22 Jun 2022 - It's time to hedge - the bear is here

REVIEW

The Australian share market saw a significant contraction in May with the All-Ordinaries Index down 3.0%, its worst month since January. The sell-off was once again led by Technology stocks with the sector down 8.7%. The Real Estate sector also performed poorly, down 8.9%, led by concerns of more aggressive interest rate tightening and associated impacts on demand. 

After a soft April, the Materials sector resumed its outperformance in May, aided by expectations of more stimulus in China. In terms of factor leadership, value resumed its leadership over growth. The value factor has now outperformed growth by 20% over the last 6 months.

MARKET OUTLOOK

The secular bull market that ended for Australian shares last August emerged from the financial crisis and was a product of successive waves of liquidity led asset reflation, as central banks pushed real interest rates lower and lower and asset values higher and higher (Fig1).

Figure 1: Successive waves of asset inflation

Source: Bloomberg, S&P 500 Chart

Asset inflation, of course, created excess demand, leaving product and labour markets acutely tight. Unemployment in Australia is now at its lowest in 40 years and with little immigration, the services sector is scrambling to find workers. Fair Work Commission awarded a 5.2% increase in the minimum wage, well above expectations.

This policy led bonanza for asset owners was a consequence of systemic deflation. No one has a complete explanation for the root cause of this deflation which you can see clearly in the value of bonds which have pushed higher for decades (long term interest rates have been falling).

The first phase took place in the 1980's with back-to-back global recessions that killed the inflation of that era. Then in the early 1990's with the collapse of the Soviet Union we had a rapid expansion of western democracies, a deepening of capital markets and the globalisation of trade. This spread of the neo-liberal 'rules based' order (capitalism) was deflationary allowing interest rates to fall and debt balances to accumulate.

The spoils of this period where not spread evenly however, laying the seeds of its demise. Asset owners captured all the gains while labour's share of GDP has fallen sharply. We now have the first generation of citizens in the west who are worse off than their parents in real terms.

The emergence of popularism and de-globalisation were the first phase of its descent. A new cold war between the East and West has manifested the next phase. With this reversal in these deflationary forces, the good times of ample liquidity and asset reflation have passed.

Even before the health crisis, we were approaching the limits of these policies in driving asset values higher as bond yields in many western countries were already negative. On a hold to maturity basis, investors were guaranteed a loss, which of course is nonsensical. Then with the health crisis, policy makers doubled down on these same policies. The excess demand created from emergency stimulus and the associated supply chain disruptions have unleashed inflation which will be with us for years to come.

Investors need to ask two important questions: Are the deflationary forces that persisted for so long still around or has their demise contributed to the inflation we are seeing today? Secondly, what has caused this inflation, is it established or transitory?

How these inflationary pressures play out will determine the duration of this bear market. If the inflation hangs around for years to come as expected then we are in a secular bear, if it is transitory and the deflationary forces resume/return then potentially shares can make new highs in the years ahead.

We are still early in this bear market. Until inflation moderates and central banks back away from hiking rates further, shares will move lower in the medium term. In the short term at least, share markets globally are oversold and sentiment is extremely bearish. In the weeks and potentially months ahead, we should see a decent bear market rally which investors should sell into as the big drawdown is still ahead in the second half of the year.

Australian shares have proven remarkably resilient through this first phase of the drawdown given our economy's exposure to commodities which are the driving force behind the inflation we are seeing. In simple terms, the Australian economy is a good inflation hedge. The 'quarry and farm' may once again avoid another global recession.

As we get into the 3rd quarter of the year however, around the US mid-term elections, western economies will be slowing quickly and the 'street' will be slashing profit estimates, pushing shares lower.

This becomes a pivotal moment for investors as the policy response will determine the next move for shares. If the inflation data improves as everyone expects, Central Banks may 'pause' on any further policy tightening. Under this scenario economies slow but avoid recession and shares can stage a significant rally early into next year. However, an early pause only ensures inflation lingers for longer, leaving us with 'stagflation'.

Alternately, Central Banks look to overshoot in tightening financial conditions further to kill inflation, only to push western economies into recession. Under this scenario shares obviously fall further into the first half of next year.

The policy response as the economy slows, asset values fall, and inflation moderates will determine which path the market follows. Either way the medium-term outcome is much the same, shares will be lower.

The emerging data is less than encouraging, with the May CPI report showing further deterioration, Central Banks are once again losing credibility as they were guiding to a moderation in the data. It seems they still have a lot more to do evident in the FOMC decision to increase the target interest rate by a full 75bpts (3 hikes in 1), which is unprecedented.

With the broader offshore indexes down more than 20% we are now officially in a bear market for shares with investors seemingly still pricing in a soft-landing scenario (green line below in Fig 2). They have never tightened once shares have fallen into a bear market before (down >20%), a further demonstration of just how far behind the curve they find themselves.

Given inflation has never been tamed once it gets above 5% without a recession, a recession more than likely beckons and we move lower (the red line in Fig 2).

Figure 2: Market drawdowns with and without recessions

Source: Stifel

While we have seen some contraction in valuations (P/E's) already as financial conditions have tightened, we are yet to see any move lower in profit expectations. With the demand shock from the COVID stimulus, many public companies are over earning, profits have moved well above trend. In a garden variety recession earnings typically fall by a least one third Fig 3 below.

Figure 3: S&P 500 Profit (EPS) drawdowns from prior peaks

Source: Stifel

If we are in a stagflation environment of lower growth and persistent inflation, then valuations may well move to the lower end of the historic range (P/E's are low during periods of inflation) which along with lower earnings leaves us with a share market that still has a long way to fall.

SECTORS IN REVIEW

The Consumer sector delivered a flat result for the month, with gains in supermarket shorts, offsetting losses in some consumer growth stocks.

Our long position in the Fuel Marketers has been gaining momentum as fuel security becomes an increasing issue for Western Governments. Ampol (ALD) and Viva Energy (VEA) refining assets, historically loathed by the market, are now generating super returns and driving upgrades for both companies. This sector is under-owned and offers defensive exposure at a cheap multiple.

As mentioned in the April monthly, the Agriculture sector is building as fertile ground for short ideas. Share prices have risen aggressively given the confluence of a strong domestic grain harvest, and sky-high soft commodity prices driven by supply-chain dislocation. We know however, as with all highly cyclical industries, that conditions are ever changing, and we should be careful extrapolating at either the top or the bottom of the cycle. Using a 'normal season' as the basis for valuation, earnings multiples look extreme. We see several catalysts, including the successful negotiation of a humanitarian export corridor in the Black Sea to correct over-inflated soft commodity prices.

Financials had a flat month in terms of attribution. Our shorts in the Banks delivered returns, as we saw the beginning of a major sell off across the sector. Banks had held up well for most of the broader market volatility of 2022. This changed when investors came to appreciate the consequences of faster than expected rate rises. We have been highlighting for some time the nexus between bank returns and the property market. Offsetting these profits was weakness in our long position Macquarie Group (MQG), we continue to see good earnings prospects for Macquarie in the short term amidst the energy market volatility. Commodities trading remains a key driver of results.

Technology delivered some modest positive returns. Largely from our short portfolio. The sector continues to be the most sensitive to higher than expected inflation outcomes. Which are then leading to higher interest rates expectation. Selling across the sector has been indiscriminate.

The Building Material companies continue to come under considerable pressure as it has become clearer that interest rates will be moving a lot higher. This is the case not just for the local Builders but the US based ones as well James Hardie (JHX) and Reliance Worldwide Corporation (RWC). As manufacturing businesses these companies are also very exposed to escalating fuel and energy costs.

In Media, cyclical business like Nine Entertainment (NEC) and Seven West Media (SWM) have come under considerable pressure on fears of a fall in advertising spending. NEC shares are starting to look attractive with a full recession now factored in.

Contractors: We expect the resources sector to hold together relatively well even as growth slows elsewhere. Monadelphous (MND) an important contractor in energy and iron ore operating in WA should perform well in the years ahead, especially as energy investments picks up. The iron ore hubs are so large and established now, having doubled in size over the last 15 years, spending in this sector will remain elevated for years to come.

As a defensive sector, Healthcare has held up relatively well in a difficult market, it's probably time to take profits here.

Resources: The lithium sector has fallen hard following some negative research pieces suggesting the market is over supplied in the medium term as Chinese production ramps up. We have a balanced portfolio of attractively prices emerging producers/explores and a short portfolio of expensive explorers in preproduction. Producers of bulk commodities have held up very well in recent weeks, it's time to take profits in some of the iron ore miners in particular. The iron ore prices is still above $150/t and looks vulnerable here.