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Setting the case for Aussie equities - From IMAP Independent Thought

By IMAP Team 

Setting the case for Aussie equities - From IMAP Independent Thought

Despite a challenging and volatile investment environment, Martin Conlon (Schroders), Anthony Golowenko(MLC Asset Management), Chris Reynolds (Infinity Asset Management), and Peter Bell (Bellmont Securities) set the case for Australian equities.

At a time when the ASX All Technology Index is down 24 per cent in 12 months but the utilities sector is up 32 per cent, as an asset class, Australian equities is currently proving to be very challenging.

It’s a view not lost on Martin Conlon - Head of Australian Equities at Schroders - whose overarching message to delegates at the IMAP Independent Thought Conference in Sydney was that the investment landscape had changed significantly.

According to Martin, the last 10 years, which saw investment markets return strong and sustained returns, had actually been abnormal. Instead, he believes the way in which advisers build and manage client portfolios from now and into the future will be quite different from what has worked over the last decade.

In setting the scene for why the last 10 years has been abnormal, Martin says the correlation between central banks’ balance sheets and global stock markets has been about 0.95 over the last decade. This has meant investors have been squeezed out of fixed income into other asset classes and riskier assets, which has driven up equities.

Aus Equities Graph 2022 ITINVpng

“The reason why life is getting more difficult is that with inflation taking off, central banks have committed to reducing the size of their balance sheets, which generally makes life harder for everyone,” says Martin.

He also adds that valuation dispersion remains high, which can be attributed to the recent financial stimulation by the Fed and other central banks. This has driven the price of assets up, regardless of their underlying fundamentals.

“So, there are some pretty high multiples, particularly for high performing stocks, like CSL, which nobody wants to sell. Those ‘love affairs’ with stocks mean that people tend to justify these multiples that are much higher than normal.”

IMAP Independent Thought Conference Panel in Australian Equities Outlook
Anne-Sophie Williams, Anthony Golowenko, Peter Bell, Chris Reynolds, Martin Conlon

There are some pretty high multiples, particularly for high performing stocks, like CSL, which nobody wants to sell. Those ‘love affairs’ with stocks mean that people tend to justify these multiples that are much higher than normal

Martin Conlon

Wealth and the economy

According to Martin, wealth has become increasingly disconnected from the economy, as cashflow tends to support wealth and the real economy provides the cashflow.

“There has been a long run separation between wealth or the value of assets in stock markets, and GDP or the revenue of the economy. Australian household net wealth, or the feeling of how wealthy people are because of their asset base, has really separated since the GFC.”

Wealth Aus Equities IT Sept 2022

He says an asset has value only because it delivers a cashflow stream, but we’ve forgotten that in recent times, and that’s why we have this separation between wealth and GDP.

In part, this separation is driven by analysts forecasting future streams of profits, which motivates investors to invest in them now. And it’s also driven by investors paying much higher valuation prices for company cashflows that were already there, which was driven by central banks taking interest rates to zero.

“It’s important to note this separation, and one way or the other, there has to be a closing of the gap between the two,” says Martin.

Energy is the building block of every economy on the planet - nothing happens without it. When you don’t have energy, you’re in big trouble. The question of how quickly can we add renewable energy and are we doing the right thing by trying to starve the rest of the energy complex, creates an interesting conundrum. It’s probably exactly what we’re currently seeing in Europe.

Martin Conlon

Beware the aberration

Inflation remains a key challenge for central banks, but Martin questions the popular view that inflation will always revert back to 2 per cent. Instead, he says an environment that reverts back to 2 per cent is abnormal.

“Many of the tensions we are currently seeing in the world have at their centre the issue of the Western world having outsourced most of its production to China. That means the dependence of the West on other countries is a lot greater than we would like it to be,” he says. “This dependence is one of the reasons why sanctions have been a lot harder to enforce by Western nations.”

However, despite the challenges of inflation and geopolitical issues, Australia remains remarkably well positioned, with an abundance of resources and commodities that the world still wants.

“Through our commodities exposure, we have minerals, food and agriculture, and relatively abundant renewable energy. We are long on all the things that Europe is currently short of and is struggling with,” he says.

However, Martin cautions that an important factor to consider is the general lack of capital expenditure spending in Australia’s energy and mining sectors since 2014. And despite the spend on renewable energy rising, the overall total of what Australia is spending on energy isn’t increasing.

“Energy is the building block of every economy on the planet - nothing happens without it. When you don’t have energy, you’re in big trouble. The question of how quickly can we add renewable energy and are we doing the right thing by trying to starve the rest of the energy complex, creates an interesting conundrum. It’s probably exactly what we’re currently seeing in Europe,” he says.

“Decarbonisation requires a change in direction and a considerable amount of spending. And that spending will require a huge amount of mining resources. Most of the infrastructure in the Western world is old and crumbling, just like we’re finding with our own energy infrastructure here in Australia. The capex bill for the future will be massive and long-dated.”

As such, Martin believes some of the enduring beliefs in the commodity cycle and what drives it, needs to be rethought, like selling commodities in a recessionary environment.

“In the U.S., Apple and Google are bigger than the entire energy and basic materials sectors combined. We have lost sight of the fact that there has been massive restructuring in the market cap of markets and what we believe the future is going to be. We tend to put a lot of emphasis on what’s worked in recent times.

“Instead, I’d urge investors to look back at history in terms of the ups and downs, rather than putting a huge amount of focus on the recent past, because I believe that is an aberration.”

What’s key for me is building cashflow resilience. From a multi-asset perspective, we’re thinking earnings growth in the U.S., emerging markets, and Europe with value, but there are risks and challenges in that market. And then there’s Australia sitting in the middle from an equity beta standpoint, particularly with yield

Anthony Golowenko

We still want to be focused on good quality businesses, with a quality management team, which offer pricing power, because that’s going to be essential in an inflationary environment. It’s important that these businesses have a defendable competitive advantage, where they are going to remain in demand if we see a weakening economic environment.”

Peter Bell

Challenges for portfolio construction

Adding his voice to the discussion, Anthony Golowenko - Portfolio Manager at MLC Asset Management - agrees there are many challenges facing Australian equities in 2022, requiring advisers and portfolio managers to rethink their portfolios to reflect the current environment.

“What’s key for me is building cashflow resilience,” says Anthony. “From a multi-asset perspective, we’re thinking earnings growth in the U.S., emerging markets, and Europe with value, but there are risks and challenges in that market. And then there’s Australia sitting in the middle from an equity beta standpoint, particularly with yield.”

He suggests investors could consider moving outside the mega caps and take an ex-20 or small cap view.

Peter Bell - co-founder and Director of Bellmont Securities - also echoes the extent to which the market environment has changed. 

“We’ve had an extraordinary period of calm and moderation. The cost of money has been virtually nothing, and that’s really seen the rise of a lot of unsustainable valuations for many parts of the market - like equities, real assets, and property - all over the world,” he says.

Peter also acknowledges that we are also living in a period with considerable geopolitical uncertainties. As such, he believes whilst we do need to be careful about looking at what has worked in the past with asset allocation, we also need to accept that much has changed in the current environment.

“With this in mind, we still want to be focused on good quality businesses, with a quality management team, which offer pricing power, because that’s going to be essential in an inflationary environment. It’s important that these businesses have a defendable competitive advantage, where they are going to remain in demand if we see a weakening economic environment.”

He adds that the challenge now is to position portfolios to be able to handle either an inflationary or recessionary environment, “because we are definitely heading into one of those phases, but only time will tell which one it is”.

Chris Reynolds CFA - an Investment Analyst at Infinity Asset Management - agrees that high quality, cashflow generating businesses are a safe place to be, as they typically perform well over almost every market cycle.

We’ve had an extraordinary period of calm and moderation. The cost of money has been virtually nothing, and that’s really seen the rise of a lot of unsustainable valuations for many parts of the market - like equities, real assets, and property - all over the world

Peter Bell

Considerations for the overall portfolio

When it comes to portfolio construction and asset allocation, Peter believes there is a solid case to be overweight Australian equities.

“Multiples are also a little bit lower here than they are globally and we’ve got pretty good exposure to materials, energy and even the building of green infrastructure, which I think will help power this asset class over the next 5-10 years and longer. This presents a reasonable argument to be overweight Australian equities. But that said, within those Australian equities, I also believe it’s important to be very discerning as to how you allocate.”

As a large commodities exporter, Chris accepts that Australia does have some significant benefits in terms of the relative play between different types of equities. And with China as a major importer of Australian commodities, he believes there are considerable tailwinds that make Australia an attractive place to invest, compared to many other parts of the world.

Finally, Anthony emphasises the importance of conducting appropriate due diligence on any investment opportunity. This includes knowing the business and understanding what it does, and who its customers are.

“What does the business do and who are their customers? The person who is buying a $4,000 iPhone, is probably the same downsizer buying furniture from Nick Scali,” says Anthony. “So, know the business, know the customer, and be selective with your investments.”

About

Martin Conlon is Head of Australian Equities at Schroders;

Anthony Golowenko is a Portfolio Manager at MLC Asset Management;

Chris Reynolds CFA is an Investment Analyst at Infinity Asset Management; and

Peter Bell is a co-founder and Director of Bellmont Securities.

They spoke on ‘The role of Australian equities in portfolios’ at the IMAP Independent Thought Conference 2022 - Sydney.

The session was moderated by Anne-Sophie Williams - Investment Director, Equities at Schroders.

 

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