Speaker 1:
Before we begin this Bennelong Funds Management podcast, we would like to acknowledge the traditional custodians of the land on which we are recording and pay our respects to elders past, present, and emerging. We celebrate the stories, culture and traditions of Aboriginal and Torres Strait Islander communities who work and live on this land, and we commit to an ongoing journey of reconciliation and respect.
Dave Whitby:
Hello and welcome to the Touchstone Asset Management podcast. My name is Dave Whitby from Bennelong Funds Management, and joining me today to provide some of his market insights, especially so on Australian equities, is the portfolio specialist from Touchstone, Ron Sargeant. G’day, Ron. Thanks for your time today, mate, and how's life for you at the moment?
Ron Sargeant:
Good, thanks. Looking forward to having a chat.
Dave Whitby:
If I could start off with something that I'm asked about on at least a weekly basis, sometimes a daily basis, given the past year is, is there light at the end of this tunnel with equity markets? Or when do you think things are going to turn around, especially so on the ASX? There's a lot of macro opinions that you can read or listen to on the radio, TV, different podcasts and depending on what you think, mate, I think some of them are often based on some stale backwards-looking data, or might even say at times some squiggly-looking lines on a chart, but you’re on the front lines there at Touchstone along with some of your colleagues and analysts. What are you actually hearing from companies when you meet with them?
Ron Sargeant:
Yeah, that's a good question. It is worth pointing out, we certainly try to meet companies and get real-time feedback, both listed, unlisted companies, small and large, rather than looking at some of the macro data, which tends to be a bit more stale. So in order to answer your question though, if we just go back a little bit first to the recent reporting season, remember the headline profit beats to misses was about 48%. In the past that's averaged more like 78%, so it was a really weak reporting season, and more importantly, the cash flow was particularly weak. Even more of a concern, the one area of strength was consumer discretionary and that's probably where earnings look least sustainable going forward.
The real reason that reporting season was so poor was operating margins missed, and that was essentially a function of costs coming in higher than expected. And why was that the case? It was interesting, Brad Banducci, who's the CEO of Woolworths, made a comment to the effect that they had underestimated how long it took for things to really flow through their supply chain. So as a result, cost inflation, they called out wages, energy, and just general supply chain costs, remaining higher for longer than they had expected.
Now that's obviously call it say six weeks ago now, and it's interesting, I spoke to a company again, a very large retailer just this week, and they said they're facing freight costs that are up 15%, energy costs up more than 20%, they think wage costs will be up 5%. So those cost issues that we saw come through over the last six months are still well and truly occurring at the moment. The difference now is the consumer has definitely started to pull back. There's been more of a move towards value.
So we talk to unlisted guys like Aldi, Costco for example. The data is showing that both Aldi and Costco have seen a jump in their store traffic. The major supermarkets, are saying they're seeing more value-seeking behaviour from shoppers. So people showing more interest in specials, they're buying more private label products. They're also saying they've seen a pickup in theft, which is something that you see when the economy gets a bit tougher. We'll see more claims from the insurers, which again is something that you see in tougher economic environments.
In terms of some of the higher frequency data, which covers a broader set of companies, that has definitely shown a decline in economic activity, quite sharp actually, since the beginning of April. And in terms of sectors where we're seeing the weakness, it's really those companies which benefited significantly through COVID, there's quite a give-back occurring now. For example, consumer electronics, we all bought a lot of that sort of stuff for our home offices through COVID. The feedback that we're getting from suppliers is they're having to discount more now to move stocks. Across the economy, we're definitely hearing that wages are coming in higher than companies had expected.
And this is all before we see, it's called the fixed rate mortgage cliff coming through over the next three months, where a lot of households are going to get a sharp increase in their mortgage costs. We think that will see the consumer further pull back their spending. Then into June and July, we think you'll get another hit from higher wages as the Fair Work Commission increases the wage rate and we expect enterprise bargaining agreements to follow suit.
That's a long-winded answer to say costs are still high and that's consistent with our view that inflation would stay elevated for longer.
Dave Whitby:
Touching on the February reporting season, Ron, can I ask you then: some of the guidance that, I mean you've provided some really good examples there from some of the recent meetings, but overall whilst it was a mixed reporting season and one that was touching more on the negative side of things, would you say that most companies were pretty opaque with their guidance for the next six months as we lead up to August?
Ron Sargeant:
Yeah, actually they were opaque with their guidance and I think generally investors were unwilling to reward the companies that maybe reported good results but were seen as being unsustainable. So that's really been a function of what we've seen through reporting since COVID occurred; that companies report and then the market has just continued to expect this downturn or this give-back maybe of strong sales.
So in the recent reporting season, we definitely saw high costs. We definitely saw companies express uncertainty. We've got the Macquarie Bank conference at the beginning of May, which tends to be like a mini reporting season, and I think you'll see the same in that companies are just going to have to say they don't really know what the outlook looks like. Anyone in consumer really just wants to see the full impact of higher interest rates come through until they can express any sort of confidence in the outlook, be it a worsening outlook or better. They actually don't really seem to know either way.
Dave Whitby:
I want to ask you about earnings, but before that, just one point that you were speaking about, enterprise bargaining agreements. Australian inflation, everyone's pretty much, well it's just a topic that we can't get away from, so too in the US as well. But would you say wages in the US can come off far more quickly than here in Australia where it might be, the increases to wages might be slower, but they would be then stickier, and so that will possibly mean that inflation will be slower to come off here in Australia? Is that a fair statement to make?
Ron Sargeant:
Yes. It's interesting when we were talking about our view that we thought inflation would be higher and would stay around for longer than expected, that was in 2021. One of the big areas of pushback that we got was people saying the Australian wage-setting mechanism through Fair Work and enterprise bargaining agreements was relatively rigid, and as a result people thought that would prevent inflation going that high.
Now of course inflation did go up anyway, but it seems that people have now forgotten about the rigidity of wages in Australia, and so they're naturally expecting them to come off quite quickly, and we don't think that's going to occur. Couple of reasons. One is Fair Work last year in its decision said that they acknowledged that workers were basically receiving a real wage cut and maybe they would have to make that up going forward. They also said they're cognizant of really the underlying level of inflation when they set their wage decision.
When you put that together, it's possible that you get in June another decision of 5% plus. And then the companies we talk to say that they're not obliged to follow Fair Work, but whilst the labour market's still quite tight, they tend to actually give it a EBA increase, which is around the level of Fair Work. So therefore, we think that wages will be 5% again this year, and you don't really see the wage or the labour market become less tight until immigration picks up through the course of this year. So we think you've still got higher wages through calendar 2023 and that will squeeze corporate profits.
Dave Whitby:
Taking that into consideration with what you mentioned with February reporting season, then you think that earnings are still too high?
Ron Sargeant:
Yes. You can look at this top down or bottom up. When you just look at the overall market’s trend earnings, you're in Australia about 13% above trend. If we look at our bottom up analysis for companies, we similarly think consensus is around about at least 10% too high, and it's particularly pronounced in the industrials. That's where we see most of the risk. If we had to sort of say where we think it's too high, it's really in operating margins. Analysts haven't shown a great ability to reflect operating leverage, really since COVID. So when COVID occurred and companies became very profitable, it was because analysts were missing the operating leverage being positive. And similarly, as we see things slow, they'll miss the operating machine leverage turning negative and impacting margins.
Dave Whitby:
That's a really good point there, Ron. We could really speak about that for quite a while. But do you think often at times it might be, in regards to consensus analysis, earnings forecasts at times where some analysts just haven't experienced a number of different cycles beforehand?
Ron Sargeant:
Yeah, it is a funny feature of the current environment that the last interest rate rise in Australia, I think was November 2010 from memory. If you think about the sort of person who would've taken away lessons from seeing a cycle of increasing interest rates and how they impacted the economy, that person now probably has close to 15 years’ experience, which naturally means you've got an analyst who's late, mid-thirties maybe. A lot of the market's younger than that, so there's a lot of people in the markets that really haven't necessarily experienced a full cycle and maybe aren't quite sure what to look for and how to react, so it does seem to be something unique to this cycle.
Dave Whitby:
That leads me then to something that we haven't experienced for quite some time, which is recession. Again, another common topic that we get asked about. Are we in Australia going into a recession? What's happening in the US as well, which might be a little bit more easier to see? However, we'd also like to ask your opinion about what does a recession necessarily mean for equity markets?
Ron Sargeant:
Yeah. It's important to make a distinction here because a lot of people talk about recession and then they start quoting US data and then they talk about the Australian market, and the two of them are relatively different. So to start with Australia, we don't think you actually see a technical recession, and the reason is twofold. One is you've got China reopening and we get a bit of a boost from that, so our trade sector should actually do relatively well. And then secondly, you've got very strong immigration coming through. So even though you might see a per capita recession, overall we think Australia might just get through without a recession.
Now that's quite different from the US, where there's any number of leading indicators and other bits of evidence that you're likely to see a recession in the US. Even though we think Australia might get through, the fact is if there's a US recession that will affect the global economy and it will affect markets, it will affect liquidity. So we will still see some impact on our stock market, even though it might not be as pronounced as if we had a recession ourselves.
Dave Whitby:
That leads then into more specific for Touchstone, what are you doing with your portfolios at the moment with Touchstone and the concentrated fund?
Ron Sargeant:
Yeah, so we always start from a position of owning quality regardless of the cycle, and really we'd say you always want to own quality, you just want to be careful that you don't overpay for it. Now that generally works well, but it's actually particularly effective in any sort of cycle where you've got a lot of uncertainty, and of course, that's right now.
What's really important, though, is that when you assess quality that you use a framework that is consistent, that's thorough and that's repeatable. We find a lot of the market puts a huge focus on trying to work out what earnings are going to be and therefore derive valuations, and they're really less systematic when it comes to thinking about quality. So that's things like the strength of the board, the strength of management, ESG, the industry strength, disruption risks.
And the reason that matters is quality's unusual in that you can get a company that is otherwise very high quality, but if they have one chink in their armour and you go into a tougher economic environment, that one chink can lead to significant risks to earnings. Primarily, we continue to focus on quality. In terms of the reasonable price part of our equation, again, it's interesting at the moment. The market's valued at about, sort of, 14 times PE. That's pretty reasonable. It's a little bit cheaper in fact than long-term averages.
But what's really important is the industrials ex financials are over 23 times, long-term average is more in the high teens, and resources are actually trading well below average. They're only around 10 times versus an average around 14. Now that reflects an expectation that commodity prices will come down, which they generally do during a US recession.
So when we put all that into the mix, we're particularly wary of some of the more expensive industrials where we think there's margin risk. We think some of the resources look more attractive, and in fact we have been able to add new stocks recently to the portfolio that we think the market has maybe taken too short a term view, where they do reflect high quality but they're better priced than you would otherwise expect. So Linus is a great example of that.
Dave Whitby:
Lastly Ron, then, we are coming up to the August reporting season. Would you think with everything that you've just said then, what would be the opportunity set post the August reporting season? I guess you've obviously got to take in consideration what the results are, but would you think once we get through August, is there a clearer line of sight for the market going forward? Has the main part of the interest rate rises that we've experienced the past year, has that largely washed through the company earnings in terms of their guidance? Just any broad thoughts as to where forward from August.
Ron Sargeant:
Yeah, so again, if we think about what's actually led to the market weakness, I guess it's two things. One is people worried about central banks and their potential to just keep on increasing, and that's really a function of the market seeing inflation come under control, which is particularly going to be wages and labour markets just loosening a little. So in Australia, as I said, immigration's picking up, so we think actually labour markets will be looser by the end of the year, so that would be positive. The market will be confident that the RBA, if anything, the next move would be to loosen. In the US, again we think actually by the end of this year, the market's actually forecasting the Fed will be cutting, but either way it'll be a more supportive environment for central banks.
And then for the more bottom up investors, you're just going to want to have confidence in earnings, and even though asset prices might be lower and you might have those impacts that I talked about from the global recession, I think at least markets and companies will have seen that weakness come through. They will know what their risks are and so they should be able to more accurately see a light at the end of the tunnel.
Remember equity markets, it's interesting, they are not very good at seeing recessions coming. On average actually from the 1950s if you exclude the big impacts of the oil shocks in the seventies, from peak market to the start of the recession on average is actually only a couple of months, but in fact, markets actually bottom about five months before the end of a recession. So markets really do look quite a long way forward. And so when you think about that, we should definitely see some bottom in markets and people start to factor in upside later this calendar year.
Dave Whitby:
There could be opportunities there, but certainly in the meantime, from what I'm hearing from you, Ron, is yep, certainly quality all the way in terms of equities at the moment.
Ron Sargeant:
Yeah, it's always quality, and we're just conscious that we think costs are probably a bit higher than the market thinks. That means that earnings are perhaps a little bit too high, but as we move through any sort of period of weakness, as we come to work out what the impact is from the consumer pulling back, we'll still stick with quality as we always do. But you might get an opportunity to buy the higher quality cyclical companies that can benefit relatively more from a rebound in the economy. And perhaps it will become apparent, some of the companies that have been able to use this period of weakness to cut their cost base or to acquire weakened competitors and therefore have more growth in the next cycle. There's always opportunity.
Dave Whitby:
Ron, I want to thank you for your time today. That was great, very informative. For our listeners, should you have any queries or be interested in anything further on Touchstone Asset Management or anything Bennelong related, please contact your local account director. But thank you very much for your time today. Cheers.
Speaker 1:
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