Investors on tenterhooks over inflation

Investors on tenterhooks over inflation

A frustrated US President Harry Truman apparently pleaded for someone to find him a one-handed economist, so he wouldn’t constantly be told “on the other hand”. Right now, inflation is at the centre of ongoing debate among economists with opposing views that are critical for financial markets.

Why is it critical? It’s a broadly accepted tenet of financial markets that low inflation supports higher asset valuations, such as higher PE (price to earnings) ratios. Likewise, the lower inflation is, the lower long-term bond yields are, which means the discount rate used to calculate a discounted cash flow (DCF) valuation is lower, which results in higher asset valuations.

Low inflation has provided a powerful tailwind to the post-GFC bull market in global equities. The Australian ‘core’ inflation measure, which strips out the effect of the more volatile prices like food and energy, peaked at about 4.8 per cent in 2008 and trended down to 1.1 per cent in 2020. In the US, core CPI has varied around 2 per cent for most of the post-GFC period, while in Europe it’s been around 1 per cent.

Financial markets are concerned that a meaningful rise in inflation will force central banks to raise interest rates, which will flip the story to a serious headwind. The potential PE de-rating would hit the higher priced tech stocks especially hard, meaning the US share market would be particularly vulnerable. And as the old saying goes about America sneezing…

So why the concern now? Inflation measures around the world have spiked this year. Australia’s headline CPI rate jumped from 1.1 per cent in the March quarter, to 3.8 per cent in June, and in the US the CPI leaped from 1.7 per cent in February to a 13-year high of 5.4 per cent in July. While the respective core rates were lower, nevertheless they too saw a substantial jump.

What has economists divided though, is whether this spike is transitory and inflation will drop back down, as the central banks argue, or structural and so will continue to rise.

On the one hand, the transitory camp argues that because prices collapsed after multiple countries locked down between March and June last year, it was always going to look like a huge increase this year after those same prices had largely recovered.

An excellent example of this is the oil price. Over the year to Australia’s June 2021 CPI figure, the oil price increased 200 per cent, from $25 per barrel to $75. Automotive fuel prices rose 27 per cent over that same period, which, by itself, added about 1 per cent to the overall 3.8 per cent increase in the CPI. If fuel prices stay the same for the next 12 months, and nothing else changes, inflation should drop back to 2.8%.

Likewise, May saw the largest year on year increase in the US CPI since 1992, but three categories that comprise about 5 per cent of the core CPI drove 50 per cent of the monthly increase, and they were all associated with transport and mainly reflected used car prices jumping by almost 50 per cent over the year.

Proponents of the transitory view point to the 10-year government bond yield, which, at 1.25 per cent, shows the financial markets are sanguine about the prospects of higher inflation. Sceptics argue that simply reflects the heavy involvement of central banks.

On the other hand, the economists arguing inflationary pressures are likely to persist point to the sweeping changes many companies are making to supply chains as they prioritise security of supply over cost, undermining the disinflationary effects of globalisation. Also, rising wage pressures, more so in the US than Australia, will increase aggregate demand and could force companies to increase prices. Finally, some argue once the acceptance of rising prices is entrenched, it becomes a self-fulfilling prophecy.

Inflation is awesomely complex and there is no cogent, complete model for it. Research by Ulrike Malmendier, Professor of Economics at Berkeley, shows peoples’ inflationary expectations are shaped by their lifetime experiences, regardless of their level of expertise. So those economists that lived through the stagflation of the 1970s might therefore be expected to be more cautious than those who didn’t. Smart investors will be well advised to watch carefully for inflation, but as usual, it’s likely the markets will pick it up well before we do.

We’re hard wired to listen to doom and gloom merchants

We’re hard wired to listen to doom and gloom merchants

It’s an old adage that financial markets climb a wall of worry, and the higher markets climb, the more worried we get about the next inevitable selloff.

Just this year, to mid-August, the ASX 200 has hit 19 new all-time highs, the US’s S&P 500 has hit 49 and even Europe’s STOXX 600 has made 31. So it shouldn’t be surprising that the worriers are sounding the alarm that the good times can’t go on forever and that a return to harsh reality is right around the proverbial corner.

As long as there have been financial markets, there has been a thriving industry of tip sheet spruikers and self-proclaimed gurus jostling for your attention with empty promises of expert insights for the low, low price of a subscription or a book.

Many of these experts make a career out of scaring the bajeezus out of people by forecasting the next imminent crash. People like Harry Dent Jr, whose books include The Great Depression Ahead (2009), The Demographic Cliff (2014) and Zero Hour (2017), and who has forecast 40-50 per cent share market corrections pretty much every year since the GFC, even offering dates for when the catastrophes will happen.

Of course, when the forecasts prove to be wrong each time he has the readymade excuse that it’s ‘because central banks are propping things up, which will only make the coming crash even worse’.

So why is it that, despite sounding ridiculous, people like Dent can always find an audience?

Nobel Laureate Daniel Kahneman, one of the godfathers of behavioural economics, made his career out of analysing why human beings have a tendency to be their own worst enemies when it comes to investing. He identified a number of biases that are ingrained into almost all of us which cause us to behave in ways that are generally predictable and usually make us follow the herd.

One of those is the negativity bias, which is the human tendency to give far more attention to negative details than positive ones. It emanates from the lizard part of our brain that is alert to existential threats, the part that presumes unfamiliar things are bad for us until proven otherwise. While it’s been critical for survival, since without it humans may never have made it past being lunch for sabre toothed tigers, it wreaks havoc with our ability to remain objective in the face of what we perceive to be a genuine threat.

It’s been proven that negative headlines on Google get more clicks, which moves the negative news items up the rankings, which makes more negative items appear in our search results and news feeds. Eventually it makes us feel like we’re surrounded by nothing but bad news. In part it’s our heightened awareness of negative news that makes us susceptible to the gloom and doom merchants who warn of coming crashes.

When markets are at all-time highs, the doom merchants have a field day cautioning that ‘things have never been so uncertain and so expensive’. However, smart investors should pause and reflect that financial markets have never, ever been, nor will they ever be, certain. If they were certain, prices would either be zero or infinitely high.

Adding to the problem is the lizard part of our brain plays tricks on us. Professor Philip Tetlock has found that we perceive bearish people as smarter, and experts who are honest enough to acknowledge the future is inherently unknowable, and instead talk in probabilities, are not only seen as dumber but also less trustworthy.

Another salutary lesson against listening to doom merchants and tipsters in general, comes from a survey undertaken by US firm CXO, in which they assessed 6,582 forecasts for the US stock market published by 68 different gurus between 2005 to 2012. The result: a success rate of 47%. You get better odds from tossing a coin.

Listed property trusts: primed for a rebound

Listed property trusts: primed for a rebound

Property was possibly the worst affected sector when governments around the world pulled the plug on their economies in 2020. Not only did workers stop going into office buildings and shoppers stopped going to malls, but landlords were forced to shoulder the added burden of rent holidays and eviction moratoriums.

Little wonder real estate indices plunged. Locally the Australian Real Estate Investment Trust (AREIT) index fell 39% between the end of January and March last year, while the global benchmark, the FTSE EPRA Nareit Global index (GREIT), dropped 28% (in USD terms).

However, lingering concerns about both delays in returning to work combined with the effect the new paradigm of working from home will have on valuations for commercial property, as well as the impact of the accelerated migration to online shopping on retail values, have seen real estate indices lagging behind the broader share markets’ recoveries following the COVID crash.

The AREITs index is still 14% below its high of last year, while the ASX200 is only 1% away. Likewise, GREITs have managed to get square with last year’s high, but they’re a long way behind the 19% increase in global shares.

These differences offer smart investors the opportunity to buy what some strategists are describing as the only cheap sector left. Tim Farrelly, a highly regarded asset allocation consultant, recently wrote “Despite pretty severe assumptions on the outlook for rental growth, such as a fall in real office rents of 45% and a fall in real retail rents of 20% over the next decade, the overall impact on 10-year returns is not nearly as catastrophic as might be expected, as markets appear to have priced in these falls and more.”

Indeed, Farrelly’s 10-year return forecast for AREITs is 6.8% per year at current levels, while the forecast for Australian shares is 4.8%. Likewise, Heuristic Investment Systems, another asset allocation consultant, has a 10-year forecast return of 6.25% and an overweight recommendation.

While AREITs do offer compelling long-term value at current levels, our domestic market does suffer some limitations. It is highly concentrated, with the top 10 companies accounting for more than 80% of the ASX 300 AREIT index, and just three sectors, retail, industrial and office, making up more than 60%. The superstar of Australian property trusts, Goodman Group, alone is almost one quarter of the whole index.

By contrast, global REITs not only offer the compelling value, plus, at more than A$2.4 trillion, the total market is more than 19 times bigger than Australia’s. The top 10 companies account for less than 25% of the index and the biggest single company is only 5%.

Most importantly, there is abundant diversification, including to sectors that offer leverage to some of the most important structural themes in global markets. If you want to gain exposure to growing digitisation, 3% of the index is data centres; or e-commerce, 12%  is industrial; for demographics, healthcare is 7%, and for urbanisation, 18% is residential.

According to Vanguard, global property was the best returning asset class in the 20 years to 2020, with an annual return of 8.5%. Resolution Capital, an Australian GREIT manager, also points out the asset class enjoyed lower earnings volatility than global equities.

Despite that history of strong returns, 2020 was its worst year since the GFC at -17%. By contrast, however, this time the fall was not because of excessive debt or weak balance sheets, it was a classic exogenous shock. With the progressive relaxation of government restrictions, conditions are in place for a strong rebound.

An added attraction is that historically REITs have been a terrific hedge against inflation, since both rents and property values are typically tied to it. This may sound counterintuitive if you’ve come across the popular misconception that REIT valuations are inversely affected by bond yields, that is, when yields rise, values fall.

Chris Bedingfield, co-portfolio manager of the Quay Global Real Estate Fund, points out that, “Over the long-term, there is actually no correlation at all between REIT valuations and bond yields. However, over the short-term, it seems there are enough investors who believe it that it becomes a self-fulfilling prophecy.” Notably, over the March quarter, GREITs returned more than 7% despite bond yields rising sharply.

To gain exposure to GREITs, you can buy an index fund, such as the VanEck Vectors FTSE International Property ETF (REIT.ASX), or, if you’re wary about the potential for COVID risks, you can choose an actively managed fund from the likes of Quay Global Investors or Resolution Capital.

Still time to get on board for value stocks

Still time to get on board for value stocks

September 2020 marked what could be one of the most significant changes in the stock market for the past 12 years: value stocks started to outperform growth stocks. Importantly, this rotation could go on for a long time to come, offering opportunities for substantial gains.

What is meant by ‘growth’ and ‘value’ stocks?

Growth companies are those whose earnings can grow independently of the broader economy, the classic example being tech companies, or some health care stocks. Value companies are those whose earnings go up and down with the economic cycle, thus they are also called ‘cyclical’ stocks.

Since the GFC ended, value stocks have underperformed growth by the greatest margin ever. Why did that happen?

Cyclical stocks are dependent on what you might call ‘organic’ GDP growth. On one side of the economy, the GFC caused a massive slowdown in private sector growth as companies tried to get their balance sheets back in order by reducing borrowing, and on the other side, governments all over the world tried to reduce their spending to avoid blowing out national debt levels, a policy also known as austerity.

The consequence was the post-GFC economic recovery was the slowest and weakest on record, so it followed that cyclical companies’ earnings growth was also weak. Naturally, investors backed growth companies instead.

Why are value stocks back in favour?

Governments around the world have responded to the COVID crisis with massive amounts of fiscal support, which has ignited organic economic growth. Here in Australia the federal government has injected the equivalent of 13 per cent of GDP in brand new money, plus another 2 per cent came from early superannuation withdrawals. In the US it’s been a mind boggling 25 per cent, and even Europe has joined in.

The upshot is, after most economies reported record falls in GDP in June of last year, we’ve seen a sharp reversal. Australia recorded back to back quarterly GDP growth above 3 per cent for the first time in the 60 year history of the National Accounts. And in the US, Goldman Sachs is forecasting 2021 will see 8 per cent growth for the first time in 70 years.

As usual, the share market has anticipated the reversal of economic fortunes and value stocks have already enjoyed a sizeable rally. From its bottom last year, the Australian bank sector has bounced 39 per cent, energy by 34 per cent (after oil famously traded below zero last year) and materials 17 per cent.

Why value stocks could rally for a while yet

While they are sizeable moves already, it’s possible the rotation toward value stocks will continue for some time yet. The sheer size of the government stimulus packages saw the Australian household savings rate peak at 20 per cent, and it’s still at 12 per cent, which represents a lot of potential spending still to come. In the US, households are estimated to be sitting on more than US$1.6 trillion in savings, or about 9 per cent of GDP.

Another reason is shown in the chart. In the 12 years since the GFC global value stocks gave up almost 30 years of outperformance against growth stocks and appear to have only just started to claw some of that back. There have been other attempts to turn the tide that were short lived, but none have been backed by such a compelling change in macro support. Indeed, Richard Bernstein of Bernstein Advisors, formerly the Chief Investment Strategist at Merrill Lynch and one of only 57 inductees to Institutional Investor magazine’s Hall of Fame, said “the difference in performance (between value and growth stocks) could be startling to investors over the next couple of years”.

Still time to get on board for value stocks graph

How to position your portfolio

There are plenty of value-oriented fund managers you can invest with, like Perpetual and Platinum. I’ve also written previously that I think the resources sector faces a strong outlook. There are unlisted managed funds that specialise in that area, like Ausbil’s Global Resources Fund, or a listed one is the Tribeca Global Natural Resources LIC (TGF.ASX). BetaShares has an Australian resources ETF, but 53 per cent is invested in BHP, RIO and Fortescue, so it’s heavily influenced by the iron ore price.

For global exposure, VanEck’s new VLUE ETF uses a proprietary ‘Value Enhanced’ algorithm to invest in a basket of 250 value stocks from across the developed markets ex-Australia. And finally, Europe, the UK and Japan also offer a value-oriented bias.

Call us today if you’d like to discuss how to gain exposure to value stocks in your portfolio.

Resources stocks will benefit from a commodities supercycle

Resources stocks will benefit from a commodities supercycle

Analysts and fund managers have recently been lining up to explain why commodity markets are on the cusp of a potentially multi-year bull market. Rockstar analysts Jeff Currie, global head of commodities at Goldman Sachs, and Marko Kolanovic, macro strategist at JPMorgan, go so far as to describe it as the beginning of a ‘supercycle’.

In the last two commodities bull markets, which happened either side of the GFC, major global resources companies rose four to five-fold, far outstripping the broader share markets, though it should be remembered the fall in between was precipitous.

Analysts describe the conditions as being in place on both the demand and supply side across almost the whole commodities complex.

Multiple drivers of demand

In the near term, the almost explosive post-COVID recovery some economies are seeing, fuelled by massive government spending and access to cheap credit, has already seen commodity prices respond. Copper has doubled since its lows of March last year, and now trades at nine-year highs, iron ore has more than doubled and is at 10-year highs and, after falling spectacularly to below zero in 2020, oil is back above US$60 per barrel. The Bloomberg Commodities Index has risen 44% from its lows of 2020.

As well as expectations of an ongoing rise in commodities-intensive infrastructure spending and construction activity, Currie points out the inexorable shift toward green energy underpins huge increases in demand for energy related metals. Already, lithium, a foundation element of most modern batteries, has risen 45% since the start of this year, and cobalt is up 58%.

The European Commission has estimated its Green Deal will require more than €1 trillion (A$1.5 trillion) to be spent over the next decade, and both China and the new US administration have endorsed a move to being carbon neutral by mid-century. With the three largest economic blocs in the world moving in the same direction, the implications for commodities demand are enormous.

Supply will struggle

COVID has also impacted the supply side of the equation, with production out of South America, which accounts for one third of global copper and iron ore production, suffering significant falls. James Stewart, co-lead portfolio manager of the Ausbil Global Resources Fund, argues in addition there has been the typical underinvestment in bringing on new mine production that you see in the aftermath of a commodities boom.

“In 2012 total mining capex was about US$75 billion, and then it fell like a stone to hit US$20 billion in 2016. While it’s picked up since, in many areas the mining industry is nowhere near where it needs to be just to replace annual consumption, let alone expand production,” he said.

For example, copper requires around 300,000 tonnes of new production per year for supply to remain constant, which translates to around $10 billion of capex, and there are no new large mines slated to come into production for at least the next year.

Currie describes most commodities as facing structural deficits, and Stewart agrees, “The process of getting even a small mine up and running, from finding the resource, to defining reserves and then building the infrastructure, can easily take four or five years, and for a big mine it can be 10.”

Stewart’s fund has been investing heavily in mining companies that supply the battery industry, where Bloomberg forecasts demand for nickel and aluminium will rise 13-fold to 2030 and lithium carbonate by nine times.

Longview Economics argues commodities, relative to equities, are as cheap as they have been in more than 50 years, lower than before the start of previous supercycles in 1969, 1987 and 1998.

A hedge against inflation

A further argument in favour of investing in resources stocks is as a hedge against the frequently cited possibility of a rise in inflation, driven again by the sharp rise in post-COVID demand. Commodity prices tend to rise with inflation, driving earnings for mining companies, which could offset concerns about the effects of rising bond yields on a portfolio’s growth stocks.

It’s not often there is such strong consensus among analysts and fund managers. Obviously a smart investor should always consider the counterfactual, but the fundamentals of demand and supply are stacking up to suggest resources stocks could be entering a multi-year uptrend.