The Red Queen's Race
Alice looked round her in great surprise. ‘Why, I do believe we’ve been under this tree the whole time! Everything’s just as it was!’
‘Of course, it is,’ said the Queen, ‘what would you have it?’
‘Well, in our country,’ said Alice, still panting a little, ‘you’d generally get to somewhere else — if you ran very fast for a long time, as we’ve been doing.’
‘A slow sort of country!’ said the Queen. ‘Now, here, you see, it takes all the running you can do, to keep in the same place.
If you want to get somewhere else, you must run at least twice as fast as that!’
- An excerpt from Lewis Carroll’s Through the Looking Glass (a sequel to Alice’s Adventures in Wonderland)
It seems like economies have made a lot of progress in the last 6 months.
Unemployment has continued to trend downwards and leading indicators of economic growth (such as purchasing manager indices) have been encouraging.
In Australia, vaccination programs have successfully been rolled out across the major states, with life beginning to look a lot more like ‘normal’ than ‘COVID-normal’.
It may therefore be a surprise to some that the S&P/ASX 300 Index has returned a meagre 0.46% for the financial year to date. First Samuels Australian Equities sub-portfolio has performed considerably better over this period (clients are encouraged to watch next week’s monthly video for an update on performance).
If we were to ignore dividends, the index has fallen by 1.24%. *Returns to 11am wed
So, what is happening? There must be a mismatch between current conditions and concerns about future conditions. Markets always need to evaluate both at the same time.
We present some ideas on what is driving the mismatch today. Why are we running the Red Queen’s Race?
Rising Interest rates,
Evergrande and the China construction / property market outlook, and;
There may be others, but the net result is higher volatility and some notable changes “inside the stock market” (to quote Stan Druckenmiller). We would argue such changes inside the stock market may bode well for ‘stock pickers’ rather than index investors. So, a quick recap of the drivers.
Source: First Samuel, IRESS
1. Evergrande and the Chinese property market
A selloff was sparked in September as Evergrande, the second-largest property developer in China (by sales), indicated that it may not be able to meet its debt repayments.
The most immediate impact to the Australian market was linked to the price of iron ore. Our resources heavy index was dragged down – with the three horsemen of iron ore (BHP, RIO and FMG) falling off their saddle, returning -13%, -22% and -17% for the financial year to date.
There was also collateral damage as the market sold off more broadly. The lessons learned during this period have endured, with the outlook for the Chinese property sector, GDP growth and property linked commodities (especially iron ore) remaining an undercurrent that the market is wary of.
Source: First Samuel, IRESS
2. Not so ‘transient’ inflation and rising interest rates
In an uncharacteristic move this week, Jerome Powell, president of the US Federal Reserve, put the description of inflation as “transitory” to bed, for good.
We have suspected the use of the term in the first place was courageous at best.
The tacit admission that inflation is likely to be here for longer and that policy may need to react sooner has validated our view that was need for caution.
In addition, Powell suggested that the extraordinary monetary policy (QE) ramped up since COViD may now be curtailed, removing a key source of liquidity for speculative markets.
As we have mentioned previously (see Bond markets bubble away and Costs are rising. Who benefits (and who doesn’t)?) rising inflation and interest rates, and changes in liquidity will have a disparate impact on companies.
Some will benefit. Some will be harmed. Some will fall somewhere in-between. Risks rise in general, nevertheless. This provides a longer-term negative under-current for market prices.
On the surface, the waters may be calm and markets relatively flat.
But underneath the undercurrents can be strong as investors looked to allocate money towards beneficiaries and away from those that are harmed.
The latest ‘variant of concern’ sparked a reflexive -1.74% sell-off of the Australian market (XKO) last week – with March of 2020 very much fresh in investors’ minds.
Much like Evergrande in September, this began with indiscriminate selling.
However, one of the awe-inspiring aspects of markets is their ability to rapidly process and price a probability-weighted measure of risk. In English: a lot of risk is likely to already be in the price.
This saw selling consolidate to a more nuanced view risk-based selling of particularly vulnerable industries. Likewise, it quickly led to a premium being placed on sectors that are likely to be resilient or benefit.
‘Omicron discount ‘
- Flight Centre (-6.4%)
- Hello World (-3.2%)
- Corporate Travel (-5.5%)
- Woodside (-7.3%)
- Santos (-8.2%)
- Oil search (-9.0%)
- Vicinity Property (-7.7%)
- Unibail Rodamco Westfield (-6.7%)
- Scentre Group (-7.5%)
- Sonic Healthcare (pathology) (+3.9%)
- Resmed (+0.5%)
- Sigma (0.0%)
While many overnight and largely self-proclaimed subject matter experts have expressed an opinion over the past week, we have been more reserved in formulating a view on what the latest ‘variant of concern’ might mean for the global economy.
There simply isn’t enough evidence at this point.
However, it is relatively clear that Omicron is unlikely to send us back to square one or have the same impact it did in March of 2020. Furthermore, clients hold a limited exposure to sectors most at risk.
The upside to the downside (volatility)
The combination of these three undercurrents over the past six months has increased both current volatility and expectations of future volatility.
This is shown below by the S&P/ASX200 VIX – a gauge of market expectations of near-term volatility. The measure is effectively the cost of insuring your portfolio against movements in its value.
Source: First Samuel, IRESS
The chart suggests that investors expect higher volatility in the near term.
While periods of change and volatility are often bad for the market – they can be great for stock pickers. The market can get it wrong during periods of rapid change and when selling is indiscriminate. This provides an opportunity to add to positions at cheap prices as well as top up existing positions – taking advantage of clients’ current cash position.