Quarterly Update :: Q4 FY 2023 - Is the tide about to run out!

General Advice Warning :: Please consider any advice or views provided in the below, general in nature and that no consideration has been given to your personal needs, objectives or circumstances. Unless it is indicated otherwise. You should consider if this advice is appropriate for you.

Quarterly Update :: Q4 FY 2023 - Is the tide about to run out!

One of Warren Buffett's famous quotes is: “Only when the tide goes out do you learn who has been swimming naked.”

Welcome to a belated 4th Quarter Portfolio Update. Apologies for the delay in delivering this. As you will read below, there has been a lot to take into consideration over the past quarter and even as I am writing this after the reporting season in the US and in the midst of the Australian truth season this has thrown caution to the wind and confused the outlook even more.

For the last quarter of the Australian Financial year (Q4 FY23) global shares gained with the advance led by developed markets, notably the US, while emerging market stocks lagged behind. Enthusiasm over AI (Artificial Intelligence) boosted technology stocks. Major central banks continued to raise interest rates in the period although the Federal Reserve Board and Reserve Bank of Australia elected to stay on hold in June. Government bond yields also rose (meaning prices fell).?

The US share market rallied +8.6%, whilst the tech heavy Nasdaq posted a +13.1% gain. The NASDAQ has now returned +32.3% over the first 6 months of 2023. Japanese shares also performed very strongly, returning +18.5% as they benefitted from lower valuations, a weak currency and a central bank committed to maintaining expansive monetary policy. The German DAX and French CAC 40 indices followed behind with returns of +3.3% and +2.9% respectively. FTSE Global Markets UK shares struggled, returning -0.3%, as sticky inflation will likely lead to more rate rises from the Bank of England . Chinese shares continued to struggle returning -6.1% as a slower than expected COVID reopening and ongoing tensions with the US weighed on the nation’s economic outlook. Australian shares performed reasonably well with the S&P/ASX Accumulation Index returning +1.0%.

Some of the view’s that are catching my attention and I am tending to agree with are:

Franklin Templeton

• “Six months ago, 2023 was expected to witness the most anticipated recession ever, a view strengthened three months ago by three of the four largest bank failures in history.”
• “U.S. equities pricing a return to positive EPS growth in the second quarter and a sharp acceleration through the second half.”
• “By contrast, economists’ forecasts suggest GDP growth will continue to slow in the coming quarters.”
• “While nominal GDP growth is expected to remain positive, this is largely a function of inflation, which is expected to cool further but remain well above the Fed’s 2% target through 2024.”
• “This conflicting view presents a dilemma for investors on which camp has a more accurate read on how the next six months will unfold.”

高盛

• We remain neutral in our asset allocation (OW cash/commodities, N equity/credit/bonds for 12m). While a soft landing with inflation normalising remains our economists’ base case, late cycle risks are lingering.?
• As a result, we expect equities to remain stuck in their ‘fat and flat’ range and think credit offers relatively low total return potential vs. cash.?
• With continued inflation normalisation, higher yields and a slower pace of central bank tightening, the asymmetry to add duration in a portfolio context has improved.
• Our baseline macro view is consistent with markets spending more time in ‘Goldilocks’ and ‘central bank put’ regimes in 2H 2023 – both scenarios tend be supportive for equities and 60/40 portfolios.?
• However, near-term the risk of a ‘Balanced Bear’ remains elevated if inflation proves more sticky or central banks tighten policy more aggressively and/or growth optimism is hit by an external shock.
• While the US remains on track for a soft landing, the global growth picture has been more mixed. China data has disappointed materially since Q2 and in the Euro area a weak global manufacturing sector has started to spill over to services. One of the risks we see for 2H is that global PMIs could start to weigh on earnings revisions, especially as inflation normalises at the same time.?
• Our strategy teams forecast virtually no profit growth (other than in Japan) this year, and mid-single-digit growth rates (other than in Asia, from a low base) next year.

AllianceBernstein

• "Why has the system proven so resilient? The key variable in developed economies is the labor market"
• "Employment growth remains strong, unemployment remains low and wage growth has kept pace with inflation in most major economies"
• "Households have begun to deplete savings cushions"
• "Until central banks are confident that inflation will fall back to target, they’ll likely be cautious about cutting rates to support growth"
• "Tighter monetary policy could lead to disruptive financial market events"
• "Tightening cycles often end in financial turbulence"
• "Higher for longer is the new policy regime"

J.P. 摩根

• The macro picture still present a number of red flags:
• Outside of the US, Japan and a handful of EM economies, incoming data have been weak and often surprised to the downside. Notably, this includes the Euro Area and China.
• Refinancing remains a big risk for many economic agents. Not all carry trades might makes sense when the cost of funding has more than tripled.
• Inflation is downshifting globally but Europe has been a notable exception. Energy is unlikely to be a tailwind for disinflation anymore.
• Risk Markets appear to be pricing-in a good amount of good news already.
• Positive news on growth and inflation are fuelling optimism for a soft-landing scenario in which inflation returns to target, providing space for DM central banks to ease.
• We remain sceptical of this outcome, however, anticipating the inflation decline to prove incomplete, leaving restrictive policies in place that should increase private sector vulnerabilities and end the global expansion.
• Equity valuations (multiples) are not pricing a soft landing, but rather a continued expansion (no landing) and simultaneous monetary easing (reduction of interest rates and/or QE).
• With no interest rate cuts in sight, ongoing QT and our base case for macroeconomic slowdown, equity multiples appear too high.

Overall, with the mixed signals from economic data, the current market valuations and projections on earnings, defensive positioning within portfolio’s remains the focus.?At this stage the tide is only low for Central Banks globally and for those who were late to the rate increase party (US Fed and Australia’s RBA for example), because inflation remains too high. As higher rates play through debt and equity markets, I am sure the low tide in those markets will start to highlight those stranded swimmers. Its these shocks that need to be washed out and avoided.

Portfolio Commentary

Last quarter I referred to the fact the ASX 200 index has traded flat and this has lengthened through Q4. This was in part to highlight that portfolio’s in general have shown resilience against the main Australian index as a comparison. It was also to raise the need that portfolios have exposure to international assets. I still am of the view that portfolios are to be actively managed to drive outperformance and manage risk. I expect quality equities will be the driver of good performance throughout this year. An active approach is still needed through locking in gains and looking to reapply those funds into ‘cheaper’ quality names with good pathways to grow.

Preview to the next chapter of the cycle: Lost and found: Small & Micro-cap opportunities

The ASX Small Ords has had a horror 18 months underperforming the ASX 50 by 19% and down 22% since the start of 2022. But there are good reasons to believe that we are at an inflection point:

1. interest rates are nearing the peak in the cycle;
2. fundamentals improving;
3. investor sentiment showing early signs of turning around; and
4. trading volumes appear to have bottomed out.

Small-cap underperformance is near the low of a 20-year range

Since the start of 2022 small caps have been in a downward trend. Small Ordinaries are down 22% and worse ex-resources (ASX small industrials) are down 24%. The performance differential between small and large industrials has widened to 2014 levels and trading near the bottom of a 20-year range. Rising interest rates and falling investor sentiment have institutional and retail investors alike shying away from this segment of the market. While it’s too early to call the bottom, we think there are reasons for optimism.

Fundamentals are turning around

Fundamental factors such as leverage and profitability (ROE) deteriorated after the 2020 COVID-19 pandemic as the cost of funding was slashed and demand came roaring back but as economic conditions worsen companies can ill afford to let fundamentals take a back seat. Fundamentals are in fact expected to improve materially and forecast to return to long run levels over the next 12 months placing them in a better position to weather a slowdown. Given their scale and exposure, small cap companies are inextricably linked to the fortunes of the domestic economy with Australian-based sales (FY22) representing 84% across the cohort. We believe this can provide some further insulation from issues facing global peers, such as:

• US regional banking;
• China slowdown; and
• rapidly slowing economic growth.

The Morgans Financial Limited Research Team have identified 15 small and micro caps that have continued to thrive despite the uncertain economic backdrop. They are backed by favourable trading conditions, sound management teams, solid balance sheets and valuation support. Features that we think will distinguish them from their small cap peers.

Outlook :: Someone will be right (again)

Even though I wrote this title last quarterly update, it still holds true and if anything probably underlines that markets are in a holding pattern until: Something economically breaks (through central banks over tightening), or un-employment remains low, earnings stay robust and inflation is persistently above target, leaving markets to ebb and flow as its done so for 2 years. Globally equity markets are now trading with a 12month forward P/E slightly above their 10yr averages. S&P 500 is at 19x, Europe is 12x, the UK at 11x, Emerging Markets is 12x and Australia is 15.5x. With this pricing representing a slight premium I am inclined to continue with the current thesis (lock in profits, seek cheap valuation quality Equities, continue holding Fixed Income and increase Cash).

Whilst every market strategist out there with much better knowledge and tools to call upon has a view, my opinion is based on some of the simple human behaviours and signals we are witnessing through advertising, car sales, home sales, company reports, CEO insights.

Here are some notes from a few leaders we have had present internally:

Jeremiah Lane , Partner and Portfolio Manager from KKR .?KKR are one of the biggest private equity and private credit investors in the world (I personally think they are the smartest people in finance) so their insights into what is actually happening is very relevant.

• KKR are not seeing any major pain in the US economy, they are surprised and impressed at the resilience of the economy.?
• Housing was expected to be source of pain and material weakness which has not eventuated.? Homebuilders slashed prices early to return market to affordability, which saw lots of demand for new build homes.? This is showing through in the numbers now with new home sales strongly up year on year.
• Without a housing collapse, hard to find a sector that can be a big contributor to unemployment/mass job losses.
• They are seeing resilience in the most cyclical sectors – suggests no recession or economic crisis coming.? Prices of debt/bonds are not appropriate given the strength.
• Consumer narrative is wrong.?“It starts and ends with unemployment.”?The consumer stats will keep beating expectations if employment is full, particularly when wages are rising year on year like they are.
• Not looking at US commercial/office property year.?“Still in the first or second innings of the downturn”” – slow moving and a long way to go.?Very difficult to value these assets, more pain coming.
• Concept of converting office to residential towers in CBD’s is not realistic. Cheaper and more efficient to demolish them and start again.

Rio Tinto ’s CEO Jakob Stausholm after their first half profit result.? Getting access to CEO’s of this calibre is an amazing edge Morgans provides.?Highlights of the meeting:

• RIO achieved 20% return on capital employed (ROCE) in the half.
• 2 key focusses for CEO, health of current business and assets + future planning of the portfolio.?Constantly looking to optimise portfolio, RIO now turning focus to growth after a decade of consolidation.
• Paid third largest dividend in 150 year history this half – US$2.9bn which is $2.61 per share
• Wrote down value of Aus aluminium smelting assets by 90% after -82% decline in profit. Stausholm has put ultimatum to Aus govt to provide ultra low cost renewable energy by roll off of gas/coal contracts in 2028/29 or assets will like be shut down.?
• Aluminium demand has grown for 23 years, 3x bigger today than in 2000.?75% of US smelters closed and 25% of Aus smelters closed, whilst China has increased 17x!?Entire global industry dominated by China which is not what the West want, so need a solution here ASAP. Japan totally relies on importing aluminium and is second biggest consumer in the world. “We are the biggest producer of aluminium in the western world.?Jakob wants it to have a future at RIO, but I can’t perform magic”.?RIO needs energy at same price as China, who have none of these limitations Australia have imposed on its miners.
• Iron ore the saviour, contributing nearly all profit.? RIO to diversify from WA via giant Simandou project in Guinea as a JV with Chinese partners.
• Said demand of iron ore very strong, but Chinese steel mills not making any money so something has to give.
• Europeans (Stausholm is Danish) don’t understand mining.? Said Australia gets it, whole country is set up to prosper from mining.
• RIO’s asset selection is based firstly on large, tier 1 assets as a preference. They’re agnostic on the commodity but have to believe RIO can do it better than anyone else.?They like copper, but Stausholm thinks prices paid are getting up there for assets.?RIO’s Resolution copper project in USA is seeking approval.?RIO thinks it would provide 25% of USA’s copper needs alone.?

As you can see from the above, resilience in numerous economies is surprising many and this is leading to expectations being pushed out. Business leaders have to pursue growth and in RIO’s case now is a good time in the cycle to do so. Energy transition is going to be the biggest theme over the coming years and industry demand will be the front runners to secure supply.

Conclusion

I am still of the view markets will continue to remain directionless whilst economic data defies the markets sentiment. I reiterate that I am not sensing a drastic cause for concern over markets, in particular stocks, but the rapid changes in Interest Rates are yet to be seen throughout all interest rate sensitive instruments including debt and capital markets. This will surely reveal a few stocks and debt holders of businesses that forgot to don the swimmers before the tide ran out. Globally equity markets are priced near enough to 10yr earnings averages and when you consider the last 10 years have held the average P/E higher due to higher growth stocks (tech) I would like to see the market considerably cheaper before actively chasing overall exposure. This will hopefully come from greater clarity of forecast economic conditions and a moderate pull back in markets. The current opportunities in Equity markets are in the Small to Mid cap Australian stocks. Cheap valuations, strong balance sheets, robust management all provide protection from the large market swings.

A Quick Note: Artificial Intelligence (AI) from a market perspective

高盛 published a quick note on AI which I thought laid out some of the current thinking and how this development plays out for businesses and markets: Generative AI may boost corporate earnings, but the effects are hard to pin down.

• Using our economists' estimate that AI adoption could boost productivity growth by 1.5 percentage points per year over a 10-year period, Goldman Sachs analysts estimate the S&P 500's compound annual growth rate in EPS over the next 20 years would be 5.4%, compared with the 4.9% their dividend discount model currently assumes. That means the S&P 500 fair value would be about about 9% higher than it is today. “Increased economy-wide output could translate into increased revenues and earnings for S&P 500 companies, even beyond those firms directly involved in the development of AI”.
• Since it's hard to predict how soon companies will be able to generate profits from AI, our analysts say it's unlikely to be fully priced in by investors in the near term. Using a range of productivity scenarios, upside to the S&P 500's fair value could be as small as +5% and as large as +14%.
• In the meantime, government policy, higher taxes or interest rates, or a slowing economy could counteract those stock market gains. And the dot-com boom underscores the risks to investors when stock valuations soar. “Stocks with high perceived growth potential are rewarded with high valuations, but investors flee and the multiple collapses at the slightest sign that the growth rate may not be sustainable”.

For the complete article, please view here.

Should you have any further queries, please do not hesitate to contact me.

Regards

Scott Fraser

Private Client Adviser

Morgans Financial Limited | ABN 49 010 669 726 | AFSL 235410

General Advice Warning :: Please consider any advice or views provided in the above, general in nature and that no consideration has been given to your personal needs, objectives or circumstances. Unless it is indicated otherwise. You should consider if this advice is appropriate for you.