This week: ASX v Wall Street
FYTD: ASX v Wall Street
Investors awoke on Wednesday morning to a sharp reversal in the price of US shares.
Overnight the NASDAQ had fallen by 5.2%, and the S&P 500 by 4.2%.
The Australian Market (XKO – S&P/ASX 300) went on to fall by 2.6%.
A desirable outcome? On the surface, no.
But the underlying driver of the move may prove to be good news, with respect to how our clients are positioned for the longer term.
The cause of the fall? The release of September’s consumer price index (CPI) print in the US.
Put simply, the release reinforced our conviction that inflation does not just simply “disappear” – with the more durable elements proving stickier than anticipated.
As our clients are aware, this is a possibility that their portfolios have been positioned for.
We explore how Tuesday’s CPI print reinforced clients’ longer-term positioning below.
For the past week, global markets have rallied.
Those in the “transient inflation” camp had hoped that September’s CPI print in the US would show a deceleration in inflation.
These investors were anticipating a soft print for two critical components of the CPI:
- Food and energy prices – a large component of “headline inflation”, which includes more “volatile” elements (although we would argue that food prices are far stickier than their categorisation would suggest).
- The price of services (largely reflective of wages) and rents – which are critical for the more enduring “core” assessment of inflation.
This did not occur and surprised the market.
The most direct reflection of this was a spike in the interest yield on five US government bonds, which rose by 20 basis points or 5.91%. Bonds began to impute that inflation may be more enduring than previously thought.
We were less surprised than the broader market. However, what did surprise us was that markets continue to underestimate the potential for inflation, given recent history.
Five stages of belief
Indeed, higher inflation for longer represents a paradigm shift that many are slow to accept. Higher inflation, to us, is a move away from the 1.5 – 3% range we have seen over the past two decades to more moderate levels of 3.5 – 4.5%.
This acceptance has been far from linear, having progressed in fits and starts.
Yet overall, we have seen a huge evolution of the underlying narrative and belief around inflation that we see has followed several “stages”.
These stages include the belief that (in chronological order):
- We will never see inflation again
- Inflation is transitory
- Inflation isn’t transitory but higher interest rates and supply chain blockages will pass and inflation will fall
- Inflation is sticky and will last longer – the only solution to inflation may be a recession
- Inflation is endemic
In our view, the market is currently at the 4th stage, on the way to the 5th.
Why is this important? Firstly, the prices of financial assets are fundamentally underpinned by expectations around inflation.
And secondly, it is the broader expectations about inflation that form a part of the enduring elements of inflation.
What Wednesday showed
In “Stage-Five”, we see that security selection (and its corollary active management) becomes ever more important in preserving investors’ purchasing power.
Wednesday was an example of the divergence in the performance between individual securities that may occur in this new paradigm.
“Expensive” technology exposures in the NASDAQ (and increasingly generally expensive companies in the US such as Apple that make up a huge part of the index) needed to reverse some of their gains, and fell substantially.
Why? As we saw on Wednesday, higher inflation generally results in higher interest rates. This broadly does not help the valuation of technology stocks or stocks that make limited cash.
But what about the Australian market? As the chart below shows, the performance of the NASDAQ has decoupled from the Australian market over the past three years.
Hence the response we saw in the Australian market was much more subdued (-2.6% vs -5.2%).
However, the parts of the Australian market that were impacted were expensive, high price-to-earnings (P/E) stocks that are priced based on expected cash flows far into the future.
In an environment of higher inflation, we expect these kinds of companies to continue to underperform.
This is shown in the chart below.
The chart plots the average P/E ratio of the most expensive 20% of stocks in the ASX200 based on their P/E ratio (the orange line), the average P/E ratio of the least expensive 20% of stocks (the blue line) and the gap between them (the green line).
As we can see, the most expensive stocks continue to be far more expensive than they have historically – with the orange line remaining elevated relative to its historical average.
We suspect they have further to fall to reach historical averages.
Our clients own very few of these stocks.
Mind the Gap: the divergence between high and low P/E stocks is yet to close
Likewise, we see “Stage Five” as being favourable for income securities linked to short-term rates, and inflation-linked bonds. These instruments have higher coupons as inflation and short-term interest rates rise.
In general, fixed-rate instruments continue to be a relatively riskier proposition, although we are seeing pockets of value emerging on a risk-adjusted basis.
Stage five: the playbook
So far, rapidly rising interest rates in the US have been tracked in Australia by our Reserve Bank (through lifts in the cash rate).
However long-term bond rates and our currency would suggest that the market doesn’t believe interest rates in Australia can rise as high as in the US.
Nor does it believe that inflation will be as high here as it is in the US.
We are now set on the path to test the mettle of Aussie households, house prices and our banks.
The Fed and the RBA need to raise to the point of pain – but where is it for the economy, and more importantly, Australian households?
Amidst this uncertainty, we have chosen to invest only a small proportion of client funds into sectors we see that are at risk. This includes banks (these are held at a weight of 17% in the ASX300, while they are less than 7% in clients’ portfolios) and companies with exposure to discretionary consumer spending.
As to the broader outlook for shares and equities? We see that higher wages and prices are great for most equities in general over the medium term.
Our clients’ own companies we see will benefit from higher prices (if they can execute on costs and contracts). These are companies with existing assets, licenses, and networks of customers.
We see strong outperformance if these companies can leverage the assets they have created over many years, assets that are becoming more expensive to replicate in an inflationary environment.
The remainder of the portfolio consists of future battery materials assets, which are driven by long-term structural forces (decarbonisation, “friend shoring” and energy sovereignty), gold and undervalued fund managers that provide underlying market exposure to many companies similar to those in our portfolio.
Australian Equities Sub-Portfolio
Ramsay Health Care (negative impact) provided an update on its discussions with private equity suitor KRR.
Ramsay’s board was seeking an upwards revision to the Alternative proposal posed by the consortium led by KKR, which would have seen Ramsay shareholders receive a mix of cash and shares in Ramsay’s French operations, Generale De Sante.
Reports are that the consortium was not willing to revise its offer, which has now been withdrawn.
We have been selling clients’ holdings in Ramsay progressively during the period in which the deal was in limbo to de-risk the position. And so, while the fall in its share price this week was large, the overall profitability of the position was less impacted.
The position, exited in full this week, has returned approximately 11.2% in a period of less than 9 months, relative to a market that fell by 4.8%.
Reliance Worldwide (positive impact) has provided a trading update for FY-23.
The market had previously been concerned about a slowdown in sales, with Reliance flagging that July trading was relatively flat year on year.
However, the company articulated that this was largely due to inventory de-stocking and manufacturers slowing down production after period of inventory build.
Yesterday’s update should allay some of these fears, with sales in August up significantly, including 19% year on year in the Americas, 11% in Asia Pacific and 8% in EMEA.
Patties Foods (positive impact), the business held as HOLDCO in portfolios is rumoured to have been sold.
An article in the Australian Financial Review has speculated that Australasian Foods Holdco (the vehicle that owns Patties) has been sold, alongside Vesco (Lean Cuisine) for a consideration of $550m.
We expect that we will be provided with further detail over the coming weeks, however, we are pleased with the crystallisation of a long-standing position at what appears to be a reasonable price.
Further detail about the sale will be provided to clients over the coming weeks.
Flare HR, an underlying holding of the Acorn Capital Expansion fund (positive impact) has been sold to accounting software provider MYOB.
It is rumoured that the company, which constitutes approximately 10% of the fund’s underlying holding, has been sold for a considerable uplift.
We expect to receive further detail over the coming months as the proceeds are distributed, but we expect it will represent a meaningful return for the fund and unitholders.