Tim Toohey ups the ante: Add risk, consider tech and favour Australia

The first half of next year will be marred by a “decent-sized recession in the northern hemisphere,” says Yarra Capital’s Tim Toohey. He also suggests, somewhat counter-intuitively, that’s precisely why now is the time to buy equities.

• Small-cap tech stocks
• Why bond yields matter
• Equity sectors to avoid
• Australia is safer than other markets

During a recent chat, Yarra’s head of macro and strategy expanded on some of his recent comments about what he believes lies ahead in the final quarter of 2022 and into 2023.

Given his view that a recession is likely, why would you want to buy equities?

"You never get to buy the market at trough pricing, you have to be a bit pre-emptive," Toohey says.

Pointing to a study his team has conducted, which stretches as far back as the 1800s, he says history shows if the improvement in market data is due in the middle part of 2023, you need to buy the equity market around seven to eight months in advance.

"And we’re not far off that now," he says.

Asset Allocation

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Starting with his view on the credit market, Toohey says his team is currently as overweight bonds as it has been for many years.

“People are now acknowledging the growth risks but as soon as inflation numbers start to ease, which we expect to start from next month, we think longer-dated bond yields will start to rally pretty aggressively. We think that’s worth positioning for,” he says.

“This will also feed into equity valuations, which is why we want to add more risk across the equity complex. In this sort of environment, we’re talking about a PE expansion via central bankers taking their foot off the throat of financial markets,” Toohey says.

But in bond yields, he finds fixed income attractive on both a relative and an absolute basis.

“On a pivot from the Fed, we’ll see some sort of collapse of front-end interest rate pricing in most developed markets, I would expect that investment grade corporate bond yields will do pretty well,” he says. His team currently has some exposure here and will probably look to increase this towards the end of calendar 2022.

Having said that he expects a recession in the northern hemisphere next year, Toohey also emphasises his belief that Australia’s economy will fare better than those of other developed nations.

“I think the Australian dollar is going up and that’s not just a feature of views around commodity prices or even the US dollar, it’s also based on relative growth outcomes,” he says.

“We think, relative to our peer group, Australia is much better placed to avoid a recession, albeit it will be pretty weak growth in 2023 versus 2022.”

Toohey also regards the Australian dollar as a good emerging market proxy for investors that are unable, or unwilling, to step into the China trade.

How rising bond yields affect equity valuations

Toohey argues that in the prior decade, equity markets typically looked expensive when assessed using fundamental measures such as price to equity, price to book or dividend yield. But relative to bond yields, equities typically looked cheap.

“But now, with the selloff we’ve gone through, if you look at a two-year forward PE on a price-to-book basis, or a dividend yield basis, the market has come back to something that looks relatively cheap. Where it looks expensive is on a bond yield basis,” he says.

So, if bonds rally as Toohey expects, many cross-asset investors will likely be tempted back into equities.

Based on the various fundamental measures mentioned above, Toohey regards equity market valuations as reasonable.

“I wouldn’t say it’s a screaming buy, but as bond yields come down, I think people will pay a lot more attention to those other equity valuation metrics,” he says.

“Given that bonds have been so distorted by the actions of central banks, maybe we should be using something slightly different, but that is the way 99% of people do top-down equity valuations.”

Ranking the equity sectors

Returning to his starting point about adding more risk into the Yarra Capital portfolios, Toohey weighs up some different parts of the Australian equity market.

“In this sort of environment, we’re talking about price-to-equity multiple expansion via central bankers taking their foot off the throat of financial markets. I think you’ll get small caps doing much better in that environment,” he says.

Toohey also believes a large valuation gap will open up once the US Federal Reserve pivots, which will also support the strengthening of the Australian dollar.

Small, mid, and even micro-cap tech stocks are starting to look attractive to some of Yarra’s portfolio managers currently. In line with his expectation of a “genuine bond rally” into the end of 2022, he says some parts of the equity market will be less caught up in consumer weakness than others.

“As a natural corollary of that, if bond yields are rallying, we’ll see some of the oversold quality ends of the spectrum in tech also start to do better,” Toohey says.
“The hallmark of this year was indiscriminate selling across much of that space, and there are some very good businesses that have also been discounted, which is where our small cap and micro-cap guys have been building exposure.”

On the other side of the ledger, Yarra Capital’s equity managers are still avoiding the consumer, REIT, Industrials, and housing-related sectors.

On the first of these, Toohey believes it’s still too early to look at the consumer sector.

“Even if rates don’t go up as much as people expect our analysis over the last nine months on the cash flow impact on households indicates it hasn’t really hit yet in any way, shape or form, and won’t until the first half of next year,” he says.

And on housing, a sector his team has been cautious on for a long time now, their expectation of falling building approvals has proven correct. “There is still scope for further falls. So, we’re still cautious there, though we'd be going there a bit earlier than consumer,” Toohey says.

He regards the industrials sector as the most expensive by a long way, describing analyst expectations for the space as “ridiculously high.”

“It’s also the area where margins are likely to come under pressure, with margins in the top 97% historically, so that margin compression story is going to be a big feature in the next nine to 12 months,” Toohey says.

“Large caps are a bit tricker because you’ve got to get the resource versus China play correct and you’ve also got to have some handle on how banks are going to deal with a pretty weak environment next year.”

He believes finding opportunities among the larger listed firms will require a more tactical approach rather than broad-based calls.

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