Volatility persists: Three key positions to watch

In late January, we recommended trimming equity risk and adopted an overweight position in cash. The risks we flagged have intensified in February. Inflation has been persistent, leading the market to accelerate pricing for interest rate hikes, and Russia has invaded Ukraine. It’s best, for now, to avoid forecasting headwinds and then doubling down as those headwinds play out.

We continue to believe a combination of strong, above-trend global growth lies ahead for 2022, that inflation will moderate into mid-year, and central banks will normalise rates gradually. This should be more supportive of risk assets as the world enters H2 2022. This month, we highlight three key positions to watch in 2022 across domestic equities, the Aussie dollar and tech stocks.

Many of the market risks we identified have played out…

In January, we adopted a more neutral risk position, trimming equities (yet retaining our preference for equities over fixed income, given the likelihood bond yields had further to rise). Key catalysts included more persistent inflation, the acceleration of central bank action, and heightened geo-political risk. While still remaining constructive for the year ahead, the immediate few months did (and still do) appear challenged, at least as far as equity markets are able to trend higher in the face of these headwinds.

During February, somewhat unusually, all of those risks have, to varying degrees, played out. Inflation surprised higher again for the US and didn’t recede as expected in Europe. In Australia, the Q4 inflation data was materially higher than consensus. Moreover, for most regions, the data revealed a troubling ‘broadening out’ of the inflation pressures from just headline oil and food, to many underlying goods and services items.

Not surprisingly, this has led to a further acceleration in the pricing of central banks’ withdrawal of uber-stimulatory policy. Markets have speedily raised US Federal Reserve (Fed) hike expectations for 2022 from three or four in January, to now six or seven. The European Central Bank (ECB) is now priced to hike this year, with president Lagarde conceding that inflation was likely to be higher and stay high for longer than previously expected, with risks titled to the upside. Despite a still dovish tone from Reserve Bank of Australia (RBA) Governor Lowe, markets are priced for four rate hikes in Australia this year.

Key questions driving markets in the months ahead

1. Will the Russian invasion of Ukraine remain contained? If it does, focus will return to strong growth and normalising rates. The complexity of the situation is only highlighted by the outrage over a democratic sovereign nation being overrun. It also lifts uncertainty about how future geopolitical events may play out. From a markets perspective, North Atlantic Treaty Organisation (NATO) arrangements suggest the war will be limited in scope. Tough sanctions have been imposed on Russia, but avoid the energy sector for fear of creating a European recession.
   
   
2. Will inflation subside? The debate over where its trend settles is arguably less material this year. For markets, key will be whether inflation embarks on an easing path without central banks needing to slow output growth.
   
   
3. Will central banks pause midway to judge the impact of hiking, given consumer sensitivity, rapid change and risks of prematurely ending the growth cycle? Real rates are likely to remain negative for some time—but reaching zero quickly could be a challenge, given consumer gearing.

How to position in Aussie equities post reporting

Domestic equities underperformed the global equity correction in January, down over 6% compared to a 5% fall for the MSCI World ex Australia index. This was the S&P/ASX 200’s fourth-worst start to the year since 1960. But domestic equities reversed much of that underperformance in February, in part to the strength of the reporting season, delivering a relatively flat result. In contrast, growing expectations for global central bank rate hikes and rising Russia-Ukraine tensions led world equities to fall a further 5% in February.

Despite the weak start to the year, the current domestic equity reporting season has been relatively strong, as far as earnings are concerned. With the results more than 75% through, bottom-up earnings for the year ahead have been upgraded by about 1%, a significant outperformance relative to the 20-year average for a 0.7% decline (see chart below). Within the market, resources and financials have enjoyed considerable upgrades, partly offset by small downgrades amongst the industrials.

Stronger-than-expected revenue has been a key driver, but in many cases, rising costs have been a significant offset. While MST Marquee notes that “raw material costs and freight are becoming less of a profit headwind”, wages growth has been a cost that’s proved harder to contain. This has led to a modest tightening in profit margins. However, underpinning the earnings and ‘capital management’ outlook, increasingly strong corporate balance sheets do not yet appear to be driving a strong rebound in capex intentions.

Australia warrants a neutral to overweight regional allocation

Looking ahead, the market’s current bottom-up earnings per share (EPS) growth forecast for June 2022 is 11% and 2% for June 2023. The forecast slowing in earnings reflects expectations that commodity prices will be materially lower into financial year (FY) 23. Excluding commodity stocks, MST Marquee calculates EPS growth of 12% for FY 22 and a strong 14% for FY 23.

Supporting the ongoing relatively strong earnings outlook is the underlying strength of the Australian economy. An above-trend global growth backdrop, as well as expectations that China (and its property sector) will be recovering through H2 2022, are positive drivers. However, like elsewhere globally, a strong consumer sector, fresh out of lockdown and flush with cash, is likely to deliver strong economic growth in 2022 and 2023. With relatively low inflation and wage growth relative to offshore, the RBA looks set to hike at half the pace of the Fed in 2022. This should lessen the headwind for the housing sector, where a backlog of work (with ‘starts’ 31% higher than a year ago) is expected to drive building activity over the coming year. Both UBS and CBA forecast 5% growth in 2022, compared with around 4% growth across the US, the UK and Europe (also above trend).

The domestic de-rating has seen market multiples compress sharply, with the S&P/ASX 200 back to its five-year average (around 16x). However, with the strong macro outlook and UBS forecasting high single-digit EPS growth, the valuation backdrop is relatively attractive globally. We remain inclined to value and cyclicals and expect materials, financials and energy to outperform. UBS targets 7800 for end-2022, around an 11% upside from current levels.

Where to for the Australian dollar?

The Australian dollar has been trading in a relatively narrow range of USD 0.70-0.72 since December last year. As the chart below shows, this is below its 30-year average of about USD 0.76.

As a typically ‘risk-loving’ currency, with a central bank currently ‘patient’ (read dovish) and still-weakening China economy in early 2022, there is clearly near-term downside risks for the currency. A further wave of global caution and risk-off sentiment has the potential to drive the currency below USD 0.70 near term (protecting, to a degree, unhedged offshore equity positions). As CBA recently reflected, “there remains a risk of intermittent falls in Australian dollar while Russia-Ukraine tensions continue.”

However, looking ahead and in the other direction, we see a number of drivers that convincingly argue for a rising trend in the local currency:

Commodity prices are likely to be well-supported in the wake of the Russian incursion into Ukraine. Apart from relative interest rates, the other key driver of the Australian dollar is commodity prices. According to UBS, Russia explains about 15% of the global coal balance, is the third largest producer of oil, the second largest producer of natural gas, and produces broadly 5-10% across the most common base metals. While geo-political events may see a region like Europe suffer high energy prices, or even supply rationing, Australia’s exports and exchange rate will likely rise.

Synchronised global growth normally leads to a lower US dollar. Away from geo-political events, a synchronised global pick-up has usually led to a weaker US dollar trend, as other regions begin tightening interest rates, often in the wake of the Fed’s moves. Indeed, despite the US having the most aggressive rate cycle priced in among advanced economies, CBA notes that “history shows the start of Fed policy tightening does not necessarily lead to a stronger US dollar”. With the UK and Europe likely hiking rates in 2022, this may weigh on the US dollar through the year.

The RBA will ultimately fall into line. As noted in the equities section, the outlook for domestic growth this year is above trend, with both UBS and CBA forecasting around 5% for 2022. Rising wage growth into mid-year is likely to convince the RBA it is time to begin gradually lifting rates. Moreover, if our expectation that inflation globally starts to correct lower from Q2, the relative unwind of policy expectations in the US compared with Australia (and elsewhere) is likely to support the local currency.

As shown below for both UBS and CBA foreign exchange strategy, the Australian dollar is expected to outperform the US dollar strongly over the coming year (and to a lesser extent the euro). For portfolios that adopt some hedging range for their global equities exposure, this would suggest leaning toward a higher share of hedging for the coming year.

Positioning in tech stocks…

There are several diverging issues confronting the tech sector at the moment.

1. What is the path of earnings and growth rates in a post-pandemic world? While the world appears to have shifted to a permanent plane of digitisation and online penetration, there are also ‘air pockets’ where post-COVID growth rates are not only surprising negatively (e.g. Netflix subscriber numbers, Peloton), but management visibility has also diminished. On the other hand, there remain pockets of enduring strength, as seen in Microsoft and Amazon’s cloud businesses and Google’s core search business (i.e. advertising).
   
   
2. What type of investments in the tech space should be considered structural versus cyclical? For example, while digital payment penetration has increased, we’ve seen with PayPal how cyclical forces have overwhelmed this. Virtual healthcare, where penetration took a step-change to higher levels, now carries some uncertainty as consumers revert, at least in part, to previous behaviours.
   
   
3. Most importantly, how do investors value these businesses and what are they are prepared to pay? We’ve seen significant weakness in unprofitable tech businesses, and broadly we have seen the multiples that investors pay for the sector, at large, decline. Yet, for now, we remain in a world of negative real interest rates. This provides some support to valuations for ‘long-duration’ cash flow companies like tech. However, investors are now being forced to ask themselves what they might be prepared to pay for a business when real rates are positive (i.e. higher discount rates), if rates were to rise as markets are starting to price (i.e. six or more interest rate hikes in the US).

Investors are, therefore, forced to grapple with the long-term perspective that businesses face an unprecedented need to invest in technologies that allow them to compete and thrive online, and that today’s consumers are more equipped than ever to transact digitally. These companies offer exposures to long-term growth, with balance sheets that are, in general, very strong. Margins are superior to the broader market and have proven relatively stable. Tech investment has a beta of around 2x to national growth in the US (and is resilient during downturns—outside the GFC, year-on-year growth has not been negative over the past 15 years) and tech investment as a share of output remains well below levels seen in the early 80s or Dotcom bubble.

On the flip side, with this success has come increased regulatory and political scrutiny, particularly as it relates to big tech. Tech stocks as a share of the S&P 500 are now at levels that rival other periods of peak concentration. And investors were prepared to take valuations that could only be sustained in the event that real interest rates, or discount rates, remained supportive. The removal of this valuation support, despite the companies and sector itself never being on a stronger footing, means that the price that investors pay for this may well be meaningfully lower than it has been at any point over the past several years.

With all this in mind, we recommend owning high-quality, cash flow generative and largely profitable tech. We’re cognisant of where valuations are today vis-à-vis the last time real interest rates were positive. 

• We are looking for a ‘valuation cushion’ (i.e. stocks that have cheaper valuations than August 2019 when real interest rates were last at 0%). 
• We are also looking for companies whose main competition remains antiquated technology (e.g. pen and paper, spreadsheets, cheque books), rather than other technology companies. 
• Lastly, we are advocating clients take a closer look at their overall allocation to tech stocks and reduce exposure in favour of other sectors. 

We remain vigilant with respect to valuation and the macro environment, as we think investors should maintain exposure through the cycle. However, how much that exposure is will need to vary as conditions change.

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