Peter Warnes on FAANGs, investing in Asia and bond market smoke signals

-- | 15/02/2022 Text size Decrease

Lewis Jackson: Interest rates, inflation, valuations, on a whole range of issues, markets are divided about what's going to happen going into 2022. The spirit of thoughtful disagreement, I'm joined by Morningstar's Peter Warnes to talk through both sides of the coin on the issues that markets are grappling with this year. Peter, thanks for joining me. Peter Warnes: Thanks very much, Lewis. Good to see you face to face. Jackson: It's good. It's good to be back. Let's kick off with valuations. So, we know that they are high, but we've also this week had earnings come in from Apple, from Google that have blown expectations out of the water. How should investors read between those two events? Warnes: Well, valuations are driven by two things – the cash flow and that drives earnings and the discount factor used in DCF models to discount future cash flows to perpetuity. So, in the last year, in the US S&P 500, 80% of the gains have come from multiple expansion and 20% from earnings growth. Don't ask me how they calculate that. But that's – I defer to higher beings. But if we take that as red, and it's plausible that's happened and is happening because of this historically low interest rate environment, and bond yields, and so forth, and therefore discount factors. So, at this point in time, we have very, very stretched valuations in the US market in particular. They have a preponderance of these high growth, big tech slanted companies, despite the fact that they might be all, kind of, tech. But there's preponderance of smaller companies in those big five, which represent 25% of the market cap of the S&P. So, you've got massive market concentration. I think 175 or 180 companies in the S&P 500 are in a bear market. They're down 20% or more from their peaks. That can't be said for the FAANGs with the exception possibly of Netflix, add in Microsoft, and then throw in Tesla, and you've got, kind of, seven groups that are big, big corporates that, if you like, got a corner on the market. The ETF flows that are using a rifle, not a shotgun, every time money wants to go into the – I want to be – I own FAANG even if it's just that much of it, it doesn't really matter. It pushes the price of that stock up. Jackson: And Peter, are you concerned? So, we've got the S&P 500, 500 stocks, but 25%, 30% of it is driven by these FAANGs, which – so far at least earnings growth seems to be good despite large chunks of the S&P 500 in the bear market. Are you worried, or what's your view on those FAANGs, those six or seven stocks that are currently holding up the S&P 500? Should investors be worried about that? Warnes: Well, Morningstar's fundamental valuations have still got Amazon and I think Google in the 4 – not 5-Star but 4-Star. They could be on the cusp of 5. So, they're in the green zone. I think that Microsoft is a little expensive. Apple is a little expensive. What I think is we can't – no one can really calibrate or know just how much pull-forward demand there is given the situation we live in right now. Jackson: We've been talking a lot about multiples for the last few minutes. We know how dependent they are on interest rates. So, interest rates are back in the Australian headlines this week. The RBA released its, sort of, monetary policy statement on Tuesday. We had Phil Lowe fronting the National Press Club Wednesday. Give us your take on inflation and interest rates and then maybe what the contrarian view is. Give us both sides of the coin in the spirit of thoughtful disagreement. Warnes: Well, we know inflation is at decade highs, basically around the world. We'll talk about our inflation. We are seeing 3.5% headline, 2.6% trimmed mean, and expectations of the trimmed mean going from 2.6% where it is now annualized to 3.25% in 2022, which is 25% higher, right? They started to get nervous when it went to 2.1%, because that just got into their 2% to 3%, kind of, range, and 2.1% to 3.25% is 50% increase, so a 50% increase in prices. And going forward, they think it's going to peel off to about 2.75%. Well, again, I don't think anyone knows, because we don't know what the forces are there. I keep saying, there's too much money chasing too few goods or services. The too few goods or services, they've been restricted or constricted by the influences of the pandemic, on labor and that labor disruption has just come all the way back and ebbed all the way up, and it's just basically choked it off. There's been no capacity restraint. The factories are still as big as they were last year or the year before. Companies haven't increased investment in physical assets. They've invested in technology, but not physical assets, because the bloody factory is still there. It's just that the workers didn't turn up and you couldn't fire up the machines. So, our capacity utilization has moved up a tick to about 80%. But in the US, it's still below pre-pandemic level. So, we don't know when these forces are going to change and when inflationary pressures are going to ease because we don't know. We can surmise and what have you, but that's guesswork and what have you. So, I think that uncertainty is driving – will drive – it will – it's got people on the edge of their chairs. They were pretty relaxed – it's transitory, it more – all of a sudden, they just moved forward a little bit. The body language has changed a little bit. Jackson: It's tightening. Warnes: And so, they're like it's not transitory, it's more a little bit niggly and persistent than we thought it was. And so, in our interest rates, blunt instruments, have experience in using that blunt instrument despite the fact that it widens this gap between income and wealth. And where's the inflation? The inflation in Australia and I presume over in the US as well and elsewhere is in the nondiscretionary or necessity path of the basket, not the discretionary. Discretionary has been cut off. You don't need a bloody Porsche. Get a Camry. But the necessity, that again, like interest rates, affects all households, because you're going to have to have them. So, that is a problem. 4.5% inflation of necessities, 1.9% of discretionary and the headline 3.5%, which I don't believe. You got this tug of war now. We're going to have to lift interest rates, and they are here, and the US is going to go much, much earlier than we will. But I think we will be – Lowe keeps saying we're going to follow or look what other central banks are doing. Other central banks are all going to increase. So, here we will be dragged along screaming, and we'll have to also lift rates from 10 basis points, which is basically nothing. Jackson: So, we've got rates in the US set to rise in March, the Bank of England has already moved, the Bank of New Zealand has already moved. And it sounds like Lowe is going to be dragged kicking or screaming to higher rates, regardless. What about growth? So, GDP growth off the charts, unemployment record low in Australia, the US as well. It seems like amazing news, nothing to worry about. But bond markets are suggesting that they are actually worried about growth. So, for investor who is looking at sunny days today, how should they interpret the fact that bond markets are looking at clouds tomorrow? Warnes: Well, I think bond markets are probably on the right track. I just want to deviate and say that my gut feel is that the recovery is not going to be as powerful as the market thinks in terms of valuations. But in terms of earnings growth, earnings growth, I think, is going to come back a little or maybe more than little. And so, we will keep an eye on it. I mean, I'm not only saying that. The Reserve Bank 4.25% growth GDP in 2022, 2% in 2023, (indiscernible), 4.4%, 2.2%. Both of them are saying, yes, we expect the recovery as the restrictions ease and the things reopen and we got a false start because of the Omicron, but it will get moving. Don't forget that we've had a huge amount of pull-through demand – or pull-forward demand that's already been satisfied and it's in durable goods. You don't go and buy a new car every year or a fridge or a TV screen, because you've already got five of those anyway. So, all that is now in the past. So, perhaps, the central banks are right. And that's why I think maybe Phil Lowe thinks he's got to be a bit careful here. I don't want to be pushing the button on interest rates just as growth is peaking. It's a quandary. Yeah, we beat him up a bit, but he's big enough and he'll have to take it, I think. But I mean, the fact is that, again, thoughtful disagreement is playing out in the market, and that's not a bad place for it to play out. Jackson: Let's zoom in on, say, two markets that maybe don't get as much attention from Australian investors. So, Europe, China, Hong Kong, relative to the US and Australia, somewhat undervalued. What's your take for investors looking at those two markets? Warnes: Yeah. Lewis, I mean, if we agree, and I'm not saying everyone agrees, that the US is highly concentrated, over-owned, and more risk for rising interest rates and we think that it's overvalued, then you have to look at alternatives. The Europe has got a lot of big, big companies. And you should look at the research we've got. We cover I think about maybe 200 or more companies across Europe. There are stocks there that – and very, very common names in the autos, in the telecommunications, in the consumer staples, in the consumer discretionary space and what have you. Find the wide moats, the low uncertainty, the good management, the capital allocation high – so that you as shareholders are getting equity be looked after. And have those on your wish list. And as this market, I think, will come lower before it goes higher and as the screws are tightened, the easy money is over – just get that into your head – easy money is over. It's a matter of how quickly they want to put the price of it up and does the reserve bank here ask the regulator, APRA, to do some lifting as well in terms of rationing the amount of money that's out there. It's the amount of money that's chasing the goods and services and pushing inflation not necessarily the price of it. Jackson: Fantastic. Warnes: So, I would look at that – in terms of China, I'd be still very, very weary, watch for what's going to happen in March, the annual conference there and what have you. There are suggestions that all is not well in the house of Xi and it's time to get the regime and all that, and you've seen what's happened. That market is in bear market territory. It's down 21% from its peak, and it's got 1.3 billion or 1.4 billion people. Well, just over the Himalayas is another country with about similar population. It is democratic. It has UK history in terms of the judicial system, et cetera, et cetera, et cetera. You're not going to get the surprise that came out of left wing and hit Jack Ma with a huge uppercut and the private – and the technology sector and what have you. So, have a look at that, because they're way behind in terms of development of China. But they will – I think that their GDP growth will be one of the highest in the non-developed world for the next 10 years. Jackson: And just to confirm we're talking about India here. Warnes: Yes, India. Jackson: Fantastic. Warnes: India. And there are a couple of ETFs there that you could have a look at. But I think, as I said, it's a much different environment out there. No one can tell you what's going to happen. And if they do, well, I think you should have another look as well. Jackson: Okay. Fantastic, Peter. Thank you as always. Warnes: It's a great pleasure, Lewis. Good to see you.