How to outperform in a market where nothing works (and the stocks to do so)
Believe it or not, economists know just as little of the future as you and I. And yet, countless hours and a good deal of ink are dedicated to deciphering every word of today's macro manipulators - Federal Reserve chair Jerome Powell, and locally, the Reserve Bank of Australia's Philip Lowe.
As Eley Griffiths Group's Nick Guidera put it, "It’s hard to recall a time when economic and geopolitical news flow was such a dominant part of the narrative in markets over such a long period."
Sure, the declines seen in equities markets have been well documented, but they pale in comparison to the volatility experienced in fixed-income and currency markets.
After all, the S&P/ASX 200 has pretty much recovered since its September lows and is now only down 6% in 2022, while the S&P 500 is still 18% in the red. Over the same time period, the yield on US 10 Year Treasuries skyrocketed nearly 226 basis points (bps), while Aussie 10 Year Bonds lifted 194 bps. It comes as St. Louis Federal Reserve President James Bullard delivers investors a rude awakening, arguing that interest rates would need to be as high as 7% to sufficiently curb inflation.
That said, it's easy to get caught up in the macro. And since functional crystal balls are hard to come by, Guidera has kindly shared the four macro trends you should actually be watching right now.
Plus, he also outlines why growth, value and inflation-benefitting stocks are needed to win in a market where no other style has emerged victorious. And of course, Guidera names a comprehensive list of small and emerging stocks that could help investors navigate this difficult period.
The 4 key trends to watch
Guidera believes there are four key macro trends that investors should have on their radars. These include:
1. US Core Inflation
This isn’t really new, Guidera said, however, long-term inflation expectations remain broadly "anchored" for now (anchored, as in the long-term inflation rate is still in line with historical averages). He added that if inflation becomes ingrained or “sticky” as consumers continue to pay up to access goods and services impacted by supply challenges, the risk of de-anchoring is a possibility. If this happens, then the "inflation correction" that markets are hoping for won't actually eventuate. Subsequently, longer-term inflation expectations could blow out higher than the range central banks are targeting.
2. Economic instability in the US
The US economy is already starting to show some cracks (i.e. housing), however, US employment continues to be solid (which you can see from hiring intentions surveys). With this in mind, the case for a pause is building, Guidera said. However, the level will come down to the data. He also noted that the typical recessionary indicators (inversion of yield curves) are starting to flash amber.
3. Economic instability in Europe
Europe is currently in "watch this space" territory, Guidera said. The winter months will be fascinating, as while challenges are anticipated, we are yet to see how the market will react. He notes that Heineken is currently cautious as European beer drinking starts to slow, which could signal the pressure on consumers' pockets.
4. Credit markets
To date, credit markets have been calm, Guidera said. But with the Australian Federal Government interest bill spiking, will it be different this time? UBS' Matthew Mish recently found that over the past 10 years, the share of risky debt issued by corporate borrowers has gone up, at the same time as the number of public companies that don’t earn enough to cover their interest has significantly increased versus history.
No factors have worked throughout 2022. So how should you invest?
Unless you have been living under a rock, you've probably noticed it's been a volatile year for markets. We have already navigated two relief rallies - one in July, with investors praying for a Fed pivot, and then again in September as investors hooked their hopes onto signs that inflation was easing up (if only a little).
"Right now, extending your positioning in one direction has proved hazardous," Guidera said.
"The reason for that is every factor seems to be working. The chart below sums it up perfectly. No one style has dominated for more than two months. With value and risk trumping momentum and quality earlier this year, only to see this sharply reverse in June." (see below)
With this in mind, Guidera recommends investors "ensure a bet in all camps" as "no definitive set of stocks has provided excess returns for more than a few months". In layman's terms, don't put all your eggs in one basket.
"Conviction is lacking among investors, with many in the market still maintaining a defensive skew and cash sitting on the sidelines waiting for the opportune time to deploy," he said.
"It’s perhaps premature to bang the table on the bullish market call. However, it’s not lost on us that we are approaching 11 months since the start of the correction.
"While we believe it’s too early to call the bottom, investors should be considering which stocks are likely to be the winners on a 12-24 month period."
From a stock-specific view, one thing does seem to be working right now - (relatively) boring stocks. Given the uncertain macro environment, investors are willing to pay up for earnings visibility - with stocks boasting profits in the here and now re-rating a lot faster than they would have previously.
"These stocks have become particularly crowded as investors are all chasing the same type of exposure," Guidera said.
"Boring is good. But you also need to be acutely aware of ownership. Should a boring stock underwhelm, you are seeing these stocks correct pretty aggressively.
Meanwhile, crowded trades which have become dangerous - particularly, when there has been a misstep or investors have been using these "defensive" stocks to ride out volatility include GUD Holdings (ASX: GUD), Aussie Broadband (ASX: ABB) and DGL Group (ASX: DGL), Guidera said.
Of course, other than the "boring" stocks, energy and resources players have also managed to outperform this year - particularly those that benefit from a highly inflationary environment. In addition, management teams that have navigated the impact inflation has had on their operating environment have been rewarded by investors.
Guidera pointed to Strandline Resources (ASX: STA), a mineral sands explorer and developer with operations in Australia and Tanzania, as well as oil and gas company Karoon Energy (ASX: KAR) and gold producer Capricorn Metals (ASX: CMM).
Some saucy and not-so-saucy sectors
While we can all agree the macro environment is challenging, Guidera is adamant there are some "terrific fundamental opportunities" available to those investors with nerve.
"At the sector level, energy continues to be a strong performer despite the weakness in oil," he said.
"It appears the market is beginning to believe the structurally short narrative, coupled with an energy-intensive green transition. In some ways, it’s becoming the new defensive tilt."
Flows to the sector also remain supportive, Guidera added, despite many suggesting that energy is over-owned. As an extra fun fact, the S&P/ASX 200 Energy Index is up 38% year to date, compared to the S&P/ASX 200's -6%. Talk about defensive!
He also pointed to the consumer discretionary sector as a major focus, albeit for entirely different reasons. This is, of course, thanks to the lag effect of rate hikes on consumers and ultimately, retailers.
"In recent weeks, we have seen how some retailers are responding, with Woolworths (ASX: WOW) and The Reject Shop (ASX: TRS) noting that consumers have been focused on value offers," Guidera explained.
"Many consumer names also have a weaker currency to contend with at a time when gross margins are elevated, which could prove to be a headwind into 1H23 results."
It is also not lost on retailers that the true picture of how consumers react to higher interest repayments is unlikely to be felt until early next year, Guidera added. Thus, visibility remains challenged from here.
Meanwhile, financials continue to be a topical space given the rate hikes we are seeing globally.
"There are signs that we are potentially closer to the end than the beginning of the hiking cycle," Guidera said.
"In this environment, financials should outperform based on history. The non-bank financials in Australia have been trading poorly, despite history suggesting their track record has been exemplary in challenging credit environments."
Last but not least, he pointed to the resources/commodities sector - as prices continue to correct from their highs and as China begins to loosen both its regulatory stance on Australian exports and its monetary policy.
"A global recession will crimp demand, but supply does remain imbalanced in multiple commodities," Guidera said.
"The electric vehicle (EV) revolution has seen the battery minerals sector at new highs, while bulks and base metals continue to lag. At some point, we anticipate this will reverse, and having the capability to invest in resources, is likely to set us up to take advantage of these opportunities."
In a falling commodity price environment, it’s unlikely any resource stock will be spared, Guidera explained, particularly lithium stocks, which have soared to eye-watering highs this year. Companies with elevated valuations, questionable project economics and a register of shareholders without long-term commitment are particularly vulnerable, he added.
Some of the big outperformers such as Pilbara Minerals (ASX: PLS) which recently became the "40th largest company in Australia and only three to four years ago was in micro-cap territory" and those currently developing projects such as Liontown Resources (ASX: LTR) are expected to be subject to profit taking.
"I think there is more opportunity in bulks like iron ore and in base metals like copper, as those markets start to normalise," Guidera said.
"Copper is more of a global play and a call on risk and recession. Iron ore is obviously far more leveraged to what happens in China. And China is one of the only economies in the world that is loosening policy while everyone else is tightening it."
"They are looking to expand in that area of their portfolio when they are pulling out of others," he said.
There isn't a wide variety of copper stocks listed on the ASX that aren't at an early stage in their development, he added. However, he pointed to AIC Mines (ASX: A1M) as a possible opportunity. As for iron ore, Guidera likes Mount Gibson Iron (ASX: MGX).
The case for a "barbell portfolio"
For those who have watched Buy Hold Sell or any of my video interviews, you will have noticed that I am huge. My veins pump with protein powder, I can lift more than my body weight and every day is leg day in my book. They don't call me Ally 'bulk gains' Selby for nothing. Obviously, I know what a barbell is, but a 'barbell portfolio'? That I had to Google.
Basically, a "barbell strategy" argues for splitting a portfolio between two extremes: high-risk and no-risk, avoiding any vanilla exposures in between - just as the pole thing connects the two weight things on a barbell.
To Guidera, this means investing in structural growth and selective value stocks on the one end, and inflation beneficiaries on the other.
"At the moment, the narrative is: Structurally higher energy prices, keeping inflation higher for longer (albeit lower than current levels), with rates continuing to rise, but with limiting effect, resulting in contracting economic growth," he said.
With that in mind, an "inflation protection" stock could be Karoon Energy or New Zealand-based Vector Limited (NZE: VCT), while "selective value" could include the likes of now heavily discounted financials, growth and consumer discretionary names - like Mainfreight (NZE: MFT), Beacon Lighting Group (ASX: BLX) or Pinnacle Investment Management Group. As for structural growth, Guidera pointed to Lovisa Holdings.
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Ally Selby is a content editor at Livewire Markets, joining the team at the end of 2020. She loves all things investing, financial literacy and content creation, having previously worked for the likes of Financial Standard, Pedestrian Group, Your...