A roadmap to navigating the COVID recovery

The market environment presents investors with a challenging juncture. In the short term, a combination of healthy consumer balance sheets, low inflation, low interest rates, and high liquidity provides a robust backdrop for returns. But in the longer term, different scenarios could play out requiring different approaches to portfolio management. For investors, complementing a portfolio of companies that work in specific scenarios with those that work in multiple scenarios offers a prudent strategy.

Checking the rear-view mirrors and the road ahead

In April 2020, we set out a plan to navigate the COVID-19 cycle. Our 3-bucket plan focused on companies that would perform well across the various stages of the pandemic: from virus outbreak/vaccine deployment, to recession and finally to recovery. Our diversified portfolio has performed well even as the cycle appeared to straddle multiple phases simultaneously. As we look forward to the end of the virus phase and the start of the economic recovery, we have an opportunity to review events and plan ahead.

Returns net of fees (%) (as at 31 January 2021)

Source: Fidelity International, Total net returns represent past performance only. Past performance is not a reliable indicator of future performance. Returns of the Fund can be volatile and in some periods may be negative. The return of capital is not guaranteed. Benchmark: MSCI ACWI (All Country World Index) Index NR (effective 1 November 2011). Benchmark between December 2006 and 1 November 2011 was the MSCI World Index, and prior to December 2006 and 1 November 2011 was the MSCI World Index ex.Australia. NR: NR at the end of the benchmark name indicates the return is calculated including reinvesting net dividends. The dividend is reinvested after deduction of withholding tax, applying the withholding tax rate to non-resident individuals who do not benefit from double taxation treaties

Short term outlook: A risk of becoming bearish prematurely 

Demand for technology devices and home improvements has driven product manufacturing and growth throughout the lockdowns and it will soon be supported by a rebound of the lagging services sector. Vaccines are providing a literal shot in the arm to people but also figuratively to equity markets. The speed and effectiveness of vaccine distribution will vary by country, but confidence is steadily rising as the programme rolls out without major hiccups.

Markets are planning for the reopening of society when 'revenge' buying and travelling will be unleashed and consumers will swap purchasing gadgets for dining out or holidays. Spending will be fuelled by positive aggregate consumer finances caused by forced savings and ongoing government transfer payments.

A combination of healthy consumer balance sheets, low inflation, low interest rates, and high liquidity provides a robust backdrop for returns. While market sentiment may already seem over-optimistic, it should be balanced with the consideration that as economies fully reopen, we could potentially have two of the strongest quarters of GDP growth experienced in developed markets. With the market near record highs and as uncomfortable as it is, the risk for relative return investors is becoming bearish too soon.

Medium term: A fork in the road

Beyond tail risks around hyperinflation and deflation, two opposing scenarios could develop. The first is a path towards conditions similar to the 1920s and the other is a return to the low growth era of 2012-2018. The challenge for investors is that these scenarios lead to completely different portfolio allocations. 

Scenario 1: The Roaring Twenties

While consumers have been spending (US personal consumption has recovered to 97% of its previous high), companies haven't been investing in capacity, creating shortages in, for example, personal computers and semiconductor chips. If corporations find the confidence to add to capacity and promised fiscal stimulus filters through the global economy, this could create a period of earnings and cash flow growth significantly higher than current expectations; mirroring the period post World War I and the global Spanish flu pandemic of 1918.

This 'Roaring Twenties' scenario would call for favouring cyclicals over defensives as earnings surprises are more likely, and for allocations to emerging markets and sectors such as financials, industrials and materials. Potential rises in interest rates would pose a risk to high growth technology stocks on lofty valuations that have been market leaders for several years, with turbo charged performance through the COVID-crisis.

Scenario 2: A replay of 2012-2018

The second scenario is more like recent experience. High debt, technological disruption and ageing demographics could steer the economy back towards a low growth world in a 'Japanification' of developed economies. In this environment, quality, growth and higher value stocks would be the cornerstone of an equity portfolio.  

Given central banks have committed to letting their economies run 'hot', scenario two is less likely. The direction of the market will be determined by which central bank is able to keep its nerve through the reopening quarters and continue with monetary and fiscal accommodation. History shows that one of the reasons why the US experienced the Roaring Twenties while the UK struggled through a lost decade was the relative differential in fiscal and monetary support.

However, there can be too much of a good thing, and there is a risk that even if the monetary spigots remain open, higher commodity prices as a result of shortages in supply could start sucking liquidity out of the system and reduce overall demand. We are already seeing shortages with automakers cutting production because of a lack of semiconductor chips and shortages of nickel and cobalt used in batteries for electric vehicles.

Expansions in supply always lag shifts in demand and any further increases in liquidity could be eaten away by higher commodity prices without any corresponding benefit for the economy. A stagflationary scenario (low growth, high inflation) that would be negative for equities and require a conservative barbell positioning in commodity-based sectors and defensives such as healthcare and food (bonds would generally perform badly as their principal value and coupons are inflated away).

Tracking indicators and returning to investment basics

When navigating uncertainty in markets, we favour diversification and detailed scenario analysis to construct a portfolio that can deliver consistent returns. Fortunately, there are signposts that can indicate which scenario is developing and we can adjust our portfolio appropriately.

Anecdotally, our conversations with companies across the globe give us a sense that corporate confidence is rising across sectors and geographies. Tracking economic indicators will show if economic momentum can be maintained beyond the initial consumer-led quarters. Growth in bank loans, PMI indicators and money supply trends could signal that the economy is transitioning towards corporate credit-driven growth and that conditions are in place for earnings growth, putting valuations at more reasonable levels.   

Maintaining investment discipline is crucial when markets approach a juncture. Timing the market at the best of times is risky, but during phase shifts is extremely difficult. Investors are more likely to be successful by returning to the fundamentals of seeking strong companies that can do well irrespective of the prevailing scenario.

Companies run by experienced and reliable management teams will find ways to outperform their peers in various environments. Look for companies focused on sustainability in industries with significant opportunities for growth and can effectively leverage technology. Biotechnology, renewable energy development, waste reduction and forward-thinking food consumption and production businesses all have huge growth potential. Companies located in emerging countries with relatively low debt burdens, also have a good chance of productive growth in the long term.

Strong convictions, loosely held

Given our holding periods generally tend to be 3-5 years, our portfolio is primarily exposed to companies that we believe will do well irrespective of the macro conditions. Complementing a portfolio of companies that work in specific scenarios with those that work in multiple scenarios is a prudent strategy.

In a market obsessed with themes and the next narrative, as contrarians we often find value in companies with less fashionable back stories but stand up to an interrogation of the investment fundamentals. These companies may be in unexciting areas and are frequently overlooked, offering diligent investors opportunities for sustainable growth at attractive prices. As the market transitions into a COVID recovery, investing requires patience and strong convictions, loosely held so investors retain the flexibility to adapt to whichever scenario plays out.

DISCLAIMER: 

This document is issued by FIL Responsible Entity (Australia) Limited ABN 33 148 059 009, AFSL No. 409340 ("Fidelity Australia").  Fidelity Australia is a member of the FIL Limited group of companies commonly known as Fidelity International.

Prior to making an investment decision, retail investors should seek advice from their financial adviser. This document is intended as general information only. Please remember past performance is not a guide to the future. Investors should also obtain and consider the Product Disclosure Statements ("PDS") for the fund(s) mentioned in this document before making any decision about whether to acquire the product. The PDS is available on www.fidelity.com.au or can be obtained by contacting Fidelity Australia on 1800 119 270. This document has been prepared without taking into account your objectives, financial situation or needs. You should consider such matters before acting on the information contained in this document. This document may include general commentary on market activity, industry or sector trends or other broad-based economic or political conditions which should not be construed as investment advice. Information stated herein about specific securities is subject to change. Any reference to specific securities should not be construed as a recommendation to buy, sell or hold these securities. Investments in overseas markets can be affected by currency exchange and this may affect the value of your investment. Investments in small and emerging markets can be more volatile than investments in developed markets. This document may contain statements that are "forward-looking statements", which are based on certain assumptions of future events.  Actual events may differ from those assumed.  There can be no assurance that forward-looking statements, including any projected returns, will materialise or that actual market conditions and/or performance results will not be materially different or worse than those presented.  While the information contained in this document has been prepared with reasonable care, no responsibility or liability is accepted for any errors or omissions or misstatements however caused. The document may not be reproduced or transmitted without prior written permission of Fidelity Australia. The issuer of Fidelity's funds is FIL Responsible Entity (Australia) Limited ABN 33 148 059 009. References to ($) are in Australian dollars unless stated otherwise. Details of Fidelity Australia's provision of financial services to retail clients are set out in our Financial Services Guide, a copy of which can be downloaded from our website.

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Bond markets were on the back foot in February, in a material way, as global positions were liquidated challenging Central Banks in a way we have rarely seen since the GFC.  The optimism surrounding the Biden fiscal stimulus (USD $1.9 trillion) and inflation expectations on short run base effects caused a liquidation of bond positions against the commentary of Central Bankers, who remain committed to low cash rates and easy financing conditions to stimulate demand in the Covid-19 ravaged economies.  The sell-off became self-fulfilling in Australia as the RBA did little to redress algorithmic and Commodity Trading Advisor (CTA) style funds continuously selling interest rates futures, causing longer term holders to liquidate as the relative value of Australian rates cheapened against other cross market nations such as the United States. Ironically, this relative value is an explicit objective of the RBA's own QE program combined with the suppression of the Australian dollar. The RBA has failed on both fronts since the inception of the QE program and leads us to believe that further QE will be required.

Whilst Australian interest rates were a surprise under performer over the month, movements across global rates markets also pushed to higher yields in unison with heightened volatility in risk free Government bond markets.  This has huge implications for all asset markets the world over. This volatility does not stay in a singular asset class for long, other similar episodes often sees volatility morph to other asset classes as interest rates are the virus that affect all things - they are our funding rates and discount rates. When risk free rates rise quickly in a heavily indebted world, that volatility can spread with dangerous implications.  The most recent example of this was Q4 2018 when bonds sold off aggressively late in the year, freezing corporate high yield debt markets (there was no debt capital market issuance of high yield bonds for around six weeks as confidence collapsed) and ultimately triggering -20% liquidation of equity markets (which in and of itself generates a flight to quality bid in Government bonds).

Fast forward to today and we now have corporate credit at more expensive valuations than pre Covid-19 which we believe is crazy, especially as risk free rates are rising which usually forces a recalibration of credit spread premiums.  As experienced from episodes like last March and April 2020, when credit reprices, it can be truly chaotic with a huge loss of liquidity - volatility in risk free rates often moves into credit before then skipping to risk assets as markets become concerned around low quality corporates, funding themselves at higher interest rates using debt capital markets or rolling existing debt obligations.  

DEFENSIVE LONGER-TERM PORTFOLIO RETURNS DELIVERED BY CARRY AND ROLL

With the sell-off in risk free markets has come a reestablishment of yield (carry) and importantly delivered a steep term structure of interest rates curve (roll).  Whilst duration often gets all the attention in bond markets for its short run movement of prices, it is actually a minor contributor to total return over time. This is critical to understand when building defensive longer-term portfolios as the major returns are delivered by carry and roll.

Looking at the last decade of bond returns, almost everyone would tell you that bonds performed because duration rallied, and that was helpful no doubt, but the vast majority of performance happens slowly in an accretive and continuously compounding manner of carry and roll (roll in very simple terms is as a 5 year bond becomes a 4 year bond in one years' time, it has a capital accretion down a steep term structure curve generating total return). This rebuilds the defensive characteristics materially for a future time and has been met with interest from many of our clients, most of whom have been underweight Government bonds within their own asset allocations and are excited to rebuild more material positions into higher yields and steeper curves.  Having just witnessed the tremendous power of the liquidity optionality available in Government bonds in March and April of 2020, many clients are now acknowledging that it was the ability to sell easily (at a premium) in times of stress that allowed them to invest in deeply discounted equities.  For many, this move made substantial portfolio returns over the later part of 2020, thanks to a clean asset allocation that is not co-mingled with corporate credit making the entire structure vulnerable (many corporate credit funds were semi-gated during this time by raising sell spreads significantly as corporate credit froze).

CARRY AND ROLL ARE FAR MORE IMPORTANT OVER TIME THAN DURATION IN PORTFOLIOS - AUSTRALIA

Source: JCB team analysis, based on data from Bloomberg.  Past performance is not indicative of future performance.

As bonds are a continuously compounding asset, they have historically done very well after periods of underperformance. The below chart is the historical performance of the bond index only, noting the strong performance that has been generated following drawdown periods.

Source: JCB team analysis, based on data from Bloomberg. Past performance is not indicative of future performance.

In viewing such historical data, it is easy to see why many clients are now considering the timing of moving up from a neutral allocation to defensive or going into an overweight allocation. We believe markets will remain volatile in the near term as we push into the middle of the year when transient short-run inflation will likely peak.

OVER THE INFLATION HILL

We have written previously about the mechanical pathway for higher US inflation (remember Q2 2020 the entire world was closed and we had negative oil prices) on data rotation alone, inflation should peak in May (base effects). We can work out a fairly tight lane way on this scenario pathway, but the one thing that is difficult to economically estimate is how long supply blockages take to clear. Once the base effect gives inflation velocity, it also takes it away just as quickly. We are preparing a white paper titled ''Over the inflation hill'' that we believe is hugely relevant as it will have impacts on so many asset classes as the journey evolves.

From a secular viewpoint, disinflationary forces of poor demographics, high debt levels (interest rate sensitivities and zombie corporate funding), technology, automation, robotics, lack of unionisation and globalisation have all been an overarching deflationary force. You can now add to that list massive economic slack and untapped labour pools the world over, so it's hard to get excited about medium to long run 'self-reinforcing' inflation.  However, short run inflation is transitory and will be much higher before base effects fall out and inflation will cool.

So the major questions now asked by many investors are; what are the triggers or the pathway towards a short run inflation peak, how chaotic can this movement become across portfolios that are broadly long risk assets, and what would be the reflexive feedback loops to other assets markets?  JCB cannot caution enough that this volatility will be very unlikely to remain in the risk free complex.  Modern day markets are actually quite fragile, and whilst prices are observable at great valuations in many things, the true test remains how deep that pricing tension really is.  If bullish risk allocations go for the door, we know that opening can become a keyhole very quickly where only the first few folks get through.

In a matter of months, we've experienced a remarkable turn-around when it comes to Australian equity income and right now it's safe to say dividends are back.

After a thorough analysis of the February reporting season, the Plato team has updated its Australian equity income outlook. We now forecast the ASX200 will return a 4.8% gross yield in the coming 12 months and think high-quality active management should be able to deliver an additional 2-3% on top of the index.

For self-funded retirees who ain't got a lot to spare, this is great news.

At every RBA cash rate cut over the past decade, self-funded retirees have been dealt a blow and earlier this year they would have heard the RBA Governor state any increase to the cash rate is unlikely until at least 2024.

Generating meaningful returns from cash in the bank or bond yields has been near impossible for a number of years now and when dividends were slashed at height of the COVID-19 crisis, many would have been wondering how they were going to make ends meet. Thankfully, the dividend recovery has been swift.

The dividend income ascent

The last article I penned for the Plato Academy in the days ahead of February reporting season, was titled Cash rate locked, dividends unshackled. I highlighted a number of reasons why we believed dividends had been 'unshackled', including APRA repealing restrictions imposed on bank dividends and Federal Labor confirming it would no longer pursue changes to franking credits for retirees. This 'unshackling' certainly eventuated and has now evolved into what can best be described as a dividend income ascent.

Below, we have illustrated the change in our ASX200 index income forecast over just 2 months - from 31 December 2020, to 2 March 2021.

When we look into this ascent, 59% of the increase (which equates to 30 basis points in yield) comes from Financials. Few predicted such a rapid COVID-19 recovery in bank dividends.

Of the Big 4, we think Commonwealth Bank looks to be a compelling opportunity for income investors today. It declared a $1.50 dividend which was 25% lower than its February 2020 dividend, but importantly it equates to only 67% of earnings. The bank has said its pay-out ratio is likely to be 70-80% this year, so we expect a stronger second-half dividend.

However, what's most enticing about CBA, is the possibility it will use excess franking credits on the balance sheet to undertake an off-market buyback in the coming year. We've previously detailed why buybacks are great for retirement income.

Dividend strength is also evident outside of the Big 4. Bendigo and Adelaide Bank's half-year result came in at almost 30% above expectations. Cash earnings of $220 million were up 2% from the prior corresponding period and a whopping 156% on the second half 2020 result. The 28-cent dividend announced equates to a prudent payout ratio of 68% and a gross yield of 4.2%.

The dividend ascent amongst the banks is not only supported by the removal of APRA restrictions on payouts, but also somewhat surprisingly strong profit announcements. This is due to fewer than expected COVID-19-related bad debts across the industry, resulting in the unwinding of provisions. In a show of confidence, even before Job-Keeper ends on March 31, both ANZ and Westpac felt confident enough to write back some of their COVID-related provisions and barring any further outbreaks or deterioration of the economy, we expect even more write-backs.

Other sectors to watch

Mining stocks are the other big contributor to the dividend ascent. 39% of the increase  illustrated above (20bps in yield) comes from mining stocks. 

Plato has been banging the drum on miners for a number of years now and mining dividends just keep on delivering. For income investors this is a space, you simply can't afford to ignore.

Of the top six dividend payers in Australia right now, three are mining stocks - Fortescue Metals, BHP Group and Rio Tinto. For dividend investors these are the 'new banks' and you can see here just how much cash they're delivering to investors.

Over the past 3 years, while many income-focussed investors have ignored these three mining stocks, they've delivered our investors 3.4% p.a. gross income and we believe the income will keep coming in the foreseeable future. The supply and demand fundamentals for iron ore prices remain in-tact and even if prices do come off $50-100 dollars per tonne, these companies still remain quite profitable. Furthermore, management at the big miners seem to have learned from past mistakes about over-investing in new mines.

Much like the banks, there is also significant strength outside the big players. Mineral Resources is a great example of a smaller miner, offering exceptional income. Last month it announced a $1.00 dividend (3.9% gross yield) on net profit up 111%.

The remanding major contributor to the dividend ascent of the ASX200 index is Consumer Discretionary stocks. In this space, many leading retailers have been thriving and we think investors will continue to reap the dividend rewards throughout the remainder of the year.

JB Hi-Fi is one of our holdings that has delivered a stellar half-year result for income investors. Its record $1.80 dividend equates to a gross yield of 5.1%. Its half-year NPAT was up 86%. What is significant for the outlook is January 2021 like-for-like sales were up 17%. This is something also seen across other leading ASX-listed retailers and we believe this demonstrates the COVID-19-fuelled retail sales momentum has further to run.

Making the most of the dividend ascent

While this analysis is broadly based on the ASX200, as mentioned we believe active portfolio management is key to maximising income for retirees. A large number of dividend traps are hidden within the ASX200 - avoiding these is just as important as identifying the dividend stars.

Over the past few years, we've also witnessed why a set-and-forget strategy is a sub-optimal income solution for self-funded retirees. Many Australian income investors have historically just sat on the Big 4 banks and Telstra, but if you look at our chart below, you can see how this set-and-forget strategy would have resulted in significant capital underperformance along with a reduction in dividend income over the past 5 years.

FY19 was the last time the Plato team labelled a period a 'dividend bonanza'. Dividends are certainly not back to that level yet, but yeah, they're getting bigger. We think the best way to ride the ascent is a highly diverse portfolio of dividend paying equities, actively managed to optimise after-tax returns.

The Plato Australian Shares Income Fund is targeting gross yield of around 8% in the coming 12 months - an additional 3% to the market delivered through our tired-and-test active investment process.