Rudi’s View: Covid, Climate Change…Correction?

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In this week's Weekly Insights:

-Covid, Climate Change… Correction?
-Conviction Calls
-Win A Book
-Research To Download

By Rudi Filapek-Vandyck, Editor FNArena

Covid, Climate Change… Correction?

As per the old adage, experts in the share market are being paid to be optimistic, but those in bond markets are being paid to look out for the next worry.

Read any newspaper these days and there are valuable concerns everywhere. If it's not virus-related (now including Australia), then surely new concern relates to consequences of climate change turning Belgium, Germany, and other parts of Europe into submerged flood plains.

So maybe the divergence between the implicit messages coming from equities and bonds should not come as a huge surprise.

One looks at the prospects for ongoing strong recovery in corporate profits, and dividends, on top of capital management and corporate actions, while the other sees slowing growth, forecasts that may prove too optimistic, and potentially a delay in central bankers winding back extreme stimulus programs.

The problem with this divergence is that ultimately, financial markets are interconnected and sooner or later rallying bonds (lower yields) will have an impact on other markets, just like rising bond yields caused a quick flip-flopping in market positioning early in the year.

However, contrary to our grandfather's share market, assessing what the next action-reaction might look like has become a lot harder these days. Share markets have been posting gains for 11 out of the past 12 months prior to July, including seven out of seven post September, and there hasn't been even a mild pullback, let alone a temporary correction, since that speedy sell-off in February-March last year.

No surprise thus, the growing consensus among investors is that bonds are rallying because the economic recovery narrative is losing its shine, and dangers for disappointment are lurking. Equities, at face value, ar trading on valuations that seem rich by historical standards, so might this provide that trigger so many have been waiting for, maybe, possibly?

One problem with that line of thinking is that it ignores the fact that share markets nowadays are much more polarised, and what is negative for one group of companies works usually to the benefit of the opposite basket of stocks.

We all have our own observations and theories about what happens in markets, and why, but mine has been that flip-flopping from one group into the other, and back again, and again, has to date replaced the old sell everything and buy back in again that used to pull markets down by -5%, -10%, or even more.

Having said so, the latest concern regarding US equities is that indices are seemingly being supported by a shrinking group of positive large cap performers. All the while the participation of retail investors in US markets might be at an all-time high.

So maybe bonds globally are spelling trouble ahead. 1Tenyear yields in the US and Australia are below 1.30% while in Germany the comparable yield is back below zero. But there is an opposite view, in that maybe bond markets -for whatever reason- are simply over-stretching themselves, temporarily, into the chosen direction.

Bonds went too far in March, maybe they are now doing it again in the opposite direction?

Bond strategist Guneet Dhingra at Morgan Stanley is one of such proponents. He's reiterating his call -with conviction!- that ten-year yields will still be at 1.80% by year-end, meaning there will be another fierce reversal similar to what we experienced during the opening weeks of 2021.

Under this scenario, of course, the reflation trade will be back with a vengeance, just as it happened between October-mid-March.

Cautious conclusions from my desk:

-Don't bet 100% on either outcome; 2021 is when a balanced and diversified portfolio is a good portfolio
-It's never too late to secure profits and adopt a more cautious approach

All-Weather Portfolio

Look no further than to the FNArena/Vested Equities All-Weather Model Portfolio to see how the reflation trade -inflation is coming!- has been gradually abandoned by equity markets since mid-March.

Portfolio performance ex-fees in March: 3.13%
ASX200 Accumulation Index: 2.44%

Portfolio performance ex-fees in April: 4.05%
ASX200 Accumulation Index: 3.52%

Portfolio performance ex-fees in May: 2.79%
ASX200 Accumulation Index: 2.33%

Portfolio performance ex-fees in June: 4.26%
ASX200 Accumulation Index: 2.30%

Portfolio performance ex-fees in July (up until Friday): 1.99%
ASX200 Accumulation Index: 0.32%

The All-Weather Portfolio is not so much a growth portfolio as it tries to combine my research into Quality performers on the ASX with a moderate inclusion of new business models and dividend providers, hence it certainly aligns more closely with growth than with reflation, with a less risky, diversified philosophy and while also not completely ignoring the re-opening trade.

But the fact the All-Weather Portfolio has now outperformed by some 5.31% over the past 4.5 months, and consistently, albeit with a lot of volatility in between, tells us all a lot about underlying market dynamics, and potentially also about the direct influence of falling bond yields after that big, sharp spike in January through to mid-March.

This is also one additional reason as to why the All-Weather Portfolio is taking on a little more caution this month.

Less Risk, But Not Defensive

Whether it has been the influence of falling bond yields on the general investor psyche or bond yields merely reflecting a change in mindset among investors, fact is the latest global fund manager survey conducted by Bank of America provides the perfect explanation of what has been happening beneath the surface of global equity markets in recent weeks.

In short: professionals and institutions have come to the view that growth momentum has peaked, with follow-through impact on portfolios and strategies. Lesser quality stocks have been sold in favour of Quality; smaller cap exposures have been abandoned in favour of large cap stocks and the balance between Value and Growth stocks has reverted back to where it was in October last year, pre-vaccine roll-outs and that US election.

Favoured long positions are back in large cap technology, while commodities remain very much on the menu too. Expectations for inflation have been pared back, which translates into less aggressive rate hike expectations; the Federal Reserve is now projected to announce its first rate hike in early 2023 instead of in November 2022.

Inflation is by an overwhelming majority seen as transitory, exposure to Emerging Markets has been wound back, but defensives are equally not in favour. The somewhat odd conclusion from the survey is that fund managers have pared back on risk, but they haven't gone defensive, and neither have they abandoned the reflation trade.

Hence, conclude the analysts at BofA, if you want to know whether/when the reflation trade is back 'on', watch the correlation between junk versus quality, small cap versus large cap, and Value against Growth. Average cash levels have risen to 4.1% from 3.9%, but that's nothing spectacular or anything to be worried about.

One problem that will present itself is when inflation might prove higher and stickier than is currently assumed, with the survey revealing only a net 22% of institutions seeing inflation higher in twelve months from now and with no fewer than 70% of respondents declaring inflation is transitory, with only 26% saying it is permanent.

73% of survey participants describes the economy as mid- or late-cycle. The net percentage that believes Value will outperform Growth has more than halved over the past month, to 22% (down from 52% in the prior month's survey).

When asked about major risks, inflation sits on number one, followed by taper tantrum, asset bubbles, then a China slowdown.

Conviction Calls

T Rowe Price head of Australian Equities, Randal Jenneke, remains true to his conviction call that investors should look to face the second half year's uncertainties and challenges through allocating more weight in diversified portfolios towards Quality stocks.

In Jenneke's universe, Quality aligns with a strong return on capital and resilient earnings growth, among other filters used such as earnings quality and cash flow generation.

T Rowe Price's Australian portfolio recently added ResMed ((RMD)), Goodman Group ((GMG)), and Carsales ((CAR)).

Those who pay attention to my research into All-Weather Performers would be quite familiar with these choices.

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Morgan Stanley's Australian Model Portfolio has incorporated six changes (three fresh buys and three sells) ahead of the August reporting season.

Have been added: BlueScope Steel ((BSL)), APA Group ((APA)), and IDP Education ((IEL)) in a bid to, respectively, capture the upside from an anticipated increase in market forecasts post-result, add some insurance in case the bond market goes off-script, plus insert extra exposure to structural quality growth.

Have been removed: Boral ((BLD)), Super Retail Group ((SUL)), and Endeavour Group ((EDV)). The latter was never actively added, rather inherited from Woolworths ((WOW)), which remains the sole consumer staples exposure in the portfolio.

Morgan Stanley too believes an increased bias towards Quality stocks in the portfolio seems but the correct strategy amendment at this stage. Both APA Group and IDP Education are considered worthy of that label.

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Let there be little doubt about the upcoming results season in Australia: it will be a paradise for income seeking shareholders with Australia's number one bank CommBank ((CBA)) returning to old form and large cap iron ore producers swimming in cash, among many more positive surprises following asset sales (Telstra ((TLS)) comes to mind) and dividend reinstatements.

Investors should expect a lot more news about dividends and capital management over the coming seven weeks. What they probably are not expecting is a lot of the same happening in the US this year.

Analysts at UBS believe the average dividend payout increase in the US this year will run at 30%, on what they believe are rather conservative assumptions for corporate payouts given so many questions remain unanswered. But if US companies prove less hesitant, the average dividend increase in the US could well amount to 40%, on UBS's number crunching.

Companies identified as most likely to suprise to the upside include the likes of Microsoft, Mastercard, Nike and Activision Blizzard. Given the average forward-looking yield on such stocks is less than 1%, it remains doubtful many investors will be looking to jump on board ahead of increased payouts and sizeable increases to analysts' forecasts.

But UBS has equally selected a group of companies whose shares are currently yielding at least 2%, which might be more of interest to Australian investors. Here we find the likes of Morgan Stanley, UPS, American Tower Corp, Prologis, HP, and Eastman Chemical Co.

While most investors' research into equities usually revolves around profits and growth, past research by Citi and others suggests a more realiable correlation can be established between rising dividends and share prices. The principle also applies to share markets in general.

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Morningstar's Best Stock Ideas have seen a few changes too over the past month or so. Lendlease ((LLC)) and TPG Telecom ((TPG)) are now included, while Computershare ((CPU)) and Magellan Financial Group ((MFG)) are no longer on the list.

Morningstar's selection process is purely valuation-driven, often in complete disregard of whatever is happening in terms of bad news or negative developments, that may force patience upon investors prepared to take the hint and act accordingly.

Fifteen companies make up the selection of Best Stock Ideas, and apart from the two already mentioned, selected ideas are a2 Milk ((A2M)), AGL Energy ((AGL)), Brambles ((BXB)), Challenger ((CGF)), Cimic Group ((CIM)), G8 Education ((GEM)), InvoCare ((IVC)), Link Administration ((LNK)), Spark Infrastructure ((SKI)), Southern Cross Media ((SXL)), Viva Energy Group ((VEA)), Whitehaven Coal ((WHC)), and Woodside Petroleum ((WPL)).

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Wilsons' recent update on its conviction insights revealed the removal of Telix Pharmaceuticals ((TLX)), following a strong rally in June, and the selection of Aroa Biosurgery ((ARX)). The latter is seen as full of potential, of course, while trading at a significant discount to peers.

Other than Aroa Biosurgery, Wilsons' list of conviction buys has thinned down to six candidates: ARB Corp ((ARB)), Collins Foods ((CKF)), Pacific Smiles ((PSQ)), Whispir ((WSP)), ReadyTech Holdings ((RDY)), and Plenti ((PLT)).

Win A Book

UK book publisher Kogan Page sent us two copies of the freshly released Crypto Wars. Faked Deaths, Missing Billions and Industry Disruption by 'crypto entrepreneur' Erica Stanford and while I am reading the first few pages already, for a book review later on, the second copy is hereby available to one lucky reader who announces his/her interest.

What you need to do: send us an anecdote about yourself and FNArena. How we met, or what we've done (or not). It can be funny, insightful, a memory, or simply a fact. Send it to info@fnarena.com with Crypto Book in the subject line and one of our staff members will organise an indiscriminate selection process to decide one lucky winner.

Cut off is midnight this Friday, July 23. Good luck!

Research To Download

Monthly Pharma & Biotech newsletter, by Independent Investment Research (IIR):

https://www.fnarena.com/downloadfile.php?p=w&n=5D7D3DDF-B61F-35A5-2D58C43ACA708F99

(This story was written on Monday 19th 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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BONUS PUBLICATIONS FOR FNARENA SUBSCRIBERS

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