Equity Strategy: Awkward Adolescence

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While the pace of the global economic recovery has slowed, the next step is another move out of covid-driven restrictions. What is the path from here for global and Australian equity markets?

-Slower pace, bumpier road ahead for global economy
-Chinese policy a significant risk
-Equity market rotation back on the cards
-Inflation possibly the biggest risk

By Greg Peel

“The post-lockdown recovery has transitioned from energetic youthfulness to awkward adolescence,” suggests Russell Investments. “It’s still growing, although at a slower pace”.

When the world went into lockdown last year, global equity markets were already bouncing hard out of March’s covid-crash depths, as investors sought to take advantage of panic-driven oversold conditions. By July, the S&P500 had recovered all losses.

The gains were driven by the stay-at-home theme, for which technology is the dominant factor. The surge in online shopping, video streaming subscriptions, video-conferencing, work-from-home equipment and even home delivery meal services provided strong tailwinds for both the technology sectors and traditional businesses with established tech capacity, such as online retail.

Technology-based sectors dominate the S&P500, and Big Tech names dominate technology. While many Australian companies were also able to ride the stay-at-home wave, the locked-down Australian economy wallowed amidst weak commodity prices. It was not until April this year that the ASX200 recovered March 2020 losses.

When last year’s lockdowns ended, it appeared the developed world had covid under control. Having been the first to enter lockdowns, China was also the first out, and the resumption of demand drove a swift rebound in commodity prices, most notably iron ore, but also oil.

When Moderna and Pfizer announced they had produced vaccines in November, global equity markets took off again. The announcement also happened to coincide with Joe Biden’s presidential win, endorsed or accepted by Americans of intelligence.

Economies were surging out of their depths faster than anyone had foreseen, and vaccine faith managed to offset an even more substantial wave of US covid cases into the new year. This was, as Russell Investments describes it, the post-lockdown recovery’s “energetic youthfulness” phase.

Then along came delta.

Aside from a bit of a breather from April through to June, the S&P500 took delta in its stride, as the vaccination rollout moved into overdrive. But what delta did achieve was to heavily impact the supply-side of global economies. This led to slower growth and, most notably, inflation spikes, as shortages of wholesale goods and labour made their impact.

And today, continue to make their impact.

The Great Debate

The great inflation debate centres not specifically on whether inflation spikes are “transitory”, as transitory has no definition in time, but on whether having peaked, inflation settles back to pre-pandemic levels or to a structurally higher level.

Mathematically, monthly annual measures of inflation must ease as each month cycles away from the deflation brought about by last year’s lockdowns and towards the ensuing months of economic recovery. Hence no one is suggesting current elevated levels are here to stay.

It is Russell Investments’ view US inflation may remain high over the rest of 2021 but decline in early 2022. The fund manager’s models suggest inflation is likely to drop back below the Fed’s 2% target in 2022 which implies, if accurate, the Fed is unlikely to make its first rate hike before the second half of 2023.

The Fed’s announced tapering program surprised the market by its pace, to be completed by mid-2022 with December assumed as the starting date, but did not lead to an expected “taper tantrum”. It was the Fed’s post-GFC policy that gave the world the “taper tantrum”, yet back in 2015 the timing to completion was almost twice as long as the Chair is proposing this time.

The lack of tantrum can be put down to many in the market believing tapering should already be underway, given the pace of economic recovery. But Wall Street did perceive a hawkish shift in Fed rhetoric, backed up by nine FOMC members forecasting the first rate hike in 2022.

It is that first announced rate hike, most believe, that will spark a true tantrum.

Last month, Citi surveyed over 90 US pension, mutual and hedge funds. Close to 60% of respondents believed inflation would be “sticky” rather than “transitory” and the majority saw the first rate hike in the second half of 2022 or first half of 2023.

JPMorgan also surveyed clients last month. Of those surveyed, 54% said the US August CPI result (5.3% annual) does not change their view on the persistency of inflation, with the balance evenly split over inflation becoming more persistent or less persistent. Supply constraints are the main drive of inflation, and 54% of respondents saw these as being temporary, with 43% believing them to be a persistent feature.

If there is any conclusion to make with regard inflation, it is that at this point no conclusion can be made.

ANZ Bank economists weigh in on the argument:

“Many of the preconditions for a sustained rise in global inflation remain in place: tight labour markets, skills shortages in a range of sectors, high commodity prices, elevated inflation expectations, central bank permissiveness, and supply chain adjustments reflecting reshoring, geopolitics and other influences are common themes across economies. We thus don’t view the current spikes in inflation as entirely transitory. Upside surprises are continuing.”

Growing Pains

We can trace inflation spikes back to supply/labour shortages, and those back to delta. It is delta that has disrupted the pace of the global economic recovery.

Of course, the sheer pace of economic rebound from last year’s lockdowns was never going to be sustained, and a slowing of pace, or “maturing” of the recovery, was always expected. But such a maturing was supposed to be smooth, not distorted by the re-emergence of a virus the world had assumed it had overcome.

Hence Russell Investments’ suggestion of maturing from youth into “awkward” adolescence.

ANZ Bank economists have cut their 2021 global GDP growth forecast to 5.2% from a prior 5.6%, with Asia, Australia and New Zealand having been the most impacted. That said, their 2022 forecast has been upgraded to 4.3%, implying two years of growth well above the post-GFC average.

ANZ’s 2023 forecast is unchanged at 3.3%, in line with the post-GFC average of 3.4%.

The conclusion is thus that the global economy still seems healthy, even if peak growth is now passed.

Yet delta has shown the world that targeting “zero-covid” is unrealistic, hence the shift towards “living with covid”. For to hold on for zero-covid would mean continuing lockdowns until a period of zero cases is achieved, which would imply an economic disaster down to the household level more damaging than the virus itself.

New South Wales is a case in point, with restrictions to begin easing for the vaccinated next week, despite the assumption such easing will likely lead to a renewed spike in cases just as the trend is easing. Hospitalisations are also expected to spike, but all hope is being placed on vaccination growth warding off hospitalisations in due course.

Victoria is taking a similar path, despite cases not yet having peaked, as world’s lockdown record holder foresees not only ongoing economic damage, but lockdown frustration reaching boiling point.

Remember last year, when everyone thought lockdowns were lots of fun?

The truth is restrictions will be gradually eased, not scrapped, and the prospect of returning to pre-pandemic “normal” remains distant at best. Australian governments, federal and state, are risking a more drawn out pandemic at the cost of saving the economy, suggesting the risk of ongoing targeted snap-lockdowns, ongoing restrictions on patron numbers, and not to mention a couple of rogue states which will do everything to ensure they are sufficiently isolated (while welcoming sporting teams).

All of which means the economy’s recovery from here will be a bumpy one at best, and we might say “awkward”.

Yet while the road might be bumpy, as long as the economy reopens and remains reopened to sufficient extent from here there is no disagreement among economists, and the RBA, the economic rebound out of lockdowns will be swift, as it was last year. Last year the future looked uncertain, but now we have experience to go by.

And this year demand is even more “pent up” than it was last year, having suffered through a longer lockdown this time in NSW, world-record days of lockdown in Victoria and on-again, off-again lockdowns in other states and regions. And this year, a reopening of the international border looms before Christmas.

Household savings rates are no less elevated this time around than last, and this year’s lockdowns of frustration appear set to unleash a spending spree even more pronounced.

The announcement of the vaccines last November provided a kicker for equity markets, as noted, but also a pronounced rotation out of the “lockdown winners”, in particular tech and other “growth” stocks, and into prior “lockdown losers”, such as hospitality, travel and leisure stocks, as well as bricks & mortar retailers, builders and building materials and machinery manufacturers.

These are the “cyclicals” that rely on economic growth, and also “value” because they had been hit so hard in the lockdown period.

But when delta hit, rotation initially reversed, ahead of a period of back and forward as investors were not really sure which side of the market to be on. US bond yields shot up, and then back down again, to complicate the issue.

With delta cases now on the decline in the US, and governments in Australia moving to a “living with covid” stance, the rotation into cyclicals and value and out of growth has re-emerged but as September showed, the road remains a bumpy one.

The China Factor

While the US economy has led the world into the digital age, Australia remains in the iron age. Hence while the slowing down of the world’s second largest economy is a threat to the global economy overall, it is less of a threat to the US but a critical threat to Australia.

No economy came screaming out of last year’s lockdowns faster than China’s, and sooner than elsewhere, which went a long way to driving the commodity price explosion that saw the iron ore spot price reach a record US$220/t. Since late July, the price of Australia’s most valuable export has halved, back to levels of one year ago.

The prices of base and other metals and minerals have also pulled back from earlier highs, on the back of Beijing’s emission reduction targets, which have forced steep reductions in China’s heavy industry output, including smelting and steel-making.

The greatest consumer of Chinese steel is the Chinese construction industry, specifically housing. As ANZ Bank economists note, the recent cycle is the first since before the GFC in which Chinese monetary policy easing has not led to strong rises in property prices. The reason why became clear when Evergrande was at risk of going under, mired in a mixture of over-supply of housing and unmanageable debt.

For some time Beijing has suggested controlling a rampaging property market and stabilising the level of debt as a share of GDP are  among its policy targets, but this is the first period in which the effort has been so overt, ANZ notes.

Property has not been Beijing’s only target recently. The Chinese tech sector, private tutoring industry, and Chinese billionaires in general have been the target of regulatory attacks, as Beijing strives to maintain a capitalist market within communist principles even at the expense of economic growth.

No individual can be more powerful than the CCP.

In the years before President Xi came to power, Beijing would routinely reverse heavy stock market falls by telling the Chinese the stock market was a good place to make money, and heading off bubbles by telling the Chinese the market was overvalued and speculators would be punished. But Xi appears to be unfazed by a Hang Seng index down -40% since February as foreign investment heads for the hills.

US investors are now split into two camps – those who see the Chinese market’s big fall as offering value, and those who believe Beijing’s random regulatory crackdowns now make China simply “uninvestable”.

For Australian investors, the issue is less so of the Chinese stock market and more a focus on China’s actual economy.

Russell Investments expects Chinese economic growth to be robust over the next twelve months, supported by a post-lockdown jump in consumer spending and incremental fiscal and monetary support. One risk, however, is that Beijing remains in the “zero-covid” cohort, immediately reinstating regional lockdowns at the first sign of a new outbreak.

Ongoing regulation is another risk.

ANZ Bank economists note Beijing’s policy choices and China’s challenges with delta have impacted economic growth materially in 2021. They now expect Chinese GDP growth rate to slow to 4% towards the end of the year, which would be the slowest rate achieved in the modern era (other than during last year’s pandemic) and lower than that during the GFC.

For 2022, ANZ sees a slight pick-up to 5%.

A point to note here:

Were China’s growth rate to be maintained around 6% each year, that would not reflect linear growth, but exponential growth. For GDP is measured in dollars, so each year 6% growth on the last would imply exponential growth in dollar terms. No economy can sustain exponential growth forever, and while China may still be included in “emerging market” indices the reality is China has well emerged, and its economy is now maturing.

The only economy larger than China’s, being the US, has grown at an annual average rate of 3.12% since 1948.

China’s property sector is its greatest internal risk, as the Evergrande saga has highlighted. ANZ believes Beijing’s efforts to control excess leverage in the property market create “episodic and pocketed problems”, not systemic problems. But housing-related lending accounts for around 30% of all bank lending in China, and housing accounts for 70% of household wealth.

The experience of Australia, notes ANZ, is that constraining housing credit at the end of a very long boom has meaningful impacts on economic growth, as other sources of credit demand fail to fill the gap.

Recall that moves to cool Australia’s house price bubble the last time around sent Australia’s economy into a tailspin, such that in 2016, the RBA was forced to cut its cash rate to a then-record low 1.5%.

The US

While the US economy is likely to sustain above-trend growth into 2022, Russell Investments suggests the easiest gains are now in the rear view mirror as the recovery phase of the business cycle matures.

Strong fundamentals (and zero interest rates) have helped drive the US stock market to new highs, with S&P500 earnings per share reaching to 20% above the previous cyclical high. The Fed will commence the tapering of bond purchases before year-end.

Meanwhile, the White House is putting its economic faith in Biden’s ambitious US$3.5trn infrastructure stimulus plan but can’t even gain approval from the Democrat side of Congress, let alone the Republicans. Indications are the plan will need to be significantly watered down.

Citi’s aforementioned fund manager survey found more than half of respondents believe the ultimate package will be greater than US$1trn but less than US$2.5trn.

There is also the matter of the debt ceiling. Despite stoic (and hypocritical) Republican resistance, history suggests an agreement will be reached at one minute to midnight (figuratively or literally) before the government shuts down.

More than 60% of Citi’s survey respondents believe the ceiling will be raised by mid-October.

The flipside of Biden’s proposed infrastructure package, and whatever it may ultimately be, is the tax increase planned to pay for it. An increase in the corporate tax rate is never a positive for Wall Street. We recall that when Trump cut the corporate rate all the way down to 21% from 35%, Wall Street took off.

Biden’s initial plan was an increase back to 28%. That, too, looks like being watered down, and particularly if the level of planned spending is reduced. Yet Citi’s survey showed almost half of respondents expecting a rate of 26-27%, up from a previous majority expectation of 25%.

Wall Street will not necessarily spit the dummy if a tax increase is approved, given the trade-off of infrastructure spending is seen as necessary, overdue, and indeed economically stimulatory. And while 27% may not be as helpful as a generous 21%, it’s still a lot better than 35%.

As for financial market investment, consensus is there’s little point in investing in US bonds in the next twelve month as the shift towards easy policy reversal is gaining pace across the globe, highlighted by Fed tapering. Which leaves equities as still the best place to be, if only on a TINA basis ("There Is No Alternative").

Consensus on that front is that as delta wanes, the reopening trade that stalled earlier in the year is back on, hence cyclicals/value are preferred over growth stocks.

The general view is that the US ten-year yield will trend towards 2% by year-end. Despite the panic bond yield spikes have caused to date in 2021, particularly for growth stocks, in isolation, 2% is hardly a major threat to S&P500 earnings growth. The long term average is 4.3%, and the US stock market has not performed too poorly over the long term.

Far from it.

In JPMorgan’s aforementioned client survey, 70% of respondents said they planned to increase equity exposure and 80% planned to reduce bond duration in the near term.

But in Citi’s survey, the average end-2021 forecast for the S&P500 was 4487, which is only 2.8% above Wednesday night’s close (October 6). The average end-2022 forecast was 4630, which is up only 6.1% from here and suggests a mere 3.2% gain over 2022.

There is widespread agreement the likes of 20% annual gains will not be seen again anytime soon. In Citi’s survey, 62% of respondents saw a -20% correction as more likely than a 20% rally from here. Citi found this “interesting”, but does not make it clear whether it’s the 62% that is interesting or the implicit 38% that think the opposite (although the number of “don’t knows” is not reported).

History tells us clearly that -20% corrections tend to be swift and 20% rallies drawn out, ie “stairs and elevators”. Markets never “crash” up by 20%.

Australia

As suggested, consensus has the Australian economy rebounding swiftly out of lockdowns and border closures. The Australian stock market enjoyed eleven straight months of gains until September came along, and October has not started well, but the impact of upcoming reopenings provides hope.

To that end, the global theme of rotation out of growth and into cyclicals/value is as much the advice downunder as it is elsewhere. Underlying that thematic is a preference for risk over defensives.

Despite markets facing near-term hurdles, Morgans advocates “looking through the noise” and sees risk assets outperforming defensive positions over the next 3-6 months.

The broker considers financials, energy, industrials and consumer services are where opportunities lay, and in sub-sector terms, travel, gaming and traditional retail. Covid-winners consumer staples and large-cap online stocks are not preferred.

Assuming no other new variant is going to come along and slap us in the face, China’s economy is the biggest risk. Morgans is thus cautious on the iron ore majors for now.

Household balance sheets are in “great shape”, Morgans notes, presumably with apologies to anyone who has lost their business or job over the past 18 months. This will support the recovery in consumption.

The broker also sees upside risk to dividends (presumably not iron ore miners) as uncertainty from covid clears, keeping payout ratios elevated.

But if you think we’re in for a second leg of stock market surge ahead, a la April 2020 to August 2021, think again. Morningstar’s analysis indicates investors should expect a total annual return from the equity market (share price and dividends) of 8% over the next five years.

That’s down from 10% over the last five years, and 28% over the past year.

Morningstar’s analysis is based on aggregating individual in-house company earnings forecasts, which suggest a slowing in earnings growth to 3% over the next five years compared to 5% over the past five. Morningstar also estimates the earnings yield of the equity market has fallen to 5% from 6% five years ago, given PEs have expanded.

Markets become overvalued if price/earnings ratios (PE) rise because sentiment drives share prices higher than earnings per share forecasts suggest. And vice versa. However since the GFC, and more notably covid, brought about historically low interest rates, what was long considered the neutral market PE between under- and over-valuation has shifted upward given futures earnings are discounted at a lower rate.

That said, Morningstar believes that while a further increase in equity prices may still possibly be driven by further PE expansion, this would be an unsustainable source of equity market returns. It is also possible that expected interest hikes down the track will lead to a reversal in the PE expansion seen in recent years.

That’s the market as a whole, which doesn’t mean individually undervalued stocks cannot still be found. But as a whole, Morningstar believes the high iron ore prices we had seen are unsustainable, and expects mining company earnings weakness to “weigh heavily” on total equity market earnings over the next five years.

From an S&P/ASX stock index perspective, this creates a problem. Most balanced funds, and market ETFs, and other more specific ETFs, invest passively according to index weightings, be it top 20, 50, 100, 200, 300 or All-Ords (500). If the weighting of one stock in any index increases, funds must passively buy more of that stock.

Assuming BHP Group’s ((BHP)) dual structure ends as planned and the proposed merger of BHP Petroleum and Woodside Petroleum ((WPL)) goes ahead, Morningstar calculates BHP’s weighting in the ASX200 would rise to 9% from 5%.

BHP is in every one of the above-mentioned indices, and is not shy of producing a bit of iron ore.

It’s Not Easy Being Green

Nor was BHP once shy of producing oil, but assuming the Petroleum merger goes ahead, the Big Australian will have taken another, major, step away from fossil fuels. BHP is not the only global commodity producer to be moving along this path.

Arguably, 2021 is the year the world woke up to climate change. Not that a “green” shift in government policy only began this year, but after a frightening run of fires, floods, snow storms and hurricanes/cyclones/typhoons, the former laggards in the “net-zero by 2050” push have rushed to join the club.

Those still wavering – we won’t name names – are being press-ganged into the club on a risk of losing global credibility, but more so on a risk the exports on which its economy so significantly relies will hit by climate-related tariffs imposed by the true believers.

While the general population of the globe is cheering on this sudden call to action, the world’s energy sector is not yet far enough along the path of switching to renewables and away from fossil fuels to make the transition a smooth one.

The end result is contradictory supply-side issues.

The global pace of increasing supply of oil and coal has come to a halt, with the odd exception. Energy companies see the writing on the wall, and have for a while, and no longer see commercial value in pressing on with more exploration and project development.

Banks won’t lend to them anyway and institutional investors will no longer touch them, on both a commercial and ESG basis. Dwindling supply is behind the astronomical increases in the prices of oil, gas and thermal coal this year.

At the same time, demand has exploded for commodities supporting the push towards green energy, including uranium, battery elements (lithium, cobalt, nickel), and the copper needed for all the wiring in an electric world.

This interim period between energy investment rising sufficiently to net-out the decline in fossil fuel investment has driven all related commodity prices higher in tandem.

Which equals inflation.

But it’s not just commodity price inflation.

2021 could also arguably go down as the year the global finance market lost its pragmatic mind. Never in the history of the world have investors been prepared to pay more for something than they otherwise have to. But this is the cost of ESG.

The shift to “green” (E) at this stage of the game requires a premium. E is the most tangible of the environment, social and governance mix, but investors are also paying a premium for the less tangible S and G, which include everything from board room diversity to tackling social inequality to corporate disclosure.

Investors are not necessarily paying a premium because they’ve become all gooey and altruistic, but rather to highlight their ESG credentials in a world shifting rapidly now towards such goals.

All of which, again, implies inflation.

The final word to ANZ’s economists, in the case of E:

“Climate change mitigation, to the extent it involves action that business, governments and individuals wouldn’t otherwise take, seems likely to reduce economic efficiency and hence raise prices in some instances. How inflationary those actions end up being, however, depends on how it is accommodated by policymakers. The shift in the global policy dynamic, particularly when compared with the post-GFC period, suggests the price gains are likely to be sustained.”

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