Michmutters

The 1973-74 bear market was a brutal one as investors fretted about rising inflation and faltering economic activity, which was exacerbated by OPEC’s decision in October 1973 to stop exporting oil to the United States.

Moving in lockstep

The US blue-chip sharemarket index, the S&P500, tumbled 42.6 per cent in the 21 months ending in September 1974.

Fast-forward almost half a century, and investors are again spooked by rising inflation and sputtering economic activity.

La s&P500 index suffered a bruising 20.6 per cent decline in the first six months of 2022, its worst first-half performance in more than 50 years.

Since then, however, financial markets have rallied strongly, with the prices of stocks, bonds and cryptocurrencies recording impressive gains.

Since hitting a low on June 16, the S&P500 has risen by 12.6 per cent, while the tech-heavy Nasdaq has climbed 16.4 per cent.

The only plausible explanation for this rally is that – like Corrigan – investors have formed the view that it’s time to go get back into the market because things can’t get any worse than they already are.

And this implies that investors are expecting global inflationary pressures will quickly buckle under the barrage of interest rate rises already unleashed by the world’s major central banks.

After all, the central banks in developed countries – such as the US Federal Reserve, the Bank of Canada, the Reserve Bank of Australia, the European Central Bank and the Bank of England – are now moving in lockstep as they lift interest rates to tackle rampant price rises.

This synchronized and historically unprecedented monetary tightening will undoubtedly reduce global demand, which will take a lot of heat out of inflation.

Indeed, there’s a major risk that these synchronized rate rises will cause economic activity to contract too sharply, plunging the global economy into recession.

Already, investors are becoming optimistic that the US central bank – which has been raising rates at the fastest clip since former Fed chair Paul Volcker conquered double-digit inflation in the early 1980s – is nearing the end of its tightening cycle.

Signs efforts are working

The Fed raised its interest rate target by 75 basis points last week, bringing its official interest rate to a new range of between 2.25 per cent and 2.5 per cent. At the beginning of the year, the Fed’s policy rate was close to zero.

Although it will take time for the full effect of these rapid rate rises to be felt, there are signs that they are already weighing on demand, which will help ease inflation.

The US housing market is deteriorating, consumer spending is falling and retailers are offering hefty discounts to clear surplus stock, which suggests the Fed’s attempts to rein in household spending to slow inflation is working.

Investors are also hopeful that falling commodity prices will reinforce this downward pressure on inflation.

Commodity prices are also coming under pressure, both from the darkening outlook for global growth and from the surge in the US dollar.

Because most commodities are priced in US dollars, a stronger greenback makes them more expensive for non-US buyers, which helps to curb demand and put downward pressure on prices.

Commodity prices soared earlier this year, as production struggled to keep pace with the global economic recovery from the pandemic, and after Russia’s invasion of Ukraine triggered a surge in oil and gas prices.

But prices for oil, metal and agricultural products have fallen sharply since early June, and this should push official inflation figures lower in coming months.

Investors were cheered last week when Fed chairman Jerome Powell acknowledged there were signs that interest rate increases are beginning to bite, and that future rate rises are likely to be smaller.

This was confirmed by the Fed’s downgrade of the state of the US economy. In the statement it released after its June meeting, the Fed said “overall economic activity appears to have picked up”.

The statement released after last week’s meeting noted that “recent indicators of spending and production have softened”.

not so neutral

Still, some analysts believe that investors are premature in betting on a dovish pivot by the Fed.

They point out that US private sector wages and salaries jumped to a record 5.7 per cent in June from a year earlier, which will continue to put upward pressure on prices, particularly in the services sector.

What’s more, they point out that although the US housing market appears to be cooling, rents lag home prices by about a year. As a result, shelter costs, which make up about 40 per cent of the US consumer price index, are likely to keep rising sharply into next year.

Analysts also believe that investors are wrong to take comfort in Powell’s comments that US interest rates are now close to the “neutral” level, where they neither constrain nor spur economic activity.

Investors interpreted Powell’s statement as further confirmation that the Fed is close to the end of its monetary tightening cycle.

But many economists are skeptical that the Fed is anywhere close to reaching a “neutral” level of interest rates.

Former US treasury secretary Larry Summers attacked Powell’s assessment that US official interest rates are close to neutral, saying that it was “analytically indefensible”.

In an interview on Bloomberg Television on Saturday, Summers said: “There is no conceivable way that a 2.5 per cent interest rate, in an inflating economy like this, is anywhere near neutral.”

He added that he was concerned that the Fed was still engaged in “wishful thinking” about how much it will take to bring inflation down from four-decade highs.

The exuberant rally in financial markets over the past six weeks suggests that investors are more than happy to join in the Fed’s “wishful thinking”.

“The farm gate prices are going up, so the farmers are doing the best,” he says.

“The milk processors are losing, but like the sunsets in the west, times changing, circles happen. When assets are at their ugliest, that’s when we are at our happiest.”

The Micro Cap Activist Fund (MCAF), run by Mr Iafrate’s Melbourne-based firm Armytage Private, was established after the financial services royal commission to target mid-priced small-cap financials.

The fund is among the top returning equity funds over the past three years according to Morningstar data thanks to a flurry of M&An activity among small financial services firms and have been on the receiving end of 10 takeovers since 2019.

The list includes Hub24’s bid for rival Xplore Wealth, Apex Group’s acquisition of Mainstream Group, 360 Capital’s deal with Evans Dixon, and Iress’ play for OneVue.

Iafrate says he owes his good run to fallout of the royal commission, benefitting from mispricing in the market as the big banks rushed to exit the advice business. “The fund focuses on financials with market caps less than $70 million…these businesses tend to have dysfunctional board, dysfunctional management, and they tend to have boards that were protective of their salaries and directorship fees,” he says.

“After the Hayne royal commission, the spotlight was put fairly and squarely on the financial services sector. There was a galaxy of small-cap financial services stocks that were listed and had no purpose.

“Once the stock price was hammered, these businesses lost the capacity to raise capital. Our fund was set up to identify takeover and M&A in this space…it has been Nirvana.”

He remembers a spate of deals in 2020 where the fund participated in three takeovers in two days: “I walked into our investment committee meeting and said ‘what the f*** do we do now’ because we just lost almost half of the bloody portfolio.”

Return to wealth

It’s not over yet, he says (“at least another three, possibly four [deals] between now and June next year”) and he is busy accumulating shares in Diverger, which provides back office services to financial advisers and accountants and is currently bidding for Centrepoint Alliance, and is a shareholder in the latter.

Iafrate is not a fan of the banks. He says vertical integration and exorbitant fees kept the boutiques like Armytage off their platforms and models. But he tips the return of advice to the big four, saying the most important people are those who influence people with money.

“The banks unloaded all of their advisory businesses, threw them in the bin, sold them for nothing, and they turned the advice business into these horrible criminals, these ogres,” he says.

“But as night follows day, they’ll be back. You mark my words. And they’ll be back because of one simple thing. The most important person in the world of financial services is he or she who has the say over the person who has the chequebook, and the financial planner/accountant/lawyer who has the trust and the respect of the client.”

Food is its next target, taking a substantial shareholding in dairy and poultry manufacturers and retailer TasFoods alongside millionaire businesswoman Jan Cameron.

In addition to the MCAF, Armytage’s flagship offerings are the Australian Equity Income Fund and Strategic Opportunities Fund. Around two-thirds of business is individual high-net wealth managed accounts, the remainder in pooled funds.

The micro-cap fund, “the pure genesis, heart and soul of Armytage”, is invitation only with around $18 million under management. They hope to get to $75 million, above which capacity would become an issue. MCAF runs with just seven stocks at a time and tends to take 10-15 per cent holdings in companies with a market cap less than $70 million.

The risk lies in the incredibly high concentration, especially if the deals don’t eventuate, trapping substantial shareholders in unloved companies. In such a small area of ​​the market, liquidity is a key issue, making it difficult to make a quick exit or execute large moves without moving the share price.

‘Look where you least expect it’

A veteran of the industry, Iafrate’s career in financial markets dates back to the 1980s, developing a key interest in business after analyzing Cadbury Schweppes at university. He went on to work for Barclays Bank and Tolhurst Noall and McKinley Wilson, before founding Armytage Private in 1995.

He founded and chaired two listed businesses, Easton Investments and Treasury Group, the latter of which held stakes in a number of boutique managers including Anton Tagliaferro’s Investors Mutual.

Asked about his approach to investing in current markets, Mr Iafrate said, “look at least where you expect it”.

“If the market is saying it’s all going to go down, and it’s terrible, then it won’t – it’s too obvious,” he says. “That’s been a consistent theme for the 40 years I’ve been in the game. If it’s obvious, it ain’t going to happen.”

Where’s the non-obvious today? Iafrate says every man and his dog knows about rising inflation and rising rates, and the impact the end of easy money it’s having on high-growth stocks. But, he expects the Reserve Bank will finish its tightening cycle by Christmas, leading to a rebound in equity markets.

With this timeline in mind, the Australian shares fund is accumulating stocks with demonstrated ability to absorb and/or pass on price increases, and eyeing sectors that will bounce once the market takes the view the worst is behind it, namely cyclicals – infrastructure, resources , consumer non-discretionary and tech.

“We feel coming into September-November that equity markets will start to base out, the interest rate genie and the inflation genie be put back into its bottle, and the market starts to rise again coming into the Christmas period,” he says.

Iafrate says, “you can’t go past BHP”, sitting in opposition to warnings from Goldman Sachs that China’s property crisis will sink the iron ore price.

He also likes copper producers IGO, OZ Minerals, and Mineral Resources, adding that investors don’t need to “drop down to the explorers” to benefit from increasing prices.

Looking out at the rows of empty buildings from his office in Melbourne CBD, Iafrate thinks the commercial property sector is flashing warning signs, arguing workers are unlikely to head back to the office in the same numbers. He also makes note of Caydon’s collapse, saying more property developers are likely to fail.

“Where there’s a lot of supply, you tend not to want to be in those types of stocks, and in commercial property…there’s a lot of supply.”

Armytage has a deep history in the sector, launching a property fund in 2008 to target property trusts that were beaten down so far that they risked causing brand damage to their parents.

Pushing back against popular opinion, Iafrate backs the Reserve Bank, saying he gets nervous when people at the golf club think they could do a better job than the experts. “It was easy for people to take cheap shots and after the pandemic hit…everyone became an overnight cash rate guru. It’s so boring,” he said.

“If [the RBA] had gone gung-ho and tried to anticipate the inflation genie or the health recovery, or got it wrong…wow. They adopted the approach: ‘we’ll get it wrong on the way up’. I can live with that.

“I’m not saying they got it 100 per cent right, but people forget the surreal circumstances they were dealing with.”

Explore more Monday Fundie

• Jacob Mitchell says these stocks will beat tech blue chips The Antipodes founder has helped the fund manager amass more than $8 billion in assets under management since just 2015.
• How deja vu helped this fundie avoid the buy now, pay later crash As speculative pockets of the market boomed during the pandemic, Atlas’ Hugh Dive reminded himself of the lessons learned from the dotcom crash.
• Why this Barrow Hanley manager is buying in China now “If your time frame is 18 to 24 months, there are a lot of good companies in China that are trading down to near their lowest levels in valuations they’ve been at for a very long time, says former Marine Corps captain Rand Wrighton.
• Private equity is the new traditional asset class In the 1980s, private equity was the asset class of risk, leverage and aggression. Now, it’s all grown up while the sharemarket is where the craziness has gone, argues Partners’ Urs Wietlisbach.
• Oaktree’s Makam calls out the credit market’s hidden risks The message from the US veteran portfolio manager to Australian institutions piling into private debt is that the returns don’t always reflect the risks.
• Why this fundie is betting his new shop on old tricks Jonathan Wilson, portfolio manager and co-founder of Elvest, says the sharemarket tumble this year has revealed compelling opportunities.