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Since late 2020, we've pivoted our portfolios to businesses likely to benefit from the economy's reopening - and generated excellent returns. But the emergence of the highly infectious delta variant makes the future far less certain. My take is that higher quality and structural growth businesses should again be on your radar.

Allocating equity portfolios to companies growing structurally or to those recovering from earlier lockdowns and restrictions has benefited from optimism surrounding vaccine developments and rollouts.

By way of example, the pent-up demand for travel has hitherto provided enthusiasm for tourism companies with strong or repaired balance sheets.

Indeed, only last week the cruise ship company, Regent Seven Seas, broke all previous opening day records with all berths booked in less than three hours, despite prices ranging from $93,000 to a quarter of a million dollars. This echoes Carnival Cruises' experience last year when more than 90 per cent of cancelled travelers chose a US$200 on-board voucher for a future cruise in preference to a refund.

In the US, leisure travel has bounced back strongly. LAX (Los Angeles Airport) is reported to be packed and struggling with the volumes. Robust demand for travel amongst employees and clients has resulted in corporate travel returning. Twenty per cent week-on-week growth has been reported over the last six weeks, reflecting the preference for face-to-face meetings over Zoom. According to one analyst, travel by Amazon staff has fully recovered to pre-COVID-19 levels. Consequently, airlines are said to be hiring like crazy, and unable to recruit enough staff.

Anecdotally, rising delta cases globally aren't currently expected to halt the reopening. By way of example, Seattle's population is 74 per cent vaccinated and that city's Governor has said it won't shut down. Notably, 99 per cent of all hospitalisations are unvaccinated.

In Australia, however, a very different picture exists

A relatively low level (10 per cent of the population) of vaccinated individuals, lockdowns and border closures mean the return to normality is less clear. The delta variant is materially more infectious than the original COVID-19 strain and is now the dominant strain in Australia.

And, importantly, with half of winter remaining, the lack of a broadly vaccinated population presents the virus with an opportunity to mutate, potentially undermining the efficacy of current vaccines. This has investors on tenterhooks.

Victorian and New South Wales lockdowns, and the spread of the virus through other states, has resulted in less enthusiasm for forward booking travel. While leading indicators from Similarweb and Google trends remained strong into May, both trended lower into June, and are likely to have fallen further in July following the lockdowns of Australia's two most populous states.

Travel companies aren't the only businesses impacted

Lockdowns must necessarily shift spending from services and experiences (that were available in open cities) to online spending on goods. Online shopping spiked during the last 12-18 months, and as consumers returned to in-store shopping, online eased. This could rapidly reverse with only essential stores permitted to open.

Of particular interest is the outlook for the beneficiaries of the boom in home renovations and home improvement. Harvey Norman, JB Hi-Fi, Nick Scali, Adairs were huge beneficiaries during last year's lockdowns. And amid the recent easing of restrictions, they continued to win. But durable goods tend to have long useful lives, meaning replacement cycles are also long. As the current renovation and building boom matures, so must the rate of growth in the sales of fridges, ovens and air-conditioners.

Elsewhere, hospitals that might have seen a bounce in elective surgeries on the back of pent-up demand suffer from deferments and rescheduling. Further lockdowns and border closures would also necessarily slow the pace of economic recovery and, consequently, demand for raw materials and energy.

Meanwhile, the boom for building materials companies, including Adelaide Brighton Cement, Boral and CSR, amid persistently low interest rates, declining unemployment and consequent strong demand for housing/home improvement, could also be derailed.

And keep in mind the stricter Sydney lockdown is accompanied by smaller support and welfare payments in the absence of Job Keeper.

It should not be surprising, in such circumstances, to see at least some capital reallocated from profitable reopeners to lockdown winners.

The key question for investors to now consider, however, is whether a reopening is undermined by a new strain of the virus that evades vaccines.

Indeed, not everyone in the UK is excited about the country's reopening. England's Chief Medical Officer Chris Whitty admitted hospital admissions could hit "scary numbers" if removing all restrictions leads to out of control infections and the opportunity for COVID-19 to mutate again.

In just the last month, the Netherlands, with more than three-quarters of the population vaccinated, suffered the devastating effects of reopening too quickly. Infections rose more than 500 per cent in just one week. Shortly after the Dutch caretaker Prime Minister, Mark Rutte, announced that face masks would no longer be required, the Dutch government started backtracking on restrictions.

New infections had doubled to 8,000 in the week ending 6 July. By 9 July, 7,000 cases were recorded in 24 hours and almost three-quarters of the new cases were in young people, half of whom were infected with the delta variant.

A possible silver lining to the prospect of a longer road to reopening is a flatter yield curve (reflecting lower growth/inflation expectations) and dovish central bank frameworks.

And when it comes to the markets, higher quality and structural growth stocks may yet again be on investors' radars.

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About the author

Roger Montgomery founded Montgomery Investment Management, www.montinvest.com in 2010. Roger brings more than two decades of investment, financial market experience and knowledge. Roger also authored the best-selling investment book, Value.able.

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With the global electric vehicle (EV) market forecast to grow 10-fold by 2025 and 50-fold by 2030, and rising demand for energy storage, there's never been a better time to be a lithium miner. Fortunately, Australia has a number of quality mining businesses for investors to consider.

When it comes to electric vehicles it appears a tipping point has now been reached and investors have been profiting from the tidal shift in sentiment with Australia's wealth of natural resources ensuring there's no shortage of opportunities.

Earlier this year, Porsche, Audi, Skoda and VW owner, the Volkswagen Group's Powerday presented the company's roadmap for battery and charging technology up to 2030. The company had already nearly tripled deliveries of EVs in 2020 to over 212,000 and now it intends to deliver a million EVs in 2021 and invest more than €46 billion in EVs over the next five years.

Major competitors have responded swiftly

General Motors recently revealed its plans to sell more than a million EVs annually by 2025 and will spend US$35 billion by 2025 on EV (electric vehicle) development. That's up nearly a third on the spending plan announced just on six months ago.

Not to be outdone, Ford announced in June it will spend US$30 billion on EV development by 2030, sell 1.5 million EVs that year, while aiming for 40 per cent of its global model range to be electric.

According to Ernst & Young, EV sales in Europe, China and the US will outstrip internal combustion engined vehicles (ICEs) by 2033, which is five years earlier than previous projections. As I have previously explained, government mandated climate change targets combined with financial consequences for the manufacture of ICEs is driving the seismic shift in production and ultimately take-up rates. Consequently, the share prices of lithium miners have surged since April, substantially outperforming the market.

In the US, President Biden's proposed infrastructure bill has set aside US$174 billion to encourage EVs, with nearly US$18 billion for a national charging network. A recent US government technology report however has suggested nearer to US$90 billion will be required for the charging network to meet the government's 2035 EV target.

Perhaps most importantly, it is this last development - a network of ubiquitous rapid charging stations - that will speed up EV adoption, with important demand consequences for upstream suppliers including lithium producers.

Growing EV markets

A plethora of predictions typically expect the global EV market to grow 10-fold by 2025 and forecasts of a 50-fold increase by 2030 are not uncommon. And with lithium demand for the burgeoning energy storage market demand expected to far exceed that which is required for EVs, it is reasonable to expect bright revenue prospects for lithium producers.

Demand, of course, is but one side of the equation. Currently, global lithium (carbonate production) is roughly 500,000 tonnes per annum. If current predictions for the 2025 EV market alone are correct, demand will exceed 2.7 million tonnes per year. If 2030 predictions are correct, expect demand to exceed 15 million tonnes. By way of examples, Institutional Investor has reported that EV sales have more than tripled since only 2017, Citi Bank predicts 75 per cent of all mined lithium will be consumed by EV batteries by 2025, and finally, the IEA predicts a 40-fold increase in lithium demand by 2040.

Of course, if new and recycled supply cannot meet demand, 'Houston' will have a problem and the EV market will simply not reach adoption forecasts.

Are lithium stocks a bubble?

Australia is uniquely positioned to supply at least some of the expected demand. If currently planned Australian lithium refining capacity is met in the next few years, however, it will still only double global supply to about a million tonnes.

That suggests to me the jump in the prices of lithium production stocks since my last article on the subject is anything but a bubble. A long runway of exploration, development and production is ahead and remember this is an investment theme that is independent of economic, COVID-19, interest rate and inflation cycles.

Lithium-ion batteries contain other metals such as cobalt, nickel, graphite and manganese. And there's no shortage of mining projects being established to extract and produce these battery materials. New technology will also help to meet some of the projected demand with green credentials. Recently, General Motors struck a deal with Australian lithium miner Controlled Thermal Resources, to extract lithium from US geothermal deposits in the US. If successful the project could deliver another 600,000 tonnes annually.

Meanwhile, Albemarle Corp., the world's largest lithium producer, is working on a new laboratory in North Carolina to accelerate production of ultra-thin lithium foils and anodes that could double energy density and halve costs.

For context, a battery mining project only differs from other mining methods by the technology employed to remove the last few thousand parts per million of impurities. The success of battery mining projects, therefore, hangs on the ability, which should not be underestimated, to achieve the necessary purity economically.

Nevertheless, the transition to green energy - and as automakers embrace the EV revolution - rising demand for lithium-ion batteries should push lithium prices up while ensuring the supply of battery metals remains short for years. According to Macquarie Bank, a slight supply deficit this year of 2,900 tons will rise to 20,000 tons in 2022 and triple to 61,000 tons in 2023. Meanwhile, Credit Suisse is forecasting a deficit of 248,000 tons in 2025.

Unsurprisingly, lithium and nickel prices have already risen steeply this year. Lithium carbonate is up 71 per cent year to date, lithium hydroxide has nearly doubled and the premium on nickel briquette is up 24 per cent - the highest level since late 2019. If, however, projected demand continues to outstrip supply - supply which has been depleted and constrained by supply chain inefficiencies - prices can surge further.

At Montgomery, one of our key investment themes this year, along with demand for income, a boom in mergers and acquisitions, has been decarbonisation. And it appears there's some durability to the latter theme.

Globally, regulators and governments will prioritise clean energy, EV sales will continue to surge as choice flourishes and, so, battery metal demand will remain buoyant. If mining production fails to keep up, producers of battery metals such as nickel, copper and lithium will have a solid 2021 and 2022, while their shares will also enjoy growing demand from a happy band of fund managers who have been hitherto underweight and who are increasingly required to make ESG-friendly bets.

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About the author

Roger Montgomery founded Montgomery Investment Management, www.montinvest.com in 2010. Roger brings more than two decades of investment, financial market experience and knowledge. Roger also authored the best-selling investment book, Value.able.

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'This time' will rarely be the same as the past. History has always been misquoted and misused; usually to support a preconceived view of the writer. Learning to identify, and then look through these distortions when reading financial musings is crucial. Especially true when the writer speaks with a tone of 'definitive authority' on the basis of the past. Here are a few tips when forming views from history;

History, it's not different this time. It's different EVERY time. Each crisis or surge is different. Nature is never constant. It is the arrogance of man to assume his 'rules' are set to never change and he is exempt from nature. The Great Depression didn't emulate the depression of 1920-1921 just like that differed to the panic of 1907. The current crisis versus the GFC has far more differences than similarities. Historical panics do have one thing in common, they all end. Stocks recover. Economies grow. People still get up every day looking to get ahead.

                                           

Historical 'context' is fine but it's not the answer. Back-tests are not called Front-tests for good reason. Understanding financial market history is not the same as it telling you what will happen next. It does provide a range of outcomes not 'the' full range of them. New outcomes frequently occur - a classic failure most commentators forget to factor in. What you can do is analyse the present and use the past to come up with reasonable probabilities when making decisions about the unknown, but never limit the outcomes just to past ones. Nature is always morphing and creating as is history. It's not static.

History warns us about ignoring human nature. It's said, 'Never bet against the Fed'. I would add 'Never bet against the human spirit'. If you are, I'll take the other side of that bet. Commentators holding a far right or left of field view tend to ignore the human spirit. They do this because it gets in the way of their belief systems. This is the heartbeat of all human endeavour and hence of capitalism too. When you take a bet against human endeavour you are betting against the heart and engine room of our lives. Doomsayers value endeavour, imagination, stubbornness, curiosity, determination, and relentlessness at zero.

History shows risk is easier to predict than returns. Strolling down memory lane helps give investors a decent approximation of potential outcomes (e.g. the presence of risk in financial assets that seek to earn an expected return above the rate of inflation). Risk means different things to different people but it is always there no matter what you do with your money or even if you're aware of it in the first place. One recurrent big risk for investors during bad times is the feeling that the good times won't return for a long time.

History helps us avoid mistakes of the past. Charlie Munger (Buffets amazing partner) once said, "I believe in the discipline of mastering the best that other people have figured out. I don't believe in just sitting down and trying to dream it all up yourself. Nobody's that smart."

The inverse is also powerful; avoiding the worst that people didn't figure out in the past to avoid lethal mistakes... is easier than emulating brilliance.

History shows life always has hardships. People have always lived through hard times and then thrived! How did one generation born into poverty and no social security get through World War I, the Spanish Flu pandemic, the Great Depression, massive social upheavals, two market crashes, and World War II - all within the span of only 30 years, and yet progressed their lives? Maybe it's that thought about underestimating human endeavour? People have many flaws but we are exceedingly adaptable. Never underestimate human endeavour and the will to progress.

                                           

Einstein once said, "I would rather be approximately right than precisely wrong." Each investment plan requires educated and analysed guess work. Baseline assumptions backed by strong theories that use probabilities to make key decisions is a part of portfolio construction. The future still remains unclear to everyone. Investment information is imperfect. You work with what you've got, update assumptions and probabilities as new information comes to light. Good plans are flexible enough to take new realities into account. Balance this with how easy it is to get caught up in the moment and to then lose perspective (temperament) - especially considering time as a factor and in every way it impacts money.

History shows temperament is more useful for investors than intelligence. Overconfidence or underconfidence during a market event is lethal. Subduing those emotional attributes in the investment decision-making process is wise. Using educated specialist third-parties such as advisers and fund managers is good insurance for this and are useful tools to managing your money, including how history is accounted for. I'll leave you with the thought below...

Our actions result from our behaviours that are determined by our attitudes...that are governed by our beliefs.

Note: Our thanks to Ben Carlson (CFA) in the USA for generating the idea for this article and for various portions of the content.

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Humans are linear by nature and our ability to grasp exponential change is extremely poor, this creates a blind-spot when it comes to assessing the potential of technology. While the cloud opportunity is already thought of in the trillions of dollars, it may actually become three to six times this size over the coming decade.

One of the most difficult things to do as an investor is delineating promotional rhetoric from a genuine glimpse of an explosive new secular trend. Separating the so-called "signal and noise" is less clear-cut than the phrase implies. For instance, the parabolic moves (up and down) in AMC and GameStop (both were recently considered bankruptcy candidates), clearly highlight how one investor's signal can be another investor's noise, with the market as polarized on the future of the businesses as oil and water.

Interestingly, often the loudest debates about a company's future are highly bifurcated like AMC and GameStop, with the opportunity worth many multiples of what the market implies today or nothing at all (similar debates were had over Amazon and Tesla too). Hence it is quite an unusual situation when the debate is not between success and failure, but rather success and unfathomable success! Paradoxically such a situation may be available at one of the largest companies in the world, with a market cap approaching US$2 trillion, Microsoft's opportunity may actually be underestimated by the market.

Before we dig into this frightening proposition, that such a "large company" has a potentially larger opportunity than we can comprehend, let's revisit some of the perspectives from Google's world-renowned futurist and Director of Engineering, Raymond Kurzweil. Famous for advancing numerous cutting edge fields, Kurzweil posits that humans are linear by nature, whereas technology is exponential. In fact human ability to grasp exponential change is so poor that even when it is presented in the plain language of mathematics, our minds often short-circuit and struggle to resolve situations that are indisputably true. For example, Kurzweil's "law of exponential doubling" notes that it takes seven doublings to go from 0.01% to 1% and then seven more doublings to go from 1% to 100%. So within 14 moves we have gone from something that is completely invisible in the linear world (0.01%), to entirely encompassing it (100%). Perhaps the global pandemic and the exponential spread of the virus has given us a real-world look at what exponential growth "feels", like given the speed with which our lives were disrupted, however, most humans are simply not built to intuitively reconcile this phenomenon.

Shifting back to Microsoft, it is generally accepted that the biggest opportunity ahead of the company continues to be cloud computing and its powerful claim on the growth of technology more broadly, driven by its privileged position with enterprises and consumers. It has also become somewhat of a consensus view that the cloud market will be over US$1 trillion within a decade, this alone puts Microsoft in exceptional shape to deliver multiples of its stock price for shareholders over that time. So case closed right, what more is there to say? So what would it mean if the consensus view was wrong and massively underestimated the opportunity. Many will raise their eyebrows and ask "how can that be, the opportunity is already over US$1 trillion", which is actually the natural default for our linearly predisposed human minds.

Perhaps thinking exponentially, a signal of how large the cloud opportunity may be, came on a recent Microsoft earnings call, during which CEO Satya Nadella made the following comment regarding the future of global technology spending:

"At the highest of levels, today as a percentage of GDP tech spend is 5%. We think it will double in the next 10 years, and if anything, this pandemic perhaps has accelerated that doubling…[and] what is the largest, most secular need? It is the need for distributed cloud infrastructure" - Satya Nadella (CEO of Microsoft)

At first blush, this comment looks trivial, but putting some numbers around it reveals quite an interesting result. Current global IT spend is ~$3.6 trillion (of which cloud is only ~10%), were it to double as a percentage of global GDP (which is also growing) over the coming decade, it would imply global IT spending would hit $9.6 trillion from current levels (~10% CAGR ). Given Nadella noted the pandemic had "accelerated that doubling" it would imply faster growth for cloud relative to pre-pandemic levels, which was already growing more than ten times (10x) faster than the industry. Hence if Nadella is right, the market may be ~US$6 trillion by 2030 or six times (6x) the size consensus perceives it to be now. Even if Nadella is wrong and there has NOT been an acceleration, the cloud opportunity would still be ~US$3 trillion or triple (3x) the market consensus. A truly staggering thought for the potential of this explosive, exponential secular trend!

At Montaka Global we have a single clear goal: to maximize the probability of achieving multi-decade compounding of our clients' wealth alongside our own by owning the long-term winners in attractive markets, while they remain undervalued.

Montaka owns shares in Microsoft.

Amit Nath is a Senior Research Analyst with Montaka Global Investments. 

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America is running out of houses

        
Source: Zonda

What it means

House prices around the world are rising rapidly - including in the United States.

Recent gains have re-opened old GFC wounds, with escalating concern of another housing bubble.

However, the data suggests the gains are driven not so much by excessive demand, but lack of supply. The number of ready to build lots is down ~50% over the past 5 years. And while some of this can be blamed on the disruption from COVID, the trend was well established prior to 2020. The issue, it seems, is the gutting of the housing industry in 2009-2010 and the subsequent lack of skilled labour available to supply new lots and houses for the new cycle.

In short, it appears recent house price gains in the US are more structural than cyclical.

 

The Aussie consumer is coming back - big time

                  

Source: ABS, Quay Global Investors

What it means

Sometimes when looking at the detail we miss the bigger picture. How often do we hear 'retail sales beat / missed expectations', and then simply move onto the next economic data point? But looking at the total data, there is no doubt - retail sales are booming in Australia.

The chart on the left tells a few stories. It shows retail sales growth on a 'moving annual turnover' (MAT) basis - in the same way a shopping centre owner would view it. On a national scale the numbers are clearly very good (+9.6% growth), and even after stripping out e-commerce sales, physical store MAT growth is strong (+6.6%) - during a pandemic!

But what about the so-called base effect? Well, the chart on the right shows that when comparing monthly retail sales to 2019, there can be no doubt - the Aussie consumer is back.

But it's all happening online … right?

 

The pandemic did not permanently change our shopping behaviour

                  

Source: ABS, Quay Global Advisors

What it means

In the heat of the moment, it is always tempting to extrapolate the current environment into perpetuity. However, mean-reversion is a hell of a thing.

Last year the narrative "the pandemic has accelerated existing trends" was popular. In reality, we are simply returning to the pre-pandemic environment. This has two really important implications for real estate.

The physical retail property story has not changed for the worse as a result of the pandemic. In fact, coupled with recent retail sales data (see previous chart), the fundamentals for physical retail have improved.

Many businesses aggressively expanded warehouse demand to cater for booming online sales during the pandemic. We believe there is some risk that industrial owners / developers are building excess supply at a time when consumer behaviour is normalising. The nightmare scenario for industrial owners is if lockdown-weary consumers return to physical retail in greater numbers and online sales fall below the pre-pandemic trend - just in time for record new supply.
 

Retail is booming in the US too

Source: BEA, Quay Global Investors

What it means

Like Australia, US retail sales are booming compared to 2019 data. And like Australia, the spoils are being shared across e-commerce and physical retail.

What's driving this?

The common story is the consumer has a lack of spending options under COVID (limited travel, dining, etc).  As such, this boom won't last.

However, we think there is more to this story - and it points to a solid (structural) change in household balance sheets.

 

Retail is booming, yet households are saving - how is this possible?                            

              
Source: BEA, St Louis Fed, Quay Global Investors

What it means

It seems like an oxymoron. How are retail sales booming at a time of a huge surge in household savings?

To understand this is to understand that the current consumer boom is far more sustainable than it may seem.

First, households are a major beneficiary from large government deficits - which is in fact the way governments proverbially 'print money' (i.e. it's not quantitative easing). So, households can simultaneously spend and accrue savings via government transfers.

Yet even when the stimulus ends, this money does not go away. Federal deficits effectively spend money into existence. One person's spending (government) is another's income (non-government). Across the non-government sector, spent savings are simply transferred between private sector bank accounts.

So this pool of money is staying in private sector hands until it is taxed out of existence by the federal government. That won't happen in aggregate until the US runs a budget surplus. And it doesn't feel like that's coming any time soon.

Said another way, we believe the recapitalisation of household balance sheets across the world is structural, and permanent.

 

The so called 're-opening trade' is very uneven

                       

Source: Bloomberg, Quay Global Investors

What it means

Since the announcement of the successful vaccine trials late last year, many stocks and sectors have performed well, benefiting from the so called 're-opening trade'.

Of course, this makes sense. However, there appear to have been a few inconsistencies. How can hotel REITs now be back above pre-pandemic prices, yet office towers (where some of the same underlying assets are located on the same street) are still trading 10-15% below?

Even within the same sector, the largest retailer landlords (Simon Property, Scentre Group) are delivering very different performances despite similar macroeconomic stories (see earlier retail charts). Moreover, by most metrics, the local landlord (Scentre) appears to be delivering better sales, footfall and overall occupancies - but remains 20% below its pre-pandemic price.

Meanwhile, Simon is trading comfortably above. 

The lesson? The re-open trade makes sense, but pay attention to the underlying stock fundamentals - perhaps significant relative value is emerging?

 

At similar points in the cycle, rising interest rates are good for real estate and not great for equities

                   

Bloomberg, Quay Global Investors

What it means

Rising interest rates are bad for listed real estate?

This is one of our favourite myths.

When the US (and the world) was recovering from the 2001-2002 recession, rising interest rates from 2004 corresponded with listed real estate significantly outperforming equities, both in the US and globally.

Why?

During the early stages of recovery, built real estate generally has excess capacity (which we call vacancy). Rising interest rates signal a strong economy, which means the vacancy is easily filled - resulting in strong earnings growth.

We acknowledge this cycle is very different. The key is to target sectors with elevated vacancy from the pandemic (office, retail, senior housing) and be wary of sectors already running at full capacity (industrial).

 

Here comes the taper … but who cares?

      
Source: Jack Bogle, Ben Carlson, Quay Global Investors

What it means

Okay, we admit we've published this a few times before. However, given the rapid economic recovery around the world, talk of a Federal reserve 'taper' (reducing of asset purchases) is causing some concern among the usual talking heads.

All too often we hear day-to-day share market returns are influenced by central bank action: 'flooding the market with liquidity' to drive up share prices. Of course, central bank liquidity does no such thing, because central bank liquidity is non-fungible with liquidity used by consumers, businesses or investors. Central bank liquidity simply facilitates the settlement of interbank transfers for and on behalf of bank customers. How 'the market' ever convinced itself otherwise remains a mystery.

Don't believe us? Well, in the decade that the US Federal Reserve was most active with asset purchases (2010s), nearly 100% of the total return could be explained by dividend yield and earnings growth. There was no P/E rerate benefit, despite the secular fall in interest rates over the decade.

This is an important observation in the current environment. Too often the Fed and low interest rates are blamed (or credited) for market performance, when the reality is that returns come from earnings growth and dividends. No matter what the Fed does, investors would be wise to spend more time thinking about company prospects rather than central bank actions.

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When speaking to clients, our investment team is frequently asked whether the market's extraordinary run is due to come to an end. It's a question many in the market are currently grappling with, and it pays to look back into history to provide a guide.

History repeating itself

In 2009, we saw only 5 drawdowns greater than 5% over the 18 months following the market's low on 6 March 2009. Surprisingly the average drawdown was just above 4%, with each drawdown lasting on average just 7 trading days.[1]

Despite seeming counter-intuitive given apparent risks, it isn't unusual for markets to recover in this fashion after a large shock. History repeated following the recent COVID-induced drawdown, with only 2 drawdowns greater than 5% since the market bottomed on 23 March 2020, and each drawdown averaging only 3 trading days.[2]

Today we find ourselves 15 months past the pandemic bottom in markets, with the ASX300 Accumulation Index having risen in 14 months out of the 15, and up a total of 67.8%.[3] The market is 7.1% above its all-time high, and continues to climb higher.

Watching the signs

We remain positive on the market over the next 6 weeks as we head into a strong reporting season. However, a number of potential issues are accumulating as we enter the seasonally weaker period into September, with bond markets, options markets and the Chinese economy all attracting our attention.

Bond markets

The US Federal Reserve is committed to keeping its foot firmly on the accelerator until either employment numbers fall dramatically, or inflation accelerates to uncomfortable levels.

US headline inflation numbers released this week unexpectedly accelerated to 5.4% year on year in June, the biggest rise since 2008. One data point certainly does not make a trend; but three data points in a row is hard to dismiss, particularly when price pressures were so broad-based. Yet inflation is still transitory according to central bankers, and any acknowledgement otherwise is still months away.

Increasing inflation fears continue to spook investors that central banks may move sooner rather than later to lift interest rates, which saw the US 10-year bond yield rise from 0.50% in August 2020 to 1.74% in March 2021. But the yield has since retraced to 1.47% as the bond market warns of a potential economic slowdown. After experiencing a sell-off, since the middle of May investors have rotated once again into the tech sector, fuelled by the bond yield fall. Market breadth is narrowing (rarely a sign of market health), with mega-cap tech shares in the US increasingly taking leadership.

Options markets

The options market offers interesting insights, with positioning suggesting nearly everyone in the market is bullish. Implied volatility remains subdued, with the current put:call ratio extremely low - reflecting a heavy skew towards upside participation with little downside protection. 'Who cares about protection' seems to be the belief of the times. When the deck is stacked heavily towards upside participation, investors can aggressively move en masse to downside protection when markets do fall - leading to an even sharper reversal.

China

Meanwhile, the Chinese economy is at an interesting juncture. Having led the world out of the COVID-induced economic downturn, several indicators suggest risks are rising. Total social financing, which is a broad measure of credit and liquidity in the economy, has been falling after the Chinese government embarked on a process of deleveraging, allowing the economy to move forward with less stimulus support.

                           

The Chinese approach is in contrast to that of the US, which continues to provide significant monetary and fiscal stimulus. Other Chinese data has also been weak recently, including the Caixin composite PMI which fell from 53.8 in May to 50.6 in June (the lowest reading since April 2020). New orders are at a 14-month low. The People's Bank of China has recently cut the Required Reserve Ratio (RRR) by 50bp, releasing an estimated RMB 1 trillion in base money liquidity and reducing bank funding costs by RMB 13b per annum. This should assist bank liquidity; however, we do not believe it represents a change in monetary policy by the Chinese authorities, with tighter prudential regulations and a continued slowdown in credit growth likely.

Alan Greenspan famously said in 1973: "It's very rare that you can be as unqualifiedly bullish as you can now." These words were spoken just before two of the worst years for the US economy and the stock market. Could the Australian market be heading for a similar comeuppance?