Rudi’s View: Will The Fed Tame The Beast?

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In today's Weekly Insights:

-Will The Fed Tame The Beast?
-Conviction Calls
-FNArena Talks

Will The Fed Tame The Beast?

By Rudi Filapek-Vandyck, Editor FNArena

In a share market as bifurcated as the ASX, leading indices such as the ASX200 or the All Ordinaries no longer show investors the true picture of what is going on.

On a three-month view, share market indices have shown increased volatility but on balance the direction has remained upwards, with the ASX200 moving away from 6600 as many times as it was able to, only to be pulled back towards it an equal number of times, sometimes in quite a violent manner.

On Monday, Australia's leading index closed at 6739.60, which is pretty much in the middle of the 6600-6900 trading range that has kept the local market in check since late last year.

Underneath all that day-to-day volatility, however, lays a gamut of portfolios and market positions that are bleeding profusely and in a lot of pain as share prices for companies including Cochlear ((COH)), Nanosonics ((NAN)), Altium ((ALU)) and Coles ((COL)), to name but a few, are trading well below levels witnessed last year.

The easy explanation that roams the internet these days is "rising bond yields", oft with an extra reference to previously bloated valuations and, in some cases, a disappointing operational performance revealed in February.

It is why shares in Magellan Financial ((MFG)) are now down more than -36% from last year's high, and the damage has even been greater for Bravura Solutions ((BVS)), or for Appen ((APX)), while the likes of Afterpay ((APT)) and Zip Co ((Z1P)) are rapidly catching up, so to speak.

The easy explanation, however, is only part of what is inflicting so much pain on market segments outside of this year's re-opening and reflation trades. While many an expert had been reflecting upon the likelihood of higher bond yields for 2021 and possibly beyond, very few would have anticipated we'd be witnessing the 10-year bond in Australia aiming for 2% by the end of February (the RBA temporarily put a stop to it).

In the US, the world's largest market for government bonds by a long stretch, the yield on the 10-year loan has now nearly tripled from below 0.60% to now 1.55%, with the occasional attempt to move above 1.60%. Back in 2012, the most recent reference to bond yields rising and weighing upon equity markets, those yields rose from 1.5% to 3%, which was a level much higher in absolute terms.

But a similar rise today would represent a near quadrupling in yields from the bottom, while 2012 saw merely a doubling. Context is all that matters in finance, and relative values and movements are more important now than in the preceding decades since yields are at ultra-low levels and debt at an unprecedented high.

Many a market analysis has put central banks in the global control room, keeping liquidity flowing and bond yields low, allowing equities and other assets to remain in bull-market mode. No surprise thus, many on Wall Street are looking at the Federal Reserve to stop this year's bond market shenanigans from inflicting so much pain on REITs, healthcare stocks and technology-driven business models, but so far, no intervention a la RBA has ensued.

For this to happen, policy makers at the world's most dominant central bank would need to become a lot more worried that selling of US Treasuries (yields rising) might become unruly, possibly out-of-control and thus a negative influence on market stability and the central bank's ultimate policy goals, which now includes allowing inflation to sustainably run above 2% for an undetermined period of time.

As with the RBA, the Federal Reserve will only intervene when it feels market stability is in danger, which might impact on the strength of the nascent economic recovery, thus weakening the labour market and finances of the US government and the average US household. While rising US bond yields are seen as the natural correction from exceptionally low yields in response to covid-19 and last year's global recession, central bankers need to be careful they communicate well and their messages are not being misconstrued or misunderstood.

Most importantly, market participants need to remain fully confident Phillip Lowe, Jay Powell & Co know what they are doing and they remain in full control over what is happening in divergent corners of the financial world. One of the narratives, I feel, that is currently read differently from the Fed's intention is that, longer-term, letting inflation run past 2% means bond yields can run a lot higher in the meantime.

This looks like the first mis-communication that needs to be addressed and Jay Powell might well make the extra-effort after the upcoming FOMC meeting, scheduled for March 16-17. But from an economist's viewpoint, let alone from the world's most watched central bankers, there doesn't seem to be a lot to be overly worried about just yet.

Yes, some share prices are down, but others are up, and the economy seems to be humming quite nicely, adding more jobs each month. While things have become a lot more volatile over the first two months of the fresh calendar year, they are a far cry from the mayhem and the emergencies that kept on popping up twelve months ago.

While the RBA felt it had to show its hand when domestic bonds rallied past 1.9% in a hurry, the Federal Reserve will be very reluctant to follow suit. Theoretically, it could go down the policy path of Japan, and the RBA in Australia, and put an effective yield control policy in place, or increase its own bond buying program, but the Fed prefers to use such options only when its communication with market participants fails.

And so the speculation can run rife in the meantime. What is he going to say? Will he say anything? I remain with the voices who believe central bankers will hold on to their communication that inflation, underlying and in trend terms, still has a long way to go until it reaches the current goal of 2% and beyond, but this year might, temporarily, see a bit of a spike because of the economic recovery.

Whether such communication will be enough to keep the bond market in check remains anyone's guess, but we will find out, soon.

The Other Factor: Portfolio Disruption

It remains true, rising bond yields put pressure on higher valued stocks and until recently parts of equity markets, both in Australia and overseas, were showing all the signs of ultra-exuberance, with parts of the investment community acting as if there is no such thing as a valuation and prices can continue to rise no matter what.

But share prices of many quality companies that released excellent results in February, accompanied with ongoing buoyant guidance, are falling virtually every day, leaving valuations derived from analysts' forecasts 25%, 30%, or even 40% higher. Surely, even if fundamental models need to incorporate higher yields, valuations for the likes of Charter Hall ((CHC)), NextDC ((NXT)), and Hub24 ((HUB)) will still remain significantly above where share prices trade?

The answer is yes, but that won't necessarily mean present market dynamics cannot last for longer. One important part of the puzzle can be explained by how most investment portfolios where positioned at the start of 2021, which was still Overweight technology and growth, while financials and cyclicals are the ones outperforming.

So what investors are experiencing in the first quarter of 2021 is, essentially, portfolio disruption, explains Morgan Stanley's US-based equity strategist, Michael J Wilson. Hence shares in CSL ((CSL)), Goodman Group ((GMG)), Afterpay and the like need to be sold to purchase shares in, say, Orocobre ((ORE)), Bank of Queensland ((BOQ)) and Downer EDI ((DOW)), and this is what creates this big swing in market momentum between divergent parts of the market.

Wilson thinks this process still has further to run, as portfolios need more recalibrating towards Value and cyclicals. Equally important, before long banks and miners and other cyclicals will look great on technical charts, while the technical picture for share prices under pressure is breaking down, which will further widen the gap as short-term traders (and others) will continue to feed the momentum.

On my observation, recurring chatter among traders is how the Nasdaq is forming a reverse head-and-shoulders on price charts, which is widely interpreted as the harbinger of much weaker index levels.

Ultimately, predicts Wilson, "Growth stocks can rejoin the party once the valuation correction and repositioning is finished", but one can sense this can still take a while, irrespective of whether the Fed calms the market next week, or not.

Active Managers January Survey

Meanwhile, the latest update on active funds managers in Australia by JP Morgan shows average cash weightings continue to trend down with January the tenth consecutive month of cash draw-downs; cash is now at a new record all-time low of 2.2%. According to the survey, cash levels fell by a further -27bp in January and are now -147bp below the two year-average.

In February last year average cash rose to 4.5%, the same level where it was in the first half of 2019. BHP Group ((BHP)) and other iron ore miners have been the trade du jour in January with the survey indicating some 70% of local active managers own BHP as a top holding in their portfolio. Another popular come-back stock has been Westpac ((WBC)).

The number of technology stocks dropped in January with the sector only representing 3.2% of major positions in portfolios; the lowest percentage point in six months. The most popular domestic tech stock among active managers remains Xero ((XRO)).

Conviction Calls

When it comes to consumer-related exposures in Australia, Macquarie recently communicated its favourites with Woolworths ((WOW)) most preferred among supermarket operators, while Harvey Norman ((HVN)) is preferred over JB Hi-Fi ((JBH)), with special mention for Domino's Pizza ((DMP)) and Flight Centre ((FLT)) in other categories.

Over at stockbroker Morgans, retail sector analysts have published their five key picks post February as Lovisa Holdings ((LOV)), Universal Store Holdings ((UNI)), Baby Bunting ((BBN)), Breville Group ((BRG)), and Adairs ((ADH)).

Goldman Sachs' most favoured consumer stocks, as published on Monday, are Super Retail ((SUL)), Coles, Domino's Pizza, Wesfarmers ((WES)), Metcash ((MTS)), and Woolworths. The broker has a Sell rating on Premier Investments ((PMV)), ahead of the release of its interim report.

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Market strategists at Wilsons made two changes to their selection of Conviction Calls post the February reporting season, with both Integral Diagnostics ((IDX)) and Appen ((APX)) removed from the list.

Whereas Integral Diagnostics' removal follows a 55% appreciation since the stock was added to the list, Appen's share price went in the opposite direction and Wilsons now refers to diminishing confidence in the company's growth trajectory ahead.

Stocks that have kept their inclusion are ARB Corp ((ARB)), Collins Foods ((CKF)), Telix Pharmaceuticals ((TLX)), ResMed ((RMD)), Whispir ((WSP)), ReadyTech ((RDY)), and Plenti ((PLT)).

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Over at Ord Minnett (and JPMorgan), a monthly review of what is happening in equity markets, and why (all roads lead to the US bond market) has led to a repeat of the Super 7; those stocks most preferred to cope with the changing landscape in 2021.

Those Super 7 are Charter Hall Group, James Hardie Industries ((JHX)), National Australia Bank ((NAB)), Rio Tinto ((RIO)), Santos ((STO)), Super Retail, and Transurban ((TCL)).

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Tech sector analysts at Credit Suisse remain undeterred in their view that each of Altium ((ALU)), WiseTech Global ((WTC)) and Xero remain well-positioned, and able, to outperform the broader market on a 12-month view.

Irrespective of the market rotating into most preferred financials and resources companies, Credit Suisse reiterates investment theses for all three remain "alive and well".

The one exception in the sector is Appen, for which the analysts continue to see downside risk to consensus estimates.

Credit Suisse has also lined up three preferred tech exposures outside of the large caps, defined as outside the ASX-100 index. Here the three sector favourites are Audinate Group ((AD8)), Life360 ((360)) and Infomedia ((IFM)).

Elsewhere colleagues at the healthcare desk have nominated ResMed, Ansell ((ANN)), and Sonic Healthcare ((SHL)) as their three sector favourites.

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Looking back at February, Macquarie believes it was a "good" reporting season for building companies in Australia. Market forecasts have risen for most in the sector during the month, the broker has noted.

Macquarie's three stock picks for the sector are James Hardie, Reliance Worldwide ((RWC)), and CSR ((CSR)).

FNArena Talks

On Wednesday last week (3rd March) I participated in a Special broadcast on the February reporting season by Elio D'Amato's Spotee on TickerTV and the result can be viewed here:

https://youtu.be/POPg8L1QwX4

This week, on Thursday (11th March) I am scheduled to appear on AusbizTV's The Call, midday-1pm.

(This story was written on Monday 8th March, 2021. It was published on the day in the form of an email to paying subscribers, and again on Thursday as a story on the website).

In addition, since FNArena runs a Model Portfolio based upon my research on All-Weather Performers it is more than likely that stocks mentioned are included in this Model Portfolio. For all questions about this: info@fnarena.com or via the direct messaging system on the website).

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