Rudi’s View: In Bonds We Must Trust

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In this week's Weekly Insights:

-In Bonds We Must Trust
-Conviction Calls
-Research To Download

By Rudi Filapek-Vandyck, Editor FNArena

In Bonds We Must Trust

Normally, when economic recession is coming, you'd expect defensives and solid & reliable Quality industrials to be among the outperformers in the share market but 2022 is not following that script – at least not thus far.

Shares in supermarket operators Coles ((COL)), Metcash ((MTS)) and Woolworths ((WOW)) are down since the start of the calendar year, while packaging giant Amcor ((AMC)) and its local offshoot Orora ((ORA)) are equally notably absent from this year's star performers on the ASX.

What to think of Australia's third largest index weight, global plasma-leader CSL ((CSL)), which only a week ago increased its profit guidance for FY23, but whose share price cannot hold on to positive momentum for longer than a few days this year?

A similar observation can be made for ResMed ((RMD)); the global leader in diagnosing and treating sleep apnoea stands to extra-benefit from a major competitor's problems. ResMed's also not so flash when it comes to sustaining share price momentum.

Is it possible, maybe, investors are simply not that convinced economies stand to lose most of their momentum in the year coming?

Not so, according to the latest global fund manager survey by Bank of America, which, according to BofA market strategists "screams" of mass capitulation.

Average levels of cash at 6.3% have never been as high since April 2001 (in the midst of an extremely brutal bear market). Fund managers are now three standard deviations underweight equities.

A net 72% of respondents sees a weaker economy on the horizon, only a smidgen off the record high print of the July survey. 91% says corporate earnings will be lower than is forecast today.

A net 74% of survey respondents sees a global recession in 2023; the highest percentage since April 2020, at the very beginning of the global pandemic.

So how then can we explain this great discrepancy between the overwhelming acceptance of recession next year, with negative consequences for corporate profits, and the failure of the usual, defensive stalwarts to perform?

I believe the answer lays with global bonds.

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It was the lauded Benjamin Graham himself who in The Intelligent Investor highlights that bond yields are an important input for determining the value of companies.

But after four decades of mostly positive impact from bonds, most analysts and investors in shares could be forgiven for paying scant attention.

In 2022, however, the direction in bond yields matters – it has mattered whole year.

For the record: higher bond yields, as we are witnessing throughout this year, impact on all listed assets, but the impact is most felt for those equities that trade on higher valuations. In a theoretical example: stocks that trade on a forward PE multiple of 32x might be pushed back to 26x while a stock trading on 9x might only be pushed lower to 8.5x.

It's not difficult to see how rising bond yields benefit the so-called Value segment in the share market, while Growth and higher valued Quality stocks suffer.

Usually, when a recession shows up on the horizon, bond yields fall in anticipation of lower inflation and central banks cutting interest rates, which also adds that extra valuation support to the more defensive-oriented stocks I mentioned earlier.

Thus far, however, inflation is still on the rise and central bankers continue lifting interest rates in response. This explains why going all-in defensive in preparation for next year's recession hasn't worked so well this year.

The obvious point to make is that virtually no-one believes inflation will not respond to central bank tightening and slowing economies, hence a time will come when bond yields stop rising as markets try to anticipate a change in direction for inflation and global interest rates.

But don't get excited just yet. This global inflection point can be as little as a few weeks away, or it can be as far away as a number of months.

Taking guidance from the above mentioned global fund managers survey, a majority of investors sees the Federal Reserve lifting its Fed Funds rate to 4.5-5% from 3-3.25% currently, implying there's still more to go if current forecasts are correct for 75bp and 50bp hikes before year-end.

The good news nevertheless is the end of this cycle of interest rate hikes is drawing nearer, unless those forecasts need another reset.

Central bankers are all too aware too much tightening might break the system, thus if inflation stays higher for longer, their first response is likely to leave interest rates higher for longer, delaying any loosening as inflation simply cannot be left footloose and free.

When it comes to the next Black Swan event, BofA's survey suggests investors are most worried about Europe and European financials.

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The advent of the next recession usually corresponds with a noticeable reduction in corporate profits. Yet again, if 2022 teaches us anything, this process too is a long and drawn-out affair.

Up to now, corporate profits have started showing various signs of emerging weaknesses, but overall corporate profitability has remained remarkably resilient, both in Australia and in the USA.

As a matter of fact, earnings estimates in Australia have recently bucked the trend and started rising again.

Yet another discrepancy?

A closer look into the finer details shows this unexpected improvement is due to rate hike beneficiaries of banks and other financials, combined with resources companies and other cyclicals, as well as ongoing benefits for major re-opening trade beneficiaries. Think Qantas Airways ((QAN)), airports, resorts, hotels and the likes.

There is no debate: this is a positive short term. However, the great unknown remains what happens next. Analysts at Credit Suisse put it as follows:

"Current EPS revisions are reflective of current rather than forward economic conditions."

Credit Suisse continues to see a -15% reduction in Australian corporate earnings throughout calendar 2023, also highlighting the danger of extrapolating current trends further out when multiple signals are warning about notable economic slowing ahead.

A warning that also applies to one sector that has found general support from this year's general dynamics; Australian banks.

From banking sector analysts at Barrenjoey:

"It is often said that it is darkest-before-dawn, but in banking it is also brightest-before-sunset."

Two weeks ago, FY22 results from Bank of Queensland ((BOQ)) showed a quicker-than-anticipated margin benefit from rising rates, which lit a fuse underneath the sector since. Analysts have been busy recalibrating their models and share prices have responded positively.

But is this simply the last hurrah before the reality of next year's slowing economy hits?

Nobody is forecasting a long and deep recession for Australia, and banks should at the very least be expected to keep their dividends at current level, but tougher times usually bring about a lower multiple for the sector, which creates a natural headwind a la bond yields for CSL, Metcash and the likes to date.

Incidentally, Westpac ((WBC)) quasi-uniformally considered today's weak laggard among the local Big Four, had more bad news to share on Monday. Make of this what you like.

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Resources too have been among key beneficiaries thus far in 2022, in particular those sections for which end users seem to have no other option than to pay up for limited supplies.

A rather sharp division has thus opened up between, say, aluminium, copper, crude oil and iron ore on the loser's end and lithium, metallurgical coal, natural gas, and uranium as this year's true market leaders.

Regarding those commodities that have proved more vulnerable to changes in supply-demand balances already (also including the agricultural sector): history shows prices can, and likely will pull back deeper, which is also why local sector analysts have been cutting forecasts over the weeks past.

On Monday, the team of energy sector analysts at RBC Capital joined the trend, reducing average Brent oil forecasts for 2023 and 2024 to US$94.75/bbl and US$88.10/bbl respectively. Arguably, these forecasts do not differ fundamentally from where prices are, but RBC's previous forecasts had a significantly higher number in mind for next year.

But maybe the true message stems from the fact RBC Capital is forecasting a multi-year bull cycle for commodities, while preaching caution for the shorter-term.

As an avid reader of investment research, including comments and views on social media, I sense there is great belief among investors that commodities a la lithium and met coal are the new defensives that simply cannot fail, but not all analysts are equally as confident.

Either way, the market will have no hesitation to put the thesis to some serious tests over the months ahead.

The one exception, potentially, is natural gas for which the odds seem to favour a very negative outcome for Europe in case of a cold winter. This spells bad news for the continent and makes escaping a damaging recession sheer impossible, but potentially great news for producers.

The overall index weight of the local energy sector is now approaching 7% – the highest percentage of the ASX100 in twenty years (including the pre-GFC Super Cycle period).

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Ongoing rises in bond yields and relatively resilient earnings forecasts have pushed back the share market's average PE multiple to circa 13x. This is down from 20x (and higher) in 2020 and 17.7x late last year.

The Australian share market has seldom appeared as "cheap" as today, with the decade past offering but two precedents: the euro-crisis of 2012 and early 2020.

Combine this with extremely negative sentiment and record high cash levels, as also revealed by the BofA monthly survey, and it is not difficult to see why some are hopeful equities might enjoy their annual Santa rally this year.

Judging from recent false starts, any relief from bonds and/or central banks is likely to be violent and quick as far as equities are concerned, with markets worrying later about next year's recessions and corporate profits.

In case of a definitive change in direction of bond yields, investors might keep in mind the gold sector and A-REITs have both been among key victims of this year's bond market tribulations.

Underlying, the need for companies to successfully navigate next year's slowing economies remains all-important, even if this hasn't proved part of the magic investing formula so far in 2022.

Conviction Calls

It appears Qantas Airways' shock announcement (in a positive way) the previous guidance for the first half will already be achieved in the first quarter was not just a one-off, company-specific event.

Auckland International Airport ((AIA)) has since also raised its guidance for the year, though, it has to be pointed out, the relatively small NZ airport is no match for the size and the brutality of the Qantas upgrade.

Clearly, the re-opening trade is still making its mark, even as we approach the end of calendar 2022.

Another company that also is not on every investor's mind, but equally managed to release a better-than-anticipated share market update is Event Hospitality & Entertainment ((EVT)) whose Thredbo asset is booming.

As a weaker AUD works to the small cap's favour, and with $100m in properties up for sale, Citi has instantly made this company one of its favourite small cap exposures for the year ahead.

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RBC Capital's energy sector analysts remain convinced the sector is but in the early stage of a multi-year bull market.

However, shorter-term some caution seems but warranted, with the analysts highlighting:

"3Q 2022 was a stark reminder that a violently strong and erratic macro headwind can temporarily trump individual fundamentals across most asset classes, and vice versa for tailwinds."

RBC has cut its price forecasts averages for the years ahead with Brent oil now forecast to average US$94.75/bbl (prior US$115.75/bbl) and US$88.10/bbl (prior US$93.59/bbl) in respectively 2023 and 2024.

RBC Capital's two favourite sector exposures are Santos ((STO)) and Karoon Energy ((KAR)).

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UBS's selection of Best Stock Ideas in Australia has seen a few changes, with both CommBank ((CBA)) and Pilbara Minerals ((PLS)) being added to the list of Least Preferred investment options on the ASX.

CommBank shares have been highlighted yet again by multiple brokers recently as the shares remain head-and-shoulders above peers -worldwide- when it comes to valuation. The selection of Pilbara Minerals seems to have a relative slant to it: others in the lithium space are seen as better opportunities.

Harvey Norman ((HVN)) and Macquarie Group ((MQG)) are no longer included, but Bega Cheese ((BGA)), Endeavour Group ((EDV)), InvoCare ((IVC)), Lifestyle Communities ((LIC)) and Magellan Financial Group ((MFG)) remain Least Preferred as far as UBS's opinion is concerned.

In more upbeat news, the Most Preferred selection of UBS's Best Ideas has been expanded with Seek ((SEK)) and Super Retail Group ((SUL)). No longer included are Computershare ((CPU)) and Metcash.

Still Most Preferred are BHP Group ((BHP)), IGO ((IGO)), Origin Energy ((ORG)), and Santos among Resources. Among Financials the choices are ANZ Bank ((ANZ)), QBE Insurance Group ((QBE)) and Steadfast Group ((SDF)).

For Industrials, UBS's selection consists of Aristocrat Leisure ((ALL)), Amcor, IDP Education ((IEL)), NextDC ((NXT)), Qantas Airways, Seven Group Holdings ((SVW)), Telstra ((TLS)), Transurban ((TCL)), Treasury Wine Estates ((TWE)), Wesfarmers ((WES)) and Worley ((WOR)); plus the earlier mentioned additions.

Research To Download

Edison Research on:

-Actinogen Medical ((ACW)): https://www.fnarena.com/downloadfile.php?p=w&n=49FCCBC8-B559-E1CF-8F264DD80D7CC794

-Alkane Resources ((ALK)): https://www.fnarena.com/downloadfile.php?p=w&n=4A1381B2-D927-8F23-F1B134A5CFB62616

-Incannex Healthcare ((IHL)): https://www.fnarena.com/downloadfile.php?p=w&n=4A21C565-A051-E8DF-A7AD45B622A4B8BB

Research as a Service (RaaS) on:

-Harvest Technology Group ((HTG)): https://www.fnarena.com/downloadfile.php?p=w&n=4A720C16-CEE4-8851-D6FE73CE2244241E

-Metarock Group ((MYE)): https://www.fnarena.com/downloadfile.php?p=w&n=4A7E47BF-FCCB-8212-C3D73E880368C19D

-Pureprofile ((PPL)): https://www.fnarena.com/downloadfile.php?p=w&n=4C92DAC1-EB5D-BFB8-62D458C7D5023C01

-Schrole Group ((SCL)): https://www.fnarena.com/downloadfile.php?p=w&n=4A847BA5-AF00-F74E-B67300986EC2AEC2

(This story was written on Monday, 24 October, 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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