June Markets Update

Surprise US CPI print sends market down 3% (June 10, 2022)

Back in April we spoke about the pervasive damage done by rising energy costs and called out the lack of planning for the energy transition that we are going through. Virtue signaling has led to a reluctance among banks and governments fund and approve any new coal, oil or gas developments.  The Russian invasion of Ukraine was the match that set fire to an already flammable energy situation. The results are now being felt in the cost of everything, from groceries, mortgage rates and sharemarket returns.

On Friday 10 June, the US monthly CPI figure was released, coming in at 8.6% higher than a year earlier. Economists were expecting 8.3%.

The surprise was met with a savage sell off in Interest Rate futures, the December Eurodollar futures implying a 3.67% interest rate on 90 day US dollar deposits by the end of December. Other futures contracts implied a better than even chance of a 0.75% increase by the US Fed at their next meeting.

Deutsche Bank are forecasting rates to rise to 4.125% by mid 2023.

The S&P500 index fell 2.91% on the day to 3900 points and was lower by 5.06% over the week. It is getting close to the 3800 level that we mentioned back in April as a possible support point.

What did go up on Friday was gold; rising $23 to $1,870 up 1.25% on the day. Gold miners rose 4.76% on the day as well, bucking the trend in every other share market sector, which we think is an important point to consider.

The big divergence in gold vs other assets indicated that although investors are betting that interest rates may rise more than expected, they still won’t be higher than the rate of inflation. This ongoing negative ‘real yield’ is still a positive for gold.

When one unpacks the inputs to inflation, much of it relates back to energy input costs. We discussed this in the April update. As energy costs remain high, this finds its way through to increases in food and transportation costs. Soon after, wage demands start to become a big component of the increasing CPI. Then there are the supply chain restraints which reduced supply of goods. Finally, 12 years of loose monetary policy has encouraged excessive borrowing which in turn has pushed up dwelling costs.

Now the central banks – armed only with the blunt instrument of interest rates – are aiming to crack a problem which is mainly related to supply. As interest rates rise, the effect is that more marginal suppliers of goods and services are sent broke, which leaves us with even less supply, and more scope to raise prices for the strong companies that remain.

Central banks can print money – not goods

Central banks are unable to create more supply. Governments make nothing and so they have no ability to create more supply. The only control they have over inflation crisis is to crush demand. Central banks do that by raising interest rates and governments do it by increasing taxes.

The reason why interest rates are likely to plateau at a level lower than inflation is simply that the economy will falter long before interest rates can rise above inflation.  The level of debt at both government and consumer level makes this a near certainty.

Sectors likely to maintain profitability through this rising interest rate cycle

Coal, oil, and gas producers

Agricultural producers

Vertically integrated fertilizer producers

Infrastructure owners

There are simple ways to invest in these themes. Betashares have an ETF with the code FUEL. The three biggest holdings in that ETF are Chevron, Exxon, and Shell. In regard to the food theme, the Betashares ETF with the code FOOD is a collection of companies involved in the global agriculture sector. We already have Infrastructure in most portfolios. While infrastructure can be hit in the short term through the interest rate sensitivity, in the longer run they tend to still have pricing power.

In the coal sector, Whitehaven Coal has a market capitalization of only $5.2 billion and will have EBITDA of $2.34 billion in the 2022 financial year.

Thinking about the longer term there is no doubt that industrial metals for the electrification boom are going to also be winners. This theme was very popular a year ago, but the results from some of the broad based clean energy ETF’s have been disappointing. The risk of ‘theme’ based ETF’s is that you can end up with some very overpriced stocks included in your portfolio. Of course, this also applies to every ETF, it’s just that the energy sector it was more hated than tobacco just a year ago, so very few stocks were overvalued when that run started.

Green energy, hydrogen, lithium, and all things electronic on the other hand have been much loved and hyped. Investors here need to be very selective because many companies (including Tesla) are still at valuations that require implausible future growth rates to justify current prices.

Some companies are many years off being profitable and may never be profitable. This is why we need to beware of hype in sectors that we can ‘clearly see’ are the way of the future. Seeing a future trend and profiting from it are two different things. We have actually had a passing interest in Fuel Cells for 20+ years. Thankfully we didn’t invest in Fuel Cell energy technology companies way back then. The three big ones that were around 20 years ago are Ballard, Plug Power and Fuel Cell Energy.

In spite of the recent renewed interest you would still be down somewhere between -64% and -99% over the last twenty years, versus a gain of 453% (total) in the S&P500.

There is an important balance between seeing the future and avoiding the hype.  

Update on Growth vs Value

Yes, we have been banging this drum for a while now.

Below is the chart of one of our preferred ‘value tilted’ listed Exchange Traded Funds QOZ versus the Market Cap weighted competitor Vanguard Australian Shares.

For the calendar year to date, QOZ is still slightly in the black, +0.58% versus -5.42% for the market cap weighted index.

The story in US markets shows an even wider divergence.

The Russell 1000 Value index vs the Russell 1000 Growth index shows a 17.39% gap in performance.

Companies that are making good current earnings in relation to their share prices will be better protected in the rising interest rate cycle.

Interest Rates

Although the rate hiking cycle is in the early phase and the small increases so far should not be troubling, it is the potential future hikes that are causing the angst in equity markets.

At the bottom of the GFC easing cycle, the RBA cash rate bottomed at 3.00% before rising to 4.75% in November 2010. Since then, investors have seen nothing but easing until the low point in March 2020 at 0.10%. We have since seen 0.25% up in May, and 0.50% up in June for a rate now at 0.85%.

The choice of a 0.50% rise in June rather than a 0.40% hike to the nice round number of 0.75% indicates the bank regretted not going harder in May just prior to the election.

Market interest rates are already factoring in a series of rapid fire interest rate hikes by the RBA. The 6 month Bank Bill Swap Rate has risen from 1.88% ten days ago, to 2.33% on 9 June.

Term deposit investors can already lock in some of those expected rate increases.

As an example, Members Equity Bank offer a 1 year deposit at 3.50%. Judo Bank has a 2 year deposit rate of 4.00%. Goldfields Cash Management account is 1.50% for $100,000+ at call deposits.

The anticipation of higher rates is also already priced into bond rates in both the government and corporate sector.

High grade corporate bonds as represented in the Betashares Australian Investment Grade Corporate Bond ETF now have a yield to maturity of 5.67% p.a. Specific corporate bond examples are Westpac Bank 3 year bonds at 3.57% yield, and 5 year bonds issued by Mineral Resources at an 8.0% interest rate.

Risks

While we hope that the rates currently factored in could be enough to slow the inflation cycle, there is a risk that the energy crisis embeds higher inflation into the economy.

Asset prices are priced for the current cycle, which would see rates top around 3.00%. However, any hint that banks may go higher than that will cause asset prices to fall further.

Watch the oil and gas prices for a leading indication of the cycle. Inflation won’t immediately fall with a retracement of oil prices, but a sustained decline may be a leading indicator of inflation changing direction.

Stay safe and diversify!