October 2022 | Monthly View

What we liked

• Australia NAB business confidence improved from 8 to 10 in August. Business conditions rose from 19 to 20. Trading conditions rose from 26 to 30. This exhibits resilience in domestic business conditions despite this year’s increase in interest rates.
• ISM August non-manufacturing (services) PMI rose to 56.9 from 56.7 in July, expanding for the 27th consecutive month and topping expectations calling for a decline to 55.1, a sign that the U.S. economy remains extraordinarily resilient.
• U.S. advance retail sales for the month increased 0.3% from July, better than the Dow Jones estimate for no change. The total is not adjusted for inflation, which rose 0.1% in August, suggesting that spending outpaced price increases. The U.S. consumer remains in a healthy state.
• China retail sales grew by 5.4% in August from a year ago, the fastest since the January-February period this year. Additionally, Industrial production rose by 4.2% in August from a year earlier, beating the 3.8% increase estimated in a Reuters poll of analysts. While positive, we look to see this improvement continue before calling a turn in recent economic weakness in China.
• China’s inflation (CPI) increased 2.5% year-on-year from a 2.7% growth in July. The reading missed analysts’ median forecast for a 2.8% gain. This is attributed to continued economic disruption from the countries’ COVID-zero policy. The positive in this data is it provides scope for Chinee authorities to continue to stimulate the economy through fiscal and monetary support.

What we didn’t

• Major central banks globally continue to ratchet up interest rates in an attempt to reduce inflationary pressures. The ECB raised rates by 0.75%, the same as the U.S Federal Reserve. The RBA increased rates by 0.5%. This year has seen the fastest rate-rising cycle in decades across the globe. These rates historically tend to have a delayed negative effect on economies, suggesting further economic slowdown for the global economy is ahead of us.
• Prices in the US remained stubbornly high in August even as the overall pace of inflation slowed for the second consecutive month. The year-on-year inflation increase came through at 8.3% in August, higher than the 8.1% expected. This maintains pressure on the U.S. Federal Reserve to raise interest rates and tighten financial conditions further.
• A gauge on the U.S. manufacturing sector fell last month, indicating that economic activity in the sector is close to contracting. The ISM manufacturing PMI fell to 50.9 in September from 52.8 in August — barely in expansion territory and below expectations. The same report showed a contraction in new orders, prices paid and employment in a sign the U. S. manufacturing sectors recent slowdown is accelerating.
• Business confidence in Germany worsened considerably in September as companies turned more pessimistic due to the energy crisis. The Ifo business-climate index fell to 84.3 points in September from a revised figure of 88.6 points in August. This is its lowest value since May 2020.
• China’s official manufacturing Purchasing Managers’ Index surprisingly grew in September to 50.1, much higher than the 49.6 predicted by analysts in a Reuters poll. Meanwhile, the Caixin/S&P Global manufacturing Purchasing Managers’ Index, a private survey of factory activity — reported a contraction with a reading of 48.1. While there was some positivity in these reports, manufacturing activity remains relatively weak in China.

Base Case

Our view of the most likely scenario for markets over the coming months, for which our portfolios are currently positioned.

72% Probability

Global economic activity expectations continue moderating. While we anticipate overall global economic activity to remain in expansionary territory, negative growth probabilities have increased. Slowing consumer discretionary spend, inventory builds, and margin compression are anticipated to be strong themes over the coming months, adversely impacting company earnings.

Potentially supporting global growth expectations is China, who we expect will accelerate to a more accommodative monetary and fiscal policy stance, to promote growth within their economy. For this stimulus to be more effective an easing of China’s COVID-zero policy is required. This is unlikely to occur until the 20th National Congress of the Chinese Communist Party takes place in mid-October. Additionally, governments of developed nations are likely to maintain moderately stimulatory policies to support long-term social objectives such as carbon reduction through energy transition, household inflation assistance packages and reducing social inequality.

Our view remains that inflations rate of increase is expected to slow, although to remain above historical averages from the past decade. This should be supportive for credit markets as well as valuations of growth assets and manifest in greater financial market stability. This is likely to be mitigated by earnings expectation downgrades, as a slowing global economy combined with high input prices dampen profit margins.

Other risks remain. Those we view as most prominent include credit market stress relating to bond and currency volatility, increased geopolitical tensions (U.S./China, Aust/China, Russia/Ukraine, China/Taiwan, Iran/Saudi Arabia), greater slowdown in the global economy than current consensus, faster than contemplated increases in government bond yields (due to inflationary pressures remaining elevated), a further increase of COVID-19 cases in China prolonging lockdowns and continued high levels of supply chain disruptions.

This scenario is likely to see us maintain a neutral medium-term view on growth assets. Capital preservation will be the primary objective through increased cash levels and appropriate company/sector allocations to those that benefit from the maturing of the business cycle and those that are able to maintain pricing power. This is likely to favour defensive industry sectors, such as healthcare and consumer staples at the expense of more cyclical sectors such as industrials and consumer discretionary. Overall, asset allocation will retain a neutral bias.

Bear Case

Our worst-case scenario for the coming months, which we are prepared to position for should conditions deteriorate.

17% Probability

Global consumer demand for goods and services falls further than expected as inflationary pressures, such as high energy costs, adversely impact discretionary spending. A deterioration in strong global employment conditions would be a catalyst this. Geopolitical tensions could act to maintain supply chain bottle necks, further exacerbating inflationary pressures. Additionally, wage pressures and higher cost of lodging become more systemic as employees successfully lobby for wage increases. This will lead to a deterioration in company profits as increased input costs, and debt servicing costs combined with lower demand converge to crimp company earnings.

Such a scenario would result in a further tightening of financial conditions, while inflationary pressures remain elevated. This could see central banks continuing to withdraw monetary support at a time as the economy is weakening. Additionally, an untimely withdrawal or reduction of central bank liquidity could derail financial markets, which have become accustomed to liquidity support. When combined with reduced government expenditure this may cause consumer confidence and spending to fall, as prior government support is not fully replaced by gainful employment income.

Elongated supply chain issues and resultant high input costs would result in upward pressure on bond yields, particularly if judged to be more sustainable. An acceleration of bond yields from current levels could see further valuation compression in financial markets, as well as adversely impacting economic activity. This effect would be more pronounced in high valuation stocks and company’s unable to exercise pricing power.
Rapid escalation in geo-political tensions or a significant or systemic credit default, due to over-indebtedness in an environment of rising bond yields and elevated volatility in financial asset prices, could see a liquidation of risk assets within a compressed period.

Above scenarios will see us take a more defensive position and reduce equity exposures replacing them with defensive assets, such as cash. The accelerating bond yield scenario would require a more nuanced shift toward companies and sectors that would be the greatest beneficiaries of such a move. Focus will be on a more defensive posture with capital preservation being the primary objective. A shift towards defensive sectors such as healthcare, consumer staples and utilities would combine with higher cash levels in this scenario.

Bull case

Our most optimistic view for markets over the coming months.

11% Probability

Economies across the developed world experience better than anticipated economic growth with economic activity exhibiting resilience. Combined with waning inflationary pressures, as supply chain bottlenecks ease, this would like lead to synchronous global economic growth as interest rate pressures ease on lowered inflationary expectations. In this scenario disposable income for consumers would increase as inputs costs for corporates reduce. The result would be more resilient earnings for companies as growth accelerates.

Fiscal support from governments would combine with sound cash levels on household and corporate balance sheets to accelerate the speed of the global economic recovery. In the event central banks resume measures aimed at suppressing interest rates below inflation levels, we would expect this to further fuel asset appreciation.

Any de-escalation of the Ukraine/Russian war would be likely to result in increased food, gas, and oil supply from Russia. The effect would be disinflationary and reduce pressure on household budgets. This would further ease pressure on central banks to continue their path of tightening monetary policy through interest rate rises.

This scenario would be positive for financial markets as improving financial conditions act to fuel demand for growth assets in a low to negative real interest rate environment. We would act by ensuring a growth asset bias with low cash levels. Additionally, if leading economic indicators began surprising to the upside a net shift towards sectors leveraged to economic growth would occur.

Stock in Focus – Sonic Healthcare

Investment Thesis

Sonic Healthcare Limited is a medical diagnostics company with operations in Australia, New Zealand, and Europe.  The Company provides a comprehensive range of pathology and diagnostic imaging services to medical practitioners, hospitals and their patients along with providing administrative services and facilities to medical practitioners.:

Key reasons for the investment:

• • Value emerges – Following a reduction in share price since the post-COVID-bounce, we saw value finally emerging in this high-quality healthcare business. Sonic continues to benefit from some level of COVID-19 testing as the pandemic continues and slowly subsides, while declines here are counteracted by growth in the base business of diagnostics and hospital services. SHL provides resiliency of earnings, which we view very attractive in a macroeconomic environment that is growth challenged.

• • Balance sheet flexibility – Management remains focused on using the proceeds from COVID-19 testing to fund the expansion of its global business, with the focus likely to be on the U.S. and Europe, given the underutilized balance sheet. Despite committing to a $500m share buyback the balance sheet has very low debt levels and should provide management with great opportunities to grow by acquisition at a time the industry is facing challenge.

• • Growth catalysts – Other upside risks include the possibility of new virus strains, which could cause temporary testing spikes, as well as a higher-than-expected stabilized COVID-19 testing level. While we expect the eventual downfall of COVID-19 testing demand, this should be offset by a healthy recovery in the base business, which will likely see a short-term boost as some backlog is caught up.

History

Sonic Healthcare Limited is the parent company of the many operating companies around the world comprising the Sonic Healthcare group. It is a public company, listed on the Australian Securities Exchange. Sonic Healthcare has its head office at Grosvenor Place in Sydney, Australia.

The growth of Sonic Healthcare over the last 25 years has been remarkable. It has been achieved through a combination of carefully chosen acquisitions and strong organic growth. Sonic Healthcare enjoys a reputation in the financial sector as a growth company that has delivered value to its shareholders.

Sonic Healthcare Limited offers medical diagnostic services to medical practitioners, hospitals, community health services, and their collective patients. The company provides laboratory medicine/pathology testing services, such as biochemistry, cytopathology, genetics, haematology, histopathology, immunoserology, microbiology, molecular pathology, prenatal testing, toxicology, and ancillary functions; and radiology services, including magnetic resonance imaging, computed tomography (CT), ultrasound, X-ray, mammography, nuclear medicine, PET CT, interventional procedures, and bone mineral densitometry. It also offers primary care medical services comprising general practice clinics, occupational health services, skin cancer clinics, after-hours general practice services, general practice IT solutions, and community-based healthcare services.

The company operates in many countries, including Australia, the United Kingdom, Ireland, the United States, Germany, Switzerland, New Zealand, Belgium.