Insights – Institutional investor

Inflexion Point

When the French team took on the All Blacks in the 1999 world cup semi-final at Twickenham, all eyes were already on a trans-Tasman clash the following Sunday. These certitudes only intensified a few minutes after half time, with the erratic French, clearly intimidated by the fearless and powerful running of Jonah Lomu, trailed 24-10. The second half is written in rugby folklore, arguably the greatest comeback in sporting history, setting up the French against the mighty wallabies for the final.

Comebacks of this nature are rare in sport and rare in financial markets. In many ways, 2020 was the year of the comeback in equities, a breathtaking sell off in Q1 followed by a breathtaking rally. Now that asset prices have approximately recovered their pre-COVID levels, they face a key test in this interim reporting season, one that will determine the winners and losers over much of the next six months.

In this note, we put together our views on where we see winners emerging from reporting season, detailing sectors, and stocks primed to benefit.

Key Themes and Associated Bellwether Stocks

In summary we see a few key positive themes starting to emerge in 2021 that will drive reporting season outcomes in particular:

MINING: Iron Ore and broader commodities higher for longer.
PROPERTY: Domestic property and construction.
RECOVERY: Broad global and domestic economic recovery.
RETAIL: Substitution of other forms of consumer spending, especially travel & tourism, with retail.
CLOUD: Cloud software and its impact on common business practices.

The following schematic identifies key bellwether stocks associated with each theme, and ones we are expecting to report earnings above consensus over the next fortnight.

Figure 1 below: 5 Key Investment Themes and Associated Stocks

What Next? Twin the unloved with an emerging theme.

This isn’t the only input in our investment portfolio.

Valuation is of increasing importance as the recovery comes through, and is ignored at your peril. We have seen the full force of brutal reversing markets in recent weeks of hedge funds that completely ignore valuation.

We suspect that a continued unwinding of shorts, a hangover from January’s returns, will permeate markets over the next few weeks. In our view the greatest upside in the short term will come from stocks with the tailwinds from one of identified themes, particularly if they are confirmed by solid outlook and commentary from one of our bellwethers, and solid valuation support, demonstrating a sufficient amount of neglect to warrant significant share price support.

The battle ground for investors for the remainder of 2021 looks likely to be US inflation, and the associated trajectory of interest rates. Interest rates after all were the saviour of growth assets in 2020, the Fed triggering an almighty equity market recovery inconceivable without its heavy handed intervention.

In the first note in our inflation series we cover the key issues and estimate forward returns on fixed income.

US CPI MoM changes: latest reading of 0.8% most significant since 2013 taper tantrum

The presence of upward readings on inflation has started with the elevated print for April CPI, of 0.8% MoM, significantly above consensus and the highest monthly increase for years. The debate around rates depends upon where one stands with regards to nature of the elevated inflation prints, and their persistence.

Of course, the pick up in inflation isn’t surprising; firstly, base effects, namely the fact that prices were so depressed a year ago as the lockdown hit that a “return to normal” will inevitably involve a significant increase in prices; second, fiscal stimulus.

To understand the role of fiscal stimulus in driving inflation requires a thought experiment: if one were to distribute one million dollars into every bank account in Australia, what would happen to consumer prices? While the magnitudes are naturally a good deal smaller, there can be no doubt as to the inflationary nature of government payments. And this differs necessarily from monetary stimulus, which favours the wealthy with the capacity for increasing their debt to equity.

Now that there is a unanimous acceptance that some inflationary pressures are inevitable, the key issue remains whether these pressures will abate in 2022, or the pre-cursor for a more prolonged and structural rise in prices. For asset allocators on a five-year view, this is the key question.

Inflation is typically associated with negative equity market returns (plot of annual equity market returns (vertical) vs CPI % change (horizontal)) 1973-

The layout of this red hot debate is as follows:

In the red corner: By describing inflationary pressures as transitory, the Fed is alluding to the fact that many of these elevated CPI prints are quarterly one-offs, that will eventually mean revert and drive the index back down to where it has been since the end of the GFC. This perspective justifies their stance on monetary policy. In addition to this, they have stated a shift towards outcomes and away from forecasting in setting monetary policy.

In the blue corner, by contrast we have many institutional investors, mainly hedge funds. Their views are being aggressively vocalised on podcasts and tv interviews, are staunchly of the view that the one-offs could become into structural issues, as the electorate become increasingly addicted to policies favouring mass handouts. This looks akin to the early 70s period, and much of the commentary alludes to this.

Inflation (horizontal axis) is also typically associated with lower profit margins (vertical axis)

Our base case remains that inflation is transitory. The risks however to being wrongfooted are enormous. This is because, as we mentioned, the Fed is focused on outcomes not forecasts.

This means they will wait for inflation to surprise majorly on the upside before acting to fend it off with rate rises. And by then, much of the damage might have been done. Company profit margins will get crimped by wage rises and increased input costs, and disposal incomes for many of the less well off in particular evaporate as the cost of basic items rise. This is the key downside risk for markets.

US Fed Funds Rate (Vertical) typically keeps up with CPI (horizontal) basis, Fed has signalled it will wait to raise rates till after the event?

Q1 2022 looks to be the key data period to determine the stickiness of CPI data. By that stage, the COVID crisis and lockdowns will be rolling out of sample, and we will start to get a sense of whether the supply-demand imbalances have started to reach an equilibrium, or whether 2021 was a sign for what was likely to come – and ultimately whether the red corner or the blue corner is right.

Up until that point, we expect numerous inflation scares to continue, as anxiety levels reach fever pitch. This is especially true of northern hemisphere economies, where lockdowns and distress have been far greater, and where the demand and associated inflation impulse in the second half of 2021 is likely to be strongest.

The US yield curve illustrates how investors are pricing in the trajectory of rates over the next 15 years: we have super-imposed where we think the yield curve should trade, and where it does trade. Despite the sell-off in February, bond market duration looks overbought. As a result, we think it will underperform cash and Australian duration – which is priced far more fairly.

The current US yield curve (orange) is expected to shift up over the next five years (grey) according to the market, our view is that this shift and steepening could be more pronounced (yellow)

In contrast the Australian YC looks much more fairly priced, right on our long term projections.

In Summary, we have a preference for Australian sovereign bonds, although are expected returns are low over global bonds. Global bonds are still not fully reflecting the economic recovery we expect in 2021 let alone any inflation. We have global bonds sharply underperforming cash.

A signpost for a permanent change in the operations of financial markets, or is it just another footnote in the absurd history of social media’s growing influence on our daily lives?

The fascinating events of the last week over in the United States, where an online mob were able to shake out shorts on a bricks and mortar computer game retailer, have caught the imagination of journalists and practitioners alike.

We will argue that this is more a harbinger of things to come, a world in which, information is disseminated instantly, and private armies are mobilised on digital platforms. This world will be absolutely a lot tougher for short sellers, and investors with short investment horizons; it will however, provide ample opportunities as capital misallocation, and security mis-pricing are left in its wake. Modern markets have just become a lot tougher for investors with short time horizons, however in the long term patience, diversification and process will be more rewarded than ever.

Gamestop

The stock closed out 2020 on a tepid $18.84 USD share price. This already represented a 500% rally of COVID lows back in April of around $3. The turn of the year however, saw this rally accelerate sharply, with the stock peaking out at over $465 USD (!) at 10am on the 28th of January.

Figure 1 below: Gamestop share price in 2021 (Source: Refinitiv Eikon)

Let’s put the stock price in a 20 year context.
Prior to this breathtaking rally of 1800% in a matter of days, Gamestop’s peak share price was a touch over $60 back in 2006.

Figure 2 below: Gamestop share price over 20 years, currently at all time highs! (Source: Refinitiv Eikon)

Over the same period, Gamestop has seen a structural decline in revenues, as shoppers gravitate towards downloading titles, a stubbornly high cost base, declining margins, despite cutting full time staff almost in half since the peak in 2017.

Figure 3 below: Gamestop Revenues over 20 years, in structural decline (Source: Refinitiv Eikon)

Figure 4 below: Net Income Before Extraordinary Items over 20 years, now loss making (Source: Refinitiv Eikon)

In our view, there can be no fundamental valuation for this stock to warrant a $460 share price.

So, if its not fundamentals driving the stock, then what on earth is going on?

Digital Revolutionaires

Perhaps its no surprise that the behaviour we have seen so regularly in the political arena would inevitably find its way to financial markets.

The ability to mobilise a private army online, in aid of a cause, has been a common feature of recent years. In this case, the recipe for revolt was, on the one hand driven by a hatred of institutional finance and hedge funds in the US in particular, on the other hand driven by nostalgia for the bricks and mortar retail landscape that struggled particularly in 2020 in the face of lockdowns. Throw in a large dose of boredom and copious amounts of fiscal stimulus.
The private armies are far from naïve of course. The battlelines are clear – regulatory filings provide a day to day perspective on enemy positions. The retreat from the hedge fund community, largely short the name for all the above reasons in the previous paragraph, has exacerbated the mania.

But that’s not all. Throw in in addition a large dose of call options, the risk of which accentuates as the stock rallies, forcing brokers to cover risk, has accelerated the rally.
The private army has effectively achieved what hedge funds have been doing for years, exploiting other participants unique situations for short term profit, by organising, and mobilising on Reddit.

Regulation the Answer?

In short, no. Regulation can assist in the short term, but long term is doomed to fail. The internet will always find method to mobilise private armies, regardless of platform. It is simply too sprawling to regulate effectively. This behaviour is here to stay.

Gravity Always Wins

There are a number of repercussions for markets.

The most prominent impact is on the aggregate behaviours that drive markets and prices in the short term.

It is often said that the financial markets are a giant voting machine, where agents cast preferences based on company prospects of future cashflows.

While this model of participant behaviour still holds over the long term, in the short term there are numerous motivations for trading stocks, beyond just maximising returns.

The most prominent motivation for trading this week has been risk mitigation, specifically short sellers and stockbrokers minimising losses. Short sellers are forced to cover positions, driven by internal risk managers and stop loss rules, and stockbrokers are forced to manage risks associated by the triggering of call options, the writing of which have been at highs not seen since the tech bubble.

These motivations for trading are so dominant in these specific companies that the long term picture on Gamestop’s cashflows are rendered entirely irrelevant. Long term, however, gravity always wins, and there is no question in our minds that Gamestop’s share price will eventually return to something like the $40 target price bandied around by many fundamental analysts.

Whither Concentrated Fundamental Long Short Equity Managers

We have argued that; in the long term fundamentals matter, but in the short term, competing motivations for trading can drive wild fluctuations away from this distant fair value. This narrative has amplified in recent years as a growing proportion of the market liquidity is driven by non-fundamental agents, whether a Reddit army, Artificial Intelligence, or passive/systematic.

This increasingly makes the environment for concentrated long-short fundamental equity strategies toxic. Unless the portfolio is sufficiently diversified, these wild stock price swings inevitably have the potential to drive significant losses, which reverberate through the portfolio. Remember that losses on Gamestop have triggered a broader cutting of short positions across the board, beyond the US market, with a number of highly shorted Australian listed names rallying as the inevitable hedge fund unwind gathered pace.

But all is not lost for long short managers – however, they will require, firstly, more patience from their investors, which will need to ride difficult periods, greater diversification, as stock specific volatility in heavily shorted names is amplified through the roof, and an awareness of these special situations beyond the institutional or corporate players and into the realm of retail private armies that are now to be considered serious players in financial markets on short investment horizons.

A long term history of the market shows that qualitatively the biggest drawdowns tend to occur when the market is euphoric, not fearful.

In this note we demonstrate why we see this market as somewhat complacent, and how this will be our biggest risk factor heading into 2021.

This does not detract from obvious positive market catalysts, such as vaccines, earnings upgrades, sky high iron ore prices, which are precisely the reason we should be both positive but yet at the same time conscious that a turn in sentiment would mean significant drop.

A fall in sentiment of this nature, the catalyst of which could and if it does occur likely will be a total left field event, is something we are actively protecting our portfolio against. We would discourage investors from putting all their eggs in the equity basket, and remaining diversified, for this precise reason.

Living with a Bi-Polar Market

This is something of a subjective and objective assessment.

In pathologizing the aggregate psychological condition of the market after a tumultuous year, one word springs to mind: bipolar. Bipolar describes fluctuations between two poles or states of extreme highs and extreme lows.

A bipolar state of the market is difficult to forecast, capable as it is of bouts of euphoric mania followed by periods of depressive hopelessness.

These sentiment swings have been especially acute over 2020, and explain a great deal of the return differences across stocks, manager returns, or asset classes.

Below is Resonant Asset Management internal indicator of risk sentiment in Australian Equities – a similar story can be found in other markets, even more acutely in the US.

What this demonstrates is the extraordinary lift in risk sentiment over the last 6 months, and given this indicator is typically mean-reverting, why we see this as an unsustainable contributor to stock prices going forwards.

Figure 1 below: Resonant Asset Management Risk Sentiment Indicator in Australian Equities. As indicator rises, investors are more incrementally more comfortable taking risk. This is typically mean reverting over long periods. (Source: Resonant Asset Management, Refinitiv)

Another indicator to use to gauge the euphoria of the market is to look at equity issuance. We can do this on the S&P 500 index by looking at a ratio of the market cap by the index level – if this quantity increases, then issuance is rising, and vice versa.

While this indicator is just at its nascent stage of a pick-up, this is undoubtedly a step change from the previous period, and since 2010, where companies have been buying back shares in aggregate.

Raisings are a net negative, as the Earnings per Share of existing shareholders falls as the share count increases.

In aggregate, 2.5% of the US market cap has been issued as additional stock on a net basis (subtracting buy-backs) over the last six months, countering any expected earnings growth on a per share basis.

Figure 2 below: net stock issuance on a rolling 6 month basis as a percentage of market cap, note this is a clean break from nearly 10 years of net buy backs. (Source: Resonant Asset Management, Refinitiv)

Guarding Against a Sentiment Swing

The bigger challenge in today’s financial markets is finding reasonably priced hedges.

With global sovereign 10 year bond yields at sub 1%, the struggle is finding reasonable priced hedges for portfolios with genuine negative correlations with equity markets and other growth assets.

Fortunately this market euphoria does yield some opportunities to pick up some reasonable priced hedges.

Hedge #1: Gold Miners and Other Uncorrelated Corners of the Equities Market

The Australian Equities market offers some unique uncorrelated exposures. Chief among them are the Gold sector, but there are others. They offer unique properties for multi-asset investors looking to hedge growth assets.

Regardless of the measure we use we see significant value in Gold Mining stocks. They have been violently sold off by short term macro traders rotating portfolios for a cyclical recovery. In their wake the traders leave companies trading on double digit free-cashflow yields. Exacerbating their misery is Bitcoin, which now seeks to test the $20k USD high from 2017 once again.

And now, the average stock in the sector is approaching valuation levels historically correlated with future outperformance.

In fact the valuation currently is associated with a historical outperformance of over 20% on a 12 month forward basis (see figure below, blue bars (LHS) is the Resonant proprietary valuation signal for ASX Gold Miners, versus orange line (RHS) subsequent 12 month total return).

Figure 3 below: Resonant Asset Management’s proprietary ASX Gold Miners Valuation model score (blue bars, left hand scale) versus forward 12m price return (orange line, right hand scale) – sector is currently undervalued to the extent it was in 2014 and 2016. (Source: Resonant Asset Management, Refinitiv, S&P)

Hedge #2: Use the ETF ILB

The iShares ETF ILB could see significant inflows in 2021.

The removal of a great deal of demand, followed by its re-instating, has caused consternation for suppliers in all economies in 2021.

The pent up demand unleashed looks quite plausibly to create an inflation spike, albeit temporary, next year or in 2022.

Inflation tends to lag the real economy, but we will see the market price inflation before official statistics suggest so.

As a reminder, ILB pay quarterly coupons linked to official releases of SPI from the ABS. This means that, should inflation expectations increase, investors will buy ILB in the expectation that the income on this product will increase.

The more persistent the perceived rise in CPI, the more likely the investor is to see fair value in this ETF.

We suggest a portion of Fixed Income portfolios should be exposed to ILB, as under this scenario, it will provide better hedging than the fixed and inflexible nominal government bond.
It will still benefit from an extended QE program, which drives down real yields. It is in fact perfectly aligned with the goals of the RBAs stated position, which is that employment is to be prioritized over inflation – ie. Inflation will be allowed to run without rising rates if employment is above a long term objective (probably around 5%).

Hedge #3: Start to Build an Alternatives Exposure

This goes beyond the scope of this particular note, but we feel that a return of volatility and the struggle to find well priced effective hedges should play in the hands of hedge fund managers.

Selectivity however is key in this space.

Investors can no longer be satisfied with paying hefty fees for trend following strategies, which are effectively automated and don’t provide the desired diversification at market turning points.

The overall balance of a combined suite of alternatives can however shield the portfolio through tough markets, particularly if they are able to effectively and skillfully employ derivative strategies, which are beyond the scope of many investor portfolios.

2020 was a tumultuous year, but significant grounds for optimism await for 2021. Two vaccines announced in November with an apparent efficacy of over 90% look set to bring back some normality to life and markets.

Below, we give Resonant’s take on 3 key investment decisions for 2021.

Key Decision #1: Wither bond allocation?

We don’t think so, at least not yet. We do however see risks to bonds building on the horizon, and we are keeping a watchful eye.

Bonds play a dual role in portfolios.

Firstly, they provide a stable income stream. Secondly, they hedge the business cycle risk inherent in Growth assets such as equities.

The stability of the income stream is both a strength and a weakness. It’s a strength because the risks of the holder not receiving it are minimal. But equally, the stability is a weakness because it is especially vulnerable to erosion by inflation.

This particular market regime, which began in 2009, has been characterized by 1) falling cash rates, 2) persistently low inflation (see figure below).

A switch in inflation regime, is ultimately the biggest risk to a long duration fixed income portfolio. This looks very unlikely next year, as it tends to strike with a lag on domestic recovery, so even if the recovery is explosive, this may only happen in 2022 at the earliest in our view.

And when that happens, rates will be slow to adjust as the RBA has consistently recently signaled a prioritization of full employment over inflation.

The second role for fixed income is to hedge risk assets. Concerns over its efficacy in smoothing the return stream of a diversified multi-asset portfolio are overdone in our view. What matters in this case, is the steepness of the yield curve (the gap between 10 year bonds and short term cash), rather than its absolute level, and the duration.

Australian sovereign bonds offer more steepness than most if not all markets, and the duration has been increasing across all fixed income segments. Finally the RBA has signaled its intention to target long term bond yields in a crisis, and will actively seek to flatten the yield curve, to ensure the currency remains competitive. That increases the likelihood of a capital gain if risk assets struggle.

Key Decision #2: Growth or Value?

One issue that has been gaining in air-time recently has been the rotation from Growth to Value. Investors are questioning how they should position for next year, and whether any Value rally can persist for most of next year.

Our conjecture is that the Growth outperformance YTD is more about sector positioning (IT, Healthcare, parts of Consumer Discretionary for Growth Managers, Energy, Financials, Cyclicals for Value managers) than Style. Resonant’s internal analysis shows that when neutralizing the sector effect, we actually find that this year has not been so bad for value investing. (see figure below, rising line indicates growth outperformance over value – this year has been flat, with some wild swings, especially November 2020).

Unfortunately, however, sector biases of the typical Value manager have been the single biggest detractor of outperformance in 2020.

Next year we expect this sector effect to neutralize – we actually anticipate a return to stock picking, as opposed to sector selection. Therefore we see potential for both Growth and Value managers to outperform, but see the outcomes driven more by pure stock selection, rather than sector selection. The key will be to have managers in the portfolio of both style stripes who can pick stocks effectively within sectors, rather than riding the wave of a lockdown.

Key Decision #3: Which tech?

2020 has been a ground-breaking year for tech companies, with the lockdown precipitating the take up of digital solutions for shopping, business meetings, social interaction and so forth.

The big question, is to what extent will these tech solutions be maintained in 2021 as conditions normalize?

We see a bifurcation in the tech space, with certain solutions going from strength to strength while other wither away.

One area where we see increasing pressure in 2021 is the Buy Now Pay Later (BNPL) space.

There is no question that the ability to better and more efficiently manage a credit pool is the key advantage versus traditional credit cards. However there appears to be a clear demographic bias to the users versus traditional banking (reference ASIC report). This is a double whammy for BNPL, firstly because responsible lending laws would make a similar allocation of credit from traditional banking an impossibility, so it has been able to become a major player extremely quickly, and secondly because the late fees have been so lucrative for much of the sector. We also know that demographically the same bias is evident in the fiscal stimulus, making the sector especially vulnerable as it rolls off early next year. (see figure below, and associated ASIC report here: ASIC report into BNPL sector)

Figure Above: BNPL usage by age relative to credit cards and overall population split (source: ASIC)

But the inexorable rise of software and cloud computing is here to stay in our view.

There will never be a better time for businesses to replace inefficient processes and infrastructure than 2021, bearing in mind the Federal Budget measures to facilitate instant write-offs.

Modernising equipment and process will inevitably lead to uptake in modern software solutions and businesses look to build for the future.

The Energy Sector has suffered more than most in 2020, as a global collapse in the oil price and economic activity set share prices on a plunge from which we have only seen a small glimmer of a recovery.

But what are the prospects now for this sector as we come to a key signpost in the coronavirus crisis, with lockdowns starting to ease globally?

Figure 1: The chart below displays Year to Date (YTD) and 1 Month (1 mth) total returns for selected ASX listed Energy stocks as at close 7th May 2020. (Source: Refinitiv, Resonant Asset Management)

Many Levered Up Balance Sheets

Amplifying the misery has been an overly aggressive capital structure in many of the stocks, some of which may need to raise capital should the commodity remain at historic lows.

Figure 2: Net Debt to Equity (High indicated highly geared) and Interest Cover ratios (High number indicates increasing cover from EBITDA for interest payments) for selected ASX listed Energy stocks (source: Resonant Asset Management, Refinitiv)

What now for the sector ? If the oil price were to gravitate back towards the 40-50 US$ range, then all manner of financial leverage risks would suddenly be put on the back burner – a scenario that could see the stocks double.

In this note we look at the key issues driving the oil price, which whether we like it or not, is the key factor in deciding whether or not as investors we should think about adding these stocks to their portfolios.

April Madness

April was a historic month – never before have we seen oil futures fall into negative territory. How this event occurred, and the future outlook for the oil price, holds the key to understanding its trajectory over the next few months

Figure 3: WTI Futures front contract (source: Refinitiv)

Modern commodities markets are a largely symbiotic relationship between speculators, hedgers and producers.

Producers care about storage deeply, particularly when inventories are running sky high in an environment such as this, with demand so low.

Speculators haven’t historically considered storage, their focus is more geopolitical and global macro-economic.

Hedgers are merely looking to manage an existing exposure in their books, so typically price insensitive, and motivated by neutralising risk.

What happened at the futures expiry in mid-April is that some speculators suddenly realised that producers were deeply focused on storage, to an extent they had not considered possible or likely. In fact so focused, that there were no buyers a day before expiry.

Will this repeat next month?

Speculators have already modified their approach to tackle storage in a more considered way.

We know this because the major vehicles for speculators, ETFs that purport to track the oil price, have switched from buying the front to spreading across multiple future expiries, and announcing that the roll will take place over a ten day period rather than in the immediate run up to expiry (for details, see: USO Portfolio Changes).

We can therefore expect a smoother ride as a staggered and incremental roll takes over a prolonged period.

In part however this is necessary because we have seen breathtaking inflows into these ETFs, and therefore into a long oil futures position. The NTAs of many of these funds has risen dramatically (3x since year end), especially when you consider that the price of these instruments has fallen dramatically (10x unit creation in end of February).

Figure 4: US Listed USO ETF Net Tangible Assets (Source: Refinitiv/Lipper)

Figure 5: US Listed USO ETF Equivalent Number of Units (Source: Refinitiv/Lipper, Resonant Asset Management)

What this suggests to us, is that the mean-reversion trade is very well supported already, and likely priced in already into the futures market. An end to the lockdown, and something of a return of demand, is largely anticipated. So how does demand look?

Figure 6: Indicative US Oil Demand (Source: Refinitiv Eikon , EMI Gasoline US Total Sales Volume) by Year – Dip down is 2020, other lines are 2014-2019

The problem for storage, is that, with every surplus in supply over demand there is incremental pressure on storage. How is production shifting to the new environment?

OPEC has already been squeezed diplomatically to cut production by around 20% – but the main swing factor, will be US domestic production. This may be why storage is less of a concern in May than in April:

Figure 7: North America Oil Rig Count (source: Refinitiv Eikon, Baker Hughes)

Rig count is now down more than 50% in record time: suggesting that the industry is adapting to new realities.

How we are playing this in portfolios

Our exposure to the Energy sector remains modest, because we feel that despite the production cuts, considerable risks still lie to the downside, and exceed current upside risks.

This is especially true when you consider how quickly speculators have moved back to a bullish position, as evidenced by the extreme buying of ETFs and other products in the US which is essentially a mean reversion trade.

We are sitting this one out, looking to play a recovery in other ways – for our portfolios, risk management remains a critical component, we will reconsider once the situation in energy markets becomes clearer, and we can benefit from a less pronounced recovery.

Infrastructure & Property

One of the key defensive cornerstones of multi-asset and equities portfolios since the end of the GFC has been the use of property and infrastructure securities. The typical structure is a trust, holding assets or part ownership of assets, an optimal quantity of financial leverage, an delivering a stable and consistent income.

We will argue in this note that selectivity and a discerning eye will now be required in this asset class, with the use of ETFs for broad passive coverage now fraught with risks now we have entered a new market paradigm.

What characterises this paradigm and how does it differ from the traditional view of this asset class?

To answer that question requires us to consider what effectively a lockdown means for our assumptions of the stability and predictability of cashflows for these assets. What the lockdown highlights, is that cashflows are far from predictable or certain, when clients and customers are unwilling or unable to utilise the infrastructure once deemed “recession proof”.

Suddenly the utilisation of the asset, and hence the revenue stream, develops a level of risk, perhaps not associated with the business cycle, but more associated with government policy around pandemic risk, and our willingness even in the absence of a lockdown, to mingle freely with our fellow citizens in a workplace or a shopping centre, where there is no exacting requirement to do so.

Sell-side forecasts are already starting to reflect the uncertainties associated:

Figure 1: In the chart below the orange line (RANGE) is the spread of dividend estimates across sell-side analysts – as the line increases, analysts are more prone to disagreement.

The blue line (STAB) is the standard deviation of estimates, a different measure of uncertainty, which essentially confirms the same trend – analysts are increasingly uncertain as to the trajectory of dividends for these assets.

(Source: Refinitiv, Resonant Asset Management)

Why does this matter

Uncertainty never was the name of the game with these securities – investors use them specifically to provide a cushion during times of market turmoil.

In addition, providers of debt capital have not factored in the incremental risk we now see: even if the RBA target rate is at record lows, the cost of debt of these assets certainly is not.
In financial markets, perceptions matter as much as reality: perceptions have now shifted, at least semi-permanently; away from stable to unstable cashflows.

The stability of cashflows and cheap cost of debt is what permits the issuers of these securities to embed financial leverage:

Figure 2: Index weighted Debt to Equity ASX 200 Infrastructure and Property Stocks (source: Resonant Asset Management calculations, Refinitiv data)

The chart above is the weighted average Debt to Equity ratio of these stocks. The series is volatile because of the way the data is reported by specific companies – suffice to say, that over the last ten years, the trend is up – from around 60% net debt to equity to at least 80% and on the latest estimate, over 100%.

Debt in itself can be a good thing for equity holders as it enhances returns. But it also increases risks, risks that are latent, not apparent to investors until they are.

What happens now

A protracted and prolonged de-rating of these securities is inevitable, particularly for assets whose cashflows were assumed immune to uncertainty, and for whom reality is now setting in. As we crunch our asset allocations, what long term risk premiums would traditionally satisfy for this asset class?

Figure 3: Risk Premium over Cash Demanded by Investors in Property & Infrastructure Stocks (source: Resonant Asset Management)

The chart above shows the return demanded by investors over cash to invest in the asset class: as you can see we have moved from a near 3% hurdle rate to invest, to near 6%, as uncertainty hits.
What is important, is how this compares to competing asset classes: and in our view, the gap between the risk premia for equities, and this asset class, is inevitably closing:

Figure 4: Risk Premium over Cash Demanded by Investors in Property & Infrastructure Stocks (Blue) vs Broad Australian Equities (Orange) (source: Resonant Asset Management)

In fact we would argue that this should not be treated as a separate asset class any longer: it is quantitatively tantamount to equity risk, and offers no exceptional or structural defensiveness, that merits its exceptional treatment.

We advocate selectivity in the main across these assets, as there are securities within the complex that will continue to offer stable cashflows, but the dispersion in outcomes across the investible universe will be large, so passive investing is the least attractive approach at this point.

The Coronavirus outbreak has blindsided markets since mid February, with equities down nearly 30% off their peak. What investors need at this juncture is a line of sight on valuations, to get a sense of what sort of scenario this sell-off represents. Analysis of this sort is vital to build a profile of the probability landscape around different coronavirus outcomes.

There are two drivers of the sell-off:

1. Projected Earnings hit: the extent to which earnings are impacted is hard to gauge but will be pronounced. The market anticipates a raft of downgrades.

2. Increased uncertainty: we have little idea what to expect in terms of the length or extent of the disruption to the economy caused by this virus. Because we can’t quantify anything, realised financial market volatility becomes extreme; making equities a less attractive investment on a relative basis to alternative investments.

We can look at quantifying the impact of point 1 and 2, to get an idea of what sort of scenario the market is pricing in; and to make a decision, given the virus data that we can track, as to whether equities is likely too bullish or bearish.

Increased Uncertainty

One of the hallmarks of financial markets over the last ten years has been anaemic volatility. Driven ultimately, in our view, by a total absence of inflation, it has been a key driver of making equities incrementally attractive and driving up the market’s fair multiple.

Let’s estimate the relationship of volatility and fair multiple. As fear and risk perception elevates, the fair multiple collapses. Conversely, as visibility and a line of sight appears on earnings and the economic hit, volatility will progressively moderate, and the fair multiple of the equity market rises.

In order to quantify the relationship, Resonant has built a simple model to estimate the sensitivity of fair multiple to the implied volatility index (S&P/ASX 200 VIX Index). Clearly, this is an exercise in educated guesswork, we still feel that a rough estimate is better than no estimate at all.. It is however no substitute for following the markets closely over this period, but it helps enhance the research process.

To estimate our relationship, we look at historical data on the Australian Equities market between 2010, when the VIX series starts, and end of February 2020.

Figure 1: S&P/ASX Australia VIX (LHS, source S&P/Refinitiv) vs Equity Risk Premium (Source: Resonant Asset Management)

Based on the relationship, we have quantified every doubling in VIX, to a 1% increase in the risk premium (ie. The equity market sells off).

Earnings Hit

Volatility and earnings are intrinsically linked. Only now are we starting to see economists quantify the full impact of the virus on the domestic economy. We are looking at two quarters of negative GDP Growth for Australia, should the lockdown succeed and the virus be contained. Citi is forecasting that GDP will contract by 4.4% over 2020 (See: Forecasting the largest percentage change GDP growth contraction in history, 24th March 2020, by Josh Williamson, Citi Economics Research)

If we assume that the stock market is an adequate representation of the economy – then we can project sales revenues (as opposed to earnings, which will be much more pronounced) for companies to fall approximately 5% over 2020. The disparity in outcomes will be huge, with some industries (tourism, travel), impacted far more than others (healthcare, supermarkets, cloud computing).

To translate the sales/revenue hit to earnings we need a sense of where corporate margins sit. And their likely trajectory. Shareholders ultimately should care about Net Margins, which have a cyclical component, and a policy component, amongst other things.

Cyclical Component: We would expect that aggregate margins would fall, as companies face fixed costs of keeping the lights on, regardless of broader conditions.

Policy Component: Governments look to cushion the blow as much as possible, by implementing tax policies and stimulus to minimise the hit to margins.

In addition to the revenue hit, we need to estimate the margin hit, to get a sense of impact on earnings.

Currently the weighted average net margin for an S&P/ASX 100 ex Financials company is currently 13%. As you can see it has fluctuated with Commodity prices in particular – the trough being in late 2015.

Figure 2: Index weighted 12m forward net margins for the S&P/ASX 100 index (source: Resonant Asset Management calculations, Refinitiv data)

Over the next twelve months, what can we possibly expect to happen to Net Margins, Revenues and Earnings?
In order to answer this question, we’ve put together a matrix of outcomes, broadly splitting the economy into V-shaped (12 weeks), U-shaped (2 quarters), and L-shaped (1+ years).

Figure 3: Approximate Revenue, Net Margins under different macro-economic scenarios

Market Projections

We think the VIX will settle around 25-30 at the end of March, and trend towards 20 for the rest of the year, as uncertainty as to the course of outcomes for this virus continues to play out. For us to get to 20, we would need a clear example of a western democracy that has successfully managed to “flatten the slope” and manage the hospital overload. For example, if Italy were to consistently and successfully slow the increase in cases, then that would bring market volatility right down, as it would demonstrate to other countries what is required to achieve this, and on what timeframe.

We suspect that if the social distancing and lockdown policies in Italy have been successful, then we are looking at a U-shaped recovery for Australian corporate earnings.
That means 12 month margins of 10% (from 13%) and a 5% revenue hit, in total a 30% hit to earnings.

Figure 4: What’s the Market Worth Under Different Volatility, and Earnings outcomes

We see our base case described above, where the market is worth 5019 points, a U-shaped recovery, 5% negative GDP Growth, and a volatile equity market to the order of a VIX at 20 from April for the next 12 months, as a price target just a tick above 5000. That would correspond to a yield of around 4.5% plus franking, and an additional 5% upside from the close price on the 24 th of March.

Finally Politicians are listening to scientists, and pursuing an appropriate strategy to change behaviour and minimise the infection rate. This is not only necessary from a health/humanitarian perspective, but also from an economic perspective. If coordinated properly and effectively across the globe, this could help minimise the economic disruption while simultaneously maximising the humanitarian outcomes.

Market Fragility

Another tumultuous week for equity markets last week, which began on Monday with a huge sell-off and continued throughout the week. Two events coincided to create a perfect storm for Growth assets: Coronavirus and OPEC Oil negotiations.

The signpost for us that the markets had changed to a new regime, occurred on February 28 th . That was the day that the domestic market forgot all about reporting season, fundamentals, and focused on the virus and its effects. The day’s trading sufficiently spooked us to think that a rejig of the portfolios was necessary.

Who Cares about Earnings?

The last time we saw a meaningful regime change such as this in markets was 2008. Over these periods, which naturally occur every ten years or so, the market becomes entirely focused on speculating the future prospects of companies over the next two quarters, at the expense of all else. This means typically a giant unwind of the most speculative active positions towards a more defensive orientation. And that is exactly what we have seen. As ever with these events, hedge funds are leading the charge.

In our portfolios, we looked at our individual stock positions over the weekend of the 29 th February and 1 st of March, and jettisoned any stock in the eye of the storm – first on the chopping block where travel, tourism and education, followed by deep cyclicals such as resources, retail, & media. We rotated nearly 20% of our direct stocks portfolio into cash.
The timing was fortunate, because this week has been the most volatile and unsettling for equities investors since the GFC.

Thank Goodness for Diversification

Our multi-asset portfolios have held up relatively well amongst the carnage. In our International Equities sleeve, we have been conscious of the prospect of a tail event given the strong run equities have enjoyed over the last few years, and have positioned unhedged, and overweight Japan (and most importantly the Yen), and Asia, underweight expensive US and underperforming Europe. Yen strength is an inevitable predictable consequence of a dramatic sell down such as this, given the repatriation of the enormous quantity of foreign invested capital which inevitably occurs.

The advantage from a risk management perspective of using precision instruments such as ETFs is only too apparent in these markets. The biggest delta has been from managing the currency right, just as it was in 2008.

Looking Ahead: Our Base Case

While it feels as though we are currently staring at the abyss, there are now reasons to start thinking of the future.

This morning the US announced that it was stopping any EU visitors for 30 days, a move that is both draconian but necessary. We expect Australia to follow suit – cases in Europe are now expected to escalate and the trend looks quite terrifying. We expect however that these extreme measures are indeed what is required to get this virus under control, along with school closures, minimisation of travel and public gatherings, and working from home.

We are now moving into the step where governments have a clear role to play, pulling massive fiscal and monetary leavers to manage what Boris Johnson described as the “once in a hundred year health crisis”.

The coordinated fiscal and monetary response will be massive in our view. Governments and central banks can ill afford to sit on the sidelines and moralise about cheap money, this is the difference between a transient global recession, which may last a quarter, and a prolonged depression that takes place over a number of years.

To put it in context, we have to think that we are staring down the barrel of sitting at home for much of the next six to 12 weeks, as this virus is contained. If we can successfully navigate this without business closures, job losses, and a total ramp up of unemployment, we can come out the other side of this with a huge ramp up in activity one this has passed, which you would have to think would somewhat compensate for the initial recession.

That is our base case: this is contained, we get an enormous stimulus both fiscal and monetary stimulus, in which case this is a buying opportunity to hold for the long term. Sentiment will whipsaw investors from now and certainly until the end of April, but we feel at this point that the base case is priced into markets.

A Gloomier Scenario

To construct a gloomier scenario, we would have to think that:

1. Infection rate in developed markets of around 70%
2. Quarantine lasts up to one year
3. Massive speight of corporate defaults
4. Mass unemployment, double digits.
5. House price crash.

None of this is likely; governments have woken up to the health crisis and steps are being taken.
Under this view, you would currently be selling equities further.

Looking Even Further Ahead

Assuming our base case comes to fruition, how does this change the world?
A few geo-political risks on our radar:

1. Iranian and Middle Eastern instability. The conservative religious government in Iran came into this health crisis with waning popularity, a botched missile launch. Iran was hit harder than most, and struggled, weighed down by inadequate health infrastructure. To rub salt into the wound, the oil price collapsed to $30, likely to trigger an economic meltdown in the country if this persists. The middle east has typically been about two camps, Saudis and Iranians. The collapse of Iran could herald more wholesale changes across the region.

2. Global Supply Chains entail sovereign risks. Back on the political agenda will the repatriation of manufacturing of key products. The electorate has woken to the sovereign risks of outsourcing all of your manufacturing and production offshore.

3. Europe is ultimately re-invigorated. This is less certain but an effective fiscal response to help Italy will dramatically alter the electorate’s perception of the European project. This is potentially a second order factor, not before much economic and political pain.

4. Locally mortgage rates hit zero or thereabouts as we enter QE. Given the cashflow crisis that many over indebted households will face over coming weeks, this effectively reduces interest payments to near zero, and allows Australians to “hibernate” until the virus passes.

These four key factors will drive:

The end of the bond market bubble – we think that the massive deployment of fiscal stimulus combined with onshoring manufacturing and production will possibly raise the spectre of inflation.
A change in behaviour – this will draw a line on the post GFC period and open up the market to more volatility and risk taking behaviour. This will draw a line on income and wealth inequality. The electorate will demand this. The business cycle will return.

More selectivity and active management will be required – the pure passive ETF model will die with low volatility and non-existent inflation. Skilled stock pickers and asset allocators will benefit hugely from the regime change.

A wholesale change in work practices. Work from home, flexible work, and so forth will all become mainstream as we get a sense of our own fragility and mortality and reconsider our priorities – economic growth is not dependent on our ability to attend an office in a CBD for 70 hours a week – software and remote access, teleconferencing, will become mainstream.