MONTH IN REVIEW

The Australian share market saw a small contraction in April with the All-Ordinaries Index down 0.83%, much less than the 8.7% contraction seen in the S&P 500. The modest move in the index disguised material moves in underlying sectors. Sell-offs were concentrated in Technology and Consumer Discretionary, down 10.4% and 3.2% respectively, while Utilities was the strongest sector, up 9.3%, and continuing its strong run as a safe haven against inflation. For the first time in 2022 the Materials sector fell, down 4.3%, which is an important development for the Australian market. We discuss further below. 

In terms of factor leadership, growth surprisingly outperformed value in April. While the Technology sector was week, 'growth' stocks in Consumer and Healthcare sectors traded better. The 'value' factor was also dragged down by the Materials sector which has now started to fall, as mentioned above. 

While May has started poorly for share markets globally, the hedges in our portfolio have so far protected the fund from any drawdown. The strategy is very well suited for the environment we find ourselves in. 
 
MARKET OUTLOOK

In April capital markets pivoted from reflation to deflationary bust as investors started to factor in a recession next year. We saw this play out clearly as commodities and commodity currencies fell sharply, including the Australian dollar. 

With this, late-cyclical sectors such as resources, which had held up relatively well, joining the rout in growth shares. The catalyst for this shift was a further tightening in financial conditions and lockdowns in China weighing on growth in the world's second largest economy. 

China historically has acted as a counterweight to growth trends in the west, this was particularly evident coming out of the financial crisis. With low vaccination rates amongst seniors in their community they have resolutely stuck to COVID-zero policies. Rolling lockdowns are weighing on growth and further disrupting supply chains into western markets. This is unlikely to change in the medium term given the virulence of Omicron. With China already in a recession, it is unable to play its typical role of balancing weakness in the west. 

The other major development last month was the breakdown in US mega-cap technology shares. This group of companies has led the share market higher in recent years. Together they account for one quarter of the value of the S&P 500. Until April they managed to escape the broader weakness in the NASDAQ.

 The 'Generals' as they are often called, reported disappointing results for Q1 2022, with Apple, Amazon, Netflix, and Facebook either missing expectations or providing weak guidance. The NASDAQ and Russell 2000 having fallen more than 20% now, joining emerging market equities and growth sectors in a new bear market. 

The Australian share market had been resilient through this earlier weakness in shares offshore only to fall sharply as commodities and mining shares broke down with the news out of China and broader concerns of a pending global recession. China almost certainly is already in a recession with growth in business activity and household spending in full retreat. 

If you break down the Financial Conditions Index (FCI) into asset values (falling); interest rates across the term structure (rising); and the US dollar (rising), FCI is tightening quickly, and we are only just embarking on a tightening cycle. 

The incidence of central banks tightening to combat inflation is the highest in many decades. This will likely end in recession in advanced economies. As these economies slow, profit expectations for public companies will fall along with valuation multiples as real interest rates continue to move higher. This is what a bear market looks like and we are almost certainly in one. 

Bear markets don't end until policy reverses course and financial conditions start to ease. We are still early in this tightening cycle, there is a long way to go. Liquidity will tighten further as central banks become sellers of the assets they have accumulated through COVID emergency measures. Bear markets typically last 18 months to 2 years and don't end until the liquidity spigot is turned back on again. Central banks are fully committed to combatting inflation and will not reverse course until inflation comes back into their target range of 2%. There is no central bank 'put option' this time around - falling asset values only helps Central Banks in their crusade to kill excess demand. 

While we are probably at peak inflation now and Consumer Price Index (CPI) and Personal Consumption Expenditures Price Index (PCE) will moderate in the months ahead as we cycle inflated data from last year, any moderation will happen slowly. Key components of the inflation basket - energy, food and shelter will remain under upward pressure for years to come. Labour markets remain acutely tight, employment needs to fall (recession) to reduce pressure on wages. 

We are in a 'secular' bull market for commodities, resource security and de-carbonisation will ensure ongoing investment in the sector for decades to come. Australia should benefit from this. While activity will slow in Australia, particularly if our major trading partner China is in recession, our economy should prove resilient even if advanced economies move into recession. There is a good chance Australia avoids the recession bullet once again. 

Having said that, commodities and mining shares are in a 'cyclical' bear along with other risk assets and will fall through the balance of this year. 

Share markets globally are over sold short term, sentiment is extremely bearish, and positioning is light. Shares should recover in the weeks ahead, an improvement in COVID cases in China would be particularly helpful. 

Any rally though should be used as an opportunity to reposition into defensive, quality names that will outperform in a slowing economy. 

Volatility will remain high into the second half of the year as financial conditions tighten further. We are still to see an exodus of retail investors who invested $1.3 trillion globally in equities through COVID. 

As markets fall in the second half of the year and investors come to realise, there is no central bank bailout this time around, a weaker tape could easily turn into a rout as we close the year. The bear is just getting started.

SECTORS IN REVIEW

The Consumer sector made a positive contribution for the month, with gains in Fuel marketing longs partially offset by losses on Agriculture shorts. 

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, which are generally 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. 

While coming at a cost to near-term performance in April, 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. To overcome this issue focus should always be given to mid-cycle analysis. Given decades of data on the Australian grain crop, we can predict with some certainty what mid-cycle earnings for companies like GrainCorp (GNC) might look like. On these mid-cycle earnings, current valuation multiples look extreme. 

Financials had a disappointing month in April. The primary driver was our long position in EML Payments (EML). EML delivered a guidance downgrade two months after its result in February. Given the volatility in the market, earnings dependability is currently paramount. As such, unexpected downgrades are seeing stocks punished by investors, with EML nearly halving over the month. In March, we saw press coverage that EML was being stalked by Private equity player Bain Capital, this saw the price above $3.00. We are cautiously optimistic that EML is forced to negotiate a reasonable price, which we view as the best outcome for investors. 

The TMT portfolio was a slight detractor of performance during the month. Our shorts in internet companies delivered as investors focused on deteriorating housing market drivers. They have also been caught up in a broader global technology sell off. Offsetting this was our technology portfolio, where losses were largely driven by our position in Life360 (360). 360 gave a quarterly update, where it reinstated guidance. We viewed the update as overall positive and were surprised to see the share price negatively impacted. We continue to see absolute and relative value in the name. 

The Mining sector was hit hard in April on lockdowns in China. The best performers recently were impacted the hardest with lithium names in particular retracing recent gains. Commodity prices were also weaker with lithium chemical and rare earths prices falling off peak levels. Coal continued to perform with our investment in Stanmore Resources (SMR) making a strong contribution. 

Healthcare: The medical device names are struggling with supply chain issues. Notably, ResMed (RMD) has had trouble locating components out of Asia. 

Industrials: Defensive industrial shares outperformed with Amcor (AMC) and Brambles (BXB) leading. Elsewhere housing names continued to struggle as investors adopted a more bearish view of housing activity and the property market- the building material names in particular were weak.

In this article, Michael Maughan, Portfolio Manager of the Tyndall Australian Share Income Fund, discusses the impact on the big dividend payers from decarbonisation and where he sees opportunities for equity income investors.

Knowing where a company or industry is in its economic cycle, allows investors the ability to judge when to invest, and when to wait for a cheaper opportunity. This is because companies are subject to different economic cycles.

For example, the mining sector aligns more with Chinese growth than the US. Understanding Capex cycles—including the coming decarbonisation cycle—are relevant for dividend-focused investors due to the deployment of cashflows within those companies.

Where has the Australian market's dividends come from historically?

First, we need to look at which sectors have yielded the highest dividends for investors.

Chart 1 shows that 37% of the yield over the past ten years has come from financials and materials. Not surprising given they are the largest sectors in the Australian market but perhaps surprising given mining companies often have a poor record in the capital discipline. That mix has changed over time, and those two sectors made up 56% of the yield in 2021.

Chart 1. 10 years of ASX200 dividends

Source: Tyndall, Jefferies

Banks have been consistent in their dividend payments except for a brief hiatus at the peak of COVID uncertainty. Materials have been more volatile with a big step down as China slowed and progressive dividend policies ceased in 2015/16, and a big step up in the past couple of years as commodity prices have boomed. However, going further back, the ability of miners to pay dividends was a function of the CAPEX they were spending and the prevailing commodity prices.

Over the past ten years, we have seen this trade-off between dividends and investment in energy names like Oil Search (now part of Santos) and Woodside. Oil Search prioritised LNG projects in PNG over dividend payments, and Woodside had a fluctuating dividend structure depending on its balance between producing assets and its LNG projects in WA.

As we discuss later in this piece, this balance could be changing.

So how could the energy transition impact big dividend payers' ability to maintain dividends?

Decarbonisation is a capex cycle to play out over 20-30 years. Firstly, companies are decarbonising their operations. Secondly, globally we need to spend trillions of dollars on new nickel, lithium, copper, and cobalt mines to renewably electrify the world.

While this doesn't sound great for dividends, the market has already factored much of this in. BHP and RIO Tinto have been explicit about the investments they are making to decarbonise their operations. BHP will increase capex by U$200 million p.a, for the next five years, and RIO Tinto will spend an extra U$500 million p.a. over the next three years.

The majority of this will go to renewable power generation in the Pilbara. Therefore, if there are extra costs of decarbonising operations (that may or may not be recovered in premium pricing), there is the capex opportunity to meet the demand created by the need for additional wires and batteries. Copper demand could double, and nickel demand could quadruple to meet Paris targets through ongoing electrification.

Net-net, this is a positive story for the diversified miners. Having growth opportunities to invest in that will generate cash and dividends in the future is much better than being a declining business with a high payout ratio. Share prices never assumed this level of cash flow was forever.

The banks have an opportunity to fund renewable projects through lending discussed by Brad Potter, Tyndall's Head of Australian Equities, in his article: Banks funding renewables set to drive growth. Chart 2. shows that Westpac has been skewing away from fossil fuels towards renewables for 10 years already. Whether the Australian banks will be able to compete with the global interest to lend to these projects is unknown, but it is more opportunity than risk.

Chart 2. Westpac's electricity generation lending over time and climate change solutions exposure

Source: The Westpac Group

Can dividends benefit from decarbonisation over the coming decades?

In the medium term, we expect that the traditional energy companies will be investing less capex, and concentrating on harvesting their current assets to facilitate the energy transition, meaning more cash being returned to shareholders through dividends and buybacks.

The mergers of Oil Search with Santos and Woodside with BHP petroleum create more balanced businesses with pristine balance sheets, strong cash flows, and a higher percentage of producing assets to fund growth opportunities or return cash to shareholders.

Interestingly, Macquarie is aggressively pursuing growth in both renewables and electricity infrastructure and have a model that develops assets on the balance sheet and then sells them down into funds in the same way the Goodman Group does for industrial property.

This focus has received a lot of attention and has been part of the stock's rerating. However, they also have one of the world's biggest energy trading businesses and therefore have been huge beneficiaries of the volatility in traditional energy markets.

The holy grail is a company that is exposed to the energy transition without necessarily being as capital intensive as a miner. One of the issues with the growth in renewables is that the transmission networks are not built for this decentralised generation structure.

We have lots of small producers, batteries that need electricity going in and out, and even household solar has changed the nature of the grid.

The result is that Australia need to add 10km of transmission lines to the existing 45km but current capacity to roll out is only 700m pa.

Downer Group is in a prime position to capitalize on this as highlighted in chart 3 as a leading player in electrical engineering and construction with 70 years' experience. Worley is also growing the part of their business that consults with the hydrogen industry, although their core fossil fuels business has associated downside risks.

Chart 3. Downer capabilities leveraged to decarbonization

Conclusion

While we see a peak in capital returns from miners due to unprecedented supply/demand imbalances and low CAPEX pipelines, the expected increased investment in decarbonisation programs is unlikely to wipe out the traditionally high yield of the Australian equity market.

The tax structure still incentivises Australian companies to pay franked dividends, and the index composition is skewed to cash-generating companies.

Over decades the Australian market has delivered net yields in the 4% range as shown in Chart 4 (5%+ grossed up for franking), and we don't expect that to change materially in the future.

Chart 4. The importance of dividend income to total return

Source: S&P/ASX; IRESS; Sub-periods are rolling five-years to illustrate consistency of income

Author: Michael Maughan, Portfolio Manager, Tyndall Australian Share Income Fund

In 1938, Ernst Chain,[1] a German-born biochemist working at Oxford University, found an article on penicillin written nine years earlier by UK bacteriologist Alexander Fleming.[2] In 1928, by fluke, Fleming noticed a zone around an invading fungus on an agar plate in which the bacteria did not grow. After isolating the mould, Fleming identified it as belonging to the Penicillium genus.[3]

But doing anything more with the unstable compound was beyond Fleming's skills, which is where Chain stepped in. He proposed to his supervisor, Australian pathologist Howard Florey,[4] that they isolate, purify and test the compound to see if it could kill microorganisms without harming their host. Florey, seeing penicillin's potential, assembled a team that in 1939 oversaw experiments where only treated mice survived.

By 1941, the group was experimenting on sick people. Because a UK stretched by war was incapable of producing enough penicillin, Florey travelled to the US to convince drug companies and officials to produce penicillin. When the US was drawn into World War II later that year, the government took over the mass production of penicillin to ensure the drug would be available for Allied forces. (It was by 1943).[5]  

In 1942, Fleming, who obtained some of the Oxford team's scarce penicillin, saved a UK woman who was dying of an infection. The Times of the UK published the feat, without referring to Fleming or Florey. Fleming's boss wrote to the newspaper praising Fleming who boasted in press interviews while Florey refused to speak to the media. Thus, many people today wrongly believe Fleming gifted penicillin to the world, even though Chain, Fleming and Florey equally shared the Nobel Prize for Physiology or Medicine 1945 and those in the know thought a self-promoter stole the credit from Florey.[6]

What matters more is Florey's vision led to one of history's key medical feats. The drug's breakthrough advantage was how cheap it was to produce. The antibiotic became a worldwide cure and boosted life expectancy, mainly by reducing childhood deaths. By 1954, for instance, pneumonia's death toll on US toddlers had plunged 75% from 1939 levels.[7]

Penicillin's wonders inspired the development of other affordable antibiotics that could combat an ever-wider array of ailments.[8] As antibiotics, antifungals, antiviral and other drugs that are grouped as antimicrobials were developed, optimists dared talk of a world without deadly infections.

What could go wrong? Four things. First, in the advanced world where prescriptions are regulated, doctors overprescribed and misused antimicrobials. Second, in the unregulated emerging world, people can buy antibiotics (many counterfeit)[9] at pharmacies without prescriptions and even find them at markets and shops. People thus mistreat or overtreat themselves with these medicines because it's cheaper and easier than seeing a doctor. The result is that up to 70% of human use may be inappropriate.[10] Third, 80% of antibiotic use worldwide is to fatten farm livestock and prevent livestock infections.[11] Efforts to curb such misuse have failed.[12] The fourth problem is that antibiotic and antifungal residue is too prevalent in third-world drug-making hubs such as India's Hyderabad.

The result? The natural immunity microbes develop over time has accelerated. 'Superbugs' have built resistance to antimicrobials and global deaths from drug-resistant bugs are mounting. Before antibiotics, only about one in 10 million bacteria would prove resistant to antibiotics. Now, given that bacteria vulnerable to antibiotics can't survive, it is estimated that up to 90% of bacteria causing infections are immune to previously effective antibiotics.[13]

As for deaths, a study led by researchers from the University of Washington out in January attributed 6.22 million deaths worldwide in 2019 to drug-resistant microbes (of which 1.27 million were a "direct result" of superbugs).[14] A 2016 UK-government-commissioned study predicted that as "routine surgeries and minor infections will become life-threatening once again" deaths would reach 10 million annually by 2050 - by when the accumulated cost of superbugs would be US$100 trillion due to the need to use costlier treatments and longer hospital stays to save lives.[15][16]

The University of Washington study suggested five ways to combat superbugs. First, improve sanitation and hygiene, especially for water, to limit infections. Second, prevent infections through vaccinations where possible. Third, reduce antimicrobial use in animals. Fourth, minimise the misuse of these drugs with people. Fifth, boost investment to find drugs that can defeat superbugs.[17]

Here lies a key handicap in the battle against infections that fail to respond to treatment. Few superbug-busting drugs are appearing because investment in the field is minimal compared with other spheres of public health. Only about US$1 billion a year worldwide is spent on research to combat superbugs compared with US$50 billion a year tackling HIV/AIDS in low- and middle-income countries[18] or an estimated US$157 billion to be spent on covid-19 vaccines through to 2025.[19]

Pharmaceutical companies, which rely on prescription-based sales for revenue, aren't investing enough because they can't recoup an adequate return for three reasons. First, the cheapness of antimicrobial generics makes hospitals reluctant to pay high prices for superbug stoppers. Another problem is that medical facilities use new superbug-busters as a fallback when generic treatments fail. A third hitch is that antimicrobials are taken for a short time only, whereas profitable drugs are usually ones that people take daily for years. The outcome is that sales volumes are too small to make new drugs profitable. As a sign of how fragile are the economics in this sphere, Big Pharma players have abandoned the superbug fight and smaller antibiotic-development companies struggle to survive, even after gaining approval for their finds.

A crisis around superbugs is building. A market failure means capitalism can't yet derive a solution to diffuse a foreseeable catastrophe. Governments need to do more when it comes to funding research and offering financial incentives for private enterprise because only alarming levels of deaths will improve the economics. Even though the pharmaceutical industry is likely to solve the problem in extremis, it would be too late for millions of people.

To be fair, policymakers are trying to stop the misuse of antibiotics - but with little success in the emerging world. To be fair again, authorities have tried to help develop superbug-busters. The PASTEUR Act of 2021 before US Congress provides incentives for research.[20] The Combating Antibiotic-Resistant Bacteria Biopharmaceutical Accelerator, or CARB-X, which is a public-private initiative, is spending US$480 million from 2016 to 2022 to solve the problem.[21] A UK initiative unveiled in April could become a global template for encouraging research because it offers to pay drug companies a fixed fee for supplying antibiotics.[22] Success might come but moneywise these efforts don't compare with the billions Big Pharma spends on research in lucrative areas. Some superbugs arise out of nature so antibiotic misuse and overuse are not to blame for all of them.[23] Doctors are finding novel ways to combat superbugs. Phage therapy, the use of specific viruses to target bacterial infections, is one of them.[24]

But greater efforts are needed. Surely in the medtech age, someone can discover a cure for superbugs. No one will care if self-promoters pinch the credit.

A flawed model

Before 1870, US pharmacies were virtually unregulated. Chemists sold remedies without prescriptions, heavily promoted quack cures and sold drugs now illegal such as cocaine, heroin and opium. Doctors overprescribed doses to be obtained from pharmacies because they knew chemists watered down medication. Newspapers so relied on advertising by drug companies they downplayed medical mishaps. By 1906, the harm to society was prominent enough to warrant the passing of the Pure Food and Drug Act, the first step in the US to regulate drug marketing.[25]

The act gave rise to the Food and Drug Administration, the US's oldest consumer-protection agency. Tougher laws in 1938 meant new drugs required the body's approval and some medicines required doctor prescriptions.[26] This doctor oversight meant the big drug companies founded after World War II aimed their advertising at doctors, not the public - by 1961, about 60% of the advertising budgets of the 22 biggest drug firms was targeted at doctors.[27] Thus formed the pharmaceutical business model, whereby drug companies identify promising molecules, test them, and, once gaining approval, target the medical industry for sales. Success is a 'blockbuster drug' that reaps annual sales topping US$1 billion year after year.

The model has provided the world with many wonder drugs but it's flawed at the same time. A major disadvantage is that many discoveries are so expensive as to be unaffordable. Another is a slowing rate of discovery of effective medicines - most of the breakthroughs such as antibiotics, the polio vaccine, heart treatments, chemotherapy and radiation for cancer were discovered between 1940 and 1980.[28] In terms of antibiotics, no major advances have come since the 1980s[29] - new drugs are variations rather than breakthroughs.[30]

A third disadvantage with the pharmaceutical business model is that the economics of certain spheres of medical research are so poor Big Pharma avoids the area and specialist start-ups can't survive. Such is the fate of research against superbugs.

In 2018, Novartis joined Allergan of the US, AstraZeneca of UK-Swedish origins, GlaxoSmithKline of the UK, The Medicines Company of the US and France-based Sanofi in quitting the fight against infections.[31]

One comfort when Big Pharma companies dodge the superbug fight is they often sell their infection-disease research units to small biotechs. The Medicines Company, for instance, in 2017 sold its portfolio to Melinta Therapeutics of the US,[32] while AstraZeneca in 2018 hived off part of its antibiotic research to Entasis Therapeutics[33] (which just announced a promising cure).[34]

But Little Pharma is besieged. The World Health Organisation says the smaller and mid-sized companies that dominate the preclinical and clinical antibiotic pipeline are "struggling to find investors to finance late-stage clinical development up to regulatory approval". As such, many companies disappear and so do their finds. Of 15 new antibiotics approved in the US in the decade to 2020, five were shelved as companies applied for bankruptcy or were sold.[35]

Take, for example, the experience of Achaogen. The US company collapsed in 2019 after spending about US$1 billion over 15 years to win Food and Drug Administration approval for Zemdri, a drug for hard-to-treat urinary tract infections and one the World Health Organization classes as an essential medicine.[36]

Somehow Zemdri is still available. To overcome the overall market failure that prevents the discovery of similar feats, the OECD said in 2017 it would take an extra US$500 million per year over a decade to make available four new 'first-in-class' antibiotics. Governments need to make this happen, just like the US government, thanks to Florey's efforts, ensured enough penicillin for the military in World War II.[37]