Rudi's View | Oct 06 2022
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In this week's Weekly Insights:
-Hope Beyond The Macro-Burden
-Research To Download
By Rudi Filapek-Vandyck, Editor
Hope Beyond The Macro-Burden
The fortunes of bonds and equities remain closely intertwined as inflation remains higher-for-longer while central banks continue tightening.
Year-to-date the S&P500 is down close to -25% but what is rather unusual is the Bloomberg Global Bond Aggregate Index is showing a near-identical -21%.
Embedded investing wisdom is bonds and equities are each other's polar opposites; they're supposed to compensate for the opposite side's losses, but not so in 2022.
The hope is continued central bank tightening will eventually break the uptrend for price inflation, avoiding a repeat of the 1970s, though it may also break the economy and/or the financial system.
Flash backs of 2007-08 are returning to the global investment community as the Bank of England has come to the aid of suffering UK pension funds. On Friday one ABC journalist tweeted a rumour an unnamed international investment bank might be in trouble and the news spread like a wildfire around the world.
Most speculation is pointing at Credit Suisse, or Deutsche Bank. [It was Credit Suisse.]
Investors have been reminded that whenever global GDP decelerates below 3%, bad things tend to happen. (It's forecast to happen next year).
Historically, a too-strong US dollar triggers the same negative impact.
Irrespectively, and contrary to central bankers' apparent confidence, investors didn't really think that winding back all of that extraordinary liquidity stimulus would be a smooth process without any hiccups.
The real issue, and one that is without any doubt on every central bankers' radar, is the shrinking availability of US dollars inside the global financial system.
The world's reserve currency is still the oil that makes the machine run smoothly. Not enough dollars means liquidity dries up and corners of the financial sector start making loud shrieking noises.
Like what just happened in the UK bond market.
The shrinking volume of US dollars (and of USD collateral) is not solely related to Federal Reserve tightening, though hiking rates and shrinking the central bank balance sheet are powerful actions in today's global predicament.
Higher oil prices, higher prices for internationally traded goods, incremental regulatory tightening and the abysmal velocity of money, pushed lower as activity in housing markets slows, are all co-contributors.
While the world needs US dollars to function, it is also directly impacted by the Fed's quest to tame inflation, whether anyone likes it or not. And only one actor has the power to print more dollars and increase the reserve currency's availability: the Federal Reserve.
Yes, you can bet your bottom dollar the Fed is keeping a close eye on what is happening in the UK, and elsewhere.
Analysts at Morgan Stanley have done some calculations in order to gauge how critical the situation is in September 2022.
On their estimates, concentrating on the four largest economies of the USA, China, the eurozone and Japan, USD money supply has shrunk by some -US$4trn from the peak in March, with the year-over-year rate of change now negative for the first time since March 2015.
Morgan Stanley's research concentrated on so-called M2 money, which includes cash, checking deposits and easily-convertible near-money supply. This measure is generally closely watched as an indicator of money supply and future inflation, in particular inside central banks around the world.
Back in 2015, highlights Morgan Stanley, the shrinkage in M2 USD money supply preceded a global manufacturing recession. This time around, suggest the analysts, the tightness is equally unsustainable; "it will lead to intolerable economic and financial stress".
The only one who can "fix" this problem is the Federal Reserve. So logically, the first question that comes to mind is: when is too much stress, too much?
Nobody knows the answer, maybe not even the policymakers at the Fed, but similar as what happened in the UK last week, they will stand ready to reverse course when too much pain threatens the global financial system, as it did on several occasions since the GFC fourteen years ago.
(As a side-remark: a recent update on the Japanese ETF industry by research and consultancy firm ETFGI puts total ownership by the Bank of Japan at 64% as at the end of August. Financial assets and central banks have never been as closely intertwined as they are in the present.)
Is it too early to start speculating on central bankers reversing policies, i.e. the oft speculated about "Fed pivot"?
I think a lot more bad things need to happen before Powell & Co will consider softening their stance on addressing today's inflation problem. Plus in the meantime, or so it appears, the problem of too-high expectations for US corporate profits is showing up through profit warnings and lower-than-expected market updates.
As I suggested two weeks ago: investors seemed too keen to treat FedEx's profit warning as company-specific and eCommerce-related. Now a similar loss in momentum is showing up at Apple, Nike, and elsewhere.
Morgan Stanley: "[…] a Fed pivot, or the anticipation of one, can still lead to sharp rallies. Just keep in mind that the light at the end of the tunnel you might see if that happens is actually the freight train of the oncoming earnings recession that the Fed cannot stop."
For good measure, the Australian share market thus far has remained fairly isolated from the heavy downward pressure wrought upon US bonds and equities this year.
The ASX200 is down only -7.69% from September last year. The S&P index for Australian Fixed Interest lost -12.69% over the period. Admittedly, part of the relative outperformance for ASX equities is the bigger representation of mining and energy companies, while lower inflation and a less aggressive RBA explain the outperformance in local bonds.
Miners and energy companies in particular outperformed during the first six months of the year, but they have since joined the gravity-pull that has weighed upon most financial assets since. Although, specific pockets are still the exception, including coal and lithium.
The Aussie dollar, however, is taking it full on the chin – with consequences that will reverberate throughout the local share market.
How long before investors start realising a stronger USD/weaker AUD is to the benefit of companies including Amcor ((AMC)), Ansell ((ANN)), Aristocrat Leisure ((ALL)), Audinate Group ((AD8)), Breville Group ((BRG)), Cochlear ((COH)), CSL ((CSL)), Incitec Pivot ((IPL)), James Hardie ((JHX)), ResMed ((RMD)), Reliance Worldwide ((RWC)), and Orora ((ORA))?
An extremely savage month of September has pulled down many of these share prices, with general risk aversion, technical selling and portfolio re-adjustments on the back of rising bond yields overwhelming just about everything else. The share market has a habit of ultimately generating the correct outcome, even if in the short term many alternative scenarios are being tried and rejected first.
The present view among forecasters generally is that USD strength will last for longer.
A favourable currency move is obviously only one of the factors in play. Costs in USD can hurt a lot, and so will an economic recession, in particular for those sectors leveraged to growth. Last week's UK development might also turn investor focus on companies that have a relatively large operational presence in post-Brexit and (surely) pre-recession Britain.
Those companies include Ansell, City Chic Collective ((CCX)), Corporate Travel Management ((CTD)), Magellan Financial ((MFG)), Reliance Worldwide, SG Fleet ((SGF)), Webjet ((WEB)), WiseTech Global ((WTC)), and Xero ((XRO)). An observant reader would have picked up a repeat of companies from the list of USD beneficiaries.
New mortgages in the UK are now burdened with a 10%-plus annual interest. Social media platforms are showing demonstrations in the streets. Already, commentators are speculating whether new prime minister Liz Truss will last until Christmas.
Not that continental Europe will necessarily fare better. There are quite a few forecasters around who think Germany is facing a deep and painful economic contraction.
ASX-listed companies with sizeable operational exposure to Europe include Altium ((ALU)), Amcor, Atlas Arteria ((ALX)), Audinate Group, Brambles ((BXB)), Breville Group, Cochlear, CSL, Domino's Pizza ((DMP)), Goodman Group ((GMG)), IDP Education ((IEL)), Lovisa Holdings ((LOV)), Nitro Software ((NTO)), Ramsay Health Care ((RHC)), ResMed, and Sonic Healthcare ((SHL)).
Equally important: the overall loss of liquidity and the threat of a global recession to date has hit smaller cap stocks on the ASX a lot harder. The Small Ordinaries has lost -22.56% over the past twelve months, while the S&P Emerging Companies index lost -18.21%.
History suggests, in the absence of a Lehman Bros-type financial calamity, the Federal Reserve won't stop tightening until the Fed Funds Rate is higher than inflation.
This does not by default imply the Fed will push the cash rate into double figures.
Assuming inflation will start trending downwards, as just about everyone expects it will, the Fed Funds Rate might "only" have to go as high as 4.50% (as rising rates on the way up will cross the rate of inflation falling).
The good news behind this projection is that bond yields will start anticipating the future pause in the Fed hiking rates, and thus peak sooner.
It's probably a fair assumption to make that a peak and subsequent softening in bond yields shall be well-received by equities – all else remaining equal.
Hence, those forecasters fixated on pinning down the next positive reversal for equities have set their timing for the fourth quarter of the calendar year, suggesting 2023 will not arrive until after a good old traditional Santa rally.
If history repeats itself this year, October might present investors both with a new low and the start of a recovery.
Markets will still have to face the downward pressure in corporate profits, but at least the macro-burden will no longer overwhelm everything else.
Strategists at stockbroker Morgans have revised their strategies and asset allocations. Straight from the horse's mouth:
"The global economy is headed for a likely recession, but most major central banks will press on with tightening monetary policy for some time yet as inflation remains uncomfortably high.
"Our targeted approach in equities favours stocks with defensive attributes, pricing power and lower exposure to the economic cycle.
"We currently favour consumer staples, healthcare, and some financials along with select materials/energy exposure.
"The ongoing volatility and market dislocation will present tactical opportunities, so investors are advised to be nimble with their cash holdings."
Morgans has only one recommended asset allocation on significantly overweight and that is cash.
Morgan Stanley: "[…] we continue to recommend an overweight positioning in Australian Healthcare.
"The lower AUDUSD assists sentiment to translation tailwinds and the relative defensive (essential) industry positioning in Europe exposures can alleviate the inevitable economic slowdown in that region.
And firmly entrenched in Quality, the sector can outperform the ASX 200, in our view, as investors shy away from building domestic earnings risks."
Strategists at Shaw and Partners:
"We want to buy companies with strong balance sheets, are well run, have large economic moats and can also be opportunistic should unique opportunities pop up in times of volatility which are often the best times to do M&A."
Shaw also suggests being overweight Australian companies that generate earnings in USD seems but "sensible" and points towards the likes of James Hardie, Amcor, ResMed and CSL.
Is there anything investors should be considering selling? Shaw strategists point towards iron ore.
"We think the outlook is soft for major iron ore producers […] Furthermore, you should also be cautious with cash burners (as opposed to 'cash earners') because in this market cash flow and profitability is king."
And then there's this quote:
"Macquarie commodity strategy team remains bearish on gold and recently downgraded the price forecasts by 5-6% for the coming quarters."
Morgan Stanley has published a global list of most preferred mining equities. The 16 selected names includes five from Australia:
Some of the international selections might equally sound familiar to investors in Australia; Norsk Hydro, Alcoa Corp, Glencore and Teck Resources.
JP Morgan's Model Portfolio in Australia has added more of Telstra ((TLS)), reduced exposure to A-REITs and added Ramsay Health Care.
Ever the bullish voice in an ocean of otherwise cautious, if not wildly bearish views, JP Morgan has set a target for the ASX200 of 7400 by June next year.
While the updated target implies a downgrade from the prior 7800, it also implies significant upside from the circa 6400 the ASX is trading at at the beginning of October.
Over in the USA, JP Morgan strategists continue to argue equities are cheap and are starting to represent "deep value", in particular outside of the US. The added observation is that market positioning is "extremely depressed".
JP Morgan also forecasts crude oil (WTI) will rally during the closing three months of 2022, re-testing US$100/bbl.
Ord Minnett explaining why the broker is cautious on equities, but still likes to keep exposure to energy and mining companies:
"In an inflationary environment we want to hold real assets, including commodities.
"However, if a global recession were to occur, metals demand would fall. The outlier is the possibility that China creates demand through large stimulatory measures.
"On balance, we have a positive bias to materials."
Research To Download
RaaS on Harvest Technology Group ((HTG)):
(This story was written on Monday, 3 October, 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: firstname.lastname@example.org or via the direct messaging system on the website).
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