What we liked

• Inflation in Australia has declined to an annual rate of 4.9%. Economists were generally expecting the October inflation figure to be 5.2%, so it has slowed down by more than predicted.
• Inflation in the U.S. cooled down more than expected in October as consumer prices held steady compared to the previous month. CPI increased 3.2% over the last 12 months, down from 3.7% the previous two months and below consensus estimates of 3.3%.
• Retail sales in China grew by 7.6% last month from a year ago, above the 7% growth forecast by a Reuters poll. Industrial production rose by 4.6% year-on-year in October, faster than the 4.4% pace predicted. While a mixed picture of economic activity is emerging from China, we are beginning to see some signs that the economy has troughed and is improving.
• Activity in China’s manufacturing sector returned to expansion in November, growing at the fastest pace in three months amid stronger domestic demand. The Caixin China General Manufacturing Purchasing Managers’ Index (PMI), which gives an independent snapshot of the sector, climbed to 50.7 in November from 49.5 the previous month. A reading above 50 signals an expansion in activity.
• Germany’s economic sentiment index surged to an eight-month high in November, exceeding market forecast. The indicator by the Leibniz Center for European Economic Research (ZEW) of economic sentiment for Germany rose by 10.9 points to 9.8 in November, back in positive territory for the first time since April.

What we didn’t

• Australian retail sales unexpectedly slipped in October, likely as consumers held off to take advantage of Black Friday sales in November. Nominal retail sales fell 0.2% in October from September, compared with a gain of 0.9% the previous month. Analysts had looked for an increase of 0.1%.
• The US economy added 150,000 jobs in October, fewer than expected, and previous months were revised lower, suggesting the economy is not quite as strong as thought. Economists had expected 180,000 new jobs. While still a solid number, the trend appears to be a weakening U.S. jobs market.
• The U.S. Institute for Supply Management (ISM) manufacturing purchasing managers index (PMI) remained at 46.7 in November. The latest figure marks the 13th straight month the index has been in contraction territory after a 29-month period of growth dating back to June 2020. The November reading was below the forecast of 47.6.
• U.S. Services PMI declined from 53.6 in September to 51.8 in October, compared to analyst consensus of 53. While still expansionary, it brings to focus weakening demand from the U.S. economy, particular in services, which have been a stellar performer this year and make up the great majority of economic activity.
• Japan’s inflation has hit a four-decade high, raising pressure on the central bank to roll back its massive stimulus. Prices rose at their fastest pace since 1981 in November, fuelled in part by higher energy costs.

Base Case

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

71% Probability

Global economic activity is expected to continue moderating over the remainder of the year and into early 2024. While the U.S. has exhibited clear economic outperformance during 2023 vs the rest of the world, we see some signs that this exceptionalism may also be waning. Slowing consumer discretionary spend and corporate margin compression are anticipated to remain strong themes over the coming months.

Our view remains that inflationary rates of increase are expected to continue moderating, although to remain above 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, 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 as employment and consumer conditions remain sound. Capital preservation will be the primary objective through appropriate company/sector allocations to those companies and sectors that are resilient earners in a peaking business cycle, as well as those exhibiting pricing power. This is likely to favour defensive industry sectors that are resilient in a slowing economy. 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 constructive expectations as inflationary pressures and increased interest rates negatively impact discretionary spending. A reversion to bank stresses seen earlier this year would be expected to further 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 and energy prices, further exacerbating inflationary pressures and placing greater pressure on central banks to tighten monetary and financial conditions – a situation more likely over the next few months, as the northern hemisphere moves into winter and requires more heating fuel. 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.

14% 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. Additionally, current global conflicts remain contained. 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 – APA Group

Investment Thesis

• APA provides our clients with a strategic investment in a number of key utility assets: the Mondarra Gas Storage and Processing Facility and the Emu Downs Wind Farm in Western Australia, Diamantina and Leichhardt Power Stations in Queensland, the Dandenong LNG Storage Facility in Victoria and the Central Ranges Gas Distribution Network in New South Wales.
• We recently invested in APA after the share price had been progressively sold off over an 18-month period. This downward valuation was largely due to concerns over the uncertain regulatory environment for the energy sector, and more recently on the surge in bond yields that lowers the value of listed utilities and infrastructure assets.
• With APA shares recently hitting a 5-year low, this created an attractive entry point for an initial position in the stock. The shares are trading on a forecast gross dividend yield of 6.6% on distributions that are still forecast to grow over the coming years.

History

APA Group engages in energy infrastructure business in Australia. It spun out from AGL and was first listed on the ASX in 2000. It is today valued at ~$10.6B.

The company operates through three segments: Energy Infrastructure, Asset Management, and Energy Investments. It operates natural gas pipelines, electricity interconnectors, gas fired power generation stations, and solar farms and wind farms, as well as gas storage, processing, and compression facilities.

APA Group comprises two registered investment schemes – APA Infrastructure Trust (APA Infra) and APA Investment Trust (APA Invest) – and their controlled entities. The securities of APA Infra and APA Invest are “stapled” together. The stapled structure provides flexibility for securityholders, allowing part of an APA Group distribution to be paid on a pre-tax basis by APA Invest in the form of a distribution of trust income.

The company has interests in approximately 15,000 kilometres of gas transmission pipelines; approximately 29,500 kilometres of gas mains and pipelines; and 1.5 million gas consumer connections. It also provides commercial, operating, and asset maintenance services to its energy investments and third parties; and invests in energy infrastructure. The company was incorporated in 2007 and is headquartered in Sydney, Australia.