Market update with Shaw and Partners, November 2021

Shaw and Partners Chief Investment Officer Martin Crabb discusses excess cash in the global economy, inflation, growth and promising investment sectors.

Thanks Clive, and Shaw and Partners are very proud to be an event partner of Financial News Network and sponsoring these discussions, and great to get some really interesting companies and their Chief Executive Officers to talk about the businesses. So, I’m given the dubious distinction of spending 5 or 10 minutes just running through the market outlook, which is nowhere near enough time, but that’s okay. I’ll try and hit the hotspots. But, before I do, I just wanted to point out that we’ve had a couple of the bank’s CFOs come in and present to us at Shaw and Partners. And they’re very buoyant about the outlook for credit and capital markets and investment banking and these sorts of industries. There is so much excess cash out there in the global economy, and a lot of these banks are seeing a continued movement of that cash into investible assets.

So, to put it in perspective, if you look at the Australian household deposits prior to February 2019, and then you look at the same number today, it’s about $200 billion more sitting in household banking deposits than was there, you know, pre COVID. If you look at that in the United States, it’s US $2 trillion. And if you look at it globally, and a couple of people have done the maths on this, it’s something like $5 trillion dollars globally. So, global GDP is somewhat of the order of the high 90 billions. So you’re looking at something like 5 per cent of GDP sitting in bank accounts that wasn’t there prior to the pandemic. So, a lot of that money’s been created by central banks printing money and has found its way into savings accounts.

So, that’s a very positive set-up for markets, and it’s a very positive set-up for consumption. So, I think that we’ll continue to see more companies coming to market, more companies raising equity capital, more companies raising debt capital, and more companies starting to invest and expand as we come out of lockdown. So, it’s a very good time to be an investor looking at small and mid-cap companies that are emerging and growth because they have access to capital. That’s not always the case. If you’re like me and you’ve been through a few cycles, there are periods where there’s not a lot of capital and it’s difficult to grow. We’re in a pretty good environment for small and mid-caps. We really like the small and mid-cap space as an investment class, and we probably prefer it to the large caps, where it’s going to get tougher.

But if I can just focus probably on the key issues that global investors are looking at at the moment and what that means for investors here, the big issue is inflation. So, people have spoken about inflation making a comeback. For most of my career in the markets… I started in the markets in the late eighties, when we actually did have inflation, and it’s pretty much gone from 12 or 13 per cent down to zero, but all during that period, people are saying it’s making a comeback. So, it’s had a lot of false starts, but obviously what’s happening now is we’re actually starting to see physical inflation flowing through. So, the CPI numbers in the United States, probably the most recent global inflation numbers and headline inflation above 6.2 per cent for the year to October. And, if you extrapolate it forward, the months of November, December, last year and January, this year, were lower inflation months. So, as they drop off, if we continue to see elevated commodity prices, etc, we will see inflation above 7 per cent, maybe even as high 7.5 per cent in the early part of next year in the United States.

So, it’s going to be very difficult for a central bank to keep rates at zero and continue to print money and buy bonds when headline inflation’s 7.5 per cent. So, the fixed income markets are starting to price in central banks’ increasing rates at a faster rate. So that’s what’s happening in bond markets, and it’s been quite unruly. If anyone follows bond markets, they’ll know that interest rates have been incredibly volatile. We had Aussie 10-year bonds above 2 per cent, in fact almost 2.1 per cent. On the last Friday of October, there was a bit of panic in the market because the Reserve Bank didn’t buy the bonds they were previously buying. So, fixed income markets have started to get very worried about inflation. And that has, obviously, implications for equity markets. But, probably more importantly, it has implications for what central banks do.

Now, all the central banks have been, you know, very accommodative. They’ve been printing money. They’ve got rates at zero. They’ve had QE. It’s something like a billion dollars an hour of new money’s being created. It’s about $8.5 trillion a year. So, that’s a lot of money that’s being put into the system, and that’s obviously kept asset prices buoyant. So, as that money comes out of the system and as interest rates start to go up, we should see some reversal to all that impetus. Having said that, as I said earlier, there is something like five trillion of that is sitting as dry powder.

So, in terms of interest rates, we see them going up at some point towards the end of next year. Central banks themselves are trying to tell us that they won’t go up until 2024, but that’s looking increasingly unlikely. So, investors are starting to price in higher interest rates, and, for borrowers, that means if you haven’t locked in your rate, it’s maybe a bit too late, maybe the price has moved, but if you haven’t locked in your rate, you should probably think about doing that because we will be looking at higher interest rates going forward than what we’ve had.

So, the implication for the equity market is that the PE ratio, which is currently about 17.5 for the market as a whole, is unlikely to push too much higher in a rising interest rate environment. So, then we come back to the earnings side, which is much, much more important in the longer term. Equity prices are driven by earnings in the long term, but they’re driven by sentiment and risk in the short term. So, the outlook for earnings continues to be positive. As I said, there’s good access to capital. The global economy’s coming out of lockdown, although there’s fits and starts. Overnight, there’s some lockdowns in some European countries, for example. So, some countries are going back into lockdown, which just means it’s a stuttering start to global growth, but there is nevertheless global growth.

So, there’s better outlook for growth. There’s access to capital. So, it’s a good time for companies to grow. But we are probably cycling some very, very strong earnings numbers already. So, obviously, Q3 reporting season in the US and AGM season here in Australia is coming to an end, and that’s been mostly positive. Analysts have been upgrading earnings. And quite a few of the outlook statements from Aussie companies have been quite positive as well. So, we had a couple in the Ag space yesterday with Elders (ASX:ELD) and Incitec Pivot (ASX:IPL), for example. So, some parts of the economy are performing better than expected. So, that’s good, but the question is, will that persist into next year, and there’s starting to be a little bit of doubt about that, mostly driven by a concern about China.

So, when I was here last month, I spent a fair bit of time talking about Chinese property developers and the fact that they’d basically borrowed too much money and the government was asking them to reduce their level of debt. And that’s had some catastrophic impacts on some of the companies, like Evergrande and Fantasia, for example. So, as China’s deflating its property development industry, it’s slowing down its construction, it’s slowing down steel manufacturing, and they’re also wanting to have blue skies. They have a blue sky policy for the Winter Olympics, which are coming up next year. So, combination of deal leveraging their property development industry and cleaning up their environment will see China’s growth continuing to slow. And, obviously, that’s very important for European companies because they’re a big exporter to China. It’s obviously very important to us. We’re a big exporter to China as well.

So, we are likely to see slower growth next year. So, we are getting a little bit more cautious on the outlook and we’re just starting to think about, well, what happens if inflation is not transitory and it actually takes hold, how should investors protect the portfolio?

So, energy’s an obvious space. Gold is another one. And also global financial. So, the Aussie financials don’t do as well in a rising rate environments, but sort of global financials do. So, if you can invest globally, that’s an area of interest. If not, then you’re looking at things like Macquarie Group (ASX:MQG) in the domestic market. So, to wrap that up, inflation may or may not be transitory. You have to assume as an investor that it’s not, and you have to be protecting yourself. Growth is strong, but is likely to slow into next year, but it is a good environment for companies that have got access to capital and growth opportunities.

So, I think the small and mid-cap space continues to look very interesting. And, with that, I’ll hand back to you, Clive.

Ends