August 2022 | Monthly View

What we liked

• Australia’s jobs market has continued to strengthen, with unemployment remaining at 3.9% last month and underemployment falling to a 14-year low. As more people joined the labour force, the participation rate jumped to a fresh record high, up from 66.4% to 66.7%. The jobs market remains strong, supporting continued strength in consumer demand.
• Australia’s unemployment rate plummeted to 3.5% in June, the lowest rate in 48 years. 88,000 more people were employed in June and unemployment fell by 54,000, pushing the unemployment rate down by 0.4% in the month.
• U.S. economic activity in the services sector grew in June for the 25th month in a row — with the Services PMI registering a read of 55.3. This was better than the consensus expectation of 54.3 and continues the recent trend of growth in demand for services over goods.
• U.S. job growth accelerated at a much faster pace than expected in June, indicating that the main pillar of the U.S. economy remains strong despite pockets of weakness. Nonfarm payrolls increased 372,000 in the month, better than the 250,000 Dow Jones estimate and continuing what has been a strong year for job growth.
• U.S. consumer spending held up during June’s inflation surge, with retail sales rising slightly more than expected for the month. Advance retail sales increased 1% for the month, better than estimates of a 0.9% rise.
• Industrial production in the eurozone increased in May, even as factories across the region continue to struggle with supply bottlenecks and high costs. Output from factories, mines and utilities rose 0.8% in May compared with the previous month. This bettered expectations for an increase of 0.2%, exhibiting resilience in European manufacturing.
• China’s consumer price index , a main gauge of inflation, rose 2.5 percent year on year in June. This was slightly above the 2.4% expected. This allows scope for further stimulatory monetary and fiscal policy in China to promote economic growth.

What we didn’t

• Australian retail turnover was up 0.2% in June, at a record $34.2 billion, its sixth straight monthly rise but also its smallest climb so far this year. Expectations were for an 0.5% increase. Retail sales have been resilient but higher inflation and interest rates seem to have taken some toll in June.
• The Westpac Melbourne Institute index of consumer sentiment fell 3% in July, its seventh consecutive monthly fall with rate hikes and surging inflation pushing sentiment down. The index has fallen 19.7% since December 2021, a precipitous tumble comparable to plunges recorded during previous economic disruptions.
• Australian business confidence and conditions weakened in June as interest rates rose amid warnings that the Reserve Bank of Australia is likely to deliver a string of hikes over the coming months to tame surging inflation. The National Australia Bank’s business confidence index fell 5 points to +1 index point in June.
• U.S. core CPI increased 5.9%, compared with the 5.7% estimate. While some signs of peaking inflation are emerging this exbibits stubborn inflation within the U.S. economy persists and could maintain pressure on the U.S. Fed to maintain a tightening bias.
• U.S. manufacturing sector saw slower growth in June. While an expansionary read of 53 was printed, this was below the 54.9 expected. In particular, was the new orders read with a contractionary print of 49.2, indicating further weakness in manufacturing ahead.
• The headline German IFO Business Climate Index plunged to 88.6 in July versus last month’s 92.2 and the consensus estimates of 90.5. This shows weakening sentiment amongst businesses within Europe’s largest economy.
• China’s factory activity contracted unexpectedly in July after bouncing back from Covid-19 lockdowns the month before, as fresh virus flare-ups and a darkening global outlook weighed on demand. The official manufacturing purchasing managers’ Index (PMI) fell to 49.0 in July from 50.2 in June, below the 50-point mark that separates contraction from growth.

Base Case

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

74% Probability

The speed of economic activity is expected to continue slowing. Despite this, we anticipate economic activity to remain in expansionary territory. Recessionary predictions are anticipated to build, as markets price in the potential for continued monetary tightening by central banks, with Europe and the U.S. most vulnerable. Slowing consumer discretionary spend and inventory builds are anticipated to be strong themes over the coming months.

Potentially supporting global growth expectations is China, who we expected will accelerate a more accommodative monetary and fiscal policy stance to promote growth within their economy. Additionally, governments of developed nations are anticipated to maintain moderately stimulatory policies to support long-term social objectives such as carbon reduction through energy transition and reducing social inequality.

We believe inflationary pressures will wane over the coming months with the rate of increase slowing. This should be supportive for credit markets as well as valuations of growth assets and manifest in greater financial market stability, following recent high volatility. This is likely to be mitigated by earnings expectations being downgraded, as a slowing global economy combined with increased input prices dampen profit margins.

Other risks remain. Those we view as most prominent include 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-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 a business cycle and those that are able to maintain pricing power. This is likely to favour defensive sectors, such as healthcare and consumer staples at the expense of more cyclical sectors such as industrials, consumer discretionary and materials. Overall, asset allocation will retain a neutral to slight bias to growth assets.

Bear Case

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

14% Probability

Global consumer demand for goods and services falls further than expected as the anticipated pick up from pent up demand underwhelms. Rather, the consumer remains apprehensive once the direct-to-consumer fiscal support from governments and central banks wanes. Additionally, supply chain issues remain as do inflationary pressures. Geopolitical tensions could act to further increase commodity prices, further exacerbating inflationary pressures. Additionally, wage pressures become more systemic as employees successfully lobby for inflation plus wage increases. This will lead to a deterioration in company profits as increased input costs, increased debt servicing costs and lower demand crimp earnings.

Such a scenario would mean financial conditions are tightening while inflationary pressures remain elevated. This could see central banks beginning to withdraw monetary support at a time when the economy cannot handle further tightening without substantially reducing demand and economic activity. An untimely withdrawal or reduction of central bank liquidity could derail financial markets which have become accustomed to liquidity support. If combined with reduced government expenditure this may cause consumer confidence and spending to fall as government support is not fully replaced by gainful employment income.

Elongated supply chain issues and resultant high input costs would be expected to place 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 corporate default (especially due to over-indebtedness in an environment of rising bond yields) 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.

12% Probability

Economies across the developed world experience better than currently anticipated economic growth from current levels. This would lead to a synchronous global growth environment as inflation pressures wane and supply chain pressures ease. Fiscal support from governments would combine with sound cash levels on household and corporate balance sheets to accelerate the speed of the global economic activity. In the event central banks resume measures aimed at supressing interest rates below inflation levels, we would expect this to further fuel asset appreciation.

Such a market dynamic would see substantial improvement in economic activity globally, particularly in service-oriented businesses that will benefit from social re-opening. Additionally, an abatement in supply chain constraints could see inflation moderate, thus reducing pressure on central banks to withdraw stimulatory measures. This would occur as demand from business and consumers combine with government and central bank stimulus measures to create a potent environment for risk assets.

This scenario would be cheered by 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 be undertaken.

Stock in Focus – Thermo Fisher Scientific

Investment Thesis

• Key reasons for the investment:
  • Value emerges – TMO is a high-quality business where attractive valuation has emerged following its ~22% price fall this year. The company is a leading consolidator within the life science sector and offers leverage to structural growth areas, such as genomics. With much uncertainty in global economic activity, we see TMO as well placed to offer resilient earnings and earnings growth. We expect this profile to provide strong support for the company valuation.
  • Catalysts for growth – Driven by end market strength and share gains in Biopharma and emerging markets, we expect TMO to meaningfully outpace peers, with diversification and scale resulting in best-in-class resilience and flexibility. Balance sheet flexibility and a management team proven in accretive acquisitions provide scope for further upside. This is further accentuated by recent company valuation pullbacks within the sector, which has created a particularly opportune environment for long-term value accretion through acquisition.
  • Consistent performer – TMO reported in late April, with all segments performing above expectations. Management upgraded their earnings revenue for 2022 with a 7-9% long-term growth rate still intact. TMO’s provides a diversified customer base, and leading scale, all attributes that we believe will prove advantageous in navigating supply chain disruptions and inflationary pressures amidst geopolitical uncertainty and any macroeconomic weakness. We expect this to be reiterated in their next quarterly result in the next couple of weeks.

History

Thermo Fisher Scientific Inc. (NYSE: TMO) is the world leader in serving science, with annual revenue of approximately $40 billion. Their Mission is to enable their customers to make the world healthier, cleaner and safer. Products and services offered provide solutions for life sciences research, solving complex analytical challenges, increasing productivity in their laboratories, improving patient health through diagnostics or the development and manufacture of life-changing therapies. With over 80,000 employees worldwide, Thermo Fisher Scientific was formed in the 2006 merger of Thermo Electron and Fisher Scientific.

The company’s Life Sciences Solutions segment offers reagents, instruments, and consumables for biological and medical research, discovery, and production of drugs and vaccines, as well as diagnosis of infections and diseases to pharmaceutical, biotechnology, agricultural, clinical, healthcare, academic, and government markets.

Its Analytical Instruments segment provides instruments, consumables, software, and services for use in laboratory, on production line, and in field for pharmaceutical, biotechnology, academic, government, environmental, and other research and industrial markets, as well as clinical laboratories.

The company’s Specialty Diagnostics segment offers liquid, ready-to-use, and lyophilized immunodiagnostic reagent kits, as well as calibrators, controls, and calibration verification fluids, ImmunoCAP for allergy and asthma tests, and EliA for autoimmunity tests, dehydrated and prepared culture media, collection and transport systems, instrumentation, and consumables, human leukocyte antigen typing and testing for organ transplant market and healthcare products.

Its Laboratory Products and Services segment provides laboratory refrigerators and freezers, ultralow-temperature freezers, and cryopreservation storage tanks, temperature control, sample preparation and preservation, centrifugation, and biological safety cabinet products, water analysis instruments, laboratory plastics products, laboratory chemicals and pharma services.