A VIEW FROM THE TOP END

Markets:

With the Federal Reserve tipping their hand a few weeks ago for when policy will begin to tighten, markets have moved forward and are now focused on H2 and Q2 earnings. Over the next 3weeks we will see most companies reporting, and expectations are high with the reflation of the economy shifting gears and vaccination rates climbing. The US 10yr treasury note continued to see its benchmark yield drop as inflation fears have been temporarily subdued. US markets have responded positively to the drop in inflation expectations as the S&P and Nasdaq rose 4.45% and 4.80% respectively. The ASX was off -0.67% over the period. Healthcare (-4.81%), utilities (-1.96%) and tech (-1.23%) held the ASX back while industrials (+5.33%), materials (includes mining, +4.91%), and energy (+2.32%) gave the index a boost. The AUD:USD exchange rate was relatively flat for the two weeks.

Ahead of the UN Climate Change Conference:

Last year the world’s nations were set to meet to discuss climate change goals, due to the global pandemic at the hand of Covid-19 the conference was postponed to this year. Now in November leaders will converge on Scotland and Italy to achieve four main goals at the UN Climate Change Conference 2021 (COP26).

• Secure global net zero carbon emissions by mid-century and keep 1.5C warming targets within reach. To reach this goal countries are being asked to come forward with ambitious 2030 emissions reduction targets to move these nations towards reaching net zero by mid-century. To deliver this goal countries will need to accelerate the phase out of thermal coal, curtail deforestation, accelerate the switch to electric vehicles and encourage investment in renewables.


• Adapt to protect communities and natural habitats. With climate change already altering our environment defences will have to be built, early warning systems, resilient agriculture and infrastructure will be needed to protect homes, livelihoods, and lives.


• Mobilise finance. To deliver the first two goals, billions will need to be spent, with those funds, jobs and growth will follow. Developed countries are being tapped to make good on their promise to provide $100bn per year. The private sector is also being targeted with international financial organisations being asked to do their part and unleash billions in lending to reach net zero.


• Work together to deliver. At COP26 participating nations will be asked to finalise the Paris Rulebook (the detailed rules that make the Paris Agreement operational)

A lot of us will have heard these initiatives before, and there will be a few eye rolls as despite talking about these goals for years, it feels like it has been all talk with no real teeth to force behavioural change. We can tell you that the scales are tipping. If you had not heard, Royal Dutch Shell, the oil super major lost a landmark case last month when a court in the Hauge order the company to cut global carbon emissions by 45% by the end of 2030. The Dutch court ruled that the oil giant’s sustainability policy was insufficiently “concrete”. The historic decision marked the first instance of legal action being brought against a multinational to force compliance with the Paris climate agreement. From 1988-2015 Shell was considered the 9th largest polluting company in the world. The ruling is set to curb Shell’s growth for years.

Shell is not the only oil major taking heat for their climate policies, and having real change enacted on them. In May this year Exxon Mobil, once the world’s most valuable company, had its board of governors fall under attack when an activist hedge fund with 0.02% of the company’s shares took over 25% of the board seats. The rally cry which Engine No. 1 used to convince Vanguard, BlackRock, the California State Teachers’ Retirement System, the Church of England and the New York State Common Retirement fund to flip the board, well it was all about forcing Exxon to address the ongoing climate emergency. Exxon did everything they could to campaign against Engine No. 1, but when the votes were counted three seats went to the hedge fund, and a company worth nearly $250bn was going to be dragged in a fresh direction in a decarbonising world. The company will now be looking at clean energy alternatives in addition to their traditional under the new leadership, as Exxon is “reenergized”.

One-way companies are pursuing net zero targets are through carbon credits. These credits are created through clean energy investment, or nature-based solutions, and certified under programs such as the American Cabon Registry, China Greenhouse Gas Voluntary Emission Reduction program, The Gold Standard, or the Verified Carbon Standard to name a few. Tradeable futures and exchanges have been created where these credits can be purchased by carbon emitters and retired to offset CO2 emissions. As of Jan 2021, the number of carbon credits on issue by the largest standards totalled 3,110 million metric tons of CO2, with 74% already purchased and retired. Current pricing can range from a few cents to $15/mtCO2. In a world where we emit 36,000 million metric tons of CO2 per year, there is real money in carbon credits and we will be hearing more about them in the future as companies shift to net zero targets, not just with their words but with their wallets.

With polluting industries looking to manage the climate risk of their business, we look to companies that are getting on the front foot. Champion Iron uses 100% hydroelectricity to fuel their mining operations. Magnetite Mines Ltd has planned to have their energy needs met with 90% green energy. Alpha HPA Ltd will also be using clean energy initiatives to 100% power their process with renewables. These are real examples in our current portfolio that work in primary industries, and are focused on a net zero future, because it is no longer just words when it comes to climate, it is beginning to be dollars and cents. Commission drives behaviour, and these companies can see the advantages of going green early.

Updating our checklist:

• Valuation: Valuations between the ASX200 and S&P500 diverged again the past two weeks. The S&P forward P/E ratio rose to 22.85x while the ASX200 dropped to 17.47x (from 19x+). A new set of earnings estimates are rolling into the forward outlook in Australia, and that has driven the ratio lower towards the long term mean as H1FY22 profits are expected to be better.


• Global PMIs: PMIs came off highs, but are still strong across the board, US 60.6, China 51.3 and Germany 65.1 are all in expansion still. In Australia we could be seeing a bit of a lull in the housing market as building approvals for May took a break and were down 7.1% after a hot April. Building material prices and a tight labour market in the trades have given some potential buyers pause.


• Downgrades on guidance: 2Q21 earnings season begins in earnest this week, and roughly 75% of the S&P will report results in the subsequent three weeks. Consensus is for a 65% increase in earnings and 18% higher revenues relative to the pandemic low in 2Q20. Last quarter earnings increased 50% and sales 11%. The financial and industrial sectors had the best stock price reactions (0.5% & 0.3%) last quarter and are likely to repeat this performance. Financials have been under pressure due to yield curve flattening, however, results are less sensitive to the shape of the curve than most investors believe. We expect favourable credit related results, some evidence consumer lending is turning and, in the days following reporting, banks could be buying back their shares.


• Infection rates to slow globally: With Sydney currently experiencing lockdown, Brisbane under mask restrictions and Melbourne on edge after numerous closures, it is hard to believe that reopening is still under way. Full vaccination rates in Canada (42%), the US (48%) and the UK (66%) continue to climb. Australia (7.7% fully vaccinated) continues to wait on supplies of vaccines as our uptake rate is good, but we are unable to ramp up mass vaccination programs until October/November. Nations are beginning to talk about treating fully vaccinated citizens differently than unvaccinated folks. Travel restrictions are the obvious differences, both international and domestic, but being unvaccinated could effect access to private businesses as well.
  
  

  You can follow Australia’s vaccination journey with our live vaccine tracker at the link below:

  
  TFM Vaccine Tracker


• Monetary and Fiscal stimulus announcements globally: Evidence is mounting that while demand is booming, supply bottlenecks will be slow to ease, which has the potential to negatively impact economic activity and prompt more inflation. The result is we now expect the Federal Reserve to raise interest rates in 2022. The minutes to the June Federal Reserve FOMC meeting reinforce the message that we are set for a tapering of QE asset purchases this year, but the form and speed it takes will be driven by data. Given this backdrop we think the pressure to taper asset purchases will build over the summer with the taper potentially announced as soon as September, although the current minutes would likely favour December. As for the form tapering takes, we suspect the template from the 2013/14 tapering program will be implemented as it is predictable and simple. We expect a consistent $15bn of reductions per FOMC meeting with a $10bn cut per month for Treasuries and $5bn for agency MBS. This may be accelerated in 2022, with tapering brought to a conclusion before the end of 2Q22. This could pave the way for interest rate hikes in the US as soon as 2H22. Now this is the US, in Australia if the Americans raise rates, the RBA could follow without inflating the AUD beyond the desired range. China surprised the market with softer policy last me week. Let me be plain, this dovish policy signal is being viewed as a sign of China’s economy weakening. Volatility in markets could well increase moving forward if China is not doing as well as first believed, a watch this space moment.
  

With earnings season underway we will get a real indicator of the health of companies as vaccination rates increase. We can already see positive estimates for the future bringing the valuation of the Australian market more in line with historic averages. While prices are still elevated the real economy is beginning to catch up. It is a new financial year, and it is a great time to get your financial house in order, whether it is with tax help from one of our tax experts, or if it is financial advice from our advisors. We wish everyone a happy beginning to the financial year, and we will be in touch again in two weeks’ time.

Regards,