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FOUR major issues are influencing markets at the moment:
Rising rates and the withdrawal of liquidity
The disruptive effect of the Omicron wave
The potential for conflict between Russia and Ukraine
Chinese policy easing
Of these, only the fourth is positive. As a result we have seen equities weaken in the year to date.
At this point the outlook for rates and inflation is the most important issue.
As the broad equity market has fallen, the growth stocks have underperformed. In the US, the S&P 500 fell 5.7% last week while the NASDAQ was down 7.6%.
The Australian market also fell, but less so given a skew to banks and resources over growth sectors. The S&P/ASX 300 fell 2.9%.
The S&P 500 and NASDAQ broke down through their 200-day moving averages for the first time in the post-March 2020 bull market.
This does not mean the market's run is over. But it is the first meaningful correction, coinciding with a shift in monetary policy and highlighting the importance that liquidity has played in the Covid era.
It is a well-understood principle that if rates, oil and the US dollar are all rising, equities are likely to drop. Oil and the US dollar index have been rising for a few months. The move higher in rates has been the final piece.
The Fed's meeting this week will be an important near-term signal. The market has adopted a very hawkish view on policy in the past three weeks. Some see potential for Quantitative Easing (QA) to end immediately; the risk of an immediate rate hike; or signs that an expected hike in March could be 50bps rather than 25bps.
We think that those moves are unlikely. The Fed may seek to assuage the more hawkish concerns, which could actually see a relief rally.
Despite a sharp sell-down in markets and the possibility of soothing words from the Fed, the underlying challenge of inflation remains.
As a result we do not see this as a time to be re-loading on some of the sold-down names.
Rates outlook
The drop in the overall market and the correction in growth has been caused by two factors: the market moving to price in rates rising to around 2% by end of next year and the realisation that liquidity will start drying up.
The market is considering four broad scenarios:
The bull case: 2% rates do the job, inflation eases, economic growth slows but remains solid, earnings continue to grow and the market valuation rating holds
Central banks over-tighten like we saw in 2018 as the pandemic makes gauging the economy hard. The economy and earnings roll over in response and the market sells off.
Rates continue to rise – possibly above 2% – but this does not derail the economy. This is a traditional scenario similar to the mid-to-late 1990s. Earnings continue to grow, supporting markets and offsetting an equity de-rating
The bear case: inflation proves persistent. Central banks have to engineer a hard landing to re-anchor expectations. This would hit earnings hard and see markets sell off
The key point is that we are looking at a very disparate outcomes, creating more uncertainty for markets
Inflation outlook
The key underlying question is what will limit and bring down inflation.
This could be a combination of:
Higher prices choking off demand and slowing the economy, ie inflation curing itself
Debt and high leverage meaning the economy is sensitive to small rate changes and modest hikes working to bring down demand
Demographics and aging populations suppressing demand and credit growth
Technological disruption continuing to act as a deflationary force
On the flip side, arguments for persistent inflation include:
Excess stimulus continuing to support demand
Structural decline in labour market supply underpinning wage growth
Transition to clean energy leading to higher fuel costs and investment spending
China shifting away from export model to dual circulation
The policy imperative as governments suppress real rates to manage debt
We don't know the outcome. But it is clear that inflation presents more an issue today than at any time in the past couple of decades.
Liquidity a significant issue
The withdrawal of liquidity is potentially as significant an issue for equities as the debate around rates.
The shift in the liquidity environment is likely to make this a tougher year for equities. In our view, persistent growth in equities since March 2020 with no material correction is due to the surplus liquidity evident in money supply data.
QA is unwinding faster than expected. US money supply growth has slowed from just shy of 30% per annum at its peak to just above 10% now. This means less surplus liquidity to be funneled into financial assets.
Early warnings signals have been evident for some time in the more speculative parts of the market.
Some, such as the ARK Innovation ETF and Chinese tech indices peaked a year ago and are off about 60% since then. Others such as crypto and the solar and IPO ETFs tracked sideways through to October/November and are off 30-50% since then. Tesla and the broader Electric Vehicle and battery sector have proven more resilient, but are showing signs of rolling over.
The overall market has held up better – particularly the growth indices – due to the performance of the mega-caps. But this appeared to be changing last week, as they also started to underperform.
The US earnings season is expected to be decent and could help offset recent weakness. But there have been some disappointments in early results, notably Netflix. There is also risk that the market focuses on near-term uncertainty from Omicron's disruption.
Credit spreads have not budged. This, along with resilient commodity prices, suggests the market is not yet at the point where it believes policy will derail the cycle.
That said, there is a view that we will need to see credit spreads widen to help tighten financial conditions sufficiently to restrain inflation. In this context, low spreads may not be as unambiguously positive as is usually the case.
It is important to note that the Australian market is more defensive and better protected in this environment due to the index mix. It is also less extended on valuation.
Covid and economic disruption
The good news is that global cases may be peaking.
New daily case data is increasingly convoluted and hard to measure. US waste water analysis suggests this wave was five times the size of the previous one, but is now rolling over.
It is becoming clear that Omicron is less severe than previous strains, though there is no consensus on why.
Regardless, health systems are coping, albeit under a lot of strain. In NSW the proportion of hospitalised patients needing to go into ICU is less than half the previous wave.
Omicron's sheer transmissibility is still creating a lot of disruption. Some companies have seen more than 30% of their workforce unable to work, leading to businesses effectively shutting down. This is a risk to supply chains, particularly if the strain becomes established in China.
Real-time surveys in the US highlight how consumers have become more cautious. Anecdotally this is also true in Australia, which could have a bearing on company outlooks in the upcoming earnings season.
All that said, the market has tended to look through near-term numbers and we suspect this will continue.
There are signs we are entering the phase of learning to live with Covid. This should help some of the oversold re-opening stocks.
Russia/Ukraine threat
The odds of a Russian invasion of Ukraine have risen considerably in recent weeks. This adds to market uncertainty and is a risk for energy markets and gas supply. This is an issue to keep watching.
About Crispin Murray and Pendal Focus Australian Share Fund
Crispin Murray is Pendal’s Head of Equities. He has more than 27 years of investment experience and leads one of the largest equities teams in Australia. Crispin’s Pendal Focus Australian Share Fund has beaten the benchmark in 12 years of its 16-year history (after fees), across a range of market conditions.
Pendal is an independent, global investment management business focused on delivering superior investment returns for our clients through active management.
Pendal’s head of equities Crispin Murray today challenged BHP’s proposal to collapse its dual-listed company (DLC) structure.
“As BHP Ltd (Australia) shareholders, we are not in favour of BHP’s proposal for the collapse of its DLC structure,” Mr Murray said.
On December 8, BHP announced a final board decision to end the DLC structure and unify its corporate structure under the existing Australian parent company, BHP Group Limited.
BHP Group Limited and BHP Group Plc shareholder meetings are expected to take place on January 20 with unification due to be complete by January 31.
“This proposal is transferring value from Australian Limited shareholders to offshore PLC shareholders. This value transfer has been evidenced by the material decline in the Australian multiple of earnings that BHP Ltd trades on,” said Mr Murray, who leads one of the Australia’s biggest Australian equities teams for independent asset manager Pendal Group.
“We appreciate that the main reason for the proposal is the greater flexibility it provides to do large M&A deals in the future. However, there are two questions we have around this. Firstly, BHP has had a poor track record in this regard historically. There is a risk that Australian shareholders pay the price for the unified corporate structure and then see more value destruction overtime. Secondly, while a unified corporate structure will make doing scrip-based M&A easier, the decline in multiple potentially negates this.”
Pendal expects that should the proposal not go through the long-term premium of the Australian listed company to PLC would return.
Below, Mr Murray outlines Pendal’s main issues with the proposal:
What has been the value destruction borne by Australian shareholders to date?
The BHP Ltd share price fell 14% in the two days (17th-18th August 2021) following the announcement of the DLC collapse.
The premium of BHP Ltd’s (ASX) share price to BHP PLC’s (LSE) share price — which had existed almost since the inception of the DLC — fell from more than 20% to around 5% after the announcement.
Even with the more recent recovery in resources, the stock has underperformed the market by about 15%, in line with the reduction in the Ltd premium to PLC.
This premium is likely to erode further if the vote goes through.
In our view, this represents a substantial, permanent and unnecessary value transfer from Australian to PLC shareholders.
BHP management expected the UK share price to re-rate to a multiple in line with the Australian listing.
In fact, the opposite has occurred.
The charts below show the absolute PE of BHP Ltd vs the ASX200 is at a 10-year low, despite the overall rise in market rating.
Relative to industrials, the stock is almost half the rating it was 10 years ago.
If a key motivation is to enable scrip-based M&A, the reduction in multiple makes any potential acquisition less appealing.
Source: Bloomberg as at 7 January 2021.
Has the dual listed structure impacted BHP’s ability to do M&A?
In our view, none of the reasons BHP is proposing as rationale for the collapse of the DLC structure would stand in the way of BHP executing its strategy.
The DLC structure was consciously put in place by BHP, at its discretion, at the time of the Billiton merger. It has now been in place for 20 years and through this time BHP has had no issue implementing its strategy or accessing capital.
BHP has a strong balance sheet and access to debt and equity capital markets across multiple geographies and listings.
In the preamble to the US Onshore petroleum stake in 2017 — and under activist shareholder pressure — BHP vigorously defended the DLC structure and concluded it was too expensive to unwind.
Most of the costs associated with the DLC collapse have increased in the interim and are expected to be $350mln to $450mln.
But M&A is not always a good thing…
We respect the BHP Board and management. However, we do note how difficult it is to execute effective, large-scale deals in the resources sector.
To highlight this, there are a number of examples of unsuccessful transactions under former BHP management. These include:
The merger with Billiton. After 15 years, BHP chose to demerge most of the Billiton assets into South 32 (S32), since they did not meet BHP’s standards of being low cost and long life. The demerger resulted in de-rating of the S32 earnings of about 33%, which persists today.
The 2011 acquisition of PetroHawk and Fayetteville for U$15.1bn and US$4.8bn respectively. An additional US$18.9bn was spent on the assets during ownership. Ultimately these assets were sold for US$10.8bn in FY18 after an attributable EBIT loss of US$5bn during ownership.
The 2005 acquisition of WMC Resources. This includes Olympic Dam and Nickel West. Neither asset has fulfilled the original expectation of returns.
There was also the failed attempted acquisition of Potash of Saskatchewan (Canada) in 2011 at a price that subsequently fell away materially.
BHP has had cumulative write-downs of $22.9bn since 2001. Much of this relates to assets bought at too high a price.
M&A in the resource sector is difficult. The likelihood is that value accrues to the acquired company’s shareholders.
That Australian shareholders wear the current value destruction from the collapse of the DLC just to simplify M&A in the future is challenging to accept.
Isn’t this really about the de-merger of the petroleum business?
In our view, reassessment of the DLC structure is tied to the decision to de-merge the petroleum business.
While BHP has stated it would go ahead with the demerger even if the DLC was not collapsed, the company has highlighted that it would make the process simpler.
We believe these two strategic decisions need to be evaluated separately.
And, again, we are not sure it is in the interests of Australian shareholders to accept the value destruction of the DLC collapse for a simpler demerger that may or may not go ahead.
Are there broader implications for the market?
The consolidation of BHP on the ASX will see its ASX 200 index weight rising from about 5.8% to about 9.6%.
While this is not the concern of BHP management, taking a macro view highlights that such a concentration of index weighting is not ideal for Australian broad market investors. It reduces diversification and impacts expected risk-adjusted returns.
It certainly will, however, lead to an increase in ‘non-discretionary holdings’ from index funds and those managing benchmark risk. This could reduce active shareholder pressure on management. We would strongly argue that this is not in the long-term interest of BHP shareholders.
Conclusion
We appreciate the company’s motivation for seeking to collapse the DLC structure in terms of simplifying management of the organisation.
BHP PLC shareholders will also benefit from this one-off gain, though many of those with current PLC stock may not ultimately be long-term holders. This is why there is very little push-back on the proposal.
But in our view, as detailed above, this proposal is clearly not in the interests of Australian BHP Ltd shareholders.
Given the clear value destruction and the questionable benefits accruing from the change, Pendal will be voting shares under its management against the proposal.
What are the 2021 lessons that will help guide Aussie equities investors in 2022? Pendal's head of equities CRISPIN MURRAY explains in this fast podcast
"I think the more speculative end of the market could be challenged this year (2022), if we don't see inflation falling away quickly.
"That leaves you focusing your portfolio again on these stocks that we think are more predictable in terms of their earnings. They have a business model that can generate free cash flow, are able to return a lot of capital to shareholders.
"That is the area we think is good protection in this probably more uncertain policy environment.
"Telstra is a good example of this. This is a telecom industry where there has been historically quite low returns in Australia, but you're now getting a much more disciplined market structure.
"No one's been making enough money. There's quite a lot of debt in some of the other companies.
"And so you're seeing more discipline, better pricing, higher returns. That's translating into much higher cash flow and it's a company that's able to return a lot of that to shareholders."
Listen to the podcast for more examples
About Crispin Murray and Pendal Focus Australian Share Fund
Crispin Murray is Pendal’s Head of Equities. He has more than 27 years of investment experience and leads one of the largest equities teams in Australia. Crispin’s Pendal Focus Australian Share Fund has beaten the benchmark in 12 years of its 16-year history (after fees), across a range of market conditions.
Pendal is an independent, global investment management business focused on delivering superior investment returns for our clients through active management.
"Cyclicals are called cyclical for a reason. Think about that folks. The clue is actually in their title.
"So I think at the margin, you should be selling some cyclicals because we've had the first COVID rebound. Now we're looking at a slowdown -- and usually that's what happens. Cyclicals tend to perform not so well and the mid-cycle stocks tend to perform much better as clearly we're in the mid cycle now.
"That tends to be areas like healthcare. Healthcare used to be quite expensive, but used to have disappointing earnings growth.
"But looking ahead, I think healthcare joins tech as being the best two sectors.
"So you want some more the same in your portfolio – which is tech.
"In our process [tech] still has what we call 'two green lights'. It's a green light for the best fundamentals in the world. It's a green light for the best trend in the world.
"And healthcare looks like it's moving that way to becoming two green lights for next year.
"So at the margin, sell some cyclicals and buy some healthcare stocks to add to your existing tech winners."
About Chris Lees and Nudgem Richyal
Chris Lees co-manages Pendal Global Select Fund with Nudgem Richyal. The pair have been working together in global equities investing for more than 20 years.
Chris has more than 32 years of investment industry experience. He joined Pendal Group's UK-based asset manager J O Hambro Capital Management (JOHCM) in 2008 after spending 19 years at Baring Asset Management, ultimately as head of its global sector team.
Pendal Global Select Fund is a global equities portfolio with a distinctive, yet proven approach and a 17-year track record of outperformance. Since its inception, the underlying strategy (JOHCM Global Select Fund) has delivered top-decile performance in Lipper and 2nd decile in Morningstar.*
This is the final weekly note from Pendal’s Australian equities team for 2022. We wish our clients and readers a well-deserved rest after a very busy year.Our weekly note will return early in the new year.
COVID and inflation have been the two big issues to watch all year. Both have taken significant turns in recent weeks, leaving the outlook for 2022 as uncertain as ever.
This does not mean that the outlook is necessarily negative.
Rather, the potential paths we head down next year look very different:
On Covid: We could be in the early phases of the largest wave. This could put substantial strain on healthcare systems, prompting renewed restrictions which could drag on the economy and escalate supply chain problems.
Alternatively we may discover the effects of the vaccines, anti-virals and potential lower virulence of Omicron mean the virus becomes more benign — to be handled without restrictions.
On inflation and rates: We could see economic strength and a tight labour market sustain inflationary pressures. This could prompt both the Fed and markets to realise that higher real rates are needed, prompting a sell-off in equities and growth stocks in particular.
Alternatively, we may see inflationary pressures ease as supply chains resolve themselves, people re-enter the labour force and structural factors such as tech and debt re-assert. In this scenario growth and earnings are good and we see bonds and equities rallying, with growth resuming leadership.
Now is not the time for betting the house on one of these directions.
We should have a far better understanding of the Omicron issue within three weeks, while the rates issue will take much of next year to play out.
Our portfolios are low on thematic risk. Instead we are looking for features such as good cash flow, strong stock-specific stories and good franchise strength.
We are maintaining a tilt to re-opening plays given the poor sentiment right now. But we are mindful of the near-term path, given the potential for more negative short-term news flow.
Markets were down last week. The S&P/ASX 300 fell 0.7% and the S&P 500 lost 1.9%.
Concerns about central bank policy and the degree to which rates need to rise to contain inflation weighed. So too did uncertainty over Covid due to contradictory research on Omicron risks and increasing government restrictions heading into Christmas.
Covid and vaccines outlook
Surging case numbers in a number of countries — notably the UK and Denmark — are fanning concerns about healthcare systems coming under strain.
The interplay between Delta and Omicron waves is complicating an assessment of the situation and government reactions. For example The Netherlands has reimposed lockdowns despite material falls in new cases, fearing that an Omicron wave will see new cases hurtle higher again.
The risk of Omicron breakthrough infections — ie vaccinated people catching the virus — is 5.4x higher than it was for Delta, according to research from the Imperial College in London.
The key question concerns the disconnection between cases and hospitalisations.
South African data is hard to interpret because it is subject to large backward revisions. For example, the number of people in hospital with Omicron was revised up 61%. Many of these patients are in hospital for other reasons and have incidentally tested positive. This is leading some to conclude that there have been far more asymptomatic cases than first thought.
The number of new daily cases in Gauteng Province — home to more than a quarter of South Africa’s population — is falling.
This has happened within a month of the wave’s start — rather than the usual two to three months in previous waves.
There are a number of theories to explain this:
Case numbers are being significantly understated due to a higher proportion of asymptomatic cases
Changes in social behaviour — people self-isolating more quickly — may have a containing effect
Better medical treatment
A portion of the community is not susceptible to the variant
A significant portion of the population is transient and has left the province as we approach Christmas
Each of these explanations have quite different interpretations.
The other issue is a disconnection with hospitalisations. Does this reflect lower severity or is it a function of the younger demographics in Gauteng?
A study from Imperial College — not yet peer-reviewed — claims there is no reason mutations in Omicron should lead to less severity. If there are lower case numbers it is because of vaccinations, the study says.
Nevertheless, the proportion of people needing critical care — as well as the length of hospitalisations — are materially lower than the last wave. This suggests there is some factor helping reduce severity.
Covid in the UK and US
The UK will provide an acid test. It is too early to draw conclusions on hospitalisation rates. But we are seeing a high incidence of positive tests among British patients hospitalised for other reasons. This suggests a high rate of asymptomatic cases.
The UK will provide the lead for US, which will be the key driver of market sentiment.
US cases overall are still not rising quickly. They are up 3% week-on-week. But this was held down by declining numbers in the Midwest. Lead indicators suggest a material acceleration with the New York testing positivity rate doubling in three days.
The most effective response to Omicron is the third jab. This reloads the number of immune antibodies, materially reducing risk of breakthrough infection.
The case growth has triggered an acceleration of boosters in most affected countries, though capacity to administer shots at this time of year is constrained.
The key issue for markets is the policy response to this wave of cases.
The near-term risk is that markets fear the worst and governments feel the need to act, reimposing restrictions. We are already seeing this come through with US Q4 GDP forecasts moderating to 6%, down from 7-8%.
This could see a sentiment-driven sell-off in markets. But it is important to note the strength of nominal GDP growth, which means earnings should remain firm.
Economics and policy
The Fed came in at the hawkish end of the expected range, doubling the rate of Quantitative Easing tapering. QE should now end in March. The Fed’s “dot points” now indicate three hikes in 2022.
The market was initially positive because there was no escalation of inflation concerns. It is worth noting that the expected terminal value of rates did not budge, remaining at 2.1% by the end of 2024.
There are two disconnections worth noting.
First, the market does not currently believe the Fed will need to raise rates in 2023. It sees rates peaking around 1.5%, reflecting confidence in inflation fixing itself.
Second, the Fed and the market both believe inflation can be fixed without real rates ever going positive.
There is a school of thought that believes this is not credible because of key differences between this cycle and previous examples:
Household balance sheets are far stronger
Fiscal stimulus is far greater
The degree of QE has been much higher
Changes to the labour market and supply chains
The impact of greenflation
Real rates have been far lower for longer
There are small signs that the Fed’s pivot is already prompting inflation expectations to moderate and that we may have passed through peak fear on this front.
There are also signals that people are returning to the labour market in the US, with the participation rate edging up.
Outside the US, the Bank of England raised rates from 0.1% to 0.25%, surprising a market that expected them to hold steady given the risk from Covid. This was seen as a negative, suggesting the BOE sees inflation as a key risk.
The ECB was more balanced, announcing the end of its pandemic program of QE but putting in place a transition program. This is designed to prevent fears that early rate rises put peripheral bond markets under pressure. Inflation is less of an issue in the EU currently, which gives them more latitude.
US fiscal policy took a twist today with Senator Joe Manchin announcing he will not support the current Build Back Better package in its current form.
This likely means the current model, which was to put in programs for one, three and five year periods to reduce their apparent cost, is dead.
Rather Biden will need to reduce the programs he wants to commit to and ensure they are fully funded. This still looks likely, given Manchin’s relationship with Biden. But it will take time and will be a set-back for renewable energy-related stocks.
Markets
Overall we believe the market environment is still reasonably constructive.
Growth is strong, companies have pricing power, rates remain very low and sentiment is not over-confident.
In the near term the Covid case spike could hold the market back. The early read on Omicron suggests any further sell-off would be an opportunity for bombed-out cyclicals.
The medium term issue is that the market seems to be underestimating the policy response required to contain inflation.
In this environment a focus on higher-returning, good-quality franchise positions is an important part of the portfolio.
It is also worth noting the continued rebound in iron ore.
This is partly driven by inventory re-stocking, but also reflects improved sentiment on China. Beijing continues to signal a more pro-growth policy shift, albeit with no major stimulus yet announced.
About Crispin Murray and Pendal Focus Australian Share Fund
Crispin Murray is Pendal’s Head of Equities. He has more than 27 years of investment experience and leads one of the largest equities teams in Australia. Crispin’s Pendal Focus Australian Share Fund has beaten the benchmark in 12 years of its 16-year history (after fees), across a range of market conditions.
Pendal is an independent, global investment management business focused on delivering superior investment returns for our clients through active management.
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