What we liked

• Business conditions in Australia continued to ease in April but remained elevated according to the NAB business survey. This reflects the enduring resilience of demand and a strong labour market. Trading conditions were lower but at +20 index points remain at a very high level, and the employment index has stabilised well above its historical average.
• U.S. federal Reserve left rates unchanged.  We feel this is prudent to allow time to get a further understanding of effects of cumulative interest rate increases, as well as the potential financial tightening from bank failures.
• U.S. job openings rose to 10.10 million jobs available after recent falls, indicating the jobs market remains strong. This part of the economy remains a very solid foundation for economic activity.
• The U.S. economy continued to grow jobs in May, with nonfarm payrolls surging more than expected despite multiple headwinds. Payrolls in the public and private sector increased by 339,000 for the month, better than the 190,000 Dow Jones estimate and marking the 29th straight month of positive job growth.
• Most European countries showed slowing rates of inflationary pressures, albeit from still very elevated levels. This continues a lower trend, indicating interest rate rises over the past year are having the desired effect on inflationary pressures. The overall rate came in at 6.1% year on year versus expectations of a 6.3% rise.
• China’s consumer price index rose 0.1% in April year-on-year, the slowest since early 2021. Month-on-month, prices declined by 0.1%. Economists surveyed by Reuters expected to see consumer prices rise 0.4%. This is positive as provides scope for further stimulus to be injected into the China economy. Also, means that China is not exporting inflation to the rest of the world through its exports.

What we didn’t

• The Westpac Melbourne Institute Consumer Sentiment Index fell by 7.9%, from 85.8 in April to 79.0 in May. The Index has fallen back to just above the dismal levels seen back in March, which recorded the lowest monthly read since the COVID outbreak in 2020.
• Sentiment among U.S. consumers faltered in May as worries over the path of the economy dragged on. The University of Michigan said that its consumer sentiment index fell to 59.2 in May from 63.5 in April.
• The economic activity in the US manufacturing sector continued to contract at an accelerating pace in May with the ISM Manufacturing PMI dropping to 46.9 from 47.1 in April. This reading came in worse than the market expectation of 47. New orders, a good leading indicator, also came in at an anaemic read of 42.6. The only good news in the report was lower prices paid, which should help ease inflationary pressures.
• The U.S. ISM Services PMI index pulled back to 50.3 in May from 51.9 in April. This falls well short of the 52.4 reading consensus was expecting. This is the fifth consecutive month of expansion for the services sector, but optimism has been steadily eroding since late 2022. Services have been the standout sector of the U.S. economy and further weakness may be a harbinger of a deteriorating economy.
• Chinese manufacturing activity data was mixed but generally remain weak considering their post-COVID lockdown reopening. Of the two major reading one showed activity continues to contract (this reads activity of large state-owned enterprises), while another came in at 50.9 vs expectations of a 49.5 read.

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 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 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. 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 sector allocation and moderate 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 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. 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, with short-term tactical positioning to be guided by macroeconomic developments, central bank actions and market positioning.

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 (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.

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 – SSE

Investment Thesis

• • High quality balance sheet – SSE is a large U.K power generation business with flexible generation capabilities. The business has large exposure to renewables and has a considerable CAPEX plan to grow renewable energy capabilities over coming years.
  • Underappreciated assets – SSE provides exposure to two structural growth areas, which we believe are underappreciated by the market, transmission infrastructure as electrification grows and renewable energy asset developments.
  • Earnings momentum – The company is now in an earnings upgrade cycle, which has been exhibited over this year. SSE has raised earnings expectations once again and across all divisions. We expect this to provide an upward re-rating by the market based upon operational excellence, combined with a greater appreciation for the company’s long-term growth drivers.
  • Regulatory support – The U.K government recently announced a plan for the future of UK energy. Highlights include a raft of previously announced schemes such as funding for offshore wind, carbon capture and new green hydrogen production projects, which is expected to be supportive for SSE’s renewable projects/funding.
  • Resilient earnings – As a power utility we expect company earnings to remain resilient, even in the event of a slowing economy. As such, our portfolio investment further increases the defensive tilt across our portfolio strategies. This is further supported by an expected dividend yield of ~4.5%.

History

SSE can trace its heritage back almost 80 years to the advent of electricity generation in the north of Scotland.
The North of Scotland Hydro-Electric Board was formed with the Hydro Electric Development Act in 1943, delivering electricity to the Highlands for the first time. Scores of hydro dams and power stations were built across the uniquely positioned but challenging terrain – dramatically improving lives across the region.

It was no easy feat, with works at St Fillans setting a world tunnelling record in 1955, grinding their way through 557ft of rock in just one week. By the mid 1960’s, Scotland could boast of 56 dams connected by over 600km of rock tunnels, aqueducts and pipelines.

In the south, the former Southern Electricity Board was created in 1948 to distribute and supply electricity in southern England.

SSE plc has its origins in these two public sector electricity supply authorities, with both organisations privatised in the early 1990s with the deregulation of energy. They merged in 1998, creating one of the largest energy businesses in Great Britain with millions of domestic energy customers alongside operating the electricity networks across both regions.

In 2008, SSE acquired Airtricity, an Irish wind farm business, doubling renewables capacity to become the largest operator in the UK and Ireland.

Today they remain the UK’s largest generator of renewable energy, in keeping within predecessors’ historic aim to provide safe and reliable electricity for all.

In 2020 SSE sold their GB electricity supply business to Ovo Energy, to focus on the core businesses of electricity networks and renewables, with complementary interests supporting the transition to a net zero world.