Regular readers of our notes will know we’ve been bearish equity markets since early 2022. However, a number of catalysts have emerged which could potentially turn market sentiment to bullish. In this article, we’ll explore the key drivers behind the market’s sudden resurgence over the past six months, and why we may just see the market higher – if highly volatile – by the end of 2023.

Catalyst 1 – Everyone was bearish going into the new year

Investors are cautious, and for good reason. Markets have seen a rapid increase in interest rates to levels not seen since 2012 (and are forecast to go higher still) and consumers are heavily indebted. Corporate earnings remain challenged in 2023 after a resilient 2022. Margins are likely to be lower given widespread cost pressures.

All this is likely to manifest itself in weak earnings guidance during the February profit reporting season. Investors have noticed, and subsequently positioned themselves for a poor reporting season. This was highlighted in the options markets as well, with investors buying four times as many puts as calls on some recent trading days. The Fed has also continued to talk markets down post rate rises, with the media suggesting we should not fight the Fed.

With such constant messaging, no wonder the bears have been out in force.

Towards the end of December, the US Emerging Portfolio Fund Research (EPFR) reported outflows of -US$41.9b from equities in one week – the highest ever recorded. Cash levels are near all-time highs.

So a weak reporting season appears to be consensus view, with the broad market already positioned for it.

However, history has shown time and time again that when all investors are sitting on one side of the boat, the opposite tends to occur. Already one large investment bank (Goldman Sachs) has changed its view, lowering the odds of a recession to 25% (versus the market at 70%). If more research houses follow, we may see an ongoing rally in the market.

Catalyst 2 – China is reflating

Now China has got rid of its zero COVID policy and is reopening, the country will stimulate its economy in 2023. We expect good growth numbers as a result, which has multiple implications. If China’s GDP rises by 4-5% next year, it will likely be the strongest performance among the G-7. Commodity markets generally, but metals in particular have embarked on an upside run ever since China re-opened in December. Uranium, copper, precious metals and, of course, iron ore have all moved higher, pricing in potentially much better demand from China. We have China’s GDP moving higher, starting in Q2 and ending the year +5% with 2024 penciled in as a +4% GDP year.

One stock benefiting from China’s reflation and on which we have high conviction is Mineral Resources (MIN). MIN produces lithium from its Mt Marion and Wodgina mines and Kemerton lithium hydroxide facility in Western Australia. It also has a highly regarded mining services business, operates its own smaller iron ore operations and has a fledgling energy business. The company has a number of growth projects underway including Wodgina train 3, the restructure of the MARBL JV with Albemarle, the Onslow iron ore development and the Norwest Energy acquisition. While the company is currently going through a period of elevated capex, we expect strong free cash flows to return from FY24. We value MIN at $110, with lithium ~50% of this, mining services ~44% and iron ore the remaining 6%.

Catalyst 3 – Is the Fed close to peak interest rates?

Historically the Fed tends to cut interest rates about 10 months after its last hike. As we know, the market tends to look six months ahead. True to form, the futures markets are predicting this very thing.

Is the rally in equities we have seen this year driven by markets anticipating a Fed pivot in late 2023? The US interest rate futures market is predicting peak interest rates in July with 77bps to go, Australia slightly later in September with 87bps to go. We also know that as global economies come out of this recessionary environment, stocks will explode higher and we will see some enormous rallies. It would be entirely logical for investors to jump the gun and get set in positions now.

US Futures Market

Australian Futures Market

Source: Bloomberg

While some sectors are yet to de-rate, others (such as technology) have already had heavy falls. Although a large part of the fall was driven by multiple de-rating due to increased interest rates, we believe the risk/reward proposition is now much more attractive.

One stock we have added to the portfolio is Netwealth (NWL). While recent fund flows have been soft and the company is experiencing significant cost growth investing in the business, the key factors we look for in a stock remain present. The addressable market is large and growing and there is a significant opportunity to continue growing market share, with share of fund flows (~40%) significantly greater than NWL’s current market share of FUM (~6%). The business generates high margins (~45% EBITDA margin) and returns, and has exceptional earnings quality and a strong balance sheet ($99m cash, no debt). In addition, management remain significant shareholders in the business (>50%). The stock may not appear ‘cheap’, trading at a PER of 37x FY24e, but we believe the company will grow into this multiple given the potential for strong sales growth over an extended period of time.

Catalyst 4 – Technical depth and breadth

We don’t usually pay much regard to technical indicators. However, two recent ones bear mentioning.

The ‘Breakaway Momentum’ indicator calculates the number of advancers vs decliners on the NYSE for a 10 day period. If it breaches 1.97, a true breadth thrust has occurred, which often happens before the start of a new bull market. It has only happened 24 times since World War 2 and the 25th time occurred in early January. The median and mean gain for the NYSE 12 months post the trigger is 20%, with a 96% success rate.

The second key indicator is the 200 daily moving average. Remember, bear markets rarely trade above the 200 DMA for more than five days. If they do, it often means the bear market is over. Sure enough, the S&P 500 recently breached the 200 DMA and held this level for five days.

So the start of 2023 has confounded investors around the globe. If one steps back, 2023 – while volatile and facing many headwinds – might be the year to dare to dream. Perhaps, against all odds and widespread belief, we’ll finish the year in positive territory.

Equity Trustees Limited (“Equity Trustees”) (ABN 46 004 031 298), AFSL 240975, is the Responsible Entity for the Kardinia Long Short Fund (“the Fund”). Equity Trustees is a subsidiary of EQT Holdings Limited (ABN 22 607 797 615), a publicly listed company on the Australian Securities Exchange (ASX: EQT).

This publication has been prepared by Kardinia Capital Pty Ltd to provide you with general information only. In preparing this information, we did not take into account the investment objectives, financial situation or particular needs of any particular person. It is not intended to take the place of professional advice and you should not take action on specific issues in reliance on this information. Neither Kardinia Capital Pty Ltd, Equity Trustees nor any of its related parties, their employees or directors, provide and warranty of accuracy or reliability in relation to such information or accepts any liability to any person who relies on it. Past performance should not be taken as an indicator of future performance. You should obtain a copy of the Product Disclosure Statement before making a decision about whether to invest in this product.

As the era of easy money comes to an abrupt end and conditions normalise, markets are now rewarding stock pickers more than ever.

Easy money has driven the ASX300 up in nine of the last 10 years – the rising tide lifted all boats. But now investors are grappling with new financial conditions: inflation is spiking, and global central bank policies are fundamentally shifting. With rate rises now imposing a cost on the use of money, investors are being forced to rethink what defines an attractive stock.

Source: Macquarie

While the contraction in price-to-earnings multiples is well progressed, we are yet to see meaningful earnings downgrades across the broader Australian market.

However, as real rates rise we expect further PE multiple contraction coupled with earnings downgrades, making for a challenging investment environment. In this market, track record and earnings quality come to the fore, giving an advantage to a well-structured investment process with a more disciplined approach.

This more challenging long-term outlook for global equity returns guides us towards businesses with our identified key quality characteristics as we remain true to our investment process: seeking out companies with strong market positions in growing industries, and the balance sheet strength and management track record to execute on growth plans.

Here are some of the stocks we believe could outperform over the next five years.

CSL (market cap $137b)

CSL develops plasma-derived and recombinant therapies to treat serious diseases. It also manufactures influenza vaccines, and treats iron deficiency and kidney disease following its recent acquisition of Vifor.

Management has proven adept at maintaining high returns (ROIC 20%+) through consistent product development and innovation to drive growth into existing and new markets. The company has high market shares in industries with strong tailwinds. Gearing is currently elevated following the Vifor acquisition; however, strong cash flows should see this return to a more manageable level. CSL trades on high earnings multiples, but we see valuation as attractive given we are expecting double digit earnings growth over the next few years as plasma collections recover post pandemic.

CSL PLASMA COLLECTIONS NOW EXCEED PRE-PANDEMIC LEVELS

Source: CSL

CSL (market cap $137b)HUB24 (market cap $2b)

HUB24 engages in the provision of investment and superannuation portfolio administration and licensee services.

Total funds under administration stands at $68bn, representing annualised growth of +80% over the previous 10 years, as HUB takes first place for net flows across the listed platform space. The company only commands ~5% market share in a large and growing market.

We believe independent platforms will continue to gain market share on a long-term view, while holding revenue margins steady. HUB trades on a PE of 29x with expected EPS growth of ~30%. Given its relative valuation to its sector and strong characteristics – including very sticky recurring revenue, high EBITDA margins at scale (50%+), sector tailwinds, track record and a first-class management team – we see HUB as a key pick.

Lynas Corporation (market cap $8b)

Lynas produces rare earth materials (particularly NdPr) that are used in the electronics, wind turbines and electric vehicles industries. It has a long life, high grade rare earths deposit in Western Australia, and a rare earths processing plant in Malaysia.

Lynas has a very strong balance sheet with cash of $1bn, meaning it can fully fund capex of $1.2b over the next two to three years to expand production capacity from 7.2kt NdPr oxide per annum to 12kt per annum. We believe the strong and longstanding management team will deliver these projects successfully.

The company is highly profitable, and we expect return on equity to remain high at more than 20% over the next few years, subject to movements in NdPr prices. We forecast improving NdPr prices over the next five years as the transition to green energy provides a significant tailwind to the market. With rising geopolitical tensions globally, Lynas holds a strategic position as the dominant ex-China producer of rare earths, with the US Department of Defence agreeing to co-fund the development of two rare earth separation plants in the USA. We believe this warrants a valuation premium.

LYNAS IS BUILDING SHARE IN A GROWING MARKET

Source: UBS, LYC

Pilbara Minerals (market cap $15b)

Pilbara offers high quality exposure to the green energy transition via its long life (26+ years) and low-cost lithium mines in Western Australia. The strong rally in lithium prices – as demand outweighs supply – has resulted in the company generating extraordinary cash flows (cash +$784m in the September 2022 quarter alone). The company now sits on a cash balance of $1.4b and appears fully funded for all announced growth plans, which include spodumene plant expansions and a downstream joint venture with POSCO in South Korea to produce higher margin lithium hydroxide product.

Although the stock is up 50% this calendar year (after a 270% rise in 2021), we believe the company still trades at attractive multiples (FY23 P/E of 8.0x) given the long duration of the green energy theme.

Source: UBS, LYC

Resmed (market cap $14b)

Resmed designs, manufactures and markets equipment for the diagnosis and treatment of sleep-disordered breathing and other respiratory disorders, such as obstructive sleep apnea.

It’s a structural growth story, with an estimated 1 billion people suffering from sleep apnea, and Resmed is a clear leader with market share of ~60%, a strong track record of high returns and strong cash generation. The company is likely to continue benefiting from a benign competitive environment in the near term. Its major competitor, Philips, is suffering a material device recall, which we believe will l see a permanent 10% step up in market share for Resmed.

Equity Trustees Limited (“Equity Trustees”) (ABN 46 004 031 298), AFSL 240975, is the Responsible Entity for the Kardinia Long Short Fund (“the Fund”). Equity Trustees is a subsidiary of EQT Holdings Limited (ABN 22 607 797 615), a publicly listed company on the Australian Securities Exchange (ASX: EQT).

This publication has been prepared by Kardinia Capital Pty Ltd to provide you with general information only. In preparing this information, we did not take into account the investment objectives, financial situation or particular needs of any particular person. It is not intended to take the place of professional advice and you should not take action on specific issues in reliance on this information. Neither Kardinia Capital Pty Ltd, Equity Trustees nor any of its related parties, their employees or directors, provide and warranty of accuracy or reliability in relation to such information or accepts any liability to any person who relies on it. Past performance should not be taken as an indicator of future performance. You should obtain a copy of the Product Disclosure Statement before making a decision about whether to invest in this product.

In his 8-minute speech at the recent Jackson Hole symposium, US Federal Reserve Chair, Jerome Powell, fundamentally shifted the market outlook. Powell strongly suggested there will be no pivot in monetary policy, and there will be ‘pain’ as the Fed engineers a reduction in demand to lower inflation. The Fed’s view on the recent 17% rally in equity markets (S&P500) could not be clearer.

Powell’s reference to the inflationary dynamics from the 1970s and 1980s was telling. It took three Federal Reserve chairmen to get the job done – with only Paul Volcker finally delivering the silver bullet. Inflation in the 70s lasted a whole decade, rather than simply being transitory. Recognising valuable lessons from the past, Powell said, “These are the unfortunate costs of reducing inflation. But a failure to restore price stability would mean far greater pain.”

The rate rise message

We’ve always believed that in order for Powell and the Fed to maintain their credibility, they cannot pivot – at least not at this point. At Jackson Hole, Powell’s message was direct – the Fed wants to make sure that the market forgets any idea of a pivot before it becomes more comfortable with inflation.

The US 10-year bond yield is starting to again price more hawkish monetary policy, with the yield rising ~60bp to 3.20% at 5 September 2022 (and seemingly heading towards the recent peak of 3.42% seen in mid-June, when the ASX300 Accumulation Index was 7% lower than today’s level). Interest rate futures markets have also become more hawkish.

Source: Bloomberg Australia RBA Cash Rate Future

It’s interesting that the Fed’s governors have lined up post Jackson Hole to reinforce the rate rise message. They are clearly puzzled by the market, and the recent strength in equity markets is seen as unwelcome. Equity market strength is expansionary; the wealth effect bolsters the economy at a time the Fed is attempting to slow down activity and reduce inflation. There’s conflict, and it’s highly likely the Fed will continue to jawbone the market until its outcomes are met.

Higher interest rates are not the only weapon in the Fed’s arsenal. It remains to be seen whether the Fed has the will to embark on quantitative tightening (QT), but this may well be the tool that is required this time. QT has been spoken about but not implemented yet. The Fed is due to start in early September by reducing its $9 trillion balance sheet by US$95 billion every month. Markets will remain apprehensive, as it’s another ‘unknown’ which deserves caution.

The return of the Powell pivot

We think it’s unlikely the Fed will allow a disorderly correction in asset prices, but it may not have full control in the short term. If this were to occur, we think Powell would quickly pivot by halting QT, and making dovish commentary about the future path of interest rates. This is an ever-present risk to our short book, and a key reason why we tend to take profits along the way in a market environment where everything seems to be driven by the Fed.

Making money in this environment

In response to the environment, we’ve cut our net exposure to the market aggressively and are now net short (both cutting the size of our long book and increasing the size of our short book). Within the long book, we are also positioned more defensively, with key exposures being healthcare, energy, and stocks that do well when interest rates rise. Our short book positions are dominated by high multiple or lossmaking stocks that do poorly when the discount rate rises, with the most shorted sector being technology. We’re also short some consumer discretionary names, which we believe will come under pressure if the Fed is successful in putting consumer demand to the sword.

With such volatility, multiple turns in markets are highly likely before the year is up. We expect to remain defensively positioned, but are also highly alert to opportunities to acquire quality businesses at cheaper prices in any market sell off. We’re looking to add our exposure to the high cash flow energy sector, and we’ll also look to add resources exposure to the portfolio in the event of a more comprehensive stimulus program in China. At the same time, we’ll likely take profits in more defensive ‘recession proof’ holdings that are beginning to look expensive.

Equity Trustees Limited (“Equity Trustees”) (ABN 46 004 031 298), AFSL 240975, is the Responsible Entity for the Kardinia Long Short Fund (“the Fund”). Equity Trustees is a subsidiary of EQT Holdings Limited (ABN 22 607 797 615), a publicly listed company on the Australian Securities Exchange (ASX: EQT).

This publication has been prepared by Kardinia Capital Pty Ltd to provide you with general information only. In preparing this information, we did not take into account the investment objectives, financial situation or particular needs of any particular person. It is not intended to take the place of professional advice and you should not take action on specific issues in reliance on this information. Neither Kardinia Capital Pty Ltd, Equity Trustees nor any of its related parties, their employees or directors, provide and warranty of accuracy or reliability in relation to such information or accepts any liability to any person who relies on it. Past performance should not be taken as an indicator of future performance. You should obtain a copy of the Product Disclosure Statement before making a decision about whether to invest in this product.

As stocks have wobbled, investors have bemoaned having no place to hide – not even in gold. June alone saw the market fall a whopping 8.97%.

However, short positions across key sectors such as lossmaking, high multiple technology and consumer discretionary stocks seem to be strong contributors to relatively solid fund performance.

Inflation sticks

Meanwhile, the Australian CPI surged 5.1% for 12 months to 31 March this year, and the US CPI rose 8.6% for May year on year, potentially moving towards levels not seen since 1970- 1980. And while last year central banks and economists were calling for the inflation spike to be transitory, the pathway of inflation over the last 18 months has been anything but. Inflation tends to be stickier than imagined.

Source: Bloomberg

Of course, the message can change over time, but futures markets are currently forecasting a 170bps increase in US and Australian rates by December.

Source: Bloomberg

Source: Bloomberg

It’s often said the central banks will keep pushing until something breaks. The only way interest rates will not follow that trajectory is if US summer economic data is so weak that a pause in hikes is considered, which is becoming more likely by year’s end.

The risk for markets

If the futures markets are correct, homeowners will see a significant increase in mortgage repayments by December. The RBA’s 50bp rate rise in June woke many people up, and the domestic housing market is already coming under pressure.

The biggest risk for markets is whether the US enters a recession. If it does, S&P500 could fall another 15% – which would have an impact on Australia. If not, the falls will be more modest.

In the global economy, wage pressure continues to build as the consumer is squeezed by higher costs of everything, from rents to fuel. We believe high debt levels make the global and Australian economy particularly vulnerable.

The current level of inflation likely also explains why consumer confidence is falling, and it’s pushed the University of Michigan index just below record lows. Consumer confidence is a key driver of consumer consumption, which drives around 70% of the US GDP.

Source: Bloomberg

Heading for recession?

Every recession in the past 40 years has been preceded by an inverted yield curve, and the yield curve inverted in early April. Looking historically, the time interval between inversion and recession averages about 10 to 12 months.

The US Fed needs to slow demand and can only do so by delivering “shock therapy” – by impacting consumers’ wealth (via stocks and house prices). The Fed will take every rate rise the market gives it, but at the end of the day raising rates is a blunt instrument.

It’s rare for central banks to engineer soft landings, particularly when inflation is above 5%. So, we believe the US is headed for a recession. This view runs somewhat counter to consensus. Until recently, most US economists had been suggesting there were no signs of a slowdown in US economic data, but the stock market indicates otherwise.

There’s also, of course, an unwind of the central bank’s balance sheet, which started this month in the US. The expansion of central bank balance sheets has inflated share prices in multiples since the GFC. It stands to reason that the opposite is also true. Federal Reserve Chair Jerome Powell’s mandate is to tame inflation.

We’re very early along the tightening journey – we’ve only had three interest rates rises so far, and the pain may be ahead of us more so than behind us. Although, it’s way too early in the rate hiking cycle to think about fighting central banks.

Source: Bloomberg

Our outlook

We’re long some defensive businesses, including Bapcor, Tabcorp and The Lottery Corporation. Auto parts are generally essential for car maintenance, while lottery tickets have proven to be very defensive during recessions.

The market wants current earnings, not future long-dated earnings, and certainly not loss makers. Loss makers have no valuation support and 17% of ASX300 are loss makers (even if some are temporary like FLT, WEB). Some don’t even have any significant revenue. This basket is where we are hunting for short ideas.

We’re short high multiple stocks – those with long earnings duration and loss makers. Of course, a constant risk for us is “bear market rallies” – these can be violent, so we’re cautious of being too aggressive in our short book.

We haven’t seen the capitulation yet. It is worth noting Cathie Wood’s beaten-down ARK Invest is still seeing inflows, even though ARK is off c.60%. This shows investors are still looking to buy the dips. The MSCI AC World 12m forward PE has derated from a peak 20x to 14x. However, global equity markets do not yet look especially cheap against history. For example, a drop to the 10x multiple seen during the 2011-12 Eurozone crisis would imply another ~30% derating.

We’ll be watching the economic data closely, with a particular focus on inflation, bond yields and whether central banks are forced to pause their tightening due to economic damage.

Equity Trustees Limited (“Equity Trustees”) (ABN 46 004 031 298), AFSL 240975, is the Responsible Entity for the Kardinia Long Short Fund (“the Fund”). Equity Trustees is a subsidiary of EQT Holdings Limited (ABN 22 607 797 615), a publicly listed company on the Australian Securities Exchange (ASX: EQT).

This publication has been prepared by Kardinia Capital Pty Ltd to provide you with general information only. In preparing this information, we did not take into account the investment objectives, financial situation or particular needs of any particular person. It is not intended to take the place of professional advice and you should not take action on specific issues in reliance on this information. Neither Kardinia Capital Pty Ltd, Equity Trustees nor any of its related parties, their employees or directors, provide and warranty of accuracy or reliability in relation to such information or accepts any liability to any person who relies on it. Past performance should not be taken as an indicator of future performance. You should obtain a copy of the Product Disclosure Statement before making a decision about whether to invest in this product.

The topic on everyone’s mind is: what does the balance of 2022 have in store for investors?

It looks like 2022 will continue to be a difficult year for equity investors, as the market experiences considerable volatility but ultimately ‘treads water’ and consolidates. In April, there were not many places for investors to hide, with the S&P500 Index down 8.8% and the Nasdaq down 13.3%, bond markets also weak (US 10-year yields up 53bp for the month to 2.85%) and gold down 2%.

Inflation bites

Meanwhile, the most recent Australian CPI inflation number surged to 5.1%. For anyone renovating (or who knows someone who is), it comes as little surprise that a key upward driver was housing construction costs as well as higher fuel prices. The US CPI came in at 8.5% for March year on year on its way to 10% and beyond, potentially challenging the highs we had in 1970-1980. Once the inflation genie springs from the bottle it’s hard to stuff back in. Back in the 70s it took a rotation of three individual US Federal Reserve Chairs to tackle inflation: it was only when Volcker took the helm in 1979 and drove the federal funds rate to 20% that inflation finally broke – along with the global economy. This time we think the Fed will not repeat its past mistakes, and inflation will be tackled faster.

That won’t be easy, however, as inflation is already becoming entrenched. Coles recently reported food inflation in the March quarter of 3.3% and suggested that price rises were only just getting started. Higher energy prices lead to higher food prices, and energy has just gone through a decade of depressed spending in new and expanded production: there simply is not enough oil and gas to satisfy global needs, particularly as sanctions continue to be placed on Russia. Our view is that oil prices have not seen their top, notwithstanding the Brent oil price is currently sitting 60% higher than 12 months ago.

The following chart shows the outperformance of the technology sector over the energy and materials sectors. The NASDAQ has beaten the global energy and materials sectors by a factor of 4 over the past decade. However, given the tech sector’s long-dated earnings profile with rapidly rising interest rates, we believe this gap in performance will close.

Interest rates on the up

The Fed has already raised interest rates twice this year, and the market is forecasting two more 50bps rises in June and July followed by a rate hike every meeting for the remainder of the year. The only thing that could halt that trajectory is if US summer economic data is so weak that a pause in hikes is considered. We saw the US equity market fall 6% during the US Fed’s taper program in 2013 and the US Fed quickly reversed course – though that may not be as easy this time, with Powell’s mandate being to tame inflation. In the meantime, as equity markets rise the Fed will take every rate hike it can get.

The Reserve Bank of Australia took the opportunity to raise rates by 25bp to 0.35% at its May meeting, above market expectations. The rate increase was immediately passed on in full by each of the major banks. It has been a long time since Australians have experienced rising home loan rates (11 years, in fact) and we expect a considerable impact on consumer discretionary spending as belts are tightened. Former Australian Prime Minister Malcolm Fraser once said “life wasn’t meant to be easy” and we think the Australian consumer is about to find out just how hard life can be in a rising interest rate environment. The consumer discretionary sector of the Australian market is down 15% already this calendar year, and that’s before many of its constituents have downgraded profit expectations (which we expect to occur over the next 12 months).

The benefit of a long short capability

We do not expect the Australian equity market to produce significant returns for investors this calendar year.

Notwithstanding, Kardinia has the added flexibility of shorting which many managers in Australia do not possess. In the last 2020 pandemic equity market sell off, the ability to short individual shares and the market resulted in Kardinia falling only c.4% when the market fell c.36%.

For a long short fund there are opportunities on both the long and short side to make a return in these markets. So how does that translate into the portfolio?

• With a global economic slowdown within the next 12 months a real possibility, household budgets will continue to squeeze. We believe consumer discretionary stocks are at risk.
• Big capitalisation companies should outperform the small caps.
• We like the resource and energy sectors and are leveraged to food inflation including Woolworths.
• We have reduced our net exposure to c.10% and our short book has materially grown in both the number of shorts and individual sizes.

Our key exposures are currently long consumer staples and inflation beneficiaries such as oil, resources (including ‘green’ metals); and short high multiple stocks, long duration earnings stories and loss makers.

Equity Trustees Limited (“Equity Trustees”) (ABN 46 004 031 298), AFSL 240975, is the Responsible Entity for the Kardinia Long Short Fund (“the Fund”). Equity Trustees is a subsidiary of EQT Holdings Limited (ABN 22 607 797 615), a publicly listed company on the Australian Securities Exchange (ASX: EQT).

This publication has been prepared by Kardinia Capital Pty Ltd to provide you with general information only. In preparing this information, we did not take into account the investment objectives, financial situation or particular needs of any particular person. It is not intended to take the place of professional advice and you should not take action on specific issues in reliance on this information. Neither Kardinia Capital Pty Ltd, Equity Trustees nor any of its related parties, their employees or directors, provide and warranty of accuracy or reliability in relation to such information or accepts any liability to any person who relies on it. Past performance should not be taken as an indicator of future performance. You should obtain a copy of the Product Disclosure Statement before making a decision about whether to invest in this product.

Jerome Powell’s re-election as Federal Reserve chair late last year was a relief to investors, but a few short months later his credibility is now on the line.

As economists continue to argue as to whether inflation is transitory or permanent, political parties know full well that inflation is disastrous at the ballot box. The US midterms will be held in November and polling doesn’t look good for the Biden administration. While the 2024 full term election is still a while away, inflation is rising. Gasoline price increases are toxic to the US voter and the prices at the pump are already at record levels, recently surpassing the 2008 spike. CPI is almost certainly going to be north of 8-9% year on year over the next few months, which is going to light a fire under the Fed.

Source: US Department of Labor

Inflation is taking off, but the outlook for the global economy remains uncertain. China has just announced a GDP growth target of 5.5% this year, the lowest in more than 30 years. Russian credit has just been downgraded to junk, while global sanctions are already creating material market distortions.

Meanwhile, the effects of higher oil prices are rippling across the economy. We believe those prices are here to stay, due largely to geopolitical events and ESG trends.

Russia is the world’s largest net exporter of oil and gas combined. According to Goldman Sachs, Russia supplies 11% of global oil consumption and 17% of global natural gas consumption (and as much as 40% of Western European consumption). However, the US has banned the import of Russian oil and gas, the UK is phasing out oil imports by the end of 2022, and the EU announced plans to cut imports of Russian gas by two thirds within a year.

The world needs to replace this supply, but OPEC has already announced that it has no plans to increase production in response to the Russia/Ukraine war. US trade envoys have been dispatched to Venezuela, with suggestions that a Saudi Arabian trip is in the planning. Of course, the US has the potential to bridge some of the shortfall by ramping up its own unconventional production; however, that appears unlikely given the US administration was elected on a clean energy platform.

Energy supply was already under pressure from ESG trends. In 2020, BP announced a plan to cut oil and gas production by 40% over 10 years and pivot towards renewables. Last year, Shell announced that its oil production had peaked and would fall 1-2% per annum as it targeted net zero emissions by 2050. This supply shortfall is occurring just as energy demand is returning after the COVID-induced lockdowns of the past two years. There is no easy solution. We do not believe there will be a quick end to the Russia/Ukraine conflict, meaning energy and commodities prices will remain elevated. The resources and energy sectors should generate attractive returns in 2022, with Australia in the box seat to outperform the rest of the world given its stable, resource rich environment.

It’s also worthwhile watching the credit and debt markets, which are so deep and more liquid that equity markets (and often equity investors) overlook the signals these markets provide. The 2yr/10yr year US yield curve is flattening, with credit markets signalling that investors are losing confidence in the economy’s growth outlook. Often it can be difficult to predict the trigger for an economic downturn, but in this case it could be the Fed raising the federal funds rate itself that causes a downturn.

The next Fed is meeting is scheduled for 15-16 March (US time), and commentary provided at the conclusion of the meeting will be critical in setting the stage for equity markets going forward. If the Fed signals a more gradual path of rate rises than the seven 25bp rate rises expected by the market over the next 12 months, it may be enough to see markets stabilise and some of the oversold and heavily shorted sectors stage a bounce. Until then, markets will remain turbulent.

We think Powell has two choices. Firstly, he could do what he has signed up to do and fight inflation by raising rates at a pace and magnitude sufficient to tame inflation. This would certainly put the brakes on inflation but would risk tipping the global economy into recession and we think the market could quickly revisit its lows.

Alternatively, he could signal a more dovish approach to monetary tightening by slowing the pace of rate hikes. In our opinion, this would likely see a broad market rally, led by the high PE growth names, including technology and loss-making stocks which have suffered such a large selloff in recent months.

Our belief is that he will choose the latter. All eyes on the Fed meeting next week.

Equity Trustees Limited (“Equity Trustees”) (ABN 46 004 031 298), AFSL 240975, is the Responsible Entity for the Kardinia Long Short Fund (“the Fund”). Equity Trustees is a subsidiary of EQT Holdings Limited (ABN 22 607 797 615), a publicly listed company on the Australian Securities Exchange (ASX: EQT).

This publication has been prepared by Kardinia Capital Pty Ltd to provide you with general information only. In preparing this information, we did not take into account the investment objectives, financial situation or particular needs of any particular person. It is not intended to take the place of professional advice and you should not take action on specific issues in reliance on this information. Neither Kardinia Capital Pty Ltd, Equity Trustees nor any of its related parties, their employees or directors, provide and warranty of accuracy or reliability in relation to such information or accepts any liability to any person who relies on it. Past performance should not be taken as an indicator of future performance. You should obtain a copy of the Product Disclosure Statement before making a decision about whether to invest in this product.

Six months ago, we wrote that inflation was on the horizon. We continue to field questions on the topic, so are revisiting it with our current thoughts.

Inflation looking less transitory

Signs continue to indicate that inflation is creeping into the system.

Central and global banks don’t tend to agree, but we think the tone will shift. In the face of a constant inflation rhetoric, the global consensus continues to push back on the structural shift in inflation. However, evidence of price inflation and supply chain disruptions are now showing up at every corner.

• Volvo has slashed the size of its IPO in the face of soaring energy costs and persistent supply chain delays.
• Nike’s first quarter sales missed Wall Street expectations by 7% due to production and shipping delays.
• Swiss food giant Nestle has increased prices in 2021 and will increase prices a further 2% in the final quarter and in 2022 to offset input costs of more than 4%.
• Unilever, which sells more than 400 brands into around 190 countries, announced that it will be raising prices of all its goods by 4.1% in the third quarter to pass on higher production costs.
• The price for durum wheat, the key ingredient in pasta, is up 60% this year.
• Delta Airlines just logged its steepest one-day drop (-6%) in a year, after warning that rising fuel costs could lead to an operating loss this quarter despite a lift in travel demand.

The Fed still sees inflation as temporary, with upticks in inflation explained away as simply the economy normalising after the pandemic shock and supply chain bottlenecks causing temporary disruption. But our US contacts note that those bottlenecks could last until 2022 or later. US Transportation Secretary, Pete Buttigieg, suggested in a recent interview that US supply chain issues may last ‘years and years’1 . Both Dubai Ports and Singapore-based Ocean Network Express, which carries more than 6% of the world’s containerised freight, have suggested an easing in supply chain disruption may not come until as late as 2023.

Listening to the key metrics

Let’s take a look at what prices have been doing in the key categories of food, energy and wages.

The UN’s Food Price Index is up 33% year on year. The index measures the global monthly price change in a basket of five food commodities, with vegetable oils up 61%, sugar up 53%, cereals up 27%, meat up 26% and dairy up 15%.

Rising fears about supply and energy security have also pushed Brent to above US$80/bbl, up 40%, and spot Asian LNG prices to US$35mmbtu, up 600% since 2019.

Source: Refinitiv, Jarden

Meanwhile, the USA labor market is already tightening. The drop in unemployment to 4.8%, and rapid 0.6% month on month wage growth, is indicative of a structural shortage of workers.

We expect the US experience to be repeated in Australia as our two largest economies emerge from lockdowns. We’re paying close attention to wage inflation in this country, given the Reserve Bank of Australia has indicated it is unlikely to raise interest rates while this metric remains subdued.

Is history repeating itself?

If higher inflation becomes entrenched, like turning the Titanic it takes time to reverse. We saw this phenomenon in the late 1970s, when three Fed Chairmen tried to stuff the genie back into the bottle – with only Paul Volcker, the last of the three, delivering the silver bullet.

We believe what we’re seeing today is remarkably similar to the experience in the 1970s. Back then, food and energy supply ‘shocks’ led the decade’s inflationary surprises. Firstly, bad weather saw CPI for food up 20% in 1973 and 12% in 1974; then came the Middle East conflict in 1973, which drove a rapid spike in the oil price.

History may not repeat itself, but it can rhyme. Today it is fuel prices, unfavourable weather and the impact of coronavirus on supply chains leading to food inflation. For the oil market, it’s the rapid move towards ‘green’ renewable energy (coupled with strong demand as the world emerges from the ravages of coronavirus) and freight costs that has led to a 70% surge in global oil prices this year.

Why does it matter?

In the 1970s, inflation had a critical effect on pushing rates higher, further entrenching inflationary expectations. According to the RBA, the 3 month Bank Bill rate was 6.6% in 1971 and 9.3% in 1974, which then jumped to 16.2% by early 1982.

Today, as inflationary pressures continue to build, several advanced economies have already increased rates, including the Norges Bank, the Reserve Bank of New Zealand and the Monetary Authority of Singapore, with the Bank of England potentially moving shortly.

The recent Australian quarterly CPI release (3.0% year on year) has ensured that inflation will remain a heated debate into 2022. At the very least: if inflation expectations build, interest rates launch sooner and bond prices continue to fall, then we should expect higher volatility in equities. Individual sector returns will diverge with winners and losers.

Equity returns historically beat inflation, within which commodities and energy sectors tend to do well. Banks and sectors which exhibit monopolistic pricing powers and hard assets, such as property, also perform strongly; whereas rate-sensitive sectors such as IT and loss-making stocks tend to underperform. We have seen this before and have positioned the Kardinia portfolio accordingly.

1 Buttigieg: Some Supply Chain Issues May Last ‘Years and Years’, Bloomberg, 8 October 2021

Equity Trustees Limited (“Equity Trustees”) (ABN 46 004 031 298), AFSL 240975, is the Responsible Entity for the Kardinia Long Short Fund (“the Fund”). Equity Trustees is a subsidiary of EQT Holdings Limited (ABN 22 607 797 615), a publicly listed company on the Australian Securities Exchange (ASX: EQT).

This publication has been prepared by Kardinia Capital Pty Ltd to provide you with general information only. In preparing this information, we did not take into account the investment objectives, financial situation or particular needs of any particular person. It is not intended to take the place of professional advice and you should not take action on specific issues in reliance on this information. Neither Kardinia Capital Pty Ltd, Equity Trustees nor any of its related parties, their employees or directors, provide and warranty of accuracy or reliability in relation to such information or accepts any liability to any person who relies on it. Past performance should not be taken as an indicator of future performance. You should obtain a copy of the Product Disclosure Statement before making a decision about whether to invest in this product.

Just as the Australian Census promises to provide a comprehensive snapshot of the country and how we are changing, so too the recently- complete Australian profit reporting season can tell us what life has been like for Australians over the past 12 months.

Growth of online sales

With so many Australians stuck behind their computer screen during the day, it is no surprise that they have been spending online with a vengeance, fast-tracking the structural move from bricks and mortar to online shopping. The CEO of Australian online book seller Booktopia stated “the pandemic was a massive bump for people buying online … online retail in FY21 was 13% of all retail. In three years by FY24 online retail will be 24% of all retail, almost double”1 .

Source: Booktopia FY21 Results Presentation

Australian online home furnishing retailer Temple and Webster (TPW) is another such example, where FY21 revenue is up 85% on prior calendar period. We also got a glimpse of current trading, with July month to date revenue growth accelerated to +39%. We expect TPW to report a tremendous uplift in gross profit, enabling significant reinvestment in FY22.

Savings rate still elevated

The savings rate among Australians has fallen, but remains at elevated levels (at ~12% of disposable income). Reporting season saw a record in dividends declared, with over $40bn of dividends to be paid: almost double that paid in the same period last year. Most of these dividends will be paid in September and October. Consumers’ banks balances will swell as a result of these record dividends as well as buybacks and the proceeds from a record year of M&A deals.

Retail will remain a beneficiary, as will the share market (given a significant amount of this cash will undoubtedly be recycled back into Australian equities). FY21 has seen some of the biggest deals in Australian history with Square’s takeover bid for Afterpay, BHP Petroleum’s proposed merger with Woodside Petroleum, MIRA/Aware Super’s acquisition of Vocus, Seven Group’s partial takeover of Boral and the bid for Sydney Airport by a consortium of super funds.

Internet data usage swelling

Many Australians no longer find themselves catching the train to work in the city. Instead, government-imposed COVID restrictions mean they are housebound, working from home and juggling the demands of home learning for schoolchildren. For this, they need a fast and reliable internet connection – and as a result, demand for high speed broadband has gone through the roof. Uniti Group’s share price increased by 133% for the year, with “work-lifestyle changes making fibre networks an essential commodity” 2 . Aussie Broadband (ABB) has seen revenue growth of more than 80% from its residential and business customers.

Solid demand for cars

While at home, people are getting onto jobs that usually take a back seat, such as renovating the house or upgrading the family car. Based on VFacts, the Australian new vehicle market grew +38% over Jan-May 2021. Strong demand, reduced discounting and a normalisation of parts and servicing demand has contributed to explosive car dealers’ results.

We have seen very strong profit results and growing forward order books from dealers like Eagers Automotive (APE) and Autosports (ASG) – both companies’ share prices have appreciated over the previous 12 months, at 145% and 118% respectively. APE’s “order bank growth is expected to continue as new vehicle demand remains strong and vehicle supply remains constrained”³.

Historical national new car sales volumes

Source: Morgans, ABS

Renovation explosion

Further to the above, Australians are building and renovating their homes with vigour, driven in large part by support from the Federal Government’s Homebuilder program. James Hardie’s Asian Pacific region’s sales growth increased 55% in the three months to the end of June. As an aside, the US restore and restoration market also grew at around 15% in the previous quarter.

Bluescope’s Australian Steel Products division, where around a third of product goes to the Dwellings segment, reported the “strongest domestic despatches since 2H FY2008, driven by record demand across both residential and non-residential construction segments … homebound consumers continued with trend of redirecting discretionary funds to renovations”⁴.

Alterations and additions – value of approvals (MAT, A$b)

Weak travel results

This spending around the home has come at the obvious expense of travel, with significant losses reported by the listed travel companies (Qantas $1.8b loss, Flight Centre $507m loss, Corporate Travel $33m loss). It’s refreshing to hear from a CEO who states it as it is, and Rex was perhaps the most direct of the airlines with its outlook statement, saying “the second half will still be struck by further waves of infection given the experience of other highly vaccinated countries. As such the outlook for the FY is pessimistic.” ⁵

It’s not for lack of trying. Australians are ready to travel. Qantas Chief Customer Officer, Stephanie Tully, commented: “So we [have] obviously been researching our customers throughout the pandemic on their desire to travel and doing that monthly and in the last couple of months, particularly for international, we’ve seen the highest demand levels we’ve ever seen. When you compare that to pre-pandemic levels of people that are likely to travel in the next 12 months, we’re seeing triple the amount of people looking to travel internationally in the next 12 months.” ⁶

Aircraft are being pulled out of storage, including the A380s, and reconfigurations are currently underway with the intention to return to the skies when the magical 70% and then 80% vaccination rates are achieved. Bolstering management’s confidence was the strength of the domestic business in the June quarter of FY21 – by the end of June, management basically saw the domestic business booking curves back to pre-COVID levels.

Concerning inventory levels

Arguably the number one theme of reporting season has been online retailers ending up with too much inventory.

Everyone seems to want to ‘invest’ in inventory as a strategic play. A stretched global manufacturing and supply chain is creating challenges – including longer lead times, higher freight costs and shipping delays – leading to companies growing inventory levels. Supercheap Retail (SUL) management said: “If it’s [inventory is] not in the shed or on the shelf today, for Christmas this year I think the chance of it being [in stock] come that peak time is incredibly remote.”⁷

However, we do not want inventory growth outstripping sales growth, and this is something we’ll watching closely in future periods. Retailers (BRG, SUL, KGN) continue to show higher levels of inventory and it’s concerning us. Only JBH and BBN have managed to keep inventory days down so far. Whether customers will be the major beneficiaries of heightened promotion activity (for inventory vulnerable to obsolescence such as technology) remains unknown; only time will tell.

What does all this mean for the future?

With COVID vaccinations accelerating across the country, we believe Australians can look forward to a happier 2022; with blunt lockdowns less likely, and more targeted measures introduced when COVID hospitalisations or deaths spike. At the time of writing, ~60% of Australians over the age of 16 have received one dose of vaccine while ~35% have received two doses. Globally, more than 5 billion doses have been given.

Source: Australian Government, Department of Health

We predict the 70% threshold for vaccinations will be reached by the end of October, which will be around the same time as AGM season. Our view is CEOs will start to get more optimistic around this event. This is likely going to continue the rotation towards coronavirus-impacted sectors.

The Kardinia portfolio is positioned for re-opening, with stocks that benefit from this comprising ~30% of the long book and lockdown stocks only ~10%. We believe some themes, such as the shift to online, are enduring, and we continue to hold exposure to the technology sector. Of course, new COVID variants and government nervousness around a likely rising death rate (as witnessed overseas) present risks to our view, but the Kardinia fund’s ability to shift its net exposure to markets in a range of -25% to +75% allows us to quickly respond to any change in outlook.

1 Booktopia FY21 Results Presentation 2 Uniti Group FY21 Results Presentation 3 Eagers Automotive FY21 Results Presentation 4 Bluescope FY21 Results Presentation 5 Rex FY21 Results Presentation 6 Qantas FY21 Earnings Call 7 ‘Zero chances of it arriving on time’, Sydney Morning Herald, 22 August 2021

Equity Trustees Limited (“Equity Trustees”) (ABN 46 004 031 298), AFSL 240975, is the Responsible Entity for the Kardinia Long Short Fund (“the Fund”). Equity Trustees is a subsidiary of EQT Holdings Limited (ABN 22 607 797 615), a publicly listed company on the Australian Securities Exchange (ASX: EQT).

This publication has been prepared by Kardinia Capital Pty Ltd to provide you with general information only. In preparing this information, we did not take into account the investment objectives, financial situation or particular needs of any particular person. It is not intended to take the place of professional advice and you should not take action on specific issues in reliance on this information. Neither Kardinia Capital Pty Ltd, Equity Trustees nor any of its related parties, their employees or directors, provide and warranty of accuracy or reliability in relation to such information or accepts any liability to any person who relies on it. Past performance should not be taken as an indicator of future performance. You should obtain a copy of the Product Disclosure Statement before making a decision about whether to invest in this product.

When speaking to clients, our investment team is frequently asked whether the market’s extraordinary run is due to come to an end. It’s a question many in the market are currently grappling with, and it pays to look back into history to provide a guide.

History repeating itself

In 2009, we saw only 5 drawdowns greater than 5% over the 18 months following the market’s low on 6 March 2009. Surprisingly the average drawdown was just above 4%, with each drawdown lasting on average just 7 trading days.

Despite seeming counter-intuitive given apparent risks, it isn’t unusual for markets to recover in this fashion after a large shock. History repeated following the recent COVID-induced drawdown, with only 2 drawdowns greater than 5% since the market bottomed on 23 March 2020, and each drawdown averaging only 3 trading days.

Today we find ourselves 15 months past the pandemic bottom in markets, with the ASX300 Accumulation Index having risen in 14 months out of the 15, and up a total of 67.8%. The market is 7.1% above its all-time high, and continues to climb higher.

Watching the signs

We remain positive on the market over the next 6 weeks as we head into a strong reporting season. However, a number of potential issues are accumulating as we enter the seasonally weaker period into September, with bond markets, options markets and the Chinese economy all attracting our attention.

Bond markets

The US Federal Reserve is committed to keeping its foot firmly on the accelerator until either employment numbers fall dramatically, or inflation accelerates to uncomfortable levels.

US headline inflation numbers released this week unexpectedly accelerated to 5.4% year on year in June, the biggest rise since 2008. One data point certainly does not make a trend; but three data points in a row is hard to dismiss, particularly when price pressures were so broad- based. Yet inflation is still transitory according to central bankers, and any acknowledgement otherwise is still months away.

Increasing inflation fears continue to spook investors that central banks may move sooner rather than later to lift interest rates, which saw the US 10-year bond yield rise from 0.50% in August 2020 to 1.74% in March 2021. But the yield has since retraced to 1.47% as the bond market warns of a potential economic slowdown. After experiencing a sell-off, since the middle of May investors have rotated once again into the tech sector, fuelled by the bond yield fall. Market breadth is narrowing (rarely a sign of market health), with mega-cap tech shares in the US increasingly taking leadership.

Options markets

The options market offers interesting insights, with positioning suggesting nearly everyone in the market is bullish. Implied volatility remains subdued, with the current put:call ratio extremely low – reflecting a heavy skew towards upside participation with little downside protection. ‘Who cares about protection’ seems to be the belief of the times. When the deck is stacked heavily towards upside participation, investors can aggressively move en masse to downside protection when markets do fall – leading to an even sharper reversal.

China

Meanwhile, the Chinese economy is at an interesting juncture. Having led the world out of the COVID-induced economic downturn, several indicators suggest risks are rising. Total social financing, which is a broad measure of credit and liquidity in the economy, has been falling after the Chinese government embarked on a process of deleveraging, allowing the economy to move forward with less stimulus support.

Source: CEIC, UBS estimates

The Chinese approach is in contrast to that of the US, which continues to provide significant monetary and fiscal stimulus. Other Chinese data has also been weak recently, including the Caixin composite PMI which fell from 53.8 in May to 50.6 in June (the lowest reading since April 2020). New orders are at a 14-month low. The People’s Bank of China has recently cut the Required Reserve Ratio (RRR) by 50bp, releasing an estimated RMB 1 trillion in base money liquidity and reducing bank funding costs by RMB 13b per annum. This should assist bank liquidity; however, we do not believe it represents a change in monetary policy by the Chinese authorities, with tighter prudential regulations and a continued slowdown in credit growth likely.

Alan Greenspan famously said in 1973: “It’s very rare that you can be as unqualifiedly bullish as you can now.” These words were spoken just before two of the worst years for the US economy and the stock market. Could the Australian market be heading for a similar comeuppance?

¹ Includes all drawdowns in the ASX300AI greater than 2% between 6 March 2009 and 31 December 2010

¹ Includes all drawdowns in the ASX300AI greater than 2% between 23 March 2020 and 13 July 2021

¹ As at 30 June 2021

Equity Trustees Limited (“Equity Trustees”) (ABN 46 004 031 298), AFSL 240975, is the Responsible Entity for the Kardinia Long Short Fund (“the Fund”). Equity Trustees is a subsidiary of EQT Holdings Limited (ABN 22 607 797 615), a publicly listed company on the Australian Securities Exchange (ASX: EQT).

This publication has been prepared by Kardinia Capital Pty Ltd to provide you with general information only. In preparing this information, we did not take into account the investment objectives, financial situation or particular needs of any particular person. It is not intended to take the place of professional advice and you should not take action on specific issues in reliance on this information. Neither Kardinia Capital Pty Ltd, Equity Trustees nor any of its related parties, their employees or directors, provide and warranty of accuracy or reliability in relation to such information or accepts any liability to any person who relies on it. Past performance should not be taken as an indicator of future performance. You should obtain a copy of the Product Disclosure Statement before making a decision about whether to invest in this product.

Markets and commentators alike are fixated on inflation, as signs suggest it is coming and will be anything but transitory.

Meanwhile, most central banks – including the Reserve Bank of Australia – are of the view that any up-tick in inflation will only be temporary. The bond market, however, has already begun to price in an increase in inflation, with the US 10-year Treasury yield rising 68bp to 1.59% for the calendar year to 9 May and the Australian 10-year bond yield rising 65bp to 1.63%.

Warren Buffet made the following comments regarding inflation at the recent Berkshire Hathaway AGM: “We’re seeing very substantial inflation. It’s very interesting. We’re raising prices. People are raising prices to us, and it’s being accepted …. we really do a lot of housing. The costs are just up, up, up. Steel costs, just every day they’re going up … So it’s an economy really, it’s red hot. And we weren’t expecting it.”

Just as Warren Buffett didn’t expect to see inflation, we don’t believe consumers are expecting it either. Inflation expectations have fallen significantly since the GFC, but the winds of change are here.

Food is perhaps the most obvious commodity where inflation will be quickly noticed by consumers; and this could be soon, if a recent report by the Australian Bureau of Agricultural and Resource Economics and Sciences (ABARES) is to be believed. ABARES believes the price of a range of fruit and vegetables could rise between 7-29% due to a drop in supply caused by the COVID-induced absence of Australia’s traditional “backpacker fruit pickers”. The Food and Agriculture Organization of the United Nations Food Price Index, which tracks monthly changes in the international prices of commonly-traded food commodities (including meat, dairy, cereals, vegetable oils and sugar) is up 30% year on year and has risen for ten consecutive months. This will have quite an impact on the purchasing power of consumers, particularly in third world countries.

There are certain parallels between the economic and political backdrop of today and that of the 1970s. Housing and commodities were two of the few asset classes that acted as effective inflation hedges then, and we suspect they will similarly perform strongly today. Right now, with inflation rising, borrowing costs reasonable and the supply of homes quite low in some Australian states, the stage is set for homes to once again become an inflation hedge. The housing market in the US and Australia has leapt, and we believe is still in the early stages of this rally.

Meanwhile, over the past year the copper price has risen 90% to US$4.47/lb, benefiting from strong demand (as government and central bank stimulus drive a recovery in global growth) and weak supply (due to years of underinvestment). With a tight market and a very low starting point for inventories, we believe the copper bull market has further to run. Indeed, Goldman Sachs believes that copper’s critical role in decarbonisation will force the price to US$15,000/t (US$6.80/lb) by 2025 – 50% higher than the current price. According to Bloomberg, Glencore’s CEO echoed those thoughts recently, suggesting a US$15,000 price is required to incentivise new copper projects.

Copper is not the only commodity that is seeing strong price growth, as can be seen from the table below.

Looking more short term, Friday’s US payroll report showed 266,000 new jobs were created against market expectations of around 1 million. But what piqued our interest was the rally in the US market that ensued after the release, with the market simply shrugging off the poor economic news. The conclusion to draw is that weaker employment growth will motivate the US Federal Reserve to extend stimulus and maintain a lower for longer interest rate setting, giving the equity market plenty to cheer about.

We believe higher inflation and higher global debt are here to stay. But the day of reckoning is still some way off..

Equity Trustees Limited (“Equity Trustees”) (ABN 46 004 031 298), AFSL 240975, is the Responsible Entity for the Kardinia Long Short Fund (“the Fund”). Equity Trustees is a subsidiary of EQT Holdings Limited (ABN 22 607 797 615), a publicly listed company on the Australian Securities Exchange (ASX: EQT).

This publication has been prepared by Kardinia Capital Pty Ltd to provide you with general information only. In preparing this information, we did not take into account the investment objectives, financial situation or particular needs of any particular person. It is not intended to take the place of professional advice and you should not take action on specific issues in reliance on this information. Neither Kardinia Capital Pty Ltd, Equity Trustees nor any of its related parties, their employees or directors, provide and warranty of accuracy or reliability in relation to such information or accepts any liability to any person who relies on it. Past performance should not be taken as an indicator of future performance. You should obtain a copy of the Product Disclosure Statement before making a decision about whether to invest in this product.