What we liked

• Australian retail sales grew more than expected in July, as consumer spending recovered after an unexpected drop in the prior month. Retail sales grew 0.5% in July from the prior month. The reading was higher than expectations of 0.3% and was a recovery from the 0.8% drop seen in June.
• U.S. consumer price index rose 3.2% from a year ago in July, with the annual rate slightly below the 3.3% annual increase expected. This is positive progress on an inflation rate that crossed 9% in July 2022.
• Retail Sales in the US rose 0.7% on a monthly basis in July. This reading came in better than the market expectation of 0.4%. While we have some concerns over credit card balance and delinquency rate increases, this data is supportive of a U.S. consumer still willing to spend.
• Japan’s economy recorded impressive growth in the second quarter of 2023 growing by an annualised rate of 6% in the second three months of the year, more than doubling expectations.  The rapid expansion was fuelled by a strong performance by the country’s export sector.
• While too early to call a sustainable recovery in China manufacturing output, recent data points show tentative signs of improvement. The two major measures from NBS and Caixin both exceeded expectations. While NBS data remained in contraction territory (albeit better than expected), the Caixin data unexpectedly moved into expansion, with a reading of 51.

What we didn’t

• Australia’s unemployment rate has risen to 3.7% for July up from 3.5% in June. While still historically strong, we may be seeing the beginning of higher rates impacting the local jobs market.
• While new job numbers in the U.S. beat expectations, rising by 187K jobs versus expectations of a 170K increase, we note the unexpected increase in the unemployment rate to 3.8% from 3.5%. While a weakening jobs market is what the U.S. Federal Reserve is aiming for with higher rates, we remain alert to the delayed impacts of this policy continuing to weigh on the U.S. jobs market,
• Economic activity in the US service sector continued to expand in July, albeit at a softer pace than in June, with the ISM Services PMI declining to 52.7 from 53.9. This reading came in below the market expectation of 53. While still expansionary the engine of US economic growth, being services, has been weakening.
• Chinese industrial production increased 3.7% year-over-year in July versus 4.4% in June, with retail sales up 2.5% versus 3.1% in June. Economists forecast increases of 4.5% and 4.8%, respectively. China’s economic recovery continuing to splutter at levels below expectations.
• UK unemployment rate rose to 4.2% as the number of jobs vacancies fell by 66,000 to 1.02 million. Expectations were for a lower unemployment rate of 4%. While still relatively strong it indicates an economy gradually more impacted by high inflation and interest rates.

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, 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 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 and 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. 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. 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 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 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 – Charter Hall

Investment Thesis

• Valuation upside – an advantageous entry point with the stock down 50% since highs in late 2021 after being impacted by higher interest rates and lower property valuations.
• Inflation easing – this will take pressure off the RBA raising rates further and will be supportive of the property sector. Purchasing a high-quality property business following devaluations is attractive.
• Diversified revenue streams – CHC owns underlying assets as well as providing asset management services. This provides some buffer against the potential for further property valuation downgrades.

History

Founded in 1991 Charter Hall provides over 32 years’ experience in property investment and funds management. They are one of Australia’s leading fully integrated property groups, utilising their property expertise to access, deploy, manage and invest equity across core real estate sectors – Office, Retail, Industrial & Logistics and Social Infrastructure.

The company has curated a diverse $71.9 billion property portfolio with 1,663 high quality properties, spanning everything from industrial properties, retail centres and premium office buildings, to our most recent investment in early learning centres.

With partnership and financial discipline at the heart of their approach their philosophy is to act best interests of customers and communities. Combining insight and inventiveness to unlock hidden value.

The company also extended its fund manager capability into another asset class with a 50% investment in the listed equities Fund Manager Paradice Investment Management (PIM), which invests on behalf of wholesale and retail investors across domestic and global listed equities. When PIM funds are included, Group FUM is now $87.4 billion.
Today the company is valued at close to $5 billion.