ASX 200 was largely flat last week, energy stocks were up on some really strong oil prices and the rest of the market sort of so-so.
Oil, Inflation, Economic Growth, FX. It’s like Tasmanians (they are all related)
Oil prices, denominated in USD have rallied significantly, up 21% this calendar year, after rising 12% last year and 45% the year before that, in which time oil has rallied from lows of $27.24 per barrel to currently be trading at $73.25.
Oil prices are a function of, like all things, supply and demand. In the interests of simplicity and word count, let’s pretend supply is steady (it’s not, and subsequently oil price forecasting is horribly difficult and often, a fool’s errand.)
The demand driver for high oil prices is broadly speaking, economic activity/growth. Want to build something? You’ll need diesel for trucks and machinery and the road they drive on is made of asphalt which also contains oil. Want to heat your house/workplace or school? You’ll need heating oil, made from crude. Rising populations, accelerating economic growth and increasing consumption drive higher demand for oil.
This is why, as we’ve seen inflationary expectations rise (represented below by the yield on the 10 year US treasury, in red), we’ve seen oil prices rally along a similar trend.
Oil, therefore, is often an astute hedge for sharemarket investors against rising inflation and rising interest rates, and why over 12 months ago we included Woodside (WPL) into client portfolios. I personally continue to like Woodside for its high quality existing production, ability to generate strong returns on its assets compared to peers, strong balance sheet, conservative management team and the company’s stranglehold on the best and brightest engineering talent in Australia.
I also like the fact that Woodside (WPL) is an Australian oil and gas producer. And as Australian’s, we get a free kick if the USD rallies against our AUD. I expect this tailwind for all of our offshore earning companies to continue. Why? Well the US has higher inflation expectations than Australia right now. The Fed cut rates harder post-GFC and subsequently, are now growing faster as a result of a lot of fast and loose money.
The most liquid markets on planet earth are the markets for government bonds and currencies, so it makes sense that these markets best represent investor expectations.
AUS government bonds have always traded at a premium (higher yield/return) relative to US government bonds, as the US was always perceived as ‘safer’ (lower risk, lower return). However, due to the divergent inflation expectations, the Australian government bonds now trade at a discount to their US comparables (blue line below now below zero). As a result, we’ve seen increased demand for USD, relative to AUD and a fall in the value of the AUD, currently worth USD $0.7223.
With inflation and interest rates in Australia going nowhere fast, and the US starting to accelerate, I can’t see this trend reversing any time soon. So that my friends, is why the AUD will continue to fall. (AUD/USD exchange rate in red below)
Why are all my favourite investment guru’s so bearish?
In the last week or so, Howard Marks of Oaktree Capital-fame released a memo titled “The Seven Worst Words in the World” in which he outlines his cautious view of global stock markets. Marks closes the note stating how he’s not predicting a credit bubble or resulting crash but certainly is encouraging caution for investors. I think most people didn’t make it to page 10 where he tempers his bearishness from the previous 9 pages where he says FAANG companies are overvalued and a low level of scepticism doesn’t “make for a positive climate for returns and safety.”
Ray Dalio, another one of my favourites, also has recently been in the media raising concerns on the back of his latest book release “A Template for Understanding Big Debt Crises”. Whilst I haven’t had a chance to read the book yet, I watched Ray talk for 20 minutes on CNBC recently and in between the interviewers trying to get a ‘headline answer’ out of him, Ray kind of confirms my view of the world (and maybe of life more generally) that it’s all about nuance and the rates of change.
Yes, interest rates are going up. Yes, when interest rates go up, asset prices go down (the discount rate on your discounted cash flow calculation increases, reducing the present value of future cash flows, all else being equal.) However, this assumes (largely erroneously in my view) that those cash flows aren’t growing.
It’s about rates of change. If earnings growth can outpace the increase in interest rates, prices won’t fall and in fact, may continue to rise. Of course, rising interest rates are a headwind. But why do interest rates rise? Because inflation is rising, unemployment is low, consumption is accelerating and economic growth is occurring. Do not confuse the end of the “Goldilocks” market (where earnings were recovering rapidly and rates were on hold) with the end of days!
There will become a time where the central bankers raise interest rates too quickly, earnings disappoint and a new trend in the global economy will emerge. I just think that human behaviour tells us that it’ll take a long and protracted period of growth before conservative and gun-shy central banks develop the hubris to hike-hike-hike willy-nilly. And in the interim, whilst strategists and commentators jump at every dot on the dot-plot, we will keep looking for opportunities for in under-appreciated, quality businesses.
Movers & Shakers
A few decent moves to close out the quarter, Afterpay (APT) bouncing back (grrrrr) and Bellamy’s (BAL) up after a horror quarter.
Webjet (WEB) down from it’s post-result highs of near enough $18, Flight Centre (FLT) too suffered. ARB continues to de-rate, down from $24 to $19 and Nufarm (NUF) down on a $238m capital raising at $5.85.
And how about those West Coast Eagles on Saturday afternoon!
One of the great Grand Final’s in my opinion, 5 goals down mid-way through the first quarter, I almost had to be resuscitated. However, when Dom Sheed kicked that goal late…fair to say I lost my mind. Here’s a photo of my Dad and me after the game (when my heart rate had normalised).
Have a good week,