Rudi’s View: Not The Bottom, Not The End

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In this week's Weekly Insights:

-Not The Bottom, Not The End
-Conviction Calls
-Research To Download
-FNArena Talks

By Rudi Filapek-Vandyck, Editor FNArena

Not The Bottom, Not The End

"For people still in their prime earning years, this bear market is likely to be as bullish in the long run as it is painful in the short run. For older investors, the decline is potentially devastating."

Jason Zweig in the Wall Street Journal, last weekend.

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As the Danish proverb goes, making accurate forecasts is very difficult, in particular about the future. Which is but one reason why I think investors put too much emphasis on forecasts and their accuracy.

A much better strategy is to identify and manage risk. This can be done by shifting allocations away from more vulnerable and volatile parts of the portfolio to defensives and cash, taking on less risk when the overall environment looks to become increasingly challenging.

Thus far in 2022, defensives have not operated as they should have, as suggested by history and the label they carry. One explanation is every new bear market differs slightly from the past, generating its own idiosyncratic framework. Another explanation is this year's bear market is only in its infancy; there's a lot more to come.

Six months in, assuming we can all agree the current bear market started in January, and with circa 60% of the ASX200 down by -20% or more, it is but normal for investors to start wondering whether The Bottom is in.

Maybe a macro-dissection, top-down style, from the process thus far can provide us with better-than-guesswork guidance in this all-important manner?

The process thus far

Those who pay attention to the finer details, and who are able to maintain a broad, macro overview, could potentially argue this year's bear market for global equities started in the early months of 2021 – well before the calendar moved into a new year.

It was then that the more speculative parts of US share markets started to falter. Take Cathie Wood's ARK Innovation ETF, for example. Its price peaked in February last year, stabilised for a while, and then fell off the cliff from early November onwards. It's still an open debate whether that fall from unbridled adoration has now ran its full trajectory.

In hindsight, ARK's step-by-step demise was simply the first signal inside the post-covid process that today has pulled major US equity indices down by -20% and deeper. Once the more speculative market segments had received their first public flagellation, liquidity was subsequently withdrawn from US micro cap stocks, then followed the midcaps with smaller-sized technology stocks attracting most of the attention.

The process, by now, was no longer confined to publicly-listed companies. In the equally exuberant and speculative crypto markets, NFTs were the first to be pulled into the abyss, shortly after followed by other vulnerable assets and faulty crypto-finance constructions, before a general rout took over the whole crypto market.

By then, the world's mega-cap technology stocks were already part of the process, and pretty much every market around the world had joined-in.

In Australia, where the major index is dominated by banks, energy companies and miners, the global withdrawal of liquidity initially showed up mostly below the surface, leaving many an investor with the false impression that whatever bad was occurring internationally might not be repeated on the ASX.

Such an assumption ignores the fact the 2022 bear market is developing through multiple, distinctive phases. Phase one was all about pricing out the Grand Exuberance that had been running wild when both governments and central banks provided additional support for covid-hit economies and markets.

Phase two kicked in when bond markets started normalising from emergency-driven levels, as inflation forced central bankers to change course and start hiking interest rates. Sharply higher bond yields triggered a violent re-adjustment in every asset trading on historically elevated valuation.

As investors sought refuge in those sectors responsible for the jump in inflation, Australian investors might be excused for thinking they were once again operating from the Luckiest Country in the world.

However, understanding how this process is now moving into the next phase means one can see why Australian banks had to be the next shoe to drop on the ASX, and why oil & gas, iron ore, coal and gold miners will follow next, not necessarily in that order and with exact timing unknown.

The next phase: corporate profits

The next phase in this year's bear market is all about the R-word; recession.

While it might take a while yet before investors find out which regions exactly will suffer economic contraction as higher interest rates, the rising cost of living and falling asset prices (housing, equities, cryptos and bonds) will exert downward pressure on household budgets and business's spending intentions, one recession that looks most likely to arrive next is a recession in corporate profits.

Zooming in on elevated margins, just about every market strategist worth his salt is today predicting forecasts for corporate profit growth are too high, both in Australia as elsewhere. What we don't know is whether sharply lower share prices are already accounting for the downgrades that haven't been implemented yet.

One extra complication investors are facing is that economic processes tend to be rather slow. Take the Australian housing market, for example. Most economists are now in agreement in that accelerated tightening by the RBA will push property prices down in 2023. Whether this will be by -5%, or -10%, or -15% is by the by.

Given plenty of historical precedents and references, a fall in property prices next year seems but a plausible projection. The problem investors are facing is how do you account for this, and its impact on consumer spending, in 2022?

Meanwhile, the upcoming quarterly reports from US corporates might shine some light on ongoing supply chain disruptions, input costs, inventories and margin pressures.

In Australia, investors will have to wait until August, with the preceding confession season offering the ability to surprise either way. On Monday, shopping mall operator Vicinity Centres ((VCX)) issued an upgrade to its FY22 guidance, accompanied by an uplift in asset valuations, and its shares rose 6.3% on the day.

The shares are projected to offer a yield well in excess of 5% and had fallen almost -9% over the preceding two weeks.

In contrast, shares in auto-parts manufacturer and distributor GUD Holdings ((GUD)) fell by some -30% between April and last week, when the company issued a profit warning, causing the shares to fall by another -19%.

The experience with GUD Holdings once again pays tribute to that old Wall Street adage that a profit warning is never fully priced-in, irrespective of share price weakness beforehand.

The problem for investors, as I see it, is that it's not always possible in advance to distinguish the next profit upgrade from that painful downgrade. And thus the risk for owning equities at this point in this bear market remains too high for comfort.

This is not to say portfolios should be reduced to zero exposure, but investors should be prepared to suffer at least one disappointment and preferably stick with solid, less risky exposures – or make a conviction call with a long-dated horizon.

As per my standard view, a healthy allocation to cash in portfolios seems but appropriate and the best possible defence against left-field, unexpected disappointment. A reminder: each of Coles Group ((COL)) and Woolworths ((WOW)) delivered an operational disappointment earlier in the year, which led to instant pummeling of the share price. In both cases investors have been reminded that solid, defensive stalwarts are not immune from the pressures this year.

Anyone who's buying shares ahead of August better account for the risks involved. I recommend you limit your purchases to cautious nibbling, and remain patient overall. This still remains an environment in which heroic behaviour will likely not be rewarded and instead can result in immaculate pain and suffering.

We haven't even found out whether there's an economic recession on the horizon. It matters not whether you believe it can be avoided or not, what matters is that you reduce the risk of maximum pain in case of an alternative scenario than the one you are inclined to side with today.

As I like to remind everyone who strongly believes energy companies and large bulk miners are the new defensives in 2022 no matter what happens: let me check my notes, when was the last time that share prices in cyclicals held up while economies were facing recession..?

Oh, that's right! It has never happened before!

Gold and gold miners are at risk of central bankers achieving what they're aiming at: bringing inflation back inside the 2-3% range.

Rally potential in the short term

May and June have been extremely harsh on Australian equities with the ASX200 losing -11% over the past ten trading days alone. We don't need all kinds of sophisticated technical indicators to assess the share market looks over-sold in the short term.

This provides yet another platform for a broad rally upwards. Given the overall macro-context, however, I very much doubt whether this year's bottom is in, or whether it matters much for the months ahead.

On consensus forecasts, the local share market's Price-Earnings (PE) ratio has now fallen to circa 12.5x – a number not seen since the troubled Grexit period of 2010-12. But a crucial input to calculate today's number stems from analysts forecasts, which are almost by definition too rosy.

On top of all of the individual considerations, while inflation is still high and surprising to the upside, and central bankers are putting their feet on the accelerator, which means bond markets cannot settle anytime soon, I believe an investor's biggest enemy is his own impatience.

From where I am sitting, there is absolutely no hurry to allocate additional funds to equities right here, right now. Unless for trading purposes, or for longer-dated conviction calls.

Incidentally, anyone still holding some low quality, low conviction exposures in the portfolio might want to use the next rally to sell and increase the level of cash. This will come in handy no matter what scenario unfolds next.

More Reading:

-Double Your Protection: https://www.fnarena.com/index.php/2022/03/17/rudis-view-double-your-protection/

-Quo Vadis, Corporate Profits? https://www.fnarena.com/index.php/2022/06/02/rudis-view-quo-vadis-corporate-profits/

-Don't Fight The Fed: https://www.fnarena.com/index.php/2022/05/26/rudis-view-dont-fight-the-fed/

-Trend Is Turning For Corporate Profits: https://www.fnarena.com/index.php/2022/05/12/trend-is-turning-for-corporate-profits/

-A Bear Market Anomaly That Confuses: https://www.fnarena.com/index.php/2022/05/05/rudis-view-a-bear-market-anomaly-that-confuses/

-Peter's Portfolio Reviewed: https://www.fnarena.com/index.php/2022/04/13/rudis-view-peters-portfolio-reviewed/

-2022, The Big Adjustment: https://www.fnarena.com/index.php/2022/02/17/rudis-view-2022-the-big-adjustment/

Conviction Calls

With earnings forecasts falling in Australia, as well as elsewhere across the globe, analysts at Jarden have identified ASX-listed insurance brokers AUB Group ((AUB)) and Steadfast Group ((SDF)) as two companies whose earnings estimates carry upside potential.

Ongoing buoyant conditions for insurers' gross written premia (GWP) and relatively insulated margins should bode well for both insurance brokers, suggests Jarden. Its preference is for AUB shares, as those have fallen a long distance more than shares in Steadfast Group.

As such, AUB is rated Buy and Steadfast Overweight with respective price targets of $27.45 and $5.10. Both shares are nevertheless trading on comparable forward looking dividend yields of 3.2% and 3%, respectively.

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From last week's strategy update by Randal Jenneke, Head of Australian Equity at T Rowe Price:

"We think it is better to prepare for slowing growth and rising recession risk in 2023 rather than dwell on what stares us in the face today (higher inflation)."

"We have increased our exposure to defensive growth, such as consumer staples and health care, funded from the more cyclical parts of the market."

And also:

"We believe that we are only in the early stages of a global earnings downgrade cycle, which is expected to intensify as recession fears increase."

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Portfolio managers at Wilsons:

" …investors will have to navigate a period where economic and earnings growth could be vulnerable to downward revisions."

Wilsons has responded to the challenge by increasing exposure to higher quality businesses, while noting companies with stable earnings growth and margins should be less at risk of disappointment, and thus should be looked at more favourably by investors at this stage of the cycle.

Wilsons, however, still cannot get too excited about consumer staples stocks, while acknowledging these stocks will become more attractive as more red flags pop up as momentum for the global economy deteriorates.

The energy sector is still liked as an inflation hedge over the coming 6-12 months, while banks remain Overweight. Goods retailers, such as JB Hi-Fi ((JBH)) and Harvey Norman ((HVN)) remain a strong No-Go Zone for Wilsons as the risk for further earnings downgrades is seen as too high for comfort.

In a separate strategy report, Wilsons explains why it is happy to stick with Goodman Group ((GMG)) and James Hardie ((JHX)) in the portfolio – both are seen as "structural stories".

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Strategists at JP Morgan, on the other hand, remain rather stoic in the face of an extremely tough environment for equities globally, as well as locally.

Globally, JP Morgan is Overweight Financials, Energy, Discretionary Retail, Industrials, and Materials.

Locally, JP Morgan has moved to Underweight on REITs and Communication Services, while upgrading Industrials to Overweight.

JP Morgan remains Underweight Defensives, in particular Healthcare, Utilities and Staples.

According to the latest data analysis, 59% of ASX200 stocks is now down more than -20% from its 52-week high price point, while 84% is down at least -10%. The remaining 16% consists of the likes of Crown Resorts ((CWN)), under takeover interest, as well as coal producers, energy companies, iron ore producers, petrol retailers and insurer QBE Insurance ((QBE)).

Year-to-date 73% of the ASX200 is now "in the red" with 35% of stocks down -20% and more.

All data in the JP Morgan analysis as at 9 June 2022.

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As inflation has remained stubbornly higher-for-longer, central bankers have stepped up their effort to temper economic growth and push inflation back inside the 2-3% target range.

As this process has rapidly morphed into a different scenario from what most investors and policymakers had in mind at the start of the calendar year, it is but logical to assume the odds of something nasty happening are shortening too.

Japanese powerhouse Nomura is the latest to now forecast a mild recession for the US economy, starting in the final quarter of 2022. Nomura has cut its 2022 US GDP forecast to 1.8% growth from a prior 2.5%, and 2023 to a -1.0% decline from a prior 1.3% growth forecast.

"Relative to previous downturns, the significant strength of consumer balance sheets and excess savings should mitigate the speed of the initial contraction. However, policymakers’ hands are tied by persistently high inflation, limiting any initial support from monetary or fiscal stimulus."

The not-so-great news is inflation is projected to remain elevated, which means the Federal Reserve has to stay on its current course for longer too. Hence, Nomura is expecting ongoing rate hikes into 2023 but from February onwards the momentum should change. Not long after, Nomura expects by the second half of next year, the Fed will start cutting rates again.

Equally important: Nomura sees more downside risks emanating from business debt than from consumer debt. As Republicans are expected to grab the majority in both parliamentary houses next year, Washington gridlock will be back, possibly exacerbating the economic recession.

US Treasuries are projected to invert -2 year versus 10 year- in Q3 and remain inverted for the next twelve months (!). As bonds will respond to the increased spectre for recession, Nomura has lowered its year-end projections for the yield on the 10-year bond, to 2.65% for end-2022 (was 3.10%) and to 1.70% (was 3.05%) for end-2023.

In terms of the trajectory of Fed tightening, Nomura has penciled in another 75bp hike in July, followed by 50bp in September, then 25bp in each meeting in November and December. This lifts the policy rate to 3.25%-3.50% by year-end. At the meeting in February, the Fed is projected to deliver its final hike (25bp) in this cycle.

By September next year, all Fed meeting announcements will involve rate cuts, this week's update suggests.

Research To Download

Independent Investment Research (IIR) on:

-Vaughan Nelson Global Equity SMID Fund ((VNGS)) – initiation of coverage: https://www.fnarena.com/downloadfile.php?p=w&n=F522DD0A-E0A9-A819-3E356C3FDE905F5D

-Magellan FuturePay ((FPAY)): https://www.fnarena.com/downloadfile.php?p=w&n=F51813EF-D05A-EFB9-84ADDE2B4B12CBCB

-MTC Digital Asset Fund – initiation of coverage: https://www.fnarena.com/downloadfile.php?p=w&n=F51BD0F5-FDFC-AC8A-B5763398A8A4A051

-ECP Emerging Growth ((ECP)): https://www.fnarena.com/downloadfile.php?p=w&n=F51BD0F5-FDFC-AC8A-B5763398A8A4A051

FNArena Talks

I will be participating in a Global Markets Webinar on Wednesday June 29th, 7pm, organised by Peak Asset Management, around the central theme of: Is This The Bottom?

Other participants are David McNamee, Director Altor Capital, Steve Torso, MD Wholesale Investor, Ron Shamgar, head of Australian equities at Tamim Asset Management, as well as Niv Dagan, executive director Peak Asset Management.

Should be interesting. To register: https://us02web.zoom.us/webinar/register/1016553643062/WN_vnto5a75SZeX8XHc_2IaxA

(This story was written on Monday 20th June, 2022. 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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