Inflation and Bond Yields Coming Out of Lockdown
– David Wanis, October 2021
Like the residents of Sydney and Melbourne, inflation expectations and bond yields have also been in lockdown for the past 3-4 months. Soothed by the macro theme du jour “transitory”, 10 year government bond yields in Australia and the US fell from around 1.5% in mid June to almost 1% in Australia by late August. The subsequent sharp move upwards in yields during September reflects both expectations of Fed tapering (reducing their asset purchase programs) as well as continued evidence price inflation across the global economy is more than just base effect impacts (comparison with COVID induced lows in early 2020).
Almost everywhere we look, prices are not just higher than during COVID, but higher than the pre-COVID levels of 2019. Looking at recent raw material prices which have yet to flow through to end consumer prices, we are still nowhere near the end of inflationary pressures flowing through the supply chain and the economy.
For investors not making macro timing calls on their portfolio, the pricing power of the businesses owned is remains paramount. As we detailed in April this year, the quality of a business underpins its pricing power – the ability to pass on unexpected input cost increases. High quality businesses with pricing power can preserve their margins and returns on capital in the face of inflationary pressure and grow nominal profits with rising nominal prices. Weaker companies, unable to pass on cost increases will suffer a decline in margins and returns, although they may see some nominal growth. Owning high quality companies is one of the best earnings growth protections against the drag of inflation.
Inflation also acts upon the P/E rating of stocks. Over the past 15 years, declining inflation and expanding P/E multiples have been a tailwind to total returns in the order of 2-3% per annum for Australian equities. Should higher inflation result in contracting P/E multiples and a return headwind, delivery of EPS growth becomes an even more important driver of investment returns.
Inverting the problem asks what should we avoid in a higher inflation world? Low quality companies whose earnings may decline in an inflationary environment, also trading at high P/E ratio’s that could shrink would be the least attractive businesses to hold should inflation rise. As we mentioned in April, these companies are surprisingly abundant in the small and microcap universe of late 2021.
An investment process able to find companies that can grow earnings despite inflation should do well in this environment. A valuation aware process should limit the potential P/E de-rating headwinds. Our process is designed to do both.
Liquidity and Returns
The other significant macro influence on investment returns over the past few years has been liquidity. In addition to lower interest rates, the expansion of liquidity has seen wide divergence in investment returns across assets and market segments. As we discussed in May those investments with less internal liquidity (free cash generation) are more sensitive to changes in the external liquidity environment. In Australian equities, the coal mine canaries for liquidity are microcap stocks. Using the S&P / ASX Emerging Companies index as a proxy it becomes clear just how much liquidity has influenced returns. Since the end of the last period of liquidity tightening in December 2018, these microcaps have returned 121% or 33% per annum – more than double the 16% p.a return for small caps.
In the 18 months since COVID lows (23 March, 2020), as liquidity taps were forced wide open, microcaps returned 241% or 124% annualised, compared to the annualised return of 56% for small caps and 42% for the ASX300. Of the 200 stocks in this microcap index only 31% are profitable.
When a basket of 200 stocks, ~70% of them speculative, rises 241% in 18 months investors need some awareness the main driver may be market conditions rather than company specific value creation and stock picking prowess. Should liquidity tighten, there are many stocks whose performance may quickly reverse.
Yesterday vs Tomorrow: Coal vs Lithium
Coal and lithium are two commodities at the opposite ends of the market spectrum. One is a high carbon emitting legacy technology responsible for large amounts of emissions that we need to reduce. The other is a critical transition commodity, a cornerstone of how we will move from fossil fuels to a more renewable energy system.
For coal the disincentives for new supply keep mounting. Social, environmental and political costs are rising, as are capital costs as both equity and debt capital is withdrawn from the sector. Continued demand will likely grow for a few more years (because there is no realistic renewable baseload alternative yet) and then begin a long decline. The structural forces reducing demand on a 10-20 year view create another barrier to new supply. High prices and super-normal returns for existing coal producers are unlikely to be competed away in a normal supply response fashion.
Lithium mining companies are the other side of this market. Investors picture demand growth as far as the eye can see and a market in ongoing structural deficit. This has certainly been true in the very short term, where a recovery in lithium prices has saved the industry from another year of losing money, and producers should now be able to generate profits at current prices (they didn’t really show that in F2021 but they should). The question is the assumption demand will exceed supply for a long time and prices will continue to rise. Unlike coal, there are no barriers for new capital to flood into lithium mining, indeed there are environmental credentials in addition to profit motives and thematic appeal for doing so. Nor does it appear a scarcity of lithium or a steep production cost curve suggesting new supply cannot be economically brought online at costs similar or even lower than existing producers. There are near term mis-matches between long lead times at auto and battery manufacturers facing off against long lead times at lithium mining and processing projects, resulting in near term demand-supply imbalances and price volatility. This volatility will probably continue but industry trends toward low returns on capital in the long run are likely.
Somewhat ironically since their approximate low point in June 2020 both Coal and Lithium prices are two of the best performing commodities and both trading at record high prices. We explained in June last year what we look for in resources stocks.
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