ANTIPODES - JANUARY 2022
Opportunities in overlooked parts of global markets, as risk is repriced
By Antipodes CIO, Jacob Mitchell
One month in to 2022 and when it comes to global equities, some of the best performers of 2021 have been some of the worst performers of the year so far.
Quite simply, we’re seeing a re-pricing of risk as real yields have risen.
Real yields and real GDP growth typically trend together. The real yield on the 10Y US Treasury Bond fell to around -1% at the end of last year (-5% using spot inflation) as the bond market was arguably pricing in the worst economic slowdown in half a decade.
We thought this was at odds with the economic data our investment team was monitoring. Even with the pace of economic growth slowing, the outlook for activity along with stickier inflation and Fed tightening suggested both nominal and real yields were too low.
Now, we’re beginning to see yields normalise.
As real yields rise, the discount rate used to value a company’s future cash flows must also rise which means today’s value of future cash flows falls. Higher real yields change the price investors are prepared to pay for growth, and it will close this very wide multiple dispersion that’s prevalent in markets today.
Higher yields are a headwind for long duration or growth equities that have little in the way of earnings today, but the potential of a large pay-off in the future. Growth – or high multiple – stocks have materially outperformed during this very long cycle, which is why they have been hit the hardest in the recent sell-off.
Is the correction over?
We think the growth/long duration trade still looks vulnerable here.
The Fed hasn’t changed its rhetoric – asset purchases will conclude in March and we could see the first rate hike fairly quickly, with the market now starting to price in up to 5 rate hikes in 2022.
To me, this drawdown feels similar to the later stages of 2018 when the Fed was tightening into slowing global growth which had been led by a slowdown in China.
The S&P fell around 20% before the Fed pivoted and cut rates to support the equity market.
But the Fed may not be able to save the day this time around because of inflation.
December’s headline inflation print was 7% and even with supply chain bottlenecks easing, we have pent up inflationary pressures in wages, rent and energy prices which can keep inflation elevated for the rest of this year, particularly in the US.
There seems to be a mismatch in between the supply of labour and the skills that are in demand, which is keeping wage growth elevated, and rents are rising because of a property bubble. Sticky inflation may prevent the Fed from reversing monetary policy even if economic activity is weaker than expected. Commentators are correctly calling this the end of the Fed put.
Importantly, the recent sell off should be kept in preceptive. The S&P is still only around 10% off its highs from the end of last year. The long duration trade has borne the brunt and we’re only just starting to see the sell-off broaden out.
While retail investors have supported the market in recent sell offs, retail is more geared than ever. Margin debt in the US is close to 4.5% of GDP which is a 20 year high. If the S&P falls further retail investors are going to start feeling some pain and could hit the panic button.
Opportunities in the market today
Even with economic growth slowing in the US, the data suggests the economy is still in a relatively good position.
The valuation dispersion between the popular high multiple versus low multiple stocks remains elevated, which means we’re seeing opportunities on both the long and short side.
In this environment, we’re looking for resilient businesses that can take profitable market share in a high inflation environment. This is important because corporate profitability will suffer with higher inflation. Investors should seek out market leaders and avoid the “value traps”.
A good example of an attractively priced resilient market leader, where profitability is increasing is Seagate Technologies (NASDAQ: STX).
Seagate is a leading provider of hard disk drives which are underappreciated part of the connected economy as the world becomes more data-intensive.
Hard disk drives are largely a two-player market with Seagate and Western Digital controlling 80% of the market.
Hard disk drives went through a prolonged period of weak performance as other forms of data storage took market share in PCs and laptops due to their faster speeds.
PCs and laptops were the largest end market for hard disk drives, so losing market share crimped both Seagate and Western Digital’s revenue.
However, as PCs and laptops was shrinking, datacentre demand, both from the hyperscalers (like Amazon, Microsoft, Facebook) and the traditional enterprise, has been growing at a very high clip and will soon account for the majority of Seagate’s revenue.
The company is pivoting from a zero-growth business to one that will see revenues grow 3-10% p.a.
Further, the profitability of the business is inflecting, with operating margins rapidly improving on a trajectory that we think has further runway in years to come. Capacity is tightening thanks to rising demand, and commentary from both Seagate and Western Digital suggests we’ll see better pricing and supply discipline through this cycle. We see Seagate’s earnings growing around 10-20% p.a.
The company is valued at just 10x forward earnings which is a very attractive multiple given secular growth trends around compute and data storage, improving competitive dynamics between the two leading players, the quality of Seagate’s business and the company’s growth profile.
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