What we liked

• Australia NAB Business Confidence rose further from 0 to 6 in January. Business Conditions also improved from 13 to 18. A positive sign of confidence in the domestic economy, despite rising interest rates pressuring discretionary spend.
• U.S. unemployment fell to 3.4% in January, the lowest level since May 1969. Nonfarm payrolls increased by 517,000 for January, much higher than December’s gain of 260,000 and their best gain since July. This is positive for economic growth in the U.S. but maintains pressure on the Fed to maintain tighter monetary policy.
• An U.S. ISM Services barometer of business conditions at companies such as restaurants and hotels rebounded to 55.2 in January after falling into contraction of 49.6 in the prior month. This clearly beat the expectation of 50.6. While aided by warmer the usual winter weather it exhibits a resilient consumer in the U.S.
• US retail sales rose in January by the most in nearly two years, signalling robust consumer demand that could bolster the Federal Reserve’s resolve to keep raising interest rates in the face of persistent inflation. The month on month increases came in at 3% versus expectations of a 1.8% increase, aided by warmer than expected winter weather in the U.S.
• China’s consumer price index rose by 2.1% in January, but ‘golden week’ spending did not have as much of an impact on inflation as expected. This is positive as lower inflation allows for further stimulus to assist economic activity pick-up in the world’s 2nd largest economy as they emerge from COVID lockdowns.

What we didn’t

• Central banks continue to raise interest rates. The RBA in Australia raising by 0.25%, along with the U.S. Fed increasing at the same rate. In Europe the ECB raised by a larger 0.5%. Higher rates continue to tighten monetary conditions. Monetary policy acts with a lag and thee increases are expected to slow economic activity throughout 2023 and into 2024.
• U.S. inflation came in higher than expected with consumer prices rising 0.6% from December to January, up sharply from a 0.2% increase from November to December. This places more pressure on the U.S. Fed to maintain and or increase interest rates to dampen demand.
• The economic activity in the US manufacturing sector continued to contract at an accelerating pace in January with the ISM Manufacturing PMI dropping to 47.4 from 48.4 in December. This reading came in below the market expectation of 48.
• The U.S. Conference Board Consumer Confidence Index® decreased in February for the second consecutive month. The Index now stands at 102.9), down from 106.0. while still relatively higher interest rates appear to be adversely impacting the U.S. consumer, who is a key driver of the economy.
• A private gauge of China’s manufacturing activity improved in January but remained in contractionary territory for the sixth straight month. The purchasing managers index rose to 49.2 in January from 49.0 in December. Expectations are for this to continue to improve as COVID lockdown effects ease following the recent easing of government policy.

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, despite recent data generally surprising to the upside. 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, as a slowing global economy combined with high input prices, negative operating leverage and currency volatility are expected to dampen company 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 companies and sectors that are resilient earners in a weakening business cycle and 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.

16% 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 the currently 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, 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.

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 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.

14% 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. 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 – Verizon

Verizon Communications was created on June 30, 2000 by Bell Atlantic Corp. and GTE Corp., in one of the largest mergers in U.S. business history. GTE and Bell Atlantic evolved and grew through decades of mergers, acquisitions and divestitures.

Today, Verizon is a global communications technology company delivering the promise of the digital world to millions of customers every day. Its market capitalisation is near USD$165Billion.

Investment Thesis

Key reasons for the investment:

• • Value emerges – A year of substantial underperformance has brought VZ’s valuation to historically attractive levels on both an absolute and relative basis, while the company also offers a well-supported ~7% dividend yield. From a fundamental standpoint, the company has a favourable business mix and should see some stabilization in wireless demand after a disappointing 2022.
  • Strong cash flow – The company’s Free Cash Flow (FCF) is set to ramp 45% by 2024 on moderating 5G capex, according to analysts. As we expect a challenged economic environment to persist over the next 6-12 months, such strong FCF is expected to be well bid by the market. We expect this to be supported by lower CAPEX from VZ after the last few years had heavy spending on 5G network spending. This investment should also bode well for growth over the coming years.
  • Improving trading environment – The Telco services sector had a poor relative performance year in 2022 based on weakening earnings expectations. It is now beginning to see an improvement after being clearly the 2022 sectoral underperformer in the U.S. Recent earnings improvements are suggesting the tide is turning for the sector as earnings begin to improve from below historical levels.

History

Verizon Communications Inc.provides communications, technology, information, and entertainment products and services to consumers, businesses, and governmental entities worldwide. It operates in two segments, Verizon Consumer Group (Consumer) and Verizon Business Group (Business). The Consumer segment provides wireless services across the wireless networks in the United States under the Verizon and TracFone brands and through wholesale and other arrangements; and fixed wireless access (FWA) broadband through its wireless networks. It also offers wireline services in the Mid-Atlantic and Northeastern United States, as well as Washington D.C. through its fiber-optic network, Verizon Fios product portfolio, and a copper-based network. The Business segment provides wireless and wireline communications services and products, including data, video, conferencing, corporate networking, security and managed network, local and long-distance voice, network access, and various IoT services and products, as well as FWA broadband through its wireless networks.