Share market investors should temper their enthusiasm as growth slows, inflation picks up

Sharemarket investors should ‘temper their enthusiasm’ and look at defensive exposures.

Shipping costs are signalling the strongest inflationary environment in more than a decade.

Sharemarket investors should “temper their enthusiasm” and look at defensive exposures, including banks, since cyclical momentum in the global economy is “peaking”, inflation is on the rise, and rising bond yields will cause “valuation headwinds”, analysts say.

The OECD leading indicator of the global economy is likely to shift to the “slowdown phase” this month or next and the global Purchasing Managers’ Index may have already peaked as re-opening drives a shift in spending from goods to services, according to Macquarie’s Australian equity strategist Matthew Brooks.

The ASX 200 index rose 0.2 per cent to 7045.9 points on Monday as gains in healthcare, energy, consumer discretionary and financials offset sharp falls in the mining sector as commodity prices slid on the back of China’s crackdown on commodity speculation.

It comes after the local bourse hit a record high daily close earlier this month before falling as much as 3.6 per cent as global markets tumbled amid concern about a sharp rise in inflation expectations.

While stimulus isn’t being withdrawn as quickly as it was after the global financial crisis of 2008, “we are past that peak too”, according to Brooks. Australia’s budget deficit is expected to be lower but still support growth as the pandemic isn’t over, and while the Reserve Bank remains dovish, “rising yields and tapering by other banks suggest we are already in a quasi-tightening cycle”.

In his view the 2021 sell-offs in special-purpose acquisition companies and bitcoin are a sign that this “quasi-tightening is impacting the highest beta assets”.

Bitcoin bounced almost 10 per cent in Asia-Pacific trading on Monday. After diving 30 per cent to a four-month low of $30,016.82 last Wednesday, the cryptocurrency almost retested that point on Sunday when it fell as much as 13 per cent.

JPMorgan strategists say it’s “too early to call the end of the recent bitcoin downtrend”.

At the same time, inflationary pressures are expected to persist, with commodity prices and shipping costs already signalling the strongest inflationary environment in more than a decade.

These rising input costs are still flowing down supply chains and Covid-19 border closures have hurt labour supply which may lift wage inflation for 12-18 months, according to Macquarie.

On that front, the OECD’s leading indicator suggests peak cyclical inflation could be two years away.

“Given the inflationary pressure, we still see upside risk to bond yields, and see a Fed tapering announcement as a catalyst for higher real yields,” says Brooks.

He argues that the strongest returns for risk assets are in the recovery and expansion phases. In the slowdown phase, investors should expect lower but still positive returns, and more volatility, as the risk appetite typically falls and defensives tend to outperform.

He favours the health and consumer staples, but adds that banks could also be “attractive defensive” stocks in this cycle as bad debts fall and dividends rise.

He says banks now have the highest earnings per share upgrades of any industry group and they tend to outperform as government bond yields rise.

Similarly, amid talk of rising inflation, Citi analyst Brendan Sproules notes “the undeniable takeaway” for the banks is that higher inflation is positive for their performance to the broader market.

“Higher inflation and higher (interest) rates have led to a truckload of time-proven sector outperformance,” Sproules says.

“There are also a few fundamental benefits as well, with the ensuing wage inflation generally good for serviceability of loans.

“History has shown that the correlation between shifts in inflation and sector relative performance is stronger for the banks than any other sector.

“This will be important as the household sector digests a run-down of excess Covid deposits over time and there is a roll-off of cheap fixed-rate loans in years to come.”

Sproules prefers the retail banks over the business-skewed banks given their stronger ability to drive core earnings, and for that reason rates Westpac a buy and CBA neutral.

Meanwhile, Macquarie says value can outperform in slowdowns, but the “odds are more balanced”.

On that score, Dimensional Fund Advisors says that while a very strong performance of value stocks in the past six months has raised questions about the sustainability of this move, it’s not too late to get on board.

CSL, Cochlear, Ramsay Health Care and Woolworths as “the type of stocks that often outperform in a slowdown”, according to Brooks.