Rudi’s View: Is Risk-Off The Message?

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In this week's Weekly Insights:

-Is Risk-Off The Message?
-Conviction Calls
-Research To Download

By Rudi Filapek-Vandyck, Editor FNArena

Is Risk-Off The Message?

It wasn't that long ago when share markets were dominated by the view that everything old was to become new again, with economic growth and inflation on the rise fueling predictions of much higher bond yields and the swift return of 'value' stocks and cyclicals while Quality and Growth were deemed grossly overvalued, poised for a big punishment to the downside.

That's not the scenario we have seen unfolding post-March.

Throughout at times excessive volatility, the 2021 whiplash market has directed underlying momentum back towards Quality, Growth and steady defensives, severely testing the conviction and resilience of those who went all-in with the previously so popular reflation trade.

Ten-year government bond yields should have been well on their way to 2% by now but instead they fell to 1.25% in the US last week and remain well below 1.50%. As bond yields remain the primary driver behind the direction of other markets, including FX and equities, it goes without saying the non-compliance of bonds has triggered heavy debates around the world about what exactly is going on.

Below are the views and assessments of some experts who never bought into the majority view that dominated financial markets earlier in the year. Given these alternative views have proved correct to date, investors, at the very least, might want to consider their merits and validity in light of recent market moves.

David Rosenberg: Tell'm They're Dreaming!

David Rosenberg, nowadays running his own research and consultancy firm Rosenberg Research, believes today's Grand International Debate merely reflects how economists and market participants get lost in tiny details that will lose all significance in due course. Instead, Rosenberg suggests, investors should focus on the bigger picture: what is the bond market telling us?

Nothing is more liquid than US treasuries, Rosenberg points out, adding: no other security than the long bond contains all the information investors need to know about inflation, growth and fiscal policy. The issue is therefore not whether bonds are "expensive", or in a "bubble", or short term overbought/oversold, et cetera; instead investors should listen to the message the bond market is signalling.

Despite many attacking central bank policies for distorting bonds and other asset markets, Rosenberg points out recent history shows bonds continue to provide important signals for investors. This signalling was as valid early in 2021 as it is today. That should be the focus for investors, not whether bonds should be lower/higher or precisely where they are trading today.

Needless to day, the bond message has changed.

Rosenberg believes the updated message is that inflation expectations have peaked. The new concern should be about economic growth, corporate margins and further growth in profits. If the bond message is correct, the Federal Reserve won't be talking about raising interest rates anytime soon, and neither will the rest of the world.

Rosenberg observes that while everybody is watching the ten-year moves, and debating its drivers and consequences, the 30-year treasury ("long bond") last week broke below its 200-day moving average at around 1.96%. While the 30-year yield has slightly recovered since, he reminds everyone the last time the US long bond made a similar move was back in 2018, prior to the -20% correction in US equities that followed. In mid-March, the long bond yield rose to near 2.50%.

But what about the double-digit GDP growth number many are predicting for the fourth quarter?

Rosenberg's analysis suggests economic growth and data have been propped up by government stimulus and support programs. Keep your focus on recent surveys and data and it should be obvious economic momentum the world around is decelerating, and that was already happening even before further setbacks in the fight against the virus announced themselves (like the lockdown in NSW).

Growth in core retail sales has been negative in the US in April and May, while sales of cars are deflating too, and so are mortgage loan applications.

Rosenberg: "Housing and autos typically lead economies in the early parts of recovery as pent-up demand gets filled. But because of the bizarre nature to this pandemic-related disturbance, these areas have already peaked out and rolled over. Now we have a restaurant/theme park/entertainment/hotel/casino/air travel led economy – good luck with this because it is only 4% of GDP. The stuff that has peaked out already is four times bigger."

If Rosenberg's assessment proves correct, equity markets could be facing a nasty correction with current overvaluation estimated at 25%, or more. The current market consensus is too sanguine on further margin increases, he believes.

Hoisington: We're Trapped!

Hoisington Investment Management Company is a US specialist on US treasuries. Its quarterly reviews are read by many in the industry. Hoisington's core assessment remains that excessive debt is changing economies and the impact from central bank and fiscal policies.

Recent Quarterly Letters: https://hoisington.com/economic_overview.html

Hoisington's assessment is probably best summarised as: too much debt cannot be resolved by adding more debt. The short-term positive impact of ever more debt reduces noticeably, creating a debt trap that forces over-indebted countries into a low growth environment. Hence, while growth, inflation and bond yields can certainly rise for brief periods, the bigger trend will eventually exert itself.

The only way to resolve the debt trap is through austerity, believes Hoisington, but modern day society won't allow it, so there is effectively no way out.

"Thus, while long Treasury yields can increase over the short run, the fundamentals are too weak for yields to stay elevated. More debt does not cure a subpar economy mired in a debt trap. […] our view is that the trend in long-term Treasury yields remains downward."

Longview Economics: Risk-Off Period Ahead

While not necessarily in agreement with the above mentioned topics, economists at Longview Economics equally believe global bond markets are likely signalling a period of risk-off is approaching for global equities. Their immediate framework for an historical reference is also the second half of 2018.

On Longview's assessment, the current reversal in government bond yields can be explained via:

1. technical factors (such as large portfolios rebalancing)
2. economic factors (momentum is slowing)
3. liquidity factors (banks are buying bonds with excess cash, including from overseas)
4. imminent start of Fed tapering (history shows tapering or ending QE leads to lower ten-year bond yields and a flattening yield curve)
5. China representing rising risks (yields have risen on China's high yielding corporate bonds)

Among the technical factors identified by Longview Economics is the observation that bonds became deeply oversold in February/March with investor sentiment having turned excessively bearish. History suggests it can take between 9 and 12 months for markets to unwind and before yields can start rising again, reports Longview.

This implies lower yields might stay with us for at least another quarter, and potentially for the remainder of the year.

Longview also notes housing is "pausing" in the US, seen as a primary reason why bond yields need to soften in order to re-stimulate the US housing market later on.

Longview believes the long term trend in bond yields is now 'up' and the current moves are simply part of the inevitable counter-trend; nothing goes up in a straight line.

When it comes to US and global equities, Longview has recently adopted a more cautious stance (though not yet negative). The forecaster believes general complacency is dominating the investor community, also reflected in the observation that nobody seems to be genuinely bearish equities these days.

Longview's proprietary global volatility indicator is at its lowest since February 2020 while a number of market indicators might be suggesting a pullback is forthcoming. The recent rally's lack of breadth is seen as yet another possible omen.

Conviction Calls

Morgan Stanley's research into Global Best Business Models could be described as an alternative version of my personal research into All-Weather Stocks ^(*) but then there are sufficient differences in both approaches to declare such direct comparison a little bit of a stretch.

Morgan Stanley tries to identify those companies that represent the highest quality in a given sector, including an assessment of whether the share price is somewhat attractively priced as well. Selection involves a plethora of fundamental filters, including ESG. It is the analysts' view that owning such companies should always be done with a two-year horizon in mind, at a minimum.

The difference in basic approach shows itself via the three ASX-listed entities that made it to the global selection in early January this year: Macquarie Group ((MQG)), BHP Group ((BHP)), and Sonic Healthcare ((SHL)). They are accompanied by the likes of Adobe, Apple, Amazon, Ball Corp and Crown Castle in the US; Akzo Nobel, ASML Holding, Evolution AB, Ferrari and Nestle in Europe; as well as Chugai Pharmaceutical, Fast Retailing and Samsung Electronics in Asia.

The average performance of "Global Quality" has failed to keep pace with general indices over the first six months of 2021 but then this should hardly come as a surprise. The calendar year started off with an unrelenting focus on cyclicals and share market laggards, even though this group of stocks has found the going a lot tougher during the second quarter.

In the long run, the team at Morgan Stanley reports, a basket of Global Quality stocks outperforms the broader market by some 2.2% annually, but thus far in 2021 the comparison with the MSCI ACWI shows a -2.8% relative underperformance. Of the 41 selected stocks, 22 outperformed while 27 generated a positive return over the period.

This still leaves 14 stocks with a negative return to date and 19 stocks underperforming.

Morgan Stanley remains optimistic noting, on an equally weighted basis, there should be 13% upside for the selection, which is trading on an average forward looking Price-Earnings (PE) ratio of 26x, with average return on equity (RoE) of 31.3% and a dividend yield of 1.8%.

(*) Paying subscribers have access to my research into All-Weather Stocks via a dedicated section on the website

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Share market experts at Morningstar remain of the view Australian shares are, broadly taken, some 15% overvalued, even with an economic recovery that is occurring more quickly and with more gusto than previously anticipated. The sole exception is the local energy sector which Morningstar finds is some -20% undervalued.

Morningstar does believe there remain pockets outside energy in the domestic market that are still good value. Morningstar analysts have identified 30 stocks –Top Picks– for the year ahead:

-In Basic Materials: Orica ((ORI)), Nufarm ((NUF)), and Newcrest Mining ((NCM));
-Communication Services: Southern Cross Media ((SXL)), TPG Telecom ((TPG)), and Sky Network Television ((SKT));
-Consumer Discretionary: Myer ((MYR)), G8 Education ((GEM)), and InvoCare ((IVC));
-Consumer Staples: Endeavour Group ((EDV)), Blackmores ((BKL)), and a2 Milk ((A2M))
-Energy: Woodside Petroleum ((WPL)), Beach Energy ((BPT)), and Whitehaven Coal ((WHC));
-Financial Services: Westpac ((WBC)), Challenger Financial ((CGF)), and Magellan Financial ((MFG));
-Healthcare: Australian Pharmaceutical Industries ((API)), Avita Medical ((AVH)), and CSL ((CSL));
-Industrials: Brambles ((BXB)), Cimic Group ((CIM)), and Aurizon Holdings ((AZJ));
-Real Estate: GPT Group ((GPT)), Ryman Healthcare (RYM on NZX), and Lendlease ((LLC));
-Technology: TechnologyOne ((TNE)), Computershare ((CPU)), and Link Administration ((LNK));
-Utilities: Spark Infrastructure ((SKI)), APA Group ((APA)), and AGL Energy ((AGL))

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Analysts at Bell Potter also released their stock picks for FY22:

-Among LICs: WAM Alternative Assets ((WAM)), MFF Capital Investments ((MFF)), and Ellerston Asian Investments ((EAI));
-Agricultural & FMCG: Elders ((ELD)), Bega Cheese ((BGA)), and a2 Milk;
-Technology: Nitro Software ((NTO)), Life360 ((360)), and Adacel Technologies ((ADA));
-Discretionary Retail & Professional Services: City Chic Collective ((CCX)), InvoCare, and Propel Funeral Partners ((PFP));
-Industrials: Imdex ((IMD)), Mader Group ((MAD)), Emeco Holdings ((EHL)), Money3 ((MNY)), ikeGPS ((IKE)), Flight Centre ((FLT)), and Rhipe ((RHP));
-Engineering & Construction: Monadelphous ((MND)), Lycopodium ((LYL)), and GR Engineering Services ((GNG));
-Healthcare: Avita Medical, Kazia Therapeutics ((KZA)), Mayne Pharma ((MYX)), Immutep ((IMM)), Genetic Signatures ((GSS)), Mesoblast ((MSB)), Aroa Biosurgery ((ARX)), Imricor ((IMR)), and Alcidion ((ALC));
-Resources & Precious Metals: Nickel Mines ((NIC)), Aeris Resources ((AIS)), and Regis Resources ((RRL));
-Energy: Cooper Energy ((COE)), Central Petroleum ((CTP)), and Beach Energy;
-Strategic Minerals: Alpha HPA ((A4N)) and Agrimin ((AMN));

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The research team at Canaccord Genuity published its selection of Top Australian Stock Picks for the September quarter. Canaccord specialises on small and micro cap stocks in the Australian share market, hence investors should not be surprised to spot a few names they might not have heard about before today:

Canaccord's selection consists of 23 ASX-listed stocks:

-DDH ((DDH))
-MacMahon Holdings ((MAH))
-Ardent Leisure ((ALG))
-Ricegrowers ((SGLLV))
-DGL Group ((DGL))
-Electro Optic Systems ((EOS))
-Fleetwood ((FWD))
-Trajan Group Holdings ((TRJ))
-Calix ((CXL))
-Secos Group ((SES))
-Adriatic Metals ((ADT))
-Bellevue Gold ((BGL))
-Boss Energy ((BOE))
-Orocobre ((ORE))
-OZ Minerals ((OZL))
-Perseus Mining ((PRU))
-Betmakers Technology Group ((BET))
-Elmo Software ((ELO))
-GTN ((GTN))
-MNF Group ((MNF))
-Praemium ((PPS))
-Uniti Group ((UWL))
-OFX Group ((OFX))

Research To Download

Independent Investment Research (IIR) on MA Secured Real Estate Income Fund:

https://www.fnarena.com/downloadfile.php?p=w&n=F367B30B-C960-846E-FB960C29FDFFCA4B

Independent Investment Research (IIR) on KKR Credit Income Fund ((KKC)):

https://www.fnarena.com/downloadfile.php?p=w&n=F35DFB68-94F5-2E7C-8E2F96679F49628B

(This story was written on Monday 12th July, 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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– 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)
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