Fundies warn of imminent market correction

Well, the kryptonite of share markets is well and truly back: Inflation. Yes, the nemesis of both common and superhuman investors alike, has risen from the dead after what had been a decades-long slumber. 

The Reserve Bank of Australia and the US Federal Reserve have both signalled that rates will be rising over the coming two years, sooner than many investors would have liked. Meanwhile, inflation seems to be alive and well in the real world, as explored nicely in the most recent Off The Charts (we're being served smaller KitKats now ... Are you kidding!?!). 

Worse still, TMS Capital's Ben Clark and Watermark Funds Management's Justin Braitling believe that a correction could be on the cards. 

Justin points to a rallying USD as a clear signal, warning of a pullback in risk assets over the months ahead. Meanwhile, Ben believes we are nearing the end of the cycle, with a bear market on the horizon in a year or two's time. 

So, how should you position your portfolio with all this in mind? You'll just have to watch this thematic episode of Buy Hold Sell to find out. 

Note: You can watch, listen, or read an edited transcript below. This episode was filmed on 23 June 2021.

Edited Transcript

Matthew Kidman: Welcome to the Buy Hold Sell thematic discussion, I'm Matthew Kidman. And inflation, the kryptonite of markets, is back. What should happen when you have inflation? Bond yields should go up. Guess what? They haven't. Who knows what's going on. It's confusing, we know. And to discuss it today, and what it means for equity markets, we've got Ben Clark from TMS Capital and Justin Braitling from Watermark. Welcome, gentlemen. Ben, I'll start with you. What's going on out there? The yield on the 10-year bond in the US is actually heading down instead of up, and we've got inflation.

Ben Clark: Yeah, it's definitely been an unusual few weeks, Matthew. Inflation continues to print higher than expected. It feels like central banks, particularly the Fed, are starting to soften investors up that rates will move a bit earlier than expected. The bond market's yields, as you said, have contracted. 

I think what the bond market is telling us is that there will be a short-term normalisation in interest rates, but it's not a structural change into a much higher rate environment. And maybe bond markets actually overshot themselves at the start of the year when they were worrying about this more.

Matthew Kidman: Okay. Justin. So we've got inflation, we've been smacked with a hard data point out of the US, and we've had the Federal Reserve tell us that it's got on top of us a bit quicker than they thought. But as we just mentioned there in what Ben said, the 10-year bond yield has come back down. Is inflation transitory, or is it here longer and the bond market's got it wrong and we've got to rethink it?

Justin Braitling: Well, I think we're seeing a reversal in these reflation signals, and it's a pretty strong message coming from across the capital market structure. We like to look at not just bond markets but bonds, equities, and currencies. And typically what happens when economies reflate there's a move out of the safety assets of bonds and the US dollar into risk assets. And equities are the pointy end of risk assets, but commodities as well. So we've seen that for the last 12 months.

And then what we've seen in the last week or so is very interesting, because those signals are all reversing. So bonds have started rallying, as you've pointed out. The US dollar has also started rallying, which is very interesting. And if you look across the currency markets the Aussie dollar and the yen, as an example, has broken down. 

So that's the ultimate reflation signal, the Aussie dollar/yen. And so bond and currency markets are suggesting we're seeing a mid-cycle pause in that reflation trade. Now the equity piece hasn't quite fallen into place yet, because we haven't seen the correction that you'd expect to have in risk assets when those safety assets start to rally.

Matthew Kidman: Okay, Justin, we'll get to the equity markets in a second, because that's what we're all very interested in. But what are you saying? That it's not transitory, we're having a pause, or is inflation under control, as reflected in those 10-year yield bonds, which are the longer-dated ones?

Justin Braitling: What we're seeing is what we see midway through most cycles. We're seeing a correction in the reflation trade. The dollar is rallying, bonds are rallying, and equities should correct. That'll go on for a couple of months. And then the primary trend will return, which is, again, this reflation trade. Bonds will sell-off, the dollar will sell-off, and equities will move back to a strong advance until the cycle completes, probably next year.

Matthew Kidman: Okay. Ben, let's bring you in here. Do you agree with that? Or are bond yields going to stay down, and this isn't a mid-cycle correction in this reflation trade.

Ben Clark: Well, if you look at last year, the million-dollar question everyone was asking is why are equity markets so strong when the news was so grim? And ultimately the market could see the economic growth that was coming. It just wasn't evident at that stage. And you fast forward to today and you can see we are in a very strong economy. 

To me, it doesn't line up where rates are versus GDP growth or the pretty exuberant conditions. I think we will see central banks move faster than expected, but I still think that the structural drivers of long-term inflation are there; ageing populations, technology, all of these sort of things that we talk about. 

I don't believe it's going to go beyond into the next zone, which is effectively what bond markets are pricing in at the moment.

Matthew Kidman: So transitory in your eyes, which sets up a nice juxtaposition between you two. So, Ben, sticking with you, how do you get your portfolio ready? What do we do? Because lower yields on the 10-year have told us to stick with long-term growth stories and get away from those cyclicals that depend on the economy.

Ben Clark: And then you've got all the COVID issues that have been created - windfalls for some companies, headaches for others. Our turnover, typically, is quite low across our portfolio. And it's really about finding what we think are great businesses and sticking with them, despite all the short-term noise about inflation, interest rates, etc. 

I think one thing I would say that looks interesting to me are the structural growing businesses that have had the COVID hit over the '20-'21 financial year. 

It's easy to forget, in Australia, the disruption that has been caused in America and Europe, particularly for businesses with big operating environments in those economies. So I think some companies are going to be cycling against weaker comps as they come into '21-'22, and they'll hopefully have this tailwind of people looking out for growth stocks again.

Matthew Kidman: Okay. Justin, it feels like you're going to go the other way. Where do you position yourself in that reflation trade that you talked about if we're just having a pause? Is it in those long-term growth stories or in the more cyclical type of names in the market?

Justin Braitling: The dollar is actually a really important part of the puzzle here. And what you find is the dollar follows very closely to growth in base money in the US. So you had this explosion in base money growth last year and the dollar deflated. That's stopped now and it's starting to normalise. That's allowing the dollar to breathe and to recover, and that's what you're starting to see now. 

So the dollar is rallying. That's the key signal for an unwind of this reflation trade. And the defensive sectors, I think, will outperform in the next couple of months as these markets correct. And then the reflation trade will resume again in the fourth quarter of the year. 

So sell those reflation sectors. The obvious one is the mining sector, that's the pointy end. As the dollar rallies, it's very hard to see those commodity names performing. So I think they will struggle in the months ahead. Similarly, with the domestic cyclicals, and energy and the banks also. 

Globally the banks really struggle when bond yields increase. We've seen the US banks break down. European banks have been under pressure. The Australian banks have been incredibly resilient, but I think their time will come in the weeks ahead. 

Then on the flip side of the coin, those bond proxies in telcos, in utilities and infrastructure, they've really been left behind in the last 12 months. So I think there's a nice catch-up rally for them.

Matthew Kidman: Okay. So you want to be in utilities, long-dated types of assets that grow over time. Ben, what about you? Can you give us some names or sectors that you want to be positioned in over this period?

Ben Clark: Just picking up on the last part of Justin's commentary there, I also agree. I think some infrastructure stocks have been really left behind. And as long as you don't believe we are going into a significantly changing interest rate environment, the yields on some of these things look quite appealing. Particularly, I would say, for the assets that have had COVID issues, again. 

Things like airports, some of the toll road operators etc, have copped it right between the eyes over the last couple of years. And the uncertainty about the reopening, I think, is creating quite a good buying opportunity in those names.

On the growth side, for us, it's those businesses that have had some disruption that we think are going to come out of it with earnings accelerating against a weaker comparable. A few examples there: Aristocrat Leisure (ASX:ALL) as gaming operations start to really ramp up across America. ResMed (ASX:RMD) as the backlog of sleep patients start to be able to get in front of hospitals, and also the new device is rolled out. CSL (ASX:CSL), which has had major issues collecting blood across the south and southeast of America. So they're the names that we're looking at, and the trajectory of the recovery of their earnings looks different in each case. And in some cases, I think the market's got overly bearish, in other cases maybe a bit too bullish.

Matthew Kidman: You've given us a few names there. A lot of those have already run, they've been going since April when that 10-year bond yield started to head backwards again. Have they gone too far?

Ben Clark: I don't think so, Matthew. In those examples, Aristocrat had a great result in May, and the CEO was about as bullish as I've heard him for some time. The digital business had a huge pull-through during COVID. 

He was saying in Vegas if you look at the occupancy rates on the strip and the big eight resorts, he said it's like New Year's Eve every weekend for the next nine months. 

So they're really going to come back into a much better environment. ResMed's had this double win, with Phillips having to do a recall of its CPAP machine. They're launching theirs, and there's a backlog of patients. And CSL is probably the one that looks the cheaper of those three. It's still got some catching up to do, I think. We'll see how it plays out.

Matthew Kidman: Justin, Ben's given us some names, you have given us some sectors. What're some names we can look at?

Justin Braitling: Again, in the growth part of the market, the GARP stocks should do quite well. You saw that in recent sessions offshore, Microsoft, Google, Amazon, these GARP names, that's the sweet spot for where we are. I'd agree with Ben on some of the names he's mentioned. The healthcare names do look like they've run pretty hard. So again, if we see a correction they'll probably participate in that. 

Some other great names that I think are worth revisiting: a2 Milk Company (ASX:A2M) which has been knocked around a lot. I was looking at the '23 estimates earlier, they're 30% of where they were 18 months ago. So I think there's plenty of scope for that business to surprise going forward. They've cleansed the supply chain, pricing's coming back up on the cross-border e-commerce platforms, and so I think there's a nice recovery to come through there.

Matthew Kidman: So, we've got this environment, Justin. Bullish or bearish the market? Can we travel up, given the environment?

Justin Braitling: Well, I think we're due this correction. You normally see one or two mid-cycle corrections. The dollar's the key. 

The fact the dollar's rallying is a real headwind for these risk assets, and so I think we see a correction in the months ahead.

Matthew Kidman: Ben, same question to you. Are you a little bit on the correction side, or you think we just march upwards and onwards?

Ben Clark: I'm on the correction side as well. I think it would actually be healthy for the market, Matthew, just a bit of flushing out of some of the heat that's developing in the market. If you take a longer-term point of view, I think we're still in the bull market that started in 2009, despite the COVID hit that we took. We are getting closer. Markets go in cycles. 

I think there is a bear market coming in the next year or two, but we've probably still got some more to go. It doesn't feel like there's euphoria out there at this stage.

Matthew Kidman: So there's a little bit of kryptonite around, but we reckon Superman, after a couple of months, will be able to avoid it, and we can go for growth again. That was a ripper of a show. If you enjoyed it and you want to see more, why don't you subscribe to the Livewire YouTube channel?

So how are our fundies positioned? 

Ben says "corrections are a normal, regular, healthy function of markets" and are not something for investors to try to "avoid" as it's impossible to time them. 

"The best way to deal with them is to make sure you’re happy with the businesses you own so your not worrying as you travel through them and to always have enough cash to take advantage of them," he says. 

Meantime, Justin's Watermark is a long/short hedge fund - so can long or short the market depending on the team's outlook. 

"Given our cautious view, we are net short approximately 8%, so if the market falls the value of our fund should increase slightly," he says. 

"In terms of portfolio construction, we have a defensive tilt in favour of defensive sectors and growth and are slightly net short cyclicals shares (including mining and the banks)."

Our fundies believe a correction could be on the cards, but what do you think? 

Ben and Justin believe a correction could be around the corner, but what do you think? Are you bullish or bearish on the market for the months ahead? Let us know in the comments section below. 

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