What we liked

• The Job Openings and Labor Turnover Survey for the month showed available positions at 10.46 million, down just fractionally from October’s total and above the 10 million forecast by analysts. The JOLTS survey is closely watched by Federal Reserve officials for signs of labour market slack. While indicating a strong jobs market, it also maintains pressure on the U.S. central bank to continue increasing interest rates.
• Continuing the strong U.S. job market theme Nonfarm payrolls increased by 223,000 for the month, above analyst consensus estimates for 200,000. While the unemployment rate fell to 3.5%, 0.2% below the expectation.
• China’s December inflation rate came in at a benign 1.8% in December. This is positive as leaves ample room for the government to provide stimulus to the economy as they emerge from COVID related lockdowns.
• China manufacturing and services activity returns to expansion on the back of economic reopening. Manufacturing PMI came in just in expansionary territory at 50.1 and beat expectations of a 49.8 read. Services saw a pronounced improvement with a read of 54.4 clearly beating expectations of 52. As a reminder, a read above 50 indicates expansion.
• German preliminary inflation data from Europe’s largest economy saw a larger reduction than expected. Preliminary annual inflation came in at 8.6% versus the 9.1% annual increase expected.

What we didn’t

• Australia’s annual rate of inflation has risen to 7.8%, marking the highest yearly increase since 1990. This was higher than the expected rate of 7.5%.
• Australian retail sales slumped 3.9% in December from the prior month. The reading broke 11 consecutive months of rises, and was far worse than expectations for a decline of 0.3%. Higher inflation and interest rates are having negative effects on the Australian consumer demand.
• Business activity in the U.S. manufacturing sector contracted for the second straight month in December, with ISM’s Manufacturing PMI declining to 48.4 from 49 in November. This reading came in slightly below the market expectation of 48.5 and indicates contracting U.S. manufacturing activity.
• U.S. non-manufacturing PMI missed expectations and has also shifted into contractionary territory. It declined to 49.6 in December, indicating that the services segment of the economy found itself under pressure. The services sector has been a beacon of strength for the past 12 months. This indicates economic activity in the U.S. is continuing to decelerate in a broadening fashion.
• Further indication of a  slowing U.S. economy was provided by retail sales numbers falling more than expected in December. Retail sales fell 1.1% in December versus expectations of an 0.8% drop. Sales numbers from November were also revised to falling 1% versus and initial read of -0.8%.

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. 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 has seen marked improvement in investor sentiment. 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 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. This is likely to be mitigated by earnings downgrades. A slowing global economy combined with high input prices, negative operating leverage and currency volatility are expected to dampen profit margins.
The current environment leaves central banks, particularly the U.S. Federal Reserve, in a difficult position. Developed economy central bank choices appear to be ease financial conditions and support the economy, while risking local currency 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.
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 weakening 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.

15% Probability

Global consumer demand for goods and services falls further than expected as inflationary pressures and increased interest rates negatively 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 (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 (through quantitative tightening) 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.

An upward acceleration of bond yields from current levels could see a return to 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.

15% 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 continue 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 supressing interest rates below inflation levels, we would expect this to further fuel asset valuation appreciation.

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 – Freeport McMoRan

Investment Thesis

Key reasons for the investment:

• • FCX is one of the world’s premier low-cost copper producers. It is in a prime position to take advantage of the “electrification” of global economies as they transition to clean energy over the next decade.
  • Economic growth concerns saw copper prices fall from USD$5.00/pound to USD$3.50/pound mid last year.
  • We viewed this price as approaching a floor for physical copper and took advantage of the correlated dip in FCX’s share price.
  • While difficult to predict short-term bottoms, the price dip provided an attractive re-entry level in what is expected to be an industry with high demand and limited supply capabilities.

History

Freeport-McMoRan Inc. is a mining company and one of the world’s largest copper producers. The Company has organized its operations into five divisions, which include North America copper mines, South America mining, Indonesia mining and Molybdenum mines. The Company’s portfolio of assets includes the Grasberg minerals district in Indonesia, copper and gold deposits, and mining operations in the Americas, including the large-scale Morenci minerals district in North America and the Cerro Verde operation in South America.

Freeport-McMoRan Inc. (“FCX”), formerly known as Freeport-McMoRan Copper & Gold Inc., was established in 1988 following the discovery of the Grasberg copper and gold deposit in Papua, Indonesia, when FCX’s former parent company, then known by the New York Stock Exchange trading symbol of “FTX”, sold 20 percent of the company in an initial public offering, or IPO. Following the acquisition of Phelps Dodge in 2007, FCX transformed into a dynamic industry leader, and combined the assets and technical teams of two great companies. FCX’s unique portfolio of mining assets was developed and acquired by several predecessor companies, including Freeport Minerals, Phelps Dodge, Cyprus Minerals, American Metal Company (AMAX), and Climax Molybdenum, among others.