Investment update with John Pearce - June 2021
The US market’s financial cycle dictates most of the developed world, including Australia. So why aren’t markets reacting to economic conditions in the US that would normally cause mayhem?
With the pandemic and its effects likely to continue for some time, and a lot riding on what happens with inflation, there are optimistic and pessimistic views—‘bulls’ and ‘bears’—on what’s next.
Key points in Chief Investment Officer John Pearce’s latest video:
- All eyes are on the US market, with May CPI inflation at its highest level in 39 years and headline inflation running at over 4%. But markets seem to be viewing these conditions as transitory.
- The pandemic has impacted the ability to manufacture and ship, and demand is now increasing as economies recover. With prices rising, and equity markets hitting all-time highs, this means we’re seeing healthy numbers across several of our investment options.
- As at 31 May 2021, our Balanced investment option had returned close to 15% and our Global Environmental Opportunities option close to 40%. These are impressive results given we’re yet to fully emerge from the pandemic.
- For the first time in a few years, our Sustainable Balanced and Sustainable High Growth investment options haven’t outperformed their mainstream equivalents. With relatively low exposure to energy and no exposure to fossil fuels, these options didn’t benefit from higher energy and oil prices.
- Currently, ‘bull’ and ‘bear’ assessments of financial markets are evenly balanced. What actually happens will depend on inflation as this will determine whether interest rates tighten, stopping the ‘bull’ market, or trend down, sustaining it.
Read the transcript
John Pearce: Hi, it’s John Pearce, Chief Investment Officer. It’s nearly the end of financial year, so I figured it’s a good time for an investment update. Today, I like to go through what the key developments have been since the last time we updated. We’ll talk about how financial year returns are panning out, and I’d also like to share some perspectives on the near-term future.
Last time we updated, in about January, we talked about where we were in the economic financial market cycle. With governments and central banks throwing a lot of stimulus at economies, it was very clear that economic growth was back on the mend. Unemployment was starting to fall.
The flat result also disguised the fact that we saw enormous dispersion between companies and sectors within the market. For example, we had companies that actually benefited from the crisis. Wesfarmers (the owner of Bunnings), Coles—they were up about 20% during the year. At the other end of the spectrum, we had Sydney Airport, Qantas, Scentre Group, down about 30% during the year.
Typically, the normal cycle would dictate that markets will start getting a bit worried about rising inflation pressures, and this would lead to fears of central banks tightening. But we questioned, is this indeed a normal cycle? Will inflation reappear? Will central banks react like they normally do?
Chart 1: Chart showing the economic / financial cycle. Typically, recession and higher unemployment is followed by: policy stimulus and market rallies; a recovery in growth and a fall in unemployment; inflation and market falls; policy tightening. Then the cycle repeats. Two question marks signify that uncertainties exist regarding inflation and market falls, and policy tightening.
Let’s see what’s happened since.
As they usually are, all eyes are on the US market, because the US market financial cycle dictates most of the developed world, including Australia. What do we see in the US? Monthly CPI inflation in the US in May, was the highest in 39 years. So, year on year, headline inflation is running at over 4%. Even if we strip out the volatile food and energy prices, core inflation is recording over 3%.
Chart 2: Chart showing US core inflation over from 1985 – 2021. A spike in inflation in May 2021 is the highest in 39 years.
Normally, that would give rise to absolute mayhem in markets. You’d have bond yields spiking, you’d have share markets falling. What did we see this time around? Bond yields hardly moved and share markets, as we know, are hitting all-time highs in many parts of the world. Why the reaction?
A few reasons. Firstly, it’s fair to say that bond yields were already rising prior to this inflation number, and in anticipation of higher numbers coming through the system. From a low of well below 1% during the depths of COVID, Australian 10-year bonds were trading at around 1.6%.
The market is also looking through these high numbers, and it’s saying it’s transitory. There’s the base effect—if you look at what inflation was a year ago, prices were declining. We were in the middle of COVID. So it’s just a high number on a low base.
Then, of course, you have supply constraints. COVID has impacted the ability to manufacture. COVID has impacted the ability to ship. With supply constraints and increasing demand as economies are recovering, we see prices rise. What does this say for financial market returns?
With equity markets hitting all-time highs, it’s not surprising that we’re seeing some pretty healthy numbers across various investment options. Let’s have a look at a selection of them.
If you look at our Balanced option—and this is to the end of May, so we still have June to go—it’s recording a number of around 15%, which is pretty high, considering we still haven’t emerged from this COVID crisis. That’s a good number. But it’s nowhere near as good as Global Environmental Opportunities, which has been our star performer for a while, with close to 40% (financial year to date). So it’s great to see that that option is holding on to some of those great gains that it made last calendar year.
At the other end of the spectrum, we have the Australian Bond option, which is recording a negative return. So as yields have risen from their all-time lows, prices have fallen, and hence a negative number.
I think it’s worth pointing out the performance of our sustainable options, Sustainable Balanced and Sustainable High Growth. We’ve become accustomed over the last few years to see these outperform their standard equivalents. Yet in this financial year, they are underperforming. Why is that?
One of the key reasons is the rise in energy prices. Bear in mind that the sustainable options do not include any fossil fuel companies. So as the oil price has risen and energy companies generally have risen in price, the sustainable options have not benefited from this, and hence they find themselves underperforming their standard equivalents.
Chart 3: Chart showing the returns of several UniSuper investment options for the financial year to the end of May 2021. Sustainable High Growth: 19.4%. High Growth: 24.2%. Sustainable Balanced: 13.3%. Balanced: 14.9%. Global Environmental Opportunities: 40.2%. Australian Bond: -1.8%.
Having said that, overall, members should be pretty pleased when they get their statements for this financial year.
So that’s this financial year. What next? As usual, we have the ‘bear’ story or the pessimist story, or the ‘bull’ story, the optimist story. Let’s go through a few key points.
The bears, what are the things that they allude to, to say why markets are going to fall? Firstly, inflation. They’re saying, well, this is not transitory. We’ve had three decades of falling inflation. And that cycle, that big cycle, has come to an end. We’ll now see an upcycle in inflation.
Valuation. Markets surely are overvalued. I want to talk about the most popular or most common valuation metric, and that’s the price earnings (P/E) multiple. It sounds technical, technical, but actually very simple. Think about the Commonwealth Bank. The Commonwealth Bank next year is expected to make a profit of around $5.10 per share on issue. The bank shares traded around $102. So, the Commonwealth Bank is trading on a multiple of around 20 times.
That compares to an average of around 14. So, we can say that the market is indeed very confident about the growth prospects of the Commonwealth Bank.
How about we apply this to the whole market, this P/E multiple? It turns out that as you can see, the Australian market is trading on a multiple of over 18 times, which is well above its 10-year average. And the US market is trading on a P/E multiple of around 21 times, which is also well above its 10-year average.
Chart 4: Chart showing that the current price-to-earnings (P/E) multiples of the ASX200 and the S&P500 are above their 10-year averages. The ASX200’s current P/E multiple is 18.6 and its 10-year average is 15.2. The S&P500’s current P/E multiple is 21.1 and its 10-year average is 16.3.
The bears might have a point here. The market is pricing in a lot of good news.
Then of course, we have evidence of some bubbles appearing. If you look at the real estate market, pretty tough to buy a house at a decent price these days. We’re seeing evidence of more and more companies that aren’t making money, listed on exchanges. And then we see some really, really silly stuff, like Dogecoin. But I won’t get started on that.
Let’s turn our attention now to what the bulls are saying. Well, they’re saying, look, this inflation, it was all expected. It will be transitory. It’ll work through the system and then we’ll get back to those secular forces, particularly technology, that will get us back down to our low inflation path.
Valuations? The market is pricing in a lot of good news because there is going to be a lot of good news. The world is emerging from COVID. We’ve got the household sectors—it’s like a coiled spring, ready to unwind. Governments around the world are still spending money. So we have economic growth expectations really booming.
Now all of this is going to feed into higher corporate profits, and indeed, it’s already happening. If we look at the US market that we say looks a bit stretched in terms of valuation, well, that’s being led by the tech sector. Have a look at how these giants are performing, or have performed, in the first quarter. The household names—these are some of the largest companies in the world—growing their sales by 30, 40, 50%. And what’s more, their business models are so scalable, that they’re growing their profits by even higher percentages.
Chart 5: Chart showing the sales and profit growth of five large technology companies. Amazon: sales growth 44%; profit growth 122%. Alphabet: sales growth 34%; profit growth 79%. Apple: sales growth 54%; profit growth 110%. Facebook: sales growth 48%; profit growth 94%. Microsoft: sales growth 19%; profit growth 38%.
There’s a great productivity story to be told. In the first quarter of this year. The US produced $80 billion more in terms of goods and services than it did in the corresponding quarter of last year, and it did this with 8.5 million fewer workers. That is an incredible increase in productivity. Once again, this will feed into corporate profitability, and ultimately share prices.
And in terms of there being bubbles, it is true that stock markets are at all-time highs. But we’re not seeing evidence of a clear bubble. There are many companies within those stock markets that are nowhere near their all-time highs. Let’s have a look at the Australian market.
Look at the top 50 Australian companies. In May, you had four companies hitting their all-time highs in terms of share prices. That sounds impressive. But then consider how many companies—there’s companies in pretty much every sector in Australia—that is trading at greater than 20% below their all-time highs. That is not what you typically see in a market that you’d characterise as a bubble.
Chart 6: Chart showing which sectors and companies hit all-time highs in May 2021, along with others that were 20% below all-time highs. In the Banking sector, only Commonwealth Bank hit an all-time high; in the Mining sector, only BHP & Rio Tinto; in the Consumer sector, only Aristocrat. The following companies fell 20% below all-time highs: Westpac, NAB, ANZ for Banking. For Mining, Newcrest Mining and South32. For Consumer, Treasury Wine Estates and A2 Milk. For Telco, Telstra. For Energy, Woodside Petroleum, Santos, Origin Energy, Ampol and AGL Energy. For Insurance, QBE, Suncorp and IAG. For Travel, Sydney Airport and Qantas. For Property, Goodman Group, Scentre, Stockland, Dexus, Mirvac, GPT and Lendlease. For Industrials, Aurizon and for Chemicals, Orica. For IT, Afterpay and Computershare.
It’s a pretty evenly balanced argument at the moment. Who will win? It all depends on inflation. I think we can look past the next few months. By the end of this year, if inflation is still coming in at around 3% or above, the central banks probably won’t have any other option than to tighten rates, and that will probably stop the bull market in its tracks, and likely reverse it. If, however, we’re seeing inflation trending down to below 2%, the bull market can be sustained.
As is usually the case, financial markets find themselves at an interesting juncture. And so is UniSuper, because on the 5th of July, we are opening up to the public. I won’t go into the reasons for that decision but rest assured, it was not taken lightly. And furthermore, it was taken with the interests of current members, as well as future members, in mind.
Outside the university sector, our brand is not as well-known as other superannuation brands. We think we have a very compelling story to tell. If you agree, we’d really appreciate if you get your friends to give us a call, or organise an appointment with one of our excellent financial planners.
Thank you very much for listening.
This video discusses UniSuper’s investment performance and recent investment decisions designed to suit UniSuper, which may not be appropriate for you personally. We’re not suggesting you should make the same decisions.
This information is current as at 10 June 2021 and isn’t intended to be an endorsement of any of the listed securities named above for inclusion in personal portfolios. The above material reflects our view at a point in time, having regard to factors specific to us and our overall investment objectives and strategies.