Quarterly Market Update – Q1 2023

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Posted on 05/01/2023

March Quarter 2023

Market and Asset Class Views

Overall

Markets were given a fair shake of volatility and uncertainty in the quicksands of 2022.

Heading into the following quarter, we take the opportunity to make minor adjustments to the mainly neutral portfolio settings that were held last Quarter into calendar year 2023.

We join market consensus that in the year ahead, we will see a lower USD, bonds with duration are now a justified allocation in portfolios and equity markets will be a balancing act with the ‘R’ (recession) word looming.

Australian Equities – we lean, in for a little

In a volatile year requiring a neck-brace, the ASX 200 ended down only 1.1% with the ASX 20 up 3.6% and small caps down 18.4%. In industry sectors, major moves were: Resources +22.3%, Infrastructure + 18.5% and Tech -32.1%. Notably, the ASX beat its US counterpart by a significant margin – some 16%. Of course, a weaker AUD helped, but reinforces the advice to AUD domiciled investors remaining unhedged on US growth assets.

Setting the scene for Q1 of 2023, we see several positive factors:

Continuing constructive commodity price outlook;
Weaker USD (attracting international flows to Oz);
Relative strength in the consumer and business balance sheets;
Strong employment outlook that won’t be dampened by immigration;
Expansionary fiscal story with the newly incumbent Labour Government yet to make hard expenditure and taxation decisions;
A rise in official rates that are less aggressive than the US, with a definitive taper and terminal rate in sight.

Naturally there are counter arguments i.e. we still see a paradox in softer consumer and business confidence surveys being at odds with actual expenditure patterns. The sharp rise in official rates has yet to play through to borrower’s cash flows, real estate values etc. To the extent that this plays out is one of debate and significant.

The Australian market remains one of the cleaner stories globally, but the China dynamic will drive relative over or underperformance. Commodities should remain well bid, a cheap AUD on TWI terms and a weak USD will support flows. The domestic economy remains solid with the financial sector not throwing out any evidence of any marked credit deterioration. Thematically, like the previous quarter, our preference is still Quality over Growth and Large Cap over Small. We expect the market to remain range bound and are happy to tilt longer on pullbacks (as now) in the 6800-7000 range and lighten at the top of the range i.e., 7200-7400.

Our preferred equity exposure – small Overweight.

US Equities – valuation are being re-based

With the S&P index closing out the quarter at 3839, we surprisingly saw an up of 7.6% for the Quarter, due mainly to a good October – but the index was down 18.1% for the year – the worst year since 2008. December was a soft month and the expectation is that January will also be soft with some modest improvement in February and March as inflation starts to roll over.

The Fed’s rate hikes program to fight rising inflation is anticipated by the market to commence tapering, but the benefit to inflation numbers from lower goods prices (supply chains and inventory) are still being countered by sticky services inflation exacerbated by a very tight labour market. Don’t fight the Fed – we see no pivot yet.

Last year’s equities fall was mostly due to the macro revaluation effect of higher rates forcing the repricing of all assets. As we write, the steep inversion of the US 2’s 10’s bond pricing spread is ringing the recessionary bell and also the harbinger of lower equity earnings as a consequence of these rate rises. The US equity market is still yet to price this into forecast corporate earnings and hence valuations (PEs are at high 18X).

Last year Value Beat Growth, Equal Weight beat Market Cap weight and Low Volatility beat High Beta. We expect more of the same for the next quarter. One bright spot of late, has been the topping out of and then marginal weakness of the USD (down 9% from the peak). This should help large components of the S&P 500 in export earnings and ameliorate an anticipated (currently shallow) domestic recession.

The rewards are matched by risks. Again, we will see how this quarter plays out. Neutral.

EU Equities – still cheap, let’s not get excited

It’s all a matter of when you put a ruler through the market. The S&P Europe 350 benchmark shed 4% in the final month to finish 2022 with a -10.6% total return for the year – but the quarter was up 9.8%. Twelve of sixteen countries contributed negatively to pan-European equity returns last year. In spite of the turmoil, the U.K. market was the brightest spot, contributing +0.33%. A proverbial straw hat in winter. Denmark punched above its weight with the second-best contribution, while Germany was a major drag, subtracting 2.1% from the S&P Europe 350.

The deep discount of the European market vs. the US finally saw some pay-off over the year, with Euro equity markets outperforming the US. This gain will be limited as the European market is structurally more cyclical and generates a lower return on equity than the US – so should be priced at a discount.

Equity market Investors now seem happy to discount the Ukraine effect – whether this is wise is a moot point. Gas prices are now at pre-invasion levels and recently released German factory orders point to a potential bottoming. The ECB is still normalising rates but cannot move up much from here until economic activity is far more robust across the broader Euro landscape. This is along standing structural issue of the EU. Despite valuation attraction, we struggle to allocate more risk to this market.

Whilst the EU is still cheap to the US, we remain Neutral.

EM Equities – it’s all about China

For the year past, China, Taiwan and Korea all dragged on returns (-17%, -19% and -25% respectively). They comprise some 55% of the MSCI EM Index. India was the bright spot, posting its 7th consecutive year of positive returns (+5.8%).

The EM story should be an attractive one. With the USD backing off, solid economic growth, robust commodity prices, attractive domestic interest rate structures, etc – it’s all good then? Not quite. China still looms as the big unknown. The market is anticipating a major domestic economic lift due to the reopening trade, especially around Lunar New Year celebrations, but this view is currently counterbalanced by a rampant Covid story, supply issues as a consequence and a structurally impaired property sector. Recent comments on the Taiwan “situation” and a “Max” Xi Jinping effect have also worked to temper allocator enthusiasm.

EM outlook will be dominated by China. With such uncertainty we reduce our weighting to a slight Negative.

Property – value starting to build

Having endured the dislocation caused by of the health crisis, rising interest rates and inflation, the REITs benchmark was down -20.5% over CY22, significantly underperforming the broader equity market benchmark.

We remain cautious as the impact of interest rate rises continue to flow through to consumers, renters, the balance sheets of listed REITs and cap rates. Thematically, listed players are looking to reduce gearing. This will happen through divestments and dilutionary capital raisings. Despite the attractions of Property as a real asset in an inflationary world, we expect the Property sector to remain sluggish in the near term.

Valuations are now significantly cheaper but prospects are uneven, we retain our Neutral setting heading into the following quarter.

Alternatives:

Gold – no pressure

Gold has served as a good store of value/hedge during the volatility of 2022. Gold historically has moved in the opposite direction to the US dollar. With the anticipation of a lower US dollar/interest rates over the year we anticipate Gold to benefit from this view. Continued Fiat currency debasement will also support and abetted by Crypto failing as a risk hedge. We retain our Neutral position on gold.

Hedge Funds – right vehicle required

Given the disparate range of funds and styles, we need to ensure we are in the right vehicle which has proven to be challenging over the turbulent year of 2022. We believe other asset classes now present better risk-reward hence we move to a slight Negative on Hedge Funds. Current preference is to Trend following strategies.

Infrastructure – inflation protected

Infrastructure rebounded strongly over the December quarter and returned +11.0%, ending CY22 flat measured in USD terms. Many infrastructure companies have an earnings link to inflation in their operating models. This means the effects on asset valuations and cash flows from changes in inflation can be ameliorated. As interest rates level out, we expect further confidence/support for the sector. We retain our Neutral allocation.

Private Equity – valuation correction to fall through

We adjust our view to a slight Negative for Private Equity, as we expect the rolling re-valuation of private assets to move closer to those in public markets and this will soon be reflected in posted returns. It has been a “Crowded Trade”, but longer-term PE is moving to a more substantial core holding in portfolios, but with liquidity consequences.

Fixed Income:

Government Credit – bonds are back in town

We increase our allocation to Fixed income – Government, with the view the class will make a comeback after experiencing an “annus horribilis” in 2022.

We are now rewarded on an out-right yield basis of 4.05% in 10-year AGBs.

As we are increasingly confident that inflation has peaked and short rates are close to their terminal level, we would expect yields to move lower during the year (albeit with volatility). As a result, the capital gain on longer term bonds will also add to the out-right running yield return and roll-down gains.

Providing investors with this return (both income and gain), leads to a legitimate justification to allocate duration bonds in the portfolio. As a result, we are seeing the resurgence in confidence in the traditional Balanced 60% / 40% (Equity / Bond) portfolio. This is now offering a far more attractive return than this time 12 months ago.

Traditional 60 / 40 Portfolio US Total Return Index

Source: BCA Research

We favour a lift in our government bond allocation by 0.5+ for the following quarter, in part restricted by ‘where do we take our allocation from’ to allocate higher.

Credit

Credit remains attractive, largely because it’s in ‘good shape’.

Domestically, Australian consumers are still spending as unemployment remains at record lows. Newspapers are sensationally reminding us that over-indebted households are struggling under the increased costs of their mortgages. There will be some stress, but believe that consumer defaults will remain at manageable levels.

Corporate default rates also continue to be at historic lows. A prospective recession may not occur locally and Corporates here are in good share at this time in the credit cycle. The REIT sub-sector is perhaps one to stay away from. Preference is also away from the expensive MTB Hybrids to other Bank securities.

Despite credit being currently in good shape, we expect some volatility will lead to a widening in credit margins in times ahead, as the impact of interest rate rises start hitting the economy with uneven impact.

In the US, we expect corporate earnings downgrades and continuing tightening in US bank lending standards. Credit spreads have priced in a recession outcome more than equity markets. Default rates are now at an implied 6%, but the usual credit cycle sees defaults rise up to 10%. We are more comfortable in the Australian vs US Credit markets for a balance of risk and return. Our preference is also for Investment Grade Credit over High Yield.

We retain our Neutral call on Credit, for the following quarter.

For further information and guidance, please contact us here.

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