Commentary: Everyone has a plan until they get punched in the mouth
The start of the year heralded a blow to asset prices. The move of central bank thinking toward inflation as a structural factor, rather than a transitory one, continues to have a large bearing on the ASX, with energy prices and labour market tightness key to our thinking in this area. Different sectors and stocks prosper in an inflationary environment than those that have outperformed through recent years.
Mike Tyson spoke from experience “Everyone has a plan until they get punched in the mouth”. January was a punch in the mouth to asset prices, after several glorious years of ever increasing equity market prices had covered many frailties in business models, which hitherto had promoted the total addressable market – the TAM. The TAM WAS the plan. Just as the RBA had a plan; and the proponents of decarbonisation being costless have a plan; and corporates with strategies pursued in different market environments have a plan. The punches are being thrown; and now the plans are being tested.
Don’t fight the FED
The first punch has been thrown by Jerome Powell. The essence of the equity market sell off, in our opinion, is not just the heightened prospect of several interest rate increases through 2022. Quantitative tightening is at least as important, whilst related to and difficult to untangle from interest rate increases. For context, the correlation between the total assets of the central banks for major economies (US, EU, Japan and China), and the MSCI World index since 2009 is 0.97. Don’t fight the Fed, indeed; the size of the asset base went from US$9t to US$31.3t during that time. If the goal was to generate employment and wages growth, and asset price inflation was simply a transmission mechanism, albeit one with social cost through the exaggeration of wealth inequality, then there should be little trouble now in reversing QE and embarking upon QT, and the policy primacy of ensuring price stability should unquestionably trump asset price deflation. That is, monetary policy should be tightened until inflation is tempered. Even at the cost of asset prices declining. As Powell stated to the US Senate in January “We are mindful that the (US) balance sheet is US$9t…it’s far above where it needs to be…”.
Powell also made clear his tolerance for the cost of asset price deflation in the pursuit of price stability in his comments after his recent FOMC speech. His concern is that the peril of inflation is a far worse spectre for social inequality; “…I think the problem that we’re talking about here is really that people are on fixed incomes who are living paycheck to paycheck, they’re spending most or all of their — of what they’re earning on food, gasoline, rent, heating their — heating, things like that, basic necessities. And so inflation right away, right away forces people like that to make very difficult decisions…”. And the better off, well, they just have to deal with it; “… The point is some people are just really in — prone to suffer more. I mean, for people who are economically well off, inflation isn’t good. It’s bad. High inflation is bad, but they’re going to be able to continue to eat and keep their homes and drive their cars and things like that...”.
Australia mimics the US
All of the above, of course, is for the US, and yet it may as well be Australia. In monetary policy and equity market direction and sectoral performance, Australia has just mimicked the US experience for some time, and that has continued to be the case this year. It’s why the apparent RBA backflip on its yield curve control policy is neither surprising nor important in our thinking for the Australian equity portfolio. The RBA has unfortunately neither been prescient with insight nor policy for several years. As my learned friend Mr Conlon highlighted in last month’s commentary, after twenty years the sum total of Australian monetary policy is to have facilitated the deterioration of lending standards such that housing now represents two thirds of system lending at world leading loan to income ratios; while investment to gdp has declined from 18% when rates were last above 5%, to 11% today. We continue to be underweight the banking sector and foresee ongoing sluggishness in underlying profit growth and a latent risk to a “punch in the mouth” through the bad debt line, should the household sector suffer any weakness.
The change in central bank thinking away from “transitory” inflationary pressures towards it being a more structural factor has had and continues to have a large bearing upon sectoral performance globally and on the ASX. On the ASX, over five years, the stand out performers remain the IT and healthcare sectors; however more recently, the energy and materials sectors have been to the fore.
Energy prices are key
That is unsurprising. Indeed, energy prices are key to our thinking on inflation. Energy is a significant input into the Chinese producer price index, which in turn is an obvious but clear leading indicator for the US consumer price index. For many years, long run rolling oil price growth has undershot consumer prices; this deflationary boon had nothing to do with labour productivity in the western world, although it was used as a basis for declining western world interest rates. At the same time, esg pressures stymied capital expenditure in the sector; annual global oil and gas field development capex has halved from US$750b through the past cycle. Even with higher prices, pressure on capital providers to fossil fuel developments has seen the availability and cost of such capital secularly change, such that supply continues to be choked. Finally, US shale has not responded to a higher energy price signal due to labour shortages in the US, stifling the economics of these projects. Call it the Greta Thunberg law of unintended consequences. Meanwhile, energy demand continues to increase, even through the pandemic; the Chinese National Petroleum Company has every year through recent years dutifully estimated Chinese demand for oil to peak in 2030. However, the estimate of the quantum of oil required in 2030 has increased with each passing year; and has increased by more than 10%, even through the past two years. The energy mix in China is also inflationary, with coal still representing the vast majority of energy consumed and increasing every year through the past cycle. The only rational reason for this to happen is cost; the internal and external pressures upon the Chinese to decarbonise means that this can only be driven by a short term economic imperative. To the extent that renewables increasingly form part of the energy mix, we can only expect Chinese PPI, and in turn, US (and Australian) CPI, to continue to experience and transmit inflationary pressures.
The inflationary bias in energy prices has also knocked into commodity prices more broadly, with hard and soft commodities, with few exceptions, enjoying stellar years. One of those exceptions is Alumina, and we consequently continue to have a significant position in Alumina Limited, and to a lesser extent, South32, in our portfolios.
Beware the labour market
Finally, we continue to be wary of businesses heavily reliant upon labour in this inflationary environment, especially those that are demonstrating a limited ability to pass through increasing input prices. Some sectors, such as telcos and insurance, are showing a better ability to manage margins this cycle than they have in the past; and others, such as supermarket operators, are showing less ability or willingness to pass through these cost pressures than they have in the past. Nuances continue through to business positioning as well; James Hardie continues to be able to hold high margins, but is now more focused upon higher priced products produced at a higher cost than its business model has proposed in prior cycles. Understanding these nuances and what they mean for multiples will continue to be critical for relative performance as investment markets transition to a higher inflation setting.
Fighting times call for fighting figures. Muhammad Ali was a very different character to Mike Tyson, and summarised the world less bluntly but just as presciently when saying “The man who has no imagination, has no wings”. In many ways, the past several years in financial assets have been about nothing but imagination. No forecaster several years ago foresaw the explosion in central bank balance sheets that has been experienced. To be fair, no one could have seen the pandemic which has exaggerated that direction and quantum, however, our hope and expectation is that there is no further need to replicate either the social experiences nor the policy responses of the past two years. In that event, as Dr Powell stated, balance sheets are “far above” where they need be. The strong correlation with asset prices on the way up will, we expect, continue to hold as the balance sheet shrinks.
Alas, it is more than possible that the deflationary forces prompted by asset price deflation will not directly impact upon energy price inflation, and hence we suspect a stagflationary environment is possible. It doesn’t much matter if that’s not the case in terms of our portfolio positioning, however, because even a more sedentary unwind of the growth in central bank balance sheets will continue to see an unwind of the speculative excesses which has been spawned by the policy settings of recent years. As an investor, as always, the best form of defence in strained market environments is a higher, cash backed, nearer term, sustainable cashflow yield. That strategy has proven valuable through the unwinding of every period of market excess in the past; a punch in the mouth, as it were, and we fully expect it to continue to prove its worth as this cycle unwinds as well. At the least, that’s our plan.
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