Rudi’s View: Bond Market Says Regime Change Is Upon Us

This story features COMMONWEALTH BANK OF AUSTRALIA, and other companies. For more info SHARE ANALYSIS: CBA

In this week's Weekly Insights:

-What's Up, Doc?
-Bond Market Says Regime Change Is Upon Us
-Banks (Dividends) In Focus
-Conviction Calls & Best Ideas
-Research To Download
-FNArena Subscription
-Webinar on Copper

By Rudi Filapek-Vandyck

What's Up, Doc?

There's a near unanimous view among share market observers that from a technical analysis point of view, global equities seem in a solid uptrend in April.

Those that have a view on the fundamental underpinnings also highlight the discrepancy with the technical picture. If anything, the chances for economic recession in the US this year are increasing, yet equities seem to be preparing for a party like it's 1999.

Don't fight the tape versus don't fight the Fed?

Short-term versus further-out?

There's plenty of anecdotal evidence suggesting institutional investors are not fully participating in this month's rally. Probably because, you know, that recession (and still too optimistic forecasts).

Research by Canaccord Genuity shows the S&P500 has never bottomed before economic recession, hence if late last year's trough turns out The Bottom for the current cycle, it would mark the first time with Canaccord's research dating back to the recession from 1957-58.

Back in 2001, the index didn't bottom until the recession was well and truly in the rearview mirror.

Canaccord's strategy is to remain patient, keep plenty of cash on the sideline while skewing the portfolio in favour of defensives, and standing ready to pounce when bad news arrives and equities are being pushed back below the October low.

Meanwhile, strategists at Morgan Stanley have to deal with complaints from customers whose patience is running thin.

The above sums it up quite nicely, I think.

Bond Market Says Regime Change Is Upon Us

One of the more fascinating pieces of market research has come from analysts at Brandywine Global, essentially deciphering the impact bond markets exert on equities based on historical precedents since the 1970s.

In summary: investors should ditch their "cheap" looking laggards and highly speculative exposures and instead opt for 'Profitable Quality' that isn't as yet overpriced. Brandywine's favourite measurement of what defines a Quality company is a high Return on Equity (RoE).

While a change in bond market dynamics has swung the market momentum pendulum away from Growth equities in favour of 'Value', Brandywine's research suggests the fact bond market curves are currently inverted is the all-important input.

Inverted bond market curves occur when shorter-dated debt carries a higher yield than longer-dated debt, traditionally seen as your typical precursor to an economic recession.

History shows, the research suggests, so-called 'Deep Value' stocks do not perform well when bond market curves are inverted, as is currently the case. The situation changes when the curve normalises, but this looks like a long while off as yet.

As explained by Brandywine, for the curve to steepen back into positive territory, the Federal Reserve needs to start cutting interest rates, and significantly so. While this signals more imminent economic trouble is forthcoming, for equities this opens up significant widening of valuation spreads leading to the beginning of a so-called Deep Value Regime, as overall returns shrink.

The underlying logic here seems to be that investors start doubting how much return can still be achieved from equities when the central bank is forced to aggressively lower interest rates, which only happens when trouble is on the horizon.

Thus investors seek safety in beaten-down assets that subsequently offer superior return, either through outsized dividends or a valuation that simply won't fall further.

In summary: when bond yield spreads are narrow and begin to widen, equity markets are in the 'Broad Value' regime. This is when profitable companies with a high RoE outperform their cheaper and lower quality brethren. When spreads are extremely wide and begin to narrow, this marks the start of the 'Deep Value' regime.

Let's try to translate this historical pattern in modern day layman's terms: when the bond market is signalling challenging times lay ahead, investors in equities become more circumspect about where to allocate their money, shying away from taking on too much risk.

Instead they start looking for profitable companies with a higher quality profile that, essentially, represent less risk.

Even without the guidance of Brandywine's bond market whisperers, the above makes all the sense in the world to me.

FNArena has this year expanded the available data on 2200-plus ASX-listed companies, including metrics such as Return on Capital Employed, Return on Equity and Free cash flow after dividends. Alas, our service does not yet include the option of ranking companies on those metrics, but subscribers have access via a company-specific search in Stock Analysis.

See also previous editions:

–https://www.fnarena.com/index.php/2023/04/05/rudis-view-dont-be-hoodwinked/

–https://www.fnarena.com/index.php/2023/03/22/rudis-view-all-weather-stocks-back-in-fashion/

Banks (Dividends) In Focus

Three weeks ago I wrote an in-depth analysis to explain CommBank's ((CBA)) sector premium (see also bottom of today's story), and on Friday regional lender Bank of Queensland ((BOQ)) issued a profit warning, effectively corroborating the conclusions drawn in what has now become FNArena's twentieth Special Report since 2006.

When times get tough for banks in Australia, risk first shows up first through regional lenders. If the situation worsens, watch the other three of the local Majors. Things have to get a lot worse before Australia's banking Supremo is forced to cut, though it does happen, of course. The last time it did we witnessed a global pandemic.

The unanswered question this time around is whether CBA can continue to show off its supreme operational resilience when the core problem sits with fixed-rate mortgages, on top of a smaller friction with flexible-rated loans. As highlighted by Citi research on Monday, CommBank is the most sensitive among local Majors to activity in the local housing market.

ANZ Bank ((ANZ)) is considered the least sensitive to local mortgages. New mortgage sales have collapsed on the back of rapid RBA rate hikes. Research by Goldman Sachs again confirmed Net Interest Margins (NIMs) across the sector will be under pressure in the months ahead.

With three of the Majors about to release financial results, Morgan Stanley once again repeated its conviction peak earnings shall be followed-up with a double-digit percentage decline and the possibility of a "bumpy" landing for the Australian economy.

Morgan Stanley predicts ANZ Bank will report the strongest result. The broker's forward projections imply no dividend cuts ahead from the Majors; not this year and not in FY24 either.

What is remarkable is that CommBank is the only bank projected to leave its dividend unchanged next year and the year thereafter (FY25), when all others are expected to announce small increases.

If correct, that would be a major divergence from what happened over the past two decades.

My story from March 27: https://www.fnarena.com/index.php/2023/03/29/rudis-view-not-about-the-banks/

(Special note for paying subscribers: the Special Report has a Bonus story included).

Conviction Calls & Best Ideas

Excerpt from a recent asset allocation strategy report by Morgan Stanley: "Bear market has not run its course yet".

No double-guessing as to why the preference lays with defensive portfolio positioning: underweight global equities, rest of the world is preferred over US markets, inside equities the bias is to pick low volatility ("Quality Defensives") exposures and defensives.

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A similar aversion towards too much exposure to US equities features the latest strategy update by Evans and Partners, alongside a warning not to have local portfolios too much concentrated around the banks – they are not defensive when credit concerns emerge, the two strategists warn.

Evans and Partners is equally preparing for a much more challenging environment, advising its clientele adding more safe haven assets looks but the right thing to do.

The strategists point towards gold, government bonds and cash, stating "opportunities are likely to appear in equity markets over the next 12 months".

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Morningstar has nominated 11 ASX-listed stocks as its Top Picks for investors looking to top up their domestic exposure.

Those 11 include Bank of Queensland ((BOQ)) which, despite Friday's profit warning, remains included and Beach Energy ((BPT)) which equally disappointed investors and analysts with its latest market update.

The other nine are:

-AGL Energy ((AGL))
-AUB Group ((AUB))
-Avita Medical ((AVH))
-Bega Cheese ((BGA))
-CSL ((CSL))
-Healius ((HLS))
-James Hardie ((JHX))
-Kogan.com ((KGN))
-Mirvac Group ((MGR))
-ResMed ((RMD))
-TPG Telecom ((TPG))
-Ventia Services ((VNT))
-WiseTech Global ((WTC))

It is Morningstar's view investors should adopt a (more) cautious view until a more certain environment emerges with the US banking sector problems likely to take multiple quarters to resolve. At the same time, the Australian share market is still believed to be trading some -5% below fair value.

Cash is considered a "useful alternative", while companies generating sustainable free cash flow are most preferred.

Top Picks across all key sectors amount to 33, including the 11 already mentioned. This leaves the following 22:

-Newcrest Mining ((NCM)) – now a take-over target
-Fletcher Building ((FBU))
-Nine Entertainment ((NEC))
-Southern Cross Media Group ((SXL))
-InvoCare ((IVC)) – still a take-over target
-Domino's Pizza Enterprises ((DMP))
-Costa Group ((CGC))
-a2 Milk Company ((A2M))
-Santos ((STO))
-Woodside Energy ((WDS))
-AUB Group ((AUB))
-Pinnacle Investment Management ((PNI))
-Westpac Banking ((WBC))
-Ansell ((ANN))
-Aurizon Holdings ((AZJ))
-Brambles ((BXB))
-Dexus ((DXS))
-Charter Hall Group ((CHC))
-Fineos Corp ((FCL))
-Megaport ((MP1))
-Manawa Energy (MNW.NZ)
-APA Group ((APA))

More Conviction Calls and Best Ideas:

–https://www.fnarena.com/index.php/2023/04/12/rudis-view-wesfarmers-wisetech-worley/

–https://www.fnarena.com/index.php/2023/03/17/rudis-view-dominos-pizza-newcrest-qantas/

–https://www.fnarena.com/index.php/2023/02/10/rudis-view-aub-group-endeavour-lottery-corp-suncorp/

–https://www.fnarena.com/index.php/2023/02/03/rudis-view-csl-mineral-resources-ridley-readytech/

Research To Download:

Independent Investment Research (IIR):

-US Student Housing REIT ((USQ)): https://www.fnarena.com/index.php/download-article/?n=805DFC57-F7E4-B779-6BD68A741663D3DB

Research as a Service (RaaS):

-Amaero International ((3DA)): https://www.fnarena.com/index.php/download-article/?n=808F5E53-D5DA-1485-9513FAD87B6AF222

-Comms Group ((CCG)): https://www.fnarena.com/index.php/download-article/?n=809B703D-B76C-91BF-73D2B248AC325C40

-Empire Energy Group ((EEG)): https://www.fnarena.com/index.php/download-article/?n=80FD4E08-A324-6FD1-7DE349E7BE83DF35

-Step One ((STP)): https://www.fnarena.com/index.php/download-article/?n=80A29411-AF3A-1F1D-23DB8B5AA6803AE1

-X2M Connect ((X2M)): https://www.fnarena.com/index.php/download-article/?n=80AA234B-01B4-4620-80316A6F5D07436D

Edison Research:

-Alkane Resources ((ALK)): https://www.fnarena.com/index.php/download-article/?n=80CFCEDD-CA2F-7179-31F6F4E6F38DA691

-EML Payments ((EML)): https://www.fnarena.com/index.php/download-article/?n=80DBA46A-B0AE-EBDF-A7512296C1CC2802

-Paradigm Biopharmaceuticals ((PAR)): https://www.fnarena.com/index.php/download-article/?n=80DED219-0FC8-54A3-2D3B19D130001369

FNArena Subscription

A subscription to FNArena (6 or 12 months) comes with an archive of Special Reports (20 since 2006); examples below.

A paid subscription to FNArena comes with numerous bonus publications and data on more than 2200 ASX-listed companies.

Subscriptions cost $480 for 12 months and $265 for 6 months and can be tax deductible (ask your accountant about it).

https://www.fnarena.com/index.php/sign-up/

Webinar on Copper

On April 19, 4pm, Peak Asset Management & FNArena are hosting a webinar on copper's role in achieving the world's zero carbon ambition.

Companies participating are Cannindah Resources ((CAE)), Cooper Metals ((CPM)), and Culpeo Minerals ((CPO)).

Registrations via https://us02web.zoom.us/webinar/register/WN_O-lXPaubSyCp70dPVbprzQ

(This story was written on Monday, 17th April, 2023. It was published on the day in the form of an email to paying subscribers, and again on Wednesday as a story on the website).

(Do note that, in line with all my analyses, appearances and presentations, all of the above names and calculations are provided for educational purposes only. Investors should always consult with their licensed investment advisor first, before making any decisions. All views are mine and not by association FNArena's – see disclaimer 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: contact us via the direct messaging system on the website).

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