Reporting season finished up with the RBA hiking rates for the 10th time since May. Have they done enough, and which large cap sectors are seeing an impact on earnings?
In this episode Paul looks back on February, the most recent rate hike and explains why learning from history is what will make us better investors in 2023.
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Andrew Dowling:
Welcome to Fidelity sound bite. A monthly podcast, we will learn from some of Australia's leading portfolio managers on what's happening in markets, how they positioning their portfolios, and the outlook ahead. I'm Andrew Dowling, your host and in this episode, Paul Taylor is back to reflect on February's reporting season. How the market is feeling and were earnings as expected? And how did the month of February go as a whole?? We're about to find out. Great to see Paul.
Paul: Andrew. Good morning. Great to see you too.
Andrew: So Paul, looking back, this February would have been your 40th reporting season since you establish the Fidelity Australian Equities Fund 20 years ago. Were there any particular takeouts that you'd like to share with us?
Paul: It was a really interesting reporting season. It's an interesting time. If we just look at the performance of the market, it was was down a little bit through the month of February, but there's probably a bit of an overlay. There was what the companies actually reported, but then there was also some macro overlay as well, which we can get into it a little bit more detail later.
But I thought the reporting season itself was broadly okay. I think there were actually more downgrades and upgrades across the market, but I think it was probably separated between large cap and small caps -I think it was probably more small caps that had that slight downgrades. Maybe they just more exposed to consumer cyclicals were a little bit tougher area, but broadly okay. I thought in terms of sectors insurance was good. Insurance had a great result, healthcare was good. You know, those sorts of sectors did quite well. Essentials did quite well, consumer staples. I think they just showed their resilience as we're starting to get into a slightly tougher period.
Some of the weaker areas were probably contractors, capital goods, and consumer discretionary, particularly in the good space as well, which is just starting to decline. So it may be a bit of a turning point, which I think will be interesting to look back. But then from a macro perspective, interest rates keep going up. So now as we see today, the Reserve Bank is at 3.6%. Whether there's one or two more? Definitely through the month was I found really interesting. There was a lot more negativity towards the RBA and the governor. I take that as it is pain entering the system. That's what I take that as. So I think we've been talking about interest rates going up for quite a while. And they have gone up, I don't think they've actually done too much as we've gone from zero to three, there really hasn't been much impact. But now at 3.6% you can almost feel sort of bit more pain entering the system.
Andrew: And it's a good point good timing and to your point, we've seen variable interest rates on home loans, pretty much double since March of last year, certainly over the last 10 months. So more and more households are probably starting to feel like they're moving from living to existing. Whereas on the other hand, the income on term deposits has increased dramatically. How do you build those very, very large, either positive or negative shifts in household income into your thinking around portfolios, companies and sectors?
Paul: Yes, so that's a good point you make. So people, you know, obviously, people generally just focus on the negative aspects of interest rates going up. But you make a good point that pensioners in particular have been living or very low deposit rates for quite a considerable time. So you now are starting to get 4% fixed term deposits, and, you know, even sort of high threes on as well, which will be positive for people, you know, savers, and for people maybe in pension mode as well. But the big impact really has been targeted towards mortgage holders. And the other interesting thing, which I touched on in last podcast as well, is that this time around probably more people, it was about estimated about a third of home buyers or more people with mortgages, went into a fixed rate mortgage, which is quite unusual, Australia is predominantly works on variable rates. Now those fixed rates started, well, they really have been rolling over, but they start to gain momentum through sort of May, June, July. June being a little bit of a peak. So I think it's really going to be interesting as we move into the next few months as people move off those very low fixed rate mortgages onto the variable rate. And that could be quite a significant increase. Now for those people that that's a big dent in their disposable income. And obviously, they're going to have to pull back on pull back on spending. And I guess, as we look to the year that's a big reason why, you know, we think essentials is the right place to be predominantly in the portfolio. And what we saw during reporting season is that supermarkets continue to do quite well. Because they are areas people have to spend on regardless of the environment. So you know, one thing I've also talked about, you know, essentials being half your wallet, that's maybe gone up to 60% due to inflation. And then you also got the shift between goods and services. It was actually interesting in the RBA announcement as well, this is the first time they broke out goods inflation and services inflation. So inflation is actually coming out of the goods sector, but inflation really is in the services sector because that’s where people are actually spending their money now. So we were all about goods in COVID. We've come out of it and now we're all services. They really want to go on holidays, they want to eat at restaurants, they want to do experiences, they want to travel. And that's where we're seeing the inflation. And one of the areas that continues to do quite well in the reporting season was also sort of COVID recovery plays as well - travel agents, airlines, theme parks, sort of tourist destinations. So yeah that higher interest rate is definitely going to pull back the consumer. I think our base case is still Australia doesn't go into recession. But as I pointed out last time, I think it's still a risk factor. And once again in the latest RBA release they start to talk about, we're getting close to the where we need to get to on rates, but market expectations is still probably you know one or two more. So we're getting close to that 4% rate or even a little over that 4% rate even
Andrew: And if we are close to that pause in RBA rate hikes. Obviously provides a little bit more certainty around what funding might look like short, medium term. Obviously companies when they are looking to invest revenue back into themselves it’s typically on a long term basis. But does this new Risk Free Rate that companies might assess off - Does that change the thinking around projects? Does that change the thinking around acquisitions and reinvesting? What are you seeing across companies and how they're thinking about it?
Paul: Yeah look, I don't think it really changes their assessment of required returns on projects. And even for us, when we try to value individual companies, you know, a big part of that valuation that is the discounted cash flow, a big part of it is the risk free rate as you highilghted. Now, that risk free rate, probably got all the way down to 1%. We certainly didn't end models and take the risk free rate to 1% and sort of 4% was about where we bottomed. So we didn't go down to one. But we haven't come back from 1 back up to 4. And I'm sure companies are the same. When they assesss projects, I’m sure they didn't take their risk free rate right down to zero to 1%, which would have made pretty much every project extremely attractive. They’re still looking. So if you if you follow that through in the model, it's probably, you know, projects, and we still be able to look at for 10-15% return, that really didn't come right down when stressed, when the risk free rate went down. But, it hasn't necessarily gone back up as well. So I don't think it'd be, certainly not from our perspective and I don't think there will really be huge changes in the way corporates viewed CAPex and investment and projects.
Andrew: And just with the banks, you know, they're obviously a valuable insight into the broader economy itself and what's happening. Are they concerned about the impact of rate rises? Turning positive obviously that’s good for sourcing funding, and less offshore funding requirements, What's the view there across the board?
Paul: That’s a really interesting one. And they have probably short term and long term consequences.
In the short term, what we've seen from the banks is net interest margin, which is basically the difference between what they lend at and what they borrow at. That spread is the net interest margin. That’s been going up. If you look at the deposit side, on a transaction account that’s often zero that they’re giving you. But when interest rates are 5%, they're making it an interest margin of five on the deposit side. But then as interest rates go from five to one, they're now making a 1% NIM. So as interest rates are really low, it actually squeezes their NIM, and they've got to pick it up on the air assets side, which is where they're lending. So as interest rates have gone out, you've seen an improvement in NIM. So they are getting a bit of a tailwind in the short term. So actually, that's growth in the short term for the banks. But what the other consequence, and I mean, this is a bit more longer term. Is obviously as interest rates get higher, you've got the potential of higher loan loss provisions, which is the big impact on banks and a slowing in the system growth. And we’re already beginning to see a slowing of the system growth. Both banks are starting to provide a little bit more provisioning. But still, we're still not really seeing it in the marketplace. But you know, as interest rates go up, and maybe there's more stress in the market, you do start to see a little bit more of that through the rest of the year. But we'll wait and see. So there’s probably short term tailwinds, long term headwinds for the banks.
Andrew: So we to from here? February reporting seasons come and gone. As we look towards the rest of the year, there will be another temperature check in August around how companies are tracking, and as you say your portfolio you take a very long term view on the opportunities that you include in the portfolio. Anything that's changed as a result of Feb or views that might change your thinking around how you position yourself?
Paul: it's a good point and reporting season is always a bit of a check on the pulse, and it's obviously great opportunity to catch up with the companies. We’ve has a number of company meetings through February which is incredible for us, as each company reports and they will have a chat with them to talk about trends etc. So it is a bit of an opportunity to you know revaluate the investment thesis: is it working, is it not working? Where's the company heading? Is it as you thought? I guess when I look at this reporting season, I guess it pretty much confirms the positioning in the portfolio. I'm very much happy with where we're structured at the moment and I got confirmation through the reporting season. So the fact that we are heavy in essentials, which is a bit more defensively positioned, but we're heavy in essentials, which I think is definitely the right place to be. So we saw good results from the supermarkets, Coles and Woolworths, some of the other consumer staples did very well, which demonstrates, really demonstrates their resilience through a tough period. Healthcare did really well, which is also part of those essentials. Ramsey healthcare, which is a private hospital operator, they were very negatively impacted through COVID is just starting to recover, the hospital system have just started to recover. So they're in a much better place.
So essentials is a big part of it, we got very little exposure to consumer discretionary goods. I continue to be happy about that. There'll be a time to step in and buy some of these, but it's just not at the moment. I think things have to get a bit worse before we're ready to step in and buy those stocks. I'm also really interested in the cheap sector. So I put insurance in that space. And so they will look at banks, were a little bit underweight banks, but we actually got a reasonable overweight on insurance, obviously, they're in a really nice space at the moment. So we're seeing a tightness in that market premium growth. So insurance companies, and specifically general Insurance, we've had a range of different natural disasters, which has really taken a lot of capital out of the sector, and then it's tightening the market. So I'm sure you are and everyone is seeing their home insurance go up, their car insurance go up, and by significant amounts. So we're seeing a real tightness and premium growth for the insurance companies. They are in a much more attractive environment going forward. One of the overweights is Suncorp, which we think is really well positioned, especially as they start to simplify their business as well. So we’re seeing tightness in that market. The other thing that's helping the insurance companies is that that short term rate. So when they get their premium, they've got to put that money to work and earn more money. So as short term rates have gone from zero to four, they're now earning more money on those premiums they get in as well. So that's improved the model, and they're relatively cheap. So we think the whole insurance sector is in a really good spot. But we're particularly positive on Suncorp. And then also, I guess, in the resource space which is also of interest to us, we continue to believe that the transition materials, you know, the lithiums, the nickels, the coppers. Ones that are really well placed as we go through decarbonisation. So that is a major trend that's gonna play out in a relatively short space of time. So you think that this is got to play out over the next 15 or 20 years. So there's a huge amount of development that needs to happen in that next 15-20 years, and it's a big drain, that's not going away. So decarbonisation is a very metal intensive phase of development. So we think those specific companies within commodities are well positioned as well.
Andrew: And well finally had to choose as a movie or a TV series that some type of reporting season how it went, what would it be?
Paul: Andrew, that is a tricky question. And I guess I'm going to slightly change the premise if you don't mind? A movie that comes to mind, I think in this environment, and a movie I absolutely loved was ‘Eternal sunshine of the spotless mind’. Now I definitely recommend that as a movie. But to me it's also that movies about people that don't like their memories, going back and getting rid of the memories of a person or a historic event. To me at the moment, we need to do the opposite. We need to be cognizant of history, we need to learn from history. And the history in these environments is actually probably not a recent history, it's actually going back a little bit. We need to be students of history. We need to look back through crises, we need to understand what happens in a recession when we get close to a recession, and what gets impacted. Because I think it's been so long, especially in the context of Australia. So we actually need to do the opposite. We need to maintain those memories. We need to strengthen those memories. We need to learn from those memories. And I think that's going to make us better investors in 2023.
Andrew: Well, thank you Paul. And here's to having a much better 2023. Appreciate you joining us today. And if you have enjoyed this episode, please share it with a friend or colleague and subscribe to your podcast or your favorite streaming platform. And we'll see you in a month. Bye for now.
Paul: Andrew, thank you. Great to talk to you as always.
SS:
Some important information on today's podcast. This podcast is issued by FIL responsible entity Australia limited AFSL number 409340. This podcast is intended as general information only and has been prepared without taking into account any person's objectives, financial situation or needs. You should consider the Product Disclosure Statement and target market determinations for Fidelity Australia products at fidelity.com.au. Please click the link in the show’s description to read the full disclaimer.
