July 2022 | Monthly View

What we liked

• Australia’s jobs market has continued to strengthen, with unemployment remaining at 3.9% last month and underemployment falling to a 14-year low. As more people joined the labour force, the participation rate jumped to a fresh record high, up from 66.4% to 66.7%. The jobs market remains strong, supporting continued strength in consumer demand.
• Australian retail sales rose 0.9% in May, the fifth straight month of growth and more than double market forecasts of a 0.4% increase. Combined with strong employment figures the underlying Australian economy remains on a solid footing.
• U.S. ISM Manufacturing PMI, a closely followed index of U.S.-based manufacturing activity, rose to 56.1 in May from 55.4 in the prior month, beating expectations of a 54.5 print. A read above 50 indicates expansion in activity, with the manufacturing PMI achieving a 24th consecutive month of growth.
• The US economy added 390,000 jobs in May, according to a report released by the US Bureau of Labour Statistics. That was above the median economist forecast for a gain of 325,000 jobs
• Demand for workers remained near record highs, with 11.4 million job openings in April, as the tight labour market continues to be a bright spot for the U.S. economy
• China NBS manufacturing PMI came in with a read of 50.2 in June, returning to expansion. following improvement in May. This increases the chance that we have passed the trough in China manufacturing brought on by COVID lockdowns.
• Chinese inflation came in at 2.1% in May, a relatively benign read. This is positive as it leaves further scope for Chinese authorities to stimulate their economy to improve economic activity domestically.

What we didn’t

• The RBA increased interest rates by 0.5% versus expectation of a 0.25%-0.40% increase. This change was made to combat high inflation levels by reducing demand in the economy.
• According to the June Westpac report, consumer confidence in Australia fell 4.5% from the prior quarter to 86.4. A reading below 100 is considered a pessimistic outlook held by the consumer. Over the 46-year history of the survey, we have only seen Index reads at or below this level during major economic dislocations.
• The U.S. Federal Reserve raised its benchmark interest rates by 0.75% in its most aggressive hike since 1994. This was at the upper end of consensus. Officials also significantly cut their outlook for 2022 economic growth, now anticipating just a 1.7% gain in GDP, down from 2.8% from March.
• Inflation in the US rose unexpectedly last month to a fresh four-decade high of 8.6%. This places further pressure on the Fed to increase interest rates to dampen demand in the economy.
• U.S. consumer sentiment fell to a record low, hitting 50. That’s 14.4% below a May reading of 58.4 and 41.5% from a year-earlier period, according to the University of Michigan survey. With over 60% of the U.S. economy consumer driven, such a low read indicates consumer demand may continue to wane, weakening the overall economy.
• U.S. retail sales unexpectedly fell 0.3% in May as inflation accelerated again. The print landed below the median estimate of 0.2% growth and showed a slowdown from April’s pace. The report signals the fastest price growth since 1981 started to cut into Americans’ demand.

Base Case

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

75% Probability

The speed of economic improvement is expected to continue moderating from 2021’s stellar growth rate. Despite this, we anticipate economic activity to remain in expansionary territory. Recessionary predictions are anticipated to build, as markets price in the potential for excessive monetary tightening by central banks, with Europe and the U.S. most vulnerable. Slowing consumer discretionary spend and inventory builds are believed to be a strong theme over the coming months.

Supporting growth expectations is China, who we anticipate will accelerate a more accommodative monetary and fiscal policy stance to promote growth within their economy. Additionally, governments of developed nations are anticipated to maintain moderately stimulatory policies to support long-term social objectives such as carbon reduction through energy transition and reducing social inequality.

We believe inflationary pressures will wane over the coming months with the rate of increase slowing. This should be supportive for credit markets as well as valuations of growth assets and manifest in greater financial market stability, following recent high volatility. This is likely to be mitigated by earnings expectations being downgraded, as a slowing global economy combined with increased input prices dampening profit margins.

Other risks remain. Those we view as most prominent include 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 building), a further increase of COVID-cases in China prolonging lockdowns 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 a business cycle and those that are able to maintain pricing power. This is likely to favour defensive sectors, such as healthcare and consumer staples at the expense of more cyclical sectors such as industrials, consumer discretionary and materials. Overall, asset allocation will retain a neutral to slight bias to growth assets.

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 expected as the anticipated pick up from pent up demand underwhelms. Rather, the consumer remains apprehensive once the direct-to-consumer fiscal support from governments and central banks wanes. Additionally, supply chain issues remain as do inflationary pressures. Geopolitical tensions could act to further increase commodity prices, further exacerbating inflationary pressures. Additionally, wage pressures become more systemic as employees successfully lobby for inflation plus wage increases. This will lead to a deterioration in company profits as increased input costs, increased debt servicing costs and lower demand crimp earnings.

Such a scenario would mean financial conditions are tightening while inflationary pressures remain elevated. This could see central banks beginning to withdraw monetary support at a time when the economy cannot handle further tightening without substantially reducing demand and economic activity. An untimely withdrawal or reduction of central bank liquidity could derail financial markets which have become accustomed to liquidity support. If combined with reduced government expenditure this may cause consumer confidence and spending to fall as government support is not fully replaced by gainful employment income.

Elongated supply chain issues and resultant high input costs would be 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 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 corporate default (especially due to over-indebtedness in an environment of rising bond yields) 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.

11% Probability

Economies across the developed world experience better than currently anticipated economic growth from current levels. This would lead to a synchronous global growth environment as inflation pressures wane and supply chain pressures ease. Fiscal support from governments would combine with sound cash levels on household and corporate balance sheets to accelerate the speed of the global economic activity. In the event central banks resume measures aimed at supressing interest rates below inflation levels, we would expect this to further fuel asset appreciation.

Such a market dynamic would see substantial improvement in economic activity globally, particularly in service-oriented businesses that will benefit from social re-opening. Additionally, an abatement in supply chain constraints could see inflation moderate, thus reducing pressure on central banks to withdraw stimulatory measures. This would occur as demand from business and consumers combine with government and central bank stimulus measures to create a potent environment for risk assets.

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. Additionally, if leading economic indicators began surprising to the upside a net shift towards sectors leveraged to economic growth would be undertaken.

Stock in Focus – Johnson & Johnson

Investment Thesis

• Key reasons for the investment:
  • Diversification provides resilience – JNJ has three major business divisions; Consumer, Pharmaceuticals, and Medical Devices. This broad diversity provides resilience during different environments and across a business cycle. The resultant resilience of earnings attracts us to JNJ as high-quality resilient earning grower.
  • Pharma Pipeline Strength – In their latest pharmaceutical update for investors JNJ highlighted 5 drugs in its development pipeline that have a $5B+ addressable market. While they are the highlights, the portfolio is diverse, with JNJ expecting at least 5% growth in its pharma division over the coming 3 years.
  • Spin-Off Catalyst – JNJ recently announced that it plans to separate its Consumer Health business segment into a new publicly traded company. The separation is expected to complete in 12-18 months. Spin-offs tend to add value as businesses are valued more highly on a sum-of-the-parts basis and it also facilitates a dedicated management team and balance sheet. We also view it positively as it could unlock greater returns from more concentrated investments for the pharma business.

History

By most measures the single largest pharma company in the world, US-based Johnson & Johnson (J&J) is also arguably one of the most well-known drugmakers among the general public.

Both these factors can be tied in part to J&J’s strong presence in the consumer sector – but behind household name products is a strong pharmaceutical backbone that has emerged over the company’s long and varied history.

Johnson & Johnson was founded over 125 years ago in the year 1886. However, it wasn’t until 1959 – 73 years and two major acquisitions later – that J&J developed its significant presence in the pharmaceutical industry.

In 1886, three brothers – Robert Wood Johnson, James Wood Johnson and Edward Mead Johnson – founded Johnson & Johnson, in New Brunswick, New Jersey in the United States. It’s said that the Johnson brothers were inspired to start the business in order to create a line of ready-to-use surgical dressings, after hearing a speech by antiseptic advocate Joseph Lister in 1885. Robert Wood Johnson served as the first president – the company became incorporated in 1887 and throughout the nineteenth century, Robert worked to improve sanitation practices.

A year later, J&J pioneered the first commercial first aid kits, which were initially designed to help railroad workers, but soon became the standard practise in treating injuries. In 1894, J&J’s heritage baby business began, by the launch of maternity kits. These kits had the aim of making childbirth safer for mother and babies. Johnson’s Baby Powder also went on sale during this year and was extremely successful. Robert Wood’s granddaughter, Mary Lea, was the first baby to be used on the baby powder label.

Between 1896 and 1897, J&J enabled a huge step forward for women’s health when it manufactured the first mass-produced sanitary protection products.

When Robert Wood died in 1910, his brother James Wood became president, before James’ son, Robert Wood Johnson II became president in 1932.

One of J&J’s subsidiaries is Ethicon, which is a manufacturer of surgical sutures and wound closure devices. It was incorporated as a separate company in 1949 so as to expand and diversify the J&J product line. Following World War II, Ethicon’s market share in surgical sutures rose from 15% to 70% worldwide.

In 1959, J&J acquired McNeil Laboratories in the US and also Cilag Chemie, AG in Europe. These two acquisitions enabled the company to gain a significant presence in the field of pharmaceutical medicines for the first time. One McNeil product was the first prescription aspirin-free pain reliever, Tylenol (acetaminophen) elixir for children.

It was in 1961 that Belgium’s Janssen Pharmaceutica N.V. joined the J&J Family of Companies. Its founder, Dr Paul Janssen, is recognised as one of the most innovative and prolific pharmaceutical researchers of the 20th century.

Today, Janssen is one of the world’s leading research-based pharma companies and markets prescription medicines in the areas of gastroenterology, women’s health, mental health, neurology and HIV/AIDS, to name a few.

Some well known brands owned by JNJ include:

• Johnson’s baby for baby care products
• Aveeno, Neutrogena, Johnson’s, Clean & Clear, and Dabao for skin care products
• Band-Aid, Bengay, Savlon, and Neosporin for wound care products
• Listerine and Rembrandt for oral care products
• Visine and Acuvue for vision care products
• Tylenol, Sudafed, Pepcid and Benadryl for OTC medicines