Weekly Market Update - 22/02/2022

The week that was

In what has become a familiar pattern, markets rose in the early part of the week amid signs that Putin’s aggressive posturing towards Ukraine might be just that, only to fall back as he appears to up the ante yet again. At the time of writing the following Monday an olive branch of sorts has been tentatively extended so maybe he does have weekly schedule to attend to when torturing world leaders. Tech and growth stocks trading on higher multiple also continued to be the touch point for risk and they fell the most at the end of the week having bounced earlier. The US market ended the week down 2% along with the UK and Japanese markets, while continental Europe and emerging markets fared a little better and were flat for the week.

Valuation concerns undermined the large US tech stocks as well as the threat of regulation with Apple now in the firing line over anti-competitive practices associated with its IOS app store. Healthcare stocks were the next biggest contributor globally, but most sectors ended the week down in what was a more broad-based fall than has been seen recently. This is a small sign that some of the perceived valuation discrepancies between tech and traditional sectors are narrowing. Another explanation is that long bond rates around the world eased while medium-term inflation expectations remained steady, implying a slight easing of real rates which took some of the pressure off tech stocks which have become increasingly sensitive to changes in rates.

Energy was in fact the worst performing sector, if not the biggest contributor by virtue of its diminished weighting, and oil prices were also down despite rising tensions surrounding Russia and Ukraine. To some extent this could be seen as a pause in the context of a 30% rise this year but also may indicate that the oil market is looking through the current crisis and the increasingly alarming headlines. Industrial metals were up slightly while soft commodities were mixed but flat overall.

In amongst the noise the Australian market marched to its own less volatile tune and seemed to be more concerned with the local reporting season, which has so far been quite positive. While cost pressures have been widely cited, they don’t seem to have weighed on profits to a great degree, perhaps because they have been passed on to the consumer. Almost halfway through the reporting season most companies have surprised on the upside and notable gainers last week were Treasury Wine Estates and Magellan, which managed to reassure edge investors with an increased dividend and assurances over a more focused strategy going forward. Fortescue was the biggest loser after reporting lower profits and lower dividends in the face of rising operating costs, a softer iron price and arguably costs associated with investing in green energy. Overall corporate guidance pointed to more buoyant conditions ahead as the domestic economy. This is sharp contrast to the global companies that reported in recent weeks and who seem more a little more worried about rising cost pressures during the remainder of 2022.

What we're working on this week

While the modest market falls of last week were broader than we have seen so far this week the rout in the so far profitless tech enterprises that make up much of the Nasdaq continued.?The ARK Innovation ETF, which has become synonymous with this type of investment, was down another 14% during the week and is down an incredible 60% in the last year. As a thought exercise we have perused some of the holdings and, as these companies are very difficult to value in the absence of established earnings, obvious bargains remain difficult to substantiate.?Interestingly one of the biggest holdings is Block (formerly Square) which bought Afterpay in an exchange of shares and so ended up on the Australian stock exchange (and still represents most of local investors' limited exposure to technology stocks). Nevertheless, such falls must be providing opportunities to the discerning investor with skills to sort the wheat the chaff.

In similar vein we have witnessed the close correlation of real rates and the larger tech stocks, (as well as the US market as a whole). Our base case is that near-term interest rate ‘normalisation’ might take us to zero percent real rates - that is 2.5-3% nominal rates for Australian or US 10-year fixed income government bonds along with a similar level off expected inflation. With the moves that we have seen so far this year we are around halfway there and we are considering what portfolio moves, if any, this might necessitate. In our view this affects equity allocations just as much if not more than the more obvious issues negative real yields imply for most defensive investments. So, while diversified portfolios have only fallen a few percent this year the fact the largest equity market in the world is down by almost 10% this year merits a minor update of some of our forward-looking dashboard assumptions and potentially some small changes to asset allocation.

On the face of it the near-term earnings environment, reasonable dividends and an economy that appears fairly resilient makes the Australian investor’s home bias more defensible than most (in most overseas jurisdictions typical home biases are even greater than here). We will wait to see if there are any surprises in the rest of the reporting season (the bulk of which will be done in a weeks’ time) before updating any of our assumptions or portfolios but for now it appears that Australia’s luck is holding. One reason may be that a relatively small and concentrated commercial environment affords companies a healthy degree of pricing power (consumers may feel differently).?A counter point to that is that our stock markets are dominated by two of the more potentially volatile sectors (materials and banking), even if they again tend to benefit from an inflationary environment.

We have had many questions on Ukraine and like most have resisted getting into the fray, feeling that any useful opinions not being talked about (and already priced into markets) are probably still residing in Mr Putin’s brain (and they may not have even reached that far). Nevertheless, we have followed the views of George Freidman of Geopolitical futures more closely than most, as he has been around the block a few times. His view is that, with the Ukrainian armed forces still outnumbering (just) the likely number of Russian forces in and around the Ukrainian border, Putin is still intent on doing just enough to further his strategic imperatives (keeping NATO out of Ukraine for the foreseeable) without bloodshed. The oil market appears to agree. Another wild card to consider is whether Xi Jinping deviates from his typically deliberate modus operandi to opportunistically move on Taiwan. For now, most observers think that is unlikely but that is precisely why it might be effective and that really would surprise markets.

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