We trust that you enjoyed your Christmas and have had a more positive start to the year than it seems global share markets are having.
Internally we have been talking about the increase in bond yields, along with rising inflation and interest rates for some time, and what we are seeing now is the market reacting to this data as it decides on appropriate valuations as risk increases along with the cost of money. It is worth noting that uncertainty exists with regards to the situation in Ukraine, and the implications should conflict commence, and this is likely adding to volatility.
If the word of the year for 2020 was “unprecedented”, some would argue 2021’s word has been “inflation”. December’s US CPI (consumer price index) was 7% for the 12 months which was the highest such reading since 1990, and the seventh consecutive month where the CPI rose more than 5% for the 12-month period.
Company after company globally are painting a picture of supply disruptions, product shortages, soaring input costs and tight labour markets.
The debate raging in financial markets is whether or not this inflation is ‘transitory,’ as supply chains normalise post-pandemic, or whether it is structural. Our sense is that given it has been with us for almost three quarters, it is more than transitory. On 1 Jan 2021, the US 10-year government bond was yielding 0.93%. Currently it is yielding 1.85% – nearly double. Similarly, the Australian 10-year yield has leapt from 0.97% to 2.02% over those months. This has a flow on effect which ultimately leads to increasing costs to business and the end consumer.
The AAN Investment Committee has been working overtime in the last few weeks assessing the portfolio and ensuring that we are well positioned for these economic changes. We admit that our focus on some of the new economy stocks has hurt parts of the portfolio, but we have also been very happy with some of the moves that have been made over the last 6 months to protect your assets.
In times like this, as we have learned over the last 20 years here at Evalesco, we need to ensure that we are invested in the right types of assets. This is why we do profess to having a relatively unexciting portfolio philosophy which is designed with times like these in mind.
As you would expect we have been in constant contact with our money managers and some of the main points to note from our discussions are:
- Our researchers believe that inflation and interest rates will remain low in the long term. They think that the factors driving the recent increase in inflation are temporary in nature and are likely to recede over the year. As the global and Australian economy continues to recover from the COVID-19 crisis, deflationary structural forces will once again start to suppress inflation. Their base assumption is for 10-year U.S. bond yields to average 250 basis points over the next 10 years.
- If the recent increase in inflation turns out to be more permanent, then bond yields may rise. In this scenario, our managers believe that the Fund’s stocks should be able to pass on higher inflation in their cost base more easily to customers due to their strong pricing power and without effecting the value proposition.
- Remember that our managers look at assets over the long term and the earnings-per-share growth for the respective portfolios are estimated to be approximately 20% per annum over the next fifteen years. Therefore, if there is a future increase in bond yields, the rising intrinsic value of the Fund will be capable of recouping any one-off negative valuation impact.
- Yes over the past 12 months, we have seen a rotation out of structural growth companies into old-world, value style and cyclical businesses. Our managers feel that Investors have been selling the future to buy the past. This style rotation has been a headwind for our portfolio but they expect these macro headwinds to return to tailwinds in 2022 and 2023 and the Fund’s companies are expected to grow revenue and earnings at rates well above the broader equity market.
- Something important to note which might give you comfort, the ten-year IRR (internal rate of return) of 1 of our active portfolio’s has risen with the sell off. The manager in focus generally sees an IRR of 18%p.a. as a buying signal for the portfolio and currently the ten-year IRR is in excess of 20%p.a. So to that end they have reduced the Australian cash towards ~4% to be now fully invested (cash levels into Dec 2021 were ~9%).
- One portfolio manager made the comment that they don’t believe it makes sense for the market to rotate out of structural growth companies that are extremely profitable and growing their market share, to value style companies that are shrinking their long-term intrinsic value “sell the future to buy the past”.
- Growth at any price companies often with very weak earnings and little to no product loyalty or differentiation have been sold off very hard (growth concept stocks eg: Zip / Before Pay etc). The companies you own have strong fundamentals, absolute market leadership, and are backed by true structural themes, which is why they are in your portfolio.
- As one fund manager was quoted saying, ‘Beware market hype, seek good management and favour strong balance sheets’. Another manager stated, ‘Given the falls we have seen, the S&P500 is down 10%, many businesses down 20%, and rate rises now priced in, this reduces risk and uncertainty and makes us more comfortable.’
From here we are looking forward to getting to reporting season which predominately starts with Resmed and Xero where investors will be forced to look at fundamentals again.
Our promise to you as always, is that we will continue to provide you with regular updates to ensure that you know how your assets are performing so you remain fully informed.
If you have any concerns, please note that our advisers are more than happy to discuss these with you at any time here.
