REVIEW

The Australian share market saw a significant contraction in May with the All-Ordinaries Index down 3.0%, its worst month since January. The sell-off was once again led by Technology stocks with the sector down 8.7%. The Real Estate sector also performed poorly, down 8.9%, led by concerns of more aggressive interest rate tightening and associated impacts on demand. 

After a soft April, the Materials sector resumed its outperformance in May, aided by expectations of more stimulus in China. In terms of factor leadership, value resumed its leadership over growth. The value factor has now outperformed growth by 20% over the last 6 months.

MARKET OUTLOOK

The secular bull market that ended for Australian shares last August emerged from the financial crisis and was a product of successive waves of liquidity led asset reflation, as central banks pushed real interest rates lower and lower and asset values higher and higher (Fig1).

Figure 1: Successive waves of asset inflation

Source: Bloomberg, S&P 500 Chart

Asset inflation, of course, created excess demand, leaving product and labour markets acutely tight. Unemployment in Australia is now at its lowest in 40 years and with little immigration, the services sector is scrambling to find workers. Fair Work Commission awarded a 5.2% increase in the minimum wage, well above expectations.

This policy led bonanza for asset owners was a consequence of systemic deflation. No one has a complete explanation for the root cause of this deflation which you can see clearly in the value of bonds which have pushed higher for decades (long term interest rates have been falling).

The first phase took place in the 1980's with back-to-back global recessions that killed the inflation of that era. Then in the early 1990's with the collapse of the Soviet Union we had a rapid expansion of western democracies, a deepening of capital markets and the globalisation of trade. This spread of the neo-liberal 'rules based' order (capitalism) was deflationary allowing interest rates to fall and debt balances to accumulate.

The spoils of this period where not spread evenly however, laying the seeds of its demise. Asset owners captured all the gains while labour's share of GDP has fallen sharply. We now have the first generation of citizens in the west who are worse off than their parents in real terms.

The emergence of popularism and de-globalisation were the first phase of its descent. A new cold war between the East and West has manifested the next phase. With this reversal in these deflationary forces, the good times of ample liquidity and asset reflation have passed.

Even before the health crisis, we were approaching the limits of these policies in driving asset values higher as bond yields in many western countries were already negative. On a hold to maturity basis, investors were guaranteed a loss, which of course is nonsensical. Then with the health crisis, policy makers doubled down on these same policies. The excess demand created from emergency stimulus and the associated supply chain disruptions have unleashed inflation which will be with us for years to come.

Investors need to ask two important questions: Are the deflationary forces that persisted for so long still around or has their demise contributed to the inflation we are seeing today? Secondly, what has caused this inflation, is it established or transitory?

How these inflationary pressures play out will determine the duration of this bear market. If the inflation hangs around for years to come as expected then we are in a secular bear, if it is transitory and the deflationary forces resume/return then potentially shares can make new highs in the years ahead.

We are still early in this bear market. Until inflation moderates and central banks back away from hiking rates further, shares will move lower in the medium term. In the short term at least, share markets globally are oversold and sentiment is extremely bearish. In the weeks and potentially months ahead, we should see a decent bear market rally which investors should sell into as the big drawdown is still ahead in the second half of the year.

Australian shares have proven remarkably resilient through this first phase of the drawdown given our economy's exposure to commodities which are the driving force behind the inflation we are seeing. In simple terms, the Australian economy is a good inflation hedge. The 'quarry and farm' may once again avoid another global recession.

As we get into the 3rd quarter of the year however, around the US mid-term elections, western economies will be slowing quickly and the 'street' will be slashing profit estimates, pushing shares lower.

This becomes a pivotal moment for investors as the policy response will determine the next move for shares. If the inflation data improves as everyone expects, Central Banks may 'pause' on any further policy tightening. Under this scenario economies slow but avoid recession and shares can stage a significant rally early into next year. However, an early pause only ensures inflation lingers for longer, leaving us with 'stagflation'.

Alternately, Central Banks look to overshoot in tightening financial conditions further to kill inflation, only to push western economies into recession. Under this scenario shares obviously fall further into the first half of next year.

The policy response as the economy slows, asset values fall, and inflation moderates will determine which path the market follows. Either way the medium-term outcome is much the same, shares will be lower.

The emerging data is less than encouraging, with the May CPI report showing further deterioration, Central Banks are once again losing credibility as they were guiding to a moderation in the data. It seems they still have a lot more to do evident in the FOMC decision to increase the target interest rate by a full 75bpts (3 hikes in 1), which is unprecedented.

With the broader offshore indexes down more than 20% we are now officially in a bear market for shares with investors seemingly still pricing in a soft-landing scenario (green line below in Fig 2). They have never tightened once shares have fallen into a bear market before (down >20%), a further demonstration of just how far behind the curve they find themselves.

Given inflation has never been tamed once it gets above 5% without a recession, a recession more than likely beckons and we move lower (the red line in Fig 2).

Figure 2: Market drawdowns with and without recessions

Source: Stifel

While we have seen some contraction in valuations (P/E's) already as financial conditions have tightened, we are yet to see any move lower in profit expectations. With the demand shock from the COVID stimulus, many public companies are over earning, profits have moved well above trend. In a garden variety recession earnings typically fall by a least one third Fig 3 below.

Figure 3: S&P 500 Profit (EPS) drawdowns from prior peaks

Source: Stifel

If we are in a stagflation environment of lower growth and persistent inflation, then valuations may well move to the lower end of the historic range (P/E's are low during periods of inflation) which along with lower earnings leaves us with a share market that still has a long way to fall.

SECTORS IN REVIEW

The Consumer sector delivered a flat result for the month, with gains in supermarket shorts, offsetting losses in some consumer growth stocks.

Our long position in the Fuel Marketers has been gaining momentum as fuel security becomes an increasing issue for Western Governments. Ampol (ALD) and Viva Energy (VEA) refining assets, historically loathed by the market, are now generating super returns and driving upgrades for both companies. This sector is under-owned and offers defensive exposure at a cheap multiple.

As mentioned in the April monthly, the Agriculture sector is building as fertile ground for short ideas. Share prices have risen aggressively given the confluence of a strong domestic grain harvest, and sky-high soft commodity prices driven by supply-chain dislocation. We know however, as with all highly cyclical industries, that conditions are ever changing, and we should be careful extrapolating at either the top or the bottom of the cycle. Using a 'normal season' as the basis for valuation, earnings multiples look extreme. We see several catalysts, including the successful negotiation of a humanitarian export corridor in the Black Sea to correct over-inflated soft commodity prices.

Financials had a flat month in terms of attribution. Our shorts in the Banks delivered returns, as we saw the beginning of a major sell off across the sector. Banks had held up well for most of the broader market volatility of 2022. This changed when investors came to appreciate the consequences of faster than expected rate rises. We have been highlighting for some time the nexus between bank returns and the property market. Offsetting these profits was weakness in our long position Macquarie Group (MQG), we continue to see good earnings prospects for Macquarie in the short term amidst the energy market volatility. Commodities trading remains a key driver of results.

Technology delivered some modest positive returns. Largely from our short portfolio. The sector continues to be the most sensitive to higher than expected inflation outcomes. Which are then leading to higher interest rates expectation. Selling across the sector has been indiscriminate.

The Building Material companies continue to come under considerable pressure as it has become clearer that interest rates will be moving a lot higher. This is the case not just for the local Builders but the US based ones as well James Hardie (JHX) and Reliance Worldwide Corporation (RWC). As manufacturing businesses these companies are also very exposed to escalating fuel and energy costs.

In Media, cyclical business like Nine Entertainment (NEC) and Seven West Media (SWM) have come under considerable pressure on fears of a fall in advertising spending. NEC shares are starting to look attractive with a full recession now factored in.

Contractors: We expect the resources sector to hold together relatively well even as growth slows elsewhere. Monadelphous (MND) an important contractor in energy and iron ore operating in WA should perform well in the years ahead, especially as energy investments picks up. The iron ore hubs are so large and established now, having doubled in size over the last 15 years, spending in this sector will remain elevated for years to come.

As a defensive sector, Healthcare has held up relatively well in a difficult market, it's probably time to take profits here.

Resources: The lithium sector has fallen hard following some negative research pieces suggesting the market is over supplied in the medium term as Chinese production ramps up. We have a balanced portfolio of attractively prices emerging producers/explores and a short portfolio of expensive explorers in preproduction. Producers of bulk commodities have held up very well in recent weeks, it's time to take profits in some of the iron ore miners in particular. The iron ore prices is still above $150/t and looks vulnerable here.

The price-to-earnings ratios of many quality businesses have fallen sharply over the last six months.  In many cases, the falls were justified.  Now that valuations have dropped, I believe investors have a far better chance of making attractive returns.  The proviso, of course, is that you buy businesses that grow their earnings.

Celebrating the recent fall in share prices might be a step too far, but investors who plan to be net buyers of equities should be at least a little excited about the recent declines.

The ASX 200 decline year-to-date of just 3.4 per cent masks the more serious declines of even the highest quality companies. Indeed, 112 of the biggest 200 companies listed on the ASX are below their price at the beginning of the year. And the average decline is 17.7 per cent. The median decliner is down 15.4 per cent.

Zip is off 76 per cent year-to-date, Pointsbet is down 60 per cent, Kogan is 47 per cent lower, Boral is 43 per cent below its price at the beginning of the year, and even high-quality company, Reece, is 38 per cent weaker. Meanwhile, other high-quality companies such as REA Group, Wesfarmers, ARB Corporation, Credit Corp and Super Retail Group are off between 15 and 25 per cent in less than 16 weeks.

Of course all of this is happening because inflation is surprising to the upside, scaring many investors as well as central bankers.  And in response the central bankers are reversing the massive stimulus that was foisted on markets and economies in response to COVID-19. 

The punch bowl that drove massive asset inflation during the pandemic is being taken away. It really is as simple as that.  The US Federal Reserve will put its balance sheet on a new course, reducing its size by up to a trillion US dollars per year.

So there's no debating; we are in the midst of a correction.  There is however a silver lining.

PE ratios have compressed materially over the course of the last six months.  Now that they are lower, investors have a better chance of making attractive returns, provided they buy businesses that can grow earnings.  Let me explain with a few simple tables.

 Table 1.  Internal rates of return equal earnings growth when PEs remain constant.

Table 1 demonstrates the investor's return, from buying and selling a share at the same PE multiple, matches the rate of earnings growth.  In all three examples the earnings growth is 10 per cent per annum.  It matters not whether the stock was purchased at 10, 20 or 30 times earnings; the investor's internal return will match the earnings growth rate provided the shares are sold at the same PE multiple that was paid for them.

Table 2.  Internal rates of return equal earnings growth when PEs remain constant

Table 2 simply reinforces the earlier point.  On this occasion the EPS growth rate is 20 per cent in all cases and irrespective of the PE the investor's return matches the EPS growth rate provided the shares and purchased and sold on the same PE.

China's economic woes, the invasion of Ukraine, supply chain disruptions and the possibility of recessions and stagflation have all offered reasons for investors to sell stocks to the extent PE's have compressed materially.  As I mentioned earlier however it doesn't matter what the contemporaneous catalysts are, throughout history whenever rates go up or inflation accelerates, PE have compressed - without exception.

Now that PEs have compressed, investors must find businesses whose earnings will grow.  Warren Buffett once observed: "Your goal as an investor should be simply to purchase, at a rational price, a part interest in an easily understood business whose earnings are virtually certain to be materially higher, five, ten, and twenty years from now."

Compressed PEs may offer that "rational" price. 

PE ratios can of course fall further and any escalation of tensions between Western allies and China or Russia would certainly do that.  Investors would have to simply ride through what we all hope would be a temporary interruption to the peace the western world has mostly enjoyed since the fall of the Berlin Wall.   To protect oneself from the idiosyncratic risk of PE contraction, it is important that not only does the company's earnings grow, but they grow at a rate that meets or exceeds market expectations.  If growth is expected to be 20 per cent and comes in at 18 per cent, the PE may contract further, offsetting the benefits accrued to investors from the earnings growth.

Table 3.  A bonus from PEs bouncing.

Assuming global peace is maintained, investors have another benefit from investing after PE compression.  Inflation will eventually peak and interest rates will eventually stop being raised.  At that point PE ratios may start to expand again.

Table 3 reveals the bonus in terms of internal rates of returns earned by investors from a jump in PE ratios at the time of sale.

In the first example, shares are purchased on a PE of 15 and earnings grow by 10 per cent per annum.  If the PE stayed at 15 at the time of sale, the investor would earn 10 per cent per annum.  But in this example, in the final year, the PE jumps to 20 times.  The result is an 18 per cent per annum return.

PE compression and stock market falls may just be the rational price investors in equities and managed funds have been waiting for.

Author:  Roger Montgomery, Chairman and Chief Investment Officer

Investing in global equity markets has felt like playing a game of dodgeball over the last two years.  Around every corner investors have been faced with a new surprise to navigate. Just as in dodgeball, where players run for cover to avoid the sting of those dreaded balls, equity investors have flocked to the safety of defensive stocks in 2022.  Year to date defensives have outperformed value, growth and cyclical stocks, doing what they are supposed to do in uncertain times: offer equity investors a shield against the onslaught of valuation pressures, slowing earnings growth and increased uncertainty.  As we continue to brace ourselves for ongoing volatility in equity markets, we prefer to maintain exposure to selective stocks with defensive characteristics - those that are winning by not losing.  Deutsche Boerse and Merck & Co are two such examples.

The big de-rating might not be over

Global equity markets have de-rated since the recent peak in September 2020, with a sharper deceleration in 2022 driven by rising inflation fears as reflected in higher 10-year bond yields.   In fact, most major market indices are now trading below their pre-Covid valuation levels.  The derating has been particularly evident in the more expensive parts of the market, such as Technology stocks.  For example, the Nasdaq Composite Index has fallen by -25% so far this year, with most of this occurring through forward PE multiples contracting from ~32 to ~23x currently.  In comparison, the S&P 500 has fallen 16% and contracted from ~22x to ~17x over the same time frame.

All major equity markets have derated sharply YTD to below pre-Covid levels

Source:  Bloomberg, 10 May 2022

Despite this overall market de-rating, most major indices are still trading in line or above their 20-year averages and remain relatively high when considering the sharp rise in 10-year yields (see chart below).  The Russia Ukraine War has also recently pushed commodity prices to new highs, raising inflation risks and potentially placing further pressure on market valuations.

Valuations may be at more risk as bond yields continue to surge

Source:  Bloomberg, 10 May 2022

Investors' fears are shifting from inflation to growth

US GDP has surged past prior cycle peaks but is now decelerating sharply.  Similarly, while 1Q22 earnings were modestly ahead of expectations on average, management commentary and guidance about the outlook has been increasingly cautious, prompting analysts to downgrade earnings forecasts for both '22 and '23.  In fact, earnings revisions breath has been declining since August 2021 and has recently moved outright negative.  Given the wide range of headwinds companies currently face, which include cost pressures, supply chain constraints, inventory build ups and potentially weaker demand from higher prices and lower global growth, it's likely that earnings revisions will remain negative for the foreseeable future.  This has historically been associated with weak overall market performance (see below).

Earnings Revisions and Price are highly correlated

Source:  Alphinity, Bloomberg, 3 May 2022

Earnings leadership has taken another step to being more defensive

At a sector level, we have however seen a sharp contrast with the classic defensive sectors, such as Utilities and Consumer Staples outperforming the overall market year to date, driven by a superior ratings performance as well as better earnings revisions versus their cyclical peers and the broader market (excluding the Energy and Materials).  Defensives have a strong track record of outperforming during slowing growth/recessionary periods, a relative safe-haven within periods of market stress.  With a broad range of defensives already reflecting these benefits in relatively high valuations, active investors need to remain nimble and look for new opportunities.  Some of these might not be seen as typical defensive plays, such as Merck & Co referred to below, but they offer defensive characteristics that should bode well in a volatile environment.  One such defensive earnings leader is Deutsche Boerse.

Just as in a dodgeball game, there are certain times in the market cycle when it is not always about running the fastest, but also about finding the best places to hide.

Deutsche Boerse- Leading stock exchange enjoying multiple cyclical & structural tailwinds

Deutsche Boerse (DB1) is a high-quality owner of various key pieces of financial market infrastructure in Europe across pre-trading, trading & clearing and post-trading.  These assets include Institutional Shareholder Services (ISS), Eurex (leading European financial derivative exchange), EEX (a commodities trading & clearing exchange), Xetra (cash equities) and Clearstream (a leading European settlement & custody provider).  These businesses all tend to command dominant or leading market positions within their segments, and as such enjoy significant barriers to entry and high margins.  These diversified businesses generate resilient mid-cycle digit % secular growth, which we expect to be further boosted by various cyclical tailwinds, including both higher interest rates and higher interest rate volatility, as well as further targeted M&A.  Consequently, we expect the company to exceed management's net income growth target of 10% (CAGR) for FY19-23E.  With positive earnings revisions and a relatively undemanding valuation multiple (current forward PE of ~21x), we continue to see more upside for DB1 in the current environment.

Deutsche Boerse - More defensive Earnings supported by several cyclical and structural factors

Source:  Bloomberg, 10 May 2022

Merck & Co- A high quality defensive with flagship growth products & consistent earnings

Merck & Co (MRK) is a global pharmaceutical company that delivers health solutions through its prescription medicines, vaccines, biologic therapies, animal health and consumer care products. MRK recently reported an impressive 1Q22 result with both revenue and earnings beating consensus expectations and the company raising 2022 guidance for both despite an expected FX headwind, driven by strength across the portfolio. Despite the relative outperformance and re-rating from 10x to 12x YTD, we maintain our position in this flagship defensive at this juncture with two main drivers for our investment case: 1) Product growth of the existing portfolio:  Both the flagship growth products Keytruda (the largest selling drug in the world, innovative immuno-oncology, 30% of group revenues) and Gardasil vaccine (blockbuster vaccine against papilloma virus/cervical cancer, ~9% of group revenues) continue to grow ahead of expectations with their high quality Animal Health business (the third largest in the world) enjoying above market growth rates.  2) Business development:  Management continue to look for new M&A opportunities to expand the business, underpinned by a strong balance sheet, with gearing at only ~2x EBITDA.

Earnings growth underpinned by a portfolio of strong flagship products

Source:  Bloomberg, 10 May 2022

Author:  Elfreda Jonker, Client Portfolio Manager

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