Storm clouds are gathering over equity markets

Patrick Poke

Livewire Markets

Earlier this year, David Moberley from Paradice Investment Management said he was keen to put the macro aside and get back into stock picking. But sometimes markets have their own ideas.

In fact, he described the February just passed as “one of the most macro driven” reporting seasons that he’s ever seen. Despite “huge beats and upgrades” from several high-quality players, macro concerns were the bigger influence on stock prices throughout the month. 

With reporting now firmly in the review mirror and the market having largely digested news coming from Ukraine, I spoke with David to get his view on what lies ahead. He shares some important trends for investors to watch, and where he’s finding the best opportunities on the ASX today. He also explains why he thinks were staring down the barrel of a stagflationary environment and the risk of recession is elevated.

Two trends to watch in the second half of 2022

David points to two important trends for equity investors to keep an eye on. The first, is the continued underperformance of COVID beneficiaries. Companies such as Domino’s, Ansell, Healius, and Sonic Healthcare all face the challenge of tough like-for-like comparables to previous years.

The second is one we’ve been hearing about for months but has now been confirmed: rising costs are starting to bite.

“The whole industrial space was flagged with cost headwinds everywhere, not just wages, but input costs. Basically, everything in the cost base is going up.”

This brings us to a dynamic that many in the Western world won’t have seen for decades, if ever. When input costs are rising faster than companies can raise prices, that creates margin pressure leading to lower profits (all else being equal). But right now, markets aren’t factoring in these lower margins David says. This can already be seen in the weak cashflows seen by a lot of companies.

The real impacts of inflation

Outside company reports, we’re seeing inflation take its grip in other ways.

The building industry has been booming, but building materials are up 40 or 50 percent in most cases. Unfortunately for builders, they generally must deliver into fixed price contracts, most of which have failed to account for significantly higher materials prices. As a result some building and construction companies have filed for bankruptcy – a surprisingly common occurrence when construction markets are at all-time highs.

Insurance companies too, such as IAG and Suncorp, have been highlight rising building costs, with rebuilding costs “way in excess of historical expectations.”

Households too are feeling the bite as staples such as food, electricity, gas, and petrol all increase.

“Most of the cost baskets for the standard person on the street are incredibly high and probably not reflective of what you're seeing in the CPI.”

So despite wages growth finally starting to pick up, it’s been more-than-offset by increasing household costs. With Australia seeming to lag the US by about six months, we can look across the Pacific for an idea of what’s to come locally.

And looming behind all this is the spectre of a food crisis. Gas is a key input for making fertilizer, and with fertilizer prices on the up, that’s going to create further pressure on already-rising food prices.

“Unfortunately, it looks like we are coming into a food crisis. There's just not enough food and the prices are going to skyrocket.”

Is a recession on the cards?

Now you may be thinking that this sounds like prime conditions for a recession: Costs going up, rates going up, households and businesses under stress. So is recession where we’re heading?

“Yeah, I think so.” Was David’s rather direct response. Though he did qualify that later, saying “I can't say for sure whether we go into recession or not, but I think the risk of that… seems to be increased and looking that way.”

“You’ve got to put it in a pre-Ukraine and post-Ukraine framework. Prior to Ukraine, the framework was looking pretty tough, right? Supply chains were already under a lot of pressure and years of under-investment in those supply chains cannot be fixed quickly. Those inflation pressures were strong and were likely to persist.”

Even prior to the Ukraine conflict, the US jobs market was very strong, but consumer sentiment was collapsing with real disposable income growth running at -10 percent due to consumer price inflation. Growth expectations were already starting to get adjusted down.

“A lot of the estimates in my opinion, were quite lofty considering the fiscal drag happening over there. A number of leading indicators were softening too. On top of that, you had credit spreads that were widening, and the market was trying to get its head around what a higher rate world looks like for some of the more distressed parts of the market.”

Given all these challenges, it should come as no surprise that earnings per share estimates were stretched too, especially given the margin pressure discussed above.

All this sounds “not great”, but that’s not the end of the challenges. The Fed has been “put in a corner” and is essentially being forced to pull its only lever: put up interest rates.

“They can't fix 10 years’ worth of under investment in supply chain, but they can fix demand. If they want to get inflation under control, they need to do it on the demand side. They need to stop demand in its tracks.”

All this is still just the situation before the Ukraine conflict. “A lot of these issues look worse,” following the invasion, he said.

Growth expectations have now been cut substantially, though inflation and rate rise expectations remain elevated. The Fed recently halved their growth estimate, while continuing to warn of rate rises.

More recently, bond markets have begun pricing in a lot of these headwinds.

“The front end of the curve is really about policy and the back end of the curve is about long run expectations of growth and inflation,” he explains. “You're starting to see a very flat yield curve, but we're not yet inverted, which seems to be the talk of the day. When are we going to invert? We're not yet inverted, but we've come all the way back. So, I think there's going to be a lot of volatility.”

(Note: The US 2yr-10yr yield curve briefly inverted on the 29th of March, US time, but closed at 6 basis points – almost completely flat. A flat or inverted yield curve is widely viewed as an indicator of a recession in the next 12-18 months.)

With the ‘Fed put’ no longer in place, David says now is a good time to be cautious.

“I think we're definitely looking down the barrel of a stagflationary environment, the risk of recession is quite elevated.”

BHP looks cheap

In this challenging macro environment, commodity producers look well supported. Stronger than expected demand combined with significant supply disruption have created a situation where many commodity producers are generating “super profits”.

Unlike previous cycles however, he notes that this one was preceded “by a huge period of underinvestment.” This means it’s unlikely that a wave of supply will come to market.

Demand will be the key data point to watch from here, and in particular, demand coming out of China, who is the marginal buyer of many commodities. Continued shutdowns in China due to COVID outbreaks could have implications for commodity demand, especially steel.

David sees BHP as a great way to play this dynamic, and he says it looks incredibly cheap at spot commodity prices.

“The company's trading at around three times EBITDA they're spewing cash, and we expect them to return over 10% of that to shareholders this year alone. Plus you get a Woodside dividend equal to about $6 per BHP share. So it looks cheap. There's a lot of cash coming out of it. And a lot of that's going back to shareholders.”

The long and short of it: opportunities on both sides of the trade

David says that downside protection looks cheap at the moment. The Equity Alpha Plus Fund is able to use derivatives to hedge downside risk, which in this case means buying put options, which increase in value as prices fall or volatility rises.

As far as specific shorts go, he said he’s looking to short “cash burners that need external capital to continue to fund their growth.”

He also sees short opportunities in cyclical stocks that are reaching peak-cycle. 

“There are a number of companies that I think are over-earning and the market is capitalising unsustainable higher earnings.”

On the long side, he likes IDP Education. It’s a stock he’s spoken about before, but he still sees significant upside.

“If you look at our framework and process it fits incredibly well. It's got one of the best management teams at the market. The balance sheet is in very good shape. They're probably getting back to a net cash position over the next few years, given the amount of cash that they're throwing out. And they don't have a lot of additional capital requirements to fund the growth opportunity that's in front of them.

“And that growth opportunity is significant. They have a leading market position in English language testing with the IELTS business. And they also have a market leading position in student placement.”

He expected “phenomenally strong” earnings growth this year and continued strong growth as they gain market share over the next three to five years.

“It's very rare to see a market leader with that sort of return profile with such a low penetration in their market.”

Despite having one of the biggest market shares in their industry, it’s still only a single-digit share, showing just how long their runway for growth remains.

COVID shutdowns have also heavily impacted the smaller end of the placement industry, where there’s a huge number of very small operators. “I'm not sure a lot of them would've survived,” he said.

Sticking to the adage that you should never let a good crisis go to waste, IDP took the opportunity to build out their tech stack while borders were closed. David says that the data that they're now able to provide to universities has created “a huge and sustainable competitive advantage around the business.”

Despite falling into the ‘growth’ part of the market, he says the valuation still stacks up, even if you account for higher interest rates.

“I'm really looking forward to seeing how this business performs over the next few years. It's got such good management team that are executing really well, and it's got huge upside… So I think it's one of the better opportunities in the market.”

Take advantage of market dislocations

The Paradice Long Short Australian Equities fund provides investors with a style-neutral, long/short, active extension exposure to Australian equities.

For more investing insights from David Moberley, please follow him here.

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Patrick Poke
Managing Editor
Livewire Markets

Patrick was one of Livewire’s first employees, joining in 2015 after nearly a decade working in insurance, superannuation, and retail banking. He is passionate about investing, with a particular interest in Australian small-caps.

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