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Inflation climbs higher as rate hikes approach

A relatively quiet week of economic data last week with business confidence and consumer sentiment the main releases locally. Of course, reporting season continues to ramp up but more on that a little later.

Globally equity markets fell -2.3% in AUD terms last week. Striping out currency movements (AUD +0.9% last week) and the MSCI World Index was positive last week as the market continues to digest a stronger than expected US jobs report which saw 467,000 jobs added in December.

The strength in US employment data all but confirms the Federal Reserve will hike rates in March which we have been proposing will happen for some time now. The unexpected strength of the jobs data all but ensures more rate hikes will now follow. Inflation data and employment data are simply too strong to expect one or two rate hikes will have the desired effect.

However, it was the release of US CPI data on Thursday that really weighed on markets. As expected, inflation data came in stronger (0.6%) than forecast (0.5%) which took headline CPI to 7.5% and core CPI which strips out some more of the volatile items to 6% – both 40-year highs.

We have argued that inflation would continue to rise during Q1 most likely peak around 7.5% and with a ‘low’ 0.4% reading for February 2021 rolling off next month, the chance is that Feb 2022 will likely rise further.

The impact of this elevated inflation figure has led to markets now pricing in a 90% chance the Federal Reserve hike rates in March by 50bps as opposed to the earlier consensus view of a 25bp rate hike and the expectation is now that rates in the US climb to 2% by December.

Whilst rising rates undoubtedly present more challenges for risk assets (equities), yields on 5-year and 10- year US Treasury notes ranging from 1.80%-2.00% should provide investors with some degree of comfort that whilst rates may indeed rise, we will still ultimately find ourselves in a ‘low’ interest rate environment.

So, what does this mean for the RBA and the portfolio?

We have been vocal in our belief that the RBA’s continued ‘dovish’ policy is behind the curve. Certainly, when you compare its response to that of other central banks.

With 4 rate hikes priced in locally in 2022 compared to the RBA’s response that “it’s certainly a plausible scenario that rates go up later this year” we continue to position and prepare the Prime Australian Equity Growth SMA for multiple rate hikes.

Our ‘Quality’ investment focus remains at the core of this portfolio’s strategy.

High quality businesses that produce strong free cash flows, have robust balance sheets and are market leaders will outperform businesses whose balance sheets are overly geared and more susceptible to interest rate pressures.

With investors having generated exceptionally strong returns with minimal volatility over the past 20 months, we believe a flight to quality will see many of the portfolio’s core holdings rerate higher.

BHP is one stock that we believe is well suited to a high inflationary environment with its ability to pass on increased cost pressures to its end consumers a major positive. We added BHP to the portfolio in October 2020 at around $35 per share and it currently is the portfolio’s highest conviction position.

Aside from iron ore which accounts for the majority of BHP’s earnings, copper represents 25% of group earnings and this plays to another thematic we are increasingly focusing on – the decarbonisation and electrification of the environment in the coming years.

The reliance on copper for climate change mitigation, EVs, power grid storage and renewable energy storage is only going to increase in our view, so from a demand-side perspective we believe the fundamentals are there.

We are also witnessing some supply-side constraints with the life span of copper mines typically shorter in duration and importantly those that do have a longer life span tend to carry some geopolitical risks such as those in Peru and Chile.

We believe increasing demand and supply-side constraints will be a positive for the copper price in the longer term and have recently added OZ Minerals (OZL) to the portfolio which is an $8.5b copper miner with its core assets being two long-life, low-cost mines in South Australia and a greenfield copper project in Western Australia coming into production in 2024.

A ‘quality’ stock that has underperformed and represents good buying

One of the biggest detractors on portfolio performance over the past 12 months has been CSL Limited (CSL) which has underperformed the broader ASX200 index by around -15%.

CSL is one of the largest global biotech companies, focusing on protein science therapies such as plasmaderived immunoglobulins (IG) for the treatment of immune deficiencies and neurological conditions in its CSL Behring division, and influenza vaccines, in its Seqirus division.

Originally formed in Australia as a Commonwealth owned entity, CSL is one of Australia’s greatest success stories and now earns half its revenue in North America and a quarter in Europe. Notwithstanding its strong track record, CSL has been a steady underperformer throughout the onset of COVID.

At current levels shares appear oversold and represent an attractive buying opportunity.

We believe there are idiosyncratic reasons for CSL’s underperformance over the short term which have translated into a broader underperformance of the healthcare sector more generally. Importantly, we believe these reasons are temporary headwinds with the long-term fundamental thesis remaining intact.

Firstly, healthcare has been disrupted by Omicron. We have seen a cessation in semi-urgent category 2 (refers to treatment required within 90 days) and non-urgent category 3 (treatment required within 12 months) elective surgeries in Australia. Elective surgery in the UK has also been disrupted.

Omicron will lead to a longer demand cycle for healthcare. Patients who can’t receive treatments will need it and this backlog is significant. Elective surgery will undoubtedly return, general surgery will return and there will be more treatment for mental health. As a result, we see a strong medium to long term trajectory for healthcare.

Secondly, the impact of lockdowns and Omicron has weighed on plasma collections in the US with slower growth also observed in two of CSL’s major competitors – Japanese-listed Takeda Pharmaceutical Company and US-listed Haemonetics Corporation.

Thirdly, the gap between supply and demand in global IG market is greater than 15%. With price increases and ongoing strong demand, we think CSL is well positioned given its global footprint and return on invested capital (ROIC) sitting above ~20%.

CSL has a strong history of execution when it comes to acquisitions and the potential acquisition of Swissbased Vifor will be earnings per share (EPS) accretive.

We believe the pressure on CSL’s earnings has now been understood by the market and is now priced into the share price which trades at a 2.5 year low.

Reporting season so far. Snapshot of what we’ve liked & what’s disappointed?

It’s early stages and reporting season really ramps up over the next fortnight. But at a headline level we have been impressed with:

• CBA – shares rallied +4.7% after 1H22 results showed continued above system growth. Loan growth at a mortgage level and at a business level both grew above system at around 7-8%.

CBA’s capital position remains comfortably above APRA’s requirement of capital levels with a CET1 ratio of 11.8% at the end of December. Importantly, CBA provided some transparency on how a 25bp rate rise will impact Net Interest Margins (NIMs) – it will increase NIMs by 4bps.

We expect to see a further deterioration in NIMs for FY22 with heightened competition amongst the big 4 banks driving NIMs lower, but we do expect some stabilisation and improvement in FY23.

CBA pleased the market announcing a $2b buy-back and increased the interim dividend by +16% from its prior corresponding period from $1.50 to $1.75.

• NWS – shares fell -1.9% having risen +11.7% the previous week after it released its Q2 FY22 market update.

NWS reported strong earnings, double digit EPS growth and an exceptionally strong balance sheet.

The move into digitalisation coupled with NWS’s strong presence in digital property (revenues +35% in Q2) helped drive a strong quarterly update.

NWS trades at a significant discount to our sum-of-the-parts valuation and remains a core holding in the portfolio

• ANZ results were underwhelming despite shares climbing +2.7%. ANZ released a Q1 update warning weaker revenues could weigh on its 1H result.

ANZ saw NIM compression of 8bps with structural headwinds impacting earnings, however, believe these headwinds will moderate with as rates rise, particularly in New Zealand.

ASX Weekly Wrap

The ASX200 advanced +1.4% last week with large caps (+1.4%) outperforming smalls (+0.6%) and mids (0.3%).

Financials (+4%) outperformed along with miners (+3.3%) which rallied on the back of price increases in iron ore, coal and a range of other commodities. Financials were driven higher by CBA‘s 1H22 result along with NAB’s Q1 FY22 report which showed a 12% increase in quarterly cash earnings.

Healthcare (-3%) and staples (-2.3%) lagged on performance. CSL and Sonic Healthcare (SHL) were the main detractors whilst Coles (COL) and Woolworths (WOW) both fell -3.6%.

Looking ahead

Monday 14th February 2022 – Friday 18th February 2022

• Monday: N/A
• Tuesday: AU RBA Meeting Minutes, UK Unemployment Rate (DEC)
• Wednesday: AU Westpac Leading Index (JAN), CN Inflation Rate (JAN),
  UK Inflation Rate (JAN), US Retail Sales (JAN)
• Thursday: AU Unemployment Rate (JAN), US FOMC Minutes, Building
  Permits (JAN)
• Friday: UK Retail Sales (JAN)

Friday 11th February, 5pm values

Friday 11th February, closing values

Key dividends

Monday 14th February 2022 – Friday 18th February 2022

• Monday: Div Pay-Date – Boral Limited (BLD), Charter Hall Long Wale
  Reit (CLW)
• Tuesday: Div Pay-Date – BOQPE (BOQPE), BOQPF (BOQPF)
• Wednesday: Div Pay-Date – Legg Mason Australian Bond Fund (BNDS)
• Thursday: Div Ex-Date – MBLPD (MBLPD), Div Pay-Date – Qualitas
  Real Estate Income Fund (QRI)
• Friday: Div Ex-Date – Argo Investments Limited (ARG)

Contact

If you would like to discuss your situation, please speak to your adviser or email clientservices@primefinancial.com.au

The information in this article contains general advice and is provided by Primestock Securities Ltd AFSL 239180. That advice has been prepared without taking your personal objectives, financial situation or needs into account. Before acting on this general advice, you should consider the appropriateness of it having regard to your personal objectives, financial situation and needs. You should obtain and read the Product Disclosure Statement (PDS) before making any decision to acquire any financial product referred to in this article. Please refer to the FSG (www.primefinancial.com.au/fsg) for contact information and information about remuneration and associations with product issuers. This information should not be relied upon as a substitute for professional advice, and we encourage you to seek specific advice from your professional adviser before making a decision on the matters discussed in this article. Information in this article is current at the date of this article, and we have no obligation to update or revise it as a result of any change in events, circumstances or conditions upon which it is based.