Christmas comes early for investors, despite fragile valuations
Financial markets look set to enjoy a merry holiday season, as hard and soft commodity prices surge. Housing markets are also powering ahead, fuelled by undersupply and low interest rates, albeit with some signs of deteriorating credit quality. Yet amid the celebrations, highly optimistic valuations continue to give us pause, especially given the renewed focus on short-term cashflows over longer dated promises.
Ho, ho, ho. Surging volumes and prices across a wide spectrum – financial assets of all hues, but also hard assets such as housing and construction linked materials, in both Australia and the US, soft commodities (notably beef most recently), and hard commodities (notably iron ore most recently) - are bearing gifts for investors this yuletide. The Australian equity market hence produced its best month in over thirty years in November, with all sectors bar Consumer Staples producing a positive return and the laggards through the past year, notably Energy (28%) and Banks (15%), having outstanding months.
The oil price started the month in the mid thirty dollar range and ended it 30% higher. The energy stocks obligingly followed, in accord with Equinor’s sage adage, the best cure for low prices is low prices. Apart from the obvious impact on demand arising from low prices, weakness in the oil price through the past year has seen the Baker Hughes rig count (rigs drilling for oil in the US), which peaked at 1,609 in 2014, drop 80% through the next two years, and hence toggle until bottoming at 172 in August this year, the lowest point in 30 years. Small changes in demand and supply can have big impacts upon prices; a lesson we have seen across the commodity complex time and again in recent years. Coupled with the Australian energy names having strategy days during the month where both Santos and Origin disclosed material planned reductions in unit costs, equity prices for the energy sector rebounded aggressively through the month.
Other hard commodity prices are also surging, such as iron ore. And little wonder; Chinese steel mills now have full order books from white goods makers until May, and China International Marine Containers noted full order books until about the same time. US HRC steel prices have almost doubled from their August 2020 prices of US$500 per tonne, and Turkish scrap prices are up 50%. Chinese port inventories of iron ore at 3 weeks of production cover are at their lowest levels for 20 years and 30% below average levels. It all suggests that whilst iron ore is trading well above our long run price assumption of circa $65 per tonne, the demand-supply balance is still tight, and that the Penfolds treatment is unlikely to be tried on Fortescue anytime soon. Whilst having long standing overweight positions in the major miners, we have not owned Fortescue which as the (initially) geared pure play on the iron ore price has been the standout equity market performer in reaction to “red gold” moving from $30 per tonne to above $140 per tonne through the past five years. Fortescue is the best performer in the ASX50 through the past twelve months, reflecting sustained operational excellence as well as this leverage to high prices. BHP and RIO have also shown more operating and capital cost discipline than many would have thought possible in the dark days of low commodity prices and hence profitability five years ago, and together with the energy companies their through the cycle operating performance stands as far superior to that evinced by many industrial companies through the past twelve months when confronted with a demand shock.
Housing markets power ahead
No demand shock in housing, in either the US or Australia. Hardies has been the best performing large industrial stock on the ASX through the past year, driven by strength in US housing and improved US sales and hence margins. And sales should be strong; the CEO of major US homebuilder Toll Brothers highlighted that “… We are currently experiencing the strongest housing market I have seen in my 30 years at Toll Brothers and we continue to increase prices … The strong demand for us began in mid May and continued through today. We attribute the strength in demand to a number of factors, including historically low interest rates, an undersupply of new and resale homes, and a renewed appreciation for the home as a sanctuary …”. In their US operations, Hardies is clearly making hay while the sun is shining; and yet, whilst at least most of those same factors could be attributed to their European operations, they continue to struggle even with increased focus from the CEO increasingly through the year. US housing continues to strengthen but at levels well below prior peaks, with current starts of circa 1.35m well below the prior peak in excess of 2m.
Australian housing, though, is again benefiting from the same factors described by Toll Brothers, with detached housing approvals now at their highest levels in 20 years. And fuelled by those stretched the most; growth in lending to those where debt to income is greater than 6 times and where loan to valuation ratios are greater than 95% are up more than 30% from a year ago. New Zealand is the same, with housing consents now running at their strongest levels in 50 years. Whilst Hardies is making record profits, Boral and Fletcher Building continue to underperform what should be able to be achieved in such buoyant local markets. Whilst in both cases operational performance and share market performance have improved in recent months from the multi-year lows in share prices seen earlier this year, the bridge from turnaround to performance remains a work in progress, and AGM voting in both cases suggests investor patience is wearing thin.
Not just activity is strong. Housing prices are also surging, and in Australia, the Government now wants to add fuel to the fire by repealing responsible lending laws. Merry Christmas, Justice Hayne, and thanks for your efforts. The RBA claimed credit for housing prices: as the RBA Governor helpfully pointed out recently “… the trend is towards higher prices at the moment and that shouldn’t surprise us; lower interest rates do mean higher asset prices. That’s part of the transmission mechanism …”. Inequality fueled by asset prices escalating at rates well above wages for an extended period of time, but increasingly so and especially through the past two years, will have a social cost. It is harder to calculate than a carbon charge, but just as philosophically critical from an ESG perspective. We have highlighted previously how and why we apply an ESG charge to financiers for this very reason, just as we do for carbon emitters and others where obvious SG issues arise. Crown is an obvious case. For anyone to feign surprise at either an obsequious Board or the fact that money laundering may occur through a casino, in the case of Crown, betrays either commercial naivete or disingenuity. Equally, and also within the gaming sector, we do not own Aristocrat but it has been unarguable since at least the 2010 Productivity Commission report that poker machines exert at least as large a toll upon society as they provide in taxes, and it is important that this cost be properly provided for in company valuations. Just as with carbon emissions, and with imprudent lending standards, our job is to identify and price the ESG risk as best we can, not to avoid them at all costs or simply constrain our analysis and pricing of ESG risks to carbon emissions, as critical as that is.
Focus turns to cashflows
November was a month not just marked by high returns, but also by a change in market leadership, with current cashflows seemingly more important than long dated promises. The trends are the same locally and globally, but the S&P500 experience is instructive. Its year to date total return of 14% has been struck on declining earnings (going backwards by 6%); whereas in the last quarter, a 4% total return reflected a derating of the market after earnings grew by 7%. The year to date rerating which drove the market return was mostly driven by returns from Technology, Consumer Discretionary, Commercial Services and Materials names; with Energy, reflecting a poor oil price, being the outstanding laggard. In the last quarter, however, as the roles of earnings and multiple revision have completely reversed as drivers of market performance, as we noted above sectors such as Energy and Banks have driven the Australian market higher.
What can we expect in 2021? Well, it’s fair to say we didn’t show much capacity to forecast the future in 2020. Whilst we can excuse a failure to foresee a pandemic, and the consequent economic wrecking and resulting stimulus, the strong reaction to the stimulus has surprised us. Perhaps it shouldn’t have. As John Authers has noted, global liquidity jumped by US$20 trillion in 2020, 25% of global GDP. To what end? It took a decade for activity to recover prior levels in the 1930’s Depression, and two years after the GFC. It has taken six months to recover from the Covid-19 economic shock; so far. As can be readily gleamed from performance differentials through the prior month and earlier, our portfolio remains positioned for a continued transition from longer dated (hoped for) cashflows to shorter dated ones; from (very) high multiples to lower multiples. Whilst simplistic mean reversion is highly unlikely, it remains the case that the multiples attaching to the highest rated stocks on the ASX are optimistic, and are hence fragile should growth not be delivered, absolutely and relative to the rest of the market, as November has highlighted.
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