Fund Managers’ Mid-Year Review

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As sharemarkets continue to rebound, fund managers target sectors and stocks appropriate to the next stage of the economic cycle and a new post-covid normal.

-Morgan Stanley expects US tapering to begin in April, 2022
-High quality equity positioning in Australia, as a hedge against inflation
-Stocks within Healthcare favoured by some fund managers
-ASX200 companies to potentially shift from capital preservation to capital allocation
-Portfolio implications of a more Chinese approach by the US
-Caution on commodities

By Mark Woodruff

Investment managers are currently weighing-up where the domestic and global economies are placed in a highly unusual economic cycle.

In describing where equity markets sit some fourteen months from the covid-lows, Citi suggests investors face early-cycle timing, increasingly mid-cycle conditions and late-cycle valuations!

In general terms, the equity market bounce-back from covid is still reverting towards the norm and appropriate covid-recovery trades can be made. However, the question as to whether that norm has changed throws up some creative investment opportunities for both the near and longer-term.

Some fund managers are retaining leverage to mid-cycle expansion, while also embracing a degree of exposure to Quality. The latter may act as a hedge to later-cycle risks that attach to building inflation and higher bond yields.

Global outlook

Morgan Stanley is positive on the economic recovery, with a strong capital expenditure cycle expected to drive activity well above its pre-covid path. The expectation is for inflation to move sustainably above 2% in the US and policy makers should be slow to respond.

As a result, there should be a hotter, shorter cycle, and with risk assets already elevated, the investment bank reduces overall exposure to credit and equities and expects the US dollar and yields to move modestly higher.

It’s felt that policy makers should err on the side of providing more accommodative macro policies to ensure an inclusive recovery, due to an uneven impact on low-income households.

Morgan Stanley predicts the official announcement of tapering by the Federal Reserve will be at the March 2022 meeting, with tapering to begin in April, 2022. It’s expected the Fed will first raise rates in the third quarter of 2023 and pursue a gradual path of tightening thereafter.

T Rowe Price is also bullish on the global economy though cautious on stocks, as valuations are seen to be elevated in both the US and Australia. The investment management firm has recently shifted to a slight underweight position in stocks relative to bonds, due to the strong market rebound to date. Also, higher interest rates leave the risk/reward balance for equities less attractive.

Meanwhile, Citi believes the combination of stimulus, personal savings, pent-up demand and changes in consumption patterns augurs well for a rapid recovery and an expansion that could last several years.

For the rest of 2021 and into 2022, Citi continues to seek selective exposure to the cyclical recovery from the covid recession, as we are still in an adjustment process or mean reversion. There’s still time to benefit from exposure to the recovery, especially via non-US markets. Certain real estate assets and select national markets, such as Brazil and the UK, are among the possibilities.

During 2022, we should expect a new, more traditional expansion and mid-cycle conditions.

From this point, the trends that have helped to reshape the world economy during the pandemic should be pursued. These include such unstoppable trends as digitisation, healthcare and renewable energy, which can help portfolios grow even amid economic turbulence. Future market dips may be an opportunity to gain or increase these exposures.

However, the world beyond covid will be rather different with a changed perspective for digitisation, healthcare and renewable energy, explains Citi. Businesses and consumers alike have discovered new efficiencies by embracing technology during the pandemic, while the development of other treatments and medical technology has accelerated. In addition, advances in renewable energy may persist far into the future.

Australian Outlook

The domestic recovery appears to be on a strong footing, according to T Rowe Price. This is largely due to ongoing policy stimulus, multi-year highs in consumer and business confidence and signs of pent up consumer demand. Inflation is still seen as a key risk and while Value is catching up to Growth, there’s still room for Value to outperform. Despite the inflation risk, the overall view for portfolio positioning is that growth and inflation may peak in 2021.

While T Rowe sees the Reserve Bank remaining dovish, long-term interest rates may rise to reflect the strong economic momentum. However, this is a scenario that should be positive for the stock market, as a steep recovery in earnings should outweigh any potential rise in long-term rates.

In 2022 fiscal stimulus is set to turn negative (the ‘fiscal cliff’ effect), subtracting from GDP growth. With a return to slower growth and sustained low interest rates, growth stocks should return to favour.

As a result, consensus earnings growth estimates will likely be trimmed and earnings momentum (upgrades less downgrades) may turn negative. There’s believed to be limited scope for interest rates to move much higher given the historically high post-covid levels of domestic household debt. 

Australian policymakers are expected to keep economic policies accommodative, especially with the covid-19 vaccine rollout missing the mark so far. 

On the fiscal side, a federal election is expected to take place in Australia within the next 12 months. The stronger recovery from the pandemic means that government revenues are $50bn more than originally projected. Thus, we can probably expect to see some additional moderate fiscal support from the government ahead of a federal election.

Overall, T Rowe Price has tilted portfolio positioning towards more domestic exposures to reflect the stronger economic performance of the Australian economy.

Near-term economic growth should remain solid, according to Morgan Stanley, even after a return to pre-covid conditions, helped by continued supportive policy settings and a strong housing market. The RBA is expected to stay dovish near-term with tapering signalled later in the year. In addition, government spending is forecast to remain at its highest share of GDP since the early 1980s. This is important for the economy, particularly because it provides some offset to the headwind the government's international border restrictions are providing to growth.

Consumer spending is expected to strengthen further as households continue to deploy excess savings accumulated over 2020. It’s thought the capex cycle will expand beyond residential construction and see broader participation from business investment as corporate confidence and conditions improve.

Although there is a risk of the sector overheating, at this stage neither the RBA nor Australian Prudential Regulation Authority (APRA) seem likely to step in to cool the sector, since fostering the economic recovery takes precedence. Housing is central in this respect, since rising residential property turnover historically has had a positive multiplier impact on the Australian economy.

Morgan Stanley sees further scope for house price increases, before macroprudential measures are put in place next year.

Inflation should also improve, particularly given less of a headwind from the Australian dollar and rent inflation in 2022. It’s expected to only reach the bottom of the RBA's target range (2-3%) by the end of next year, lagging the US in particular.

Australian Equity Portfolios

Based on analysis by T Rowe Price, the Value rebound is only half-way through so there is still an improving outlook for domestic cyclicals though much of the easy gains have passed. For Australian equity portfolios it’s not too soon to think of taking profit on some of the Value positions that have done well and to position for a return to favour of Quality, and to a lesser extent Growth in 2022.

Later on in 2022, under the scenario of negative earnings momentum, Value is unlikely to continue to outperform Growth and T Rowe Price expects the Value rotation trade to first fade and later reverse.

As a result of the above view, the investment manager has been capitalising on the underperformance within the high-quality segments of the market. This underperformance over the past year has created opportunities for previously out-of-favour businesses such as select healthcare names.

To fund these changes T Rowe has taken profit selectively in positions where prices have run very strongly and where either valuations or earnings deceleration pose risks. Some examples of this are within the Bank sector and iron ore exposures. Regarding the latter, for the first time in the history of the investment bank’s strategy, there has been a full exit of pure play iron ore exposures.

Morgan Stanley concurs on the opportunity in the high-quality segment of the market. In short the investment manager is advocating better Value and sound Quality.

While the case for better Value remains intact, the deep value opportunity has largely passed and a more broad reflation exposure makes sense. Hence, reflation is still a persistent theme to stay exposed to though it makes sense to pivot towards the greater quality.

This in Australia can continue to be played through select Materials exposure with laggard opportunity in Energy. Fiscal beneficiaries also are supported while Banks and Diversified Financials also retain Value credentials.

Risks to the global and domestic outlook 

As mentioned previously, inflation is seen by T Rowe Price as the key risk. Beyond that, mutations in the covid-19 virus could side-track vaccination efforts, geopolitical concerns relating to China could worsen and cyberattacks are becoming an increasing problem.

Citi agrees to the extent of nominating cybersecurity as a long-term thematic investment. Ideally, such an expense would not be necessary for firms and governments, let alone individuals. However, the broker believes it may eventually be considered an “information technology staple,” and something we all need to do to protect our data and assets.

Randall Jenneke from T Rowe Price also alluded to two less-talked-about risks on the domestic front. One is increasing government intervention in specific areas of the economy, as evidenced lately in the Energy sector. 

Another risk that may impact upon the long-term growth potential of the Australian economy is a rise in taxes to fund government policy to address inequality in society. While this is more evident in the US at this stage, it has the potential to overtake much-needed and little-addressed action on economic productivity.

What are the stock opportunities?

After the worst year in nearly a decade for the Healthcare sector, ResMed ((RMD)) in particular appeals to T Rowe Price. The sleep business is set to improve as economies open, a new product is on the way and the valuation is at its most attractive in over five years.

JPMorgan is in agreement on ResMed. In a mid-year review by sector, the company rated as the top pick in the Healthcare space. The launch of a new device platform should support a strong lift in top line growth in late FY22 though will likely weigh on sales in the near-term. Upcoming catalysts include news around the features offered by the new S11 device, a strong lift in ex-US sales due to recent competitor challenges and news on US recovery as the economy reopens.

Morgan Stanley also takes a more active weight in the Healthcare sector, which features heavily in quality rankings, via becoming Overweight CSL ((CSL)) and adding Ansell ((ANN)).

The weighting for Banks, which are improving on quality factor metrics, is also lifted, while an increased capex theme is explored through Worley ((WOR)).

Under the heading of growth at a reasonable price (GARP), Aristocrat Leisure ((ALL)) should also perform well after strengthening its business during the pandemic, according to T Rowe Price. In addition, the company also has some new product opportunities. Again JPMorgan agrees and rates Aristocrat Leisure as the top pick in the Gaming sector. The company has consistently been gaining market share in North America and further digital growth (new titles and iGaming) and capital management opportunities are available.

Also, structural changes of late within the domestic auto sector and across dealership networks should benefit Eagers Automotive ((APE)), notes T Rowe. It’s felt the underlying business model has changed in regard to supply chains.

The post-covid environment

After covid, Morgan Stanley believes the strategic focus for ASX200 companies will shift from capital preservation to capital allocation. It’s felt Australian companies can and should consider acting on growth and investment activities.

In regard to dividend payouts, prior covid-curtailed returns have begun to rebuild to historically higher levels of payout. Morgan Stanley sees the theme enduring this year though would direct investors to growth in sustainable yield, when considering exposure to this pillar.

While buybacks and capital returns have been a secondary consideration versus dividend returns over the last decade, it’s considered the decision post-covid may be more finely balanced. This is because of the potential for accelerated restructuring, the existence of still-excess franking balances and tax-effective distributions that can attach to such activity.

For much of the post-GFC/pre-covid period, the focus for larger-cap industrial companies on the ASX had been to constrain capital, pursue cost-out and efficiency opportunities and distribute free cash flow via elevated dividend payouts. 

Now, Morgan Stanley sees an acceleration in capex spend in the post-covid environment, with fiscal incentives adding to the pulse. Companies should be sought that have a history of capex intention, an ability to pursue capex initiatives and have expected growth in revenue and margin in their outlook.

Finally, while IPO and secondary placement activity has remained highly elevated, the M&A cycle in Australia is lagging. Thus, the investment bank screens for sectors and stocks demonstrating strategic capability to engage in inorganic capital deployment.

The broker's research seems to have identified the local REITs sector as screening well across various related filters.

In portfolio changes, Morgan Stanley includes Mirvac Group ((MGR)) while retaining exposures to Goodman Group ((GMG)) and Scentre Group ((SCG)).

The mid-year sector review by JPMorgan also highlights Goodman Group as the top large cap REIT pick and Waypoint REIT ((WPR)) as the preferred ex ASX100 REIT.

Longer-term trends – A G2 world

The adoption of a more Chinese approach by the US is the latest development in what Citi calls the emergence of a “G2 world”.

Citi’s base case is that there will be increasing strategic competition between the world’s two foremost powers, especially in fields such as technology and security. There’s also expected to be a moderate escalation in restrictions on trade and corporate activity, but no military conflict.

Likely investment beneficiaries include producers of semiconductors, satellites, software, renewable energy, commodities in the US and China, as well as markets in Southeast Asia.

Investments in infrastructure and the boosting of welfare aims to make the domestic market more attractive and sustainable, while companies may at the same time be hindered from investing abroad. This is the reverse of the pre-covid era of conservative fiscal policy, global free trade and offshoring.

The US is to looking to strengthen domestic competitiveness, the aim of the American Jobs and Families Plan. China’s concept of long-term development called “dual circulation” also focuses on domestic development and self-sufficiency, while further opening up to the external market.

Overall, Citi believes that the US-China relationship is shifting from a state of heightened confrontation under Trump to a more nuanced two-pronged approach of external competition and more focus on domestic development, aided by state capitalism on both sides. In some ways, therefore, the two powers’ economic models are coalescing.

Impact of G2 on portfolios

An important implication of the “G2 world” case is that global investors should have meaningful exposure to both the US and China in their portfolios. Citi believes that intensified strategic competition could accelerate the two countries’ growth.

More state capitalism in the US may be helpful, while in China that approach has proved effective in directing large amounts of capital towards strategically important industries.

Caution on commodities

As mentioned previously, iron ore is unlikely to sustain record levels, according to T Rowe Price.

Morgan Stanley also cautions commodity prices are overshooting fair value on a 12-month basis, and maintains an overall neutral stance.

However, annual copper demand growth is expected to be significantly higher, starting in 2021, while oil has started the year drawing down further and more often than average, putting upward pressure on prices.

Australian interest rates

The global trend in fixed income is for higher long-end yields as, broadly speaking, central banks get closer to normalising and the recovery continues.

In fixed income, Morgan Stanley thinks the more interesting story is in mortgages, as they offer an attractive hedge against a more uncertain macro environment.

Both fixed income assets and cash are broadly unappealing to Citi as they are highly vulnerable to rising inflation and deliberately suppressed interest rates. However, there are some attractive areas within fixed income, which include exposure to inflation-linked bonds and variable rate loans.

The emphasis is on lower duration for T Rowe Price, which sees a preference for bank loans and high yield over government and investment grade credit.

For clients seeking to limit future increases in financing costs, Citi believes there is a case for doing so while many central banks’ policy rates remain at zero or below.

Exchange rates

As vaccines roll out and policy makers look to ease border restrictions, the level of the Australian dollar will be an important driver of the recovery in services trade. As a result, it’s expected the RBA will continue to focus on the exchange rate. This is a key reason why Morgan Stanley expects an extension of the QE program with another $100bn of purchases through to early 2022.

The investment manager thinks the second quarter of 2021 will be the "last hurrah" for Australian dollar strength and doesn’t believe the recent intraday high of US$0.8007 will be breached. The positive forces that have persisted for the last 12 months appear to be shifting. Unlike last year, markets have now largely (if not fully) priced in a global V-shaped recovery that was aided both by policy and positive vaccine developments. Additionally, fiscal policy in Australia has begun to turn with the expiry of the JobKeeper wage subsidy. 

Finally, Morgan Stanley sees the US dollar modestly higher in a narrow range.

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