Brendan Moore, Author at Carnbrea

Quarterly Market Update – Q1 2023

Posted on 05/01/2023 by Brendan Moore

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.

DAA Calls enclosed proposed are for general investment purposes. Please discuss with Carnbrea the suitability of any recommendation to portfolios and the context of client SAA construct, holdings, return analysis and tax consideration. This document has been prepared and issued by Carnbrea & Co Limited ABN 33 004 739 655 (‘Carnbrea’), Australian Financial Services Licence No 233763. Any advice included in this document is general in nature and does not take into account your objectives, financial situation or needs. Before acting on the advice, you should consider whether it’s appropriate to you. If a product we recommend has a Product Disclosure Statement (PDS), you should read it before making a decision. Past performance is not a reliable indicator of future performance. Derivatives are leveraged products which means gains and losses are magnified and you may lose substantially more than your initial investment. We do not endorse any information from research providers that we provide to you, unless we specifically say so.

Quarterly Market Update – Q4 2022

Posted on 01/10/2022 by Brendan Moore

December Quarter 2022

Market and Asset Class Views

Overall

There is a market saying “If its grey – stay away”. In our DAA table opposite we have a lot more grey than usual. This means we are largely playing to our long-term SAA settings as we now sit in a fast-moving market, which for DAA can be problematic. So, we focus on the long term. Notwithstanding this, advice to clients inside asset classes is to be more defensive in sector holdings with a major tilt to Quality. Weaker stories in equity and credit holdings will come under pressure. Duration and yield in Government and Investment Grade are now presenting a viable alternative to the previously dominant ‘There is no alternative – TINA’ story.

The strong USD and associated global market impacts is the dominant theme across our current thinking. This one driver will determine where markets play out this quarter. As the $A heads lower to 60c we do advise clients to consider to start increasing hedge positions against $US assets.

Portfolio Resilience is key.

Australian Equities – starting to show value?

Amazingly the quarter just passed was positive with a +0.45% return. Notably the ASX MidCap 50 was up +5.2%. September was a horrible month with Utilities, Real Estate and Industrial sectors continuing the poor quarter and with Energy and Healthcare providing some positive performance.

The question is now being asked as to whether the bulk of the bad news has been already priced in? We have several tailwinds here: a resilient consumer – to date – in the face of rising interest rates and cost of living supported by record low unemployment and higher wages. Despite the petrol tax relief ending, energy price pressures on the back of a weaker oil price have ameliorated.

Overall, the Australian market is one of the cleaner stories globally. Preference is for Quality over Growth and large cap over small. Whilst the China story presents a binary outcome the expectation of a “muddle through” and low $A should support markets.

Almost a modest overweight, but not quite yet – Neutral.

US Equities – valuation matters

The Fed’s continuation of rate hikes to fight rising inflation, economic growth and geopolitical concerns, and a soaring U.S. dollar combined to drive losses across US equities in the quarter. Technically the S&P 500 is weak, breaking its 3-year moving average with the next level of technical support back at 3200 which is the 6-year moving average.

Current EPS for 2023 for the S&P 500 is $231 (Factset) and the forward PE stands at 15.2x. This is “cheap” based on recent history, whether this represents good value depends on the answers to the following questions:

What impact will the strong “wrecking-ball” USD have on US domiciled multinationals through softer earnings?
Apple’s sales numbers point to even the mighty are facing a softer market. All the majors or is it Apple specific?
Energy price movement as higher prices will act as a tax or boost to consumer spend.
US employment remains robust and recent consumer spending remains elevated.
US Housing with mortgage rates over 6% will act as a brake.

A better price entry point but, we will see how this quarter plays out – Neutral.

EU Equities – cheap but for a lot of reasons

German inflation accelerated during the quarter with the CPI index rising from 8.8% to 10.90% year on year. At the core was energy costs jumping 43.9% and food 18.7%.

Despite EU Equities being cheap, key consumer demand indicators reflect concerns around elevated inflation, energy supply uncertainty (Nord Stream fractures haven’t helped) and the unresolved geopolitical conflict in Ukraine. European listed real estate was down 17.1% for the Quarter and a whopping 42.0% for the 12 months.

We cannot pass without commenting on the UK, as recent events point to the perils of politics and where the bond vigilantes emerged as victors. Given the prevailing confusion playing out through currency and bond markets, the UK equity market remains a no-go zone.

Whilst the EU is cheap and we are expecting a bounce back at some point, we remain Neutral.

EM Equities – pick your winners carefully

Depreciation of the Chinese yuan sees its onshore value at the lowest point since the GFC – i.e., 2008. This reflects a strong USD, Covid restrictions, divergent interest rate policies and low domestic CPI at 2.5%. The bottom line here, is that weak domestic demand is limiting Chinese firms’ ability to pass on higher prices. Domestic demand remains subdued and industrial profit growth contracted for the second consecutive month in August, falling 2.1% in the first eight months of the year. Policymakers will continue to ease domestic policy to reflate the economy and the PBoC will probably cut rates further.

Elsewhere, global semiconductor demand has fallen back in a post Covid world and improved inventories and thus will keep Taiwanese and South Korean markets under pressure. Brazil has been somewhat a star with strong GDP and interest rate dynamics and Latin markets were up 3.6% over the Quarter as Argentina starred at +57.3%. India remains attractive but flows by Australian investors into this market remains low.

EM remains a mixed bag and with a strong USD and the China story providing a lot of the headwinds, we retain a Neutral stance.

Property – disciplined allocation required

The listed property sector has been a big asset underperformer. The strong rise in bond yields has been the main culprit as this is the main determinant in deciding what rate to price commercial real estate at. Coupled with the fear of a recession we saw the S&P ASX 200 AREIT index slipping -6.7% for the quarter cementing a -21.5% for the 12-month period. Whist property is often flagged as being Inflation proof the market is struggling with the sheer rapidity and magnitude of rate rises.

There is a plethora of competing forces here i.e., replacement cost, occupancy forecasts, post Covid office and retail trends, supply factors, immigration, rising interest rates etc. Investors should retain preference for ‘A’ grade properties..

We see property as an attractive longer term asset class. Until we have a clear view on the level of terminal Interest rates, we remain defensive and hence Neutral.

Alternatives:

Gold – under pressure, be patient

Gold has struggled in the face of the all- powerful USD. Speculation is that there has been some central banks selling as a funding mechanism to support FX activity through currency support. We retain for its innate ability to be a strong performer on a weaker USD and role in geo-political insurance.

Hedge Funds – right environment requires right vehicle

Given the heading captures a disparate range of funds and styles, we need to ensure we are in the right vehicles with the right themes. Preference is to market neutral funds, long-short strategies with associated skills and track records as well as commodity and trend following strategies.

Infrastructure – good run now crimped

Whilst we have seen a flood of money into Infrastructure with CPI structurally adjusting revenue streams, the sharp rise in rates across heavy geared balance sheets has seen a quarter of underperformance.

Private Equity – gravity will impose

At some point PE valuations will need to address the price developments in the listed market. We highlighted this last quarter and now re-emphasise that PE valuations will be brought down by listed market comparable. We down weight our exposure to PE to Neutral.

Fixed Income:

Government Credit – the Rate-hikers guide to the galaxy

We concluded our last quarterly with ‘Government bonds become more attractive, currently paying a 3.25% yield up from a 1.5% yield 12 months ago.’

The same 10-year Australian government bonds are now paying 3.9% a quarter later. In hindsight we leant back into duration a little too early pressure and rising interest rates.

We are now better rewarded with this level of return and in this economic environment we now see reason to reduce our negative view on duration bonds and move the portfolio setting back to neutral. This infers that our view is that we will start to see a peak in inflation heading into the start of the new year and the potential for yields to drop thereafter.

September saw the Fed deliver its third consecutive 75bp rate increase and revised its projections to show that another 125bps of rate hikes are likely this year and that policy will continue to tighten in 2023.

Fed Funds Rate Expectation

Source: BCA Research

Elsewhere, the Bank of England and Swiss National Bank lifted rates by 50bps and 75bps, respectively. Not to mention rate increases in Norway, South Africa, Indonesia, the Philippines, and Taiwan. Global financial markets responded poorly to this synchronised tightening with equities selling off and bond yields rising across the world.

Move to Neutral, yields are now attractive but CBs are not done yet.

Credit

Credit has been a favourable and rewarding asset class to be invested over the recent quarters and given the greater uncertainty in global markets a wider range of outcomes are now emerging in credit markets.

A big driver of ‘credit health’ is the balance sheet that credit is being lent to. As we see rising costs (inflationary) and central bank responses (lifting interest rates) both corporate and consumer balances sheets are tightening. This means lower quality credit opportunities should be avoided as greater risk is present.

Greater individual risk (idiosyncratic) is also occurring; therefore, loan documentation and capital structures need extra diligence to ensure the full understanding of the investments particularly if we see economic growth decline.

Overall, we retain our neutral view on credit with a vigilant ‘risk increasing’ bias.

For further information and guidance, please contact us here.

Quarterly Market Update – Q3 2022

Posted on 05/07/2022 by Brendan Moore

September Quarter 2022

Market and Asset Class Views

Australian Equities:

Over the June quarter, the ASX200 finally succumbed to the reality of increasing inflation and subsequent need for markedly higher interest rates. The index traded to a low of – 14.2%, during the quarter, before closing down 12.22% for the period and closed out at -6.78% for the 2021/22 financial year. Paradoxically, Intra-quarter the index had traded to within 0.5% of its record high of August 2021.

The “behind the curve” RBA finally acknowledged that inflation was an issue and responded in quick succession, by lifting interest rates by 0.50% to 0.85% in their June meeting. This was first consecutive hike since 2010 and the biggest increase since February 2000, albeit prevailing rates then were 5.5%. Governor Lowe conceded that further increases were likely as he flagged that CPI could peak at 7%. Economists and the market expect multiple hikes to come, with expectations of circa 2.5% by year end.

With all the major banks passing on the full rate hike to their mortgages, domestic facing risk assets suffered as investor fretted that this would lead to a slowdown in mortgage lending and increase in bad debts as the economy slows. A number of strategists have cut their GDP estimates for CY22 to sub 3% versus previous 3.5% and to circa 1.8% for CY23.

The upcoming June half-year reporting season is expected to see solid earnings growth for the year of approximately 24%, however the subsequent outlook for FY23 is anaemic at around 2% EPS growth. The market decline has seen valuations retreat to a forward PE ratio of around 14x. We remain alert to the forward guidance from company management during the results period for clarity on forward earnings.

The risk-off environment has driven the AUD lower with a corresponding lift in in the USD hitting 20-year highs. With the RBA removing the bond yield control curve and lifting rates contrary to their previous 2024-time horizon has seen a loss in trust by international investors in the AUD bond market, resulting in lower AUD demand or a higher premium. We expect a solid terms of trade, combined with rising local rates would see AUD drift higher over the following quarter to the low 70’s.

We move to a Neutral weight for the September quarter.

US Equities:

A turbulent quarter saw the S&P 500 trade into bear market territory, falling at worst -23.5% from its record high in early January. The likelihood of sustained interest rate hikes over the balance of this year dented investor enthusiasm for risk assets. For the quarter the index fell 8.38% and -16% for the June half, the worst first half of the year since 1970. The Nasdaq Composite ended H1 down 30%, the largest drawdown since 2002, in the aftermath of the dot.com collapse.

The Federal Reserve lifted interest rates again in their June meeting by 0.75% to range 1.50-1.75%, acknowledging they will need to be more aggressive to tame soaring inflation. The hike was the biggest since 1994 and their “dot-plot” forecast for rates is now 3.4% by year end versus 1.9% forecast in March. They revised up their expectation for inflation to 5.2% in CY22, as the latest May actual CPI data printed at +8.6%, the highest level since December 1981. The Fed is however, still chasing the market.

The response in equity markets was brutal, as investor concerns of economic slowdown and reduced earnings hit sentiment. We wrote in our May CiN-sights of the likelihood of “More Shocks” for risk assets; we now have the inflation plus the interest rate shock, the challenge for central banks is to avoid the “recession shock”.

The Q2 reporting season is underway with consensus EPS growth estimate of 4.3% YoY, which has been revised down from 6% at the end of March. Whilst the one year forward PE ratio has dropped to circa 15.8x, which is below both the 5 and 10-year average, focus remains the commentary from management on trading conditions and the economic outlook.

We retain our Neutral weighting.

EU Equities:

The Stoxx600 fell 8.13% during the June quarter, as ongoing supply chain issues and the energy crisis courtesy of the war in Ukraine hit sentiment. Inflation across the region contained to spike, with the EU zone release at record highs and the UK at the highest since 1982.

The ever-dovish ECB has finally conceded inflation is a problem, announcing it will lift interest rates by at least 0.25% in its July meeting. This coincided with a lift in their forecast for CY22 CPI to 6.8% from 5.1% in March. The latest May CPI hit 8.1% YoY, a record high for the region and a fourfold increase over the last 12 months. They have also slashed their growth forecast for CY22 to 2.8%, down from previous 3.7%, as 1Q22 growth was a slight beat at +0.6% quarter on quarter. As much as the Fed is behind the curve, the ECB is behind even further.

Conversely in the UK, economic growth stalled as the latest April GDP data reported a fall of -0.3% MoM for the second successive month of contraction. Coupled with a continuing spike in inflation to 9.1% the highest level in 40 years, the more pragmatic central bank (the BoE) has responded with a fifth consecutive hike in interest rates to 1.25%. This cost-of-living surge has also seen the UK Government introduce a further £15bil support package for households which will be partially funded by a 25% windfall tax on energy companies. The latter is expected to raise £5bil over the next year.

Earnings growth for the Stoxx600 are expected to slow significantly in 2Q22 to circa 6% YoY versus +35% in Q1. The retreat in the index has seen the forward valuation for the market fall to a PE of 12x, its lowest level in a year. However, the outlook remains challenged as the impact of the energy crisis continues with the sanctions on Russian energy imports pushing fuel prices to record peaks. These ongoing cost pressures across the region have led to an increase in industrial disputes, as workers across a number of industries take strike action as wage growth fails to keep up with the elevated inflation readings.

We retain our Neutral weighting.

EM Equities:

The MSCI EM index lost 3.30% over the last three months, better than their developed market counterpart.

Helped by more stimulatory measures, investor sentiment in China has been improving which coincides with the ease of Covid19 restrictions. There are also signs that authorities would ease up on regulating internet platform companies and tech giants. China has intensified efforts to stimulate growth, with measures including tax cuts, loosening of vehicle sales quotas and an acceleration of infrastructure spending. However, the zero-covid policy still remains, underlining that the economic activity continues to face the risk of future lockdowns. Moreover, the property market slump is dampening local government finances. Thus, constraints at the local government level will keep the recovery modest. We therefore maintain a neutral view to Chinese equities.

Taiwan Manufacturing PMI fell in May and output shrank for the second straight month, due to material shortages and softer demand amid Covid restriction in China. Similarly, South Korea PMI also declined. As major semiconductor manufacturers, there are near-term risks for both regions. However, the long-term drivers remain strong amid a shift towards semiconductor intensive areas of electric vehicles and artificial intelligence.

Indian and Indonesian equities were the region’s worst performers after strong gains from previous quarter. Some EM regions like Latin America held up well during the quarter thanks to outlook for commodities.

To combat continued inflation, many EM countries have continued their rate hiking cycle. The Reserve Bank of India raised its key repo rate by 50 bps to 4.9% during its June meeting, after May’s surprise off-cycle hike. The Central Bank of Brazil increased the Selic rate by 50bps to 13.25% in June, bringing borrowing costs to the highest since 2016. It was the 11^th consecutive interest rate hike since it started tightening.

A stronger US dollar, as a result of the Fed rising cycle and geopolitical tensions, will hurt Emerging markets in two ways. Firstly, capital inflows will reverse as international monies return to the safer confines of the US. Secondly, higher US interest rates will make it more expensive for EM borrowers to obtain financing and pay down their existing debts. Counterbalancing attractive valuations in emerging markets, EM countries are vulnerable to tighter US financial conditions and falls in commodity prices.

We maintain a Neutral weight on EM equities.

Property:

The performance of A-REITs has continued to trend lower over the June quarter, down 17.68% and underperforming the broader market. So far in 2022, A-REITs as measured by the S&P ASX200 A-REITs index posted a loss of 23.53% in comparison to the broader ASX200 which is down 9.93% CYTD.

Latest market data points to a weakening of key economic fundamentals. Business and consumer confidence declined in May. NAB forecasts negative retail trade growth given a combination of cost-of-living pressures and expectant interest rate hikes.

In the short to medium term, we see interest rate risks persisting for A-REITs leading to increasing cost of debt, cap rate expansion and downward asset revaluation pressure.

The property sector has experienced significant repricing during the recent valuation pull-back. With further rate hikes in sight, in line with other risk assets, we retain our Neutral call on the listed property sector.

Alternatives:

Private Equity

Private Equity is an Equity market and it is subject to the same economic forces as its listed counterpart. Private equity normally has a valuation lag to listed markets due to its less frequent pricing cycle. So, if we regard listed market valuation trends as a key determinant in unlisted asset future performance, the resetting of PEs, growth expectations etc. will flow through to private markets. We therefore down-weight the allocation to Private Equity to Neutral for the interim.

Gold

The Russian/ Ukraine conversation has now been over-taken by inflation to become the top market risk to gold. This has led to some downward pressure on Gold. While historically gold has not been the best inflation hedge compared to other assets such as infrastructure, it does provide insurance against major equity downturns and currency debasements. We are mindful that gold is close to its highest real price in 800 years. However, we are comfortable to continue hold gold in portfolios. But at a Neutral setting.

Hedge Funds

Our house view is that hedge funds are to add value during times of volatility has proven correct with the Dow Jones Credit Suisse Hedge Fund Index posting a positive quarterly return in this challenging environment. We specifically note that each hedge fund by nature is different, therefore fund manager selection and ongoing monitoring is crucial. Overall, we continue to hold our mild positive stance for the upcoming quarter, with the view that hedge funds offer low-correlated returns and provide a diversification effect, enhancing portfolio’s risk-adjusted returns.

Infrastructure

Infrastructure is currently our preferred asset providing inflation protection in a portfolio. Unlike commodities and real estate, which also provide inflation hedge to varying degrees, and at different times, infrastructure assets are more nuanced in that they are often essential services with regulated inflation protection characteristics. We lean to the defensive characteristics of infrastructure in the current market conditions.

We re-enforce our call that inflation linked infrastructure is a positive 2 call, for the following quarter.

Fixed Income:

Government Bond

Back in May, US President Joe Biden announced his top domestic focus was inflation and market data suggested the pace of inflation was starting to slow. However, the latest numbers released in June have indicated inflation is running hotter than before. The Federal Reserve responded with a 75-basis point rate hike, the largest single-meeting hike increase since 1994. US Fed Chairman Powell opined that “inflation is far too high” and there seemed to be agreement among the committee that similar sized rate increases “should be on the table for the next couple of meetings”. Market expects that rates will reach 3.25%-3.5% by the end of 2022.

US Inflation Expectations Spike Higher

Source: BCA Research

The countervailing view in the FI market has been that the aggressive rate setting regime will cause a hard landing and the FED will be actually cutting rates by late 2023. The bond market has started pricing this in and we have seen rates 2 year plus out correcting for this view.

With a similar view, over the last two quarters we have been gradually reducing our negative view on government bonds. Whilst we have seen a major bond market sell-off, we had started to “lean-in” by adding more duration-based FI back into the portfolio. The selloff has been bigger that our last Quarter’s view but recent market action has seen a reasonable recovery.

Government bonds are now offering attractive yields, currently paying 3.00- 3.25% up from 1.52% 12 months ago. We retain slight Underweight view on Government bonds.

10 Year Government Bond Yield

Source: S&P Capital IQ

Credit

Within the credit market we are starting to observe a strong divergence in credits in terms of quality and risk. Overall credit is becoming more challenging than 12 months ago. While some segments still offer superior returns, there are increased risks inherent in certain areas that warrant deeper analysis and monitoring.

Key concerns lie around the flow through effect from the increased inflationary pressures and rising interest rates, especially credits reliant on the consumers back pocket. Weaker demand in the broader economy which will hit businesses (and borrowers) in the months to come.

Globally, Business profits have remained relatively resilient, and credit defaults have stayed near all time-lows. However, with higher input costs due to supply and labour shortages, higher financing cost from rising interest rates, corporate health is likely to begin to deteriorate. We therefore continue to hold Neutral allocation to Credit.

Robust risk management and asset selection is required in credit investing. We are steering away from property, specifically construction related property. Our preference is towards asset backed structures with low loan to value ratios, credit protection and enhancements and to those secured with real assets.

For further information and guidance, please contact us here.

The Interest Rate Tightrope

Posted on 01/06/2022 by Brendan Moore

June 2022 Monthly CiN-sights

Major global equity markets ended flat after a turbulent May trading, bouncing off their intra-month lows as hopes inflation may have peaked boosted confidence. Whilst no surprise that central banks will continue to lift interest rates, this has seen valuations retreat, prompting some investors back into risk assets. During the month the S&P500 and the Nasdaq Composite both snapped a seven week losing streak, the longest since 2001. The S&P500 briefly flirted with bear market territory before closing the month unchanged, off 13.9% from its peak. The ASX200 was down 3% for the month.

The Federal Election saw the Labor (ALP) party return to power for the first time in nearly a decade. At the time of writing they are set to govern with a majority, likely winning 77 seats. A majority will potentially provide the new Government with more fiscal flexibility in the face of monetary policy tightening. With inflation spiking, one focus of the election campaign was wages to address the cost-of-living squeeze, with the ALP supporting upward adjustments to combat these pressures on households. Their agenda has also signalled greater urgency in the change of Australia’s climate policy, which is supportive for our Carnbrea ESG model portfolio.

Whether or not we have seen the peak in inflation, expect to see global Central banks continue to tighten monetary policy to combat the current multi-decade CPI highs. Unfortunately, these policy makers have been woefully behind the curve on the heightened global inflationary pressures and only now are being forced to react. The US Federal Reserve has conceded it will have to continue to take aggressive interest rate action to cool inflation, but their challenge with this policy is not causing a growth collapse. Economists expect consecutive hikes over the remaining five FOMC meetings this year, with some forecasting +0.5% at each meeting.

Even the dovish European ECB is expected to lift rates in coming months for the first time in a decade, as inflation prints at over three times their target rate and the region’s largest economy Germany, recorded an astounding 33.5% YoY increase in the April producer price index. Even excluding the volatile energy prices courtesy of Russian sanctions, the index still rose 16.3%. In the UK, the BOE seems to have been the most pragmatic with four consecutive hikes and the Governor stating that inflation could spike to 10%. The latest CPI data in the UK hit a 40 year peak of 9.0% YoY.

In Australia, the RBA’s May 0.25% increase in the official cash rate was the first hike since November 2010. Similar to their global peers, the board now expects more will follow as they lift their 2022 domestic inflation estimate to 6% and 4.75% for headline and core respectively. Most forecasters see interest rates at 1.5% by year end and circa 2.25% in 2023, which has led to GDP growth expectations for CY23 being pared back to around 2.25% from previous 2.5-2.75%. As global economic growth expectations have dimmed, not surprisingly the volatility has spilled over to the AUD. Having rallied to a 2022 high of 0.76 in early April as commodity prices spiked, the currency came under pressure through May as forecasters cut their global GDP estimates, particularly for China, our largest trading partner. Estimates for China’s CY22 growth have been slashed to approx. 4.0% from 5.0% as strict Covid lockdown restrictions have curbed activity, with one economist cutting their expectation to only 3% growth versus the official government estimate of 5.5%. This slowdown was evidenced by a surprise fall of 2.9% YoY in April industrial production, the first decline since March 2020. Combined with an understandable slump in retail sales and the ongoing concerns on the domestic property market, the PBOC unlike other central banks, cut its 5 year prime rate by 15bps to 4.45% to stimulate activity. The read through to global supply chains remains challenging.

AUD/USD Rate Over the Past 6 Months

As the US Q1 reporting season comes to a close, we have seen solid earnings growth for S&P500 companies of +9.2%. However, the commentary from several management briefings was weaker guidance into Q2, noticeably from some of the mega-tech names plus a highly challenging cost environment as seen with behemoth retailer Walmart (and Target). Retailers are experiencing a wave of pressures with fuel, staff and inventory costs all ratcheting higher in an environment where there is an inherent risk to consumer discretionary spending, courtesy of the income shock consequence of inflation. Strategists in the US have continued to reduce their year-end target for the S&P500, with estimates now in a range of 4,000 to 4,200. One analyst flagging that a recession in 2023 could see the index fall to 3,400.

As global equity markets reprice to now hawkish central banks, the continuing priority for investors is appropriate valuations in this period of rampant inflation and rising interest rates, coupled with the threat of a global growth crunch. Forward PE valuations have retraced, with the ASX200 now trading on circa 15.0x for FY23, albeit with a muted earnings growth outlook. In the US the S&P500 PE ratio has fallen to 17.0x, which is now below its 5 and 10 year average. We retain our current neutral weighting to US and EU equities and slight overweight to AU, which will be reviewed in our upcoming September quarter asset allocation due for release on July 1^st.

Global Equities are More Attractively Valued After the Recent Sell-off

For further information and guidance, please contact us here.

Disclaimer

This information is provided by Carnbrea & Co Limited ABN 33 004 739 655, Australian Financial Services Licence No. 233763. Any advice included in this document is general in nature and does not take into account your objectives, financial situation or needs. Before acting on the advice, you should consider whether it is appropriate to you. If a product we recommend has a Product Disclosure Statement (PDS) or a Prospectus, you should read it before making a decision. Past performance is not a reliable indicator of future performance. Derivatives are leveraged products which means gains and losses are magnified and you may lose substantially more than your initial investment. We do not endorse any information from research providers that we provide to you, unless we specifically say so.

More Shocks?

Posted on 02/05/2022 by Brendan Moore

May 2022 Monthly CiN-sights

Global equity markets struggled again in April, following on from a volatile March quarter where a number of macro shocks impacted investor sentiment. These shocks of geopolitical events, commodity/energy price spikes, surging inflation and the resultant interest rate response, health fears with ongoing Covid lockdowns in China (impact on supply-chains) and the cost-of-living pressures, saw all major US indices fall. The Nasdaq Composite index recorded its worst month since 2008, falling 13.3% and the S&P500 declined 8.8%. The ASX200 recovered from its low point of -3.3% intra-month to end down only 0.86%.

Domestically, the Government released their 2022/23 Federal Budget which not surprisingly saw a major focus on the current cost of living challenges with a number of fiscal stimulus measures announced. A halving of the fuel excise (22.1c per litre) for 6 months, an extra $420 tax offset for low and middle income earners and a $250 one-off cash payment for eligible social security recipients were the key items for households. More broadly, the focus on infrastructure spending continued with an additional $17.9bil concentrated on roads and rail plus a new home guarantee scheme worth $8.6bil.

With the Prime Minister, Scott Morrison subsequently calling a General Election for May 21st, this will be an interesting time for the ASX as inflation tensions have continued to pressure the RBA to respond to these pricing issues with interest rate hikes. The March quarter CPI release saw YoY headline inflation at 5.1% and core at 3.7%, the highest levels since 2001 and 2009 respectively. With the core CPI number now sitting above the RBA’s 2 to 3% target range, a number of economists forecast a rise in their May 3rd meeting, which would be the first hike since November 2010. The tone in the RBA April meeting was more hawkish as they acknowledged inflation will lift over coming quarters and they have removed their wording of being “patient” with rates.

Australia CPI, Trimmed Mean and Weighted Median, Annual Movement,%

In the US, the Federal Reserve has raised rates for the first time since 2018 as inflation spiked. The latest March headline inflation number rose to its highest YoY level of 8.5% since December 1981, albeit the core monthly number which excludes the volatile food and energy components was a slight beat on expectations. The previous optimistic narrative of “transitory inflation” is gone and with the current elevated CPI levels impacting household finances, economists are now asking can the FED actually manage to deliver a soft landing for the economy. Even with wages growth running at circa 5.5%, pay checks are being eroded with the elevated inflation reading and highlights the risk to consumer spending. The market consensus is rate hikes at each of the remaining six FOMC meetings in 2022, with the year-end Fed Funds rate estimated at a minimum of 2.5% and above 3.0% into 2023.

Is the next shock for markets a possible US recession in 2023? Coupled with a potential fiscal shock as government’s remove the unprecedented pandemic stimulus programs – some commentators have started to flag this threat is escalating. One major global forecaster now expects the US economy will record negative growth in the latter part of next year. Bond markets have reacted to the expected move by central banks with the US and AU 10 year yields selling off to the highest levels in four and eight years respectively. As rates rise across the curve the challenge for corporates will be this translating into higher borrowing costs, combined with a possible slowing economic growth outlook. For investors, it will be the appropriate equity valuations especially for the high multiple growth names.

Bond Yields Movement over Past 5 Years,%

The US 1Q22 corporate reporting season is underway and has recorded positive growth. To date we have seen more EPS beats versus analyst estimates, but some of the mega-Tech names have either missed expectations and/or have given weaker guidance for Q2, pressuring US equity indices. For the quarter, the current estimate is for a 7% YoY earnings increase. The CEO of JPMorgan Chase noted in their results commentary that the economic growth outlook for Q2 and Q3 remains intact with healthy corporate and consumer cash levels, however beyond that he flagged increasing challenges as the FED responds with rate hikes to combat soaring inflation.

In our latest June quarterly outlook we reduced our equity weighting to both the US and EU markets, whilst retaining a mild overweight to AU. We remain comfortable with this exposure given the composition of the respective indices – the broad US S&P500 is more heavily focused to tech names, whereas the ASX200 with its concentrated focus to resources, energy and domestic banks, is supportive for the local market. Additionally, the government’s ongoing commitment to infrastructure spending validates our overweight stance in this asset class.

For further information and guidance, please contact us here.

Disclaimer

Quarterly Market Update – Q2 2022

Posted on 01/04/2022 by Brendan Moore

June Quarter 2022

Market and Asset Class Views

Australian Equities:

In comparison to major global equity markets the ASX200 performed well over the March quarter, ending up 0.7%. Volatility increased during the period as investors factored in likely hikes in interest rates as inflation in many jurisdictions hit multi-decade highs. This was coupled with Russia’s invasion of the Ukraine lifting fears of commodity supply constraints, with price rises fuelling further inflation pressures and economic growth concerns (oil prices hit a 14 year high).

Domestic growth rebounded as we exited Covid lockdowns, with the latest GDP data for the December quarter reporting the best growth since 3Q20, at +3.4%. Household consumption was a major contributor, being the strongest in five quarters at +6.3%. Market economists continue to be optimistic, expecting GDP to be mid-4% for CY22 and circa 3.5% for CY23. Whilst higher inflation is a possible headwind for growth, this is anticipated to be offset by higher commodity prices and export volumes. The latter recorded an 8% increase to a record high of $49.25bil in the latest January release and the trade surplus printed the second highest on record.

The RBA again left interest rates unchanged at 0.1% in their March meeting, having announced in their previous meeting they would cease their bond buying (QE) on February 10^th. They see the global environment continuing to recover from the pandemic and the AU economy remaining resilient, however the war in the Ukraine is a major new source of uncertainty. Their updated economic estimates acknowledge inflation will increase more quickly than previously thought, with core CPI now expected to be at 3.25% by year end. The impact of the invasion of the Ukraine is a risk for further commodity price rises. Domestically they expect a robust economy, with GDP growth of 4.25% at year end, supported by unemployment at a current 14 year low and estimated to drop further to sub 4%. Governor Lowe did comment in a speech that it is a plausible scenario that rates could rise later in 2022. Most economists expect the RBA will hike rates this year, with a number expecting a move in June as inflation spikes on commodity price increases.

The December half reporting season concluded with a mixed scorecard. Whilst overall earnings were positive, this was mainly driven by the large cap sector, whereas small caps saw more earnings misses and thus full year downgrades. Supply chain issues and inflation were key themes cited by management, which present challenges into FY22/23 if we see economic conditions deteriorate. ASX200 EPS growth estimates for FY22 remain at circa 14%, however current FY23 expectations are only for a flat to slight rise in earnings.

The AUD hit a four-month high of 75.20 in late March as global commodity prices spiked on supply concerns, courtesy of the invasion of the Ukraine and sanctions imposed on Russia. The strength in the terms of trade is supportive of the current levels, as has been the recovery in global growth. The risk is a correction in that growth outlook if central banks struggle to contain the inflation run-up and tighten rates aggressively. We remain neutral on the AUD.

The FY23 Federal Budget saw further fiscal stimulus with the Treasury being a major beneficiary of rising commodity prices. In advance of an expected Federal Election in May, it was no surprise the government targeted assistance to the cost of living as inflationary pressures impact household finances. We stay alert to external shocks – the war in Ukraine, commodity prices, China lockdowns disrupting supply chains and bond yields, but believe the composition of the ASX200 with a strong resources and energy focus plus an accommodating rate environment for banks is supportive of the market.

We remain Overweight,

US Equities:

A volatile March quarter saw the S&P500 hit an all-time closing high of 4,796 in early January, then enter a technical correction falling at worst -13% as inflation spiked and expectations for interest rate hikes were aggressively raised, combined with the war in Ukraine. By quarter end the market had recovered some of this decline and ended down 4.95%, as hopes increased for a ceasefire in Ukraine and investors digested the Federal Reserve’s (FED) outlook for CY22 interest rates and inflation.

As inflation continued to spike and hit forty year highs, the consensus among economists increased to expect the FED would hike interest rates at all of their seven meetings over the remainder of CY22. The latest February inflation data printed at the highest level since 1982, with headline at +7.9% and core at +6.4% (YoY). The FED’s hawkish pivot in January was confirmed in their March meeting as the committee lifted rates by 0.25% (range 0.25-0.50%), the first increase since December 2018, highlighting they are acutely aware of the need to return the economy to price stability and anticipate ongoing increases in the target range will be appropriate. The so called dot-plot projection of Board member expectations has lifted to an estimate of 1.9% for the Fed funds rates by December, up from their previous 0.9%. The narrative has changed with Chairman Powell now saying rate hikes could become more frequent and aggressive in size. They raised their official estimate for CY22 core and headline inflation to 4.1% and 4.3% respectively and reduced their GDP forecast to 2.8% versus 4.0%. The latest GDP growth for 4Q21 was +6.9% QoQ and +5.7% for CY21.

A continuation of rising costs were again evident in the 4Q21 reporting season, with corporates across multiple industries flagging price pressures. This burden has spread from the ongoing supply-chain disrupted industries to strong wage expense in service industries, with a number of the major US banks flagging they expect circa double-digit expenses increase for CY22. The impact of the war in Ukraine and retaliatory sanctions against Russia are lifting concerns on supply chain disruptions beyond just the energy sector, given the two countries combined are major exporters of numerous commodities; such as wheat, lumber, fertiliser, refined copper, aluminium and processed nickel. At a consumer level, the oil price shock has pushed the average US vehicle gas price to its highest nominal price on record.

The 4Q21 results outcome was a beat at +31% earnings growth and the first time in 12 years that has seen four consecutive quarters above 30% growth. This drove the overall market to historic peaks and saw Apple Inc. become the first US company to hit $3.0 trillion in market value. The consensus for 1Q22 EPS growth is currently +5% YoY and for CY22 +9.1%, with the bears closer to a 5% estimate for the latter. This year’s more muted outlook has seen equity strategists downgrade their year-end target for the S&P500 to around 4,700 (with one conservative estimate at 4,000).

The outlook has become more challenged as central banks grapple to control spiking inflation, without suffocating economic growth or causing a recession. As we have opined previously, the FED unfortunately has a poor record of managing a sustained run-up in inflation.

We move to a Neutral weight.

EU Equities:

Having hit an all-time high at the beginning of January, the European Stoxx600 suffered a technical correction over the course of the March quarter. Increased geopolitical tensions, rumours of Russian aggression against the Ukraine and their subsequent invasion on February 24^th caused markets to fall 6.5% over the period. Europe’s trading relationship with both countries, particularly in commodities, combined with concerns on elevated inflation and ongoing Covid outbreaks caused investors to lower risk asset exposure.

The war in Ukraine has overshadowed a solid recovery in economic growth across the region. The EU recorded 5.3% GDP growth in CY21, the revival in activity beating both the ECB and the IMF’s 5% expectation. Likewise, in the UK the latest data for January showed the strongest growth in seven months, with GDP now 0.8% above pre-pandemic levels. The EU’s reliance on both nations for significant commodity imports has raised questions on the both inflation and the growth outlook. Russia provides the EU with approximately 40% of its natural gas and 25% of its oil imports, the prices of which have both spiked. The Ukraine exports of raw materials and agricultural products to the region have grown 50% in Euro terms over the last 5 years. The crisis has increased concerns on the outlook for CY22, with market economists cutting their GDP estimates and the European central bank lowering their forecast to 3.7% growth vs. previous 4.2%.

As globally, EU inflation has continued to rise and hit a record high for both headline and core CPI of 5.9% and 2.7% YoY respectively. The ECB left interest rates unchanged in their March meeting, but suggested they could end their QE program by 3Q22. They also acknowledged that the current geopolitical issues will have a material impact on growth and inflation courtesy of higher energy and commodities prices. Their estimate for CY22 inflation was lifted to 5.1% vs. 3.2%. In contrast, the Bank of England raised rates for the third consecutive time to 0.75% as inflation hits a 30 year high (headline 6.2% and core 5.2% YoY), with the BOE suggesting an 8% level is possible over CY22.

An additional challenge is the resurgence of Covid cases in some EU countries such as Germany and Austria, who are recording new peaks in daily cases since the start of the pandemic. With the former ending all Covid curbs mid-March (as other jurisdictions have also done), the test will be the impact on activity as was seen in January’s stalled industrial production of zero growth courtesy of on-going supply constraints.

A better than expected 4Q22 results season was not enough to calm investor nerves in light of the Ukrainian crisis. EPS growth for the quarter was +43%, up from the 38% expected in early January. Likewise, for CY21 a 78% increase was a beat on the earlier 73% expectation. Consensus estimates for 1Q22 are +13.5%, however we expect to see downgrades if the region’s economy continues to stall. Despite the uncertainty, M&A activity remains active with major takeover bids in the telecoms, industrials and financial sectors. We expect volatility to remain through the June quarter. From a humanitarian standpoint hopefully we reach a ceasefire in the Ukraine quickly, which would be positive for market sentiment, however macro issues of inflation and supply chain disruptions will persist, thus we move to a Neutral weighting.

EM Equities:

The EM equity market experienced a similar quarter as the developed world, with the MSCI Emerging Markets Index recording a loss of XX% amid a global sell-off in risk assets in February.

After two years battling a pandemic, the Russia-Ukraine conflict adds to the complexity and concerns around inflation and the economic recovery. While it is still too early to say what the longer-term ramification will be, the obvious first-order consequences are tougher sanctions on Russian companies. Notwithstanding the impact, Russia only accounted for a very small proportion in Emerging Markets Indices. During the March quarter, market leading index provider MSCI has further made the decision to remove Russian securities from the Emerging Markets Indices, effective 09 March 2022.

EM countries that depend on Russia and Ukraine’s supply of energy and food will feel the pain of price spikes. Conversely, Southeast Asian markets with significant oil or commodity production, held up well during the quarter.

Many are comparing China with Russia in terms of political and economic positioning. However, China is more far more integrated into the global economy – being a major end market for most Western companies and a major supplier into Western markets. The Chinese government is keen to spur domestic consumption, provide support to the economy but is sensitive to the structural imbalances in its economy (i.e., property)

China is currently going through the worst Covid outbreak since Wuhan two years ago, which has caused lockdowns in large parts of the country. We see the Chinese lockdown system will these figures, but the economy will suffer. China’s GDP growth slowed down to 4%, amid multiple headwinds including a property downturn, supply chain issues and the Covid19 outbreaks. Economists are betting on rate cuts by the People’s Bank of China in the next two months and a further easing of restrictions on the property sector to stimulate construction activity and the broader economy.

South Korea’s economy expanded at the fastest pace in 11 years amid a strong demand for exports from the US, Europe and China. Manufacturing PMI also rose to an 8-month high in February boosted by car production and semiconductors. Taiwan’s factory and output growth slowed down, albeit solidly overall.

From a valuation perspective, Indian stocks are relatively expensive within EM markets and the oil/ commodity price surge is likely to hurt Indian company profits more in the months to come. We see Chinese stocks oversold and therefore expect a rebound on stimulus announcement. In EM ex-China, the food and oil prices shock, monetary tightening in some countries and a lack of fiscal stimulus in others will hinder overall growth.

We see EM stocks as fairly valued, but the direction of their next move depends on gaining more clarity on the corporate profit outlook, visibility on shifts in trade balances and sentiment on geopolitical trading bloc realignments. We remain Neutral on this asset class.

Property:

Over the quarter, A-REITs experienced a sizable pulled back in line with risk assets driven by elevated inflation expectations, bond yields and geopolitical tensions. This saw the index down 7.7% in comparison to with the broader ASX200’s +0.7%.

Domestically, economic fundamentals remain sound with the latest GDP data delivering a positive message for Australian economic recovery as consumer demand surged back from coronavirus lockdowns. Retail sales and consumer spending remains healthy as shown in January and February’s reading.

Historical data suggests that REITs trade poorly during periods of bond yields escalation in comparison to the border market. With rate hikes on the horizon, we stay cautious and remain Neutral on the Australian listed property sector whilst actively monitoring the flow-on effects from the global supply chain challenges and bond yield movements.

Alternatives:

Private Equity

Our maximum setting in Private Equity has come into question heading into the next quarter, courtesy of the geopolitical risks.

We take the view that the illiquid nature of private assets is a positive for the portfolio amidst times of significant sell-offs as managers avoid the necessity to liquidate. We remain positive that experienced private equity managers can manage their portfolios adequately with-in the current environment, noting specific sectors, industries and companies will be adversely affected.

We take direction from public equity markets over the next quarter as a lead indicator as to when and if we down-weight our exposure to Private Equity later in the year as conditions for new Vintages potentially deteriorate. We retain our Overweight call and remain bullish towards Private Equity for the coming quarter.

Gold

Gold was tested as a safe-haven asset during the Russian/Ukrainian war and passed – rising (1.94%) since the beginning of the year. Though a stronger $A has muted this return

Where to from here?

We gain confidence in the long-term allocation to gold as portfolio hedge against long term adverse macroeconomic and short-term geopolitical events. We also see stronger Central Bank support through a diversification away from the USD for reserve requirements. We retain our Neutral setting in the portfolio with an understanding that further escalation of geopolitical tension will likely lead to a higher gold price and vice versa.

Hedge Funds

Our favourable, slight positive view for the previous quarter was intended to add diversification to the portfolio ahead of any major market moves. The index (HFRX Global Hedge Fund) out-performed public markets returning -2.00% over the quarter.

We retain this view particularly towards unconstrained Hedge Funds which can tactically benefit by moving into or hedging assets that are linked to the continued inflationary pressures and significant up-swing in commodities. We remain Overweight.

Infrastructure

We have benefited from positive performance with the increased allocation to Infrastructure from the March quarter, +1.02% as measured by the S&P Global Infrastructure TR Index.

The continued inflationary pressures make Infrastructure attractive being an inflation sensitive asset class. Given the defensive nature of certain types of infrastructure assets with the opportunity for upside participation, we retain our Overweight call on Infrastructure for the coming quarter.

Fixed Income:

Over the March quarter, bond markets have undergone a significant repricing, driven by major central banks’ tightening on both monetary and fiscal fronts with interest rate hikes and slowing of asset purchasing programmes, which has been further fuelled by Russia’s invasion of Ukraine US 10-year bond yield jumped from 1.51% at the end of last year to 2.34% by quarter end. Similar moves were observed in the domestic market where a similar outlook for inflation sent AU 3-year yields surging to their highest since early 2019 to 2.43%, with the 10-year bond yields climbing to 2.875%.

Bond yields movement over past 12 months

Source: Thomson Reuters

Last week, the shape of the yield curve also started to change, as we saw the short-end of the curve creeping up and the gap between 2 and 10-year Treasuries – as well as 5 and 10-year – dipping into negative territory. Although the fears of an imminent US recession may be premature, we continue to watch the level and shape of the yield curve closely, as the bond market usually provides a timelier and more accurate signal on the economic outlook than the equity market.

US short-term / long-term treasury slope

Source: BCA

Inflationary pressures in the service sectors and labour markets remain elevated particularly in the UK and US economies, however the latest data is pointing to a fading upward pressure on global inflation particularly in the goods sector with an easing in supply chain disruptions.

On the policy front, the Fed appeared to be committed to bring inflation expectation back in line – with Chairman Powell stating that rate hikes could become more frequent and aggressive in size followed by the 25bps hike in the March FOMC meeting. The market is expecting the current tightening cycle to peak in mid-to-late 2023.

Acknowledging the possibility for yields to rise further over the coming June quarter, we believe that the inflation expectation and interest rate movement is largely priced in. We therefore move to modest Underweight on traditional long duration Government bonds. Looking at the market through the credit lens, we expect household consumption and corporate earnings to continue to be supported by the generous fiscal spending and the current headwinds such as inflation pressures, geopolitical uncertainty and the lingering pandemic situation to gradually subside. With the higher all-in yields from higher rates and wider credit spreads, we move to Neutral from modest Underweight in Credit.

For further information and guidance, please contact us here.

Take a Hike

Posted on 01/03/2022 by Brendan Moore

March 2022 Monthly CiN-sights

Global equity market volatility increased during February as investors raised their expectations that US interest rates will see multiple hikes this year plus elevated geopolitical tensions as Russian military forces invaded the Ukraine. Locally, economists predict an increasing likelihood that the RBA will also tighten rates by year end. For the month, major global indices the S&P500 and the EU Stoxx600 fell 3.1% and 3.35% respectively. The ASX200 fared better, being +1.1% for the month.

As headline and core inflation rates hit multi-decade highs in a number of major economies, the rhetoric of central banks has changed from transitory inflation to acknowledging that pressures in the economy are more broad-based, thus requiring a hawkish pivot on their previous policy stance. The current US reporting season highlighted this spread from ongoing supply-chain disrupted industries to strong wage expense growth in service industries. This is being amplified by energy price spikes on the geopolitical issues. We opined on a number of occasions in our 2021 monthly publications that global inflation appeared to be more problematic and that would likely require a change in this unprecedented expansionary policy setting.

The challenge for central banks now, is can they manage the rate hike cycle to combat this rapid acceleration in inflation. In the latest January US FOMC meeting, the Committee conceded that it expects it will soon be appropriate to raise the target range for the federal funds rate. With US January CPI data hitting 40 year highs for both headline and core inflation of 7.5% and 6.0% (YoY) respectively, a number of economists now expect 6 to 7 rate hikes over the course of 2022. Most expect a hike in the March FOMC meeting and that by year end US rates will be at circa 2%. History suggests that the US Federal Reserve has struggled to contain a sustained run-up in inflation without causing a recession, an obvious risk for equity markets.

US CPI 12-Month Change, Since 1980, %

In the European region, the Bank of England has responded to UK inflation hitting 30 year highs of 5.5% by announcing two back-to-back interest rate hikes (the first time since 2004), taking rates to 0.5%. They will also cease new purchases in its QE program as they lifted their estimate for inflation to peak at 7.25%. The ECB left rates unchanged in their February meeting, but acknowledged that inflation risks in the short term are tilted to the upside whilst still expecting these risks to dissipate by year end. January inflation in the EU region hit a record annual level of 5.1%, courtesy of an ongoing energy crisis.

The RBA has left rates unchanged at 0.1%, but ceased their bond buying program during February. They are committed to maintaining highly supportive monetary conditions until inflation is sustainably within the 2 to 3% target range and achieve a return to full employment. Interestingly, they have lifted their CPI estimates for CY22 to above 3%. As the unemployment rate continues to track down and total employment hit another record high in January, the consensus among economists is for the RBA to lift rates sometime in 2H22.

Corporate reporting season in both AU and the US has been positive. Locally, the December half results have seen an increasing ratio of earnings beats vs. misses for the large caps. This has pushed FY22 EPS growth estimates up to mid-teens, however current expectations for FY23 are for a flat to slight rise in earnings. A number of companies cited supply chain issues were still impacting their operations. In the US, Q4 earnings for the S&P500 reported 30.7% growth. This is the fourth consecutive quarter of growth above 30%, the first time since 4Q09 to 3Q10 that this level of successive increase has been achieved. For CY21 earnings were +48%, with current estimates for CY22 sitting at a 9% YoY expansion.

The critical issue for equity markets is how aggressively might central banks tighten rates if inflation remains problematic and what impact could this have on the growth outlook and valuations, especially for the high multiple growth names. Whilst a Fed funds rate of 2 to 2.5% would seem relatively benign versus the average over the last 40 years, rising rates are likely to cause challenges in more debt-laden global environment.

Effective Federal Funds Rate, Since 1980, %

We remain alert to inflation indicators and any easing in supply-side constraints, which some strategists are suggesting will occur into the second half of the year as Covid hit manufacturing industries return to more normal levels of operation. This coupled with central bank policy response, will dictate our asset allocation into the June quarter and for the balance of 2022.

For further information and guidance, please contact us here.

Disclaimer

ESG Investing – From Satellite to Core

Posted on 01/02/2022 by Brendan Moore

February 2022 Monthly CiN-sights

The early January strength in major global equity markets, with the Dow Jones, S&P500 and the Stoxx600 all hitting new record highs, proved to be short-lived. Volatility returned as mounting inflation fears, hawkish central banks and geopolitical tensions saw major indices close lower for the month. The ASX200 and the S&P500 both had their weakest month since March 2020, falling 6.35% and 5.3% respectively. With inflation hitting multi-decade highs in the US, the Federal Reserve indicated a possible interest rate hike as soon as March. This move away from the most accommodative policy in history has raised concerns on risk asset valuations and the growth outlook.

With the market transitioning from an easing to a tightening cycle, asset classes and industry sectors are being repriced based on the new economic factors and expectations. Whilst we expect the market to gyrate, we retain our asset allocation calls for the quarter based on economic fundamentals. Please see our Quarterly Market Update – Q1 2022 for more.

In our Model Portfolio suite, we administer an ESG portfolio which is continuously being refined as the sophistication of the industry deepens and the more high-quality product becomes available. Here are our latest thoughts.

There was a time when environmental, social and governance (ESG) issues were the niche concern of a select group of ethically responsible investors. That time is long gone.

Client demand, government policy, central bank encouragement and regulatory requirements are all driving the investment profession to integrate ESG factors throughout investment processes.

One of the main reasons for ESG integration is recognising that ESG investing can reduce risk and enhance returns, as it considers additional risks and injects forward-looking insights into the investment process. Companies with strong ESG strategies are also better positioned to benefit from sustainability megatrends.

Another reason for implementing ESG stems from the recognition that negative megatrends will, over time, create a drag on economic prosperity as basic inputs (such as water, energy and land) become increasingly scarce and expensive, and the prevalence of health and income inequalities increase instability. There is an understanding that, unless these trends are reversed, the economies will weaken, and be ever more exposed to sustainability-led bubbles and spikes.

Examples of ESG Issues:

Of the three ESG factors, governance is the element most often taken into consideration by traditional investment analysis. A 2017 CFA Institute ESG survey showed that 67% of global respondents take governance into consideration in their investment process; ahead of environmental and social factors (both on 54%).

As of 2018, the largest sustainable investment strategy globally continued to be negative screening, with a combined US$19.8tn in assets under management. This is followed by ESG integration, which had grown by 69% over the prior two years.

Negative screening is the largest strategy in Europe.
ESG integration commands most assets in the USA, Canada, Australia and New Zealand.
Corporate engagement and shareholder action constitute the predominant strategy in Japan.

Responsible investment assets by strategy and region:

Most assets were allocated to public equities: 51% at the start of 2018; whereas the next largest asset allocation is in fixed income, with 36%.

Asset classes in global ESG investing (2018):

Various initiatives have also contributed to increasing the investment industry’s awareness of ESG, among these is the United Nations Principles of Responsible Investment (PRI). The PRI comprises an UN-supported international network of investors (signatories) working together towards a common goal to apply ESG to investment and ownership decisions.

PRI signatories have grown circa 30% a year since 2006. In April 2021, PRI asset owner signatories numbered 606 and managed aggregate assets of over US$31.2tn; the total number of signatories was 3,811.

This rapid acceleration of interest in ESG investing demonstrates the market opportunity for ESG, which is a major development that will shape the future of finance.

We expect ESG integration to become, if not already, a core consideration of investment portfolio allocation. Reach out to your Carnbrea adviser for the latest ESG Model Portfolio factsheet.

(Reference: CFA Certificate in ESG Investing Edition 3, 2021)

For further information and guidance, please contact us here.

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Quarterly Market Update – Q1 2022

Posted on 04/01/2022 by Brendan Moore

March Quarter 2022

Market and Asset Class Views

Australian Equities:

The ASX200 rose slightly over the December quarter as the emergence of the new Omicron Covid-19 variant and persistent global inflation fears lifted concerns on the resilience of the global recovery. In contrast to developed market peers the local index failed to hit new record highs, but did manage to rise 1.53% over the quarter. For CY21 the index gained 13%, which lagged the performance of major global peers.

The re-opening momentum of NSW and Victoria exiting lockdowns saw 3Q21 economic growth fall less than expected, which was augmented with an upbeat outlook in the corporate AGM season. The Federal governments’ mid-year economic outlook highlighted the strong rebound from the impact of the Delta outbreaks, underpinned by our high vaccination rate and effective policy support (Federal funding has totalled $337bil or ~16.5% of GDP). They upgraded their GDP growth estimate for FY22/23 by 1% to 3.5%, with the unemployment rate expected to fall to lows of 4.25%, a level not seen since before the GFC in 2008. A number of economists are more bullish, expecting GDP to expand by at least mid-4% for the next two fiscal years.

The RBA once again left interest rate unchanged at 0.1% and maintained their $4bil per week QE program in their December meeting. An update on the latter will be given in their February meeting. The Omicron variant is seen as being a new source of uncertainty, but is not expected to derail the recovery. Whilst they reiterated their commitment to highly supportive policy, economists have interpreted their commentary to be slightly more hawkish with their acknowledgement of higher inflation and leading indicators pointing to a strong labour market recovery. Market expectations have now moved to a likely end to the QE program during 1Q or 2Q22 and an interest rate hike around the end of the year. The more aggressive forecasters expect rates will be back to around 1% by mid-2023 as GDP rebounds strongly in CY22 to circa 5% and core inflation hits the 2.5% midpoint of the RBA’s target range.

The banks full year reporting season saw a return to increased dividend payout ratios from the Covid-19 reduced levels a year ago. The results did however highlight competitive pressures in retail banking and evidence of margin contraction. Overall, the equity market continued to see record levels of M&A activity as bidders continued to take advantage of low funding costs and available capital. Earnings estimates for FY22 remain robust, with EPS growth for the ASX200 expected to be circa 14%.

The AUD finished the year closer to the lower end of its 12-month trading range which has been between 70c-80c. We don’t see any near-term surprises to impact a move from this level into early 2022, albeit expect to see more volatility as we move through the year. We maintain our neutral view on the AUD.

Into the first quarter of 2022 we expect volatility to remain with the new Omicron strain and ongoing global inflation fears testing the resolve of central banks to retain supportive monetary policy. Whilst the ASX200 will ultimately follow major global indices, we remain confident that policy in AU will continue to support the recovery, particularly as we enter a Federal election year which will likely see additional material fiscal stimulus. GDP will be underpinned by the strong growth in employment plus consumer spending, courtesy of record levels of household savings (20% in 3Q21).

We remain Overweight.

US Equities:

US equity markets continued their rally to new record highs during the December quarter. This was despite increased volatility with a hawkish tilt from the Federal Reserve, ongoing inflation pressures plus concerns on potential economic disruptions from the spread of the new Omicron Covid-19 variant. The S&P500 ended the quarter with a 10.7% gain (+26.9% for CY21), courtesy of another reporting season beat with 3Q21 earnings up 40% from initial estimates of +30%.

The Federal Reserve (FED) kept interest rates unchanged in the 0-25% range in their December meeting, however a more hawkish pivot by the committee saw them announce a faster QE taper into 2022, reducing their asset purchases by $30bil per month and suggesting possible rate hikes over the course of the year. They conceded that inflation has continued to exceed their target, but the labour market is still to reach levels they assess as maximum employment which has led to imbalances in the economy. Once again, they trimmed their CY21 GDP forecast, lowering to 5.5% from 5.9% and lifted CY22 marginally to 4.0%. The path of growth for the economy is still seen as dependent on the course of Covid-19, albeit solid progress on vaccinations and easing of supply constraints are expected to support activity. Their headline and core inflation estimates for CY22 have been upped to 2.6% and 2.7% respectively.

Rising costs were evident in the Q3 reporting season, with companies across multiple industries flagging ongoing challenges with supply issues and labour costs. The latest consumer price data printed at multi-decade highs, with producer prices seeing the largest YoY advance in history. Compounding this is strong consumer demand with a number of the major US retailers reporting much better than expected same-store sales growth. Whilst the FED maintains employment growth still has upside given it remains 3.9mil jobs below the pre-pandemic peak, the recent November payroll numbers recorded their eleventh consecutive month of growth and the unemployment rate of 4.2% is at its lowest level since the 3.5% in February 2020. A number of economists expect inflation to remain elevated until mid-2022, with the headline number to remain above 6%.

Q3 GDP grew 2.3%, which was slightly better than the downwardly revised estimates, with personal consumption continuing to be a key growth driver. Keeping the expansion in check was a resurgence of COVID-19 cases, resulting in new restrictions and delays in the reopening of establishments in some parts of the country. The consensus among economists is for CY22 growth of around 4%, albeit some have started to trim 1Q22 on concerns of the spread of the Omicron variant.

Earnings are anticipated to remain robust with 4Q21 EPS growth of 21%, which would be the fourth consecutive quarter of earnings growth above 20%. For CY22 analyst estimates are for circa 10% growth YoY, with a year-end target level for the S&P500 around 5,100.

We remain Overweight.

EU Equities:

The European Stoxx600 continued to hit record highs during the December quarter as strong corporate earnings and initial dovish central bank policy decisions lifted investor confidence. This enthusiasm waned into quarter end as a resurgence of Covid-19 across the region sparked a fourth wave of the virus. Countries have reinstated restrictions, plus inflation fears continued to rise combined with a more hawkish stance from central banks. For the quarter the Stoxx600 index rose 7.25% and +22.0% for CY21.

The growth recovery persisted, with the latest September quarter GDP recording a +2.2% improvement on the prior period. The European Commission expects CY21 growth will be 5%, which is up from their previous estimate of 4.6%. This is consistent with the latest IMF October economic review and the current consensus forecast of circa 4.5% for CY22. The UK also saw GDP rise with the latest October monthly release showing +4.9% growth YoY. Industrial production numbers have eased across the region as supply constraints continue to hamper activity.

The emergence of the new Omicron Covid-19 variant as the region enters the winter period has seen a large spike in cases, with Germany, France and the UK recording their highest daily infections of the entire pandemic period. In some countries, such as Austria and the Netherlands, they have gone back into hard lockdowns and many are reintroducing tougher restrictions on their citizens plus halting intra-country travel (particularly from the UK). At the time of writing whilst daily case numbers are high in countries like the UK, fortunately the hospitalisation and death rates have remained stable and not risen back to the peaks seen at the end of 2020. Across the bloc, waning immunity and to date low booster vaccine rates present a challenge.

The regions central banks have started to diverge in their policy support as inflation hits over 20 year highs in both the EU and the UK. The Bank Of England announced its first rate hike since 2018, being a 0.15% lift to 0.25%. They acknowledged that inflation pressures will remain in the medium term and see a level of 5-6% being maintained until at least April before easing in the second half of 2022, thus modest action was required. Conversely the ECB has retained their supportive monetary policy setting, keeping interest rates at 0%. Whilst admitting the inflation spike will be higher and longer than previously thought, they still expect it to fade next year thus any action now would be an unwarranted headwind for the economic recovery. They will also slow their QE purchasing into 1Q22, before winding it down in March.

The equity market had been supported by a robust Q3 earnings season with an EPS increase of 60% for the Stoxx600. This was augmented with a continuation of high M&A activity in the telecoms and industrial service sectors. The outlook for Q4 is for earnings growth of 38% and circa 73% YoY for CY21. Into CY22 consensus earnings estimates remain healthy, with an expected 1Q22 increase of 16% and +6% for 2Q. The region remains at a discount to developed market peers and valuation remains attractive.

We remain Overweight.

EM Equities:

Emerging Market Equities have again lagged developed equities over the quarter on the back of the strengthening US Dollar, geopolitical tensions as well as rate hikes across several EM countries including South Korea, South Africa, Mexico and Russia.

GDP growth in Q3 2021 softened across the EM countries after the post-pandemic bounce, while inflation continued increasing. The Central Bank of Brazil raised interest rate again in December, marking the seventh consecutive interest rate hike in 2021, in order to consolidate a disinflation process. On the other hand, India intends to maintain an accommodative monetary policy stance as long as necessary to support economic growth.

China’s economic growth slowed down amid several headwinds including supply chain disruptions, a persistent property bubble and negative credit impulse. The People’s Bank of China slashed the interest rate by 5bps to 3.80% in a bid to support growth in the slowing economy. China’s regulatory clampdown continues targeting some of the country’s biggest private technology firms, as evidenced by the delisting of Didi from New York Stock Exchange after coming under intense regulatory scrutiny. While many of the regulatory changes attempt to lower the cost of housing, education and healthcare to young and middle-class families, the impact on overall growth is still uncertain. We see this backdrop continuing for the next few quarters, however many of these risks have already been reflected by equity valuations. Current valuation of Chinese equity is attractive from a long-term view.

South Korea’s PMI increased, indicating a faster yet marginal improvement in the health of the economy, amid supply chain disruption and material shortages. However, output declined in Taiwan region with softened new orders growth.

We see opportunities emerging in Latin American and EMEA-based digital businesses that stand to benefit from the increase in internet penetration and usage across these regions.

Emerging market equities saw a lot of volatility over the past year, and we expect this to continue in 2022. However, emerging market equities look attractive from a valuation perspective. The recent pull back in EM has improved the valuation profile of the sector. Vaccine roll-out in EM has been catching up with developed markets, including in India, which should result in fewer future restrictions on activity, enabling bottlenecks to be addressed and reducing disruption to manufacturing and logistics in 2022.

We therefore move from a mild underweight to Neutral on EM Equities.

Property:

The strong performance of A-REITs continued into the December quarter. The asset class as measured by the ASX 200 A-REITs index, returned +10.07% over December quarter and ending the year with 12-month return of +26.14%.

Despite the lockdowns, the Australian economy has remained relatively resilient. The strength in the housing market has been an important tailwind over the past 12 months, with the support of employment, contributing to the strong economic recovery over this period. APRA responded with earlier-than-anticipated prudential tightening which is likely to result in a modest slowing in price growth near-term from current levels. A number of economists expect the RBA to hold off from hiking in the near term, lagging Fed’s shift in monetary policy.

As investors’ hunt for yield continues, REITs remains an attractive asset class with risk-adjusted return comparable to public equities and high dividend yields. The accelerated and new trends in real estate as a result of the pandemic is expected to continue to create opportunities for investors in selected sub-sectors.

In the near-term, we expect moderate levels of inflation and rising rates to continue to paint a supportive macro backdrop for REITs, albeit the equity-linked price volatility, elevated valuations and potential rising cap rates. We prefer REITs with short-term leases over those with long-term leases since the former can adjust rents more quickly. Structurally, sectors supported by the growth of the digital economy such as Industrial are expected to outperformance.

With the recent stellar performance, we take profit and move to Neutral on Property heading into 2022.

Alternatives:

Private Equity

Supported by both demand and supply factors, a) as more investors seek companies that are not available in public markets as alternatives to listed markets, and b) as companies remain private for longer – research house Preqin expects the global Private Equity as an alternative asset class to more than double, from US$4.42 trillion in 2020 to US$9.11 trillion in 2025.

Private Equity investment activity has rebounded strongly in 2021 with the help of abovementioned factors and global economic recovery, as we see YTD buyout investment volumes surpassing U$800 billon (approx. US$450 billion in 2019 and 2020), and dry powder shrinking to lowest level in the past decade. Albeit the rising entry multiples especially for high growth, quality companies. We remain comfortable with our Overweight position to Private Equity.

Gold

There were 6 bull factors outlined in our recent December CiN-sight publication. Heading into the new year we see low likelihood of the occurrence of these factors over Q1 2022, being inflation blowout, sharp decline in real rates, bond market Japanification, Fed taper followed by modest increment rate moves, as well as more Fiat currency printing.

We remain Neutral on this sub-asset class and continue to expect Gold to act as an insurance policy in an environment where inflation is running at an elevated level and as a consequence of excessive money printing which acts to debase all non-real assets.

Hedge Funds

Hedge Funds, typically a favourable asset class during times of market volatility. Strategies and managers which can leverage mis-pricing opportunities to amplify returns in light of volatility are well positioned heading into the next quarter and benefit from the current environment.

We retain our modest Overweight position.

Infrastructure

The outlook for Infrastructure has improved heading into 2022. The considerations are twofold: the subdued duration impact on valuation and increasing global infrastructure spend.

As the global economic recovery continues to gain momentum supported by the recently passed bipartisan Infrastructure Investment and Jobs Act increasing US government non-defence spending to around 3% of GDP, a level comparable to the 1980-90s and larger than the 2020s [BCA Research]. We hold the view that in the medium to long-term, the fundamental value and outlook for infrastructure assets remains positive. However we expect higher near term volatility in this asset class as global short-term interest rates continue to creep up.

We also note investor’s hunt for yield remains and infrastructure continues to provide attractive levels of income despite price volatility in the listed space.

As such we move to Overweight on Infrastructure for the coming quarter.

Fixed Income:

We end the December quarter with a perplexing outlook for the Fixed Income sector. Real bond yields have been lower only once in the last 60 years, while inflation is already at its highest level in 30 years. If the Bond Markets are expected to be the best barometer of economic outlook, is the barometer broken/stuck?

Markets see inflation as the number one tail risk in the economic outlook and the cause of a potential bloodbath in bond markets, yet 10-year nominal bond yields in the US and Australia are stuck around 1.5%.

Over the past quarter we saw central bank guidance move to a less accommodative stance as “transitory inflation” views have been tempered by the realisation that some of the cost pressures will be far stickier and structural than assumed. Rate rises which has been signalled to occur in 2024 by officials have now been formally brought forward by 18 months. This has seen the yield curve respond by flattening, with short rates rising and long rates falling. The market has viewed this as a positive in dealing with inflationary forces and acts as a de facto tightening in monetary conditions, hence the rally in rates.

Some of the smaller developed market monetary authorities have started tightening conditions through the cessation of QE activities and actual raising of rates following similar trends in Emerging Market economies. Again, this is seen as a positive pre-emptive force.

Also, traditional long duration Government bond markets, swamped with supply, are now increasingly the domain of return insensitive investors (central banks etc.) and those mandated by regulation to be there (i.e., banks and insurers). For the private investor, Fixed Income serves now more as a ballast to growth assets and not a contributor to return. But Cash can do this without the prospect of capital loss. So, back to our conundrum of the broken barometer and the answer – time will tell. We had set our Fixed Income allocations for most of last year underweight and have been rewarded for the call. We expect more of the same this quarter and retain our Underweight call.

Looking at the market through the credit lens, similar to last quarter, we are only mildly negative to support allocation to growth assets elsewhere in the portfolio. We saw some sell-off in high yield credits as the Evergrande issue and tapering fears washed their way through markets. Now, with US and Australian earnings markets in upgrade mode, we see a supportive backdrop to credit, though we expect spreads to remain range bound. Also positively, global growth and deleveraging trends are supportive, default rates remain historically low and most assets are an attractive floating rate construct. Spreads available to investors to cover expected losses remain attractive i.e. in surplus and credit upgrades are outnumbering downgrades. In summary higher yield is better quality than what it was 6 months ago. Also importantly, higher Inflation in this sector is not seen as a major structural concern.

We retain a modest Underweight in Credit.

For further information and guidance, please contact us here.

Gold – Losing its Lustre?

Posted on 01/12/2021 by Brendan Moore

December 2021 Monthly CiN-sights

Equity market volatility returned in the final trading days of November amid fears the new Omicron Covid-19 strain could derail the global recovery, after major US indices and the EU Stoxx600 had recorded multiple new all-time highs. The new market peaks were despite simmering inflation fears, with both US headline and core inflation rates hitting the highest levels since the early 1990’s and the EU reporting its highest YoY level on record. Markets had been supported by robust Q3 earnings in both regions and dovish central banks. The ASX200 slipped 1.33% over the month.

In Carnbrea’s Asset Allocation process, we hold and label gold as an alternative asset. By definition, this means gold should have a low, zero or inverse correlation to traditional risk classes, such as equities.

We also regard gold it as a “Defensive Alternative” where its key attribute is capital preservation in economic conditions where we expect a devaluation of “fiat”¹ currencies and rampant inflation. Despite this key attribute, over the last 12 months where we have seen extraordinary levels of money supply expansion and a sharp rise in inflation, gold has been at best, lacklustre.

However, gold has many faces and often behaves counter-intuitively to what investors believe should happen. Let’s analyse the current bull factors for gold:

Hedge against a weak US Dollar.
Inflation hedge.
Geopolitical hedge.
Fiat currency debasement hedge.
Alternative investment to negative Interest rates (real and nominal).
First choice for monies seeking Safe Assets.

Gold is often viewed and traded as a proxy currency. Like the Australian dollar, gold is priced in US Dollars. So, if the world has a negative view on the USD, then gold should rise in value – as does the AUD.

As gold does not pay an interest rate and has holding costs, it can be seen as akin to a perpetual zero-coupon bond, thus is ultra-sensitive to rising interest rates (as all long-duration bonds and assets are).

Gold is often viewed as a safe haven in periods of geopolitical uncertainty.

Gold has for a long time played the role of being the safe asset of the first choice. We would argue that cash ranks in front, given flexibility and familiarity – but, only for the short term. Until Bretton Woods in 1971, when Gold was delinked from the USD and replaced with naked fiat money, gold was “money”. Gold still makes up 16.4% of Central Bank assets², which increased their holdings by 333 tonnes in the first half of 2021 and are some 40% above long-term average holdings³.

Chart 1: The purchasing power of major currencies and commodities has significantly eroded relative to gold

Why is Gold Struggling Now?

A strong USD as the US economy continues to outperform the rest of the world. This is courtesy of strength in US GDP and asset markets, thus consequently gold and the AUD have been pressured.
Gold Prices react negatively to rising interest rates in the short term. This year we have had rising rates and expectations of further rises.
Geopolitical tensions. Despite fears of Chinese aggression, Iran nuclear standoffs, etc., global tensions post the recent Xi Jinping and Biden talk’s looks to be diminishing.
Despite claims of inflation now being unleashed, the US Treasury Inflation Protected Securities (TIPs) market, where investors go to buy inflation-linked bonds, is telling a different story.
Gold may be losing its role as safe haven of first choice, with competition for this role being in the form of Crypto currencies.

Chart 2: Market value of gold and crypto assets: Cryptos are eating gold’s lunch, and there’s plenty more to eat

For Gold to rise from here in the Short-Term:

Inflation perceived as rampant, with Central banks unwilling or unable to keep the markets inflation expectations in check.

With bond rates managed by Central banks at unnaturally low levels, any sharp decline in real rates (whether less positive or negative) would boost gold prices

Markets come to the realisation that the global economy is unable to withstand even a small rise in policy rates. Japanification of bond markets.

Moderate moves in the steepening of the global bond yield curve. Rates do move but the Fed is able to allow tapering and then modest incremental rate moves.

Geopolitical shocks.

More expansion of money supply by Fiat currency printing central banks whether by Covid-19 relapse or other causes.

Chart 3: Major asset classes investment growth

Role of Gold in Carnbrea Model Portfolios

In our Balanced Portfolio as part of our Alternative allocation, we target a neutral holding of gold of 3.0-4.0%, held in an unhedged currency vehicle GOLD:ASX. Unhedged, as we see gold providing benefit in a “risk-off” scenario also coinciding with a weaker “risk off” currency such as the AUD. If we were sitting in Frankfurt where German Bunds are both negative in nominal terms and even more so in real terms this percentage would be higher.

As a real asset, gold should also begin to shine when real yields (after adjusting for inflation) remain negative i.e. when the bond rate remains under the inflation rate as they are now.

We expect gold to act as an insurance policy in an environment where inflation is running at an elevated level and as a consequence of excessive money printing which acts to debase all non-real assets. As gold, once an esoteric marginal asset, has now been democratised via ETF’s, it allows retail investors the same diversification access as institutional investors.

¹ Fiat currencies are all kinds of money that are made legal tender by a government decree or fiat and not pegged to a physical commodity such as gold or silver (Britannica and Wikipedia)

² International Monetary Fund, International Financial Statistics and data files.

³ World Gold Council, Gold Demand Trends Q3 2021.

⁴ BCA Strategy report, 25 November 2021. [1] VanEck

For further information and guidance, please contact us here.

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