Should investors trust the bears or a new economic cycle?

Investors who look through bearish signals will find companies poised to benefit from economic strength.

ST Wong

Was it really just 18 months ago that the price of oil was negative? Oil producers had such a glut they were literally paying buyers to take barrels of oil off their hands. What has changed?

Commodities experienced a boom. Residential property, industrial property and shares boomed alongside. Was this just a trade in risk assets resulting from COVID-19, or the beginning of the next economic cycle?

Investors must navigate many mixed messages. Every economic or financial report refers to some form of slowing growth. Bearish market observers are raising the prospect of stagflation overhanging the US economy, and Evergrande’s debt problems in China.

Some near-term headwinds have emerged. Several CEOs said in the August corporate reporting period that global supply chain constraints, the stop-start approach to lockdowns and rising costs are key challenges.

Yet, the fundamental strength of the economic rebound remains intact. The impact of more effective vaccine distributions globally provides confidence, and other positives suggest we are indeed in a new economic cycle.

Some commentators have tried to draw parallels between this economic cycle to the period following the global financial crisis. But the contrasts are stark: consumers and corporates emerged from the global financial crisis in a position of weakness; both are now in a position of strength.

When recovering from the GFC, banks and households wanted to unsaddle heavy debt burdens brought on by years of excess. Governments were hemmed in by fiscal austerity measures. The consumer felt the cut resulting from declines in net wealth or net worth. Consequently, businesses were either reluctant or had little incentive to invest for future growth.

By contrast, current personal savings rates are at elevated levels as households socked away excess cash which would have been used for entertainment, holidays and other lifestyle pursuits. Banks are not in a de-gearing phase, as bad loans have not been an issue, while governments don’t seem likely to be in a fiscal tightening phase.

This strength is evident in the household, with additional cash balances significantly above pre-pandemic levels. Investment bank Jarden estimates that since March 2020, households have built up a buffer of $202 billion (10 per cent of GDP or 19 per cent of consumption), with $114 billion in additional bank deposits plus a further $88 billion in extra debt repayments.

Consumer potential

So, we are looking for opportunities with companies that benefit from a strong consumer. These include businesses related to housing and ancillary goods and services.

Sure, there are short-term risks investors should understand. For example, some businesses have benefited from a pull-forward of demand and will not sustain these high activity levels; and navigating Australia’s open-shut economy is somewhat more art than science for retailers as businesses grapple with supply chain issues (an inventory build-up ahead of Christmas could lead to losses if shopping is subdued).

It’s important to look through the short term to focus on companies with durable businesses – those with the ability to price their goods and services well, and with credible plans to grow their businesses. Auto parts retailer Bapcor and national baby goods chain Baby Bunting fit these criteria – both companies service a consumer segment with essential needs, have reasonably limited competition and room to expand.

The second big positive for the economy is the latent capacity sitting with corporates. Much like the consumer, corporates pulled in their appetite for investing and capital expenditure after the global financial crisis.

Investing for growth

Today Australian corporates are in a much better starting position. They have de-geared significantly while the demand outlook, from a consumer perspective, looks healthier. A key differentiator is that demand has been more concentrated in goods compared to services. Underpinned by a recovery outlook and strong balance sheets, conditions for investments and capital expenditures are positive.

Investors should consider companies that can benefit from rising business spending and are investing for growth. The media sector is often forgotten as lagged beneficiaries of consumer confidence and business spending. Radio broadcasters such as Southern Cross Media and HT&E should benefit from improvements in advertising budgets as the economy recovers.

Through the pandemic a number of companies have taken the opportunity to position themselves for growth. In the aviation sector, Alliance Aviation acquired a number of aircraft at depressed prices which will yield high incremental profits as activity recovers.

Perpetual, Pinnacle Investments and Macquarie Group have all made acquisitions in financial services firms, with a view to growing those businesses – in contrast to shrinking major banks.

While the bears can be relied on to appear when we hit some bumps along the way, the argument for a new, stronger economic cycle is compelling.

ST Wong is chief investment officer at Prime Value Asset Management.

Source: Australian Financial Review

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