Today’s topics

• State of play
• Factor premia
• Commodities
• Aus macro
• Iron ore
• Sector performance

State of play

An extension of last month’s playbook, flat to down yields, rising breakevens, surging commodities and narrowing credit spreads. We continue to trim equities into market strength, and are now ~-5% underweight shares at the overall portfolio level.

Factor premia

If you are a Quality or Growth manager, you will be feeling some pain. If you are the nexus of Quality Growth, you will be feeling lots of pain. If you are a QGARP manager, but didn’t see Value in commodity stocks, you are…well, you get the idea.

And it doesn’t really matter whether you focus on factor premia, calculated in absolute space (which is the left hand graph), or sector relative space (right hand graph). Both are bad. Unless you were a value manager, you didn’t get anywhere near the benchmark, over the past year.

Commodities

You might have seen the points highlighted in the tweet below, from Tracy Alloway, about what might be driving commodities at the margin.

The “commodities coinification” point makes sense, if it weren’t all of them (as shown below).

Easiest explanation is macro first (low real rates) meets surging demand meets supply side issues associated with COVID meets China stimulus. I do buy “speculative excess”, but it’d be after the first three points.

The Michael Pettis argument about the eventual China-ship-turning-inexorably-to-consumption-share is correct, but, that transition has been on pause over 2020/early 2021, as indicated below.

China’s level of debt had been growing at a fairly prodigious rate; the relatively recent effort to degear (as part of the shift away from investment orientated growth towards domestic consumption) and stabilise h/h debt was completely reversed in the wake of COVID.

As such, the spread to “line-of-best-fit” has grown to an absolutely eye-catching level, when plotted against income.

Aus macro

Confidence

We think the data is at cycle highs.

Momentum is strong, but valuations are very stretched. The drivers of the re-rating are difficult to sustain (particularly in Australia, where the lending boom and commodity price boom are driving everything). We’ve moved further underweight at the overall asset class level to shares.

Retail sales

Retail sales had slowed materially in the lead-in to COVID. A log plot shows this drop below trend. Then the world changed. An arguably enormous pull forward in demand for many items, which will almost certainly give a lot back over the next few years.

This is especially the case if your trend fit is c2018, where the slow down is most marked. Either way, we see this as a material negative to all discretionary retail stocks, from HVN, to JBH, to NCK and APE.

Iron ore

We made the point earlier that Quality and Growth had underperformed materially, as a style, as an investment strategy. Much of this is attributable to the enormous rally in Banks and Resources, both of which sat firmly in the “Value” camp.

In the case of Resources, well, we’ve been here before, twice previously in our careers. It’s painful to endure in the short run, given we are underweight in our direct equity portfolio, but, we think, will prove as temporary as previous supply side squeezes. As always, the cure for high prices is high prices. And nothing about the below graph suggests “sustainable”.

In our view, the commodity producers have translated peak margins into pricing in perpetuity, particularly in iron ore, copper and steel.

Or, if you prefer, peak returns into peak valuation multiples.

We will remain underweight, particularly as geopolitical risks abound (tabled below).

There was also the whole “suspension of economic dialogue” thing from last week, which sure makes you wonder about the above multiples.

And here’s what is baked into the price, using a stock specific example. Extrapolate forward the market cap at a decent proxy for the market return (eg a 7% CAGR total return, for the next 10yrs). Divide that future market cap by a range of assumed terminal multiples, to get the implied required NPAT 10 years out. Compare visually the trajectory (path) of this implied NPAT to the historicals (what the company has actual done) and consensus (what the market thinks will happen).

You can see that FMG needs to maintain current earnings over the next decade to generate that market return. That strikes us as extremely unlikely.

Sector performance

Been quite the crunch for high flying IT names. We continue to see significant downside risk to many of the tech names, most especially for
the nexus of tech health (stocks like PME) and for tech finance (the BNPL space, which we think has another 80% or so to go).