February 2022 | Monthly View

What we liked

• Australian retail sales surged past forecasts for a second month in November as consumers splashed out their pent-up savings. Figures from the ABS showed retail sales jumped 7.9% in November, adding to an already stellar 4.9% rise in October, smashing expectations of a 3.9% gain.
• Australia’s jobless rate dropped to the lowest in more than 13 years. The economy added 64,800 jobs in December, lowering the unemployment rate to 4.2% from a previously reported 4.6% in November.
• U.S. Housing starts rose 1.4% to a seasonally adjusted annual rate of 1.702 million units in December, the highest level since March. This beat expectations with economists polled by Reuters had forecast starts falling to a rate of 1.650 million units
• A surprise growth in euro area retail sales in November. Retail sales came in at +1.0% vs -0.5% month on month expected, indicating that consumer demand is still somewhat holding up going into year-end. That despite omicron risks increasing over December.
• China’s manufacturing and service sectors showed unexpected signs of recovery to close out the year. China’s official manufacturing purchasing managers index rose to 50.3 in December, up from November’s 50.1. The result was better than the 50.0 median expected.
• China has begun a monetary easing cycle. This is of particular importance as most of the developed world is reducing their accommodative monetary policy stance. They reduced the one-year loan prime rate by 10 basis points from 3.8% to 3.7%. In December, the PBOC cut the one-year loan prime rate for the first time since April 2020.

What we didn’t

• The National Australia Bank’s monthly business survey for December showed confidence tumbling by 24 points to an index of minus 12 from plus 12 the previous month. This was on the back of rampant Omicron spread across the country.
• US Federal Reserve looking to reduce their accommodative monetary stance. While this was anticipated, the lack of clarity on the speed of withdrawal provided by the central bank has created uncertainty in markets.
• Sabre rattling from Russia related to the Ukraine as well as conflict in Yemen involving opposing factions in Iran and Saudi Arabia. While conflict never a positive these regions supply much of the world energy needs, exacerbating potential impacts on the global economy.
• U.S. ISM manufacturing data fell to a reading of 58.7 in December from 61.1 in November, the lowest tally since last January. While still a strong read (anything above 50 indicates expanding activity) it did miss estimates. However, on a positive note, supply constraints are starting to ease, and a measure of prices paid for inputs by factories fell by the most in a decade, which should act to decrease input pricing pressure.
• US non-farm payrolls increased by 199,000 jobs missing expectations of 400,000 jobs. Despite this the unemployment rate dropped to 3.9% from 4.2% in November, underscoring tightening labour market conditions.
• U.S. retail sales fell much more than expected in December as surging prices took a big bite out of spending. The report showed a decline of 1.9%, considerably worse than the Dow Jones estimate for just a 0.1% drop.

Base Case

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

70% Probability

The speed of the economic activity improvement is expected to moderate from 2021’s stellar growth rate. Despite this global economic activity is expected to remain above average although lumpy as COVID along with continued supply chain disruptions.

Central banks in developed economies are expected to diminish their ultra-accommodative policy stance as economies improve and inflationary pressures build. This is likely to manifest itself with increased market volatility over the coming months. The exception to this appears to be China, who is expected to begin a more accommodative monetary policy stance to promote growth within their economy. On the fiscal front governments have indicated they are willing and able to step up with spending to support their economies. Governments are expected to maintain stimulatory policies with an eye to sustain employment and wage growth, as well as supporting long-term social objectives such as carbon reduction and social inequality.

Risks remain. Those we view as most prominent include increased China and Australia/U.S. trade tensions, greater slowdown in the global economy than is currently expected, faster than expected increases in government bond yields (due to inflationary pressures building), a further increase of COVID-cases across different regions pressuring health systems, continued high levels of supply chain disruptions and stimulus packages that underwhelm expectations.

This scenario is likely to see us maintain a constructive medium-term view on growth assets. Capital preservation will be targeted through appropriate company and sector allocations that benefit from the maturing of this business cycle. Overall asset allocation will retain a bias to growth assets.

Bear Case

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

15% Probability

Global consumer demand for goods and services falls further than expected as the expected pick up from pent up demand does not eventuate. Rather, the consumer remains apprehensive once the direct-to-consumer fiscal support from governments and central banks begins to wane. Additionally, supply chain issues remain as do inflationary pressures. There is also potential for new strains of the COVID virus to cause governments to increase lockdown measures, further supressing economic activity. In this environment we observe slowing growth while higher inflation levels place pressure on Central Banks to begin withdrawing monetary support.

An untimely withdrawal or reduction of central bank liquidity could derail financial markets which have become accustomed to liquidity support. Any failure of governments across the globe to extend or further stimulate their economies through fiscal spending would further erode confidence. This may cause consumer confidence and spending to fall as government support is not fully replaced with gainful employment income. Such a scenario would likely see a level of dislocation in financial markets across the spectrum.

An apparent risk is rising government bond yields. The disruption of supply chains and high input costs is 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 valuation compression in financial markets continue, as well as adversely impacting economic activity. This would be more pronounced in high valuation stocks and company’s unable to exercise pricing power in such an environment.

Left-field events such as a rapid escalation in geo-political tensions (especially between the US and China) 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 in a compressed period of time.

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. The overall focus will remain on capital preservation.

Bull case

Our most optimistic view for markets over the coming months.

15% Probability

Economies across the developed world continue to exhibit strong economic growth with a reacceleration of economic activity. This would lead to a synchronous global growth environment, where economies that have lagged see accelerated growth . Substantial fiscal support from governments would combine with high cash levels on household and corporate balance sheets to sustain the speed of the global economic recovery. At the same time COVID becomes endemic, resulting in mobility improvements and increased economic activity. In the event central banks maintain measures aimed at supressing interest rates, we would expect this to further fuel asset appreciation, while any extension of these accommodative policies would provide support for re-rating of asset values.

Such a market dynamic would see substantial improvement in economic activity globally, particularly in service-oriented businesses that will benefit from social re-opening. This would occur as pent-up demand from business and consumers combine with massive government and central bank stimulus measures to create a potent environment for risk assets. Sectors expected to benefit most in this environment are those leveraged most to economic activity, in many cases these are the same companies that were most adversely affected by the COVID-19 induced lock downs.

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.

Stock in Focus – Honeywell

Investment Thesis

• Key reasons for the purchase:
  • High quality diversified business – Honeywell International Inc. is a technology and manufacturing company. The Company operates through four segments: Aerospace, Home and Building Technologies, Performance Materials and Technologies, and Safety and Productivity Solutions. They are a multinational business that is a leader in all segments. The business is valued at ~USD$145B with an annual revenue base of ~USD$35B per annum. As the business cycle evolves, we see high quality diversified businesses such as HON outperforming as their earning remain resilient in an economic environment likely to see elevated inflationary and interest rate pressures.
  • Strong performance – HON’s recent quarterly exhibited the resilience of the business. The company raised its earnings guidance and saw a slight lift in margins. In an environment of supply chain constraints and inflationary pressures this testament to the resilience and quality of the companies diversified divisions.
  • Supply chain onshoring beneficiary – As companies look to repatriate supply chains back to home countries following recent disruptions, we see HON as a beneficiary of the shift. We expect this to provide a multi-year tailwind for the company across all divisions.

History

Honeywell is a U.S. multi-national business with operations across the globe. It operates as a diversified technology and manufacturing company worldwide. services multiple industries, with the company valuation around USD$140 Billion. It primarily operates in four areas of business: aerospace, building technologies, performance materials and technologies (PMT), and safety and productivity solutions.

Honeywell has a long history. It began trading in 1885 as the Butz Thermo-Electric Regulator Company. Founded when the Swiss-born Albert Butz invented the damper-flapper, a thermostat used to control coal furnaces, bringing automated heating system regulation into homes. The following year he founded the Butz Thermo-Electric Regulator Company. In 1888, after a falling out with his investors, Butz left the company and transferred the patents to the legal firm Paul, Sanford, and Merwin, who renamed the company the Consolidated Temperature Controlling Company.

In 1906, Mark Honeywell founded the Honeywell Heating Specialty Company in Wabash, Indiana, to manufacture and market his invention, the mercury seal generator.

Today its Aerospace segment offers auxiliary power units, propulsion engines, integrated avionics, environmental control and electric power systems, engine controls, flight safety, communications, navigation hardware, data and software applications, radar and surveillance systems, aircraft lighting, advanced systems and instruments, satellite and space components, and aircraft wheels and brakes; spare parts; repair, overhaul, and maintenance services; thermal systems; and connected solutions and data services for aftermarket, as well as wireless connectivity and management services.

The company’s Honeywell Building Technologies segment offers software applications for building control and optimization; sensors, switches, control systems, and instruments for energy management; access control; video surveillance; fire products; remote patient monitoring systems; e-cooling heat transfer agents; and installation and upgrades of systems.

Its Performance Materials and Technologies segment offers automation control, instrumentation, and software and related services; catalysts and adsorbents, equipment, and consulting; and materials to manufacture end products, such as bullet-resistant armour, nylon, computer chips, and pharmaceutical packaging, as well as Honeywell forge connected solutions.

The company’s Safety and Productivity Solutions segment provides personal protection equipment, apparel, gear, and footwear; gas detection technology; cloud-based notification and emergency messaging; mobile devices and software; supply chain and warehouse automation equipment, and software solutions; custom-engineered sensors, switches, and controls; and data and asset management productivity software solutions.