Today’s topics

• China data
• COVID case rates
• Bond yields
• REITs
• Banks
• Market multiples
• Sectors in focus

China macro

The monthly “data dump” of economic indicators for China contained few surprises. Retail sales were a miss, at 17.7% relative to consensus expectations of 25%, but, to our mind, the data is full of noise given the base effects from the prior year, and as such we’d suggest that activity is simply a lot higher than last year, but with some of the “oomph” in the growth rate coming out as conditions normalise.

The “credit impulse” (which measures the change in flow of new credit relative to GDP as %) continues to show signs of rolling over, which we view as a negative for incremental commodity demand more generally.

The housing market remains red hot, the monthly averages continuing to accelerate. The noises about property tax, and additional regulation, to cool the market appear to be gaining a momentum of their own (President Xi recently reiterating that “houses are for living in, not for speculation”) but so far, nothing concrete.

Fixed asset investment (i.e. cities and their connective infrastructure of roads, rail, bridges) and residential (housing, apartments) investment propel steel production to record levels.

Combined with generally flat additional supply from sea-borne markets and you have a squeeze on iron ore.

However, we suggest that

• High household debt (constrained consumer)
• Overvalued housing (price growth too aggressive, for too long)
• Unproductive investment (too many empty cities, roads and rail to nowhere)
• Policy measurers foreshadowed above (the property taxes, the comments from President Xi)
• Trade issues (the relationship between China and Australia, which is arguably more political than mere trade related)

all act as an overhang to the market, and as such we remain comfortable with our underweights to commodities.

COVID

The EU flow of new COVID cases continues to improve. India likewise shows signs that the top is in. Given the normalisation of excess deaths in the US (and the start of peak driving season) and the likelihood of ongoing reopening in Europe, we see a supportive environment for oil pricing to remain.

Many of the Australia listed oil companies have not performed as well as the underlying commodity itself, however, we think eventually investors have to confront the reality of the cashflows coming out of these companies, over time, which will lead to a re-rate.

Bond yields

We continue to expect the US 10 year yield to move towards 2.5%, a level that was a) pre-pandemic and b) pre the 2019 manufacturing “recession scare” that caused the yield curve to invert prior to COVID.

In part, this view is predicated on the size of the US fiscal stimulus, which pushed retail sales through the roof, and suggests, to us, that the recovery packages were, quite possibly too large (i.e. overdid it), raising the spectre of overheating and inflation.

Whilst we think it will ultimately prove transitory, in the interim, it should raise longer dated yields, and drive the US dollar higher.

Our direct equity portfolio has a preponderance of offshore dollar earners (stocks like RHC, CSL, BXB, QBE) which should benefit from a falling AUD, and is underweight cyclicals, which should perform (relatively) poorly against a backdrop of meaningfully higher yields.

Perhaps to clarify that point further, we think that higher rates will filter through to rates everywhere, which should slow (help slow) hot (overheated) housing markets through higher mortgage rates, and, reduce speculation in commodity markets by increasing the opportunity costs of treasuries (government bonds). That mix would threaten the “economic recovery playbook”, meme-ed visually below.

REITs

A short comment, noting the NSW government decision to acquire CBD commercial assets, in order to provide room for the Sydney West Metro station. In a market where Office REITs are battling negative leasing spreads, high incentives, and the ongoing narrative affect of “work from home” the compulsory acquisitions should serve to lower the total supply, and helping to improve net absorption (the difference between newly leased space and recently vacated space).

We hold DXS (a predominantly office REIT) in our diversified portfolios.

Banks

With the majority of major banks reporting over May, we note the updated bad and doubtful debt charges relative to total assets (here, specifically, loans that are 90 days past due, as a percentage of assets).

In some instances they are declining (BEN), remaining elevated but appear to have peaked (CBA, BOQ, ANZ, WBC) or increasing (NAB).

And to our minds such data is not readily reconcilable with multiples (here price to sales, and price to earnings) that are at or near highs in both an absolute and relative sense.

We continue to see the banks as over-earning, and believe that the housing market is likewise overheated (which would likely be contributing to the positive sentiment towards the banks).

Market multiples

The graph below gives a good sense of how elevated the multiples to Consumer Discretionary and Materials are (and how elevated the tech stocks were). As usual, it’s not the level (which in the case of price-to-book is a function of ROE) but rather shifts over time, that are the signal from an asset allocation perspective.

We can likewise see this when looking at sector aggregates for price-earnings multiples, although it doesn’t work as well if the whole sector is over-earning, which we think it is in the case of materials.

We have narrowed our underweight to REITs at the portfolio level (both at the diversified portfolio level, as well as at the direct equity portfolio level) given the favourable valuation discounts. Likewise, we are overweight energy, viewing the sector as very cheap.

Sectors in focus

We note below that there are quite a few compellingly priced opportunities across the Teleco and Transport, sectors.

The graph shows indexed share price performance over the past year, with the black horizontal line representing the benchmark over that time. That most names are below the benchmark lines shows that they’ve underperformed, quite substantially, over the past year.

We own TCL in our direct equity portfolios, and more recently, SYD, viewing them as attractively priced, high quality infrastructure assets, that will benefit from the ongoing improvements in global case rates, and the (eventual) prevalence of a vaccinated population.

TPG remains a standout underperformer, and it is one we own in our equity portfolio. The near term underperformance stems from the resignation of TPG’s founder, and shortly afterward, his long serving CFO. Management turnover, not long after a major merger is completed is often taken negatively by the market.

As such, we took comfort from the recent AGM trading updating, in which management continued to suggest they are “tracking well to guidance” and the merger has continued “to come together quicker and better than expected”. Longer run, we think industry consolidation, improved rationality in mobile pricing, the roll-out of 5G networks, and the end of the margin overhang from the transition to the NBN will prove supportive to earnings growth (and the share price) over time.