Fast forward market with Kate Howitt

Fast forward market with Kate Howitt

In the current environment of supportive Fundamentals and low Friction, will strong Flows overwhelm stretched Figures? Or will everything come to a grinding halt?

Watch Kate Howitt, Portfolio Manager for the Fidelity Australian Opportunities Fund, as she discusses these themes plus insights and observations on the Australian equities market covering:

  • How can investors navigate the equities market considering the 4 Fs?
  • What will stop these market dynamics and will likely change?
  • Observations from February’s reporting season

 

Simon Glazier:

Well, good afternoon, everybody. Thank you so much for joining us today. My name is Simon Glazier and it's a pleasure again to host you for today's discussion. Before we get started though, just some brief housekeeping. We are planning on going for about 40, 45 minutes today. And if you have a question, you can submit that question via your Zoom portal.

Simon Glazier:

If you're on a mobile phone, unfortunately that functionality is not available at this point. But we have had a number of questions come through during the registration process, which is great. We thank you very much for that. And it helps us shape today's discussion. Again, a reminder that we have CPD points. Those CPD points will be available post today's session.

Simon Glazier:

Today, we're joined by Kate Howitt, portfolio manager for the Fidelity Australian Opportunities Fund. Now, before we kick off, a bit about Kate. As if not busy enough grappling with the global pandemic, in case you've missed it and what it means for her portfolio ... Kate was named in Citywire's list of the Top 30 Female Fund Managers globally in the world, ranking 11th out of 1,762 female active managers, which is an outstanding achievement.

Simon Glazier:

Kate is also at the forefront of Fidelity with regards to ESG. Considering the impacts of ESG when it comes to investing, I'm sure that she'll be happy to dive into that a little further as we move through today's conversation. Kate's a founding member of the Australian Equities Team here in AUS, has been with Fidelity since 2004, and managing the Australian Opportunities Fund since inception in 2012, delivering strong returns since that time. A stellar 11.7% per annum for nine years, which is no mean feat. Outperforming the ASX 200 Index by roughly 180 basis period per annum. Of course, that's after fees.

Simon Glazier:

Today, Kate, it's great to have you here with us and providing insights as to how you're seeing the market and what's shaping up for us in 2021. And really, what considerations you make and all of us should be thinking about when it comes to investing. Again, we've had plenty of questions and thank you for that. But with that, Kate, if I can, I'll hand it over to you to take us through today.

Kate Howitt:

Great. Thank you, Simon. Thanks everyone for tuning in today. Appreciate your time. Maybe at some point we'll be able to go back to doing these face-to-face. But for now, I'm sure there's a lot of you that we can now have this conversation that we wouldn't be able to without the magic of Zoom. We'll be grateful for that. What I'm going to talk about today with my slides ... There we go. I can do this tech thing.

Kate Howitt:

When I am looking at the markets, the phrase that comes to mind is, "Is the market on fast-forward?" We'll spend a bit of time talking about that and a little bit of time at the end to talk about how the Fund is positioned. I think most of you would be familiar enough with Fidelity to know that we are overall a bottom-up, stock-specific house. We're not a macro-driven house. We are all about individual stocks, business models, our analyst team working to talk to members of the supply chain, do our due diligence, and work out really good individual stock opportunities.

Kate Howitt:

But when it is time to look at the market, I have always just followed a really simple, three-bucket model. I want to understand what's going on with fundamentals, where valuation is starting, and what's the picture on flows. Because if we've got good economic tailwinds that are feeding through into earnings growth, if we've got low or attractive starting valuations, and if you've got flows coming into the market, then all things being equal, markets are going to go up and vice versa.

Kate Howitt:

What I'm going to talk through today, is just extending a little bit. Still talking about fundamentals, flows and valuation that I'm calling, "Figures," just because then I've got a few more Fs. I'm also going to talk about friction or the reduction of friction, because that's another factor, I think, that is speeding up what's going on in markets.

Kate Howitt:

If we start with fundamentals, you don't need a lot of nuance to see what's the big driving fundamental of the world today. It's the pandemic that we've been through and coming out the other end of it. We're incredibly lucky to live in Australia. Australia has just done so well on testing, so well on genomic testing, so well on sewerage and geographic testing, so well on track and trace, so well on quarantine. That has really just led to a really outstanding result in terms of cases and fatalities.

Kate Howitt:

Now, the world has prospect of vaccines, and that puts an end-date on this, that we know it's not going to have to drag on for another year or two of lockdowns. And then, the interesting thing is we've now got Joe Biden in the White House in the US. What's interesting about that is, as you would all know, he was Vice President to Barack Obama. And so, he saw Barack come to power and then the economy sputtered along for the first two years. They didn't really do enough stimulus.

Kate Howitt:

Because of that lacklustre economic outcome, they then subsequently lost some seats in the mid-term elections two years later. They really saw their ability to put through their legislative agenda just dwindle away. And so, it's pretty clear that Joe doesn't want to make the same mistake this time. There's a lot of stimulus coming through. We just saw the additional $1.9 trillion dollars stimulus come through. And so, that has been the final outworking of this pandemic in the US. It gives the new Democratic administration all the cover they need to push a really stimulatory agenda.

Kate Howitt:

What's happening? To summarise ... Last year, all the conversations, is it going to be an L? Is it going to be a U? Is it going to be a W? Is it going to be a K? We can call it now. It's a V. This is what a V looks like. Now, why, in downturns, do we wonder about it being an L or a U, where things bubble along the bottom?

Kate Howitt:

Because in a typical economic downturn, everyone takes some pain. The government will have less tax revenues. Corporates will get less revenue, and so they'll lay staff off and they'll do less investment. Households, you have someone lose their job, so they'll fall back on their spending. And then, banks will have people default, and so they'll fall back on their lending.

Kate Howitt:

And so, what you have is all of those then impact the next negative spiral down. It can be really hard to find the circuit breaker that puts a floor under that negative spiralling down. But what we had this time was the government said, "We will be the shock absorber. We will pretty much keep other economic participants whole." And so, that has had a big impact. We haven't had a vicious cycle. Corporates have still had the confidence to continue investing and to keep people on their payroll. Individuals have had the confidence to keep spending, because they haven't lost their jobs, because job keepers have preserved a lot of jobs. And the banks have kept on lending.

Kate Howitt:

Furthermore, we've for this interesting twist where work-from-home enables people to no longer be tethered to a CPD. You can do that tree-change or sea-change that you'd been wondering about doing and thinking you'd have to wait until you were going to retire. We've had this tailwind of demand for housing in regional areas. And the Reserve Bank put through a stimulus measure called the TFF, the Term Funding Facility. That gave banks the confidence to offer attractive fixed-rate loans for four years, last in the generation. That's been an increasing tailwind for property.

Kate Howitt:

The conventional wisdom is that you have an economic downturn and the housing market, particularly in a high-debt society like Australia, the housing market's going to spiral down and amplify it. Instead, housing has pushed against the downturn. One further tailwind is the state of software means that even though we've been locked down and haven't been able to go to the Westfield or go to restaurants, we've been able to get pretty much everything delivered to us. A lot of that consumption was able to continue.

Kate Howitt:

I think the questions from here are the risk of relapse. And I don't just mean medically, I mean economically. There's got to be some kind of tail risk from the virulent strains. Although our team in London of medically trained doctors, our analyst team who are keeping across this stuff for us, feel that vaccines will be able to cope with these. Even though they may need to be reconstituted a bit like the flu vaccine is every year. We have a question about vaccination rate.

Kate Howitt:

As I mentioned, Australia has done, globally, so well. We're one of the top countries globally. But ironically, because of that, we don't have a real urgency around vaccination. And so, we are running behind other countries. That's not necessarily bad for us, but if we don't get high levels of vaccination, we're going to have a lot of trouble reopening our international borders. And then, that would become an issue for us.

Kate Howitt:

There's a bit of a question about the role of a job keeper. Some estimates of 100,000 jobs that could go with that. But then there are other estimates that are more sanguine about that. One of the unsung heroes of last year was the iron ore price. The iron ore price just levitated during the year. That was a huge tailwind to our economy through revenues, royalties, tax take. And then, also one of the things we learned last year is that Australians on average spend about a one billion dollars a week on outbound tourism.

Kate Howitt:

We haven't been able to spend that, obviously. That means we've been spending it instead at Bunnings, and buying toys. A lot of things like jet skis sold out, which is not what you would think in a global pandemic. And so, there is a bit of a question in my mind. When we are able to open up our borders and we can all start doing that holiday to Fiji or Bali or whistler again ... Are we going to have the inbound tourism and the inbound students to offset that spend? Or do we actually find that our consumer spending weakens a little bit?

Kate Howitt:

But overall, you'd have to say the outlook on the fundamental side is really going quite well. Now, if we move on to talking about flows. This chart, the pink line is the US liquidity base. The grey line is GDP. The orange line is ratio between these. And you can see that liquidity is the highest it's ever been. This chart goes back to 1790. That's a pretty good history of data. Even in the US build-up of liquidity to fight the second World War in the 1940s, we didn't have this much liquidity sloshing around the system.

Kate Howitt:

The blue line is the Fed balance sheet. The Fed's only been around for 100 years, but you can see there's been nothing like it, in terms of the scale of their balance sheet relative to GDP. What all of this ... It's supply and demand. You have so much supply of money. It means the price of that goes down. In the post-year C period, we had, "Lower for Longer." This whole narrative around secular stagnation, that there were these structural forces that were holding interest rates lower and lower and lower. Demographics, technological deflation, these debt burdens that had already built up.

Kate Howitt:

By the end of last year, governments around the world were taking on additional big-debt burdens. Then, the narrative actually shifted towards, "Lower for Forever." How can we ever increase these interest rates? Because governments just simply won't be able to service them. Now, of course, markets love to go to an extreme and then swing back. So we go to the extreme of lower for longer, lower for forever, and now we're back into our, "Higher for Now."

Kate Howitt:

We've had rising rates. Now, obviously, policy rates at the short end of the curve are held low, but as you go further out the curve, nominal rates have been coming up. Inflation rates also up, but not quite as much. And so, real rates have been increasing. Now, the last time we had a significant impact from this was the Taper Tantrum of 2013. Then, real rates kicked up 150 basis points in the space of less than six months. And that had a big impact on the pricing of risk assets.

Kate Howitt:

We're not seeing anywhere near that scale of movement, but this bouncing off the bottom of zero rates has meant negative returns for some duration of bonds. This is the worst outcomes for bonds in decades. You guys are all across AUS at all locations, and you know that's an issue. Bonds are supposed to be the safe, sleep-at-night part of our portfolio. To see absolute draw-downs in bonds is a bit of an issue.

Kate Howitt:

How do we interpret this? Well, I have been talking for years, post-crisis, about the fact that governments have built-up these big debt burdens, and therefore governments will need to work off these debt burdens by following the playbook of financial repression. And I've called that, "Lock bond holders in the barn and burn down the barn." If you are a bond holder and you're in the barn, and you can see that maybe the flames are being lit, maybe it's time to at least get partially out of the barn.

Kate Howitt:

We've had flows from bond market into equity markets, and a whole range of other asset classes. These bond market refugees leaving their natural homeland. Last year, a lot of money got packed in money market funds or no-duration cash funds in the US. Some of that is coming out, because they no longer need a safe place to hide. You've also got this phenomenon of pandemic punters. People who are in the stock market more for entertainment than because they're trying to save for their retirement.

Kate Howitt:

Because of this, you're getting some really interesting and weird flip-flopping of the correlation between bonds and equities as you get these intersecting interplays between the two asset classes. And that's making asset allocation also a bit tricky. What are the big questions from here? Well, one of them has to be, "Is this the end of the 40-year bond bull market?" Over 40 years, interest rates have gone down, down, down, down, down. Bond prices have gone up, up, up, up, up. Are we at the end of that?

Kate Howitt:

If we are, then we're going to see continued flows from bonds into equities are pretty much every other asset class in the world. Or we're just going to see those interest rates ... They go under 1.50, they head up to maybe 2.00, 2.50. And everyone goes, "In the low-rate world that's a pretty good return. I'll go back." Those bond market refugees head back into bond land, and those flows come out of equity markets, causing at least a near-term top in equities. And at some point, all the pandemic punters will actually be able to go back and do all of the things they used to do for entertainment.

Kate Howitt:

Moving on to talking about valuations. This chart doesn't go back quite so far. It only goes back to 1948. The top line is the S&P 500, the US Stock Market. If you look at the top right, what we've done there is we've overlaid the last two previous secular bull markets. The 1980s, 1990s, and the 1950s, 1960s. What that suggests is, if you think we're in a secular bull market, then we're about halfway through.

Kate Howitt:

Then, when you look at the bottom, some interesting things start happening. If you look at these ratios, you've got stocks to commodities, growth to value, large to small, and US to non-US. All of these are starting to look like they're at about the point where you could get a rotation. We think that you could be in the midst of a secular bull market, but still see a bit of a change of leadership. Now, I call this ... Some valuations are going back down the asymptote. Let's talk through that.

Kate Howitt:

When we were in lower for longer, we had low interest rates. We then swung over to lower for forever at ultra-low interest rates. Now, you guys know how valuation works. You take your future cash flows, you discount them back at a discount rate. As your discount rate goes to zero, the value you compute for those cash flows goes asymptotically up towards infinity. Now, we only saw one stock note from a broker last year actually putting an infinity value on something. So, it didn't get too entrenched.

Kate Howitt:

But, of course, what that means is that what goes up can come down. When the interest rates go down and then bounce, it means the valuations go right up the asymptote and then slide back down. We had interest rates climbing, and we had a preference for ultra-duration in bonds, ultra-duration in stocks. But now, we're coming back in, and we don't want that much duration. Now, this is interesting. Because if you go back almost exactly a year ago when markets were selling off, there was a lot of chat then of, "Are we at the end of the bull market? Is the bull market turning into a bear market?"

Kate Howitt:

One of the clues to that was people were looking at that for a change of leadership. These high-growth, tech stocks, quality stocks that had led on the way up. Did they roll over? Because we go back to the dot com. You had the new economy, high-growth software companies that all led on the way up. And then, once you reach that point, then there was revulsion towards those. Those were the ones that fell harder, and it was the old economy ones that held up. The question was, "Where are we going to see this change of leadership," last April.

Kate Howitt:

We didn't, actually. What we saw was that the software companies fell less on the way down and rebounded more on the way up. No change of leadership. And yet, now we are starting to see some of that rotation where the large is giving way to small, growth is giving way to value and cyclicals, and there's a preference for hard assets. Now, the way stock markets work is technicals and flows will create price movements. And then, Wall Street will come in with a narrative around that.

Kate Howitt:

As we went to ultra-low rates and ultra-duration, then we have to have a narrative around that. And so, we've had this narrative of, "These stocks are changing the world," as the Tesla or Ark effect. Now that you've got interest rates going back up, you've got valuations coming back down, now there's a bit of a question around those narratives. What are the questions? Well, if you go back in time and look, you'll see a growth stock will be on a higher P/E than a value stock. But if you roll the earnings to five years, you'll find that the P/Es converge.

Kate Howitt:

What that tells you is that markets generally equilibrate around five years forward earnings. That waxes and wanes, but broadly that's where it's been historically. Now, last year, when we moved into this ultra-low rates, ultra-duration, then that horizon blew out. It's impossible to calculate if it blew out to 10 years or 15 years, because when you look out that far, your EPS estimates are all just rubbish. But it went a lot further. You were looking a lot further into Tesla's earnings profile to justify its current share price.

Kate Howitt:

Then, what happens, of course, with this swinging back from ultra-low rates to rates going back up, long-duration coming to short, we swung all the way back to a six to 12-months time frame. Now, the market wants stocks that are reopening beneficiaries. Ones that got hit by COVID shutdowns, and then now are going to reopen and bounce off the bottom.

Kate Howitt:

Again, this pendulum. We were here, we swung out there, we've now swung all the way back. At some point, the pendulum will swing back more to a more normal five-year forward horizon. The other thing that will impact in this valuation ratio will be inflation. And so, we'll talk about that a little bit.

Kate Howitt:

Now, I want to talk about friction. This is a chart of the flows being raised into SPACs. Special Purpose Acquisition Companies, or what you and I would call a cash box. And this always reminds me of the South Sea Bubble, where there was this massive raising. And it was a massive raising to undertake an endeavour, the purpose of which no one is to know. It was this super secret, but really cool thing that they were going to do in the South Sea. Currently, SPACs are raising a billion dollars a trading day in the US.

Kate Howitt:

This is amazing, because this is people just tipping in money on faith. It's a measure of FOMO. The other low-friction phenomenon that we've seen is in the US. Robinhood. Trading for very low cost, very low friction. It's not just in the US. CommSec said that their trading volumes have doubled in the year. They've got 230,000 new accounts, a lot of them on the app. What's going on? Well, we're seeing financial innovation. It's not just SPACs and low-cost trading. For decades now, we've had new things like ETFs and algorithmic trading coming in.

Kate Howitt:

All of these make it easier to get money into markets. And now, the combination with social media is getting interesting. This is not the first time this has happened. Go back to the 1500s, we had the printing press, which allowed pamphlets, which then led to a lot of political instability and revolutions. If you go back to the early 1900s, we had the telegraph. And that allowed the ticker tape, which allowed an extraordinary expansion in stock market participation and was part of what led to the Roaring '20s.

Kate Howitt:

In the 1930s and '40s, most households in the US and Europe got these big wireless receivers. And so, the family would sit around to listen to broadcasts. A lot of Hitler's speeches were actually broadcast into the living rooms of families across the North Atlantic world. And then, the BBC used radio to help organise and support the resistance. Now, we've got social media and internet memes.

Kate Howitt:

Where it gets interesting is we're reliving what happened in the Roaring '20s with the ticker tapes. When you put mass communications with markets, you get what's called reflexivity. This is a George Soros term about how markets can create their own reality. If we were all sitting around, betting on the outcome of a sports match ... If we all took one side and said, "Okay. This team is going to win." We would change the odds and we would change the payout, but we wouldn't change the underlying score of the game.

Kate Howitt:

Whereas, with markets, if we all get onto Reddit and then use our Robinhood accounts to buy up GameStop, then we do actually change the outcome of the game. This was recognised as not being healthy to the operation of markets. In the Roaring '20s, these were called Pool Operations. And they were actually prohibited in the US, with the Securities Act of 1934. It's a little bit tricky, because Pool Operations are when you explicitly coordinate. But if I just post on Reddit, "Hey, this stock has a lot of shorts," and then everyone decides to pile into it, does that really fall under the Pool Operation description?

Kate Howitt:

There's some regulatory water that needs to pass under the bridge. Now, this would look like all of this trading adds a lot of liquidity to markets, but because mostly if it's with payment for order flow on the other side, it's not actually creating liquidity that we recognise when we're trying to put institutional sums of money to work. Markets have apparent liquidity, but we would say they actually have less real liquidity.

Kate Howitt:

What question arises out of this? Well, one of them, I think you just have to say, "Is that a sign of a market top?" It's a bit of the ... Where you've got shoeshine boys giving stock tips. When you have teenagers wanting to get trading accounts, people wanting to use their stimulus check to punt in the stock market. Now, again ... Historically, financial innovation is nothing new. If you back through industrial revolutions, what you find is there's always an industrial innovation that comes through, like the steam engine.

Kate Howitt:

But it can't have its full impact on the economy until it's deployed. And deploying it takes a lot of capital. You always get financial innovation to pull in the capital that can then be used to deploy the new industrial innovation. There's always financial innovation that comes in. There's a new financial innovation that comes in with every big new industrial innovation. And it's what allows the market top to happen, and with hindsight, generally is a sign of market top over years.

Kate Howitt:

The other point that I find really interesting about this is that last year we were all getting very nervous about the fact that a majority of US millennials were saying that they thought socialism was a good way to organise the economy. And that's a bit of a worry for those of us who believe that capitalism is a better way to organise the economy. I find it really interesting that you've now got a cohort of socialism-loving millennials who are now all over trading in the stock market.

Kate Howitt:

Either that means they just don't really know what socialism or capitalism is, or they're having a change of heart. Either way, I think it's interesting. You can't talk about financial innovation without talking about Bitcoin. But without going down that rabbit hole, I think the key question there is just, "Is it digital gold? Or is it a digital tulip?" That's taken us through our four Fs of fundamentals, flows, figures, and friction. But I've thrown in a bonus. But wait, there's more. You also get a fifth F.

Kate Howitt:

And this is inflation. Now, many of you will have seen this chart before. Again, this is where I look at, if you're a policy maker today, and you know you've got a lot of debt on your balance sheet and you know you need to deal with it ... And you're trying to look for lessons from history, you can look at the unsuccessful but not terribly painful deflation of Japan. You can look at the successful but terribly painful deflation of the US in the Great Depression. You can look at hyper-inflation in the Weimar Republic of Germany. All of those are very uninspiring analogues.

Kate Howitt:

Or you can look at the US, post-WWII in the 1950s of financial repression. Hold bond rates low, let inflation rise above them, give negative real returns to bond holders for 15 years. Hey, presto. Your debt is worked off, your economy has done well. It's just that bond holders have had a loss in purchasing power. What's happening with inflation? Well, we are following the financial repression playbook.

Kate Howitt:

Governments have increased their debt load. Governments have jammed through a lot of fiscal stimulus to prime the economy for inflation. You've got these sparks flying around from bottlenecks in the global supply chain from the pandemic. In Australia, we set yield ceilings. In the US and Europe, we are really just jawboning around those and we haven't formally set them. You're getting a little bit of a testing. Bond market participants are testing central bankers on there.

Kate Howitt:

This thinking that inflation is coming has led to demand for stocks, for property, commodities, anything hard-asset. We are desperately seeking a goldilocks inflation outcome. Central banks have made it very clear they want inflation. They will not change policy until they get inflation. They need it because it is the key ingredient of financial repression. The good news is they're going to get inflation at least on a temporary basis three to four percent.

Kate Howitt:

But we need more than that. We need it to be sustained. We need moderate inflation for many, many years. But we don't want high inflation. Now, even in the US, where they had this wonderful period of financial repression in the 50s and 60s, which was a great period of growth and productivity ... That did ultimately lead through to higher than desired inflation in the 1970s. Inflation, it tends to come in and do its part, but then wants to take over the whole show.

Kate Howitt:

I think the real question of inflation is, "Is this the end of secular stagnation?" And that really comes down to Joe Biden versus the forces of secular stagnation. What were those forces? Well, one of them was technologically driven deflation. This means that software might mean that it's really hard to get cost push inflation. When my teenage daughter decides that she needs to watch five times as much Netflix as I think she needs to, that doesn't cost Netflix five times as much so they now charge me five times as much.

Kate Howitt:

Software has zero marginal cost of production. When what we're demanding increasingly are digital goods, then that might not actually push through inflation in a way that it would have previously when we were demanding manufactured goods. Secondly, if we've got a lot of demand for new employment, say, in Amazon distribution centres and for Atlassian coders, but the unemployed people that we've got are a lot of older people who have worked for banks for 30 or 40 years ... There might be a skillset mismatch.

Kate Howitt:

Again, that demographic mismatch might mean that even though we've got labourers to slack, it's not going to feed through into inflation. The other question I have to throw in here is just ... I'm just building up a list in my mind of things that could usefully be set by price discovery in a market environment that we are now trying to technocratically control. Interest rates at the short-end, interest rates at the mid, interest rates at the long-end. The cost of capital. The unemployment rate, the inflation rate. All of these things we are trying to technocratically micro-manage.

Kate Howitt:

Now, putting all of that together. We talked about the fundamentals. And my colleagues at FMR, Fidelity Management Research in the US, they manage a trillion dollars. When you've got a trillion dollars, you can't do anything quickly. Their macroeconomic group looks at the five to seven year business cycle to give them pointers of where they are and how to edge that trillion dollars around. When I talk to them, they say what's extraordinary is that we have compressed that five to seven year cycle into one year.

Kate Howitt:

In the past 12 months, we went from late-cycle to recession to early-cycle to mid-cycle. All in the space of 12 months. The economic fundamentals of the globe have been on fast-forward. We've just fast-forwarded right through that whole cycle. We've talked about flows from bond market refugees and pandemic punters. That's brought in multiples of the flows that we've seen in previous years into a very short space of time, so flows are on fast-forward.

Kate Howitt:

We've talked about valuation and how we've rapidly iterated from seeking ultra-duration to coming back to seeking no-duration at all. Those kinds of valuation iterations are happening very quickly. And then, we talked about how low-friction innovation is churning over money in the markets in a super fast way. And then, we've got this question of Joe versus secular stagnation. Is this a completely different change in the inflation paradigm? That's where we've got to on markets. I'm going to just check with Simon if there's anything we want to just delve into there or if I'll move on to the portfolio.

Simon Glazier:

Thanks, Kate. That is a really good overview. And I think, "'flation," is going to catch on whether it's real or just the word. It's pretty catchy. There's a few questions coming through. And I might just focus on maybe one part of the market here in AUS, which has always been a big part, and that's the commodities market. Interested on your thoughts of, "What does a low or a zero-carbon future mean for commodities?"

Kate Howitt:

Yeah, I think that's a great question. As you say, hugely relevant for Australia, given the dominance of the commodity side of our market. It's quite funny, right? Most developed economies, they move from primary production to secondary production to tertiary production ... And Scooby's working up. In Australia, we have this huge part of our economy, which is still primary production, iron ore and coal. And that's been hugely beneficial. Sorry. Hopefully, she'll settle down.

Kate Howitt:

Now, BHP put out a climate change report at the end of last year. And they've got a slide in there that I think is really so interesting. For their key commodities, they looked at the ratio of demand for that commodity for the next 30 years as a ratio of demand for the last 30 years. Now, keep in mind the last 30 years is the entire period of this huge urbanisation of China. We all know if I said, "Tell me one word to describe what's driven commodities up the past couple of decades," you would all say, "China."

Kate Howitt:

As a ratio going forward, they find that for petroleum. maybe you want a little bit less over the next 30 years, depending on your scenario. If you look at iron ore, you want more. And this is even though China has gone through the bulk of its urbanisation. They find for a commodity like nickel, that over the next 30 years, the world needs three to four times as much nickel as it has needed over the past 30 years. The one word backwards-looking for commodity demand is, "China." But on a forward-looking view, the one word for commodity demand is, "decarbonization."

Kate Howitt:

There is somewhere between 100 and 150 trillion dollars US that needs to be spent to decarbonize. Now, just to put that in context, the US economy GDP turnover every year is about 21 trillion. Some time in the next 29 years, we need to take five to seven of those years and do nothing in the US economy, except invest to decarbonize. The scale of this thing is absolutely enormous. Of course, everything needs to be focused on trying to make it cost 100 trillion not 150 trillion, because that's a big difference.

Kate Howitt:

But you are just not going to get there without metals to do it. All of the solar panels, the wind turbines, the new grids and distributions. Everything involved in decarbonization involves more metals. And that is going to be a tailwind for our commodity providers into the future.

Simon Glazier:

Excellent. There are a couple more. But again, conscious of time. If we flip to the fund positioning slide, something that is obviously apparent is we've had this confirmation that we've had a V-shaped recovery. Right? Like you said, yep, it's a V. But there's also a lot of risks on the horizon. Maybe in the next little while, just talk through how you manage the various risks in markets within the portfolio.

Kate Howitt:

Yeah, thanks. On this slide, I think most of you would be familiar with this. It's a way of just classifying business models. And I have always believed that in a small, narrow market like Australia, it really doesn't make sense to say, "I'm only going to look at one kind of stock mispricing." I think in a narrow market like this, you just want to look at any kind of mispricing that might give you an idiosyncratic opportunity.

Kate Howitt:

The other way of saying that is, in the portfolio, I want the driver of return to be idiosyncratic stock returns. To do that, you have to diversify away other sources of risk, such as style risk or sector risk or size risk, to the extent you can. I always like to own a range of these. You can see the yellow block here, the thoroughbreds. These companies have high returns and they can reinvest those high returns. Those are fantastic and they're classic growth stocks. They did really well last year and particularly towards the end of last year with that move into ultra-duration.

Kate Howitt:

On the other hand, my tortoises, that's something like Lendlease. These are not fantastic businesses. They either have low returns or they're a victim of cyclicals. And they were unloved for much of last year. But really come into their own now that investors are looking more at that short-duration phase. A group of stocks that doesn't fit into this framework is commodities, because obviously sometimes their returns are high, sometimes they're low. I just mentally think of them off to the side. But I always want to have an allocation in there too.

Kate Howitt:

An allocation to energy that no one wanted to have early in the year, that has now come back into favour with the renewed strength in their oil price. If you look at the top ten holdings in the fund, I always want these to be internally inconsistent. What I mean is, I never want to have this stocked full of growth names or value names or large names or small names. I always want to mix. I always want a range of stocks that, if the world goes one way, some will do well. If the world goes another way, some will do well.

Kate Howitt:

You can see, I've got my Lendlease for when, out of love, low P/E stocks do well. I've got my Commonwealth for when banks are back in favour. I've got my Megaport for when that software and growth is in favour. Santos for when the oil price and commodities are doing well. Evolution Mining for when the world looks terribly scary and we all reach for our seat belts. I want to have an insurance policy in place.

Kate Howitt:

And Goodman and CSL are those core, quality growth companies that are wonderful value creators through time, but where the valuation got a little bit ahead of itself. They were my largest holdings for several years, and I've now brought them back a bit. Just to reflect the fact that there were big opportunities elsewhere just for the short-term.

Simon Glazier:

And looking at that top 10, there are a couple of newer names in there. But just in terms of looking over a 12 to 80 month period, what type of name change or turnover would you expect in some of those key holdings?

Kate Howitt:

I never target turnover. I always feel like turnover should not be something you manage. There was a lot more turnover in the portfolio last year than there would be normally, and I think that's appropriate when the opportunities on-offer are shifting so quickly. I did move the portfolio last year from a long-term holding in Oil Search into Santos. And if you boil it all down ... There's a lot into a decision like that.

Kate Howitt:

But when you boil it all down, you can say the key thing was on ESG factors. With climate change, you're seeing that drilling in the Arctic Circle is becoming a lot harder. Ironically, the growth for Oil Search is out of their Alaskan assets. They are only allowed to do work out there in the middle of winter, when the ground is frozen. But we are seeing some mining companies up in the Arctic Circle are having downgrades, because the permafrost is melting. Global weather pattern changes actually mean it might be harder to ever realise value from those assets.

Kate Howitt:

On the flip side, Santos will be a relative winner in an ESG world through a quirk of history, which is that the gas that they've been pulling out of the Cooper Basin for decades is inherently really high in CO2. Just as, a history of the reservoir. They've always has to separate out the CO2. And then, what do you do with it? Well, you pump it back into the reservoir to boost pressurisation and boost your recoveries.

Kate Howitt:

They've been doing carbon capture storage for many, many years. They're actually probably one of the longest-lived carbon capture storage companies in the world today. Of course, they are now live to the opportunity this gives them. They're stuck out in the Cooper Basin. They're not hemmed in by big industrial cities. So they could do a lot more in terms of solar power. And then, do hydrogen electrolysers. Generate hydrogen, put that into the gas pipelines and turn into ammonia, ship it up to current gas customers in Japan and Korea. A lot of interesting optionality.

Kate Howitt:

I own Santos for its ESG optionality even though 100% of its revenues now are dirty carbon. But it's not about what they're doing today, it's what they're doing to decarbonize. It doesn't help save the world if we just divest from dirty companies and don't support companies who actually are part of the 100 trillion investment that needs to happen.

Simon Glazier:

Yep. Again, just conscious of time. There might be room for one more comment. But two low, low-index weight positions that you've got some conviction in there are almost at the opposite ends of the spectrum. You've got Treasury Wine, TWE, there, which some would say that the value is cyclical play versus Megaport. And we've had a few questions come through. Is there any context you can put to those two holdings?

Kate Howitt:

Yep. Treasury Wine, most of you would know, got hit last year because of the Chinese government putting punitive tariffs onto Australian wines. Basically, the market reaction to that, if you reverse-engineer it, it was to take that China revenue line and zero it out. Now, we think that is too conservative for a couple of reasons. Treasury Wine have been reshaping the global wine industry and pulling it into the modern age by breaking that nexus between a wine brand and a plot of earth.

Kate Howitt:

Penfolds has been related to vines in South Australia. They're now saying we can do Penfolds out of California. We can do Penfolds out of France. That's all still maturing and in the vats, and not yet bubbled and ready for sale. But in the next couple of years, it will be. The pessimistic view is that Penfolds is no longer relevant in China, and all that work they did to build that brand is now out the window. We don't think that's going to prove to be correct.

Kate Howitt:

We think that they will be able to sell American and European Penfolds into China and maintain their relevance. We also think that there is upside from the way they are reshaping their portfolio and getting rid of the lower-margin commercial wine, and focusing more on the masstige and luxury wine. In a space in consumer, where there's a lot of names that have run really hard on the near-term spending that Australians have been doing, we think that there's some good value in Treasury Wines.

Kate Howitt:

Megaport is a software business. What we like about Megaport, is it is at the heart of a three-sided marketplace. Two-sided marketplaces, we're all pretty familiar with. This is something like Seek with job seekers and employers. Or REA with property sellers, property buyers. Or even Amazon. Buyers and Sellers. When you're in the middle of that two-sided marketplace, it can be a really powerful economic position.

Kate Howitt:

Now, every so often you find a three-sided marketplace. And that can be even more powerful. The ones you'd be most familiar with would be Visa and MasterCard. When I go to the café, I put down my credit card. And then, Visa and MasterCard sit at the middle of the café, the card issuer, and the merchant acquirer, and have to coordinate all of those.

Kate Howitt:

Now, Megaport sits at the middle of the Cloud. It will be a corporate that will put their data into the Cloud using a data centre and a cloud provider. So Fidelity might put its data into an Equinix data centre using Amazon Web Services, and Megaport does the software-defined networking that puts all of those three together. And it's a powerful thing, because they have to be independent. A lot of things in tech are going to get sucked into either Amazon or Google or Microsoft. The big guys will go, "Yeah, that's good functionality. We can do that."

Kate Howitt:

Whereas, for that, you're a market maker when you're sitting between. Corporates want to be able to pull their data out of AWS and put it back up into Azure. And if they go with one or the other, they can't do that. Megaport sits as an independent market maker between those. Currently, unprofitable. Right in that basket of tech that is out of favour right now. But going to flip into profitability soon, and has some really strong cash flows coming through. And so, happy to ride that through.

Simon Glazier:

That's great, Kate. And we've just gone to 12:48, so we're a couple of minutes over. But just want to say thank you for that insight. I think the way you wrapped that up and encased that in the world that we live in down to the portfolio-level is truly an amazing effort. Thank you very much for your time. Also, thank you everyone for joining us today.

Simon Glazier:

If we didn't get to your question, which there have been a few, please reach out to the team. We're here and we're here to support you in as many ways as we can. But with that, again, a reminder that CPD points will become available probably around 10 business days after today. But, again, thank you for joining us. See you soon.

Kate Howitt:

Thanks, everyone.

 

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Kate Howitt is a portfolio manager in Fidelity's highly successful Australian equities investment team.

Since 2007, Kate Howitt has had sole responsibility for a range of mandates for domestic and overseas clients including the Fidelity Australian Opportunities Fund.

Kate has been named Money Management’s Women in Financial Services Investor of the Year in 2015, Lonsec's Rising Star in 2016 and was included in CNBC's 2016 ranking of the world's top 20 female portfolio managers across both equities and bonds. In 2020, she was named in Citywire’s list of the best 30 female fund managers in the world.