Challenging Times for the Market's Speculative Elements

Andrew Clifford, Co-Chief Investment Officer, Platinum Asset Management

1st May 2021

We are now more than one year on from the COVID-19 outbreak and the subsequent initial lockdowns that resulted in a collapse in global economic activity and stock markets. While the pathway of the virus has been one of rolling waves in response to lockdowns, reopenings and now the rollout of vaccines, since the March 2020 lows, economic activity has experienced a strong and steady recovery, as have stock markets. Indeed, many of the world's major stock markets have comfortably surpassed their pre-COVID highs[1]. Fuelling this recovery in both economies and stock markets has been unprecedented (peace time) government deficit spending, funded through the printing of money.

The question is, where to now? It is highly likely that the global economy will continue its strong recovery path over the course of the next two years. In concert with this recovery, government bond yields will likely head higher, which will prove challenging for the speculative elements within stock markets.

Economic activity will likely continue to recover

There are numerous reasons to expect that global economies will continue to recover. The most obvious is the ongoing reopening of economies, as vaccination programs take us toward the post-COVID era. With current headlines focused on the failure of vaccination rollouts and the outbreak of new variants of the virus, this may seem an overly optimistic statement to many. However, the success of the vaccination programs in the US and the UK, where 32% and 46% of each population respectively has received at least one vaccine dose, shows what can be achieved once health systems swing into gear[2]. Where vaccination programs have been slow to start in some locations, such as Europe, an acceleration is likely, especially as the availability of dosages continues to improve. Variants in the virus are an expected setback, but fortunately the vaccines are being refined to address the variants, as they normally would with the annual flu vaccine.

Over the course of 2021, it is highly likely that we will move toward a situation where we return to freedom of movement across the world's major economies. With this, we expect industries such as travel and leisure will continue their recovery, and with that, elevated levels of unemployment will continue to fall. With a light at the end of the tunnel on COVID and rising employment, consumer confidence has started to bounce back (see Fig. 1).

Fig. 1: US Consumer Confidence Bouncing Back

As such, a release of pent-up consumer demand across a range of goods and services should be expected. Indeed, households are well-positioned to increase their spending, as large portions of government payments last year were saved and not spent, resulting in unprecedented increases in savings rates (See Fig. 2).

Fig. 2: US Households Well-Positioned to Spend

Additionally, in the US, consumers' bank accounts will be further inflated, with the recent passing of the US$1.9 trillion fiscal package. It is estimated that US consumers would need to spend an additional US$1.6 trillion dollars, or 7.5% of GDP, just to return to trend savings levels.[3] The recovery from the COVID-19 collapse is likely to be a very strong rebound that will play out over the next two to three years.

Given the levels of fiscal and monetary stimulus across the globe during 2020 and 2021 to date, the US will be at the epicentre of the recovery. The ongoing stimulus efforts in the US, including a potential additional US$3 trillion of spending on infrastructure and healthcare over the next decade, make the rest of the world's efforts pale into insignificance. Indeed, China appears to be stepping back from stimulus programs, having already achieved a strong economic recovery.

Nevertheless, the US stimulus will help growth in Asia and Europe via the trade accounts, as is already apparent in the strong recovery in China's trade surplus (see Fig. 3).

Fig. 3: China's Trade Surplus Expands

Long-term interest rates will likely move higher with the recovery

As a result of the strong rebound in economic activity, interest rates will likely rise and indeed, they already have. The reference here is to long-term interest rates, such as the yield on the US 10-year government bond, rather than short-term interest rates set by central banks (e.g. the Reserve Bank of Australia). In the fastest-recovering economies, US 10-year government bond yields have increased from 0.51% in August 2020 to 1.74% at the end of March, while Chinese 10-year government bond yields have risen from their April 2020 lows of 2.50% to 3.21% at the end of March (see Fig. 4).

Fig. 4: US and China 10-Year Bond Yields on the Rise

In both cases, these yields have returned to pre-COVID levels. It is not surprising that yields on government bonds are rising, as this is generally the case during a recovery. The issue is just how much further they may rise, given expectations for a very robust growth environment in 2021, the substantial amount of new bonds that will be issued in the months ahead and nascent signs of inflationary pressures.

Daily readings of consumer prices already show inflation heading back to levels last seen in mid-2019. As we discussed in our December 2020 quarterly report[4], markets in a broad range of commodities and manufactured goods are seeing shortages in supply, resulting in significant increases in prices. One high-profile example has been the auto industry having to cut production due to shortages in the supply of components. Given the complexity of supply chains and the various factors that have been impacting them in recent years, such as the trade war and then the sudden collapse and recovery in demand in 2020, predicting how long such shortages will persist is difficult. However, it is interesting that these price rises, usually associated with the end of an economic cycle, are occurring at the start of the cycle instead.

Beyond the current supply shortages and associated price rises, the longer-term issue for inflation is how governments will finance their fiscal deficits. As we have discussed in past quarterly reports, when governments use the banking system (including their central banks) to finance deficits, it results in the creation of new money supply. The idea that the creation of money supply in excess of economic growth is inflationary, has lost credibility in recent years, as inflation didn't arrive with the quantitative easing (QE) policies of the last decade. However, the mechanisms by which banking systems are funding current fiscal and monetary policies of their governments are clearly different to what was applied during QE. Rather than delve into a deep explanation, we would simply point to the extraordinary growth in money supply aggregates, where in the US, M2[5] increased by a record annual rate of 25% almost overnight in mid-2020. These types of increases did not occur during the last decade of QE policies. Further growth in M2 awaits in the US, following the latest rounds of fiscal stimulus, though the percentage growth figures will at some point fall away as we pass the anniversary of last year's outsized increases.

So, we have a strong economic recovery from the ongoing reopening post COVID, fuelled by fiscal stimulus, already tight markets in commodities and manufactured goods, plus excessive money growth. Given that we also have central banks committed to keeping short-term interest rates low for the foreseeable future and allowing inflation to exceed prior target levels, it is hard to see how we can avoid a strong cyclical rise in inflation. It is an environment where there is likely to be ongoing upward pressure on long-term interest rates. To see US 10-year Treasury yields above 3%, a level last seen in only 2018, would not be a surprising outcome.

Rising long-term interest rates will represent a challenge for the bull market in growth stocks

In recent years, we have emphasised the two-speed nature of stock markets globally. As interest rates fell and investors searching for returns entered the market, their strong preference was for 'low-risk' assets. At different times they have found these qualities in defensive companies, such as consumer staples, real estate and infrastructure, and at other times, in fast-growing businesses in areas such as e-commerce, payments and software. At the same time, investors have been at pains to avoid businesses with any degree of uncertainty, whether that be natural cyclicality within their business or exposed to areas impacted by the trade war. Last year, this division was further emphasised along the lines of 'COVID winners', such as companies that benefited from pantry stocking or the move to working from home, and 'COVID losers', such as travel and leisure businesses.

Over the last three years, these trends within markets created unprecedented divergences in both price performance and valuations within markets. However, as we noted last quarter, this trend started to reverse at the end of 2020, as a combination of successful vaccine trials and the election of US President Biden pointed to a clearly improved economic outlook. The result was 'real world' businesses in areas such as semiconductors, autos and commodities started to see their stock prices perform strongly and this has continued into the opening months of 2021.

Meanwhile, the fast-growing favourites continued to perform into the new year, though these have since faded as the rise in bond yields accelerated. Many high-growth stocks have seen their share prices fall considerably from their recent highs, with bellwether growth stocks such as Tesla (down 27% from its highs), Zoom (down 45%) and Afterpay (down 35%).[6]

Theoretically, rising interest rates have a much greater impact on the valuation of high-growth companies than their more pedestrian counterparts. As such, it is not surprising to see these stocks most impacted by recent moves in bond yields and concerns about inflation.[7] Many will question whether this is a buying opportunity in these types of companies.

While they may well bounce from these recent falls, we would urge caution on this front, as for many (but not all) of the favourites of 2020 we would not be surprised to see them fall another 50% to 90% before the bear market in these stocks is over. If our concerns regarding long-term interest rates come to fruition, this will be a dangerous place to be invested, and as we concluded last quarter, "when a collapse in growth stocks comes, it too should not come as a surprise".

If there is a major bear market in the speculative end of the market, how will companies that investors have been at pains to avoid in recent years (i.e. the more cyclical businesses and those that have been impacted by COVID-19) perform? While these companies have seen good recoveries in their stock prices in recent months, generally they remain at valuations that by historical standards (outside of major economic collapses) are attractive. It should be remembered there are two elements to valuing companies: interest rates and earnings. Of these, the most important is earnings, and these formerly unloved companies have the most to gain from the strong economic recovery that lies ahead. As such, we would expect good returns to be earned from these businesses over the course of next two to three years.

For many, the idea that one part of the market can rise strongly while the other falls, seems contradictory, even though that is exactly what has happened over the last three years. In this case, for reasons outlined in this report, we are simply looking for the relative price moves of the last three years to unwind. We only need to look to the end of the tech bubble in 2000 to 2001 for an indication of how this may play out - when the much-loved 'new world' tech stocks collapsed in a savage bear market, while the out-of-favour 'old world' stocks rallied strongly. This was a period where our investment approach really came to the fore, delivering strong returns for our investors.

DISCLAIMER: This article has been prepared by Platinum Investment Management Limited ABN 25 063 565 006, AFSL 221935, trading as Platinum Asset Management ("Platinum"). This information is general in nature and does not take into account your specific needs or circumstances. You should consider your own financial position, objectives and requirements and seek professional financial advice before making any financial decisions. You should also read the relevant product disclosure statement before making any decision to acquire units in any of our funds, copies are available at www.platinum.com.au. The commentary reflects Platinum's views and beliefs at the time of preparation, which are subject to change without notice. No representations or warranties are made by Platinum as to their accuracy or reliability. To the extent permitted by law, no liability is accepted by Platinum for any loss or damage as a result of any reliance on this information.

Funds operated by this manager:

Platinum Asia Fund (C Class), Platinum Japan Fund (C Class), Platinum International Fund (C Class), Platinum Unhedged Fund (C Class), Platinum European Fund (C Class), Platinum International Brands Fund (C Class), Platinum International Health Care Fund (C Class), Platinum International Technology Fund (C Class), Platinum Global Fund, Platinum International Fund (P Class), Platinum Unhedged Fund (P Class), Platinum Asia Fund (P Class), Platinum European Fund (P Class), Platinum Japan Fund (P Class), Platinum International Brands Fund (P Class), Platinum International Health Care Fund (P Class), Platinum International Technology Fund (P Class)

Inside the bond market sell-off

Jay Sivapalan, CFA, Janus Henderson Investors

March 2021

Funds operated by this manager:

Janus Henderson Australian Fixed Interest Fund, Janus Henderson Conservative Fixed Interest Fund, Janus Henderson Diversified Credit Fund, Janus Henderson Global Equity Income Fund, Janus Henderson Global Natural Resources Fund, Janus Henderson Tactical Income Fund, Janus Henderson Australian Fixed Interest Fund - Institutional, Janus Henderson Conservative Fixed Interest Fund - Institutional, Janus Henderson Cash Fund - Institutional, Janus Henderson Global Multi-Strategy Fund

Beware the beauty contest

Charlie Aitken, Aitken Investment Management

20th April 2021

When reflecting on the past year, one notable takeaway for the AIM investment team is to be mindful of keeping our focus on business fundamentals rather than attempting to profit from whatever narrative is driving the market. This sounds simple enough on paper, but resisting the temptation of falling into this 'narrative fallacy' is quite difficult to achieve in practice - to such an extent that many investors step into this mindset without even realising it.

The reason is deceptively simple: by definition, the vast bulk of daily news we all consume has almost nothing to do with the fundamental drivers of long-term value. Instead, daily news flow shapes the short-term expectations that drive the dominant 'narrative' in markets.

To understand why we believe it is critical for investors to differentiate between fundamentals and narrative, we turn to John Maynard Keynes. Though primarily remembered as an economist, Keynes managed the King's College endowment at Cambridge from 1921 to 1946 with great success, delivering a tenfold return over a period where UK markets were essentially flat.

In The General Theory of Employment, Interest and Money, Keynes addresses the impact of market expectations on prices:

The actual, private object of the most skilled investment today is 'to beat the gun'; [...] to outwit the crowd, and to pass the bad, or depreciating, half-crown to the other fellow.

This may be likened to those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole; so that each competitor has to pick not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view.

It is not a case of choosing those which, to the best of one's judgment, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practise the fourth, fifth and higher degrees.

There have been some fascinating real-world tests that explore this mindset. The Financial Times posed the following question to its readers in 2015:

Guess a number from 0 to 100, with the goal of making your guess as close as possible to two-thirds of the average guess of all those participating in the contest.

Suppose there are three participants who guessed 40, 60 and 80. In this case, the average guess would be 60, two-thirds of which is 40, meaning the person who guessed 40 would win.

In theory, a large group of people guessing a random number between 0 and 100 will eventually average out to 50. However, a 'first-degree' thinker would likely reach that conclusion, and then guess 33 (equal to two-thirds of 50). A 'second-degree' thinker might conclude that there will be enough first-degree thinkers to move the average guess closer to 33, so the 'smart' guess would be 22 (two-thirds of 33). The 'third-degree' thinker would guess 15 (two-thirds of 22), the 'fourth-degree' would guess 10 (two-thirds of 15), and so on. (In reality, the average guess in the Financial Times puzzle was 17.3, meaning the 'correct' guess was 12).

Carried to its logical conclusion, it becomes obvious that the problem inherent in such a game is that there is a circular reference: each participant's guess alters the outcome, meaning contestants end up trying to guess what the other players might be guessing, and adjust their own guess accordingly. There is no point at which one can confidently get off this train of thought in the knowledge your answer is correct. The concept has come to be known as the Keynesian Beauty Contest.

Real-world examples

This concept quite accurately describes a market where the participants stop paying attention to the fundamentals of an asset, but rather attempt to speculate about what other people might pay for the asset at some point in future. Under such conditions, the best 'narrative' attracts the most investor interest. Sure as night follows day, inflows follow interest, pushing up prices as new buyers enter the market. Combined with some good, old-fashioned fear of missing out on easy, quick returns (the result of a collection of behavioural biases hardwired into our psychology), this dynamic can lead to prices dramatically disconnecting from the underlying economic value of an asset as more investors crowd into it.

However, the 'narrative' is essentially just the consensus opinion constructed from the collective psyche of market participants. When the consensus narrative changes for an asset that has divorced from underlying fundamentals, the outcome to investors is usually a permanent and material loss - particularly when huge amounts of borrowed money have been involved in bidding up the price. The 2007/2008 US housing market crash ("house prices can only go up!") that triggered the Global Financial Crisis is a vivid example of what can happen when crowded assets owned by leveraged speculators undergo a material change in narrative.

The AIM investment process is based on determining the intrinsic value of a business. While market value tells you the price other people are willing to pay for an asset, intrinsic value shows you the investment's value based on an analysis of its fundamentals and financials. We believe that discounting future cash flows that can be distributed to the owner of an asset is the best way to determining the intrinsic value of most investments. While there are some shortcomings, it has the advantage of anchoring our estimate of value to some sort of economic reality.

Digital assets

Of late, there has been an explosion of interest in non-cash-generating assets where determining a reliable estimate of intrinsic value is nearly impossible. We would point to the meteoric rally in cryptocurrencies, or the sudden interest in non-fungible tokens (NFTs) - essentially, tradable digital certificates that use blockchain technology to prove ownership and origin of digital assets - as examples. (Christie's recently auctioned off an NFT of the work of digital artist Beeple for USD69.3mn; the image remains freely viewable and downloadable on the internet.) These assets may have utility and even scarcity over the long term, but recent price action seems to us to exhibit all the hallmarks of a Keynesian Beauty Contest.

The behaviour has arguably spilt over to other asset classes and certain pockets of the equity market. Given that capital is essentially free, many market participants are using borrowed money to place leveraged bets on asset prices continuing to rise. We find it noteworthy that there have been several liquidity-driven 'unwinds' in markets this year; from publicly available information, massive amounts of leverage were involved every time. We cannot claim to know how any of this will end, but we do know that leverage combined with highly crowded market positioning rarely ends well when an unexpected external event causes forced selling.

When allocating our investors' capital, we try to understand whether the expectations embedded in the market price of the businesses we own bear at least some semblance to reality when applying a reasonable range of estimates. We try to control for fundamental risk by sticking to businesses that have strong balance sheets and generate meaningful amounts of cash. (As the wisdom goes: revenue is vanity, profit is sanity, but cash is king.)

In short, we think that by sticking to a defined and repeatable process will serve investors a lot better than trying to claim the first prize in a Keynesian Beauty Contest.

Funds operated by this manager:

AIM Global High Conviction Fund

Chris Gosselin, CEO of Australian Fund Monitors, speaks with Michael Tobin, Founder and Managing Director at Vantage Asset Management. Established in 2004, Vantage Asset Management Pty Limited is an independent investment management company with expertise in private equity, funds management, manager selection and operational management.

Vantage Private Equity Growth 4 (VPEG4) is a closed-ended Private Equity fund which started on 30 September 2019 and which is due to close on 30 September 2021. The Fund continues the investment strategy of Vantage's previous two Private Equity Funds, VPEG3 and VPEG2. The Fund invests in Private Equity funds based in Australia, along with Permitted Co-investments, to create a well diversified portfolio of Private Equity investments.

Why this COVID-Hit Sector is Still Attractively Priced

Steve Johnson, Forager

April 2021

Funds operated by this manager:

Forager International Shares Fund, Forager Australian Shares Fund (ASX: FOR)

5 Lessons from a decade of growth stock performance

Steven Johnson, Forager Funds Management

19th April 2021

I wrote last month that Forager has been selling some wonderful business over the past few months. That has been controversial for some of our clients. Never sell a great business is a lesson many have taken from the past decade of growth stock outperformance.

I argue that it's not the right lesson. What has worked is not necessarily what works.

Which doesn't mean there are not lessons. If holding great businesses forever is the wrong conclusion, hold for longer than you did seems irrefutably obvious given the value of some of these businesses today.

A refresher on business valuation

The value of a share is the present value of all the future cash flows that it is going to pay you into perpetuity. We aim to buy those shares at discounts to fair value and sell them when they reach or exceed it, amplifying the returns that are generated by the underlying business.

With perfect foresight, the logic of this strategy would be irrefutable.

Of course, the future is unknowable and highly variable. In practice, we make the best estimate of what those future cash flows are going to be and put a lot of work into understanding the range and magnitude of the uncertainties. Our estimation is going to be off the mark. The question is which way.

The main lesson of the past 10 years is that getting it wrong on the low side (being too conservative about the future of a business) can be as expensive as getting it wrong on the upside (being too optimistic). When someone says they sold a wonderful business way too early, what they actually mean is that they drastically underestimated its value.

So, with that all as a precursor, here are some of the shortcomings I have gleaned when it comes to erroneously concluding a stock is expensive.

1. Reversion to the mean is a thing. But it doesn't need to be soon

Jo Horgan, the founder of Australian makeup giant Mecca Brands, was quoted in the Australian Financial Review last week saying: "With same-store sales (growth), we have an absolute goal as a business that we'll never get below 10 per cent" . I admire Jo's optimism. And I'd love to own a share in her business (she says there are no plans to list on the stock exchange). In the long term, however, not only are we all dead but everything reverts to the mean. It's not possible for any business to grow faster than the global economy forever, otherwise, a slice of the pie becomes bigger than the pie itself.

But forever can be a long time away. A common valuation mistake is to assume a good business stops growing rapidly far too soon. My valuation models often assume high growth for the immediately visible future, but a reversion to more subdued growth within the next five to ten years.

Google and Facebook are recent examples of businesses still growing 20% per annum as they head into their third decades of existence. Australian examples like Cochlear and Resmed have grown at more than 10% per annum for three decades. Sometimes the insight into a stock is not what's going to happen over the next five years. It's what is going to happen in the decades after that, when the power of compounding really kicks in.

2. Great products create their own demand

Total addressable market is some jargon you will hear a lot when it comes to growth companies. Rather than making the common mistake of underestimating the growth runway, analysts jump straight to the endpoint. Back in 2010, the Google argument was something like this: Global advertising spend is roughly US$500bn. We expect it to grow 5% per annum over the next 10 years, making for a 2020 addressable market of US$800bn. Online should grow to 30% of the total and I think Google, being the great business it is, can be 30% of the online share. Adding all that up, in 2020 I think Google will be generating US$73bn of revenue.

That wouldn't have seemed a stupid guess in 2010. Alphabet's revenue was US$29bn in that year, making it already one of the world's largest advertising businesses. But it was wrong by a factor of more than two (parent company Alphabet's 2020 revenue was a whopping $182bn). Analysts weren't wrong about the shift to online. They just underestimated how much additional demand Google's products would create from customers that previously weren't spending a cent. Millions of small businesses that couldn't afford newspapers or radio now have a way of advertising to potential customers. Google has grown the market and pinched its competitors' revenue.

The lesson here is not to think of addressable market as something static. It, too, is a variable. And when you find a great company it invariably finds a way to grow demand for much longer than anticipated.

3. The world is smaller than it's ever been

The concept of winner takes all is nothing new. It is simply economies of scale taken to their logical conclusion. Warren Buffett recognised in the 1960s and '70s that most US cities were going to end up with just one newspaper. The newspaper with the most readers generates the most advertising revenue which allows it to spend the most on creating content that attracts the most readers. Supermarkets (size makes for lower prices) and stock exchanges (liquidity) have long shown the same characteristics.

The difference in the 2020s is that the winners can be global. Melbourne had one great newspaper business, and so did every meaningful city in the world. Now there's Google, which dominates the Western world. Netflix is not just killing Australia's Nine, it's killing every free to air and cable channel in the world.

This is worth keeping in mind when contemplating the value of your business. Harrods and Selfridges were wonderful London-centric businesses. What if Farfetch is the Harrods of the world?

4. Standard heuristics are flawed when valuing rapidly growing companies

All of this plays into the most common mistake. "Rocket to the Moon trades at 40x earnings, therefore it is expensive". It's a lazy conclusion (I've been guilty). And it can be very wrong.

Twenty years ago someone (me?) looking at Cochlear could have reached that exact conclusion. It was trading on a price to earnings ratio of more than 30.

With the benefit of hindsight, you could have paid 150 times earnings and have still generated a 10% annual return (including dividends). All of these heuristics, or rules of thumb, have assumptions behind them that need to be probed. Under what scenario is 40 times earnings expensive? What would it take for 40 times earnings to be cheap?

Conventional measures lose relevance in the context of long-term compounding math. When a company compounds earnings exponentially (15% per annum for the last 20 years in the case of Cochlear), the fair value can be a seemingly absurdly high multiple of early-year earnings.

5. Conservatism still the name of the game

Having said all of that, I'd still argue the wider trend at the moment is towards dramatic overvaluation of potential growth. The logic used above is being applied to a lot of businesses that don't deserve it. Very few of today's optimistically priced growth stocks will become the next Google or Cochlear. And, because so much of the anticipated value depends on what happens in 10 and 20 years' time, the consequences of overestimating long-term growth rates can be dramatic.

We need to be wary of selling just because a share price has risen. We need to put as much work into the decision to sell a great business as we did the decision to buy it.

But growth is just another variable. We're going to apply the same margin of safety we apply to all the other variables. And we're not going to let the exposure to any one business become an irresponsibly large part of either Forager portfolio.

As Scottish poet Robert Burns wrote in To a Mouse, "In proving foresight may be vain: The best-laid schemes o' mice an' men, gang aft agley." Often go awry they do.

Funds operated by this manager:

Forager Australian Shares Fund (ASX: FOR), Forager International Shares Fund

Market Outlook - Dispelling some myths

Justin Braitling, Watermark Funds Management

22nd March 2021

Myths abound. Is a bubble forming in shares? How long will the reflation trade last? Are we in a new mining super cycle? Is it over for technology and growth shares? All good questions that I will try and answer.

While the broader share market has been grinding higher in recent months, beneath the surface we have seen a meaningful rotation out of defensive shares into cyclical parts of the share market. As long-term interest rates have started backing up again, we are also seeing a change of leadership out of growth securities back into value.

By midway through last year, the first COVID wave had passed, and activity was picking up quickly. The reflation trade was on, and the US dollar fell while risk assets and commodities rallied with the promise of recovery. This shift out of defensive shares that benefited from COVID into cyclical sectors was the primary market trend of last year.

In the depths of the crisis, as capital shifted into the safety of bonds and central banks pumped liquidity into capital markets, real bond yields turned negative in most countries. All asset classes are priced relative to the risk-free sovereign bond. The value of growth shares is very sensitive to movements in this discount rate, particularly those that are loss making with the promise of future profits (think of Tesla TLSA:US). Most of these growth names reside within the technology sector. They benefited further from the health crisis, as businesses everywhere were forced into the digital age. Technology, the largest sector in the US share market, was pivotal to the turnaround in shares last year as it became clear these companies were benefiting from the crisis.

While the health crisis was the icing on the cake, these companies had performed well in recent years as real interest rates had fallen across advanced economies. The 30-year bull market in bonds (and the associated decline in rates) almost certainly peaked along with the COVID mortality rate mid-way through last year.

In the final quarter of 2020, we got the promise of a vaccine and a glimpse of a post-COVID world. Bond markets quickly worked out there was too much stimulus afoot for a global economy that was recovering quickly. Prices fell sharply and yields shot up, becoming a headwind for the technology sector that had benefited from the crisis and from low interest rates.

How long will the reflation trade last?

In terms of leadership, the reflation trade may mature sooner than previously expected, which has important implications for market leadership. Price signals in bond and currency markets are key to reflation.

The US dollar along with bond prices, peaked in March of last year when the share market bottomed. Both have since been falling as the global recovery takes hold.

The US dollar fell as capital shifted out of safe havens into risk assets such as equities, emerging markets, and commodities.

On the other side of the ledger, defensive sectors such as utilities, telecom, infrastructure, staples, and healthcare underperformed. Because the Australian dollar is a commodity-linked currency, it has rallied through this period, making life tougher for Australian companies that generate sales offshore. As examples, global healthcare names have struggled recently, while mining and energy shares, along with domestic cyclicals, have led the market higher.

In recent weeks, the US dollar is looking like it may have bottomed for now. Key currency cross rates in the commodity currencies, the Australian dollar and Swedish Krona, and safe havens the Japanese Yen and Swiss Franc have confirmed this.

If the US dollar has bottomed, we are likely to see a reversal in the reflation trade and a setback for equities and commodities in the near term. This is the first major red flag we have seen for the reflation settings in a year and should be monitored carefully.

How we are responding

We will use any further strength in these reflation sectors to rebalance our portfolio in favour of defensive names that have underperformed meaningfully and are now looking more attractive.

We have also been short industrial companies that operate offshore, and we will rebalance our exposure here also as the Australian dollar retests prior highs. If we are correct, its high of 80 cents is probably in for the medium term and equities could be in for a rough ride in the second quarter of 2021. This lines up nicely with the movement in bond markets, where the damage from rising yields has probably played out in the short-term allowing defensive sectors which have struggled in recent months to recover.

The chart below supports this, with the movement in yields complete for now and the cyclical rotation probably also over for the time being.

Investors should watch the US dollar. It holds the key, with positioning now at extreme levels and everyone now short the dollar. This means a second-quarter 2021 rally and associated sell-offs in equities could be one of the big surprises for this year. 

           Source: Refinitiv Datastream | Fig 1

Are we embarking on a new mining "supercycle"?

A key aspect of the reflation trade is stronger commodity prices? Colourful rhetoric has emerged around this, led by brokers and speculators trying to find a story to match their reflation settings. It goes like this: Negative interest rates and excessive money supply growth create price inflation which is good for 'hard asset' (commodities) versus paper assets, that is, shares. There has been little investment in new mine development in the aftermath of the mining bust, leaving markets undersupplied in the medium term, and of course, we have the excitement around the green revolution and EV's in particular.

We are seeing an upswing in demand for commodities as advanced economies report nominal growth approaching 10% this year, but this is a typical though admittedly strong recovery in the business cycle.

The two prior mining booms in the modern era have been associated with a step-change in the demand curve as Japan and China have industrialised. We do not have this on the horizon. If anything, the intensity of China's commodities consumption is easing.

Some niche commodity segments look undersupplied in the medium term as EV penetration builds - Lithium, Cobalt, and rare earth metals in particular - but these are niche segments. The incremental demand for industrial metals- copper and nickel should be adequately supplied by new mine supply (for copper) and new processing methods (for nickel).

In bulk commodities it is true: no one in their right mind is investing in coal outside of China, which consumes more than half the world's coal.

In Iron ore, steel demand will moderate further in the medium term as China pivots away from capital formation. In line with this, China's Ministry of Industry and Information Technology (MIIT) has called for lower crude steel production this year to curb emission (steel accounts for 15% of emissions).

The supercycle thesis lines up nicely with the reflation thematic that is driving markets. There is no fundamental basis for the elevated prices we are seeing across the commodities spectrum, markets are simply not that tight.

This does not mean the thematic does not persist - in the medium term, it probably will. As activity is normalising in advanced economies in H2'2021 and Chinese growth slows, the National People's Congress set a disappointing growth target for this year (China always acts counter-cyclically to western economies); investors are likely to lose confidence in sky-high commodity prices.

While we do not foresee another supercycle in mining and energy shares, they may outperform the broader share market in the medium term. The underperformance of Value and commodities versus shares more broadly in recent years does look like its due to reverse-refer to Fig 2 below. This of course can happen in two ways:

1. commodities can inflate relative to shares or
2. shares can deflate (fall) relative to commodities.

A bear market in shares can deliver the same outcome. 

          Source: Stifel | Fig 2

Is technology about to crash?

Technology has performed incredibly well through this bull market, now in its twelfth year, for many reasons. The digital economy has grown tremendously as households and businesses have embraced technology. This shift has clearly accelerated with the health crisis, as discussed above.

While in some sectors, demand has been brought forward by the crisis, such as with e-commerce, generally, the acceleration in the digital economy will continue. COVID was a great awakening to the benefits of a digital economy, that message has not been lost on a single business we speak too. Those that lead in technology will invest to stay in front and the slow adopters caught wanting through the crisis will spend to catch up.

There is still tremendous momentum in each of the enablers of technology adoption: e-commerce; Cloud and SaaS computing, the internet of things (connected devised), and big data to name the main ones. This has become obvious to businesses and households awash with liquidity; they will keep investing given penetration is still early for many of these services. Fig 3 below is inciteful in showing the divergence in profit growth for Tech and non-Tech sectors. It explains why Tech is a dominant sector in the US share market and how challenged our own share market is by its relative absence.

            Source: Goldman Sachs | Fig 3

Of the two major tailwinds pushing technology shares higher - the health crisis and low interest rates - the first is abating and the second is reversing. As the fundamental drivers of technology adoption are very much intact, the sector can still perform but is unlikely to lead the way it has in recent years.

As real rates are likely to keep moving higher in the medium term, a second tech boom to complete this bull market looks less likely. The golden years of leadership from technology and growth seem for the time being behind us.

Does this cycle end in a share market bubble?

This is less likely now. Bubbles form through price-to-earnings ratio expansion as investors get overly excited around popular themes, including the 'The Nifty fifty' companies that led the first wave of globalisation in the 1960s; and of course, the Dot.Com phenomenon in 2000.

As interest rates are now retracing, PEs should contract rather than expand, earnings growth (EPS) will have to do the heavy lifting if shares are to move higher from here. While profits are clearly recovering from depressed levels and beating expectations, forecasts that had been slashed through the depths of the crisis and are now more reflective of the strong recovery unfolding.

We are moving through the sweet spot of the earnings cycle now where profits surprise (the second derivative of earnings revisions has peaked) it gets tougher as we move into the second half of the year.

The exuberance of the 1920s bubble can be traced back to the Genoa conference of 1922 when western leaders restructured the gold standard. Instead of redeeming each other's currencies in gold, they elected instead to hold foreign currencies in reserve in lieu of gold. A consequence of course was the creation of additional credit, which fuelled asset inflation, culminating in the Great crash of 1929.

If ever there was a catalyst for a bubble, then surely zero interest rates and money printing would constitute one. While credit is abundant and readily available, we are not seeing the sort of credit expansion that has inflated bubbles in the past. This may still emerge though if current liquidity settings are maintained for too long.

For the reasons laid out above, the two principal themes that may have led to a broader market bubble in commodities and/or technology are looking less likely now. Despite all the talk of bubbles, they are extremely rare- we have had just two in the US share market in the last hundred years, the 1920's and in 2000.

In Fig 4 below using a CAPE P/E ratio you can see those two episodes. We came close in the 1960's with the 'Nifty 50' and again today. Using this measure, we're not technically in a bubble YET.  

            Source: Stifel | Fig 4

This does not mean we want to have bubbles emerge in certain sectors of the market. We are clearly seeing this already in cryptocurrencies, certain commodities, green energy, and disruptive technologies (ARKK:US), where we have well-formed price bubbles.

It is important to monitor the development of these price signals as they are indicators of when the broader market may turn. Bitcoin as an example has led all-important tactical and strategic tops in risk markets since 2012! Right now, the parabolic shape of the cryptocurrency looks like a major top is not far away. Similarly, keep an eye on other emerging and disruptive technologies where we have bubbles in place. (ARKK:US, TSLA, LIT). As investors abandon these themes, we will move closer to a major market top.

       Source:  GMCP | Fig 5

We have all the ingredients in place for a late-cycle bull market. Stretched valuations Fig 4 exuberance (bubbles) in popular segments; the full commitment of traders (cash allocations are low and net length amongst hedge funds is very high)- retail investors are back (retail volumes are at a 20-year high); and little downside protection (CBOE Put/Call ratio also at a 20-year low).

Once everyone is all in, unhedged and fully committed, all we need is a shift in the policy settings to complete this cycle. The 1920 bubble burst when the newly formed Federal Reserve started raising rates in August 1929, precipitating the crash two months later. This cycle will end in a similar manner, maybe not with a crash but a good old fashion bear market at least.

This brings me to my key concern around the outlook. The events of the last year have reminded us of how uncertain the future can be. The contrast confidence of investors in future policy settings is palpable. We have our own RBA Governor Lowe, indicating interest rates will stay at the zero bound until 2024! Ditto with the US Federal Reserve. They have created a rod for their backs. I also hear strategists confidently predict a tapering of QE starting in one year, which means we want to see rates increase for a further 2 years once QE is fully unwound.

While inflation has been absent in recent years, we have shifted into a very different environment. As Larry Summers recently observed, with growth rocketing along at 10% nominally and loads of stimulus still to come, the output gap that policymakers are relying on can 'snap shut' very quickly. The under-utilisation of resources is in certain (largely unproductive) sectors only, not widespread. Take the recent NFIB Small Business Job Openings 'Hard to Fill Index' survey as an example, it just hit its highest level in 50 YEARS. This is a very dangerous environment to be anchoring to longer-term forecasts.

For the post-financial crisis period, growth in western economies was sluggish and policy settings were very accommodative to support growth. This was the 'Goldilocks economy' that investors have revelled in as interest rates have shifted lower and asset prices have inflated.

Right now, Goldilocks' bike is moving very fast, she is developing a speed wobble and heading for a brick wall- (the output gap -snaps shut). The outlook is very uncertain, the economy is out of equilibrium and rebalancing violently. This is a very difficult economy for policymakers to manage, leaving us far more susceptible to a policy mistake - the risk premium should be high reflecting this. Instead, exuberance prevails for investors across most asset classes, which should make you very nervous.

As we move into next year, I suspect western economies will be running too hot, capacity in product and service sectors will have tightened considerably (snapped shut), and policymakers will be forced to tighten more quickly than markets will allow. Leverage is much higher, the tolerance for higher interest rates much diminished and asset markets that are grossly overvalued will move into a long over-due bear market.

Funds operated by this manager:

Watermark Australian Leaders Fund, Dalton Street Market Neutral Trust, Watermark Absolute Return Fund