June 2022 | Monthly View

What we liked

• Australia’s business conditions strengthened further in April. Business conditions — measuring hiring, sales and profits — advanced to 20 points in April from a revised 15 the prior month, a National Australia Bank Ltd. survey showed.
• The Australian economy added about 4,000 jobs in a month disrupted by Easter. While expectations were for 30,000 jobs to be added the underlying strength was a huge shift of workers from part-time to full-time employment and hours worked increasing by 1.3%.
• The U.S. economy added slightly more jobs than expected in April amid an increasingly tight labour market and despite surging inflation and fears of a growth slowdown. Nonfarm payrolls grew by 428,000 for the month, a bit above the Dow Jones estimate of 400,000.
• U.S. retail sales rose 0.9 percent in April, a solid increase that underscores Americans’ ability to keep ramping up spending even as inflation persists at nearly a 40-year high. Consumers continue to provide critical support to the economy even after a year of seeing prices spiral higher for petrol, food, rent, and other necessities.
• Data from Germany showed improvement in business confidence in May. The monthly survey conducted by Germany’s Ifo Institute showed on Monday that the Business Climate Index improved to 93 in May from 91.9 in April, surpassing the market expectation of 91.4.
• China’s central bank lowered the five-year loan prime rate (LPR) by 15 basis points to 4.45 percent in May, its biggest cut in the mortgages-referenced benchmark for longer-term lending. This comes as the government vows to fast-track pro-growth policies amid a slowing economy.

What we didn’t

• Rising cost of living and the prospect of months of increasing interest rates caused consumer sentiment in Australia to plummet to the lowest level since August 2020, according to the Westpac-Melbourne Institute consumer sentiment index. The drop has been blamed on high inflation and expectation of higher interest rates.
• Jay Powell, head of the US Federal Reserve, communicating that the central bank has made reducing inflation their priority. This would entail tightening financial conditions and may be at the expense of economic growth and employment.
• The latest numbers on the U.S. manufacturing sector show a broad decline in momentum, although it remains in growth mode. April ISM figures showed an expansionary read of 55.4 but this was under the 57.6 expected.
• Euro zone retail sales fell in March as falling consumer confidence and rising inflation squeezed household spending. Sales volumes declined 0.4% in March from the previous month, below a consensus forecast for a 0.1% increase among economists polled by The Wall Street Journal.
• COVID related lockdowns in major Chinese cities continue. This is crimping economic growth in China and adversely effecting global supply chains. This acts to add to global inflationary pressures.
• China reported a drop in retail sales and industrial production in April — far worse than analysts had expected. Retail sales fell by 11.1% in April from a year ago, more than the 6.1% decline predicted in a Reuters poll.
• Chinese Industrial production also dropped by 2.9% in April from a year ago, in contrast with expectations for a slight increase of 0.4%. As a result, further monetary stimulus is expected from China.

Base Case

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

72% Probability

The speed of economic improvement is expected to continue moderating from 2021’s stellar growth rate. Despite this, economic activity is expected to remain in expansionary territory. Recessionary predictions are expected to build as markets price in the potential for excessive monetary tightening by central banks.

Supporting growth expectations is China, who is expected to accelerate a more accommodative monetary and fiscal policy stance to promote growth within their economy. On the fiscal front, other countries 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 promote wage growth, as well as supporting long-term social objectives such as carbon reduction through energy transitions and reducing social inequality.

We expect inflation expectations to wane over the coming months with the rate of increase expected to slow. This should be supportive for credit markets as well as valuations of growth assets. This will manifest itself in greater stability in markets, following recent high volatility.

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 is currently expected, faster than expected 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 constructive medium-term view on growth assets. Capital preservation will be targeted through appropriate company and sector allocations that benefit from the maturing of the current business cycle and those that are able to maintain pricing power in an inflationary environment. 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.

14% Probability

Global consumer demand for goods and services falls further than expected as the expected pick up from pent up demand underwhelms. 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. Geopolitical tensions could act to further increase commodity prices, further exacerbating inflationary pressures. This will lead to a deterioration in company profits as increased input 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 with 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 continue, 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. The overall focus will be a more defensive posture with a focus on capital preservation and a shift to defensive sectors such as healthcare, consumer staples and utilities.

Bull case

Our most optimistic view for markets over the coming months.

14% Probability

Economies across the developed world experience accelerating economic growth from current levels. This would lead to a synchronous global growth environment as inflation pressures wane and supply chain pressures ease. Substantial fiscal support from governments would combine with high 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 pent-up 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.

Stock in Focus – Woodside Energy Group

Established in 1954 Woodside Energy Group has grown to become one of the largest energy producers globally. With a market capitalisation of $29 Billion it supplies 5% of globes liquified natural gas (LNG). The company has over 3,500 employs and has shipped over 6,400 cargoes of LNG since 1989.

Woodside Energy Group Ltd engages in the exploration, evaluation, development, production, marketing, and sale of hydrocarbons in Oceania, Asia, Canada, Africa, and internationally. The company produces liquefied natural gas, pipeline natural gas, condensate, liquefied petroleum gas, and crude oil. It holds interests in the Greater Browse, Greater Sunrise, Greater Pluto, Greater Exmouth, North-West Shelf, Wheatstone, Julimar-Brunello, Canada, Senegal, Greater Scarborough, and Myanmar projects.

Woodside recently merged with BHP’s petroleum business. The new Woodside will be among the top 10 independent oil companies worldwide, not counting the seven vertically integrated super majors. With a market cap of around $63 billion, it will also edge ahead of Fortescue Metals as the ASX’s eighth most valuable company.