Shannon's view on the current market environment.
The headwinds for risk assets remain elevated as the end of the financial year approaches, with stubbornly high inflation, rising interest rates and slowing growth translating to a very different picture to what has been experienced for many years. Perhaps if markets were still trading at all-time highs, it might be easy to look at the macro picture and sell, but markets have corrected significantly already and the question for today is: ‘are we at the bottom?’.
The answer to that question relies on a multitude of variables, and sadly, we will only know that answer looking back in hindsight. So, rather than trying to ask that question, perhaps a more prescient question is: ‘is the long-term outlook, after this correction, positive or negative?’. In response to this question, it is worth noting that while the growth outlook has softened, that has yet to translate significantly into the underlying performance of listed companies, at least en masse. So, the sell-off in equities has been a de-rating of valuations which, given the significant increase in long-term interest rates, is more than appropriate in some areas of the market. In other areas, however, we continue to feel that the blanket sell-off offers opportunity more than concern. Looking at the chart below, and we can see that the market price/earnings (P/E) multiple has contracted significantly and is now at long-term averages in Australia. Historically, buying at depressed market multiples has always offered good long-term performance, so unless we see significant downgrades to the ‘E’ number in the equation, it’s hard not to see today’s market as a buying opportunity in the right companies.
Avoiding the wrong companies is the biggest key in this environment. Pre-profit growth companies, for example, are undoubtedly facing an existential crisis as the availability of cheap capital dries up, and investors in both listed companies and, according to reports from venture capital firms, unlisted companies are shortening the leash on the ‘growth at all costs pursuit’ that became so commonplace. As these companies cut spending to reach cash flow positive sooner, the growth outlook is undoubtedly at risk. So, despite the massive sell-off many of these companies have experienced, they remain high-risk opportunities.
We continue to feel that the inflationary outlook has risk to the downside. While central bankers have now moved from the ‘transitory’ description of certain inflationary pressures, our view is that the transitory period has simply been extended. Logic suggests that supply chain issues caused by lockdowns in China and the war in Ukraine will unwind once China moves on from its COVID-zero policy and the war in Ukraine ends, and there is no way the reduced demand induced by tightening monetary policy can solve those problems. Those pressures will end, and the only question is when.
With that view in mind, our view remains that the outlook for interest rates is overstated, and the recent fall in long-term government bond yields is supportive of that view. Part of that view is because we believe central bankers will try their best to avoid recession in their pursuit to tame inflation (especially with much of the inflationary pressures caused by supply rather than demand), and part of that view is that higher interest rates will have an impact sooner than expected. In Australia, CBA’s CEO Matt Comyn predicted interest rates to rise to the 1.5% level and, given the average Australian homeowner’s sensitivity to rising interest rates, we tend to agree with him. Many Australian homeowners simply can’t afford mortgage rates to effectively double, so the RBA will be very careful about tipping the economy into recession and triggering a massive fall in home prices.
So, while the headwinds remain ever-present at the moment and continue to cause volatility in the short-term, markets remain forward-looking and will bottom before these headwinds subside. In our view, the best strategy in the short-term is to ensure your portfolio avoids the riskiest names (such as those pre-profit growth names that could prove to be value traps) and continues to look to the long-term. And ultimately, we know that the long-term performance of equities after significant falls is excellent, and the investors coming out on the other side will be the ones who resisted panicking.
