10 months that shook the world

The American John Reed wrote the authoritative account of the 1917 Russian October revolution, ‘Ten Days That Shook the World’. Late last year, global central bank liquidity peaked after progressive injection since the global financial crisis (GFC) and a subsequent binge since March 2020 as an attempt to counter the impact of COVID-19. That peaking was prompted by the US Federal Reserve declaring that inflation would be targeted and asset price depreciation, should it occur, would be collateral damage in an attempt to help those living "hand to mouth", who would be otherwise hurt most by inflation embedding itself into expectations. Since that time, the withdrawal of liquidity has been modest; but the impact upon asset prices, especially those assets valued at high multiples of current earnings, has been impossible to understate. While other contemporary factors have contributed, such as the impact upon energy and food prices exaggerated by the Russian invasion of the Ukraine and the dislocation of Chinese supply lines following COVID-19, the Fed pivot from quantitative easing to quantitative tightening has indeed set in train ‘Ten Months That Have Shaken the World’. That relationship has held true with ASX-listed equities, and not only did it continue, it intensified through the September quarter, as reflected in the performance of a number of sectors of note through the quarter.

Real estate

Real estate investment trust (REIT) underperformance was aggressive and prompted by balance sheet concerns, due to bond yields selling off at the same time as cap rates remain compressed at their lowest ever levels. Cap rate spreads above bond yields are now at their lowest point in 30 years, and vacancy rates in central business district (CBD) office markets remain at elevated levels, with Sydney and Melbourne CBD markets, which were both sub 5% in 2019, now at close to 15%, with Brisbane and Perth CBDs both at higher levels. 

At the same time, in its latest results Dexus (ASX: DXS) highlighted that capitalisation rates for their office portfolio tightened to 4.75%. 

While the sector has a large amount of its debt hedged for the next couple of years, clearly asset values have material scope for downwards revision with risk free rates flirting with 4%, high and increasing vacancy rates and maturing debt needing to be refinanced on more stringent terms and prices. Into this environment, being a seller – such as Mirvac (ASX: MGR) with their announced intention to sell $1.3b of office assets – will be an interesting experience, albeit to be fair transactions which have occurred recently have been at tighter cap rates than we may have expected.

Consumer discretionary

The retail sector, directly through retail REITs and indirectly through industrial REITs, pays the rent for much of the REIT sector. We estimate that retail spend in Australia is circa $40b above trend, which has been a very predictable series since inception in the early 1980s. 

Put another way, that translates to earnings for the sector being at least $4b above sustainable levels. 

Initially driven by stimulus payments, retail sales have remained strong reflecting the strength in employment. However, cracks are starting to emerge. Baby Bunting (ASX: BBN) reported a slight (2%) reduction in gross margin, reflecting a weaker Australian dollar and higher energy prices (in the form of fuel). Its market value in turn fell 25%. These factors – higher cost of goods sold due to a weaker Australian dollar and higher domestic transportation costs reflecting higher energy prices – will be broad in application across the sector. Should employment falter, the sector's earnings could materially fall, very quickly. Which is why the savvy operators at Premier Investments (ASX: PMV) have reduced the weighted average lease expiries to less than two years. This is prudent; good times have been had, but it would be folly to assume they can be perpetuated.

Financials

The banks remain prone to the same type of recalibration, albeit they enjoyed a strong quarter, with the only one to report during the period – CBA (ASX: CBA) – the laggard. The banking sector can be subjected to periodic bursts of enthusiasm as to its earnings prospects, which tend to be doused as soon as the next set of results are presented. We saw that with CBA's recent result; for all the expectation of net interest margin increases, they dropped 18 basis points through FY22. Overall, net interest margins have been broadly stable for the sector for a decade – certainly more stable overall than the margins reported by many industrial companies – and while it is fair to expect the FY22 dip to be recaptured, it is probably ambitious to expect the sector to enjoy a secular increase in net interest margins as interest rates increase, albeit remain at relatively low absolute levels. 

Most importantly, the Reserve Bank of Australia Financial Stability Review in October 2022 highlighted that banks' provision balances as a proportion of gross loans, at close to 50 basis points for the sector, are at their lowest ever point, suggesting that this, as a source of profit growth, has largely matured.

The only way we see the banking sector to sustainably grow its profitability from here is through underlying profits before bad debts, which will be challenging in a slowing volume environment. System loan growth is now 9.3%, with housing at 7.6%, and business at 14.1% (the highest level of growth since the GFC). This must slow as interest rates increase (or, put another way, interest rate increases will continue until the growth in credit and inflation slows). Deposit growth also continues to be strong. Inflation in monetary aggregates is obvious, albeit it (curiously) continues to be ignored by the central bank when setting interest rates. Returns on equity, after years of strong credit growth and bad debts still at negligible levels, are still just shy of 10% for the sector, almost as low as it has been through the past 25 years. 

To be fair, at a stock level, CBA is earning returns well above the sector and Westpac (ASX: WBC) returns well below; with pre-provision profits at CBA being $5b higher than Westpac’s on a cost base only $1b higher. 

Given the business mix skew in each case is far more similar than different, those numbers highlight the stark impact management can have on operating performance over time. For several years, as NAB (ASX: NAB) lagged in operating and market performance, it was our largest overweight in the sector given the latent earnings improvement that could be generated with better operational performance. Management change several years ago has presaged just such a change in NAB’s organic performance, such that it is now the only major bank consistently gaining market share in loans and deposits, and it appears to be doing so on service, not price. The share price has reacted accordingly, and now could provide a template for management at the bank laggards in how to create market value. The proposed ANZ (ASX: ANZ) acquisition of Suncorp (ASX: SUN) suggests ANZ management missed the memo; NAB underperformed for two decades when mergers and acquisitions were seen as a preferred path to value creation. They have only improved their market performance more recently since Ross McEwen joined as CEO and focused the organisation upon organic execution.

Materials

While materials was another poorly performing sector, BHP (ASX: BHP) has been a strong performing stock. It has significantly outperformed RIO (ASX: RIO) through Mike Henry’s time as CEO. A disposition of energy assets and a bid for Oz Minerals (ASX: OZL), boosting the group’s exposure to copper, have both been warmly received. During the same period, RIO has continued with a series of snafus notwithstanding an asset base which continues to be worth materially more than the market value of the group. The battery grade lithium RIO sources from its boron operations in California and its prospective Jadar lithium mine in Western Serbia are afforded little value as part of the conglomerate, and yet taking a line through the magnificent performance produced through the quarter by pure play lithium miners listed on the ASX (such as Mineral Resources and Pilbara Minerals ASX: PLS) the RIO lithium operations on a standalone basis should have a larger market value. 

To reflect this, RIO has created a new battery minerals segment, which has 1,250 employees over five countries. 

Of course, battery technology will drive a large amount of compounding growth in demand for a sustained period for lithium (and copper, nickel and other commodities) and the geopolitics will require any fund processing facilities being developed in the Western world to take account of any potential bottlenecks in China and to satisfy long term offtake agreements agreed to by car makers. However, a long run incentive price is still needed for each of these commodities in order to determine a fair value for the commodity producers, and on our reckoning the long run lithium prices imputed now by the ASX-listed producers, are ambitious. To its credit, BHP has made the same point publicly in order to justify its acquisition of a lithium producer, in an attempt to redress what (at current commodity prices) appears to be a strategic gap in its portfolio.

Consumer staples

United Malt (ASX: UMG) has been a poor performer since its demerger two and a half years ago from Graincorp (ASX: GNC). While exogenous events have hurt – COVID-19 hitting consumption in end malt markets of beer, Scotch whisky and food, a drought in Canada affecting supply, and the Russian invasion of Ukraine also impacting upon soft commodity prices – the group has continued to invest without return, a path well worn by Graincorp prior to the demerger. In each case, this has proven a poor strategy for shareholders. 

Since the demerger, Graincorp has stemmed operating and capital expenditure, and while significantly benefitting from the very best climactic conditions they could hope for, management’s focus has also contributed to the significant outperformance enjoyed by shareholders since that time. 

In recent months, Graincorp has announced that the chief financial officer is leaving the group, and more recently it has confirmed the departure of the chief executive officer (CEO), who prior to the demerger had been the CEO of the combined group. Much has been said about the impact of focused management benefiting Graincorp shareholders since the demerger; there is now an opportunity for the United Malt Group (UMG) board to appoint new senior management with a mandate to apply the same operating disciplines to UMG.

Utilities

The utilities sector had a poor quarter as investors were confronted with the magnitude of reinvestment required in the domestic energy sector to facilitate the energy transition. Having seen the experience at UMG and other companies and sectors where significant investment does not necessarily attract sufficient return, AGL's (ASX: AGL) disclosure of a new strategy and the requirement for it to invest $20b in this transition to maintain its industry position was met with resignation, if no longer shock. Unlike the domestic energy generation and retailing sector, we sense that there are significant latent earnings to be realised within UMG should this opportunity not be squandered. In that vein, the former Cleanaway (ASX: CWY) CEO Vik Bansal has recently been appointed as Boral’s CEO. The playbook at Boral (ASX: BLD) does not appear a lot different to that at UMG; stop expanding the asset base and start expanding profits and cashflows. After a lacklustre decade of operating results despite strong volumes, we expect the results at Boral could also surprise in years to come following Mr Bansal's arrival.

Healthcare

One exception to the rule that earnings momentum is King, Queen and Californian citizen all rolled into one in driving market performance, is the performance of the healthcare sector. At 10% of the market, healthcare trails only the banks (21%) and mining (18%) in terms of its market significance on the ASX. 

The multiple for the healthcare sector, though, is still at an extremely high level relative to its own history and the rest of the market. 

Mining, at an F23 P/E of eight times and Banks at an F23 P/E of 13 times, has weight in the index mostly because of their sheer weight of earnings, with neither being priced on a demanding multiple and both enjoying strong earnings growth through F22. At an F23 multiple though of 34 times, and with F22 earnings for the sector declining and the modest F23 EPS growth forecast of 5% already being subjected to downgrade, the strong market performance of healthcare stands in stark contrast to the earnings momentum driven movements for many other sectors and stocks on the ASX. It also reflects a heavy reliance upon profits sourced in the US, with profit growth being far more muted from operations in all other countries. 

Our portfolio performance was hurt through the month by Ramsay Health Care's (ASX: RHC) underperformance after KKR failed to complete its $20b takeover proposal for Ramsay. Whilst ostensibly access to Ramsay's 53% owned French business, Ramsay Générale de Santé, was the reason for KKR to abandon its offer, this business is laden with debt and represents little equity value in our Ramsay valuation. The repricing of credit through the past quarter is more likely to have had a material impact upon KKR's intentions, than inhibiting access to the relatively immaterial French segment. Ramsay's equity value is overwhelmingly driven by its Australian operations, which have suffered from the deferral in procedures in Australia through COVID-19 being greater than experienced anywhere else in the world, but in turn now stands to benefit from the work generated in ensuing years as this backlog is cleared. We also note that much is made of the value of Ramsay's underlying property portfolio; and while we would prefer the group remain vertically integrated, with its major competitor Healthscope (ASX: HSO) currently selling some of its Australian hospital assets, a more transparent look through valuation may be able to be derived to augment the Ramsay valuation.

Market Outlook

There are many ways that asset prices, sectors and stocks have been shaken by the tightening of liquidity through the past quarter. We detailed above our views on how the change in conditions is starting to impact on most ASX sectors, and indeed the local experience often mimics the global experience. While many of these changes have reflected the "Ten Months that Shook the World", we suspect we are nascent in these impacts, especially as inflation pressures are not abating quickly and several structural changes – such as the ironically named US Inflation Reduction Act – will prevent this from occurring. In turn, many asset prices will continue to be pressured. 

Multiple divergence between high and low multiple stocks, even after the correction of the past ten months, remains at a level rarely seen in history. Earnings growth and revisions are not, however, consistently favouring the highest multiple sectors. The most curious aspect of earnings releases coming from high multiple names through the past ten months in this context has been the lack of expected revenue growth, and the narrative switching to cost reductions and an improvement in cashflows. We continue to believe that harder assets will produce higher relative cashflows and can continue to be brought at lower relative multiples than financialised peers. Our portfolios remain positioned accordingly.

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