Where Paradice is investing ahead of an inflationary pulse

With all eyes on the upcoming reporting season, the Aussie equities market will need some seriously good earnings results to meet rising ASX valuations. 

At Paradice Investment Management's recent webinar, head of large caps for Paradice’s Australian Equities fund Troy Angus said the current ASX valuation multiples are at their highest levels since the tech bubble in 2000. 

“That's driven by low-interest rates and a significant component of stimulus, which has effectively rerated the multiple investors are paying for the market well in advance of the earnings,” said Angus.

“Earnings need to catch up to support the moves that we've seen in the market. And in our view, that's going to need a bit of inflation,” said Angus.

Source: Citigroup Research

He suggests the earnings catch-up period needs to occur over the next 12-24 months to support the market. But he emphasises the duration of these inflationary pulses remains unclear, as does their final elevation.

The case for inflation

Paradice’s Aussie equities managers are positioning for inflationary conditions towards the latter half of 2021, driven by activity across commodities and commodities producers in their portfolio. It’s a call that resonates with forecasts from legendary investors Bridgewater’s Ray Dalio and BlackRock’s Larry Fink at their recent panel at Future Investment Initiative (FII).

The Paradice team is seeing a strong trend of inflationary pulses driven by stimulus-driven demand and supply constraints.

"['Inflation is] evident in a lot of the commodity prices we looked at, whether you're thinking about iron ore and copper, some of the agricultural commodities prices, which include corn, wheat, even some of the chemical inputs or the fertiliser inputs into those commodity markets,” said Angus.

Source: Citigroup Research

“So we've seen some broad-based moves in commodity prices, which would indicate, or certainly give you some confidence, that you're likely to see an inflationary price higher at some point this year,” said Angus.

How will markets react? 

The likelihood of inflation has not yet been priced into the market, Paradice suggests higher inflation will mean higher bond yields and put downward pressure on the extraordinarily high valuation multiples, effectively levelling out the discrepancies we’re currently seeing.

Source: Citigroup Research

“What is also evident is as inflation increases, then investors, historically, have derated. That is, (investors have) paid less for the market and investments in general."

“Our view is you're likely to see a derating of the multiple that investors are paying for markets currently. And conceivably, you've already seen a peak in that multiple,” said Angus. 

The market will need to be wary of the rate of inflation growth, and whether or not that growth is faster than expected. It’s possible for inflation to overshoot targets and hit risky territory. The balancing act is in inflation pushing down the valuation multiple sustainably in conjunction with the improvement to earnings over the next 12-24 months.

“What we can't tell you yet is whether or not that inflation will be persistent. Will it persist beyond 2021 or so? Currently, in terms of our position, we're playing the portfolio's position for what we see, which is the inflation, without making a call on the persistence of that inflation,” said Angus.

Paradice picks: where to find inflation

With the Australian market being heavily weighted towards resources, commodities and financials, Paradice has given solid attention to a cyclical recovery for the following stocks in their Aussie equities fund. Their overall position is to stay long on value and short on duration.

• Commodities: Paradice’s fund is long on the commodities producers, which include the likes of BHP (ASX:BHP), Rio Tinto, iron ore, and copper and energy. Alongside these commodities, Paradice also is positioned with Incitec Pivot (ASX:IPL - chemicals and fertilisers), Newcrest (ASX:NCM - gold), and South 32 (ASX:S32 - predominantly base metals, but also includes manganese and coking coal).
• EV materials: Angus points toward a “decade of growth” for battery producers and underlying materials, such as lithium and graphite, with Europe and China releasing dedicated policies to drive more consumers towards electric vehicles (EVs).
  

“Markets require, globally, eight times the current lithium being produced by 2030, two to three times the amount of graphite being produced, and two to three times the amount of rare earth currently being produced over the course of the next decade.”

• Long on financials: Angus is optimistic about the banks, with effective results from the government stimulus and banking measures to buffer the impact of COVID-19. “The stimulus has obviously worked, not many consumers have felt much significant stress and thus, everyone's paying their mortgages.”

Conclusion

We look forward to seeing whether 2021 holds some positive news for Paradice's Aussie equities fund position. With several central bank measures keeping bond yields depressed, it's imperative for earnings to increase and provide those lower multiples in this heated market. 

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