Commentary: Unstoppable force meets immovable object

Market review

While not quite having the drama of Joker versus Batman, the inflationary forces which are meeting highly indebted consumers and governments across the western world are creating a decidedly discomforting environment. The sources of inflationary pressure are many and varied. Profligate government spending and ultra-low interest rates during COVID as well as supply chain interruptions and immigration shutdowns no doubt contributed, and hopes of a rapid reversion as supply chain pressures eased have proven optimistic. These pressures are hitting highly sensitive economies without much shock absorbing capacity remaining, meaning policymakers are walking an uncomfortably tightrope.  While the review of operations and performance at the RBA may be warranted, given central banks have undoubtedly been instrumental in fuelling asset price speculation and excessive borrowing, when it comes to tipping money into the real, rather than financial economy, governments probably need to shoulder more of the blame.

Looking at the financial system through a sustainability lens does not make for pleasant viewing. Cursory observation of the budget deficit position of major western economies suggests it has been some time since tax receipts bore much resemblance to spending, even ignoring the COVID-induced spike. Deteriorating demographics and a global inability to address issues such as spiralling healthcare and social security costs mean one needs to be an unbridled optimist to believe governments will ever be in a position to repay debt. Access to ever larger amounts of funding remains crucial as new deficits are added to the stock of debt requiring refinancing. Given this picture, the term ‘risk-free rate’, the traditional benchmark against which other asset pricing is measured, may come under greater scrutiny in the future. Much of this has been the case for many years, meaning there is every possibility it may continue, however, in the famous words of Herb Stein, “If something cannot go on forever, it will stop”. Investing without countenancing the possibility of a change in these conditions is unwise and the direction of change is asymmetric.

Please note that mentions of securities, sectors and regions are for illustrative purposes only and not to be construed as an investment recommendation.

Source: Datastream

We have emphasised previously the importance of central bank intervention in supporting asset prices over the past decade. Much as we would prefer company specific factors to be the primary driver of markets, evidence suggests otherwise. The correlation of equity market performance with central bank balance sheet size is alarmingly high. While savage moves in bond market pricing have occurred against a backdrop of minimal reduction in balance sheet size, incremental direction has been important. Price distortion is often gradual when natural buyers are crowded out; when artificial buyers leave and natural buyers return, wide price gaps can close abruptly. As is the case in equity markets (where turnover is declining) and property markets (where listings are declining), as increasing proportions of asset value sit in the hands of passive holders, fewer transactions are validating the valuations of an ever larger base. Open marketplaces have been the most reliable way to determine fair prices for centuries. Any move away from this price setting mechanism should be viewed with scepticism. Interestingly, recent months have seen major players such as the People’s Bank of China and Bank of Japan reverse direction. Rhetoric which suggested an appetite for shrinking balance sheets seems to have faded quickly as the prospect of anything resembling symmetry in asset prices proves scarier in practice than in theory.

Source: factset, Schroders

Hit with a blunt instrument

Suppressing demand with a blunt instrument (interest rates) is unsurprisingly creating some issues in a nuanced economy. Lags in the impact of interest rate increases given the unusually large proportion of fixed rate loans induced by taking the cash rate to virtually zero, have led to surprising resilience in discretionary spending. Savings rates are evaporating more quickly in the demographics which hold most of the mortgage debt and are most important to spending, however, suppressing demand is taking a little longer than expected. Interest rate rises are benefiting older demographics with lower propensity for incremental spending. Younger demographics, many of whom have largely given up on entering the insane housing markets in Sydney and Melbourne are spending elsewhere, with recreation, pubs and travel recovering strongly and delivering exceptional results for players such as Endeavour Group. Premiumisation as Endeavour Group calls it (buying more yuppie gin rather than the cheap stuff for those not familiar with this invented word) has also continued to improve margins for Dan Murphy’s.

Volatile demand shapes as a potential challenge for nearly all consumer-facing companies in the coming year, and we remain cautious on the potential for outsized profit gains which COVID drove to more than evaporate as demand abates. Pathology players such as Healius and Australian Clinical Labs highlighted the difficulty in managing volatility, as delays in removing costs added during the COVID testing boom saw margins collapse. Retailers, almost always the canary in the coal mine, saw varying trends. Supermarkets have proven resilient to date. Coles and Woolworths both delivered solid results as COVID costs faded and high levels of inflation were recouped fully from customers. Both reported sales had held up well into the new year with volume growth in positive territory despite ongoing high inflation. Importantly, price indexing versus Aldi for both players is as favourable as it’s been in recent years, providing confidence that pricing relative to peers is not the source of margin gains.

Retailers exposed to household goods are more mixed, with solid revenue and earnings results from JB HiFi and Bunnings, contrasting with signs of weakening sales and momentum at players such as Nick Scali and Harvey Norman where price reductions are becoming necessary to drive sales. E-commerce continued to provide more than its fair share of headaches as the search for a profitable business model aligned with customers deciding that leaving the house wasn’t a bad idea after all. Temple and Webster and Kogan may be at the epicentre of the adjustment, however, all evidence suggests to us that a profitable business model will require customers paying more for delivery than for in-store shopping. As traffic again chokes roads full of potholes and labour and fuel costs head higher, the relative economics of stores is improving. For players such as Coles and Woolworths with vast store networks, this is good news for earnings sustainability. No such luck at Dominos. Perhaps highlighting the challenge of sustaining exceptional performance and low cost positioning, cost pressures across food, labour and delivery costs left the company with little choice but to push pricing. While experience varied across regions, with Australia better than most, price rises induced the same sort of indigestion as the cheesy crust.

It never rains

The insurance sector has been a tough place to make money of recent years, unless of course you’re an insurance broker, in which case you’ve received the benefit of commissions on higher insurance premiums without the pesky costs of higher claims. Suncorp, IAG and QBE have spent most of the past few years chasing higher reinsurance and claims costs, as every premium increase was swallowed by another catastrophic event and escalating car and home repair costs. While weather and climate will remain challenging risks to price, we continue to find appeal in businesses which are beneficiaries of higher interest rates, have faced an extremely challenging period for weather conditions and command valuations which expect rain and not sunshine. While recent results reflected more progress from QBE than its domestically focused peers, in using the NSW government weather barometer (installing a desalination plant at the peak of drought conditions and raising the wall of Warragamba Dam at the peak of flood), sunnier days should beckon.

Source: Suncorp Half-year Results Presentation

‘Future facing metals’ and the butterfly effect

When you leave marketing in the hands of miners you can’t expect miracles. Slogans aside, there is little doubt the sustainability debate has taken a more pragmatic turn in recent times. The insanity of adding up the carbon emissions in a portfolio is giving way to a recognition that new electricity grids, wind farms and environmentally friendly buildings will not be constructed from air and massively distorting capital provision to the economy will hinder rather than assist decarbonisation. The necessary materials will require incremental investment and even dramatically unpopular fossil fuel businesses require investment to sustain them while alternatives are constructed. The enormous disparity in commodity pricing versus cost curves continues to present outsized valuation challenges, with sharp falls in spodumene and lithium pricing over recent months highlighting the risks in elevated pricing. While producers such as Pilbara Minerals have done an exceptional job of turning the price explosion into cash, the truth is no-one can profess great insight into price trajectory when governments, regulation and emotion create demand imbalances with which physical markets cannot keep pace.

The ‘butterfly effect’ potential from decisions which often reflect political expedience was starkly illustrated by the recent announcement from the Pakistan government that they were expanding coal fired power generation from a little over 2GW to 10GW. As Europe managed to largely avoid the potentially disastrous outcome of energy shortages in a cold winter through commandeering every available LNG cargo at stratospherically high prices (the equivalent of US$400 per barrel oil), the butterfly effects were perhaps ignored. Across oceans, those energy shortages were inflicted on others. Pakistan, having invested in dominantly gas-fired power, and unable to compete with Europeans on price, wore the pain. Unsurprisingly, the victims sought to improve their own energy security through more diverse and reliable sources of energy supply. There seems little recognition that starving investment in gas production within Europe and sacrificed resilience and baseload capacity played a major part in initiating this sequence of events. We remain extremely wary of climate objectives which outstrip the ability of physical markets to keep pace. Engineering may need to trump politics, not the reverse.

Market outlook

Beware of averages

Distilling large amounts of data is tough. Average mortgage size, average age, average income, average household size; while countless measures such as these can provide insight into the health of banks’ balance sheets, demographic shifts, housing affordability, housing shortages and the economy more broadly, they can also disguise the picture. Average multiples in the domestic equity market are currently flattered by very low multiples for resource stocks and moderate multiples for banks. These are in turn supported by ongoing buoyancy in iron ore, coal, oil and lithium pricing in the case of resources, and solid net interest margins and virtually zero bad debt experience for banks. Industrial multiples remain elevated, and while a subset of industrial businesses are still enduring depressed conditions, many others are facing much tougher conditions. Characterising markets as reasonably valued based on averages is misleading. We would suggest markets are fairly fully priced when more sustainable earnings levels are incorporated. 

Source: Factset, Schroders. Past performance is not a reliable indicator of future performance and may not repeat. For illustrative purposes and not an investment recommendation.

Asset prices and overconfidence

A decade of artificially supported asset prices and government spending excess has induced significant behavioural change. Belief in the inability of house prices to ever fall significantly and guaranteed long-term gains from buying ‘good quality’ stocks is pervasive. The words of Herb Stein are lost on many. Investors focusing on the past decade have come to justify earnings multiples well above those which have prevailed over most of history for companies believed to have long-term growth. While the expectation that growing earnings would allow these stratospheric multiples to be retained and parcel duly passed to the next investor (allowing capital gains to take the place of dividends) has been shaken a little in the past couple of years, all evidence suggests the valuation gaps between the popular and unpopular remain extremely wide. Though behaviours which took many years to learn may take some time to unwind, we vastly prefer the odds in sensibly priced businesses.

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