Trump, patience, and the impact of rerating
When President Trump asked the Fed to rein in plans to push rates up, it listened. That has led us to ask many questions in terms of valuations, and if we needed to adjust our risk-free rate. We have done so, and over the coming weeks we will revisit all our holdings based on this revised number.
Mintech is the word. Mining and Technology were the twin pillars of strength in the Australian equity market through the first quarter, as unlikely as that may seem. The old world and the new; the nearest dated cashflow returns in the market on the one hand, and the longest dated on the other.
As bonds in Australia moved from 2.8% a little under six months ago through 1.8% at the end of the last quarter, following the global path, the equity market has followed suit. This global move followed the Book of (President) Trump. In mid-December, the financially savvy New York property developer turned President let his feelings be known to the Washington Post: “I’m doing deals, and I’m not being accommodated by the Fed. I’m not happy with the Fed. They’re making a mistake because I have a gut, and my gut tells me more sometimes than anybody’s brain can ever tell me”. Cue real policy missives from the POTUS account, through Twitter: “It is incredible that with a very strong dollar and virtually no inflation, the outside world blowing up around us, Paris is burning and China way down, the Fed is even considering another interest rate hike”. And then, a day later, “I hope the people over at the Fed will read today’s Wall Street Journal before they make yet another mistake. Also, don’t let the market become any more illiquid than it already is. Stop with the 50 Bs. Feel the market, don’t just go by meaningless numbers”. Fed Chairman Powell heard the President. On 4 January, he announced that the Fed was prepared to be “patient” with monetary policy. A few days later, in another speech, Powell used the word “patient” four times when describing the Fed’s approach. Message conveyed, message received; rates are not going up, liquidity is not being tightened. The total assets of the Fed, ECB and Bank of Japan more than tripled through the past decade, prompting the S&P 500 and many equity indices to quadruple from their lows. For the first time in a decade, and only because of the Fed, central bank assets reduced through 2018. That precipitated the fourth quarter fall in asset prices last year, in turn prompting President Trump’s tweets, and ultimately the Fed changing course, preferring to be “patient” than to compound the (very modest) liquidity withdrawal of 2018 into 2019. Equity markets have responded on cue, seeing asset prices surge through the first quarter.
That has raised several questions for us in terms of our valuations. Should our mid-cycle riskfree rate assumption change following this Fed policy change? Can a scenario be envisaged where rates are likely to increase globally through the next several years? Can Australian rate settings move upwards if downwards pressure continues to be exerted upon global bond yields? And, finally, should we assume revenue and profitability declines from prior levels for domestic earnings in the event that we reduce our assumption for long-run risk-free rates?
In turn, we have reduced our risk-free rate for the third time in the past decade, from 3% to 2%. In doing so, we deliberated whether to move it lower; spot, after all, was 1.8%. As this number continues to converge on zero, the sensitivity to each 50bps change compounds, and its effect across the market varies. For example, those with revenues derived mostly from foreign operations (for example, mining and energy producers) should have lower revenue sensitivity to this change than more domestically exposed entities (such as the banks and many retailers). Those with prices set outside of free market forces (such as many infrastructure and healthcare product companies) may also have less revenue sensitivity than domestic cyclicals.
This has already become apparent in market forecasts. Through the past decade, earnings growth for industrial companies listed on the ASX has been positive cumulatively but less than 5% every year. The February reporting season saw downgrades to the point where forecasts for FY19 earnings growth for industrial stocks is negative, albeit modestly so. The trend, however, suggests that as the risk-free rate in Australia declines, so too do earnings for many industrial companies, especially those domestically biased. In turn, this presages the ongoing pressures we see arising for many industrial companies, such that valuations should not simply increase by the amount of the increase in multiple arising from the reduction in the risk-free rate; earnings revisions may in some cases more than negate all of this apparent gain. Being lowly geared and a low-cost producer — or less commonly, having a sustainably superior service or product offering which bestows pricing power — is critically important for an industrial company in this environment.
The best performing sector in the first quarter, in Australia and globally, was IT. While the sector performance in the quarter was a similar experience, there are two big differences in looking at IT globally as opposed to locally. One difference is that in 2018, IT globally was a market performer, whereas in Australia it had a strong year. Secondly, free cashflow generation globally for IT companies is in the main very strong, and M&A levels relatively small, whereas in Australia it is the reverse, with goodwill a high percentage of total assets and free cashflows minimal. It is true that lower discount rates increase the relative value of longer dated cashflows, and hence longer dated growth may in turn attract a higher valuation as rates decline. The trickier issue is the more practical one of what will those cashflows actually be, and will the large amount of growth that is already priced in eventuate. As we have highlighted previously, given the paucity of current cashflows for many companies in this sector, in our view, the best way to align their current market pricing against global comparables is by reference to price-to-sales multiples, and on that basis the Australian stocks could easily halve from current levels, in which case they revert to something approaching where they were, in many cases, a little more than a year ago. Cumulatively, the market cap attaching to these companies is akin to that of Woolworths; a doubling or halving is a large impact upon relative market performance, as can be seen in the performance of many active managers (including us) against index through the past year and the first quarter.
Apart from IT, the miners were the other outstanding performer through the quarter. As our resources analyst, Justin Halliwell, is keen to point out, this is due to prices increasing through a restraint of supply, and notwithstanding demand being relatively muted. The supply restraint is a function of strategic convergence in (to use Rio Tinto’s parlance) value over volume; and tragedy, in the form of the failure of Vale’s tailings dam at Brumandinho in Brazil, which has seen the enforced closure of 15%–20% of Vale's output. In turn, iron ore prices have increased to their highest levels in five years, and at a margin per tonne level the major producers are at record levels of profitability. The portfolio continues to be overweight metal producers. While the investment case has by definition diminished as the market valuations have increased in line with spot earnings and cashflows, in a yield-hungry world this sector is currently producing more cashflow to support that yield relative to its market cap than any other on the ASX.
Risks can come from different sources. The most obvious to equity investors is operating leverage – earnings downgrades are normally met with a greater fall in the equity price than the fall in earnings growth expectations (just as, in the longer run, upgrades typically are accompanied by a re-rating). Financial leverage hurt equity owners far more than operating leverage through the GFC years, but ever since easy monetary and credit conditions have rendered financial leverage impotent as a risk to equity holders. Predictably, the equity in more leveraged entities, both publicly and privately owned, has done better in such an environment. The January resumption of the monetary policy put – through the word “patient” – will likely see this endure, rather than be challenged, and has significant consequences for portfolio structure in an interest rate sensitive market such as Australia. We in turn have reduced our long-run bond rate assumption; can only look to be as vigilant as we can in assessing financial and operating leverage, while not blinding ourselves to the inevitable episodic opportunities that present themselves.
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