that the Federal Reserve no longer has much more tightening to do, and that realisation most likely will allow markets to front-run (so to speak) the change in central bank policies.
Morgans refers to "later this year". Others, including Morgan Stanley strategist Mike Wilson suggest The Bottom might happen in the fourth quarter of 2022.
The second key dynamic that is weighing upon equities this year is the widespread anticipation that corporate profits will not keep up with present forecasts, and thus expectations need to be lowered in the form of cuts to consensus estimates (see also further below).
Again, history suggests, this is a process vital for equity markets to find a bottom and prepare for the next bull market. But history also shows this is a multi-month process.
A few snippets from a recent report by Morgan Stanley:
-equity markets tend to bottom on average 2-3 weeks before the consensus earnings revision ratio troughs;
-the average time taken between the date of the first move into negative earnings revisions and the trough in revisions (i.e. maximum downgrades) is 7-8 months;
-the quickest transition recorded thus far still required approximately 3 months
"Given that earnings revisions for MSCI Europe currently remain positive, this timetable would imply that we are still a few months away from a likely bottom in equity indices."
I'd argue what applies to Europe, equally applies to Australia and the USA.
Of course, none of this will prevent the industry from embracing the next calls that The Bottom is in. And again. And yes, again. Until it -finally- happens.
Don't be impatient. Make sure the recession, real or mild or otherwise, doesn't evaporate your capital.
More Weekly Insights to read:
-Balancing Between Opportunity & Risks: https://www.fnarena.com/index.php/2022/06/30/rudis-view-balancing-between-opportunity-risks/
-Not the Bottom, Not The End: https://www.fnarena.com/index.php/2022/06/23/rudis-view-not-the-bottom-not-the-end/
-Double Your Protection: https://www.fnarena.com/index.php/2022/03/17/rudis-view-double-your-protection/
This is no longer an audacious, left-of-centre view, but analysts forecasts seem too rosy and a reset needs to occur.
This reset, ultimately, will determine how much 'value' is genuinely on offer in equities, at least for the next 12-18 months.
So how much of a reduction should investors -realistically- prepare for?
The magic number, it appears, is -20%. In recent weeks market strategists both in the US and locally have mentioned the number as a good reference point for how much of a general reset needs to occur in the months ahead.
Investors should note that when the likes of Morgan Stanley strategist Mike Wilson and UBS's Richard Schellbach mention this number, they do not include a severe, long-lasting recession in their forward modeling. Hence theirs is not a worst case scenario.
Why are forecasts too high?
In simple terms: the general context has changed. Companies have emerged from covid re-openings with strong (or strongly recovering) demand, cycle-high profit margins, and cheap operating and financing costs; and all that is now changing, including the threat of a fall in consumer spending as housing markets are deflating.
Offsetting this negative outlook are UBS's observations that Return on Equity (ROE) for Australian companies doesn't look stretched, while earnings in general do not look out of line with long-term trends and corporate balance sheets, in general, are sound. Not everyone would back the same statements regarding US companies, but we'll soon witness Q2 report releases and the market's responses to them.
In Australia, despite the rather dour outlook, also given energy is still on a roll and banks might yet surprise to the upside in the short-term, UBS is still projecting the ASX200 to finish 2022 at around 7000, implying there remains potential for a small positive return over the next six months, though the calendar year as a whole would stay in the negative.
Assuming UBS's assessment won't be too far off from reality, the ASX200 will be positively carried by the Energy sector and by Consumer Staples on respectively elevated inflation readings and high visibility and stability in earnings. Just like virtually everybody else, UBS is shying away from Consumer Discretionary companies.
UBS's motivation for the latter: "we are not inclined to fight what looks like a vicious earnings downgrade cycle hitting the sector".
What we can tell from UBS's assessment is this won't necessarily be a quick process (the broker is anticipating six months of downward reductions to forecasts) and -equally important- some sectors and companies will be impacted much harder than others. Apart from Consumer Discretionary, UBS doesn't like Healthcare or Real Estate.
The analysts also believe low expectations for Australian banks seem appropriate.
In portfolio terms, as well as from the angle of positive earnings momentum, UBS still very much likes miners and energy producers with the added caveat that both sectors can turn around quickly if/when/as the market turns its attention towards an economic hard landing scenario.
One of the complicating matters for investors today is share prices have already fallen, and by quite a lot for those sectors potentially under threat of a housing downturn. See, for example, shares in James Hardie ((JHX)) and Reece ((REH)), but also REA Group ((REA)), Westpac ((WBC)) and Australian Finance Group ((AFG)), to name but a few.
However, the sector that -by far- has suffered most outside of small cap technology stocks concerns Discretionary Retailers and other consumer-oriented companies, including Breville Group ((BRG)), Wesfarmers ((WES)) and Bapcor ((BAP)). BNPL stocks have pretty much been decimated.
Shares in Tyro Payments ((TYR)) have lost -64% over the past three months, and -84% from June last year. EML Payments ((EML)) shares have sunk -57% in three months. Temple & Webster ((TPW)) shares are refusing to sink below $3 this month. In September last year they touched $14.
The obvious question that arises here is how much worse can the news become so that these share prices are not yet an opportunity for investors willing to look through day-to-day volatility?
Retail sector analysts at Citi had exactly that same question on their minds when reviewing their inhouse projections ahead of the upcoming August results season recently.
Their view remains that while Australian households are facing increasing cost of living pressures, those same households are also well-positioned to cope with and adjust to the tougher environment as mortgage burdens increase and petrol and weekly shopping become more expensive.
The Citi analysts would tend to agree that, maybe, whatever lays ahead in terms of operational headwinds, it's already in the price for most discretionary retailers. But there must be enough uncertainty still, as not every consumer stock under coverage is rated a Buy.
Those who are currenly Buy-rated at Citi are: Coles Group ((COL)), Woolworths ((WOW)) and Super Retail ((SUL)), as well as Harvey Norman ((HVN)), Beacon Lighting ((BLX)) and Nick Scali ((NCK)), and also Premier Investments ((PMV)), City Chic Collective ((CCX)), Lovisa Holdings ((LOV)), and Michael Hill International ((MHJ)).
As the momentum for local housing has only recently started to turn, and with economists projecting 2023 will be the year Australian property prices will suffer a big step backwards, it might be a while yet before investors can comfortably say that all the possible negatives have been accounted for through lower share prices for these companies.
It remains yet an open question as to how investors in general might treat these stocks if FY22 results in August, as I anticipate, will likely surprise to the upside as the real challenge, next year, still lays ahead?
Over at Shaw and Partners, healthcare analysts Jonathon Higgins and James Bisinella suggest the local healthcare sector is now looking attractive too with the pair in particular highlighting small caps Capitol Health ((CAJ)), Healthia ((HLA)), and Monash IVF ((MVF)).
Meanwhile, the return of heavy rains in NSW suggests there might be more negative news forthcoming from insurers Suncorp Group ((SUN)) and Insurance Australia Group ((IAG)), though investors didn't seem too fazed about it on Monday.
The coming few weeks in particular might prove revealing for investors as some companies will issue an upgrade or downgrade to their prior guidance, while analysts are now looking over their models and projections, wondering what needs to be changed ahead of August, and which share prices look too far out of sync with what is likely to unfold.
Stay tuned. This process of re-alignment with the upcoming economic downturn has hardly just begun, at least as far as profit forecasts are concerned.
More Weekly Insights to read:
-Quo Vadis, Corporate Profits? https://www.fnarena.com/index.php/2022/06/02/rudis-view-quo-vadis-corporate-profits/
-Trend Is Turning For Corporate Profits: https://www.fnarena.com/index.php/2022/05/12/trend-is-turning-for-corporate-profits/
The outlook for oil prices, reports Longview Economics, will be determined by five factors:
-the outlook for Russian oil production;
-how much spare capacity does OPEC have;
-US shale supply growth – how much in 2023 & 2024;
-Iran & Libya (i.e. the ‘wildcards’);
-Oil demand growth (in the context of a global growth slowdown or even a recession).
No surprise thus, with so many variables in play, the market is currently beset with wildly varying and opposing scenarios and investment views.
Longview Economics sees market surpluses building into 2023, meaning lower prices should follow, but ask JP Morgan and the answer is: shares in energy producers offer the best risk/reward proposition in equities, in particular after the recent sharp sell-off.
JP Morgan sees the energy sector improving on Quality, Growth and Income – historically a rare combination. As the sector, globally, is still enjoying exceptionally high free cash flows, JP Morgan believes both investors and the sector itself will be keen to buy the shares post any correction from here.
Energy companies remain underowned by the world's institutional investors, JP Morgan points out, and many are now starting to review their ESG policies. JP Morgan strategists have been Overweight the energy sector since late 2020 and have used the recent sell-off to reiterate their positive conviction for the sector.
The bifurcation in views continues with Citi asset allocators singling out gold, Brent crude oil and the Bloomberg Commodity Index for underperformance to end-2022.
Meanwhile, the heavily Energy and Financials overweighted JP Morgan Model Portfolio clocked off on FY22 with a record financial year performance, outperforming the ASX200 by 480bp. That performance, it turns out, was just as much determined by what was not in the portfolio.
On the portfolio managers' own judgment, the largest benefit came from not owning any shares in Westpac ((WBC)) with the likes of National Australia Bank ((NAB)), QBE Insurance ((QBE)) and Macquarie Group ((MQG)) instead contributing handsomely. In the Technology sector, the absence of Block ((SQ2)) was, simply put, a blessing.
In the Materials sector, Rio Tinto ((RIO)) underperformed, but luckily the portfolio also held Sims ((SGM)), South32 ((S32)) and IGO ((IGO)). The absence of Sydney Airport ((SYD)) cost the portfolio, as did an Overweight allocation to Fletcher Building ((FBU)).
With the end of FY22 approaching, the Model Portfolio made a number of changes:
JB Hi-Fi ((JBH)) has been removed to pull down the Consumer sector to Underweight. Exposure to Woodside Energy ((WDS)) has been increased. Healius ((HLS)) is out, which means exposure to Healthcare is now concentrated in CSL ((CSL)), and a little bit of Ansell ((ANN)).
Elsewhere, Insignia Financial ((IFL)) has tested patience for too long and has now been replaced with Insurance Australia Group ((IAG)). JP Morgan much more prefers insurers anyway. Plus Newcrest Mining ((NCM)) has been replaced with South32. The latter must have been sold down earlier in the year (see portfolio performance comments earlier).
JP Morgan retains one of the most optimistic views on the local share market with its year-end target for the ASX200 of 7800 implying no less than 19% upside potential.
Morgan Stanley's Macro+ Model Portfolio finished FY22 316bp better than the ASX200 with the latter's -6.5% performance over the year marking the index's sixth worst financial year since 1983.
Energy and Untilities proved the big positive drivers, while Financials, Technology and Discretionary were the largest detractors over the past twelve months.
This Model Portfolio currently is Overweighted Resources and Healthcare and Underweighted Banks, Consumer stocks and anything linked to the local housing market.
Tech analysts at Citi have steered their focus towards the upcoming demand and margin challenges for Australia's tech sector as the inhouse view has shifted towards a 50/50 chance for a global recession in the year ahead.
Over at stockbroker Morgans, Andrew Tang and Tom Sartor, responsible for general strategy, have changed their relatively sanguine tune in that the outlook for risk assets, including equities, is now deemed too risky for comfort.
Morgans sees elevated volatility ahead and a real chance equities may only genuinely start bottoming towards the end of the calendar year, assuming inflation by then prints lower numbers and central bank tightening could be near its peak for this cycle.
Morgans' portfolio recommendations have thus shifted to Underweight global equities and Neutral Australian shares, plus a heavily Overweighted allocation to cash.
Morgans' list of Best Ideas for the ASX has been enlarged with the inclusion of AGL Energy ((AGL)) but multiple names have been removed after yet another housekeeping exercise.
Also removed are Atlas Arteria ((ALX)), Hub24 ((HUB)), Volpara Health Technologies ((VHT)), Atomos ((AMS)), and Universal Store Holdings ((UNI)), as well as Namoi Cotton ((NAM)), HealthCo Healthcare & Wellness REIT ((HCW)) and Waypoint REIT ((WPR)).
From Wilsons' strategy update:
"Our base case remains that slower demand (particularly for goods) in concert with an improvement in the global economy’s supply-side should help ease inflationary pressures over the next 6-12 months."
"However, solving the inflation problem with a global recession would still likely result in further downside for stocks, at least in the short-term."
"Normally the equity market does not bottom until the recession has at least started, so “if” we are going into a recession, we doubt the market correction has fully played out."
Market strategists at Macquarie remain in favour of defensive portfolio positioning, stating "We do not think the conditions for a low have been met".
It is the strategists' view that investors should use bear market rallies to reposition portfolios for a potential US recession in early 2023. The inhouse view at Macquarie is that such a recession now has a 60% chance of happening.
Macquarie's research of past precedents has shown that leading into a recession, staples, utilities, healthcare, telecommunications and gold are the best performers while industrials, diversified financials, basic materials and real estate tend to be hit hardest, all else remaining equal.
Following on from analysing the 15 recessions in the US since 1927, Macquarie analysts have identified the following most preferred exposures among ASX100 stocks (all rated Outperform): Coles Group, Endeavour Group ((EDV)), Metcash ((MTS)), Transurban ((TCL)), CSL, Ramsay Health Care ((RHC)), ResMed, Amcor ((AMC)), Orora ((ORA)), Newcrest Mining and Northern Star Resources ((NST)).
Asset Classes Over The Decades
For those scholars who like to study the ins and outs, the swings, as well as the roundabouts: two charts by Atchison that summarise the periods of FY13-FY22 and FY03-FY12.
Observe how in FY22 only commodities and direct property managed to beat inflation, with emerging markets the year's dog in the doldrums.
My latest interview with Peter Switzer:
Research To Download
Independent Investment Research (IIR) on Tribeca Global Natural Resources ((TGF)):
(This story was written on Monday 4th July, 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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