What we liked

• Actions by regulators in overseas market appear to have stemmed the risk of more systemic stresses in the global financial system, following the recent collapse of banks in the U.S. This has acted to reduce volatility in global markets over the past month.
• About 53,000 people found work in Australia in  March, according to data released by the Australian Bureau of Statistics, outstripping forecasts for modest employment growth of 20,000. The gains meant the jobless rate held steady at a near-five-decade low of 3.5%, while there are now almost 900,000 more people in work than at the onset of the pandemic.
• The annual Core PCE Price Index, the Federal Reserve’s preferred gauge of inflation, edged lower to 4.6% from 4.7% in the same period, compared to analysts’ forecast of 4.7%. At the margin this should act to reduce pressure on the Fed to continue to increase interest rates in the fight against inflation.
• The US economy continued to churn out jobs at a brisk pace in March, pushing the unemployment rate down to 3.5%, a historically low level. Nonfarm payrolls increased by 236,000 jobs in March supporting U.S. household balance sheets and discretionary consumer spend.
• China’s manufacturing sector continues to see evidence of expansion in terms of production activities and market demand, with the purchasing managers’ index (PMI) coming in at 51.9 in March. This came above the expectations of 51.5, according to economists in a Reuters poll.
• China’s consumer inflation in March hit the slowest pace since September 2021. While some see this as a pointer to lower-than-expected growth following relaxation of COVID lockdowns we view it more positively as it allows further monetary and fiscal support from officials to support growth.

What we didn’t

• Global bank stress, with three banks folding over the month. The fast rise in global interest rates has been a concern of ours for a while as it tends to lead to financial system pressures. While we do not believe the issue will become a credit or systemic issue, it does highlight the elevated risk dynamic in economies and the financial system caused by the combination of high inflation and an aggressive rate hiking cycle.
• The U.S. manufacturing sector sank deeper into contraction in March. The Institute of Supply Management’s manufacturing purchasing managers index (PMI) fell to a 21-month low of 46.3 from 47.7 in February, well below consensus forecasts for a more modest drop to 47.5, exhibiting a deteriorating backdrop for manufacturing activity.
• The U.S. services sector slowed more than expected in March as demand cooled. The non-manufacturing PMI fell to 51.2 last month from 55.1 in February. A silver lining to the data is that decreasing demand should act to reduce inflationary pressures.
• Job openings in the U.S. fell below 10 million in February for the first time in nearly two years, in a sign that the Federal Reserve’s efforts to slow the labour market may be having some impact. Available positions totalled 9.93 million, a drop of 632,000 from January’s downwardly revised number.
• In March, U.S. retail sales decreased by 1%, surpassing economists’ predictions for a 0.4% decline. This suggests that consumers are feeling the impact of a more challenging economic climate.

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 – L1 Capital

L1 Capital is a global investment manager with offices in Melbourne, Sydney, Miami and London. The business was established in 2007 and is owned by its senior staff, led by founders Raphael Lamm and Mark Landau. The team is committed to offering clients best of breed investment products through strategies that include long short Australian equities, international equities, activist equities, a global multi-strategy hedge fund and U.K. residential property.

Investment Thesis

Key reasons for the investment:

• • Provides our clients with a differentiated invest approach to global market investing with a long/short strategy. Thus the manager seeks to take advantage of both price increases and price decreases in global share markets.
  • The firm has built a reputation for investment excellence, with all L1 Capital’s strategies delivering strong returns since inception.
  • The fund has displayed annualised returns of 20.6% since 2014.
  • The fund is well positioned to take advantage of the volatility created in the current inflationary/rising interest rate market.

History

L1 Capital manages money for a range of clients including large superannuation funds, endowment funds, financial planning groups, asset consultants, family offices, high net worth individuals and retail investors. The firm is committed to offering clients best of breed investment products.
The portfolio is invested in the L1 Capital Long Short Strategy, launched in 2014, has delivered net returns of greater than 25% in 6 out of the 7 calendar years it has been running and is the best performing long short fund in Australia since inception.
The fund has won several awards overs its history including:

HSBC Survey – ‘Best Performing Hedge Fund Globally’ in 2015 and ‘Top 20 Hedge Fund Globally’ in 2016, 2017 and 2021.

Zenith Awards – Winner | Zenith Fund Awards ‘Australian Equities – Alternative Strategies’ 2022.