Nathan Masalski:
Welcome to the latest Touchstone Asset Management podcast. My name is Nathan Masalski and I'm one of the account directors at Bennelong Funds Management. Today I'm joined by Ron Sargeant, who is portfolio specialist with Touchstone Asset Management. Thanks for joining us today.
Ron Sargeant:
Good to chat Nathan.
Nathan Masalski:
Now Ron, perhaps in starting, would you like to paint a broad picture around some of the broader global macro events playing out, and perhaps their impacts on markets both globally and here in Australia?
Ron Sargeant:
It's a broad topic, but I'll just preface it by saying we're primarily bottom-up in our approach. And the reason for that is we can, I think more easily get an edge by talking to customers, their suppliers and the companies themselves, and we can assess quality by doing that, which we don't think is done particularly well in the market. Now, all of that being said, from time to time as a result of doing all of our bottom-up work, we get quite strong top-down views. A great example of that was in 2021, we were very confident that inflation was strengthening and would come in above market expectations and lead to higher interest rates.
At the moment, our view is inflation's kind of peaked out, but it will remain elevated. We are worried about the US fiscal position, that is they're just basically spending a lot of money and it's unsustainable. Now both of those factors are playing through into higher bond yields in the US, and if anything you would say yields might actually move a little bit higher, but it's real rates moving bonds now. It's not inflation. It's just simply there's not enough demand for bonds and so interest rates go higher.
The other important global factor at the moment is obviously tensions in the Middle East and that leads to higher oil prices. We were already positive on oil because we thought supply would be under pressure, but again, that just gives us confidence with a higher oil price that inflation will remain elevated.
So we then draw that back to Australia, what does it mean? We think wage growth here will remain strong, and that's because of our relatively rigid wage setting mechanism. Obviously we think energy prices remain high. So we're in a similar situation where inflation, whilst it may have peaked, should remain quite high. And that means the RBA, you can see from their recent guidance, they're kind of thinking one more rate hike.
At the household level, households are under pressure. We've talked previously about the pressure from mortgages moving from fixed to variable. We're at the peak of that pressure at the moment. And importantly, around 60% of households have already worn through their savings buffers and by the end of the year that'll be about 80%. So definitely in terms of pressure on the domestic economy, we're kind of at the peak now and we start to get a bit of relief from higher immigration. So that means, as we expected, we saw a per capita recession but not an outright recession, and hopefully we can look forward to better conditions as we move through 2024.
Nathan Masalski:
Great, thank you, Ron. That's fantastic. You've touched there on the Middle East and the US, any just thoughts before we jump into the fund itself on China and how things are playing out there? It's been topical in the media in recent times.
Ron Sargeant:
Yeah, we follow that quite closely obviously owing to the resources, and we've also owned Treasury Wine Estates for some time and we're quite confident that probably in the near term you might see tariffs removed. So we need to be more aware of the health of the Chinese consumer because I think that will be very important for Treasury over the next 12-18 months.
In terms of the China top down, we had been concerned that their property market was much weaker than people thought and would result in lower economic growth, and then in turn we thought they would stimulate, but they would be less likely to go back to the ultra-aggressive infrastructure-led policy of the past, and that's all played through. So there's a lot of talk of stimulus. There will be more of that. We think it will be, involve some infrastructure, but it's more likely to be sort of green projects to allow electric vehicles, et cetera. They've talked that they're going to do some infrastructure spending, but around water recycling and water kind of projects. So yeah, we think that's not terribly iron ore intensive, so not as positive for Australia and not as commodity intensive.
Nathan Masalski:
Thanks for that broad macro piece. It's a great update. Perhaps now moving on to an update on the fund’s current positioning, the recent reporting season, comments there perhaps.
Ron Sargeant:
Yeah, it was a good reporting season. It was the ninth in a row actually for positive attribution for the fund, which was great. And of course now we're sort of moving through AGM. I guess the thing that was different about the reporting season just gone was the volatility. One in every eight stocks moved by more than 10% on their result, which is about double the average. The other thing that was notable was that it was PE expansion which explained a lot of the upside moves, but it was earnings downgrades which explained stocks moving lower. So what that means is basically investors were willing to look through some of the soft results by cyclical companies and just buy them regardless and therefore that led to the PE re-rating, but they sold defensives that had earnings misses and you could see it in the earnings revisions. The average earnings upgrade was only plus 2.7%, the average downgrade was around 9%.
Now we're already seeing some signs that those trends have continued as we get the current AGM updates. Just this week we had Bapcor come through with a very weak earnings update and that's supposed to be quite resilient, you know, it's automotive spending, people getting their car repaired, but there's obviously weakness there. So we expect more of the same, people becoming quite concerned about the inflation pressures on some of the defensive companies and perhaps still willing to look through at better times in 2024 for cyclicals.
Nathan Masalski:
Ron, you've been talking for a little while now about the weakness coming through by the consumer in the market. Can you give us a view of how that played out over the first half of 2023 and into the second half and perhaps also into 2024 as well?
Ron Sargeant:
Yeah, during the recent reporting season, it was particularly weak. In fact, it was the worst reporting season for consumer stocks in 13 years. More than half of the consumer companies downgraded their earnings by more than 10%. We've seen a number of the impacts we expected come through. So I mentioned we're at the peak impact from the fixed to variable mortgage rate reset. We're cycling the low and middle income tax offset, the tax buffers, that were given to households this time last year. And as I said, households are also wearing through their savings, which is sustained earnings. So we saw a weak reporting season, but what's interesting is the recent Kepler data, which is high frequency retail spending data, has been very weak. Down as much as 12% on last year, and the real per capita consumption has been as weak as minus 5%, which is as bad as I can remember in my career.
In terms of categories, electricals particularly weak. I would just say though there's a couple of categories doing quite well and they're basically ones that benefit from good weather. This time last year the weather was quite poor, so again it just gives us confidence. We own Wesfarmers, which obviously has Bunnings, so we still think some of the results like Bunnings should be relatively resilient.
Nathan Masalski:
Great. Well overall, things sound relatively tough at the moment. Have we sort of got closer to perhaps to the bottom of the cycle with better times ahead?
Ron Sargeant:
Yeah, we're certainly nearer the end of the cycle than the beginning. For some time we'd been talking about expected earnings downgrades. If you think back sort of mid to late 2022, the market had 12 months forward EPS growth of around plus 8%. That's fallen by 14%. Expectations are now for EPS growth in 2024 of minus 6%, and what's notable is the downgrades have been largely due to resources. Industrials have actually been surprisingly resilient. So we still think you'll get some further modest weakness in earnings, perhaps low to mid-single digit downside, but what will be different is that will come through from the industrials.
The market looks relatively reasonably valued, maybe marginally overvalued. So when you put all that together, given we know the market will look through the last part of the earnings downgrades, that's why at this point in time we're starting to think about what we want to own for the next upcycle.
Nathan Masalski:
Well, on that note then Ron, how potentially have you positioned the portfolio and some of the changes and the forward outlook for some of the stocks in the portfolio?
Ron Sargeant:
So as a general comment, the team would like to own the higher quality cyclicals, preferably ones that have used the period of weakness over the last couple of years to improve their businesses, in anticipation of rates peaking out, and as you suggest the next cycle commencing. So as an example, we bought James Hardie this year. Now that's been a good call. We knew that they could be impacted by higher US interest rates, but of course higher rates now mean less building. Which actually, if anything means you've got more of an undersupply of housing in the US as we move through the next cycle. So a little bit of pain now, but potentially more upside.
Now, the other area we've been overweight is energy. As I mentioned earlier, we quite like oil, so we've had names like Ampol and that's performed well. What's changed, I guess is we've had all this talk of GLP-1, so the drugs like Ozempic, which were diabetes drugs that were now being used to help people lose weight. That's meant that some of the healthcare stocks, which are obviously in the bucket of defensives, they're high quality companies and they're now actually particularly cheap. We think in some instances they've been dealt with too harshly. We don't think they'll all be impacted by GLP-1 drugs, and therefore, oddly enough, it's actually the defensives that are quite often looking attractive now as well as some of those cyclicals that I mentioned.
Nathan Masalski:
Great. Well, it seems at the moment Ron, that healthcare stocks are very much in the limelight. Can you give us some other views on some of the other stocks in that part of the market, perhaps CSL, ResMed and others that are playing in that space?
Ron Sargeant:
Yeah, I'll start with CSL because that's the one we own. It's actually, at the moment it'd be the top ranked stock in our universe on our sort of quality value matrix. So even if we take an extreme view as to the takeup and adherence to all the correct protocols by people that might take GLP-1 drugs, it really does have a minimal impact on CSL. They may see some competition in parts of their portfolio. But it was interesting, they recently had an investor day and a maintained guidance for double-digit earnings growth with increasing return on capital. So management's still very positive, very positive feedback from the industry. What we think is going on is you've got people that are putting on, or hedge funds that are putting on shorts of healthcare stocks. They basically just put on a short basket of stocks. CSL is a large stock within the healthcare universe, and therefore it sort of gets caught up in the shorting. It's not really that people have taking a stock specific negative view.
On ResMed, as I said, it's not one we own. It's certainly a better than average quality company, but not as high as CSL. It doesn't display the same value characteristics. Now, that might seem an odd comment given it's halved. So CSL is down about 25% recently, ResMed down about 50. I guess the reason that we haven't been as interested in that is we had a view that it had benefited from issues at Phillips. It's one of its major competitors, and that people had overly capitalised those benefits into the stock price, and so therefore we thought the starting point was inflated.
So we still definitely prefer CSL, but acknowledge that as with any sort of change in markets, quite often people get a little bit too excited in the short term and then longer term they actually don't factor in enough of a change. But we certainly think at this instance, at the present time, we can say that the perceived impact from GLP-1 drugs on a lot of sectors like consumer, obviously healthcare, it may be a little bit too much in the short term.
Nathan Masalski:
Thanks, Ron. Any final comments perhaps before we wrap up today?
Ron Sargeant:
I guess the only other sector that people usually ask us about is banks, and we've had a view for some time that their margins were too high and would come down. We're still seeing a lot of competition in mortgages, so we're about to go into the bank earning season. So we think you'll see some of that come through. There will be some talk of bad and doubtful debts moving higher as households are under more pressure, but nothing too serious. More than anything though, we just think it's going to remain a difficult market for the banks. And it's interesting, each of them has sort of their own specific issues that people will focus on.
So CBA have been seeing some weaker volumes, which may feed into more competition, but that'll be a focus. For Westpac, people are going to be looking quite closely at the costs. So we have owned NAB and we think that's the pick of the bunch, relatively less exposed to some of the concerns we have and looks reasonable. But if anything, across our portfolio, we make a lot of being index unaware, and this is a great time where we think there's more opportunity out of sight of the major sectors of banks and resources, into some of the other areas where we see more quality on offer at better value.
Nathan Masalski:
Great. Well, Ron, thank you so much for your time today and the overview of the portfolio. On that note, we'll finish up. Thank you, Ron.
Ron Sargeant:
Great, thanks Nathan.
