THIS YEAR ended up being “just as unpredictable as 2020,” Pendal’s head of equities Crispin Murray said at his bi-annual Beyond the Numbers webinar this week.
“The pandemic has bitten back with the delta wave, we had peak growth as stimulus flowed through in the US and now we’re contemplating how central banks extract themselves from emergency policy measures.
“China continues to be belligerent on trade and has also had a slowdown driven by global growth slowing and by their own delta wave.
“And finally, we continue to see the impact of ESG in terms of ratings of companies and company strategy.”
It would be natural to think markets would struggle amid the disruption.
But instead, equities have risen almost 15 per cent in the last six months in Australia.
“It’s easy to say it’s been driven by earnings because earnings revisions have been material.
“But when you actually dig down it’s a little bit more complicated than that.”
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The resources sector has seen substantial growth in profits but a significant derating as investors discount future growth, while industrials and banks have been re-rated by the market despite more modest earnings growth.
“I would look at those returns in the last six months and say about half of it really is a function of earnings and still another half is to do with the continued rise of ratings, which reflects a fall of about 50 basis points in bonds,” say Murray.
Murray says the earnings season was characterised by four distinct themes:
As risks to the pace of economic growth emerged, markets re-rated companies that could generate their own growth.
The more muted economic outlook is driven by a few different factors. Government stimulus is fading amid the rise of the delta COVID wave which has again triggered lockdowns and held back economic recovery.
Supply issues are affecting industry’s ability to meet demand. And overlaying it all is the prospect of a tapering of monetary policy support for economies and the risk of a policy mistake.
“It’s a combination of these factors that has led to the market just being a little bit wary on growth expectations.
“We’ve seen that in the rally in bonds.”
This means investors are once again putting a premium on growth stocks over value stocks.
Inflation is the big unknown that could derail this trend.
“The inflation debate is not yet dead,” says Murray.
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Murray sees a few potential drivers of inflation. An ageing population is tightening the supply of labour while at the same time shifting consumer spending to areas like healthcare where productivity gains are less able to offset demand.
Supply chain fragmentation because of COVID risks lift costs for businesses. And the massive spending needed for the shift to clean energy has the potential to lift prices.
There is also a policy imperative in favour of inflation as it will allow governments to erode debt.
Murray says two paradoxes emerged in reporting season.
The first was that amid the rotation to growth, some of the stocks that suffered the most under lockdown returned to market favour.
“There was enough evidence from the June quarter where we had a brief window where the economy was almost back to normal that there was pent up demand, and that these companies were seeing good leverage to that.”
The second was that there was a disconnect between earnings revisions and sector performance during the reporting season. Commodity stocks had strong earnings but performed badly while tech, gaming and discretionary consumer had poor earnings revisions but performed well.
“That was highlighting that the market is very much forward looking right now.”
The size of corporate activity like mergers and acquisitions or asset sales has been materially higher this earnings season, says Murray.
This is driven partly by rising share prices which typically underpin M&A. The low cost of capital due to low interest rates and high liquidity is also driving activity.
There is also a “winner takes all business model mindset” emerging in growth industries driving companies to pay up for scale.
And in so-called sunset industries such as the fossil fuel sector there is a push to bulk up balance sheets by merging to reduce dependence on capital markets.
This is also being driven by ESG factors as companies reposition their businesses.
Environmental, social and governance factors are increasingly shaping how companies are behaving.
“We’ve moved from the phase where ESG was a focus on risks that were being underappreciated and under managed … what we’re now seeing is the allocation of capital being driven by this.
Some $250 billion cumulatively has flown into ESG funds, “but this is just a proxy”, says Murray.
“What we’re seeing is far more money behind this… a lot of existing equity funds are overlaying ESG filters in the way they invest.
“So, companies recognize now that there are certain pools of capital that they can only access if they have a certain type of strategy.”
This has led to a de-rating of fossil fuel industries despite a rising oil price.
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.
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