The biggest risk to the bear case

Ben Griffiths

Eley Griffiths Group

A quandary has taken hold, the real nub of which is whether the US economy is moving into recession - or simply experiencing a growth scare. This needs to be clarified as soon as practicable as it is the US economy that will drive the global economy into recession.

The indications from several leading economic indicators (eg OECD, ANZ series) point very clearly to something a little more acute and broader than a simple growth scare.

It is worth noting that the 10 year -3 month section of the US yield curve inverted (turned negative) 6 weeks ago but flipped positive this past week. Further, the closely scrutinised 10 year-2 year section of the curve has resolutely remained positive. These movements indicate an element of investor incertitude and cloud the conviction around the case for recession.

Ric Deverell, Senior economist at Macquarie Bank, cautions that a heavy retreat in US business investment will be the likely catalyst for a US recession and this will occur if the current trade uncertainties are allowed to persist. By comparison, the underlying health of the US consumer, a major contributor to US GDP, is fine.

It was interesting to see Morgan Stanley downshift their equity recommendation this past week from equal-weight to underweight after a year of sitting on the fence. I get it; the onset of negative data is, and will be, problematic, for US corporates. 

Consensus US Earnings growth in 2019 is tipped to be an anaemic 2-3% following on from 10%, 20% and 25% growth respectively in each of CY16,17 and 18. The Q2 US reporting season is presently underway and investors will have the opportunity to temperature check earnings momentum in coming weeks.

The biggest risk to the bear case

Locally we will shortly commence our reporting season. Pre result warnings have been benign and expectations in the main appear to be largely contained. It is, however, a time of heightened share price volatility.

My time in markets tells me that share price indices at all-time highs (US) or within reach (Australia) when combined with benign credit markets portend a bullish outlook for stock prices. Further, investor scepticism is running at ‘healthily’ high levels and this is constructive.

In aggregate, stock valuations are defendable, whether through the lens of equity risk premiums, measured against prevailing levels of inflation or even historical yardsticks. The seemingly coordinated global central bank putsch to manage cash rates lower will continue to drive the hunt for modest-high yielding financial assets, such as equities. Morgan Stanley might be right when they suggest 

the largest risk (to the equities bear case) is a scenario where growth recovers while central banks continue to pile on the stimulus”.

Three small caps we like in this market

A position was accumulated in Equity Trustees (EQT) during the past quarter. The group is a leading provider of trustee services to the professional investment market as well as offering traditional estate planning and HNW/charity administration and advice.

Management have been busily restructuring operations for almost two years with the business better positioned now to pursue growth options here and abroad. The allure of the US$80tn global funds management business has seen the group open a capital-light European office.

A conservative balance sheet should augment any growth agenda. In the wake of the Hayne RC it is easy to envision an environment of increased compliance and corporate governance reinforcing EQT’s value proposition.

Your manager continues to be a supporter of gold producer/explorer Saracen Minerals (SAR), a holding central to our favourable view on bullion. Management have proven to be masterful stewards of capital over a long period of time. Their ability to grow production ounces through exploration, development and acquisition is close to sector best. We await their seven-year production outlook (including revision to resource/reserves) due to be announced in the month ahead.

Steadfast Group (ASX:SDF) is another investee company that EGG analysts have had a successful association with for a considerable period of time. A seasoned executive team, led by Robert Kelly, have assembled a phalanx of equity and network insurance brokers as well as specialist underwriting agencies that write ~ $5.5bn worth of premiums p.a.

The insurance premium rate cycle continues to ‘harden’ (improve), benefitting underwriters and brokers alike with this positive cycle having further to play out. The company is presently rolling out a digital client trading platform for the sale of commercial insurance lines.

Underwriter participation has grown quickly and in certain lines eg Bizpack, Steadfast has been able to secure a 10% share of turnover. The prospects for international adoption of the platform are yet to be explored. The company is in the process of bringing IBNA brokers (~90) into the Steadfast network, a significant strategic manoeuvre assuming the majority of member firms make the move. 

Markets are at an inflection point

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Ben Griffiths
Principal and Portfolio Manager
Eley Griffiths Group

Ben Griffiths is the managing director and a senior portfolio manager at Eley Griffiths Group and has over 30 years of financial markets experience. He Co-founded Eley Griffiths Group in 2002 with Brian Eley following a successful career as joint...

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