November 2022 | Monthly View

What we liked

• The RBA has tempered the pace of rate rises. After recent 0.5% increases the RBA has reduced increases to 0.25% over the past two meetings as they look to gain more evidence on the economic impact of their aggressive monetary tightening so far this year.
• The U.S. labour market showed strength in September, with private companies adding more jobs than expected. Businesses added 208,000 for the month, better than the 200,000 Dow Jones estimate and ahead of the upwardly revised 185,000 in August.
• A gauge of broad U.S. business services activity remained resilient and moderated less-than-expected at the end of the third quarter, a sign that the economy is holding up well despite growing risks such as high-sky inflation and rising interest rates. The ISM September services PMI eased to 56.7 from August’s 56.9 print, versus a forecast of 56.00, expanding for the 28th consecutive month.
• US employers added 263,000 new jobs in September as the unemployment rate dipped to 3.5%. The jobs market has shown signs of slowing recently after regaining all the jobs that were lost during the pandemic. Growth has remained robust despite rising interest rates and growing fears of a recession, although some signs of weakening are beginning to emerge. A slowing jobs market will ease pressure on the U.S Federal Reserve to continue increasing interest rates.
• China’s economy recovered at a faster-than-anticipated pace in the third quarter. Industrial production data – a measure of activity in the manufacturing, mining, and utility sectors – showed a steep increase in September from a year earlier. While encouraged by the improvement, the trend remains in question as we look for a more sustained improvement before being confident of a more sustained improvement.

What we didn’t

• Australia’s inflation rate accelerated in the September quarter as energy prices soared, heaping pressure on households and businesses, ensuring more interest rate rises to come. The consumer prices index (CPI) has risen 7.3% over the past year. Economists had predicted annual CPI would quicken to 7% from the 6.1% pace reported in the previous quarter.
• The US ISM Manufacturing PMI declined to 50.2 in October from 52.8 in August, pointing to a loss of momentum in the manufacturing sector’s growth. This was the lowest reading in over two years. In a positive the report showed weakness in prices paid by manufacturers, showing that inflation in goods is materially reducing, reducing overall inflationary forces.
• The number of job openings in the U.S. plunged by more than a million in August, providing a potential early sign that the massive U.S. labour gap is beginning to close. Available positions totalled 10.05 million for the month, a 10% drop from the 11.17 million reported in July. While still elevated, the drop can also be seen as a positive as it reduces pressure on the stretched labour market and may reduce wage inflation as a result.
• U.S. retail spending stalled in September as shoppers faced high inflation and rising interest rates. Economists had been expecting retail sales to edge up 0.2%, following an upwardly revised 0.4% jump in August.
• China manufacturing data was mixed. There was some sign of improvement in the NBS Manufacturing PMI for September coming in ahead of expectations at 50.1 versus 49.6 expected. Despite indicating that manufacturing activity moved back into expansion the overall manufacturing activity within China remains historically weak.

Base Case

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

73% Probability

Global economic activity expectations to continue moderating. While there is still a chance that global economic activity may remain in expansionary territory, negative growth probabilities have increased in many jurisdictions. Slowing consumer discretionary spend, inventory builds, and margin compression are anticipated to remain strong themes over the coming months, adversely impacting company earnings. Despite this extremely negative sentiment and market positioning could fuel aggressive rallies in the short-term.

Additionally, governments of developed nations are likely to maintain moderately stimulatory policies to support long-term social objectives such as carbon reduction through energy transition, household inflation assistance packages and reducing social inequality. In the U.S. this may be challenged by a Republican swing in the mid-term elections, which is likely to cause a gridlocked government. Ironically, this has historically provided a positive market backdrop.

Our view remains that inflationary rates of increase are expected to slow, although inflation is expected to remain above historical averages from the past decade. 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 expectation downgrades, as a slowing global economy combined with high input prices and currency volatility dampen profit margins.

The current environment leaves central banks, particularly the U.S. Federal Reserve, in a difficult position. Their choice appears to be ease and support the economy, while risking USD 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.

Other risks remain. Those we view as most prominent include credit market stress relating to bond and currency volatility, increased geopolitical tensions (U.S./China, Aust/China, Russia/Ukraine, China/Taiwan, Iran/Saudi Arabia), greater slowdown in the global economy than current consensus, faster than contemplated increases in government bond yields (due to inflationary pressures remaining elevated), a further increase of COVID-19 cases in China prolonging lockdowns, energy supply disruptions with pricing remaining volatile and continued high levels of supply chain disruptions.

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 that benefit from the maturing of the business cycle and those that 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. 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, such as high energy costs, adversely impact discretionary spending. A deterioration in strong global employment conditions would be a catalyst this. Geopolitical tensions could act to negatively impact supply chain bottle necks, further exacerbating inflationary pressures. 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 combined with lower demand converge to crimp company earnings.

Such a scenario would result in a further tightening of financial conditions, while inflationary pressures remain elevated. This could see central banks continuing to withdraw monetary support at a time as the economy is weakening. Additionally, an untimely withdrawal or reduction of central bank liquidity could derail financial markets, which have become accustomed to liquidity support. When combined with reduced government expenditure this may cause consumer confidence and spending to fall, as prior government support is not fully replaced by gainful employment income.

Elongated supply chain issues and resultant high input costs would result in 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, 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 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.

11% 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. 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 growth accelerates.

Fiscal support from governments would 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, we would expect this to further fuel asset valuation appreciation.

Any de-escalation of the Ukraine/Russian war would be likely to result in increased food, gas, and oil supply from Russia. Additionally, an easing of China’s COVID-19 lockdown policy would further ease supply chain constraints. The effects of such developments would likely be disinflationary and reduce pressure on household budgets. This would further ease pressure on central banks to continue their path of tightening monetary policy through interest rate rises.

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 sectors leveraged to economic growth would occur.

Stock in Focus – Transurban

Investment Thesis

Transurban Group develops, operates, manages, and maintains toll road networks. It operates 21 toll roads in Sydney, Melbourne, and Brisbane in Australia; the Greater Washington area, the United States; and Montreal, North America. The company is headquartered in Melbourne, Australia.

Key reasons for the investment:

• • Earnings resilience – TCL provides resilient earnings and dividends throughout the business cycle. This characteristic is expected to be more attractive in a slowing growth environment and ensure TCL is well bid by the market. The recent announcement of a 2nd half dividend of 26 cents/share exemplifies this. This is above consensus levels. TCL also expects free cash coverage to be over 120% of the dividend, providing a strong buffer to expected dividend payments.

• • Project upside – Key upside risks are for TCL are a stronger-than-expected rebound in traffic volumes, especially the US express lane assets; and a higher-than-expected tariff adjustment due to higher inflation.

• • Inflation buffer – TCL toll road operator contracts are in most cases inflation linked. This provides earnings protection in a higher inflation environment.

History

Transurban Group develops, operates, manages, and maintains toll road networks. It operates 21 toll roads in Sydney, Melbourne, and Brisbane in Australia; the Greater Washington area, the United States; and Montreal, North America. The company is headquartered in Melbourne, Australia.

It is one of the few large infrastructure companies still listed on the Australian Stock Exchange (ASX), as many of its peers have been bought out and privatized over the past decade.

The company has close to 10 million customers worldwide and is a top 15 company on the ASX, with a market capitalization of ~$40Billion. The company has been operating for over 20 years and has a direct workforce of over 3,000 and overall employs over 9,000 people to operate it many roads under management.

Throughout the past decade, Transurban has been able to rely on the support of key industry super funds, most notably UniSuper, which is one of its largest shareholders, and AustralianSuper, which is increasing its direct investment in WestConnex to 20.5%. Transurban has partnered with some of the world’s leading infrastructure investors as shown by the presence on the WestConnex deal of Canada Pension Plan Investment Board, Caisse de dépôt et placement du Québec and the Abu Dhabi Investment Authority.