WAM Vault

Positioning for inflection points in Australian large-caps

Matthew and John share how they are positioning for outperformance ahead of some inflection points still to come in equity markets this year, including tighter financial conditions once central banks start scaling back their monetary policy support.

James Marlay: Hello and welcome to the latest instalment of WAM Vault. My name is James Marlay and I am your host. Today I am joined by Matt Haupt and John Ayoub who are Portfolio Managers of WAM Leaders (ASX: WLE). Matt and John, great to see you both again.

WAM Leaders is coming up to its five year anniversary which is a really nice milestone and even nicer when it has been marked with periods of strong performance. One of the marks of WAM Leaders is having been able to successfully pick inflection points in the market. I am keen to know what you think is the big inflection point that sits ahead of us now?

Matthew Haupt: I think the two real big ones this year are around China credit. Obviously last year they went incredibly hard trying to get the economy going during the coronavirus outbreak. That was 12 months of intense credit origination, infrastructure. Everything was firing on the policy front to get them going. We think this year that will decline. We are starting to see early signs of it declining now. The last few months have been soft, but our big call this year is the credit impulse in China slowing and affecting commodity prices. Obviously with commodity prices, everyone is really bullish on them at the moment. We are a bit more cautious on those bulks, iron ore in particular. I think that is a big inflection point this year.

The other one would be around tapering. Last year fiscal and monetary policy were incredibly easy, the best it has been in history. It is really a historical moment. Everything was fired at the economy to try and get it going and get asset prices high. That will come to an end this year. What I mean there is policy will be withdrawn. It will be a very easy withdrawal at first but eventually that will accelerate. And already the market has  interest rates hikes priced in with a terminal rate. What we are looking for now is any change in the pace of the hikes and a change in the terminal rate as a key determinant of how we position the portfolio.

James Marlay:  John, if we take ourselves back 12 months, the big call was the reopening and the economic recovery. What are some of the opportunities that you see right now?

John Ayoub: If we take a step back, we have seen a two-paced recovery. Much of the domestic markets and domestic economy, domestic facing economies, have recovered, particularly in Australia. But we still have not seen international borders open up. There are elements of the market which still have some ways to go. If we put that perspective back on equity markets, valuations have become relatively full on a lot of names, but we still see pockets where recovery still has not been fully played out. Sectors like healthcare, in particular CSL (ASX: CSL), you have not seen the volumes of collections recover and we still think next year you will start seeing that starting to advance. Qantas (ASX: QAN), you still have not seen international travel and corporate travellers fully return. So from that perspective we still see there are pockets, but valuations are starting to get towards the upper end. For us, we are starting to become more and more selective around those opportunities. And there are fewer of them.

James Marlay: One of the topics you did not touch on Matt when you talked about inflection points was inflation.Inflation is the grand debate that is taking place for many investors at the moment. What is your view on inflation and what does a rising inflationary environment mean for equity investors?

Matthew Haupt: Yes it is the question everyone is asking at the moment, is the inflation transitory, is it structural? The key point is, you actually do not have to get it right in the medium-term. We are going to have higher inflation. We have seen that coming through already, merely from base effects. You will get higher inflation and that will feed this trade. In the medium and long-term, we actually do not know where this will lead. Our view is that there is a lot of deflationary effects in force. It was thought that large monetary increase will cause deflation over time. The thought used to be that it would cause inflation but studies have shown that it is actually deflationary over time. I think we can park that medium to long-term view and just focus on short-term to medium-term view where we will get higher inflation. You have to position your portfolio according to that. We are looking at where you park your money in a high inflationary environment and normally it is around hard assets, such as commodities, which goes against the credit cycle, but the base metal commodities will actually get some attraction of flow into those.

John Ayoub: If we add to that, what we are seeing in the inflationary environment is we are starting to see the early stages of cost pressure coming through from all scopes of business.  For the last five years, we have been characterised by cost outs and most companies have been talking about cost outs. We are going to be seeing the opposite story over the next two to three years. What we really need to see is that top line growth coming through. If you look around the world, supply chains are still bottled up and you are starting to see lumber price accelerate up. We have to work out how long this lasts, when wage pressure starts to creep through. We are starting to see that already, particularly in Western Australia around miners and cost pressures there from a wage perspective and talent basis. Again, we have to watch this really carefully and see how long it lasts because as borders open up, we should start to see migrant workers return to Australia, which should alleviate some of those cost pressures. But from that standpoint, we really need to see the top line growth as corporate Australia starts to accelerate.

Matthew Haupt: That is an important point too around output gaps because economies are still under their potential gross domestic product (GDPs). As that output gap closes, that should be inflationary. That is why we are quite confident in the short-term that you play the inflation, you play the higher interest rate environment, and they are things you can really put your money towards working in the short-term.

John Ayoub: Lastly, what we are most excited about is that we are starting to return to normal markets. I think we are getting towards the end of thematic investing and just lower rates forever and people buying sectors rather than stocks. From that standpoint we are really excited about the opportunities that we get from a stock selection basis as opposed to just pure thematic investment.

James Marlay: You gave us an inkling to a disagreement that you have with a common view that we are in a commodities super cycle at the start of one. Can you tell me about that view?

Matthew Haupt: When you look at previous commodities super cycles it was really a demand driven event where you had the urbanisation of China for about 20 years, that was an incredible driving force of the commodity cycle. China has mini cycles of boom and bust based on credit. We are on the downturn of this at that moment. The supply side problems at the moment are driving this thematic around the super cycle and also the inflationary pressures of money printing. That is the common thesis of the super cycle, which I think is wrong. I think that supply side will get sorted out. It is a restocking event. Economies were closed for 12 months. Everyone ran down the inventories. Now people are scrambling to get the inventories back, manufacturing back and building that base. That is a driver. We are not in a commodities super cycle. Unless there was another country which could pick up the slack from China because they are the gorilla in the room, accounting for over 50% of childbirth, 70% of iron ore. They are the driving force of commodity prices in the short-term, so I do not think we are.

John Ayoub: Just to add on that supply side, and go back to closed borders. Labour is really tight, and if you look at how coronavirus-affected countries like Chile and Peru, it is really affected the supply output, and also Brazil. From that standpoint, as that starts to normalise, we should see some equilibrium returning to commodity markets broadly.

James Marlay: Matt, let’s switch from one dominant sector in the top 100 to another dominant sector which is banks and financials more broadly. The banks have had a great run up. We have talked about it in previous WAM Vault instalments. What is your view on the banks and how are you playing that financial sector?

Matthew Haupt: We are still very positive on the banks. The trade last year was quite obvious – trading at a discount to books. Now, the trade is a little less obvious based on the share prices. The story of Australian banks is still around capital management. We actually have not seen them enact capital management, and we will see them over the next three to six months really start to give back some of that excess capital. Commonwealth Bank (ASX: CBA) will probably launch an off-market buy back with a large franking component. National Australia Bank (ASX: NAB) will do smaller, bite-sized buy backs over the next few years. The capital management story is real, that will come through. Also, the provisions which were raised during the coronavirus period obviously will come back as the Australian economy has performed quite well through various measures through support and containing the coronavirus. There is still legs in the financial trade. It is probably done most of its work but you can easily see another 10-15% upside from here, or holding else equal, in the environment at the moment.

James Marlay: Outside of the banks what are some of the opportunities that you have found in the financial space?

Matthew Haupt: The insurers are probably lagging where the Australian banks were. The Australian banking sector raised provisions on the forecast of economic conditions being bad. Insurers got hit with the business interruption insurance claims or potential claims so they have raised provisions for that. It is just taking longer to unwind those business insurance, or the BI. We believe the insurance sector is probably six to nine months behind the Australian banking sector as far as trade goes. There is still an upside in the Australian insurance sector, it is just going to take a little bit longer to get paid from that. I think that is a key area where there is still some upside.

John Ayoub: A couple of others potentially is Computershare (ASX: CPU) and Challenger (ASX: CGF). Challenger is something we have reintroduced into the portfolio recently on the back of a weak update. We think as the world normalises and rates start to head up, and they start to get control of some of their risk parameters internally, we think they could re-rate.  So there are still pockets of opportunities starting to emerge in financials.

James Marlay: Well we have talked about a few sectors and stock specifics there. Matt, I was wondering if you could wrap things up by giving us a synopsis on your outlook for the Australian economy and some of the key things that are catching your eye domestically?

Matthew Haupt: With the Australian economy there is obviously a disconnect with the share market, which is always the case. The share market is always forward-looking. If we look at the Australian economy, we would say we are coming out of a recession, we are at early cycle. The stock market I would say is late cycle, because when you move policy rates where they went to, you pull forward returns. Your future returns are limited now. The economy is catching up towards the share market. It is just a debate about will the economic recovery be as fast or into the policy withdrawal? It is a balancing act at the moment. The way I look at the Australian economy is that it will be incredibly supportive until the Federal Reserve moves. We are going to sit behind the Federal Reserve. The RBA will not move until the Fed moves. We will probably get towards Q3 or Q4 before we get tightening in the Australian economy on the policy front. I am quite constructive on the Australian economy, until we get that tightening and that is just going to make the recovery a bit more benign because we are in this extraordinary period where policy rates could not be any easier. The RBA are holding the three year rate down. It could not get any easier than this. We are in the best conditions we could possibly be in, but the mismatch between the economy and the share market says future returns for the share market are limited because the policy will be going the other way.

John Ayoub: And from that standpoint, we are confident around active management and focusing on rotating the portfolio when we see opportunities. We think there is going to be a significant dislocation towards the back end of this year. We are watching the market very carefully and ensuring that we position the portfolio and manage risk accordingly over the next six to 12 months.

Matthew Haupt: This period of excesses which we are in at the moment, you see it everywhere, different asset classes, crypto, all that will come out of the market as tapering happens because that is all predicated on ultra-low rates and the death of Fiat, which once we start tapering, will kill off that argument. That excess in the market will come out as soon as tapering starts is our view.

James Marlay: Matt, for investors and shareholders out there, how would you summarise the opportunity that exists in WAM Leaders from this point going forward?

Matthew Haupt: For WAM Leaders shareholders, it is the two big inflection points this year, and historically we have been very good at capturing those inflection points. We have two – the credit impulse from China rolling over, and also tapering this year. Those are two important events and we are quite excited about when they play out.

James Marlay: Well Matt and John, great to catch up.  Thanks for your time today.

John Ayoub: Thank you.

Matthew Haupt: Thanks.

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