Weekly market update - 28th of February 2022

The market reaction to Russia’s invasion of Ukraine was more subdued than many would have expected, though there has been underlying volatility.  The S&P500 actually ended up last week, gaining 0.8%. This is possibly because the market had already priced in a high probability of conflict – alongside the underlying issue of higher rates.  The sentiment was cautious as a result. The view that sanctions would not cover key commodities and NATO forces would not engage on the ground tempered perceived near-term impact on the broader global economy.  A spike in gold, oil, wheat and other commodities unwound in the space of a few hours. This was a catalyst for recovery in parts of the market that initially fell the most.

The domestic market was hit harder than the US with the S&P/ASX 300 off 2.4%. This seems mainly due to anticipation of a more negative reaction in offshore equities.  This sentiment-driven fall overwhelmed a reasonably positive final week of reporting season, which underpinned the consistent message that the domestic economy looks set to recover well while cost pressures are building in certain areas. Economic strength will probably also continue to underpin inflationary pressures, which could be exacerbated by the geopolitical risks triggered by Russia last week.

This makes the policy response even more challenging.

Ukraine

The situation is fluid and uncertain.

Here are some observations from meetings and calls with ex-government and the intelligence community who have been relatively accurate in their predictions:

Putin’s goal is to re-establish the reach of Russia, to restore what he believes is its historic place. In previous speeches he has specifically mentioned Ukraine, Belarus, Kazakhstan and Moldova – but not the Baltic states which have joined NATO. He wants regime change and disarmament in Ukraine as part of a broader push-back against NATO expansion.

In this context we should not expect a sudden change in strategy from Russia or a preparedness to negotiate some form of compromise. Putin’s actions in Chechnya and Syria are a concerning precedent. There is a view that Russia will gain some form of control of Ukraine, followed by an extended insurgency.

At this point domestic politics don’t appear to be a constraint on Putin’s actions.  Global sanctions are not designed to stop Russia’s invasion, given the long lead time to implementation. Rather, they establish a strong coordinated response that over time can cause substantial damage to the Russian economy and send a clear message that there are severe consequences for attempting to change borders by force.

Sanctions were beefed up over the weekend. Restrictions on Russia’s central bank – which limit access to foreign reserves – and the shift in stance from Germany were particularly notable. The tougher response was facilitated by the broad public reaction, which has encouraged Western governments to do more.

Sanctions have been designed to avoid causing too much pain to the West. Some banks can continue operating. There is a delay in imposing sanctions and key commodities are excluded. The breadth of countries involved makes sanctions more effective and sends a strong signal about unity of purpose.
We should be mindful that as the invasion continues there may be additional pressure to sanction commodities, or Putin may choose to disrupt supply himself.

If Russia secures Ukraine, the likelihood that Putin would invade a NATO nation and test the commitment to Article 5 is regarded as low. But Russia is likely to engage in more disruptive activity, such as cyber-warfare. There is a high risk of some form of misunderstanding leading to an escalation of tensions.

China is not partnering with Russia. Its position has already partially shifted, but Beijing appears to be navigating a path that does not condone the invasion but allows Russia to distract the West. The strong view is that this will not trigger a move on Taiwan — though a number of experts say in three years it could well be in a position to do so.

Quantitative measures of geopolitical risk have spiked.  Last week’s invasion means the stakes are now far higher. In our view, the key risk is that the more strain there is on Putin, the more unpredictable he becomes.  This adds to some risk premium in markets.  Additionally, despite the initial exclusion of commodity markets, the longer the conflict extends, the greater the pressure to take more substantial actions in this area.  In contrast to the Iraq wars, there is reasonable probability the risks stay elevated for a longer period.

Other, longer-term impacts are already becoming apparent. This is likely to trigger an escalation in defence spending globally, with Germany already signalling this.  This will be combined with a reappraisal of energy policy in the West. Significant sums will need to be invested to accelerate the energy transition and build resilience in the supply of energy and other critical commodities.  This reinforces this long-term theme of far higher levels of investment which underpin commodity demand.

Economics and policy

Some are questioning whether central banks will delay rate hikes in response to the Ukraine crisis.  Economic momentum appears to be building, particularly in the US. We have seen incomes remain strong, unemployment claims hit 52-year lows, Covid cases decline and strong capital goods shipments and house prices accelerate.

US personal income growth has now cycled through all the additional hand-outs people were receiving.  While it fell marginally below the growth in outlays for the first time since Covid struck, the savings rate remains in normal territory. This indicates households have been able to maintain spending without dipping into the excess savings built up over the past two years.

Markets

The combination of high volatility and a growing use of short-dated options by retail and institutional investors has exacerbated recent market moves.  This year we have seen rising volatility force investors to sell down risk. This can have a self-reinforcing effect due to the technical nature of options.  The sharp bounce at the end of last week shows this trend can operate in reverse — which may be supportive in the near term, particularly if volatility starts to subside.

In terms of other assets oil is very hard to call in the near term.  There is still a potential for a deal between the US and Iran, which is probably worth $10-15 off the price in the near term. There is also the threat of releasing strategic reserves. But the medium-term fundamentals are supportive given low inventory, improving demand and potential supply disruption.

Soft commodities are the other key sensitive area to watch given the political consequences of high food prices. Wheat traded almost identically to oil.

Stocks

Domestic market moves were dominated by the Ukraine news, which muted reactions to positive results such as NEC and exaggerated negative reactions.  Banks underperformed after a good run on initial concerns that the rise in rates may be slowed given geopolitical uncertainty. That narrative has quickly unwound.  The 32% bounce back in Block(SQ2) (formerly Afterpay) on Friday highlighted the potential for a positioning unwind in this market.  The underlying themes for reporting season have been constructive with regard to the domestic economy. Rising costs are an issue, the ability to price for it is key.

Good results

Nine Entertainment (NEC, +2.2%) delivered a strong result, leading to 14+% upgrades to net profit after tax (NPAT) in FY22 and ~7% upgrades for FY23. All elements of the business are doing better than expected. Broadcast revenue is now seeing growth vs pre-covid, while the outlook for Stan looks more assured than last August with average-revenue-per-user (ARPU) and subscriptions higher. NEC’s valuation remains attractive with the business still sub-4x EBITDA one the stake in Domain (DHG) is excluded.

Coles (COL, +5.7%) managed costs very well even as online revenue grew at 50% year-on-year. As a result EBIT grew in the low single-digits, versus the decline at Woolworths (WOW) which is seeing similar trends in online. The main difference between their performance was COL’s ability to execute on a cost out program of $100 million.

Cochlear (COH, +13.3%) surprised the market, with ancillary products offsetting the expected softness in its core implant product as a result of omicron disruption at hospitals. Net margins were reiterated for FY22 and FY23, driving consensus upgrades.

Block (SQ2, +7.1%) rose 32% on the result, to end up 7% for the week. Fears about Cash App gross profit growth were abated by management’s comments around year-to-date trading. Afterpay’s trends were relatively weak, but not in focus at this result.

NextDC’s (NXT (+6%) result beat expectations on both the top and bottom line, with upgrades to FY guidance. Management were very positive on the outlook over the next 12-24 months, with a strong pipeline of contracts and capacity investments being brought forward to meet demand. It is trading at 28x next-12-month EBITDA, in line with the five-year average and a smaller than average premium to US peers

Reasonable results

It was hard to read too much into Qantas’s (QAN, -4.7%) result given such a disrupted half. The main focus was the balance sheet, where net debt came in better than expected at $5.5bn and is expected to fall further this half as capacity ramps up. All in all it was a good result given all the complexities of operating a half where capacity was just 18% of pre-covid levels. The company has hung in there for 18 months since the capital raise and remains well positioned for demand recovery, with cumulative cost out running at a significant $850m pa. The stock’s reaction was driven by Ukraine and concern over oil.

The Woolworths (WOW, +5.2%) result highlights the challenges of dilutive online sales. Store sales declined and costs grew 10% largely from supporting online revenue growth. Operating capex remains elevated and growth remains low. The stock bounced on the defensive rotation and hopes inflation will help improve sales momentum. Remains expensive on FY22 PE of 30x.

Brambles (BXB, -3.2%) had a decent result, delivering 5% EBIT growth in a half challenged by cost inflation and negative volumes versus the prior comparable period. Aggressive price increases to cover cost inflation were delivered. However lower maintenance and repair costs in the half have been a one-off benefit, as customers are not returning pallets given pallet shortages. Free cash flow remains elusive.

Ampol’s (ALD, -6.7%) result was held together by refining strength into the end of the year. Cash flow, dividend and the balance sheet all improved, although the stock’s reaction reflected concerns over the impact of high oil prices. The company’s prospects are leveraged to returning mobility, which is happening. The outlook for the recent Z Energy acquisition and continued recovery in refining will also be important. If it all comes together, the stock is trading on attractive levels.

Viva Energy (VEA, -3.7%) delivered a decent result given the effect on fuel volumes from lockdowns. Management have done a good job and the stock looks attractive with growth prospects, although capital intensity is rising.

Costa Group’s (CGC, -6.1%): result came in slightly ahead of consensus. The stock initially responded well to a positive outlook statement which points to solid domestic pricing, favourable weather conditions and growth expectations for China. The subsequent unwind was linked to EPS downgrades due to higher net interest and D&A guidance — of which most is linked to new Vital Harvest lease. It is trading a reasonable levels with the outlook looking better than it has for 18 months.

Oz Minerals (OZL, -4.7%) delivered a largely in-line result, with large parts pre-announced. South Australian labour availability issues in the reported period have largely corrected. Management reporting a weather-disrupted slow start to 2022. 

Alumina’s (AWC, -9.2%) result was in-line with expectations, helped higher by rising alumina and aluminium prices. FY22 cost and capex guidance increased due to high consumables inflation and capex. The stock fell as resources sold off on volatility around the sanctions.

Rio Tinto (RIO, -3.9%) missed expectations for the half, but this was minor relative to a record FY21 result and a dividend driven by high commodity prices. Another example of higher cost inflation creeping in. RIO paid out 92% of FY21 free cash flow and the FY22E dividend yield is 6.5%. Likely to see earnings upgrades coming through as commodity prices remain elevated.

Wisetech (WTC, -4.2%) delivered soft revenue, but a 10% beat on EBITDA. Its 49% EBITDA margin was well ahead of expectations on lower cost investment. This carried into an EBITDA upgrade for FY22. The overarching concern is whether too much cost has now been stripped out of the business, potentially stifling revenue growth. But there was enough in the result to maintain WTC’s premium multiple to other tech peers.

Disappointing results

The Dominos Pizza (DMP, -19%) result demonstrated that a large part of its strong earnings growth in FY21 was due to COVID-driven changes in customer demand, which in Japan are now partly unwinding as restrictions normalise. The company’s comments around rising food and wage costs also raised concerns about margins on the stores they own — and on the pace of rollout of new stores if franchisee profitability suffers.

Sonic Health Care (SHL, -7%) missed expectations and is seeing Covid testing fall in Australia and US. It announced a $500m buy-back but the market is looking for acquisitions.

A massive increase in price realisations for its spodumene lithium ore offset a disappointing operational performance for Pilbara Minerals (PLS, –7.8%). FY22 guidance for both unit cost and volume downgraded.

Altium’s (ALU, -5.1%) result was better than expected, but was low quality. EBITDA margin guidance was softer than expected. Subscriber trends also softened and raised some concerns about the ability to meet long-term targets.

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