Weekly market update - 31st of August 2022

The late northern summer repose and the domestic focus on earnings season were dramatically disrupted by Jerome Powell’s short-but-direct speech at the Jackson Hole central bank conference last week.  Powell reminded the market of his singular focus on bringing down inflation, even if it brought “some pain to households and businesses”.  The S&P 500 slumped in response, ending down 4% for the week.  The S&P is now down 5.5% and the NASDAQ is off 7.5% from their Aug 16 highs.

Powell’s message was not so much the need for rates to go higher than markets expect. Rather, rates would need to be sustained at restrictive levels for some time to bring inflation under control.  This is at odds with recent optimism that rates would fall in 2023. This saw US two-year yields rise 17bps and 10-year yields up 7bps to 3.04%.   The Fed’s stance emphasises the importance of the total financial conditions index as a signal. This means bond yields are underpinned and equities are capped while inflation remains an issue.

Three other developments also weighed on sentiment:

1. Oil back above US$100 A week ago the Iran deal looked likely and the market expected oil to drop sub-US$90 on the incremental supply. But on Tuesday we got the “Saudi put” under the oil price. Riyadh’s minister of energy effectively indicated that OPEC+ supply agreements would continue in 2023 and flagged the prospect of supply cuts in response to higher volumes from Iran. He also highlighted a view that there was a disconnection between the physical and paper oil markets. This can be interpreted as a belief that the US is manipulating the oil price down and OPEC will act in response.
2. European power prices surge higher We are now at levels where huge swathes of German industry is unviable. This is driven by the inexorable rise of gas prices. Storage levels in Germany are approaching 80% — but this level is required in winter even when flows from Russia are normal. Moscow is now allowing only 20-40% of normal flows. If this continues, no amount of storage will suffice.
3. US dollar index (DXY) breaks back to 20-year highs This creates liquidity pressures in many other countries. A return to the trifecta of higher bond yields, oil and US dollar is typically bad for equities. That said, the outlook for oil is still challenged by the potential for weaker demand as the global economy slows.

The petrol price remains a key signal for US inflation expectations — and therefore yields and hawkishness from the Fed.  So there is potential for inflation to resolve itself faster — requiring less policy pain if it comes down.  But for the moment the market is back in a nervous holding pattern with 4000 on the S&P 500 viewed as a key support level.

Australia

Australia enjoyed a short respite from global macro factors. On balance, the busiest week of reporting season delivered a neutral outcome.  Consensus expects FY23 earnings to rise 4%, up from +18% in FY22.  Revisions to earnings expectations are flat for FY22 and -2% for FY23 compared to four weeks ago.  In FY23 resources earnings expectations are now 4% lower and 1% higher for banks, with the rest of the market revised down 2%.  In terms of results, consumer staples disappointed as supermarkets proved less defensive than hoped. Companies delivering capital management — such as Qantas (QAN) and Nine (NEC) — performed better.

Economics and policy

Fed Chair Powell kept his Jackson Hole speech short and narrowly focused for deliberate effect, sending a strong message on inflation.  The odds of a 75bp move higher in September have jumped to about 60 per cent.  The curve of implied hikes is moving back towards its June highs and is a long way above the end of July lows.

The market is divided into two broad camps:

1. The Fed will drive the economy into recession as it looks too literally at current data and over-tightens. This triggers a recession and earnings downdraft that takes the market back to the lows.
2. The Fed is bluffing. It wants to send a hawkish message to restore credibility, but knows the economy is already slowing rapidly and inflation data will improve. This gives it scope not to push rates too hard. This scenario leads to bond yields falling and is more positive for equities.
   The next Federal Open Market Committee meeting concludes on September 21 — so with more employment and inflation data to come the outcome is yet to be determined.

In terms of inflation, the Core PCE price index rose 0.1% month-on-month — less than expected — and continues a run of incrementally more-positive data.  This may be an unwind following the June spike in core PCE.  Averaging across the two brings it back in line with the run-rate from January to May.  The Core Services PCE price index came in at 4.2% year-on-year. This was also lower than expected and is the lowest print since December 2021.   The Cleveland Fed’s ‘nowcast’ measure of inflation also continues to track lower, as do the Evercore surveys of wage pressure and retail pricing power.

Australian equities

The S&P/ASX 300 finished down 0.6% last week, not capturing Friday night’s slump in US equities.  It held up on the back of reasonable results and better performance from the resource and energy sectors.  Consumer staples underperformed on the back of disappointing results from Coles (COL) and Woolworths (WOW).  Small caps also underperformed, which is a sign that the rally driven by defensive positioning has run out of steam.

Key observations on result so far:

1. Pricing power is a key point of differentiation. Disappointing results mostly reflect insufficient moves to offset cost pressure, particularly in the building-related sector and companies with European exposure (eg Dominos Pizza, DMP). Meanwhile companies such as Wisetech (WTC) and Qantas (QAN) showed the value of pricing power.
2. Costs are a headwind to some of the defensive stocks, leading to less defensiveness than expected. We saw this in Endeavour (EDC), Coles (COL), Woolworths (WOW) and Ramsay Health Care (RHC).
3. Some cyclicals are not experiencing the weakness many feared, eg Nine Entertainment (NEC) and some advertising-related names.
4. Companies with cyclical tail winds are performing well. For example the lithium sector remains strong, as does oil refining.
5. The market is liking capital return. New buy-backs from NEC and QAN were well received

Selected results

Well-received

Qantas’s (QAN, +10.2%) current run-rate suggests returning to pre-Covid EBITDA in FY23, restoring profitability far faster than many expected. The cost impost from fuel is being managed via a combination of ticket prices and higher yields on flights. It is reducing domestic capacity by 10% in 1H FY23 to manage fuel and improve operational reliability. Permanently higher earnings from freight and loyalty programs, as well as the restructured cost base, also underpin the earnings rebound. Strong FY22 cash flow have seen debt fall to below pre-Covid levels, allowing a surprise $400m buyback.

Nine Entertainment (NEC, +4.4%) delivered 24% EBITDA growth. All divisions were positive and the mix shift in revenue continued a trend towards digital versus traditional media. Revenue growth has gotten off to a strong start in FY23. Though revenue is expected to slow in 2H, management expect it to remain solid. This confidence was reflected in a 10% stock buy-back. Nine is investing for growth — adding cost pressure in FY23 — but remains cognisant of aligning cost growth with the revenue environment. 

Viva Energy (VEA, +6.5%) had pre-guided to a strong set of numbers. The commercial business outperformed and has maintained strength into the current period. The retail fuel division disappointed, but the outlook for margins and volumes is positive. Management spoke positively about the outlook for refining into 2H of the year. Given strong current cash flow the refining dividend was brought forward, which is a positive signal for future capital returns. 

Iluka (ILU, +9.2%) delivered strong numbers which were slightly ahead of expectations. Management were positive on the outlook for the mineral sands market, in contrast to more cautious peers, noting a more disciplined industry structure.

Wisetech’s (WTC, 8.9%) result was hard to fault. It delivered exactly what the market wanted on the top-line and a little bit more on the margin front. The outlook looks solid for next 12 months. WTC’s software is viewed as monopolistic with substantial pricing power, resulting in higher incremental returns. M&A is firmly back on the agenda and they have the cash to fund it. 

Altium (ALU, +18.5%) delivered 22.5% revenue growth for FY22 and 36.2% EBITDA margins. This beat guidance, mainly due to outperformance of the more cyclical Octopart business, which has been a major beneficiary of semiconductor shortages. The company has set aggressive guidance set for FY23 and we have some caution on the outlook.

Disappointing results

Endeavour (EDV, -13.0%) disappointed on accelerating 2H costs in the retail liquor business, related to the demerger from WOW. Elevated margins from Covid-boosted revenues and lower promotional activity have unwound much faster than expected. Revenue growth is slowing faster than expected as the economy reopens.

The Coles (COL, -8.8%) supermarket business delivered what looked an in-line result. But this was achieved by pushing expected costs from supply chain investment from FY22 to FY23. Q4 sales growth of 3% was also weaker than expected given the category grew by 6%. Food inflation of 4.3% implies negative volume growth, while cost and volatile volumes are a headwind to profitability. The capex bill from supply chain investment was also increased. All these issues result in Coles continuing to trade at a 15-20% discount to Woolworths.

Woolworths’s (WOW, -6.6%) result ended in line with expectations after a challenged first half. It did better than COL in the second half, with revenues growing 5.6% and supermarket profits up 9.7%. This was a good outcome given the half was disrupted by Covid absenteeism. Working capital was a drag on cash flow with a shift to holding more inventory as a buffer to Covid disruption into FY23. WOW NZ supermarkets saw EBIT fall 30% to below pre-Covid levels, creating concerns about the defensiveness of these businesses in the current environment. WOW also provided a weak trading update post the year end, with supermarket revenues declining 0.5% in the first eight weeks of FY23 — materially lower than expected and implying volume declines of over 4%. WOW also dampened expectations for food inflation supporting profits given the related challenges and signs of consumers trading down in supermarkets.

The market was expecting a reassuring outlook from Reliance Worldwide (RWC, -9.5%) due to the relative defensiveness of its repair & remodel exposure and benefiting from lower inputs prices such as copper. Instead the company reported -3% revenue growth in July and provided no guidance on margin outlook, disappointing the market. The company is seeing flat demand from end consumers, but believes there is some destocking happening from its smaller wholesalers. RWC also has material exposure to the weak economic outlook in Europe.

Star Entertainment (SGR, -2.8%) disappointed market expectations due to cost inflation. Higher labour costs weighed, as did compliance costs as a result of regulatory inquiries. The cost disappointment was partly offset by a strong short-term trading environment, with revenues +9% versus pre-COVID levels in July to mid-August. The final report from the NSW inquiry is to be handed down at the end of August and a QLD inquiry is underway.

Dominos Pizza (DMP, -5.9%) initially pleased the market with the accretive acquisition of new territories in Singapore, Malaysia and Cambodia. Management were confident sales growth would accelerate from a weak start to FY23 as it rolled off the base effect and price changes flowed through. But the market became concerned that there was material earnings risk in the European business due to the combined impact of weakening economies, rising costs putting pressure on franchisees, and plans for 15% price rises putting volumes at risk.

Indifferent results

Wesfarmers (WES, -2.0%) grew core earnings 3% better than expected, with EBIT flat year-over-year on what is an elevated level of profit due to Covid-boosted revenues and margins in retail. High commodity prices helped the chemical, energy and fertiliser divisions drive the beat, with tailwinds that should continue into FY23. Like many other retail results, cash flow was pressured by increasing inventory across all retail businesses, to align with elevated sales and as a buffer to covid disruption.

South32 (S32, +1.0%) delivered a solid set of financial results and extended its buy-back. Slightly higher cost guidance drove small FY23-24 earnings downgrades.

Lithium producers Pilbara Minerals (PLS, +16.4%) and Allkem (AKE, +12.7%) delivered weaker-than-expected results. But this was more than offset by ongoing strength in the lithium price, which remains supported by tight supply.

Lynas (LYC, -7.1%) delivered an upbeat take on the rare earths market, with pricing seen as stable and demand growth very strong. FY22 financials were in-line, but capex guidance of A$600m in both FY23 and FY24 was higher than expected. In the absence of a rebound in pricing, this will leave FCF limited over the next couple of years.

Alumina (AWC, -1.6%) reported mixed results for the half with the focus on stemming losses at the San Cirprian refinery in Spain. While a reduction of capacity to 50% will help limit losses, overall alumina unit costs are expected to be remain high this half, not leaving much room for free cash flow. 

Costa Group’s (CGC, -1.1%) result was in line with recent guidance. There was no new negative information but also no real surprises. Avocados and citrus were headwinds. Cost inflation has been an issue for industry, but CGC looks to have managed through okay and set up for a better CY23, with avocados recovering from their lows and citrus resetting. 

Judo Capital (JDO, -1.9%) restored some confidence with an outlook for continued growth, minimal credit quality concerns and an expected jump in FY23 margins. But this was tempered by news of further acceleration in costs driven by headcount, wages and tech investment. This introduces uncertainty on the path to medium-term targets, which won’t be fully resolved until JDO delivers a tech investor day later in the year.

The Lottery Corporation (TLC, -1.8%) underperformed due to operating cost guidance for the newly demerged company being above market expectations. Revenue growth in the beginning of FY23 has been weak but the company has attributed this to jackpot sequencing rather than weaker underlying demand. The market is concerned the company has some Covid driven revenues still to unwind.

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