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Economics Team

Investment Committee Overview

Introducing our Economics Committee, standing from left to right: Brendan Gilmour, Kris Wrenn – seated: Isaac Robinson, Juanita Wrenn. Hudson’s Economics Committee and the Investment Committee are interrelated.

Written by Juanita Wrenn

Annual inflation rate to 4.9%, from June’s 5.4%, suggesting that rates will stay on hold again this month. Inflation is still higher than the target rate. Still expect to see at least one more interest rate increase (possibly two as unemployment is still extremely low, the Aussie dollar weakening against the US, and vacancy rates are still tight)  before plateauing and then ultimately decreasing to more of a neutral rate.

Looking back to the experience during the 1989 to 1991 period in Australia when there was the interest rate induced ‘recession we had to have’. The recession persisted even though the RBA were sharply cutting interest rates throughout the period! The difference this time round is that interest rates had been so low for so long prior to the first interest rate increase in May 2022. In economics, there is a concept of a ‘neutral rate of interest’ – one that is neither expansionary nor contractionary. Economic consensus is that in Australia and the US that neutral rate is about 2.5% to 3.0% p.a.

In the current cycle in Australia, the RBA cash interest rate did not get into ‘tightening’ mode until December 2022 i.e. RBA taking the cash interest rate about 3.0% – the first seven hikes from 0.1% to 3% merely reduced and then removed the existing ‘loose monetary policy’. One reason we haven’t seen economies falling into recession is that interest rate increases only became restrictive in the last 12 months. What is different this time, to the period of 1989 – 1991, is that the tightening cycle started from such a low base.  The fixed rate cliff is just starting in Australia as borrowers on fixed interest rate loans move to variable rates. The US has much longer fixed rates (up to 30 years) than Australia, so this effect is not expected to be as sharp as in Australia.

After introducing Michael Furey in our introduction, I thought it might be good to attach some notes from our Investment Committee Meeting held this month with Michael.

Summary of Economic and Market Conditions – Michael Furey

Higher than desired inflation locally and overseas combined with increasing cash rates from central banks around the world have resulted in an increasingly weaker economic outlook.

Bond market yield curves suggest a recession is still a possibility in the USA. Australia’s yield curve has recently shifted to negatively sloping (10yr – 3yr, 10yr – 2yr) suggesting recession is a serious possibility.

Source: www.worldgovernmentbonds.com

As the Australian chart shows above, yields are relatively high to where they have traded earlier in the year, and cash is higher than some government bonds.  This provides some comfort in holding Cash and Bonds for defensive purposes in the case of recession or an equities market sell-off, particularly given there are still inflation pressures that may result in higher cash rates.

The following chart shows High Yield Adjusted Spreads in the USA, and despite expected economic slowdown, which would ordinarily increase default risks, high yield spreads are not particularly wide suggesting there are possibly greater downside risks than upside risks in high yield. Hence, there is a preference for higher quality bonds over lower quality or high yield bonds.

Source:   www.fred.stlouis.org

In Australia the following charts show that investment grade credit spreads are slightly wider in Australia than the USA, hence a bias towards Australian investment grade credit is preferred to global credit.

Equity market valuations appear to be most stretched in developed markets which is particularly the case for growth and quality that have run strongly in 2023.

Current valuations suggest a preference for Emerging Markets, although an equity market sell-down due to recession concerns are likely to impact all markets so a generally defensive equity strategy is preferred.

Investment Selection Themes and Considerations

Current Macro Themes at the time of writing include:

Lower liquidity from the Silicon Valley Bank and other Small/Medium Bank collapses

  • With many USA depositors previously withdrawing funds from many small and medium-sized banks in the USA, there is likely to be a crunch on credit liquidity as these banks seek to repair their balance sheets by accepting deposits without loaning funds.
  • Alongside this, deposits have flowed to larger banks which are typically more conservative thereby not increasing the liquidity in the US Banking system
  • This adds up to another factor contributing to slowing the US economy and adding risks to share markets and high yield markets.

High inflation which is possibly moderating combined with higher interest rates.

  • Higher interest rates should place downward pressure on valuations or highly indebted securities.
    • This may favour well-priced “Quality” companies or perhaps cheap “Value” securities relative to market.
    • Higher interest rates enable banks to expand the spread on their product suite, thereby increasing profit margins.
    • High inflation provides companies an opportunity to increase prices and therefore margins … may favour Consumer defensives.
    • Private assets, including private equity, venture capital, direct property, and infrastructure, have not been marked down very much despite the rapid increase in yields and interest rates … there is no hurry to invest in fully invested private vehicles.
  • Slowdown of the Global Economy and/or Potential US Recession
    • Discretionary and expensive investments are likely to continue to come under pressure as unemployment slightly increases. At the time of writing (August), unemployment has stayed low in the USA, Australia, and other developed economies.
    • High Yield investments look appealing on a nominal yield basis but the spread to government bonds is much tighter than a potential recession would suggest.
    • Maintain higher quality in bonds.
    • US Dollar will likely strengthen if/when equity markets increase in volatility. compared to AUD, it is the highest for around 6 months
    • Liquidity providers, e.g. cashed-up private asset funds, may benefit as liquidity dries up in the face of recession.
  • Climate Change and Australia’s sharp shift towards renewable energy
    • ESG-friendly securities and investments were sold off in 2022 as they were previously expensive … and were out of favour versus the 2022 Value trade … this has reversed somewhat in 2023.
    • Providers of infrastructure or items to assist Australia’s sharp shift towards electric vehicles provide an opportunity considering Australia’s current underinvestment.
    • Government support for renewable energy is likely to increase as the emergency increases … does this provide an improvement opportunity for the Australian energy sector.
  • Post-COVID
    • China is the last major economy to open up and this potentially presents an opportunity for Emerging Markets which have largely suffered over the last year or two.
    • Valuations of Emerging Markets are around half of Developed markets so present a long-term opportunity.
  • Value versus Growth
    • Current value to Growth valuation spreads, primarily in the uSA< are the widest they have been since the tech wreck … this presents a relative trade opportunity considering the current higher interest rates and, therefore, higher return hurdles for most investors.
  • Russian/Ukraine War
    • This should keep energy and food prices higher than otherwise as other producers replace these two mass providers.
      • At the time of writing (3 August 2023), energy and food prices are trading at their lowest levels since the second half of 2021, i.e. before the war.
    • The end of the war is unknown but when it comes it will likely produce a decline in commodity prices which does increase Australian equity risks.
    • The current war does favour weapons manufacturers (e.g. Boeing, et al.), and commodity producers (e.g. BHP, RIO, et al.) although timeframe is an unknown, and therefore presents unknown downside risks.
  • Artificial Intelligence
    • ChatGPT has opened a can of worms providing a simple solution for reducing numerous middle-management roles including paralegals, marketing, et al.
    • This is an opportunity for AI providers such as Google, Amazon, and Microsoft, but also may provide opportunities for margin increases for numerous service providers.
      • There appears to be a current threat to Google’s search engine monopoly as Microsoft’s Bing search engine is taking market share by teaming with the ChatGPT engine that provides superior searching functionality.

Summary of Long-Term Themes with Upside Potential

Emerging Markets, Emerging Market Value, and Global Small Companies

  • Low Valuations

Environmental Investment

  • Particularly in Australia
  • Renewable Energy and Infrastructure assets

Artificial Intelligence

  • Although not at any price

Private Equity/Private Debt

  • Preferably cashed up and ready to provide liquidity as economies slow.

Source: Delta Research and Advisory, MSCI

  • Within Emerging Markets, the Value style is currently trading on a PE of which does not happy too often, and presents significant upside potential and is a style bias worthy of consideration after growth has taken off since the start of 2023.

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