Crispin Murray: what’s driving Australian equities this week

Pendal's Head of Equities, Crispin Murray

Here’s what’s driving Australian equities this week according to Pendal’s head of equities Crispin Murray (pictured above). Reported by portfolio specialist Chris Adams.

MARKETS CONTINUE to grind higher, though breadth is narrowing and technical signals suggest we could be in for a period of consolidation.

Last week the S&P/ASX 300 gained 0.14% and the S&P 500 1.71%.

At this point the market continues to look through domestic lockdowns. Domestic cyclicals held up last week, while growth stocks took a breather from their recent run. 

US payroll data was reasonable, but did nothing to change expectations on central bank tapering. OPEC’s latest meeting on output policy will stretch into this week, while oil prices continued to rise.

Covid and vaccines

Case numbers in the Sydney cluster are rising faster than the previous Avalon and Crossroads outbreaks. The good news is testing is also much higher — so the overall ratio of cases to tests is likely to be much closer to previous outbreaks.

At this point lockdowns and effective contact tracing suggest this outbreak should be containable within weeks rather than months. This is certainly the view reflected in markets.

Other parts of the world are re-opening, prompting a debate about our path to normalisation. At some point there will need to be a leap of faith allowing a degree of Covid in the community on the premise that it won’t lead to poor health outcomes.

The maths around target immunity levels for domestic re-opening is a function of variant transmissibility, vaccine effectiveness and vaccine penetration.

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The Delta variant’s greater infection rate has raised the required threshold of immunity. The shift to greater use of Pfizer should help. We may see an acceleration in the timing of second doses.

We suspect the trigger may be availability of vaccine for anyone who wants it, rather than a specified proportion of the population vaccinated. But this is unlikely to arrive before the fourth quarter of 2021. A full re-opening of international borders is likely to be delayed beyond this.

We continue to watch the UK carefully as a possible test case, where new case numbers continue to climb sharply, but hospitalisations remains subdued.

Economics and policy

June payrolls came in stronger than consensus at the headline level in the US with 850,000 new jobs added. But the overall picture was mixed.

Hours worked dropped marginally while the unemployment rate rose a touch to 5.9%. The overall participation rate remains low at 61.6%.

The key outcome was no shift in sentiment towards the timing of Quantitative Easing (QE) tapering or rate hikes.

There are still 5.5 million fewer jobs than before Covid (about 40% of which are in leisure and hospitality). The paradox? While a lot fewer people are employed, there are clearly bottlenecks in labour supply which are creating wage pressures.

How material this is — and how permanent — will be tied to the participation rate. This is unlikely to be resolved until we get into the fourth quarter of 2021. By then all unemployment insurance payments will have expired and parents will be able to send their kids to school.

Until then the employment data is unlikely to bring forward tightening expectations.

Inflation outlook

Debate on inflation remains the key macro issue.

We are tracking several bottlenecks in this regard. Some logistical issues appear to be the worst they have been since 1974. Analysis by Goldman Sachs on the temporary factors driving inflation suggests they peaked in May at 1.05% incremental inflation and should halve by November.

This means that even if the inflation thesis is correct, it will be hard to detect in the next few months. Combined with ongoing QE, this could keep bonds range-bound and prevent any dramatic rotation back to value in the equity market.

That doesn’t mean we are not creating seeds for higher inflation in the medium term. Last week’s data on US house prices — which are growing at their fastest rate in 30 years — is a reminder of the wealth effects created by current policies.

Markets and stocks

US holiday season has generally seen quieter markets.

Last week US 10-year Treasury yields fell 10 bps to 1.43%, while their Australian equivalent fell 9 bps to 1.48%. The US Dollar index strengthened 0.4%.

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Brent Crude rose 1.5% to US$75.16. We are waiting to see if OPEC agrees to raise production to help offset the rebound in demand. The UAE is withholding agreement at this point, arguing for a greater share of production.

Inroads made into global oil inventories are worth bearing in mind. They peaked at about 1200 million barrels in December 2019, fell to about 330 million barrels on a rebound in demand and are now falling 50-60 million barrels per month. Additional supply will be needed to ensure a smooth run-down of inventories as Europe and the US continue to re-open.

This is supportive for an oil price remaining in the US$70-80 range — and perhaps even nudging above it.

The Australian market’s FY21 return was the highest since 1992.

It was driven by a rebound in earnings, with the valuation multiple effect actually contracting over the year. Deeper cyclicals such as steel, building materials and gaming performed best given their high operating leverage. Defensives such as infrastructure, utilities and gold miners fared worst.

It is interesting to note the material de-rating of metals and energy sectors despite very strong pricing fundamentals and earnings momentum. Energy stocks, in particular, have not performed on a rising oil price. 

The disconnection here is probably tied to a view around the sustainability of economic growth and the increasing impact of Environmental, Social and Governance (ESG) issues on the cost of capital.

ASX highlights

Last week AGL Energy (AGL -9.8%) was the worst performer in the ASX 100 after announcing details of its demerger. The plan is to split into a company that holds the “dirty” assets (Accel) and a “clean” company (new AGL).

AGL appears to be using the latter to raise capital and give Accel a stake to act as collateral for refinanced debt. Management also highlighted more headwinds to near-term earnings from wholesale gas costs and low electricity prices. EBITDA was set to drop more than 20% in FY21 ahead of another material step down in F22.

We continue to see the stock as a value trap given the overhang of a capital raise, the overlay of regulatory risk, and the ongoing issue of low electricity prices.

Lendlease (LLC, -7.1%) delivered another downgrade. Lockdowns in the UK and elsewhere disrupted development projects and there was a lack of clarity around the company’s current strategy.

Nine Entertainment (NEC, -3.7%) fell after gaining the rights to the UEFA Champions League European football competition for its Stan Sport service. The market was quick to factor in cost without any offsetting benefits. Nine is continuing to see strong advertising demand — so far unaffected by the recent lockdown.

IDP Education (IEL, +17.8%) was the best performer following its acquisition of British Council’s Indian operation for $238 million. This leaves IDP as the only administrator of British Council’s English language tests in India. It’s the biggest market for these services, growing about 20% per annum pre-Covid. The deal is expected to be 13% accretive since it’s financed from the balance sheet rather than capital raising, with scope for additional synergies.

Metcash (MTS, +7.8%) delivered a well-received result. The supermarket business was a mild disappointment since operating leverage was not as high as expected. But it appears to be holding onto gains in market share. This was offset by strength in hardware and liquor, which combined are now a greater share of earnings than the supermarket business. Management announced a share buyback, surprising the market and signalling confidence in the outlook. 

Telstra (TLS, +5.6%) rose as it announced the sale of a 49% stake in its mobile tower division to a consortium of super funds. The price was a substantial premium to overall group valuation multiple and above market expectations. This reflects strong demand for less economically-sensitive infrastructure assets. Roughly half the proceeds will be returned to shareholders. 

Find out about Crispin Murray's Pendal Focus Australian Share Fund

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