Investing in large caps ahead of two major inflection points

Conditions could not be more supportive at the moment, but inflection points on the horizon will wind excesses out of Australian investment markets, as China eases its stimulus and the Reserve Bank of Australia (RBA) hints at monetary policy changes. 

Impending dislocation calls for a rotation into stocks that look set to benefit from changing conditions, where growth and activity will be spurred by the real economy as opposed to the central banks. The key is positioning portfolios ahead of the curve and realising that the days of emergency monetary policy settings and stimulus are numbered, creating two major inflection points for Australian large caps.

1. The Reserve Bank will adjust policy soon

We believe the RBA will soon settle on no extensions to the yield curve target for the November 2024 bond and announce an open-ended purchase program. Minutes from the central bank’s June board meeting support this view and suggest more flexible approaches to quantitative easing will be tabled in July, setting the scene for a gradual move into tapering next year. One of the options includes moving to an approach where the pace of bond purchases is reviewed more frequently, based on the flow of data and economic outlook.

Emergency settings are not as necessary in Australia now as they were when the pandemic first took hold. The economy is above its pre-pandemic levels, expanding by 1.8% in the first quarter of 2021, which was above consensus. These figures were fuelled by strong consumer and business spending and followed a 3.2% gain in the fourth quarter of 2020. Those numbers alone indicate that is a question of when, not if, the RBA will start changing tack.

Further, the RBA will most likely follow the US Federal Reserve’s lead, which is edging closer to adjusting monetary policy. The Fed has revised its inflation and economic growth forecasts, with officials now expecting two interest rate rises by 2023. Following the June gathering of the Federal Open Market Committee, Chairman Jerome Powell also suggested tapering talk is approaching – we think this will occur by the annual Jackson Hole conference in August.

When financial pressure gets higher, companies reliant on easy money and supportive conditions become exposed. It is our view that financials like insurance stocks will be a beneficiary of this inflection point, buoyed by investors rotating into cyclicals with exposure to real GDP growth, and out of stocks with unsustainable valuations.

2. Commodities set to suffer from China’s slowdown

China is by far the largest consumer of bulk commodities like iron ore globally and it consumes more than it produces, generating demand for exporters like Australia. It has long been a major player in this market, and as a consequence, global iron ore prices are often highly correlated with China’s GDP growth.

When COVID-19 hit, the Chinese Government rapidly increased credit origination and infrastructure investment as a recovery measure. The stimulus China put into the market was substantial and drove commodity prices higher, together with supply issues for copper in South America and a flight to ‘safe haven’ assets amid inflation fears.

Now, demand is set to slow. China’s credit impulse, which measures new credit as a proportion of GDP, is easing. Another measure we track is the China Li Keqiang Index, which proxies China’s economic activity using three indicators; railway cargo volume, electricity consumption and loans disbursed by banks. This measure also rolled over in March this year, following a very strong 2020.

Further, normalised conditions are returning, with self-sustaining economic growth – in April, China’s GDP growth was recorded at 18.3% year-on-year for the first quarter. China was also the only advanced economy to record positive economic output for 2020.

Some argue that we are in a resources super cycle, but we believe that we are experiencing a confluence of events such as:

• an excess of liquidity; 
• inventory restocking; 
• overstocking due to delays; and 
• supply constraints impacting miners.

In saying that, we also believe careful selection can reap rewards with commodities stocks. For example, manganese, which is a battery metal, is in hot demand outside of China, including from electric vehicle manufacturers.

Inflection points create opportunity

Understanding and predicting inflection points gives investors a relatively rare opportunity to gain early exposure to sectors that are set to benefit from a change in conditions. While those tempted by the excesses of high-growth stocks stand to lose their gains, active managers who move ahead of the curve stand to benefit from this moment in history. 

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