As society was exhaling from the post-war world of 1946, Arthur Lefford from NYU's Department of Psychology took particular interest in people's decision-making ability, especially as many generations (if they were so lucky) had just survived several globally disruptive periods. The new world presented choices and options that could lead to solutions on the social and economic problems that were now presented before them. This evolving case study provided Lefford the platform to challenge whether people expressed the (in)ability to act based on objectivity and rationality. Unsurprising to many of us in 2021, the results of the study found that people's agreeability to a message is often strongly correlated with their perception of the choice being more logical or rational. The inverse also applies; when there is disagreement with a message, people often consider this to be emotional. Decades later as the natural progression of this field of study cascaded into the world of finance, behavioural finance emerged and sought to study the effect of psychological factors on the economic decision-making process.

The focus of behavioural finance is the idea that investors are limited in their ability to make rational economic decisions, whether that be influenced by their own biases, by a lack of self-control or resources (i.e. time), by peer pressure (i.e. herd mentality) or a number of other social, cultural and external factors. If studied and watched closely, this irrationality can begin to reveal some patterns of behaviour and can lead to opportunities. The opposing camp to behavioural finance however, is the Efficient Market Hypothesis. The Efficient Market Hypothesis asserts that investors are rational, fully-informed, and that (stock) prices reflect all available information at any given time and therefore always trade at their fair value. Essentially making the ability to generate an excess return impossible.

From our perch, it currently appears that the broader financial system may be playing out a behavioural finance tragic's greatest fantasy. Alongside the apparent equity market exuberance and interest in speculative assets, it seems experts and arm-chair journalists are also attempting to forecast when the RBA interest rates will begin to rise. Whilst these pre-emptive calls make for fascinating reading, they can feed into the broader market's fear & greed complex. Simply, when interest rates are rising (or are lifted ahead of schedule), people are fearful they won't be able to pay their (increased) mortgage repayment and when they are declining (or are cut AHEAD of market consensus), greed dominates as money is perceivably cheap(er). From a business perspective, when interest rates rise, it tends to have a detractive effect overall as debt becomes more expensive (increasing the cost of starting new projects, assuming they are partially debt funded), consumer spending rates generally reduce, and cash leaves the system to be channelled elsewhere (e.g. the household mortgage). The converse also remains true, should interest rates be lifted at a point which is BEHIND consensus, this may allow markets to continue climbing further over the near term.

Interestingly however, should interest rates rise ahead of schedule and shock the market into price recalibration to reflect this new environment, one would expect fear and by that virtue, volatility to accompany irrationality as it replaces the current market exuberance. Perhaps this is what pundits and experts alike are trying to time or forecast. Timed correctly, one can quickly adjust a portfolio on a value vs growth or technical vs fundamental basis with the intent to be in the more favoured style. We however prefer not to market time or fluctuate between styles to try and match the macro environment. Conviction (or lack thereof) to an investment strategy and ethos can often be the difference between consistent and inconsistent returns.

It appears quite likely that at some point in the medium term the RBA will lift interest rates; from the lens of our investment strategy, we believe that timing this movement is largely an exercise in futility. For as long as irrational economic decision-making continues, one can expect volatility and with it, market opportunities for those who look.

As Australian equities have rebounded from the lows of late March 2020, many investors have doubted the rally's staying power. Pessimists argue that, based on most valuation metrics, stocks are pricey, which implies weak returns ahead.

But we believe that this overrates the predictive power of valuations - particularly in the short term. Instead, investors need to understand that long-run equity returns are driven by multiple components, of which valuation is often the least important.

Indeed, it is likely that in coming years investors won't be able to rely on rising equity valuations for their returns. To achieve high returns and realise their investment goals in this environment, they are going to have to become even more focused on identifying the companies that can produce strong earnings growth and cash flow.

Only 3 components

                Source: Refinitiv

Figure 1 above decomposes Australian equity market returns into their key components. As you can see, there are only three sources of returns:

• Income (grey bar) - dividends
• Earnings (orange bar) - how fast have companies grown their earnings?
• Valuations (blue bar) - how has price/earnings multiple changed? Does the market now value companies more or less for a given level of earnings?

The first two components of return are generally referred to as the 'fundamental' components, whilst valuations are often referred to as the 'speculative' component of return. The latter has earned this moniker because it is driven by unpredictable investor emotions, such as fear and greed, in the short term. (The sum of these components approximates the return on the stockmarket, shown with a black diamond.)

An erratic contributor

The sources of return never change. But their order of importance does. That is, during any of the five-year periods presented, one of these variables will exert a disproportionate influence on total equity returns. Conversely, there will be periods where a component makes little contribution.

There is no doubt that when valuations expand it can have a dramatic positive impact on total return. But valuation's contribution is highly erratic: sometimes positive, sometimes negative. When the P/E ratio expands, the stock market generally produces double-digit returns. And when the ratio contracts, returns fall into the single digits.

In the second half of the 1980s and the second half of the 1990s, for example, the P/E ratio was a strong driver of the era's spectacular market returns. But P/E detracted from market performance through the years 2000 to 2015 when valuations subsided from the start of the high tech bubble.

The exhaustion of PE expansion

When P/E multiples are expanding, interest rates are typically falling, and vice versa. For the two decades between 1980 and 2000, the downward trend in interest rates boosted P/Es, which resulted in huge growth in total equity returns.

More recently, we have seen this play out as central banks worldwide have drastically cut interest rates to support economies facing pandemic pressures.

But with interest rates now having already been reduced to the floor, the era of P/E expansion has been exhausted: it is unlikely that rates can fall much low and push further P/E expansion. Instead, rising rates over the coming years -as economic growth recovers -- are likely to force a modest decline in equity valuation multiples, similar to what markets digested through the years 2000 to 2010.

This negative outlook for P/E ratios emphasises the other two sources of equity return: earnings and dividends. As you saw in Figure 1, earnings and dividends, unlike the highly volatile P/E ratio, have had a consistently positive effect on total return over the last forty years. In fact, for much of the last twenty years, earnings and dividends have continued to boost total return, while P/Es have hindered market performance.

The emerging primacy of earnings and dividends

But while earnings and dividends become more important as sources of returns, the period of double-digit earnings gains for the broader equity market will soon be behind us as economies normalise post the COVID-19 pandemic. Going forward, earnings growth will likely occur at a more modest single-digit rate.

Fortunately, our investment process has always focussed on finding the companies that can materially grow earnings. In this environment, our expertise in identifying the profitable growing businesses of the future comes to the fore.

Meanwhile, because they are often a preferred method of free cash flow deployment, dividends are set to emerge as a more important component of total equity returns. Although we are biased to companies that can grow earnings faster than the market, we will continue to learn everything we can about a company's free cash flow and what it signals for the businesses capital management policies.

A solid year of returns from equities

Valuations are not good predictors of short-term market returns. It is futile for investors to use valuations to time the market day-to-day or month-to-month.

Valuations could fall but that does not mean returns have to be negative if the other two drivers contribute enough.

For long-term investors, the best course is to continue investing according to your plan, regardless of what the market does. You may, at times, buy when valuations are high; on other occasions, you will buy when valuations are low. It should all come out in the wash over the long term.

Our base case is we expect a year of solid returns from equities in 2021, but with the usually very high degree of uncertainty. At a very high level, the global economic recovery, which is currently playing out, suggests that earnings growth should positively contribute to markets in 2021. The big differences could arise from valuations. Dividends should also be well supported this year, particularly in commodity and consumer-related stocks.

We think investors can no longer rely on a rising tide of higher valuations to lift all stocks. Alpha or outperformance, where it can be found, we be a larger portion of total investor returns. For us, we will continue to focus on finding undervalued small and mid-cap companies that through a superior product or service can one day become the future leaders of tomorrow. These type of businesses will continue to be rewarded with expanding valuations as the market recognises their superior growth trajectories.

Producers in both China and the US are facing higher costs, prompting growing concerns that inflation could threaten the global economy - but China isn't waiting to find out given its recent history with inflation.

Interestingly, Chinese consumers are facing much less pricing pressure than their American peers, so why are the Chinese more concerned over higher commodity prices? This could be a potential headwind to Chinese economic growth.  Top Chinese officials like Premier Li Keqiang and Vice Premier Liu He recently expressed concerns for manufacturers and the adverse effect of rising commodity prices including the potential pass-through to consumers for some goods. In response, Chinese regulators were tasked with curbing the excessive speculation in the commodity market by imposing new limits on the trading of commodities and increasing some export taxes.

China has clear reasons to fear inflation with memory of past price increases still vivid, including the +135.2% surge of pork prices and +5.2% consumption inflation in February 2020. But, in our view, the threat of no inflation pass-through is more pressing.

Is China exporting higher prices?

Since joining the World Trade Organisation in 2001, China has engineered a complete industrial system. The upstream raw materials sectors have been dominated by big companies, which are closely associated with central or local governments. These companies have the pricing power to transfer the input cost pressure to mid- and downstream companies. Notably, the producer goods price increased by +12.0% in the last twelve months, as of May 2021. But the inflation pass-through stopped here and did not flow downstream. The price of consumer goods increased by only +0.5% during the same period. Mid- and downstream companies failed to pass the higher input cost to the consumers. A few factors contributed to the no pass-through of inflation which are discussed below.

Figure 1 - China Producer Goods vs Consumer Goods

                                  Source: Bloomberg, JCB.

Firstly, the competition at the mid- and downstream level is fierce. When Chinese manufacturers had a limited technology edge, they won market share via lower prices thanks to cheap labor costs. This led to overcapacity and triggered the supply side structural reforms of 2015. Prior to the full blown COVID-19 impacts, industrial upgrading and technology innovation was still undergoing and far from complete. In short, if your competitive edge is price, you cannot jack-up price so easily.

Secondly, there is no positive domestic demand shock in China. Unlike many developed countries, the Chinese government didn't implement a large fiscal transfer to boost household balance sheets. The recent retail sales and service output data showed that demand is growing but at a lower-than pre-COVID-19 speed. With largely stable domestic demand, mid- and downstream manufacturers could not raise prices without losing market share. Due to the strong recovery of overseas demand, those downstream manufacturers, who have the capability to compete in overseas markets, may charge higher prices, i.e. exporting the inflation. However, the recent appreciation of RMB has posed a headwind. The latest survey data shows the slowdown of new export orders.

Figure 2 - Chinese producers pass through the price pressure to US customers

                                  Source: Bloomberg, JCB.

Overall, high commodity prices without inflation pass-through simply means profit squeezing for mid- and downstream firms. In late May 2021, Chinese state media reported that some downstream producers stopped taking new orders as the more they produced the more they lost. In our view, China shouldn't worry too much about the threat of the high consumer inflation for now as it is difficult for downstream producers to pass through the price pressure. However, the profit squeezing caused by the no pass-through is right here. We believe it is a headwind to Chinese economic growth, which explains why policy makers are tackling the high commodity prices.

Some Chinese trading firms have increased inventory of physical commodities and tried to corner the market. Regulators called them to stop the market speculation and manipulation. China would also maintain the macro prudent policy and keep the credit impulse low. This would avoid spurring the property bubble further. Historically, lower China credit impulse was linked to lower commodity prices.

However, things may be different this time. The expansionary fiscal policy from the Biden Administration could make the U.S., instead of China, the marginal buyer in the commodity market. While U.S. consumers use the stimulus money to pay for higher gasoline prices during their summer trips, Chinese producers could face further profit squeezing. History suggests that the turning of profitability in the Chinese corporate sector can have significant impacts on regional equity markets, with associated impacts across the macro spectrum, investors should pay attention to the lack of pass-through pricing power given this higher inflation impulse in China as an early warning sign of fading corporate profitability.

Figure 3 - China Credit Impulse falling

                                      Source: Bloomberg, JCB.

Figure 4 - China Corporate Profit Index vs MSCI Asia x Japan Index

                                      Source: Bloomberg, JCB.