DPW Model Portfolio Rebalance Commentary Q4 23

NAVIGATING THE COMPLEXITIES OF Q4 2023

Portfolio Performance and Review

Equity markets ended the year on a very strong note, driven by an apparent Fed pivot and an ongoing decline in bond yields. The MSCI World ex Australia index jumped a further 4.8 per cent in USD terms, taking the quarterly gain to 11.3 per cent, the best quarterly performance since 2020.

For the year the global market was up 24 per cent, extraordinary considering the recession fears associated with a 500-basis point Fed tightening in response to high inflation, concerns over parts of the banking system early in the year, the ongoing Ukraine-Russia war, and the Israel-Hamas conflict in early October. At the heart of the strong market performance was the resilience in the global economy and in corporate earnings as well as the larger than expected decline in inflation, which allowed markets to effectively rule out the worst-case scenario of a central bank induced recession.

After lagging markets for much of the year, Australian shares rebounded sharply in December, rising 7.3 per cent to close to record levels. the Australian market rose by 12.4 per cent for the year, more than 10 per cent behind global equity markets.

Key Perspectives Heading into 2024

As we set our sights on 2024, a few key perspectives emerge. Equity markets continue to carry a hefty price tag, with a low equity risk premium, particularly evident in Australian and international shares. The current risk premium falls well below the expected long-term benchmark, prompting consideration of three potential scenarios: inflation, deflation, and the elusive Goldilocks.

In the inflationary scenario, a lack of rate cuts in the next two years could trigger a 30% fall in equity prices, presenting a tough road for equities if inflation remains stubborn. Conversely, deflation, marked by a 10% earnings downturn due to a recession, would necessitate aggressive rate cuts and a 10% sell-off in equities. The ‘Goldilocks’ scenario hinges on a delicate balance – cash rates need to decrease, either in the U.S. or Australia, while company earnings remain intact, ushering in an economic soft landing.

The ‘Goldilocks’ scenario is gaining favour among market participants, contributing to a stronger-than-expected equity market, driven in large part by the tech giants atop the S&P 500 index. However, uncertainties persist about the market’s level of certainty regarding the Goldilocks scenario and its implications for future equity market returns.

Market Outlook: Disinflation and the Trajectory of Global Growth 

Our view is grounded in the belief that disinflation is a real phenomenon, with short-term inflationary pressures being discounted by the market. Developed economies, including Australia, are witnessing a decline in inflation, albeit at a slower pace than desired by central authorities.

Looking ahead, we identify two likely scenarios—Goldilocks and deflation—as the dominant forces over the next twelve months. While the market seems inclined to price in a soft landing, we remain cautiously optimistic, waiting for more substantial data before committing to a stance. This cautious approach aligns with our belief that GDP economic growth must show a sustainable upward trajectory before a significant increase in equities exposure.

Bond Markets: Attractiveness and Timing Considerations

Bond yields are currently elevated, signaling a ‘higher-for-longer’ scenario, both in Australia and overseas. Bond markets remain volatile, with sentiment skewed towards pessimism, as evidenced by underweight positions held by Commodity Trading Advisors and other systematic market participants.

While bonds do not mimic equities due to controlled supply and demand dynamics, they become indispensable in a protracted GDP slowdown. In such a scenario, aggressive rate cuts by central banks could drive capital returns on bonds. However, our cautious stance dictates that it is premature to take a substantial overweight position in duration for protection against an equity market downturn.

Interest Rates and Equity Investment Style

The implied equilibrium RBA Cash Rate and U.S. equilibrium rate present contrasting pictures, with implications for mortgage rates and inflation. Long-term inflation assumptions and sustained high-interest rates prompt considerations for inflation-linked bonds or extended duration, depending on the unfolding economic narrative.

Equity Investment Style: The ‘Value’ or ‘Growth’ Dilemma

The perpetual debate between ‘Value’ and ‘Growth’ investment styles persists. Having switched to the Growth style in March 2023, we remain committed to quality-growth stocks, particularly in the technology sector, given the modest global and Australian earnings growth.

The dominance of the ‘Big 5’ technology companies, namely Apple, Google, Microsoft, Meta and Nvidia who are driving Artificial Intelligence (AI) and leading in commercialization, keeps us anchored to quality-growth stocks for the time being.

 

SUMMARY OF MARKET VIEWS AND PORTFOLIO CHANGES

Our current stance is neutral on equity markets, with a watchful eye on data confirming the extent of the GDP growth impact for 2024. We maintain an exposure to ‘Quality-Growth’ equities, underweight duration, and corporate credit, while favouring diversified market-neutral alternative strategies possessing both defensive and growth characteristics.

Shifts in sector weightings and strategic repositioning reflect our anticipation of changing market dynamics. Portfolio changes involve a nuanced adjustment, with no new stocks introduced this quarter, nor any stocks being removed.

We are down weighting positions in WiseTech (WTC) and Technology One (TNE) to fit into our 6% IT industry sector weight limit after Block Inc (SQ2) was reclassified to the “buy now, pay later” financial sector. Likewise, we are down-weighting Cochlear Ltd (COH) and CSL Ltd (CSL) to maintain our weighting to Health Care while leaving room to increase our exposure to ResMed Inc (RMD).

Notable stock adjustments include an increase to Breville Group, ResMed, and TPG Telecom.

Breville Group (BRG) is an industry leader in small household appliances. With services inflation, we have seen considerable upward price pressure worldwide on takeaway coffee prices which we feel will ultimately benefit sales of home coffee machines.

ResMed Inc (RMD) has suffered greatly from a crowded hedge fund short trade, on the back of weight loss ‘miracle’ drugs. Our view is that risks are now tilted to the upside, and that the ultimate impact on sleep apnea prevalence has been considerably overstated.

TPG Telecom (TPG), which operates Vodaphone, looks poised to benefit from the recent Optus outage. When a similar issue happened to Vodaphone, it lost 5% of market share and precipitated upgrades for its competitors – our view is that history has a strong chance of repeating.

Asset Allocation and Fund Selection: A Dynamic Approach 

Diversifying the portfolio further, we introduce two new strategies in the Alternatives Assets sleeve, in anticipation of potential macro-economic challenges in 2024.

We now have five constituent Alternatives Assets strategies within the portfolio:

1. CFS Aspect Diversified Futures Fund (new) – Managed futures trend following strategy with long term track record, robust and repeatable process. Aspect uses systematic modelling and tactical allocation to opportunistically profit from market trends as they arise. The Fund is equipped to capture profit in both rising and falling market environments, while simultaneously delivering returns that have a low correlation to the returns of traditional asset classes over the long term.
2. Colchester Emerging Market Bond Fund – Relative value strategy in investment grade sovereign government bonds and currencies in Emerging Markets (mainly Brazil and Mexico) with potentially higher income yield and attractive capital appreciation (relative to developed markets) over the medium term.
3. JP Morgan Global Macro Opportunities Fund – Uncorrelated, liquid, low risk strategy that attempts to profit from market volatility caused by geo-political or economic themes using financial instruments to create short or long positions based on outcomes predicted by JP Morgan research. A market bet on an event or theme can cover a wide variety of assets and instruments including options, futures, currencies, index ETFs, bonds, and gold.
4. Perpetual Pure Equity Alpha Fund (new) – Aims to generate positive returns with minimal volatility by combining both long (to hold) and short (to sell) positions Perpetual takes advantage of rising and falling markets and provide some protection against falling markets. Through fundamental research, Perpetual aim to identify opportunities to buy quality undervalued companies. On the short side of the portfolio Perpetual opportunistically target stocks they expect to underperform.
5. VanEck 1-3 Month U.S. Treasury Bond ETF (TBIL) – Invests in a portfolio of US dollar denominated Treasury Bills issued by the U.S. Government with a maturity ranging from 1-3 months. U.S. Treasury Bills have a very high credit quality and one of the most liquid securities offering a potential portfolio hedge against “risk-off” periods and periods of rising rates. TBIL has a current yield to maturity of 5.34% pa.

Our intention is to allocate more to Alternatives Assets should macroeconomic data deteriorate through 2024.

Additionally, two new active strategies are integrated into the International Equities allocation to enhance performance and align with our updated Capital Markets Assumptions:

1. Arrowstreet Global Small Companies Fund – Active quantitative strategy with a long-term track record of outperformance and a reasonable management fee of 0.90%. Arrowstreet replaces our previous passive strategy, Vanguard MSCI International Small Companies Index ETF (VISM).
2. Pzena Emerging Markets Value Fund – Bottom-up, fundamental strategy, with a robust and repeatable process. Value is fertile ground in emerging markets because investors tend to overreact to news, providing opportunities to pick up bargains when stocks are oversold. Valuations of Emerging Markets equities and the trajectory of expected earnings make them very attractive at this point in the cycle.

We are reducing our passive exposure to Australian equities, by reducing State Street SPDR S&P/ASX 200 (STW), to bring us closer to the Dynamic Asset Allocation on the back of our updated Capital Market Assumptions, detailing our 12-month return forecasts for the various asset classes.

Elsewhere, we reduce portfolio cash and ActiveX Ardea Real Outcome Bond Fund (XARO) to facilitate a rebalancing in portfolio weightings.

Our DPW portfolios are rebalanced quarterly to remain dynamic and responsive to the evolving financial landscape. As we navigate through uncertainties, our commitment to prudent risk management and a nuanced approach always guides our asset allocation decisions and investment selection process.

 

In this article we have not considered any person’s objectives, financial situation or needs. You should, before acting on this information, consider the appropriateness of this information having regard to your personal objectives, financial situation or needs. We recommend you obtain financial advice specific to your situation before making any financial investment or insurance decision.