Making sense of this stunning rally

Livewire readers have so far nailed their bullish call on the market. Since we published those survey results, the ASX 200 train is full steam ahead (up +21.50% to be precise).

The three critical questions for investors now are: 1) Is there much gravy left? 2) Where are the next sector rotation opportunities? 3) What can make the locomotive stall or potentially go backwards?

In this extended interview, Catherine Allfrey of WaveStone Capital and Matt Williams from Airlie Funds Management address those questions. They also suggest how investors can structure their portfolios and call out companies that have what it takes to survive and thrive in this environment.

Notes: Watch, read or listen to the discussion below. This episode was filmed on 3 June 2020.

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Edited Transcript

Matthew Kidman: Welcome to the thematic discussion brought to you by Livewire Markets. I'm Matthew Kidman, and today we're going to talk about the great disconnect. The disconnect between what the share market's doing and what the economy is doing. The treasurer came out today, announced GDP was down in March, and officially said, "We're in a recession." What did the share market do? It got a fire under it and went up another 2%. It's up over 30% since the end of March. It all doesn't make sense. To discuss this strange situation I've got Catherine Allfrey from WaveStone, and Matt Williams from Airlie. Matt, I'll start with you. Is the market crazy? Because the economy is obviously not in a good state at the moment.

Matt Williams: Yeah, it is certainly factoring in a very bullish scenario. I mean a V-shaped recovery, if you like. I think they may be right, but I think there's plenty of unknowns around how unemployment comes back in the second half of the year and what happens with consumer spending. I mean, so many Australian companies listed on the market, are B to C companies, business to consumer, and really rely on consumer spending. The market has taken a very strong view. I'm not so sure that's correct, but we'll find out.

Liquidity driven rally

Matthew Kidman: Okay, Catherine, but on the other side, we've got stimulus everywhere, like we've never seen before. Interest rates next to zero. Is that going to get us through, and the market is right, and the V shape that Matt's worried about, is that going to happen?

Catherine Allfrey: It's definitely a liquidity recovery, and the difference this time around is this is an impact on the real economy. So what's the government done? It's come in with massive stimulus and it's happened globally. It's not just here in Australia. So as a result, we're just seeing an unprecedented response to both the health crisis that we're facing and the fact that governments realise unless they want to have mass unemployment, they've got to provide the stimulus and put the economy on life support and hope that once those payments come off, that we can recover and move on.

Matthew Kidman: So you're saying the central banks never lose, whatever game they play; they always eventually win?

Catherine Allfrey: Well, they eventually win. They have so far. And that's been another lesson of this crisis, I think.

The market has bounced. What to do now?

Matthew Kidman: Okay. Matt, we'll go back to you. So what does that mean? You sound cautious. Does it mean that you play defence at this point? Because every day we turn up and we watch the market and stocks are jumping really quickly on the upside. So is it time to get defensive if you can, or even raise a bit of cash?

Matt Williams: I think any well-structured portfolio has a bit of offence and defence in it, and you're taking a sort of a medium-term view. I mean, for example, in our portfolio we'd think about Aurizon as an infrastructure defensive type play. We'll get a dividend out of that. On the other hand, we've also got a lot of Aristocrat, which we think is quite offensive, and even Qantas, you're playing offence with that kind of company on the recovery front. It's structuring that portfolio and having a bit of both, but making sure that if indeed... It looks like we're through the crisis, but if the crisis gets worse, if it suddenly comes back, that you can survive, these companies can survive. If things go better, then they can thrive. It's really that balancing act within the portfolio.

Matthew Kidman: You used a word there that everyone's forgotten, dividend. Are they going to be important going forward, and is yield going to have its day again, sometime in the near future?

Matt Williams: I think dividend is going to be massively important. I mean, you look back over the last 10 years and the stat is that more than half your return has come from the dividend in the Australian market. So you really want to have those companies that can sustainably pay a dividend. It's all up in the air right now. I mean, the banks, what's their dividend going to be? You're playing a bit of that defence, you're having things that you think will definitely pay a dividend and then you've got your offence, well, we're not sure, but if things get better than these companies will thrive.

Still on the offensive

Matthew Kidman: Catherine, do you like that cocktail of attack and defence at the same time or is Matt just off the money and you should be all go hard, things are going higher, low-interest rates.

Catherine Allfrey: That's been the problem, is that obviously, we had the massive, fastest selloff in history, and then you had to suddenly change from being defence into offence, and it's all those defensive companies in the last six weeks that have really underperformed; just going nowhere. Now you have to start looking and saying, right, is that enough, and then rotate your portfolio around. It seems like every time one sector moves, then it stops and then another one starts.

Matthew Kidman: So? What's the mix?

Catherine Allfrey: We're still offensive at the moment, and that's because of the stimulus payments that you've seen. We have a fair few defensive, and we're starting to look at the defensive names again, in terms of whether we should top them up.

Matthew Kidman: And what fits into that category in this market?

Catherine Allfrey: In this market, because we still want businesses that are executing well, I would say Woolworths is one of those companies that fits well there. The question is too, in terms of some of the infrastructure stocks, they've obviously got sold off and they were used to be seen as defensive companies, now they're more like offensive companies. We've been swapping one for the other there. We've steered clear so far of stocks such as Telstra in terms of defensive because again, they've had earnings downgrades recently as well from the analyst community. It's just more trying to pick companies that we see sustainability with some growth, with management teams that are executing well.

Have investors missed the boat with banks?

Matthew Kidman: A lot of stocks have received a lot of love in recent times, last six, seven weeks. The banks and the other financials didn't seem to get as much, but last week, low and behold, the great rotation and banks got a fire underneath it. The rotation into financials, do you think that's deserved? Does it have more legs? Should we be looking at them again, big part of our market?

Matt Williams: Yeah, it was certainly their turn. I think once the market realised that the crisis is not as dire as maybe some predictions were six weeks or so ago, turned their mind to the sort of oversold, I guess, banks. But the banks are... So they're up, what 14% I think in the last week and a half, the financial index. The banks are going to bear the brunt of the crisis of the outcome of this. We've got 10% of the mortgage book on deferrals. We've got less than that in the SME loans also on deferrals. There's a lot of unknowns on how this all works out, and again, it goes into unemployment, what happens there and into housing. What we do know for sure about the banks is that they're going to have to structurally alter their dividend payout ratios and they've got to come lower. So that puts me really on the sidelines. I think it was their turn to rally from a little bit oversold, but to see it sustainably go from here, I'm not so sure.

Matthew Kidman: Okay. Catherine, staying with the financials, it can make or break anyone's year who is a fund manager to be overweight/underweight banks in the Australian market in the last two years, to stay underweight; and you win. What about now? Just the same question directed at Matt. Is it time? Is that the defence we're playing or is it just too many uncertainties until we get to September, October and the interest issue comes up and the bad debts and so on?

Catherine Allfrey: Okay. Like Matt, I thought that they were getting down there. They were trading at 0.7, 0.8 times book value, and I guess when you're going through a bad debt cycle, you stop looking at PEs and dividend yields because they're not paying your dividend yield so you go to what are they versus their book value. So what we could see was that they were trading historic lows. All they needed was some sort of economic news to come out that was positive and away they'd go. When the treasurer came out and said, "Oh, sorry, we made that mistake. There are 3 million less people on JobKeeper." I can tell you, the banks were popping champagne corks. Not that they actually believe that 6 million people were going to be on some sort of payment, but at the same time, I think they were like quite relieved because  that sort of almost caps off how many of these deferral payments that Matt was just talking about, could occur.

Catherine Allfrey: I think they're good for a trade. The problem is long-term is this low-interest rate environment, what happens to the banks? It's terrible for banks to have the cash rate at 25 basis points. It makes margin management really, really difficult. But the analysts have put in massive provisions in their forward forecast for the next three years. So it's not only just this year, they've forecasted elevated losses for the next few years ... so the question in my mind, and I thought once I saw that news from the government, I thought, right, it's not going to be as bad as what the analysts are forecasting.

Matthew Kidman: So bullish from this point now they've rallied a bit?

Catherine Allfrey: No, I'm not... Not super bullish, no.

What about insurers?

Matthew Kidman: Yeah. And so the other big sector in the finance game is insurance, and they've been left behind as well. That sector. Views on that?

Catherine Allfrey: General insurance, okay. We've seen massive claims in terms of the bush fires so that was unexpected. Again, insurers get hit on the investment portfolios with lower yields. Overall, we've had a change of management with IAG as well, and Suncorp, of course, about 10, 15% of its business comes from the bank, so clearly the same issues as the banks are facing. They seem to be evenly priced. They're in a sort of oligopoly type market structure which is quite favourable so they do have some pricing power but fairly priced as far as we're concerned.

Matthew Kidman: Matt, general insurance, pretty big part of our market. A couple of big companies, important, haven't bounced. What do you think?

Matt Williams: Yeah. I hope they get a turn because I own some Suncorp and I've been waiting for their turn to bounce in the market and they just haven't done it. I think it's tough. They're having to pay higher re-insurance because of the bush fires and the claims of last year. Their market share has just slowly and progressively been chipped away at by the up and comers. The market structure is good, but it's not as good as it used to be, and I think they've found it tough to get the pricing that they've needed to. Hopefully, I'm giving all the bad points, but I think that a lot of that is in the price for these companies, and I'm hoping that they get their turn to rally soon.

Summing it all up - how should investors be positioned?

Matthew Kidman: OK. That's a bit of light there. Just to sum up, it's a funny situation at the moment: crashed, bounced. Can you afford to be on the sideline? People like us, we've got to be there all the time, but for your average person at home, can you be on the sideline or do you have to be in the game given interest rates are so low?

Matt Williams: Yeah, I think it's interesting. We were talking at work just recently about if we were left to our own devices, our mandates are to be invested. If we were left to our own devices, you could have not been in the market or had a much bigger cash waiting. I think you've always got to be there in some respects and you can tinker around where your weights are, but you're absolutely spot on, official rate at a quarter of a percent, there is companies out there that will give you a plus 5%, pretty reliably, we think, with franking. So why wouldn't you be in the market?

Matthew Kidman: Catherine, same question. It's the one everyone wants to know. Can we afford to be out given the rally, and everyone's hesitant and saying I've missed it?

Catherine Allfrey: Well, there's the old acronym, TINA, there is no alternative, unfortunately, because where else can you invest at the moment? We don't know in terms of residential property prices. That's yet to come. We've seen the actual rental vacancy rate increased dramatically, particularly in the major cities. So what's going to happen to house prices? Personally, I wouldn't be going and buying a house at the moment. I'd be waiting for that price fall to come through and be reflected in the housing market. For equities, I'm happy to be still invested.

Matthew Kidman: So there you have it, TINA, and all your friends out there, pick up your bat and ball and go and have a go.

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