What we liked

• Australian quarterly inflation data came in lower than expectations. The headline consumer price index for the April-June period was 6% higher than a year earlier. This was lower than the 6.2% expected, providing some relief to markets as relieves some of the pressure on the RBA to raise the cash rate further.
• The business activity in the US service sector continued to expand at a strengthening pace in June, with the ISM Services PMI rising to 53.9 in June from 50.3 in May. This reading came in above the market expectation of 51 and exhibits resilience within the domestic U.S. economy.
• US durable goods orders jump 4.7% in June vs. 1% expected. This strong read is an indication that corporations and households remain confident. Durable goods are high priced, so tend to be a strong indicator of household and business confidence.
• US inflation fell sharply to 3 per cent in June. The annual increase in the consumer price index slowed from 4 per cent in May to 3 per cent in June, the slowest rate of inflation since March 2021, reducing pressure on the U.S. Federal Reserve to increase interest rates more aggressively to fight inflation.
• China’s consumer inflation rate falls to zero. We have a foot in the “like” and “dislike” for this data point. The “like” is that it provides scope for the government to step up economic stimulus. The “dislike” is that it exhibits an economy with weak demand. Encouragingly, signs from the latest Chinese politburo meeting is that they will step-up fiscal and monetary stimulus to encourage economic growth.

What we didn’t

• The RBA raised the official cash rate by another 0.25% in May, taking the official cash rate to 4.1%. We expect this to place further pressure on household spending as mortgage servicing pressures build, particularly at a time when many mortgages are rolling off low interest rate fixed income loans.
• Australian June retail sales contracted by 0.8% versus expectations of no change. This indicates that higher interest rates are beginning to bite on discretionary consumption demand.
• U.S. retail sales rose a tepid 0.2% in June, reflecting a shift in consumer spending habits and signalling softness in some parts of the U.S. economy. Sales had been forecast to increase 0.5%.
• In June, U.S. average hourly earnings rose by 12 cents, or 0.4%, to $33.58, ahead of expectations of a 0.3% rise. While positive for consumer spending, this places further inflationary pressures on the U.S. Fed to increase interest rates.
• The ZEW Indicator of Economic Sentiment for Germany shows a significant decrease in the latest July 2023 survey. At minus 14.7 points, it is 6.2 points lower than the previous month.
• China’s economy expanded 6.3% in the second quarter from a year ago, falling short of market expectations as export demand remained tepid and sinking property prices sapped consumer confidence.

Base Case

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

70% Probability

Global economic activity is expected to continue moderating over the remainder of the year, despite recent data exhibiting some resilience. Slowing consumer discretionary spend, inventory builds, and margin compression are anticipated to remain strong themes over the coming months, adversely impacting company earnings.

Our view remains that inflationary rates of increase are expected to continue slowing, although to remain above historical averages from the past decade. In isolation, this should be supportive for credit markets as well as valuations of growth assets and manifest in greater financial market stability over the medium-term. This is likely to be mitigated by earnings downgrades, as lower inflationary pressures and impacts from a slowing economy impair company earnings.

The current environment leaves central banks, particularly the U.S. Federal Reserve, in a difficult position. Developed economy central bank choices appear to be to ease financial conditions and support the economy and financial system, while risking local currency weakness and higher yields and inflation or continue to fight inflation and risk more severe economic weakness and potential bond market/banking stress. The actions of policy makers to move in either direction will be a large driver of financial market performance over the coming months. It Is possible that continued liquidity injection from central banks to shore up the financial system will provide continued support for risk asset valuations.

This scenario is likely to see us maintain a neutral to slightly positive view on growth assets over the next few months. Capital preservation will be the primary objective through appropriate company/sector allocations to those companies and sectors that are resilient earners in a weakening business cycle as well as exhibiting 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. Should liquidity injections continue to be a feature of central bank policy, tactically increasing positions in risk assets may be warranted.

This will likely remain the investment stance until such time that we get a clearer macroeconomic trend emerge or we see central banks reducing their efforts to provide liquidity into financial markets. Overall, asset allocation will retain a neutral bias, with short-term tactical positioning to be guided by macroeconomic developments and central bank actions.

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 current sanguine expectations as inflationary pressures and increased interest rates negatively impact discretionary spending. Recent bank stresses are expected to tighten bank lending standards also. This could act to place pressure on the currently very strong global employment conditions.

Geopolitical tensions could act to negatively impact supply chain bottle necks, further exacerbating inflationary pressures, placing greater pressure on central banks to tighten monetary conditions. 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 (from higher interest rates) combined with lower demand converge to crimp company earnings.

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

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. Such a situation would see us move rapid and meaningfully into cash at the expense of equities. Further to this, the recent stresses seen in globally systemically important banks could lead to more bouts of liquidity events, which would be expected to have a pronounced negative effect on economic growth.

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 further 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.

16% 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 and financial conditions continuing to loosen. 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 economic growth accelerates.

Fiscal support from governments could 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 and potentially adding further liquidity enhancement measures to support financial systems, we would expect this to further fuel asset prices.

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 cyclical sectors leveraged to economic growth would occur.

Stock in Focus – Schlumberger

Investment Thesis

• Attractive growth drivers – SLB is an oil services business expected to benefit from higher well development and exploration activity. While energy prices have fallen from their high levels, we view the current price structure as having limited downside, with substantial upside potential. This view is based on the marginal production cost across the spectrum being close to current prices. As such, we expect demand for oil services in such an environment to remain robust and improve.
• Industry consolidation – Due to lower energy prices over the past decade as well as environmental pressures, activity in the oil and gas industry has been historically low over the past decade. This has meant competition in the industry has waned over the past 10-15 years. We expect this to be very beneficial to remaining providers, of which Schlumberger is a market leader. This is expected to provide demand and margin support.
• Technology leader – SLB, in our view, has a sustainable business model as it has invested heavily into low-carbon technologies. It is a leader in harnessing geothermal energy, carbon capture and sequestration, energy storage, developing hydrogen as a source of energy as well as improving the environmental impact of lithium extraction. We expect demand for these areas to provide structural multi-year growth, on top of the services they provide to more conventional oil and gas energy sources.

History

Schlumberger was founded in 1926 by two brothers Conrad and Marcel Schlumberger from the Alsace region in France as the Electric Prospecting Company (French: Société de prospection électrique). The company recorded the first-ever electrical resistivity well log in Merkwiller-Pechelbronn, France in 1927. Today, Schlumberger supplies the petroleum industry with services such as seismic data processing, formation evaluation, well testing and directional drilling, well cementing and stimulation, artificial lift, well completions, flow assurance and consulting, and software and information management. The company is also involved in the groundwater extraction and carbon capture and storage industries.

The Schlumberger brothers had experience conducting geophysical surveys in countries such as Romania, Canada, Serbia, South Africa, the Democratic Republic of the Congo and the United States. The new company sold electrical-measurement mapping services, and recorded the first-ever electrical resistivity well log in Merkwiller-Pechelbronn, France in 1927. The company quickly expanded, logging its first well in the U.S. in 1929, in Kern County, California. In 1935, the Schlumberger Well Surveying Corporation was founded in Houston, later evolving into Schlumberger Well Services, and finally Schlumberger Wireline and Testing. Schlumberger invested heavily in research, inaugurating the Schlumberger-Doll Research Center in Ridgefield, Connecticut in 1948, contributing to the development of a number of new logging tools. In 1956, Schlumberger Limited was incorporated as a holding company for all Schlumberger businesses, which by now included American testing and production company Johnston Testers.

Today the company is headquartered in Houston, Texas and has a market capitalisation of USD$82.5 Billion and earned in excess of USD$8 Billion in revenue last year. The business continues to evolve into growth areas such as, harnessing geothermal energy, carbon capture and sequestration, energy storage, developing hydrogen as a source of energy as well as improving the environmental impact of lithium extraction.