2021: The Year of Doubt
Others see a world dominated by central bank interventions, fiscal stimulus, a virus that refuses to surrender, still rising inequality, asset price inflation and a growing consensus on climate action, but I look upon 2021 as the Year of Doubt.
- Are equity prices finally ready to come back to earth?
- How high can house prices rise, really?
- Is bitcoin making a fool out of all of us?
- 'Value' stocks have had a rough time for most of the past decade, why aren't they rallying more?
- Surely corporate bonds are today's ultimate bubble?
Other macro questions are also floating to the top:
- Inflation cannot stay "hidden" forever, or can it?
- Why are bond yields falling?
- Whatever happened to gold as the inflation-safe store of wealth?
- Is global debt ever going to shrink? Are we already too late to save the world from climate disaster?
- Is war with China inevitable?
- What will the New Normal look like?
These are still only a selected few of the many doubts and questions that live inside human brains in 2021. And yet, somehow equity indices have denied all forecasts for a range-trading outlook, or worse, and set new record after new record as we approach mid-year.
It's just one of many inconsistencies inside financial markets in 2021.
Doubts, and many persistent questions. They may, on balance, not have held back share market indices over the past half-year, but they dominate the landscape underneath the surface, where individual stock prices reside.
Take engineers, contractors and mining services providers as an (excellent) example.
With global economic indicators running hot and commodity producers enjoying a strong revival in prices for iron ore, copper, crude oil and the like, share prices for those companies servicing the commodities sector should be well and truly shooting the lights out by now.
They most certainly are not, with the occasional exception that is ALS (ASX: ALQ) or XRF Scientific (ASX: XRF).
Yet, most sector analysts remain adamant:
All of our key indicators suggest a high likelihood of a sustained increase in mineral investment that we believe will likely provide plenty of demand for services through the cycle, from exploration to construction and production, analysts at Canaccord Genuity reported on Monday.
"Commodity prices are at multi-year highs, mining ECM activity remains very elevated and the balance sheets of the majors are stronger than they have been in over a decade."
Yet, share prices for the companies involved are trading well below valuations and price targets set by Canaccord and other sector analysts. Shares in Seven Group (ASX: SVW) are trading -29% below the consensus target. Monadelphous (ASX: MND), widely seen as the quality standard for the sector locally, is well off from the price reached in December and nowhere near the $12.39 consensus target.
It can get a lot worse elsewhere in the sector. Shares in NRW Holdings (ASX:NWH), highly leveraged to iron ore and infrastructure spending, are currently trading no less than around 79% below the consensus target.
This now leads to the rather odd situation that when a broker like Canaccord Genuity adds four additional mining services providers to its coverage, total coverage of the sector rises to eight Buy recommendations out of nine, including one Speculative Buy, and with NRW Holdings as the sole Hold-rated stock.
But share prices are not moving.
The key reason is doubt. There are plenty of reasons to suspect not every company in the sector will equally benefit from tomorrow's boom time conditions triggered by increased spending by governments (on infrastructure) and by commodity producers.
The costs for doing business across the sector are rising, which casts a question mark over future profits and margins, not in the least because all companies are battling with a lack of available skilled labour in Australia.
There are question marks too about how much spending will actually occur.
Not everybody is on board with the idea of a new prolonged commodities cycle and the likes of coal and oil are increasingly finding it harder to attract fresh capital as ESG investors avoid exposure and others see a world increasingly adopting net zero emission pledges and targets.
For a sector that usually follows customers around the world, border closures and travel restrictions are not helping, and neither are equipment and machinery shortages.
Shareholders will be hoping their company will be among the positive surprises in August, but so far investors have decided it's way too difficult to separate winners from losers, not wanting to be exposed to the next profit warning.
The story so far for mining services providers is not fundamentally different than for owners of office towers, retail shopping malls, online shopping channels, car parts and aftermarket services, travel and leisure stocks, insurers, or your average small cap technology company.
Share prices might no longer be as depressed as they seem for mining services providers, in all cases there is plenty of doubt in investors' mind that can put a lid on share prices on any given moment.
But no doubt is as high as for the 2021 reflation trade.
The new calendar year started off with the idea that vaccines would take care of the global pandemic and border restrictions, and re-opening economies would trigger one ginormous V-shaped recovery leading to tight labour markets, inflation, higher bond yields and less accommodative central bankers. All hail to the banks and a potential new Commodities Super Cycle!
In practice, however, what we have witnessed is one extremely rapid switch from last year's beneficiaries into market laggards ('Value') on the back of bond yields doubling from exceptionally depressed levels, but that widely anticipated and commented upon reflation trade has found it increasingly difficult to retain composure from, say, mid-March onwards.
On Monday, in complete defiance to general sentiment, UBS issued a Sell recommendation for Rio Tinto (ASX: RIO) on its persistent conviction that iron ore prices will be a lot lower in the years ahead.
This means, suggest the analysts, that while dividends and cash flows still look attractive this year, near-term risks are increasing and the share price will start reflecting this. UBS's new price target is $104. The shares closed at $123.47 on Friday.
One of the reasons to potentially doubt ongoing strength for iron ore and other commodity prices is the fact the Chinese domestic economy seems to be slowing quicker than anticipated. A second reason would be the fact Chinese authorities' intention is to reduce speculation in order to pull market prices down.
But there are plenty of other reasons to doubt the reflation trade from here.
Economic indicators globally are suggesting the V-shaped momentum is slowing. Is it peaking, maybe? If this proves the case the general conversation will soon shift to: is the Fed repeating its policy mistake from 2018?
A worst case scenario would be for inflation to stick around for longer while economies revert back to snail pace growth. Imagine what would happen if central bankers focus on the first, ignore or underestimate the second, and then start hiking interest rates.
One reason to temper one's enthusiasm for the economic growth outlook is the ability of covid-19 to mutate regularly and continue causing mayhem across the globe. As we've all been witnessing in Australia, governments are not without flaws when it comes to rolling out mass vaccination programs and communicating uniformly and with consistency to their populations.
How long before investors might need to have another look at next year's corporate profit forecasts, possibly concluding they might be too high?
One reason to doubt the strength of the economic recovery thus far is that, looking beyond the various headline numbers, there appears to be a close correlation between government support programs and spending by businesses and households. What does this tell us about the exact outlook when such government support is no longer active?
All of the above, and then some, is being reflected in today's bond markets in which the 10-year US Treasury is falling apart, not showing higher yields as one would expect to happen in a world that has seen central bankers turn gradually more hawkish (or less dovish, whatever your angle) with seven voters on the Federal Open Market Committee (FOMC) now suggesting the US could potentially see rate hikes as early as next year.
In order to remain consistent with the narrative from earlier in the year, US ten-year bond yields should now be eyeing 2%, but they are moving into the opposite direction. This would be consistent with (much) slower growth ahead and no inflation to worry about.
History shows bond markets are far from perfect, but they do get the outlook correct more often than equities. There are quite a number of heroic tales of investors who managed to escape the carnage from the GFC because they heeded the warning from bond markets in 2007, and sold out before it all started crumbling.
In the same breath, it is way too early to tell what exactly is happening in bond markets, and how long it may last. Plus, of course, bonds can be wrong.
Strategists at JPMorgan, for example, have been telling their clientele not to give up on the reflation trade because bond markets have stopped supporting that trade, at face value, for now.
They suspect a number of technicalities are behind the downtrend in bond yields since they peaked in March, but the uptrend should resume as soon as the Fed starts talking about and preparing for 'tapering', which, according to most forecasters, is bound to occur later in 2021 or early next year.
But what if bonds are suggesting global growth is trending back to the slow pace that was prevalent pre-pandemic, implying this year's burst from last year's bottom, supported by never-before-seen government support and central banks' largesse, was simply a brief, one-off, phenomenon?
Soon inflation will make room for disinflation, again?
From a portfolio perspective, and in line with my prior writings and commentary, I remain of the view that genuine portfolio diversification, whereby one outcome in the Grand Inflation Debate does not fully destroy or make this year's investment return, remains the appropriate way to deal with this year's volatility and uncertainties.
Keeping cash on the sidelines to take advantage whenever opportunity arrives seems but appropriate too.
FNArena offers independent and impartial market analysis, on top of proprietary tools and applications for self-managing and self-researching investors. The service can be trialled for free at (VIEW LINK)
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