May 2022 | Monthly View

What we liked

• The National Australia Bank monthly business survey’s confidence index rose a further three points to 16 in March, continuing the steady gains seen since December. The business backdrop in Australia remains constructive.
• U.S. March retail sales report came in slightly better than expectations with upward revisions to February. Headline sales were slightly above expectations, increasing 0.5% in March, with February revised up 50bp to 0.8%.
• Economic activity in the U.S. services sector grew in March for the 22nd month in a row, with the Services PMI registering a read of 58.3. This was 1.8 above February’s read of 56.5, showing increased activity in the services sectors of the U.S. economy.
• University of Michigan’s U.S. Consumer Sentiment Index for April rose to 65.7 from 59.4 last month, above the expected reading of 59.0. While readings remain historically weak, an improvement in consumer sentiment is a positive for the trajectory of the U.S. economy.
• The jobless rate in the eurozone declined in February, as the recovery in the labour market continued despite supply-chain disruptions and rising prices. The eurozone jobless rate fell to 6.8% in February from a revised 6.9% in January.
• Germany’s business confidence unexpectedly improved in April as the economy showed its resilience after the initial shock of the Russian attack. The business climate index rose to 91.8 in April from 90.8 in March. The reading was forecast to fall to 89.1.

What we didn’t

• Consumer prices in Australia have surged by the most in more than 20 years, with the cost of living up 5.1 per cent over the past year. The last time inflation was this high was in June 2001, when prices rose 6.1 per cent largely due to the effect of the recently introduced 10 per cent Goods and Services Tax. Interest rate rises are expected as a result.
• The Westpac-Melbourne Institute index of consumer sentiment, which fell 0.9 per cent to 95.8 in April, from 96.6 in March. A rating of 100 indicates the country is neutral, so it would seem confidence levels are still quite weak as consumers grapple with higher inflation and interest rates.
• U.S. Fed official continued their recent hawkish commentary on inflation and interest rates in their meeting minutes from their March meeting. Fed officials reached consensus at their March meeting that they would begin reducing the central bank balance sheet by $95 billion a month, likely beginning in May. There also were strong indications that half-percentage point, interest rate increases are ahead.
• U.S. ISM Manufacturing PMI, a closely followed index of U.S. based manufacturing activity, slipped to 57.1 in March from 58.6 in the prior month. This compares to the 59 read predicted by economists. This is the lowest level since September 2020 and exhibits a weakening demand environment for goods. Despite this, it should be a noted a reading above 50 indicates activity expansion.
• Eurozone retail sales rose only slightly in February, missing expectations. The volume of retail sales increased 0.3% in February compared with the previous month, after a 0.2% on-month rise in January. Economists polled by The Wall Street Journal had forecast a 0.5% increase for February.
• China’s manufacturing activity slumped to its lowest level since February 2020. The official Manufacturing PMI a key gauge of manufacturing activity, came in at 47.4 in April – below the 50-point mark separating growth from contraction. This is on the back of COVID induced lockdowns in major cities across 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 the economic improvement is expected to continue moderating from 2021’s stellar growth rate. Despite this global economic activity is expected to remain in expansion territory. This is mainly due to Geo-political tensions, COVID induced lockdowns in China and continued supply chain disruptions.

Central banks in developed economies are expected to neutralise their previous ultra-accommodative policy stance as economies improve and inflationary pressures build. This is likely to manifest itself with a continuations of market volatility over the coming months. The exception to this appears to be China, who is expected to begin a more accommodative monetary policy stance to promote growth within their economy. On the fiscal front governments 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 social inequality.

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. 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.

16% 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.

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 crimping 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.

Bull case

Our most optimistic view for markets over the coming months.

12% Probability

Economies across the developed world experience accelerating economic growth from current levels. This would lead to a synchronous global growth environment, where economies that have lagged see accelerated growth. Substantial fiscal support from governments would combine with high cash levels on household and corporate balance sheets to sustain the speed of the global economic recovery. In the event central banks maintain measures aimed at supressing interest rates below inflation levels, we would expect this to further fuel asset appreciation, while any extension or implementation of new accommodative policies would provide support for re-rating of asset values.

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 – Woolworths Group

On Friday, 5 December 1924, Woolworths Stupendous Bargain Basement opened for business in Sydney’s Imperial Arcade. Percy Christmas, Founding CEO said of the event: ‘Every city needs a Woolworths: Sydney has it now. Every man, woman and child needs a handy place where good things are cheap.’

Today Woolworths employs close to 215,000 people with the business worth close to $50 billion. It operates through Australian Food, New Zealand Food, BIG W, and other segments. The Australian Food segment procures and resells food and related products, and provides services to customers in Australia. It operates 1,076 Woolworths supermarkets and Metro Food stores.

The New Zealand Food segment is involved in the procurement and resale of food and drinks, and provides services to customers in New Zealand. This segment operates 184 countdown supermarkets, as well as engages in the wholesale operations. The BIG W segment procures and resells discount general merchandise products to customers in Australia. This segment operates 176 BIG W stores.