11 November 2020
This report has been prepared by Northcape Capital, the underlying investment manager for the Warakirri Ethical Australian Equities and Warakirri Concentrated Australian Equities Funds.
Market Review and Outlook
The Australian equity market recorded a positive return in October up 1.9%. The ASX300 Index outperformed most global peers where rising Covid cases were a drag on markets in the Northern Hemisphere. In the US, news flow and share price reactions centred on the Presidential election, where uncertainty over the potential outcomes dominated market sentiment over the month.
The rise in the domestic equity market was driven largely by the bank sector which was up 7.5% over the month of October. In general, the equity market was supported by the prospect of further monetary stimulus and the resilient reopening of the domestic economy, especially following the easing of restrictions in Victoria.
However, the impact of the rise in Covid cases outside Australia was evident in the poor returns over the month from travel names in Australia, such as Flight Centre (-18%), Corporate Travel (-15%) and WebJet (-10%). Transport infrastructure stocks such as Transurban (-5%) and Sydney Airport (-7%) also lagged due to the rise in US bond yields.
From a sector perspective, there was wide dispersion in returns over the month. Information technology (9%), financials (6%) and consumer sectors outperformed, while ‘bond proxy’ sectors such as industrials (-4%) and utilities (-2%) underperformed. Energy and materials sectors were also both down (-1%) over the month. Interestingly, the energy sector has shown the weakest performance over the last 12 months (down some -40%).
In other news, the frequency of company updates has increased as we move into AGM season. While to date the trading updates and outlook comments have been mixed, there has been little change to our view that the trough in market earnings will continue into 2021.
M&A activity is restarting after a pause during the period of high volatility earlier this year. In fact, the best performers in the ASX100 in October were Coca-Cola Amatil (CCL 31%) and Link Administration Holdings (LNK 28%) – both targets of M&A. We expect further increases in M&A supported by large variations in valuations, weak organic growth prospects in some sectors, widespread strategies to divest non-core businesses, and very low borrowing costs.
In early November, the RBA changed strategy and decided to adopt quantitative easing by purchasing $100bn of government bonds with maturities of 5-10 years over the next 6 months. It has also signaled to financial markets that it will maintain interest rates at a very low level over the next 3 years as it does not foresee inflation moving back into its target range on a sustainable basis within this time frame.
The RBA also lowered the cash rate to 0.1%, although this is largely symbolic as market rates are already at this level due to excess liquidity.
The actions of the RBA have implications for both asset values and also relative valuations within the equity market. By attempting to flatten the yield curve the RBA is effectively reducing the risk free rate which influences the rate used by investors to discount future cash flows back to a present value. This has pushed asset values higher in recent months and may provide further support over coming months. In theory lower interest rates should be positive for valuation of growth stocks. However, we are aware that the current rating of stocks in this category do not leave much room for error or disappointment. We have been selectively scaling back our positions in Seek and Xero although we continue to remain comfortable in exposure to a broad range of other growth names including Hub24, IDP Education, REA and several health care companies.
The major banks face pressure on profitability from low interest rates, as seen in their recent results. The RBA moves will exacerbate this headwind, which is likely to persist for several years. Our portfolio holds a modest exposure to the banks which is well below benchmark weight.
A continuation of low interest rates may also see governments promoting expansionary fiscal policy post COVID-19 instead of targeting a balanced budget and reduction in Government debt. Highly expansionary monetary and fiscal policy should support economic activity and reduce downside risk to the economy.
Stocks in Focus
Xero (9%) outperformed the market along with high-growth tech stocks in general, which enjoyed a further re-rating locally. Xero has been our preferred exposure in this area because of its strong and durable competitive advantage in addition to attractive growth prospects. However, we have taken the opportunity of strong relative performance to reduce our exposure.
IAG (9%) outperformed as domestic trading conditions improved, with insurance rates continuing to harden and volumes holding up given fiscal and monetary support. IAG’s relative valuation appeal also benefited under recent market conditions.