PERFORMANCE UPDATE
A very strong quarter across all risk levels.
Performance is underpinned by strong manager alpha (value add) across many subsectors, with both equities sectors and alternatives particular standouts.
Our Australian Equities sleeve performance has been particularly pleasing for the quarter, outperforming the benchmark by 4.21% on a net-of-fees basis. The performance is underpinned by our allocations to quality growth stocks such as Xero and Technology One, which have demonstrated diligence around cost control and continued to grow earnings during their recent half-yearly results announcements.
Our commentary this quarter focuses on:
- Economic Data and Interest Rates.
- Prospects for Emerging Markets.
CPI & GROWTH
After three consecutive months at the start of the year where US CPI has been above consensus, we finally got an in-line print in April. This remains the key global macro piece of data due to its influence on the Fed’s monetary policy stance.
Rents and housing contribute around one third of the US CPI.
The chart below plots Zillow Observed Rents Index (which is a real time, though more inner-city driven index) versus the shelter component of the CPI (which is what the Fed uses in its analysis).
Suggesting the Shelter Index is highly likely to track the Zillow real index down, given their historical relationship. This will act as a disinflationary force over the next few quarters.
However, we still believe a 2% CPI target will be difficult for the Fed to achieve, primarily because fiscal policy is playing such a prominent part and with wage growth remaining stubbornly high.
When we strip out housing from the CPI numbers, we notice inflation trending up above 2%.
These are the sticky components of inflation, ultimately driven by wage rises, that are pushing up price acceleration beyond the target.
There has already been pressure from media commentators suggesting the 2% target is ‘arbitrary’ (for instance, commentary from Al-Erian) and should be lifted to a range. All of this speculation strongly suggests that the political willingness to fight inflation is not as strong as it once was. This has real investment implications for portfolios and markets.
WHAT DOES IT MEAN FOR MARKETS?
A common recent refrain in financial markets has been the attractiveness of government bonds when priced at a yield of over 4%. We will argue that even without any rate rises, that equates to a relatively unattractive return.
Consider the typical trader, either institutional via a prime broker or retail on margin. These investors dominate flows in most stable market periods because their horizons are necessarily shortened by cashflow requirements and portfolio volatility.
If we put ourselves in the shoes of this financially levered investor, they are currently borrowing at a minimum of 5% currently, to invest in either duration or equities.
At the moment, neither looks an attractive prospect on a passive basis.
With US government bond yields at 4.2%, you are effectively generating losses.
With US equity earnings yields at 5%, you are barely breaking even, with considerable volatility.
How do we invest in this period, given these challenges?
- We must be active. Passive strategies are overweight in parts of the market (government bonds and large cap equities), look most vulnerable.
- We must use alternatives to generate returns. These alternatives should be in differentiated and unconventional sources.
- We must focus on either the undervalued parts of financial markets (for instance, Emerging Markets (‘EM’) or Japan) or on parts of the market well adapted to shifts to a higher rate (for instance, large cap tech which is demonstrating its capability).
BOND MARKETS
In a higher funding costs environment, the carry trade for the levered investor becomes increasingly less favourable. That is, the net gain between the cost of borrowing and the income from investments has shrunk. Case in point is a potential investment in the US 10-year bond which has a current nominal yield of 4.4% (as of 15 May 2024). Given a prevailing interest rate of 5.50%, the real return for the levered investor who borrows the entirety of their investment is negative at -1.1%.
Stable markets are dominated in the short term by levered investors, for instance global macro hedge funds, who are becoming increasingly reliant on picking tactical rotations given this feeble long term forward return of -1.1%. This has exacerbated volatility in these markets in our view and may well continue to do so until the curve normalises from its current inverted position.
Let us consider what bull and bear cases for the US and Australian duration markets look like in practice.
Firstly, is the prospect of a bull steepening in the US bond market. Bond investors are already factoring in a good deal of rate cutting and, assuming zero capital return on 10-year US treasuries (essentially an assumption that market rate forecasts are correct), then achieving a reasonable return on bonds would necessitate a scenario worse than merely low interest rates at x%. Our position on this has not changed: the arithmetic is unambiguously poor for bond investors. We are talking of a pickup in unemployment of at least 2% and inflation falling below the target for a significant pay-off to occur.
Secondly, the other prospect for the bond market is a bear steepening. It would only require higher rates for longer, not a significant set of rate rises or a considerable pick-up in inflation. It would merely require inflation between 2% and 3% for this eventuality. The risks in the bond market are therefore definitely tilted to the downside.
The final left tail threat is the sheer size of the budget deficit. What is especially unusual about this deficit is the timing: typically, budget deficits occur when GDP is falling sharply, and government maintains or increases spending to counter falling economic activity. However, we are not in the midst of a recession in GDP, in fact quite the opposite. To our minds this is symptomatic of an electorate dealing with a COVID hangover, a time at which fiscal support was accelerated after a long hiatus.
The arithmetic of the Australian bond market is more favourable, with an upward sloping yield curve, recent budget surpluses (albeit a more stimulatory recent federal budget), and room to cut relative to current expectations. This is demonstrated below), showing an upward sloping yield curve within five years.
EQUITY MARKETS
Looking at equities, valuations nonetheless appear high. In Developed Markets, MSCI World is trading at 18.1x PE whilst US equities are trading even higher at 20.4x PE whilst Emerging Market trades at 12.0x PE. Notably in the US, outside the Magnificent Seven names, earnings growth is comparatively weak making this market even less appealing.
We remain overweight structural growth and quality stocks, taking profits where appropriate, and continue to search for pockets of relative value.
- Look for pockets of relative value. For instance, Emerging Markets and Japan.
- Look for pockets of earnings strength as the economy transitions to higher rates. For instance, large cap tech which continues to grow earnings more strongly than the market appreciates.
One area of particular interest currently is Emerging Markets. Emerging Market Equities have recovered dramatically since the trough in January, the point at which doomsday commentary on the Chinese economy reached a crescendo.
Emerging Market returns and flows of capital are primarily driven by two factors: the overall health of the global economy and the strength of the US dollar. Emerging Markets as an asset class is conventionally seen as a risk-on trade which is correlated with strong global economic health and a weak USD.
GLOBAL HEALTH OF ECONOMY
The global economy looks to continue to grow apace at 3.2% during 2024 and 2025, matching that of 2023. Furthermore, global inflation is forecast to decline steadily with most major central banks on the verge of loosening monetary policy, case in point being the Fed which is expected to cut interest rates in the second half of the year. Indeed, key Emerging Market central banks have already begun easing monetary policy. On the back of this, we are likely to see a reacceleration of global economic growth.
This outlook is reflected in the consensus earnings growth projections in both Emerging Markets, at 19% (2024) and 15% (2025), and Developed Markets, at 11% (2024) and 13% (2025).
Nonetheless, headwinds to economic growth remain significant. Specifically, the continuing trade tensions between US and China, sticky inflationary pressures, the Russia-Ukraine conflict and tensions in the Middle East.
USD STRENGTH
USD strength has historically been more negatively correlated with the economies of Emerging Markets (EM) than Developed Markets (DM)
*DXY is the US Dollar Index which tracks the dollar’s value relative to the currencies of the US’s most significant trading partners.
This is due to a number of reasons including:
- a stronger USD often being correlated with higher Fed rates (as opposed to Emerging Market rates) causing Emerging Market capital outflows (which are traditionally heavily reliant on foreign investment and capital); and
- a stronger USD means higher interest payments to be paid by Emerging Market nations/companies who often primarily have debts denominated in USD.
*DXY is the US Dollar Index which tracks the dollar’s value relative to the currencies of the US’s most significant trading partners.
Whilst the USD appears to be in a current period of strength, in the medium to longer term as the Fed lowers rates, we are likely to see a weakening of the USD and to see Emerging Markets become an increasingly more attractive trade.
FUNDS UPDATE
Most of the active funds in the portfolio had another strong quarter beating benchmarks.
Some of our focus recently has been on those funds that are struggling a little in the current environment, these include:
Ardea Real Outcome Fund: our detailed conversations with the portfolio management team suggest the key difficulty over the last year has been the sharp swings in volatility in rates markets. This has impacted their interest rate put component, which has seen wild swings in P and L. The management team have taken steps to mitigate this. We remain committed to this strategy in the longer term, we see this as a short-term market effect.
CFS Small Companies Core: it’s been a tough quarter, with key positions faltering on earnings relative to consensus. This team has a long-term track record delivering alpha in small caps at a very reasonable fee.
PORTFOLIO CHANGES
Overall, we are pleased with the composition of the portfolios, we have made two small changes within the Australian Equities and International Equities asset classes.
Australian Equities: We have trimmed our position in Macquarie Group (MQG) -2.5% and added a small position in Origin Energy (ORG) +2.5%. We like Origin for its relatively attractive valuation, defensive qualities and key support post fallout from the failed takeover bid in late 2023.
International Equites: We are rebalancing our allocation between the hedged and unhedged VanEck MSCI International Quality ETFs to bring our currency exposure to our long-term Strategic Asset Allocation weight of 70%.
Regards,
Greg Davis
Director
Greg Davis Authorised Representative 1245528 and Davis Private Wealth Pty Ltd Corporate Authorised Representative 1299449 are authorised representatives of Sentry Advice Pty Ltd (ABN 77 103 642 888, AFSL 227748.
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