Thesan’s inaugural year was both challenging and exciting. We launched our first Separately Managed Account in partnership with Nexus Private Wealth, continued to build our technology offering for our clients with Praemium and navigated arguably the most challenging global geopolitical and macro-economic conditions since the 1970’s.
Notwithstanding the challenges faced, hard work and determination saw Thesan double our funds under management during the year, provide clients with a respectable investment experience and enter financial year 2023 set to launch multiple new initiatives to better serve our clients.
This annual review and market outlook discusses our expectations and strategy for the remainder of calendar year 2022, and looks at our current portfolio construction and the fundamentals that support the allocation.
A tough 6 months but reasons for optimism….
Global markets saw the worst start to a year not seen since 1970. The S&P 500 started the year around 4800 and finished around 1000 points lower while the ASX 200 began just shy of 7600 and also declined by around 1000 points. It was all due to one reason – inflation. Massive liquidity injections by central banks into the economy throughout the Covid-19 years of 2020 and 2021 caused price rises certainly unseen by both the RBA (given Philip Lowe thought rates wouldn’t increase until 2024) and the US Federal Reserve (given Jerome Powell dismissed 2021 inflationary evidence as ‘transitory’).
Regardless of whether inflation is from the supply side shocks that have stemmed from covid lockdowns, central banks fight inflation by raising rates to dampen aggregate demand given they can’t impact the supply side of the real economy. Rates have increased from effectively around 0% and currently stand at 1.5-1.75% in the US and 1.35% in Australia. How far will they go you ask? A good guide is the 2yr rate which is currently indicating that both the Fed and the RBA are around 50% off the highs. Given current headline inflation is running at 8.5%, real rates are still negative and monetary policy is still highly accommodative. Either we see inflation coming down or the Fed/RBA will be forced to further increase rates which should be preceded by further increases in rates. How does it all end? I see 3 possible scenarios.
- Soft Landing – By far the best possible outcome, I see roughly a 20% probability that central banks raise rates to a level high enough to reduce inflation without increasing unemployment or lowering growth to any great extent. The jobs data recently released in the US sees jobs growth stronger than expected which, when coupled with declines in inflation expectations, still gives hope of a soft landing.
- Recession – Tighter monetary policy raises the possibility of an economic slowdown that causes a recession. Certainly Jerome Powell recently admitted that a recession possible, but preferable to prolonged sticky inflation. It won’t come as a surprise to any that we have probably seen the lows in unemployment rates both here and in the US. The sharp increase in rates puts the probability of recession at around 45%.
- Stagflation – By far the worst outcome is persistent inflation, low growth or negative growth and higher unemployment. A recession is hard enough for people to endure, but continued sticky inflation eroding savings and wages gives no respite for either investors or consumers. Sri Lankan style problems of civil unrest caused by high inflation in food and fuel could spread across other developing nations which leads to further global economic instability. Unfortunately, the probability of a 1970s style stagflation scenario is also around 35%.
With such economic gloom where do markets go from here? I was recently asked during an Ausbiz interview what my best guess for future market direction was. For consistency, I will repeat my response – When it comes to equity markets, I will always believe that a company’s value is really a function of earnings expectations and the associated Price/Earnings multiple. Using expected 2022 earnings of $225 per share and multiple of 15.5, the S&P 500 should see fair value somewhere between 3400-3500. If the US market did fall further toward those levels, I would expect the ASX 200 to unfortunately follow accordingly. If this is the case, what then am I optimistic about?
A Chance to Buy In
If there is one lesson thus far from 2022 it would have to be that diversification is paramount. Declines in equities markets across the world gives investors a chance to buy in to companies at levels far cheaper than previously seen. Thesan is preparing a US focused managed fund which will allow investors to buy directly into a diversified portfolio of ‘best in class’ US companies that will provide them with direct access to some of the world’s highest quality companies. Such companies include Technology companies like Apple, Microsoft and Alphabet, Financials such as JP Morgan, Morgan Stanley, Healthcare companies such as Pfizer, Eli Lilly, Merck and Energy Companies like Exxon Mobil and Chevron. More details to come.
Corporate High Grade Bonds are Back
With higher rates individuals can now take exposure to higher yielding quality corporate bonds from issuers such as Macquarie Bank, Mineral Resources and Commonwealth Bank at yields of ~ 6%. Such levels haven’t been seen in years and is a welcome return for investors who demand income above capital growth for a duration of at least 5 years. Speak to Thesan for more information pertaining to Individual Managed Accounts with investment grade corporate exposures.
Looking Forward
My most favoured asset allocation continues to be defensive for the time being.
Specifically –
- 25% Australian equities,
- 25% US Equities,
- 25% Corporate IG Bonds, and
- 25% Cash
I like profitable companies with strong balance sheets and reasonable P/E multiples. I generally do not like European equities given economic uncertainty or Chinese tech companies given the CCP can change policy with regard to ‘common prosperity’ goals whenever they want. I like having 25% cash, but will look to deploy that as the economic situation becomes clearer in 2H22. Market volatility will continue but I remain optimistic about the long term despite my strong desire to not fight the Fed in the short term.
Portfolio Review
The new year brought forth a transitionary period for global markets– a fundamental paradigm shift marking the end of cheap money and accommodative interest rates around the world.
The many expansive macro-economic changes that rapidly eventuated required a highly active approach to the portfolio construction and shift from a growth to defensive bias. High volatility across all asset classes is evidence that valuations are difficult to cement, with so many unknown variables, changing by the minute, as central banks strive to tackle inflation, and the world navigates heightened geopolitical tensions.
In a global recession almost all assets decrease in value but with high single digit inflation prints around the world, staying 100% cash is just as problematic. In terms of portfolio construction we have since January 1 2022 transitioned the portfolio to accommodate the three potential scenarios mentioned by Paul above.
Australian Equities Portfolio
- As a hedge against persistent inflation, an overweight position in materials was established.
With the expectation that capital could become scarce, that exposure was obtained in the larger and more capitalised ASX listed materials companies, and a preference for those with strong cash flow yield. Exported commodities are also priced in US dollars therefore an overweight exposure to this sector provides some upside when the Australian dollar weakens, a typical response to global market uncertainty.
- As a hedge against recession, I have adopted an overweight position in consumer staples and energy. I have also adopted an underweight allocation to the consumer discretionary sector, continuing only to hold a small allocation of high-conviction positions. An overweight allocation to the real estate sector provides upside potential if interest rates rise more slowly than expected, and acts as a high-yield bond proxy.
- I remain underweight Australian financials and long-duration assets such as information technology with a view of re-entering the technology sector once quantitative tightening completes.
- As a further defensive bias I have an overweight allocation to industrials and a significant cash position that can be re-deployed when macro-economic conditions become more tenable, in line with the target allocation mentioned above.
When formulating the preferred sector allocation, I turned to the most recent previous quantitative tightening cycle (Dec-2015 till Dec-2018) for insight. Notwithstanding that inflation was not as prominent a consideration and geopolitical tensions more benign, the historical data supports my current analysis.
During the last Federal Reserve tightening cycle materials, energy and consumer staples were the best performing sectors for the entire period. In the current environment, China’s economic slowdown and record inflation adds complexity.
Falling commodity prices on heightened recession fears has caused Australian miners to be sold off recently. Under the surface though, even at current commodity prices Australian mining companies continue to generate strong cash flows thanks to the strength in the US dollar. The biggest unknown at present is China’s zero COVID strategy and another broad lockdown may require the allocation to be reconsidered. In the meantime, fundamental overweight positions to energy, materials and consumer staples in Australian equities makes logical sense– diversified with an allocation to US mega-caps, fixed interest and cash.
Engaging with Companies we Own
On 11 April 2022 I had the pleasure of travelling to Melbourne to visit BWX Limited’s brand new facility at Clayton. The >$30m investment in state of the art automation was an impressive sight to see. The Company seeks to produce not only their flagship Sukin brand using the fully automated production line, but also bring in the leading US natural skincare brand Andalou Naturals to be produced internally rather than by third party manufacturers.
It has been a challenging year for BWX. COVID disruptions and some miss-step investment decisions by the recently departed previous CEO has presented a busy step into the role for Mr Gration.
Talking with Chairman Ian Campbell and Mr Gration at the investor day, I was reassured by the steps being taken to realign the strategic plan, including a renewal of the board. With the exception of their digital businesses, BWX’s portfolio of high margin brands in my opinion occupy a sector with long-term growth prospects evidenced by larger multi-national skin care companies working towards their own natural, cruelty-free product offerings.
It was also pleasing to see Twiggy Forest’s Tattarang Ventures take a ~20% shareholding in the company which now places them beside Bennelong Australian Equity Partners as a substantial holder.
I remain committed to my investment in BWX and have participated in the recent capital raising.
Closing Comments
It goes without saying that the start of 2022 has been one of the most challenging times I’ve experienced during my role as a portfolio manager. Commitment to fundamental principles and diligent analysis has shown proven results in this bear market. Ultimately this next 6 months is likely to be an opportunity to buy discounted assets for the long-term. During the last half of calendar year 2022 Paul and I will be hosting webinars that may be of interest, but the most exciting is the new products that are scheduled to launch before Christmas.
As always, I am available for existing and new clients to talk through existing investment strategies or discussing new ones. You can now book meetings directly online here:
