In this week's video insight Roger discusses what could be next for the stock market. We already know that P/E ratios have compressed considerably, and taken into account all of the increase in bond rates. What they haven't done, of course, is priced a very significant recession, nor have they priced the possibility of a financial crisis of any description. But what happens if rates stop rising, and if economies don't go into a recession, and we don't get a financial crisis?

Transcript 

Roger Montgomery:

Hi, I'm Roger Montgomery, and welcome to this week's video insight. Well, bearishness pervades almost every corner of the market at the moment. In my travels, in talking to brokers, other fund managers and economists, I don't find many people who are very bullish at all. In fact, most of them expect another leg lower in the stock market. Of course, for me, that starts to become optimistic because if everyone's already bearish, there's not many others left to become bearish. Those who are bearish have already sold, there's not many people left to sell, and so it may be that prices are now on the cusp of a bounce.

But rather than speculating about that, let's just think logically about what could happen next. We already know that P/E ratios have compressed considerably, and taken into account all of the increase in bond rates. What they haven't done, of course, is priced a very significant recession, nor have they priced the possibility of a financial crisis of any description. We'll address those two subjects in a moment.

But if rates stop rising, and if economies don't go into a recession, and we don't get a financial crisis, then there's a very real possibility that the indiscriminate selling that we've witnessed recently becomes something more discerning and buyers return to the market to look for downtrodden, high-quality growth companies. That's one possibility. The other possibility, of course, is that the deterioration in consumer confidence, such as what we're seeing in New Zealand at the moment, after five interest rate increases there, and a similar event here in Australia is a consequence of rising prices as well as declining property prices, could result in less funding being available to venture capital and private equity companies. If that happened, then that would mean a lot of people who are currently employed, thanks to the altruism of shareholders, could become unemployed.

There's also a more significant possibility that those people employed in construction, and remember construction is the third largest employer in Australia, there's a very distinct possibility that those people have less work on. And that's because falling house prices and rising costs make people defer or delay any alterations and additions that they might have conducted on their properties. And so it's significant to think about, or important, rather, to think about the possibility that we get rising unemployment from those sectors of the economy that are being funded by altruistic shareholders, those who have previously had very cheap money or free money to access to be able to fund startups, venture capital and private equity. Or there's a possibility that we see unemployment rising amongst those people in the construction sector.

Now, thinking through the transmission mechanism of that, if that happened, then we would get a much more significant decline in economic growth, and then the possibility of a recession goes up. But as I said earlier, in the absence of a recession and in the absence of a financial crisis, and I don't think any of those two things are very likely right now, then we're in a situation where we've had indiscriminate selling, pushing P/E ratios very, very low, and that of course means the possibility of better returns in the future. So if indiscriminate selling gives way to more discerning buying, we'll get an expansion of P/Es again, and that will increase the return available, that would normally be available, rather, just from the earnings growth.

So my suggestion now is to start dipping your toe back in. It's not a recommendation of course, but it's something that I'm doing myself. I don't know whether prices will rise from here or continue lower. It could be that the rest of my peers in the market are absolutely correct and we get another leg down. I just don't know. But I do know that there are some mouthwatering opportunities already appearing, and rather than try and predict what prices are going to do next, I'd rather start filling my portfolio with wonderful businesses at rational prices. That's all I have time for today. I look forward to speaking to you again next week, and in the meantime, please continue to follow us on Facebook and Twitter.

Speaker:  Roger Montgomery, Chairman and Chief Investment Officer

A recession is commonly defined as two consecutive quarters of real GDP decline. It is characterised by falling economic activity, increasing unemployment and decreasing consumer and business confidence: with both groups being more cautious in their spending. Investment spending also slows. The GFC, between mid-2007 and early-2009, was exceptionally bad on all of these metrics, resulting in a significant fall in share markets - the previous peaks of which were not recovered for another five years. And yet, over those same five years, many disruptive companies outperformed the S&P 500 (quite significantly in some instances). How could that be?

Over the five years it took the S&P to recover its 2007 high, Netflix's share price grew +731%, Amazon +180%, Apple +164%, Alphabet +30%

Source: Bloomberg

Then, as now, there were a number of key disruptive trends working their way through the economy. Smartphones were becoming ubiquitous, e-commerce was in its infancy but growing strongly, online advertising was taking hold and streaming was beginning to benefit from faster download speeds. The simple answer is that the disruptive trends benefiting these companies were a greater force relative to the economic headwinds they faced.  

E-commerce and Amazon

For many decades, retail was a story of growing concentration, housed in a physical structure of some kind, from the early day 'mom-and-pop' shops to shopping centres. However, it was the advent of the internet in the 1990s that brought with it the ability for consumers to browse and shop online, a much more convenient solution. Even with logistics networks that were not yet properly built out, e-commerce took market share from brick and mortar retail each year. E-commerce's share of retail in the US still grew at the depths of the GFC between 2007 and 2008 (3.5% and 3.6% respectively), and the trend accelerated to the point until today (aided by superior logistics networks and same day delivery). 
 

E-commerce as % of Total Retail Sales in the U.S.

Source: U.S. Department of Commerce

Online Advertising and Google

There was also significant change underway within the advertising industry at the time of the GFC, fuelled by digitisation and the changes to consumer behaviour that it brought about. Time spent online increased, so advertisers needed to follow. This time, however, companies placing advertising had granular targeting capabilities the likes of which were never available for traditional media such as newspapers, magazines, radio and linear television. Once again, a better, more efficient solution had arrived. So while the global market for advertising declined significantly during the GFC (almost -10% in 2009), market share within the industry tells a very different story. 

% of Total Advertising Revenue by Category (Global)

Source: Magna

Some of the more inefficient means of advertising, where reach (the number of people who saw the advertisement) was also suffering, experienced declines of almost -20% at the low of the GFC (linear TV was the only exception, largely a function of increasing - but peaking - growth in pay TV households). These types of advertising never recovered. Meanwhile, online advertising grew +5% at a time when many businesses didn't know whether they would trade the following week. Online growth did slow from +20%, but given the overall market for advertising declined -10%, it resulted in some very large market-share gains.

Streaming and Netflix

There was also an interesting dynamic occurring in the lead up to and during the GFC in the entertainment industry. Pay TV households in the US were still growing, but streaming was also becoming an increasingly appealing option. It was a new and better way to consume content from the largest and best studios, although often with a slight delay, but without the $100-200/month price tag of cable. That it was a better solution was often lost on those working at incumbent entertainment companies. The head of Time Warner Jeff Bewkes famously stated in 2010 that Netflix was not a threat to media companies and that it was "a little bit like, is the Albanian army going to take over the world? I don't think so." We know how that played out. During the GFC Netflix managed to grow from 7.5 million subscribers to 20 million subscribers by the end of 2010 (a respectable +39%, 3-year subscriber compound annual growth rate).

Netflix Subscriber Growth from Inception to 2021

Source: Company Filings

Smartphones and Apple

The iPhone was launched at the beginning of 2007 and arguably kick-started the mobile revolution (although it wasn't the 'first' smartphone). The product launch came just a few months before early signs of financial stress and at a time when Nokia was king of the mobile market, with market share of almost 50%. But the iPhone was different. There was no stylus or keyboard, it provided access to the open internet in a way that smartphones of the past didn't and there was soon an app for anything and everything (especially functions previously performed by other devices). It was simply a better solution than its predecessors and it was because of this that Apple grew its iPhone sales from nothing in 2006 to 4 million in 2007 and 48 million by 2010. It wasn't just Apple iPhone sales either - smartphone sales showed significant growth, despite higher price tags and severe economic weakness:

Number of Smartphones Sold to End Users Worldwide from 2007 to 2021

Source: Gartner

There are many new disruptive trends happening right now that are unlikely to change course in the face of economic headwinds. Carmakers aren't going to go back to making more internal combustion engine vehicles, nor are they going to cut back on safety features like advanced driver assistance or digitised infotainment (all of which is powered by semiconductors). Business aren't going to turn back on their digital transformation plans. They certainly aren't going to cut back on their cybersecurity budgets either. 

And interestingly, many of the disruptive trends listed above still have a long way to go, even after more than a decade of progress: online advertising shows no signs of slowing, e-commerce is at under 20% penetration, streaming represents only 46% of TV viewing and smartphones are undergoing a 5G supercycle. 

Despite the potential of a recession, disruption marches on. 

Invest in inflation. It's the only thing going up.

-- Will Rogers

Every day we read about higher costs of food, energy and property via higher interest rates, while our pay packets don't seem to be rising as fast as the cost of living. 

We're being told to learn to cut back on our quality of life and to expect lower returns going forward from our investment portfolios because of ostensibly more difficult business conditions and, prima facie, higher than typical stock valuations.

The spigots of 'helicopter money' opened by central banks all over the world are slowly being closed along with rising interest rates that make the traditional 'safe haven' of fixed income, riskier than recent historical experience would suggest. In addition, the spectre of war is a key risk as the probability of conflicts increases during poor economic times.

What is an investor to do? In an environment of low economic growth, high inflation (a situation known as stagflation) as well as tightening monetary and fiscal policy along with geopolitical risks.

A sensible thing one can do is to put more onus on tangible, hard assets versus the recent popularity (and erstwhile success) of investing in abstractions. In these adverse market conditions, we believe that it's prudent to get back to the basics.

Accordingly, factors such as positive cash flow, positive real returns (post-inflation), relatively low valuation multiples, returns to shareholders via capital initiatives and strong market leadership positions we view favourably. 

Which asset classes will be resilient?

We can use history as a guide in comparing similar environments in the past with the present day. The stagflationary environment in the 1970s is a reasonable comparable in some ways to the present day, with numerous 'oil shocks' experienced analogous to the global 'energy molecule' crisis being experienced today.

The sector that experienced the best returns over this decade was the energy sector, with the worst returns coming from the technology sector. Value and small-cap assets performed best throughout the decade, with growth assets and government bonds providing the worst relative returns.

Accordingly, we believe the most favour sectors to be going forward to be:

• Energy - unpopular and cheap due to ESG mandates with material operational leverage to higher energy prices going forward
• Agriculture - defensive, real asset class, albeit with typically lower returns
• Tangible goods and commodity producers - will benefit from the trend towards greater localisation and the unwinding of globalisation

It's important to observe that recent inflation has been driven by shortages and supply chain disruptions. Rising rates are unlikely to control inflation in the short term. Inflation has been labelled the 'silent tax' as it essentially measures the fall in a currency's purchasing power. It reduces the standard of living for the majority, which has the knock-on effect of reducing economic activity and increasing the probability of a recession.

Accordingly, it's imperative to invest with those stewards of capital that can outperform the rate of inflation earning a real rate of return, thereby preserving one's purchasing power and quality of life. Passive market exposure may not provide this however, we firmly believe that the appropriate actively managed funds in combination with other uncorrelated assets provide a higher probability of preserving an investor's wealth in real terms.

Since August 2018, the ASX200 Total Return index has compounded at an annualised rate of 8.79% per annum. Over the same timeframe, as an example, the Datt Capital Absolute Return Fund has doubled the index return: achieving 17.73% per annum (past performance is no guarantee of future performance) at lower relative risk, despite some of the most turbulent markets in living memory.

This demonstrates the importance and value of adding high performing active managers; with the ability to invest within the sectors experiencing tailwinds to a diversified portfolio as a potential hedge against inflation.

Author: Emanuel Datt

June 2022

Abbott Nutrition, which controls 48% of the US$2.1 billion US infant-formula market, in February recalled three product categories and closed a plant in Michigan after four babies who had consumed its powdered milk became sick with life-threatening bacterial infections even though there was no proven link.[1] By May, the US had a shortage of baby food - as in bare shelves (a nationwide out-of-stock rate of 43%),[2] panic buying, parents resorting to dangerous homemade remedies,[3] and infants hospitalised because not even doctors could obtain the specialised formula they needed.[4]

That such a wealthy country has a shortage of baby food symbolises how the world is dogged by scarcity. The global manufacture and distribution of basic, essential and technological goods is muddled. The world's food supply can't get to everywhere it's needed. Countries reliant on imported energy are vulnerable. At an industry level, automobile production is hampered by a lack of parts. Industrial revenue has dropped due to a backlog of orders. Restaurant margins are under pressure. Retail is lacking stock and staff. Building is delayed. Tech companies lack the essential components. Some niche industries such as 'fast fashion' (online-clothing sales driven by Instagram influencers) face collapse.    

Supply is snarled for (at least) eight reasons, and the damage is magnified because many are occurring at once. The first and underlying problem is that supply lines are too precarious. One hiccup in these over-complicated, sprawling and self-organising production networks causes a shortage. Outsourcing and specialisation taken to the nth degree have meant that multinationals don't even know who are their suppliers. About 70% of 300 companies surveyed by India-based Resilinc Solutions in 2020 couldn't identify their suppliers in China just after covid-19 became apparent.[5] Adding to the mess is that an overreliance on China, just-in-time production, minimal inventory practices and high industry concentration reduce the margin of error for supplies. Even before the crisis in the four-producer US infant-formula market was apparent, a US Department of Agriculture report in February listed tackling industry concentration as "priority one" of six to strengthen the US food supply.[6]

The second reason for shortages is climate change. Floods in China, heat waves in India and droughts in the US - more locally, heavy rain and not much sunshine in Queensland - mean crops are failing to enjoy the temperate weather needed for good harvests. Climate-change-related blows to food in storage (electricity failures that lead to a loss of cold storage) and damage to transport infrastructure "could significantly decrease availability and increase the cost of 22 highly perishable, nutritious foods such as fruits, vegetables, fish, meat, and dairy," the UN Intergovernmental Panel on Climate Change warned in March.[7] The other side to climate change is that its solutions are naturally hostile to investment in fossil-fuel production, and oil, gas and coal shortages loom when there is no foolproof replacement.

The third reason is a scarcity of labour. Low unemployment means companies are struggling to find enough qualified workers. So firms are forced to cut production. In the US, for every two job openings in March, there was only one unemployed person.[8] A lack of workers has added to shortages when it has manifested as a disruption to transport. Think not enough truck drivers.

The fourth reason is 'chipageddon', the term for a lack of microchips over the past two years because demand has outstripped global production capacity. Since a piece of silicon that contains nanoscopic electronic circuits component powers so many goods these days, the result is a shortage of everything from lightbulbs to cars to medical devices.[9]

A fifth reason for shortages is the tension between China and the West that is impeding trade and investment - Intel CEO Pat Gelsinger in 2021 said Beijing-Washington strains made it hard for chipmakers to expand production.[10] As well as deterring investment, the politically driven impediments include export bans, tariffs and import quotas. 

Another reason for the shortages (especially of microchips) is covid-19. Lockdowns and logistic disruptions especially at ports hammered production and jammed container deliveries by ship and truck at a time when government stimulus boosted demand for goods. Freight costs rose so much companies such as Costco, Home Depot, Ikea and Walmart found it cheaper and more reliable to hire ships. China's 'zero-covid' response this year to the Omicron strain is bound to extend 'Made in China' shortages.

The seventh reason is Russia's attack on Ukraine, two countries that account for 12.4% of calories traded, much of it to poor countries.[11] Western sanctions to punish Moscow are denying European businesses the Russian oil and gas they need to operate. Blackouts are possible, as are factory closures.[12] The sanctions are blocking the export of the fertiliser that helps farmers worldwide maximise crop output. In Ukraine, the fighting, Russian plundering and sabotage of rural production and Moscow's siege of Black Sea ports are blocking the export of grain staples.[13] Many warn of a global famine. The head of the UN's World Food Programme in May cautioned that hundreds of millions of people are "marching to starvation" in what could rank among the worst humanitarian disasters since World War II.

The last reason given here for the shortages is fear of shortages. The panic-driven hoarding that emptied supermarkets of basic goods at the start of the covid-19 pandemic is reappearing in other forms. The US-based International Food Policy Research Institute said by early April at least 16 countries had banned export amounting to 17% of traded calories to stockpile local supplies. The list includes India outlawing wheat exports and Malaysia forbidding poultry trade at a time when 80% of the world lives in countries that are net importers of food.[14]

The shortages behind delays, waste, forgone production and lost sales come with notable macroeconomic and political consequences. Economic growth will be lower than otherwise and inflation higher because scarcity makes prices much more sensitive to demand. Even if demand is steady, interruptions to the supply of goods result in the 'supply-side' inflation that central banks can do little to subdue. At the same time, high demand for labour leads to wages-price spirals that enshrine inflation, though at least central banks can calm an overheated labour market with rate increases. But the combination of reduced demand to subdue wages inflation, forgone production from supply shortages and hard-to-suppress supply-side inflation is stagflation.

The political consequences of shortages and inflation are the protests directed at authorities that litter history, most prominently when hunger is driving the anger. Sri Lanka's deadly political turmoil and economic collapse is the latest example; all the more tragic because a government decision in 2021 to ban fertilisers and pesticides created a famine.[15]

In a world of shortages, how can businesses and policymakers help? Governments are pondering sending in navies to get produce through the Black Sea. So far, too risky. More mundane decisions include that officials can reduce the amount of grain used in biofuels to help the world can feed itself.[16] Policymakers could prioritise fomenting another 'Green Revolution' by encouraging the adoption of 'agritech' to boost crop yields.[17] Business options include proper mapping of their suppliers, 'reshoring' and diversifying sources. Firms can use shorter shipping routes, undertake more frequent stock updates, pre-order and manage inventory levels more prudently. Truth is there are no quick solutions. The age of scarcity will pass but not for a while and not before it has shaken the world.

To be sure, the 'everything shortage' is an exaggeration. Many would say that capitalism responded brilliantly to a surge in demand for medical and durable goods during the pandemic.[18] Policymakers are exaggerating the inflationary effects of shortages to shift blame from the excess demand they created with their fiscal and monetary stimulus during the pandemic. The worst appears over for shipping disruptions - peak dislocation seems to have been late last year. Same too for chip production, according to car makers,[19] while US retailers are complaining of too much inventory. But that's due to a drop in demand. Governments are taking action. Washington in June used emergency powers to solve a logjam of imports of modules and components for the solar-power industry.[20] But businesses immediately said this action would impede their efforts to boost domestic production.[21]

Whatever the best way to ensure the US advances solar power, governments have the lesser role in solving today's shortages because their conventional economic tools are of little use. By and large, scarcity is a problem that business needs to solve. Babies depend on it.

Organic failure

In 2019, Sri Lankan President Gotabaya Rajapaksa unveiled "Vistas of prosperity and splendour," his vision for the island nation that had long been self-sufficient in food. Among many goals was one to "promote and popularise organic agriculture during the next 10 years".[22] In April 2021, Rajapaksa embarked on the world's greatest organic farming experiment when he suddenly banned the importation of chemical fertiliser and pesticides and ordered farmers to go organic without any help from imported organic fertiliser.[23]

The results are tragic. Within six months, Sri Lankan rice production plunged 20% and rice prices soared 50%. The government was forced to import rice and ease the ban on chemicals.[24] But coupled with the pandemic's blow to tourism, the loss of tea exports to Russia and rising oil import prices, the U-turn wasn't enough. Sri Lanka has collapsed economically and politically. (Rajapaksa was ousted in May.)

To some extent, Rajapaksa's shift to organic farming was a reversal of the great advances in farming in the 1960s when emerging countries adopted modern techniques.[25] Led by US scientist Norman Borlaug who won the Nobel Prize for Peace in 1970 for sparking the Green Revolution, crop yields surged, often doubled, across developing countries, especially the Indian subcontinent, thanks to the introduction of "higher-yielding short-strawed, disease-resistant wheat" that demanded the use of fertilisers and pesticides.[26]

Organic farming produces up to 50% less food per hectare than conventional farming because it requires farmers to rotate soil out of production for pasture, fallow or cover crops.^[27] Amid warnings of a global famine due to a fertiliser shortage and adverse weather, the world needs another technologically driven Green Revolution.

Adversity spurs innovation.[28] If babies and others are in want, watch for technological advances in farming to ensure the world can feed itself again.

By Michael Collins, Investment Specialist