July 2023 | Monthly View

What we liked

• Australian monthly inflation data came in lower than expectations. The monthly reading (note the quarterly data remains the most comprehensive read of inflation in Australia) was 5.6% inflation increase year on year. This was lower than the 6.1% expected, providing some relief to markets following the previous months high reading.
• U.S inflation showed further signs of easing rising by 4% for the year ending May. Analyst expectations were for 4.1%. While a positive as it reduces pressure on the central bank to continue raising interest rates, we are conscious that it is comparing to very high levels 12 months ago, so the base effect of the numbers helps provide a slowdown in the rate of inflation.
• In a similar vein, the U.S. Producer Price Index (a measure of business input costs) showed a negative month on month move reducing by -0.3%. While a net positive, we remain concerned that this negative pricing action for producers could put pressure on company earnings through negative operating leverage.
• U.S. consumers spent more on retail items and at restaurants between April and May, with the Commerce Department showing a 0.3% month-on-month increase. This suggests domestic consumers remain defiant against inflationary pressures.
• China’s inflation rate remains benign increasing by 0.2%. The positive of this low inflation number is that it provides much scope for Chinese official to implement stimulatory economic policies to promote economic growth. That said the number does point to a slower than expected recovery so far following the re-opening of the economy from COVID lockdowns.

What we didn’t

• The RBA raised the official cash rate by another 0.25% in May, taking the official cash rate to 4.1%. We expect this to place further pressure on household spending as mortgage servicing pressures build, particularly at a time when many mortgages are rolling off low interest rate fixed income loans.
• The NAB Business Survey for the May showed a significant slowing in activity and has highlighted general apprehension towards the future economic outlook. The survey results reported widespread weakening across most of its indicators, as high inflation and interest rates are acting to stunt growth and general market optimism.
• U.S. ISM services data fell to a reading of 50.3 in May, missing expectations of 52.6 read. The services sector has been the standout in the U.S., so a deterioration in this segment of the economy would be further sign of the economy weakening. This could be a  sign that credit conditions and the drawdown of pandemic savings are finally hitting services activity.
• The European Central Banks (ECB) raised rates again. This time by 0.25%, to 4% as it attempts to dampen inflationary pressures. This places Europe in a precarious economic situation as the bloc’s economic growth is slowing considerably and rates continue to rise.
• Chinese industrial output grew 3.5% in May from a year earlier, slowing from the 5.6% expansion in April and slightly below a 3.6% increase expected by analysts, as manufacturers struggle with weak demand at home and abroad. It highlights the underwhelming economic recovery taking place in China following the repeal of COVID lockdowns.
• Adding to indications of an underwhelming economic recovery in China retail sales, a key gauge of consumer confidence, rose 12.7%, missing forecasts of 13.6% growth and slowing from April’s 18.4%.

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 over the remainder of the year, despite recent data exhibiting some resilience. Slowing consumer discretionary spend, inventory builds, and margin compression are anticipated to remain strong themes over the coming months, adversely impacting company earnings.

Our view remains that inflationary rates of increase are expected to continue slowing, 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 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 and 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. Capital preservation will be the primary objective through appropriate company/sector allocations to those companies and sectors that are resilient earners in a weakening business cycle as well as exhibiting 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. 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.

15% Probability

Global consumer demand for goods and services falls further than current sanguine expectations as inflationary pressures and increased interest rates negatively impact discretionary spending. Recent bank stresses are expected to 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, further exacerbating inflationary pressures, placing greater pressure on central banks to tighten monetary conditions. 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.

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 continuing 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 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 – Macquarie Group Ltd

Investment Thesis

Macquarie Group Ltd. offers banking, financial advisory, investment and funds management services.

It is one of Australia’s largest banking operations based on a number of measures – market capitalisation, total assets, share of household deposits and share of residential and investor lending.

Key reasons for the investment:

• • Leveraged to Structural Tailwinds – MQG provides unique capabilities and track record in renewable energy advisory, development and management. Additionally, it provides access to private markets and alternative asset management, an area in which we expect to see continued strong growth.
  • Strong Balance Sheet – MQG has a proven record of well-timed capital raising providing the company with a high level of balance sheet flexibility, allowing them to make strategic acquisitions to add long-term value.
  • Capital Management – Macquarie have a strong management team, proven capital allocation methodology, pay a consistent fully-franked dividend stream, and can take advantage of diversification across a number of international investment markets.