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It is an unfortunate, yet widely accepted maxim that good news doesn't sell newspapers. However, as we reflect on the end of another twelve months that leaves us wanting to see the word "unprecedented" banned from the dictionary, we find ourselves feeling optimistic. Household and corporate balance sheets are in great shape, helped along by international border closures. Australians spend $65b a year overseas, and that money is now trapped in our local economy. While we lose out on the $45b we typically bring in from tourists annually, these imported tourist dollars tend to find their way only into very targeted parts of the economy; such as, the travel, tourism, and hotel sectors. By contrast, trapped locals are spending widely across the economy and saving too: we're seeing it in record deposit levels for the banks, in booming retail spend, rebounding new car sales and record used car prices. It's becoming clear that international borders are likely to remain shut for a while yet, so we expect this strength to continue.

The economic backdrop is further supported by rising house and record iron ore prices. Put simply, the Australian economy is in the best shape it's been in years. Further, we've managed the pandemic better than other countries, yet the performance of our stock market has lagged, only recently exceeding pre-pandemic highs. As per below, in October our market was one of the worst-performing major markets, despite our economy being one of the most resilient in the world. We made the case six months ago that the Australian market looked like good value in a relative sense, and the subsequent 10% rally likely reflects that.

 

            

Source: MST Marquee

Risks to the outlook

1. Inflation

So where to now? The first potential fly in the ointment is always interest rates, given the price of money sets the price of every asset class globally. The main debate raging in markets right now is about inflation. With inflation numbers rebounding off last year's global economic decimation, the debate is over whether it is likely to be transitory (a one-off bump as supply chains normalise post-Covid) or structural (a multi-year demand unleashed and things get out of hand). We are certain that we will see an uptick in the near term in inflation; most of the companies we talk to are calling out pretty significant raw material and labour market inflation, and a desire to pass this through in terms of price increases. So it is definitely underway.

As for what happens after that - exact corollaries in history are impossible to find, but we see two possible precedents:

Is it an echo of the December quarter 2018, when the Fed was raising rates in response to a dramatic uptick in global input costs and associated inflation, only to reverse course (within a few months) as inflation faded due to the immediate demand destruction response? i.e. a short-lived blip?

OR

Is it an echo of the 1970s, when raw material spikes fed into a wage-price spiral that got out of hand for a decade?

 

Obviously if it is more like the latter scenario, every asset globally is overvalued. However, a few things lead us away from thinking scenario two is likely. Firstly, the 1970s was an era with a lot of directly inflation-indexed wages, which added to the feedback loops that saw raw materials spikes driving a wages/prices spiral. Secondly, debt is a very deflationary force, and the world has a lot more debt now than the 1970s. The increase in global debt levels increases the sensitivity of debt-holders (which include most homeowners) to increases in interest rates. So you get a demand response very quickly when you increase rates, which is what we saw in 2018.

In Australia, we see monetary policy settings stuck in emergency mode, when there is no (economic) emergency. Anyone who's attended an auction recently can tell you interest rates are too low. This will need to be addressed over the next few years; however, in our view, one or two rate rises would likely dampen demand enough to have the desired effect. We do not think we'll see cash rates heading back towards 3% (which would be very bad for equity markets).

So we lean towards thinking structural inflation is a tail risk for portfolios, rather than a base case. In all fairness, this has been the "consensus" view for the last six months, but we note a subtle shift is taking place, with more and more voices leaning towards scenario two. So we think the market is beginning to worry about a more extreme inflationary scenario, which could throw up opportunities.

2. China

The other tail-risk for markets is the worsening diplomatic relationship between Australia and China. We've avoided exposure to companies that generate the bulk of their revenue in the Chinese market. Where we remain vulnerable in our portfolio is through our position in resource companies such as BHP and Mineral Resources. We can't rule out trade disputes spilling into iron ore, however unlikely; mining participants warn us they believe China is willing to "shoot itself in the foot to hurt Australia". In order to mitigate this risk, we invest only in mining companies with diversified earnings (not solely iron ore), and rock solid balance sheets: Mineral Resources is net cash, and BHP should end this year with net debt of only 0.2x EBITDA.

 

Hitting the road: observations from our travels

We have availed ourselves of reopened state borders to get back out on the road again this year, with trips to Brisbane, the Gold Coast, Melbourne and WA. These trips left us feeling enthused about the high-end, quality operations and the level of innovation being undertaken across the country. In April we travelled to Ormeau, Gold Coast to meet with Kees Weel, CEO and founder of our portfolio holding, PWR Holdings. PWR make radiators and cooling systems for motorsports (supplying every Formula 1 team), high-end original equipment manufacturers (e.g. Porsche, Aston Martin) and a number of exciting emerging applications such as electric vehicles and defence. We were blown away by the level of technical expertise and innovation in walking the factory floor, and it's always good to be hosted by a CEO who greets everyone in the factory by name. This is a true Australian success story; PWR's radiators are regarded as some of the best in the world, and PWR enjoys very healthy economics as a result (c30% EBIT margins, >40% return on invested capital).

In June we travelled to WA and met with a few mining companies. We were left feeling that the shift to a global clean energy system should create fantastic opportunities for Australia, which is rich in many of the mineral resources that are needed to facilitate this shift over the next 20 years. Further, geopolitical tensions could play in Australia's favour, with the desire for countries and OEMs to construct ex-China battery supply chains providing an opportunity for Australia to exploit its position as a low-cost supplier of critical battery materials such as lithium and nickel.

One particularly exciting opportunity is in lithium. In order to meet our Paris Agreement targets, the IEA estimates the world will require over 40x more lithium than was used in 2020, driven by a 25x increase in EV sales.

 

                  

Source: IEA

Unlike other battery metals, whose demand profiles are greatly influenced by the way battery technology develops over the next few decades, lithium demand is relatively immune to the way battery chemistry ends up going.

On the supply side, the industry has just gone through its first proper boom/bust cycle. With lithium prices more than halving from their 2017 peak, many new projects were scrapped and mines put on care and maintenance. Now, with demand picking up, the industry looks set for a supply deficit emerging as early as next year. As such, we would expect further price rises.

                                                      

Source: Credit Suisse

This is good news for two portfolio holdings: Mineral Resources, which operates Mt Marion and (currently mothballed) Wodgina mines, and Wesfarmers, which recently acquired Kidman Resources and is developing a lithium hydroxide plant in Kwinana, WA. For Mineral Resources, we think their lithium business has the potential to be worth >$3b, well in excess of the current c$1.2b we believe the market is valuing it at today, or $10 a share on today's $50-odd share price.

Overall, we feel the future is bright for a number of Aussie industries and businesses, and we remain happy co-investors along the way.

 

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