Rudi’s View: Inflation?

This story features VIRGIN MONEY UK PLC, and other companies. For more info SHARE ANALYSIS: VUK

In this week's Weekly Insights:

-Inflation?
-A Golden 'Value' Opportunity
-One Giant Data Leap Forward For FNArena
-Research To Download

Inflation?

By Rudi Filapek-Vandyck, Editor FNArena

A lot of what happens in the share market, in particular this year, relates to relativity and simple mathematics; both I feel are not necessarily well understood, let alone fully appreciated by many an investor.

To illustrate my point, let's imagine a company called XYZ; bear with me, it'll be worth it.

XYZ previously reported profits after tax of circa $100m but due to a series of misfortunes that has now shrunk to $25m and the share price reflects this. The usual scenario unfolds. The board appoints a new CEO, who brings in a new broom, takes write-offs, announces a restructuring and new plans are being communicated and executed.

The following year net profits rise to $50m, a doubling from the disaster year everybody likes to forget. A turnaround is in motion!

Soon investors are back on board and the share price reflects this new enthusiasm.

As it happens, the new management increases profits by $25m in each of the two following years, which results in big share price gains and a valuation that is fully reflective of this newfound growth momentum.

Happy days are here again!

Of course, any cynic can see what is happening here, the company is simply back to where it was four years ago. Hopefully it now operates from a better condition and market position, but certainly the share price multiple is now significantly higher. The following year, however, net profits come out as $102m.

Does this now mean the narrative that built on the back of three consecutive years of strong growth achieved was wrong? Or was it correct for as long as it lasted?

****

Arguably the same dynamics are very much in play today for economic growth, corporate profits, (most) share price performances, yields on government bonds and readings of consumer price inflation (as well as twelve month investment returns for asset managers).

The past months have seen yields doubling on 10-year government bonds in Australia and the US, which is one helluva move, albeit from extremely low yields in 2020, which has had a significant impact elsewhere, leading to significant money flows into cheaply priced cyclicals and covid-victims in equity markets.

Compare Virgin Money UK ((VUK)) with Kogan.com ((KGN)) or Lynas Rare Earths ((LYC)) with Altium ((ALU)), banks versus healthcare; you get the idea.

This reversal in trends that existed pre and during the pandemic has also triggered a fresh narrative that is now front and centre of every investor's mind: inflation is coming, how do I protect my portfolio?

But is inflation really on the horizon? Central bankers don't believe this is the case, but their view can be wrong, of course. There are current problems with supply chains because the world is no longer dominated by open borders, which is bad timing given so many locked-in consumers remain ready to spend. But isn't this but a temporary phenomenon?

Apparently, financial markets don't seem to think so. Or are they?

****

A recent analysis by EFG chief economist Stefan Gerlach suggests financial markets are expressing a lot less anticipation of inflation than the current ruling narrative would like us to believe. This further reinforces my personal view that global bond markets are merely pricing out the emergency from last year's pandemic, rather than pricing in the advent of a new era of higher inflation.

Let's start with some facts: the yield on a 10-year US government bond in February last year was circa 1.60%. Let's call it around today's level, shall we?

Admittedly, it had been trending up towards the 2% in late 2019, but to see that yield above 2% we need to go back to July of 2019. Equally correct: that yield has been flirting with 3% on a few occasions, albeit in a persistent long-term downtrend.

In case anyone's interested: the absolute low point last year was 0.34%.

Gerlach's argument is that while common opinion refers to indexed bonds (otherwise labelled as 'inflation protected' bonds) to calculate breakeven inflation, and thus to the market's inflation expectations, in the real world those bonds are heavily influenced by risk-on and risk-off situations in financial markets. His research, for example, suggests a strong link between the VIX ('fear index') and moves in implied breakeven inflation.

Common sense tells us this is but logical. During times of panic or greater uncertainty, large investors redirect money towards safer places, and indexed bonds are a relatively small market, but a safe haven nevertheless. The conclusion from Gerlach's analysis is that any real adjustment in the market's anticipation of inflation has been a lot less dramatic, but also that the current estimate of breakeven inflation is about 0.2% higher.

0.2% more sounds a lot less scary/powerful than inflation expectations have risen by 1.65%. Equally so, at 2.5% implied breakeven inflation is now approaching levels of 2011-2013, with markets clearly pricing for lower inflation since 2014.

This matters for a few reasons. The most important one is that the bulk of the adjustment in bond markets is now likely behind us. Instinctively, this makes a lot of sense also further supported by many a Wall Street forecaster placing the 10-year at or near 2% by year-end and the fact yields were still below this level by late 2019.

In the share market, this means some adjustment might be overdue in that share prices that have been treated as major victims for rising inflation expectations might have been oversold while some of the beneficiaries might have risen too far. I note, for example, shares for the likes of Afterpay ((APT)), NextDC ((NXT)), ResMed ((RMD)) and Xero ((XRO)) have already bounced off their lows, and quite strongly too.

On the other side of the coin, shares in the above mentioned Virgin Money UK and Lynas Rare Earths are trading well above broker targets. And they are far from the only ones.

****

But wait, this ain't the end of this story just yet. A lot of the inflation-is-coming-back narrative draws inspiration from past experiences, or from the misguided interpretation that central banks injecting unprecedented amounts of liquidity in the global financial system ("printing money") must eventually lead to an outbreak in inflation.

Both forecasts, while repeated many times post-GFC, have been painfully proven incorrect. What if history does not repeat and, dare I say it, today's overall context remains very different from pre-GFC dynamics, the current cyclical, post-recession upswing notwithstanding?

Such is the view of investment managers at Hoisington, specialised in analysing and investing in US Treasuries and whose views and forecasts over the past years have certainly been more accurate than not. Hoisington stoically continues to reject the market's current adoption of the inflation-is-coming-back narrative and instead predicts it won't be long before bond yields will start trending lower again.

What we have been witnessing in recent months is thus simply a cyclical aberration as the world recovers from recession, plus, of course, investors' wildly inaccurate presumption that everything old shall soon become new again. Disinflation not inflation lays ahead, is the forecast made from undeterred conviction, with the CPI expected to continue undershooting the Federal Reserve's 2% target.

Hoisington's view of the world centres around the enormous accumulation in global debt, which, simply put, supports growth in the short term but erodes an economy's growth potential further out. All major economies today, China included, are deeply embedded in debt, and there is no straightforward strategy to reverse course.

Meanwhile, every dollar added in debt generates less and less in actual growth. Add deteriorating demographics and it appears the world is doomed for structurally slower growth, still. The occasional cyclical upswing when coming out of a deep recession is not going to make a fundamental difference.

Add technological advancements and it appears the fight against structural disinflation will have to continue for a lot longer. Meanwhile, in the background of all of this, the damage inflicted by the pandemic and the rise of new technologies is simply not captured by how we measure GDP growth, argues Hoisington.

The latter means economies will continue operating well below potential for years into the future. Not exactly a scenario for consistently much higher wages, or for much higher consumer price inflation in a broader sense.

Bottom line: high debt undermines economic growth. Global debt is nowhere near to shrinking. Hoisington's conclusion: "While no two cycles are ever alike, the trend in long bond yields remains downward."

Those who'd like to read Hoisington's research, can do so via https://hoisington.com/economic_overview.html

****

Put all of the above together and there's probably a valid argument to make that financial markets have once again done what they do best: exaggerating to the upside as well as to the downside for different parts of the bond-reset story. In practical terms, this means that any further increases in bond yields, misguided or not, will gradually lose their potency in terms of impact elsewhere.

For those investors left bruised and disappointed by how markets have treated last year's covid-winners: this is not the time to abandon ship. In fact, on my observation, some experts are once again warming towards technology and structural growth companies with Shaw and Partners' June Quarter Research Monitor advocating investors start accumulating beaten down stocks in those sectors with a longer-term horizon in mind.

After all, cyclicals and your typical value stock might still enjoy support from the cyclical upswing and maybe even from further rising bond yields in the short term, growth stocks come with potential for many more years of ongoing strong growth. Shaw and Partners very much likes the Buy Now, Pay Later sector, with Zip Co ((Z1P)) its sector favourite.

Among your typical software and services companies, the broker has pointed its clientele towards Fineos Corp ((FCL)), Nitro Software ((NTO)) and Whispir ((WSP)).

Shaw's Large Cap Model Portfolio has equally made some interesting adjustments, selling out of CommBank ((CBA)), South32 ((S32)) and BHP Group ((BHP)) while switching out of CSL ((CSL)) in favour of ResMed ((RMD)) instead.

Other additions are ANZ Bank ((ANZ)), Northern Star ((NST)), Goodman Group ((GMG)), Suncorp ((SUN)), and Wesfarmers ((WES)).

****

The FNArena/Vested Equities All-Weather Model Portfolio outperformed in March with a total return of 3.13%, lifting the three months performance to 2.15% and the six months performance to 2.75%. The latter two numbers might serve as an indication of how one-sided market momentum has been since November last year.

Anyone interested in receiving the All-Weather Portfolio update for March, send an email request to info@fnarena.com

A Golden 'Value' Opportunity

The price of gold bullion has found itself on the wrong side of market momentum. One look at the USD price chart for the past twelve months is sufficient to back up that statement, and then some.

That is one ugly looking chart.

Investors should not be surprised though. I have repeatedly and consistently pointed out, over the years and in more recent times, that gold's ultimate master is the US bond market, more precisely the direction of US government bond yields corrected for inflation.

Those yields are still negative, but a whole lot less so than in 2020 when gold briefly rallied to a new all-time high, for which, by the way, analysts today blame defensive ETF inflows at that time.

But what is catching analysts' attention this month is how much worse the performance has been for share prices of gold mining companies. If you think gold's price action is looking ugly, try Newcrest Mining ((NCM)), or St Barbara ((SBM)), or Gold Road Resources ((GOR)), to name but a few.

The gap between today's share prices and consensus price targets, often freshly updated only a couple of weeks ago, can be up to -80% in the case of Alkane Resources ((ALK)), which is usually not a sign of a healthy operation, but others in the sector easily trade -40% or more below target.

Even Newcrest Mining, not exactly a small fish even on a global scale, is trading more than -20% below target. No guessing thus as to why sector analysts at JPMorgan (white-labelled by Ord Minnett) expressed support for the sector this week, while observing various share prices are back at levels last seen in 2016, when gold was priced -US$600/oz lower.

Analysts at Shaw and Partners released the graphic below, showing how huge the gap has grown between gold miners (in red) and the rest of the mining sector (in black). Shaw is convinced gold miners are poised to narrow that gap in the current quarter. Not only is many a local producer ideally positioned to grow production and profits, gold bullion itself is ready for a come-back as inflation is picking up and bond yields will not rise forever.

Shaw's two sector favourites are Northern Star ((NST)) and Newcrest Mining, with the added observation that all gold equities researched by Shaw are currently trading in 'value' territory.

One Giant Data Leap Forward For FNArena

At the risk of not sounding nearly enthusiastic enough, but the FNArena website has made one giant leap forward this week by adding historical financial data for nearly 1700 ASX-listed companies.

Thanks to FactSet, FNArena subscribers now have access to key past performance data for all their beloved companies, plus a lot more.

The roll-out occurs in stages throughout the remainder of calendar 2021 and the present stage 1 shows EPS, DPS and sales/revenues for the past six years in addition to our regular two-year forward looking estimates.

All one has to do is search via Stock Analysis. Be it CBA, or BHP, or the more obscure VMY, OLI and 4DS; it's all in the system from today onwards. Below is a snapshot of what the latest addition looks like for Macquarie Group.

For those interested in which stocks are represented in key indices, we also added the S&P/ASX All Technology Index, with all 69 constituents on display.

We can but hope that all of this makes all of you as excited as we are. And there's more in the pipeline. Lots more.

Research To Download

RaaS on the former PS&C Limited, nowadays trading as Future First Technologies Limited ((FFT)):

https://www.fnarena.com/downloadfile.php?p=w&n=A890202B-95DD-ECE7-122BD67C040A8897

(This story was written on Monday 12th April, 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).

****

BONUS PUBLICATIONS FOR FNARENA SUBSCRIBERS

Paid subscribers to FNArena (6 and 12 mnths) receive several bonus publications, at no extra cost, including:

– The AUD and the Australian Share Market (which stocks benefit from a weaker AUD, and which ones don't?)
– Make Risk Your Friend. Finding All-Weather Performers, January 2013 (The rationale behind investing in stocks that perform irrespective of the overall investment climate)
– Make Risk Your Friend. Finding All-Weather Performers, December 2014 (The follow-up that accounts for an ever changing world and updated stock selection)
– Change. Investing in a Low Growth World. eBook that sells through Amazon and other channels. Tackles the main issues impacting on investment strategies today and the world of tomorrow.
– Who's Afraid Of The Big Bad Bear? eBook and Book (print) available through Amazon and other channels. Your chance to relive 2016, and become a wiser investor along the way.

Subscriptions cost $440 (incl GST) for twelve months or $245 for six and can be purchased here (depending on your status, a subscription to FNArena might be tax deductible): https://www.fnarena.com/index.php/sign-up/

Click to view our Glossary of Financial Terms