Three Observations for Year End
– David Wanis, December 2020
After an incredibly unusual year, we take stock and observe where we are starting 2021. No one needs (or wants) another recap of 2020. No one should want a series of forecasts for what 2021 holds (because no one knows). As we did last year, we simply stop to observe where we are now for three issues we think are quite important – the relative value of Australian small cap equities, the market pricing of inflation and commodities, and the state of the Australian consumer.
Australian small caps not expensive relative to other assets
Like many risk assets, in comparison to historic pricing, small caps look expensive. However, those periods also saw low risk assets offering much higher nominal and real yields. Cash in Australia now has a negative real yield – meaning that inflation is likely to be higher than the nominal interest you earn on cash balances, resulting in a decline in real purchasing power of holdings cash over time. Avoiding risk now has a real cost not just an opportunity cost.
- RBA official cash rate at 0.1% and negative 1.4 – 1.6% in real terms
- 3 Year government bond at 0.1% and 10 year government bond at 1%, both negative in real terms
- Investment grade corporate bonds offering a 1% yield to maturity
- Higher yielding credit offering around 2 – 3% yields
- Small cap equities – pretax earnings yield of around 7%
You cannot escape volatility or potential drawdown which makes equities the wrong asset for investors with short time horizons, however for longer term investors drawdowns are only damaging if you change your mind about your risk appetite at the wrong time. Treat your portfolio like private equity and assume you cannot access it for many years, and the experience is very different.
The ~7% pre-tax yield for the small cap benchmark, and over 8% for our portfolio, can be thought of as the extra yield the portfolio earns to compensate for volatility and drawdown risk. Part of this is paid out every year (2.3% dividend yield for the market, close to 3% for our portfolio – both almost fully franked), the rest is retained by the companies to invest in growth opportunities. Even before reinvestment growth is considered, our portfolio should be able to increase earnings in nominal terms to keep pace with any unexpected inflation that emerges (unlike bond coupons).
Our portfolio has delivered net total annual returns of 15.5% per annum since inception. Today in absolute terms it is not too far from where it started in February 2019 priced to fundamentals. Relative to the market, the portfolio is higher quality, with less financial leverage and a more attractive valuation than two years ago. Relative to cash and bonds it has a higher relative yield today than in early 2019.
Inflation expectations and commodity prices are picking up
At the end of 2019, longer term US inflation expectations (as measured by the 5y5y inflation swap) were 2.1%. 12 months (that feels like about five years) later, the same measure of inflation is now higher at 2.3%. Regardless of your view of whether inflation, disinflation or deflation is the most likely outcome, the market pricing of inflation is now higher – not lower – than a year ago.
Industrial commodity prices are mostly higher relative to a year ago. Iron Ore (+73%), Thermal Coal (+35%), Copper (+27%), Nickel (+21%), Aluminium (+10%) as well as currency alternatives such as gold (+25%), Silver (+49%) and Bitcoin (+300%). Coking Coal (-32%) and Oil (-21%) are some of the few industrial commodities that declined.
Soft commodities are also higher. Corn (+22%), Soybeans (+38%), Wheat (+15%), Cotton (+13%), Lumber (+115%), Palm Oil (+15%) and Sugar (+14%) are all up. Coffee (-3%), Cattle (-5%) and Lean Hogs (-5%) the few that have declined in price.
The total market capitalisation of all global developed market resource and agriculture stocks (ex-energy, ex-microcaps) is ~US$1.1Tr in around 200 companies. There are individual technology stocks with larger market caps than this entire group. This market value – attributed to assets developed over many decades – is a fraction (like 1/10th) of the increase in central bank balance sheets during 2020 alone. Should the tens of trillions of dollars in disinflation sensitive assets (government bonds, corporate bonds, growth equities etc) decide that inflation is something to worry about and that portfolios need some real asset hedging in commodity producers, the investible market is just not that big by comparison.
A large move higher in inflation and yields in 2021 would be unexpected.
Australian consumer in rude health and ready to spend in 2021
- Consumer confidence is at the highest level in over ten years
- Consumer savings rates are at their highest level in a generation
- Interest rates are at record low levels and credit is available and being pushed out aggressively in any and all forms: housing, personal, auto, credit card, buy now pay later
- House prices are appreciating, which creates longer term social problems, but has real near-term wealth effects for large parts of the economy
We acknowledge much of this comes at a cost of government debt increasing significantly – although few can know what this really means. We are unsure it matters to the actions of the average Australian consumer. Indeed, we suspect the consumption pattern of the average skeptical economist over the next couple of years will largely mirror those of the masses ignorant of the dismal science.
“People don’t think what they feel, don’t say what they think and don’t do what they say”
– David Ogilvy (founder of Ogilvy & Mather) and known as the “Father of Advertising”
What matters to company profits is what people do. What they say, think or feel matters far less. In 2021 we will be watching what the Australian consumer does.
We know almost nothing and of the future even less
To us, diversification means holding a portfolio with the greatest likelihood of achieving our investment return objectives under as many unknowable futures as possible. Inflation. Deflation. Value. Growth. Resources. Industrials. We build a portfolio anchored to quality and robust to uncertainty. What we give up to achieve this is the one optimal portfolio for one specific future. If we knew with certainty a given set of outcomes in 2021, we would structure our portfolio differently. However we respect the reality that despite our own bouts of over-confidence, the future remains unknowable and we must invest accordingly.