PERFORMANCE UPDATE
The portfolios performed in line with expectations during the quarter as all asset classes continued to rally.
Performance was underpinned from continued strong alpha from the Australian equities’ subsector.
The largest contributor to performance within the asset class was our underweight allocation to the Metals & Mining Sector and overweight to the IT sector contributed over 240 basis points of outperformance vs benchmark.
Elsewhere, our allocations to international equities and fixed income continued to yield positive returns for the portfolios.
MACROECONOMIC OVERVIEW
US Labour Markets
The US unemployment rate ticked up to 4.3% in July 2024, the highest rate since the COVID-19 pandemic.
These numbers have triggered media commentary around a so called ‘Sahm Rule’, where every recession was preceded by 0.5% rise in unemployment.
Exhibit 2, shows the labour force participation rate increased by 20 basis points between May and July while the unemployment rate increased by 30 basis points. Supply has been a driver of rising unemployment as well as demand weakness.
US Inflation
Inflation in the US has moderated in recent months, driven by outright deflation in Core Goods and disinflation from Energy and Food.
The final stretch to reach the Fed’s inflation target of 2% will need to be delivered by Services and Housing components. Exhibit 3 demonstrates the stickiness of these components in the overall PCE basket.
Wage growth is a key driver of many components in the PCE basket and Services inflation is particularly sensitive to wage growth. Wage growth is generally driven by labour market dynamics, when labour markets are too tight. Exhibit 4 demonstrates this relationship.
US Interest Rates
The US yield curve remains deeply inverted, with over 125 basis points of cuts priced in over the next 24 months.
In recent weeks, yields on longer tenors have also begun to fall as the market prices in the prospect of a US recession. Exhibit 4 below shows how the shape of the curve has changed over the last year.
The deep inversion of the curve makes investment unattractive under the assumption that the curve does not fall further. We would need the Federal Funds Rate to fall below 3.5% within 5 years to provide a capital return and justify an investment in US duration.
In our view, to reach this level, we would need a much more serious pick up in unemployment and a full-blown recession.
Australian Labour Markets
While the US labour market has loosened, the Australian market remains extremely tight.
The Participation Rate has continued to climb, increasing by 0.2% month-on-month to sit at an all all-time high of 67.1% in July.
A 0.1% increase in unemployment caused by a 0.2% increase in workers joining the labour force indicates the stretched state of worker supply in the market.
Wage growth also remains at historically high levels, with wage growth for the quarter ended 30 June 2024 sitting at 4.1%. Wage growth has remained above 4% since Q3 2023.
Australian Inflation
A tight labour market with strong wage growth has caused inflation to become range bound above the 3.50% mark.
Recent disinflation has been caused by electricity rebates in some states impacting the power components of inflation.
Without the impact of electricity rebates, CPI would be at 3.7% year-on-year, underpinning the tough challenge for the RBA.
Australian Economic Growth
Recent growth numbers have been anaemic, with Fiscal expenditure keeping GDP growth positive for the last two quarters.
Fiscal expenditure during 2020 – 2021 was supported by an iron ore price of around $150 USD/t.
With the Iron ore price falling to under $100 USD/t this year off the back of weak Chinese demand. Government revenues will be under pressure.
Unlike the US, Australia cannot run unfunded deficits for prolonged periods without bond markets dramatically increasing the cost of borrowing.
Australian Interest Rates
While the Australian government bond yield is also inverted, it displays a more attractive shape across the longer tenors of the curve.
There is an upward sloping shape between the 5-year and 10-year tenors making it relatively more attractive than the US.
United Kingdom
UK GDP growth remains sluggish, with high interest rates continuing to weigh on economic activity.
Budgetary constraints make austerity more likely than any significant fiscal expansion at this time.
Public sector net borrowing remains at elevated rates and Finance Minister Reeves has suggested tax increases may be included in the Oct 30 budget.
No UK prime minister wants a humiliating political legacy of unfavourable comparisons with lettuces, and that will ensure budget balance will be prioritised.
Europe ex – UK
Europe is constrained by EU rules on fiscal expansion enshrined in the Stability and Growth Pact (SGP) (i.e. deficit limit of 3% GDP, debt limit of 60% GDP).
Real GDP growth QoQ remains sluggish as the traditional manufacturing powerhouse of the EU, Germany, sees increased competition in its leading industries from Asian economies looking to offload goods not purchased domestically.
Emerging Markets – China
China’s growth prospects are middling (projected at 5% Year on Year at Q2 2024 but likely to be lower), with urban residential construction—a key economic driver since the 1990s—still in sharp decline.
Emerging Markets ex – China
Other Emerging Markets look healthier than China, with key EM central banks beginning to ease monetary policy. On the back of this, we are likely to see a re-acceleration of Emerging Market growth with consensus earnings growth projections in Emerging Markets at 19% (2024) and 15% (2025).
EARNINGS OUTLOOK
United States
US earnings remain robust post the recent reporting season. Companies in the US Information Technology, Semiconductors and Communication Services industries continue to benefit from strong earnings upgrades.
IT stocks (labelled) still account for a large portion of earnings revisions, with the average stock receiving a 4.75% increase in expected forward earnings by analysts.
While earnings growth continues to exceed analyst estimates, forcing them to revise forward earnings upward, among these companies, stocks – in particular US large cap technology names – remain attractive.
Australia
In Australia, the recent reporting season has been weaker than expected with the average stock’s forward earnings growth downgraded by 0.9%.
In terms of sectors, those exposed to interest rates and commodities – Real Estate (Mirvac, Charter Hall, Dexus), Metals & Mining (Fortescue), Energy (Whitehaven Coal, Ampol) and Utilities (Origin) did particularly poorly.
Information Technology performed particularly well, with stocks such as WiseTech exceeding analyst estimates, continuing the strong track record of sustained high earnings growth and expanding profit margins.
Rest of the World
Throughout the rest of the world, excluding the US, the picture is bleaker. P/E’s in European markets were the only ones to fall in the last quarter.
While earnings growth in Japan appears to be negative, there is a strong positive contribution from corporate actions as companies continue to dissolve complicated cross holdings and return capital to investors through buybacks.
While Japan, has a falling net income, we believe this is due to headwinds from the recent appreciation of the JPY, as most companies listed in Japan are exporters and are therefore exposed to currency fluctuations.
POLITICAL OUTLOOK
US Election – Policy Differences
Rest of the World
- Australia: Chalmers vs RBA, with fiscal spending keeping recession at bay, but RBA targeting inflation.
- Messy French elections.
- UK fiscal woes and lettuce paranoia.
- Fiscal outlook in the EU.
- China’s precarious economic position and Xi’s options.
- Japan signalling rate hikes and unwinding years of financial markets behaviour.
INVESTMENT OUTLOOK
Given our objectives as long-term investors, our base assumptions for our five-year outlook have remained relatively static over the recent months.
We are starting from a weak carry or risk premium position on global developed equities – expected returns based on long term valuations relative to cash are negative to modestly positive across developed markets in particular.
Earnings upgrades are propping up the US market when or if they peter out, we may be in trouble – we must keep a close eye on earnings, it is the key catalyst. Currently we do not have a view that earnings estimates are too high.
So far, no recession, it’s the fast collapse we need to watch out for, not a modest increase in unemployment. The bond market appears to be pricing in a recession, but this requires a serious collapse in one specific industry to get negative GDP growth – for instance housing – for this to occur.
The political environment of fiscal spending can keep recession at bay by stimulating areas such as healthcare for instance or more direct support. This culture can persist for longer than expected and is a direct contrast to the austerity post GFC.
PORTFOLIO CHANGES
With uncertain times ahead, we are preserving turnover budget and making only a few changes to the portfolios.
Changes
- During the quarter, we sold our position in Cochlear (COH) across all DPW portfolio’s.
- We have increased our position in BHP from c.6% to c.10% of our Australian equities’ portfolio.
- We have reduced our cash position across all portfolios to 2.5%, allocating any excess cash to Australian fixed income assets.
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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