Rudi’s View: Bonds Versus Earnings

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This week's edition was written prior to highly anticipated meetings by the RBA locally and the FOMC in the US but has lost nothing of its relevance post both events.

In this week's Weekly Insights:

-Bonds Versus Earnings
-Signal Says Sell, But Don't Sell
-Autumn Has Arrived For Sydney Properties
-Covid Is Changing The World
-Copper: Supercycle With A Twist
-Conviction Calls

By Rudi Filapek-Vandyck, Editor FNArena

Bonds Versus Earnings

As far as historical battles between financial markets and central banks are concerned, the past two weeks have generated a lot of excitement for bond traders locally who had chosen to challenge the RBA's resolve in a global context that saw inflation worries spike, including among the mighty central bankers in countries like Canada, the UK and the USA.

In case readers are not quite familiar with events or with the finer details behind the October bond market massacre (for the many on the wrong side of the trend), the RBA has maintained it won't be raising the official cash rate until 2024. On occasion the central bank puts money where its official target lays through buying Australian government bonds so that the forward yield on those bonds that expire in 2024 remains around the current cash rate of 0.10%.

But local bond traders had been testing the RBA by selling bonds and pushing up the yield. Then all it took was one CPI release that surprised on the upside, pushing core inflation to 2.1% and the central bank's defense of that 0.10% level got pretty much smashed into smithereens.

At one stage the yield on those 3-year government bonds rose to 0.80%, or seven times above the level the central bank had been defending as accurate and appropriate.

Admittedly, it's not quite up there with George Soros breaking the Bank of England's defense of the British Pound back in 1992, a victory that earned Soros' fund a cool $1bn at the time, but the achievement should nevertheless not be underestimated either: the local bond market has forced the RBA explicitly into a change in official monetary policy.

That change has not yet been communicated, but it is tangible and real because the RBA can no longer defend a target of 0.10% when local bonds are suggesting otherwise. This is why the message from Governor Philip Lowe and Co on Melbourne Cup day this year carries a lot more weight than usual.

The real question is, however, whether the RBA's (yet to be communicated) confirmation that plans to lift Australia's cash rate to a more "normal" level on the back of a stronger economy and stronger-for-longer price inflation also signals a change in overall dynamics for the local share market.

Here I can only repeat the view I have been expressing for weeks: the local bond market has overshot, its implied pricing now appears well over the top, way too aggressive.

To put it bluntly: either equities are too sanguine about the way forward for inflation and bond yields, or the bond market will have to calm down and retreat from its newfound trend/momentum.

My allegiance still lays with the second scenario. Plus the recovery for the share market throughout October, including for stocks like Goodman Group ((GMG)), CSL ((CSL)) and TechnologyOne ((TNE)) suggests I am not too far off the mark with my assessment as to how exactly this ongoing battle between the bond market and the RBA will most likely unfold.

As I suggested last week: I'd be flabbergasted if Philip Lowe stands ready to start lifting the official cash rate from mid next year onwards, and then in quick succession proceeds with a series of follow-up hikes by late 2022. More realistic, I think, is assuming the RBA has accepted defeat and might suggest sometime in 2023 looks "plausible", if not "possible".

But let's wait and see, shall we?

The second most important issue at the moment, one that is receiving a lot less attention, is that global economic momentum is slowing. Were this to go on for longer, companies locally and in the USA might find it increasingly difficult to beat or meet expectations. I hope we all realise that equity markets are where they are in 2021 -at or near top-notch valuations- because corporate performances have been nothing but extraordinary, on average, and broadly speaking.

Financial results in Australia post-August have been a lot less supportive, as also proven by Westpac ((WBC)) on Monday, but the AGM season has generated more positive than negative momentum. Plus, it has to be pointed out, strong and solid businesses are still showcasing their nouse and positive operational momentum, including by Home Consortium ((HMC)), Aristocrat Leisure ((ALL)), Charter Hall ((CHC)), Macquarie Group ((MQG)) and yes, even ResMed ((RMD)), though the latter's cautious outlook for the coming two quarters has triggered a reversal in share price momentum.

While investors, and market commentators, tend to be worried about elevated valuations, I think the biggest risk between now and February lays with companies that cannot meet guidance or expectations, especially among smaller cap companies. Last week, Codan ((CDA)) shares fell -18% on weak forward guidance. Control Bionomics ((CBL)) quickly went from 70c to 47c. Shares in Damstra Holdings ((DTC)) closed at 71c on Monday. Two months ago, these were trading at $1.20. One year ago, they were priced above $2.

a2 Milk ((A2M)) shares have fallen, again, and Woolworths ((WOW)) disappointed too. Today, Westpac shares lost more than -7%.

These are but a few examples, but they show investors where true and tangible risk lays. Regime change has arrived. Those shenanigans in the bond market are only part of the story and in my view not even the most important part.

Signal Says Sell, But Don't Sell

When is a technical Sell signal not a signal to start taking risk off the table and sell some shares?

Right now, apparently. As one of the technical models used by Longview Economics is flashing Sell, CEO and chief market strategist Chris Watling has urged clientele of the firm to ignore the signal.

Markets have been strong, and investors are nervous, acknowledges Watling, and yes, Longview's SELL-Off indicator is flashing warning signals, but other indicators and models are still supportive and Watling believes there is only limited evidence of euphoria in markets against a background of a still supportive macro and liquidity environment.

Looking over global equity markets, Watling notes multiple indices and sectors have broken out of multi-month trading patterns, which should bode well for overall momentum, in particular since risk appetite is recovering from the scary risk-off conditions that had gripped the month of September.

As such, Watling is anticipating a period of sideways movement, or a minor wobble at worst. Certainly nothing to get overly worried about, until we're back in euphoria.

Autumn Has Arrived For Sydney Properties

And just like that, market momentum in the Sydney real estate market is evaporating at breakneck pace.

Gone are the long queues for house inspections, the fiery bidding wars, the tactics to place an offer before the auction date.

What remains (of course) is the underquoting by agents, but both on personal observation and feedback from industry sources it is clear the overall temperature for properties in Sydney has cooled down remarkably, and suddenly.

Who or what is to blame remains an open question. Is it the end of lockdowns? Is it the prospect of rising interest rates? Is it fear for falling house prices?

It goes without saying, a few weeks of cooling down in one market does not necessarily make for an accurate signal, but the loss in overall buyer interest is remarkable, to say the least, and in sharp contrast with the frenzy that characterised this market until a few weeks ago.

Let's find out how sustainable it is, and in what form this reversal will start impacting on industry data and indicators.

Covid Is Changing The World

'Life after covid' is gradually transforming into 'living with covid' in most countries. A recent report by Boston Consulting Group (BCG) highlights this also means lots of changes, of which some will be delaying a return to pre-pandemic growth and conditions, while changes elsewhere might prove of a more permanent character.

Apparently pet owners worldwide have decided more online purchases are the way forward and they are unlikely to abandon the practice, leading to a stronger growth trend post-covid for those businesses providing supplies and services.

There are victims too. While households are keen to get back on a plane to travel for leisure and holidays, business travel might never recover. And share a thought for the owners of bricks and mortar movie theatres now large parts of the population have fallen in awe with online streaming and gaming.

Both businesses and investors will have to assess which of the changes are now essentially new trends, and which ones are only of a fleeting nature, as well as how to best respond to these changes. See, for example, also Jarden's research into packaging, further below.

Covid also has strengthened consumer's consciousness on environmental sustainability, resulting in shifting priorities, as well as in political demands, plus changes in consumption, reports BCG.

Copper: Supercycle With A Twist

Resources analysts at Citi have held two convictions in 2021; copper is in the early stage of a multi-year supercycle, and a sizable sell-off is on the cards for the months ahead.

A recent in-depth study into the red metal's dynamics and outlook has further reinforced both predictions. Not only has Citi become even more positive on the future price level and the duration of copper's superycle, the team equally remains convinced the price is set to fall quite dramatically over the next six months or so.

Put both predictions together and it won't surprise anyone, the team at Citi sees the next sell-off as a strong buying opportunity for the longer term.

Citi's strengthened bullishness on copper's outlook longer-term is because of the global trend towards decarbonisation, which translates into new supertrends for renewable power generation and electric vehicles and on current technological insights, those trends depend on copper; lots of it.

So why the big sell-off in the mean time?

Citi believes shortages in global power, coal and gas markets, in combination with China's weakening economic momentum, added on top of more persistent shortages of chips (semi-conductors) and container ships will ultimately result in global manufacturing stumbling into a temporary slow-down and this will have ramifications for demand, and the price of copper.

All this is happening while producers globally are ramping up production, meaning the scenario of slowing demand is set to meet growing supply. As we all know, this is never a good outcome for a commodity such as is copper.

Now, to put some numbers to the thesis: US$8200/tonne is seen as the post-sell off target while Citi's long-term price assumption has risen to US$9000/t from US$7500/t as a base case scenario, while a more bullish environment can pull copper further north to US$12000/t (as an average). Copper is currently priced at circa US$9800/t.

Conviction Calls

A general update on the Australian consumer sector has led analysts at Jarden to reiterate their current top picks on the ASX: Woolworths ((WOW)), Coles ((COL)), Metcash ((MTS)), Wesfarmers ((WES)), Domino's Pizza ((DMP)), Premier Investments ((PMV)), Accent Group ((AX1)), Beacon Lighting Group ((BLX)), and The Reject Shop ((TRS)).

The broker is (a lot) less positive on Super Retail ((SUL)), JB Hi-Fi ((JBH)), and Harvey Norman ((HVN)).

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Stockbroker Morgans has removed ANZ Bank ((ANZ)), TechnologyOne ((TNE)) and Senex Energy ((SXY)) from its selection of Best Ideas in Australia. In their place Westpac ((WBC)) and Atlas Arteria ((ALX)) have been added.

That happened before Westpac's market update on Monday.

Morgans' Best Ideas now contains 45 names. I previously named all of them, prior to these recent changes, in Weekly Insights of October 11:

https://www.fnarena.com/index.php/2021/10/14/rudis-view-bhp-codan-macquarie-santos-and-qbe/

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Macquarie analysts recently observed most listed fund managers on the ASX seem underwhelmingly priced with valuations across the sector now seen as attractive, both in absolute and relative terms.

Macquarie in particular likes Magellan Financial ((MFG)), Pendal Group ((PDL)) and Pinnacle Investment Management Group ((PNI)), with Pendal Group the broker's number one choice.

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Jarden initiated coverage on the local packaging sector with an Overweight stance for the sector in general on belief investors are underestimating how much growth lays ahead with covid effectively providing a boost through more eating-at-home and with the ongoing ability for the sector to pass on higher input costs to customers.

Jarden's sector favourite is Amcor ((AMC)), ahead of Orora ((ORA)) and Pact Group ((PGH)).

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One recurring theme among analysts recently is better-than-expected growth prospects for the global and local steel sector and here Jarden recently initiated coverage with a Buy rating for Sims ((SGM)) and an Overweight rating for BlueScope Steel ((BSL)).

(This story was written on Monday 1st November, 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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