This article is a transcript of a webinar held by Cameron Harrison on 7th October 2021
View the presentation here.

We are presently going through a period of elevated inflation due to COVID related supply curtailment, just-in-time bottlenecks, significant goods demand in the US and consequential flow on to shipping costs, shipping containers being in the wrong place, and the collapse in discretionary service demand. The reasons are many, but the just in time dynamics of global trade supply have been currently upended but will ultimately resolve with additional contracted shipping capacity and services demand re-emerging to rebalance US goods demand. Overall we believe these price impacts will be transitory, and this appears to be reflected in final goods pricing.

We can see that core inflation expectations are moderate, illustrated below in the COVID 19 disruptions graph. Further below we can see the breakdown in the US of input, intermediate and final prices. Input and intermediate prices are elevated but business is being restrained in passing these costs on to consumers through final prices. This reflects a belief that elevated prices due to supply issues are transitory.

Similarly, transitory inflation is seemingly how both bond markets and equity markets are assessing currently elevated prices. We see that US 10-year bond markets are pricing lower-for-long interest rates with little concern for current inflation. Yes, there is presently some short term volatility, but 10-year bond rates rising from 1.15% to 1.5% is merely pricing some improvement in economic conditions from what were absolute lows. This is largely due to the question of when the Federal Reserve will begin to reduce its purchase of government bonds or taper. The other question testing markets is whether growth in the US has peaked. All of this adds up to markets still selecting to ‘look through’ the current supply-side inflation and adopting lower for longer interest rates. We think this doesn’t adequately reflect the changing economic landscape.

We are of the view that the developed world and particularly US economic growth will be healthy through 2022. This will be driven by fiscal stimulus, still relatively low-interest rates even if they rise progressively over through to 2024, accumulated household savings and pent up services demand. We can see that Australian household saving growth is elevated and ready to be utilised. Even if only partly utilised, the extent of household savings is a huge add-on to normalisation spending on service. These conditions are replicated in the US.

For growth to be sustainable though, government spending or fiscal policy is going to need to continue to contribute. This fiscal support needs to occur simultaneously as monetary policy is required to normalise through tapering and the raising of interest rates. Again, this clearly has volatility written all over it. The below graph illustrates US corporate debt, and in particular net debt is comfortably positioned. So in terms of general company health after a short COVID health recession, corporates are in good shape.

As we have mentioned, we see the current largely supply-side inflation pressures abating, but that more meaningful demand-side inflation is likely to emerge. In particular, given our strong economic growth expectations and our view that the Reserve Bank here and the Federal Reserve in the US will act too cautiously to moderate monetary conditions, there is a high that risk of broad-based inflation and wages pressure emerge. The re-emergence of demand for services will be a key watchpoint. Accommodation is the biggest component of US Consumer Price Inflation. The below graph shows current rents which exemplify the hugely elevated levels of aking rents at present. The significant risk is that with immigration curtailed, wages growth elevates and feeds into inflationary expectations fuelled by real cash rates that are held too low for too long

When positioning our investment portfolios for the coming shift in interest rate, we must first note the very unusual starting position for markets; the COVID-19 driven recession was unlike any previous recession, with household incomes increasing and equity markets delivering stellar returns. Largely due to the extreme policy response by both central banks in the form of rate cuts to near zero and quantitative easing to reduce long-end yields and governments in the form of stimulus cheques and other spending packages, most notably infrastructure. As this recession was a health crisis, that then caused an economic crisis, it gave policymakers a head start to apply support measures; it is unlikely that we will be so lucky next time. The end outcome is that instead of starting the recovery cycle with suppressed market valuations, which would normally be between 14-16x forward company earnings, we instead have markets at all-time highs and a PE ratio north of 22 times, a similar level to the DOTCOM boom in late 1990.

So, do high valuations mean bad returns in the short term? In short, no. The chart below shows the distribution of annual returns over a 1-year (green line) and over 10-years (black bars), when the starting valuation is above 30 times on a cycle adjusted basis; a position that we currently find equity markets in. Despite high valuations, the distribution is skewed to the right, implying a greater chance of positive 12-month returns than a negative. So despite the high valuations, it does not mean that markets are certain to collapse in the short term. However, over a 10-year horizon, this is not the case. The distribution is significantly tighter, with outcomes falling within a plus-minus 10% return.

Not so long ago, at the beginning of the year, we had a taste of what the inflation trade would look like, as economies reopened bond rates rose sharply, creating concerns over the impact of higher inflation. Then as quickly as this occurred, the delta-variant forced many economies back into lockdowns and restricted economic activity. The turning point for this was the 13th of May and we can see a clear delineation of performance across sectors in the months leading up to the point and the months after this date, which is shown in the bar chart to the right. As bond markets rose, the sectors at the bottom of the chart – Industrials, Materials, Financials and Energy – drove the performance of the market. Companies within these sectors have higher operational leverage to the cycle, as economic growth accelerates their earnings tend to growth faster, offsetting the impacts of falling valuations. During this period, more secular growth sectors like Utilities, Technology and Staples all underperformed.

As of today markets are yet again going through the same gyrations and the portfolio allocation implications are reasonably obvious; you want to be overweight the sectors that are leveraged to higher growth. Shift to look at our portfolios now, it should come as no surprise that we have a very different sector allocation to that of the benchmark. The notable deviations where we are overweight are circled in red on the chart to the right of the slide.

Firstly, our industrial allocation is 30%, compared to under 10% for the index. The industrial sector can be broad, for our portfolios this covers investments in logistics and railroads, such as Union Pacific in the US, equipment manufacturers like XP power in the UK and smart industrial companies like Honeywell. The common thread being they are business-to-business companies that benefit disproportionately as economic activity increases.

The second point of difference is our allocation to Consumer Discretionary, which includes our investments in home builders and home supplies, automotive, and finally retail operators like Home Depot, similar to Bunnings. The key to inflation moving from transient to persistent will be consistent wage growth – the sectors that I have outlined will benefit from higher disposable incomes.

Finally, we are underweight Technology companies, we do own Microsoft due to its excellent management, wide economic moat, and importantly it makes acceptable profits unlike many of its peers. We also invest in industrial technology like Honeywell that focus on business-to-business services, as they typically have higher barriers to entry.

The end result is a portfolio that has a higher forecast earnings and dividend growth without the need to invest in companies with sky-high valuations. To put this another way, it is higher growth for a lower price.

Cameron Harrison have been advising business owners and their families on asset allocation and intergenerational wealth management for over 50 years. We have demonstrated over a long period our ability to manage investments through both the good times and bad by keeping the client at the centre of our business.

For more information on our approach to investment strategy or any other inquiries, please contact us on +613 9655 5000.