What we liked

• The RBA has tempered the pace of rate rises. After recent 0.5% increases the RBA has reduced increases to 0.25% over the past two meetings as they look to gain more evidence on the economic impact of their aggressive monetary tightening so far this year.
• Australian headline consumer price index for last month was 6.9%, slowing from the 7.3% pace reported for September. This came in lower than the expected 7.4%. A positive as it reduces pressure on central banks to continue hiking interest rates aggressively.
• U.S. inflation rate surprised to the downside coming in at an annual pace of 7.7% against expectations of an 8% increase. While lower inflation helps with U.S. consumers disposable income, it also reduces pressure on the U.S. Fed to increase interest rates.
• Non-farm payrolls in the US continued to grow more quickly than expected last month. Non-farm payrolls increased by 261,000 during the month of October. This exceeded expectations with economists having pencilled in a rise closer to 200,000. Like any positive economic data in the current environment, it is tinged with negativity as it reduces the pressure on the central bank to further increase interest rates.
• U.S. shoppers spent more in October, showing continued resilience amid persistently high inflation and an early start to the holiday shopping season. That’s the biggest monthly gain since February and better than the 1% economists had expected. Consumer spending was flat in September.
• European flash inflation figures came in at 10% annualised rate, lower than the anticipated 10.4% increase. While still high it increases the likelihood that peak inflationary increases may have peaked as inflation across most of the developed world come in at rates lower than expected,
• Chinese annual inflation rate came in at 2.1% versus and expected read of 2.4%. This is a benign read that provides Chinese authorities will plenty of room to stimulate their economy to improve demand and production.

What we didn’t

• Australian consumer confidence has plunged below the levels seen during the global financial crisis, causing a record number of households to slash their Christmas spending plans. The Westpac-Melbourne Institute Consumer Sentiment Index dropped 6.9% in November and is now only just above COVID-19 pandemic lows.
• The economic activity in the United States manufacturing sector contracted in November with the ISM Manufacturing PMI declining to 49 from 50.2 in October. This reading came in below the market expectation of 49.8. Below 50 indicates manufacturing activity contracted. This is the first contraction since May, 2020, a time when COVID lockdowns were coming into force.
• U.S. ISM Services PMI declined from 56.7 in September to 54.4 in October, compared to analyst consensus of 55.5. This exhibits further slowing in the U.S. economy. Like any negative economic data in the current environment, it is tinged with positivity as it reduces the pressure on the central bank to further increase interest rates.
• Two indicators on China’s economy in October missed expectations and marked a slowdown from September. Retail sales fell by 0.5% in October from a year ago — the first decline since May — and industrial production grew by 5%, coming in below expectations. Analysts polled by Reuters expected retail sales would slow to 1% year-on-year growth in October, and that industrial production would also slow to 5.2% growth.
• Chinese manufacturing PMI came in with a reading of 48, lower than the 49 expected. This indicates further contraction in Chinese manufacturing activity. This follows on from contraction seen over the past few months as weak demand an COVID lockdowns impact economic activity in China.

Base Case

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

73% Probability

Global economic activity expectations to continue moderating. While there is still a chance that global economic activity may remain in expansionary territory, negative growth probabilities have increased in many jurisdictions. Slowing consumer discretionary spend, inventory builds, and margin compression are anticipated to remain strong themes over the coming months, adversely impacting company earnings. The recent rally in equity markets has diminished much of the extremely negative positioning and sentiment in markets. This is expected to refocus the market on fundamental drivers, reducing the probability for further rallies based on technical indicators alone.

Our view remains that inflationary rates of increase are expected to slow, although inflation levels are expected 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 and currency volatility dampen profit margins.

The current environment leaves central banks, particularly the U.S. Federal Reserve, in a difficult position. Their choice appears to be ease and support the economy, while risking USD weakness and higher yields, or continue fighting inflation and risk more severe economic weakness. The actions of policy makers to move in either direction will be a large driver of financial market performance over the coming months. For this reason, diversification and a defensive positioning through cash holdings remain prudent.

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, energy supply disruptions with pricing remaining volatile 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. 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 tighten financial conditions.  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 combined with higher interest rates adversely impact discretionary spending. A deterioration in strong global employment conditions may be a catalyst for this. Geopolitical tensions could act to negatively impact 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 (through higher interest rates) at a time as the economy is weakening. Additionally, an untimely withdrawal or reduction of central bank liquidity (through quantitative tightening) could derail financial markets, which have become accustomed to liquidity support. When combined with reduced government expenditure due to high indebtedness, 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 inflation and interest rates, 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.

10% 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 supressing interest rates below inflation levels, we would expect this to further fuel asset valuation appreciation.

Any de-escalation of the  Ukraine/Russian war would be likely to result in increased food, gas, and oil supply from Russia. Additionally, an easing of China’s COVID-19 lockdown policy would further ease supply chain constraints. The effects of such developments would likely 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 – Santos

Santos is a global energy company committed to ever-cleaner energy and fuels production with operations across Australia, Papua New Guinea, Timor-Leste and North America.

Santos is one of Australia’s biggest domestic gas suppliers and a leading LNG supplier in the Asia Pacific region. Santos is committed to supplying critical fuels such as oil and gas in a more sustainable way through decarbonising projects, including Moomba CCS project.

With a strong, low-cost base business supplying oil and gas and a clear action plan to develop cleaner energy and clean fuels, Santos is resilient, value accretive and at the leading edge of the energy transition.

Investment Thesis

Key reasons for the investment:

• • Energy in high demand – Despite growth moderating in the global economy and potential for demand to weaken, we expect continued energy supply issues to keep oil and gas prices well bid. This should in turn be positive for energy company valuations and allow them to maintain elevated levels of capital returns to investors through share buybacks and dividends.
  • Cash Flow – STO reported quarterly revenue of US$2.2 billion in its most recent quarterly update in October. The company provides strong free cash flow (FCF) generation, a particularly attractive trait in a higher interest rate and inflationary environment, as currently prevails. STO reported quarterly revenue of US$2.2 billion in the last quarter, with accumulated free cash flow for the first three quarters of the reporting year coming in at US$2.7 billion, which represents an annualised FCF yield of 23%.
  • Strong Balance Sheet – As a result of the strong FCF, gearing is now down to a low 20.8%. We expect this will allow the company to offer a growth profile, even at lower oil prices. Capital management remains a key focus with increases to both the interim dividend and on-market share buyback program announced in their recent quarterly.

History

Santos made its first significant discovery of natural gas in the Cooper Basin with the Gidgealpa 2 well in 1963. The Moomba 1 discovery in 1966 confirmed this region as a major petroleum province. As a result of these discoveries, Santos had a commercially viable quantity of gas and entered into gas sales agreements with the South Australian Gas Company, the Electricity Trust of South Australia and the Australian Gas Light Company. Gas supplies commenced in 1969.

After a number of acquisitions in the 1990s, Santos became a major Australian operating enterprise with interests in Indonesia, Malaysia, Vietnam and Papua New Guinea, the United States and the United Kingdom.

Today, as outlined in the Santos’ 2022 Climate Change Report, Santos is focused on its climate transition strategy and action plan as it works to become a net-zero emissions energy and fuels business by 2040, in step with the goal of the UN Paris Agreement on climate change.