What we liked

• The Reserve Bank of Australia has extended its interest rates pause for a fourth consecutive month as it assesses whether the sharpest increase in borrowing costs in three decades has done enough to temper inflation.
• ISM U.S. non-manufacturing PMI rose to 54.5 in August, the highest reading since February and up from 52.7 in July. A reading above 50 indicates growth in the services industry, which accounts for more than two-thirds of the economy. One potential area of concern in the report was businesses paying higher prices for inputs – a potential sign of still-elevated inflation pressures.
• U.S. durable goods saw so-called core orders jumped 0.9%. That figure omits defense and transportation and is a proxy for broader business investment. So, while this is encouraging overall orders remain below trend.
• Inflation in the euro zone fell to its lowest level in two years in September, suggesting the European Central Bank’s steady diet of interest rate hikes was succeeding in curbing runaway prices albeit at a growing cost for economic growth. Consumer prices in the euro zone rose by 4.3% in September, the slowest pace since October 2021, from 5.2% one month earlier, according to Eurostat.
• Both China’s official manufacturing purchasing managers’ index (PMI) and the Caixin/S&P Global manufacturing PMI were in expansion for September. While still underwhelming, we are encouraged by signs of some “green shoots” in manufacturing activity.

What we didn’t

• U.S. bonds yields rose to fresh highs in September. With the 10-year bond yield peaking at 4.64%, the highest rate since 2007.
• U.S. unemployment rose to 3.8% in September, higher than expected. While mitigated by the increased participation rate, some signs are flashing some jobs weakness. Hourly average earnings rose 0.2% for the month, also missing expectations. This said employment in the U.S. remains robust and some weakness is welcome to assist in reducing inflationary pressures.
• U.S. ISM manufacturing index rose more than expected in August to stand at 47.6 versus 46.4 in July (consensus was 47.0), but this is the tenth consecutive month it has come in below the break-even 50 level, indicating contraction.
• Another weak read this month for this survey in the German IFO survey. The IFO index is Germany’s most prominent economic leading indicator. At 85.7 it dropped for the fifth month in a row. This is one of the weakest IFO index readings of the last five years. The current assessment component continued its recent downward trend with the only positive coming from future expectations improving slightly.

Base Case

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

72% 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 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 continue moderating, 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, higher yields and inflation or continue to fight inflation and risk more severe economic weakness and potential bond market/banking stress. The actions of policy makers to move in either direction will be a large driver of financial market performance over the coming months. It Is possible that continued liquidity injection from central banks to shore up the financial system will provide continued support for risk asset valuations.

This scenario is likely to see us maintain a neutral to slightly positive view on growth assets over the next few months as employment and consumer conditions remain sound. Capital preservation will be the primary objective through appropriate company/sector allocations to those companies and sectors that are resilient earners in a peaking business cycle, as well as those exhibiting pricing power. This is likely to favour defensive industry sectors that are resilient in a slowing economy. Should liquidity injections continue to be a feature of central bank policy, tactically increasing positions in risk assets may be warranted.

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 provide liquidity into financial markets. Overall, asset allocation will retain a neutral bias, with short-term tactical positioning to be guided by macroeconomic developments and central bank actions.

Bear Case

Our worst-case scenario for the coming months, which we are prepared to position for should conditions deteriorate.

13% Probability

Global consumer demand for goods and services falls further than current constructive expectations as inflationary pressures and increased interest rates negatively impact discretionary spending. A reversion to bank stresses seen earlier this year would be expected to further 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. A situation more likely over the next few months, as the northern hemisphere moves into winter and requires more heating fuel. 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 into the financial system 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 – Verizon

Investment Thesis

• Value emerges – A significant price pull-back has brought VZ’s valuation to historically attractive levels on both an absolute and relative basis, while the company also offers a well-supported ~8% dividend yield, and PE ratio of six times earnings. From a fundamental standpoint, the company has a favourable business mix and should see some stabilization in wireless demand.
• 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 and early 2023 based on weakening earnings expectations. It is now beginning to see an improvement after being a sectoral underperformer in the U.S. Recent earnings improvements are suggesting the tide is turning for the sector as earnings begin to improve.

History

Verizon Communications Inc., based in New York City and incorporated in Delaware, was formed on June 30, 2000, with the merger of Bell Atlantic Corp. and GTE Corp. Verizon began trading on the New York Stock Exchange (NYSE) under the VZ symbol on Monday, July 3, 2000. It also began trading on the NASDAQ exchange under the same symbol on March 10, 2010. Today it has a market capitalisation of ~USD$140 Billion.

Verizon Communications Inc., through its subsidiaries, 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.