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Four fruitful themes show plenty of juice in the market

In my March column for Firstlinks, I poured cold water on the bearish arguments promulgated by some stock market observers and commentators. Noting the rising influence of companies demonstrating the most extraordinary business economics ever seen, I disabused the Cassandras of their concerns and fanciful notions of imminent doom for equities. Valuations are supported by a hitherto unseen combination of unconventional monetary and fiscal support.

Meanwhile, evidence of burst bubbles in some individual stocks and market sectors last year is proof that bubbles can ferment and collapse without disrupting the entire market. The whole market is not a bubble if Systemically Important Financial Institutions do not hold the assets subject to irrational exuberance.

Conditions in place for a strong year

In summary, 2021 has the potential to be a great year for equities. Since the beginning of the year, the S&P500 is up more than 11%, the NASDAQ 8.5%, and the S&P/ASX200 6% higher.

Meanwhile, the pace of US economic recovery continues to surprise upwards, and central bank balance sheets could continue expanding into next year.

Australia's economic activity has returned sharply to pre-COVID levels, unemployment rates are declining abruptly, and labour markets are improving with the conclusion of JobKeeper forcing many individuals back to work to earn an income.

Over in the United States, last year's stimulus amounted to 10% of GDP, but in 2021, at 20-25% of GDP, this year's stimulus will more than double last year's. Many companies are already reporting their best-ever outlooks, as well as sequential revenue acceleration over recent months.

Lower inflation is structural

All this growth could, of course, produce an inflation surprise in the coming months. And while that could cause some ructions in the market, the central banks have repeatedly explained their willingness to look through interim inflation figures, believing them to be temporary.

Central bank belief in fleeting inflation concurs with our view that lower inflation is structural. Thanks to software and IT advances, the marginal cost of delivering goods and services has permanently shifted lower for many companies. Remember, inflation wasn't a threat before COVID hit, and that was when much higher employment levels existed. Two decades of low inflation suggests a structural change, and that's before we consider currently high household savings.

As Australia's Treasury noted way back in 2011:

"By reducing aggregate demand, higher rates of saving and lower household spending may also reduce pressure on prices and wages and therefore interest rates, while more moderate rates of gearing will reduce households' exposure to negative economic shocks."

It seems unlikely we will see a rapid re-emergence of permanently higher rates of inflation, at least until we see much lower levels of unemployment and perhaps stronger wages growth. Inflation of 2% is unlikely in the absence of at least 2% wages growth.

Plenty of juice left in the market

Despite Australian GDP printing above the RBA's upside scenario for four quarters in a row, some investors believe the recent gains means there's little juice left in this year's equity market returns. We, however, believe value and growth remain available and in plain sight. A residual question therefore is where can preferred opportunities be found?

There are several themes with investment merit.

The first is cloud computing, which is a game-changer for business. Only the most prominent companies could afford a dedicated in-house IT department and data storage in years past. The advent of third-party data centres changes the competitive landscape allowing smaller businesses to access enterprise-level technology at a fraction of previously prohibitive prices. Consequently, cloud permits digital transformation while enabling disruption by a multitude of companies for which IT was once a barrier to entry. And according to some estimates, penetration of enterprise-level cloud adoption is about 25%. That is where smartphone penetration was 12 years ago and where laptop penetration was nearly 20 years ago.

Low current penetration statistics suggest a long runway for cloud computing growth and far beyond the temporary fillip afforded by Covid lockdowns. We believe these companies are more than merely 'Covid winners'.

A second area of opportunity can be labelled 'income'. The search for yield remains heightened and global. Members of pension funds worldwide are struggling on income rates of less than 1% so the demand from their pension funds for assets that produce reliable, if not dull, income streams is acute. Witness, for example Telstra's desire to split off its mobile towers to permit a 'fairer' reflection of their value. Also, note the NSW government's contemplation of a sale of its gambling tax revenue streams.

With rates likely to remain low for some years, ASX listed REITS that offer stable and growing income streams could prove increasingly popular.

A third field of opportunity is offered by the roll out globally of a vaccine. While many investors seek to take advantage of first-order beneficiaries such as travel agents and education providers, the second and third-order consequences will be companies taking market share from slower or less nimble operators and consolidation in some sectors with mergers and acquisitions taking advantage of apparent synergies.

We bundle a fourth theme under the heading 'stimulus'. Companies that benefit from government support programs such as, for example, the newly extended HomeBuilder grants scheme are obvious candidates here. Less obvious perhaps is that when the Covid pandemic is over, the world will have the luxury of focusing on other concerns such as climate change. Electric vehicles, clean energy, and decarbonisation will take a more prominent role in the headlines than they already are in such a world. Australia, of course, is rich in all the minerals required for the manufacture of lithium batteries, including lithium itself, and the ASX is rich with listed suppliers, developers and explorers.

Australian investors may have many reasons to be very optimistic indeed.

 

Roger Montgomery is Chairman and Chief Investment Officer at Montgomery Investment Management. This article is for general information only and does not consider the circumstances of any individual.

 

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