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MFG Asset Management 2022-inreview

The World

confronts an unusual number of difficulties

Arvid Streimann, PM Magellan’s Global Strategy

Arvid Streimann,
PM Magellan’s Global Strategy

Nikki Thomas, PM Magellan’s Global Strategy

Nikki Thomas,
PM Magellan’s Global Strategy

Arvid Streimann, <br>PM Magellan’s Global Strategy

Arvid Streimann,
PM Magellan’s Global Strategy

Nikki Thomas, <br>PM Magellan’s Global Strategy

Nikki Thomas,
PM Magellan’s Global Strategy

Efforts underway to resolve them will favour quality companies.

So far 2022 has been unusual for the number and magnitude of events that have taken place. The shifting to the endemic stage of the first pandemic in a century, the largest invasion in Europe since World War II, and the first 75-basis-point increase in the US policy interest rate since 1994 are just three of significance. Layering on to that is an escalating climate crisis and inflation at highs not seen in decades. Many of the issues are inter-related, the result of significant imbalances in supply and demand across many markets. These are difficult times for investors across asset classes, as governments and central banks attempt to reach a steadier path.

What is driving share prices and how do we protect wealth during such times? We outline what we believe are the issues of most significance to the global economic outlook and to global equity returns.

Let’s start with inflation. US inflation is hovering around four-decade highs and is unlikely to slow sharply any time soon. European and Australian inflation, among others, are too at unusual highs. The excesses of fiscal and monetary policies implemented to deal with forced economic shutdowns to save lives during the pandemic have fuelled huge demand for goods and, more recently, services. Those same shutdowns also led to significant lost supply, and supply-chain disruptions. Add in a war in Europe, which led to sanctions and loss of access to commodities, especially energy, and supply disruptions have been exacerbated. Further fuel to the inflation-inducing imbalances comes from the climate crisis. Bushfires, droughts, floods, rising sea levels, water shortages et al are causing widespread destruction in cities and to productive land. The cost is not just lives lost, but a persistent rebuilding that strains resources and more disruption to food supplies.

“Further fuel to the inflation-inducing imbalances comes from the climate crisis.”


When you stimulate demand with close-to-free money but have limitations on supply, prices will soar. History shows out-of-control inflation damages livelihoods and so there is an ‘unconditional’ approach to reduce inflation to acceptable levels. To do this, most major central banks are tightening monetary policies by raising interest rates and reducing financial liquidity via quantitative tightening. Central banks are moving away from stimulatory levels set during the pandemic that with hindsight were too loose because they transferred huge sums to consumers and created excessive demand. The problem is that monetary policy cannot easily quell inflation driven by impediments to supply; its effect will be to reduce demand. Today’s inflation is driven by both. The risk in attempting to slow inflation with a tool that only reduces demand-led price increases is that rates might be increased to a level that triggers a recession.

Signs have already emerged that tighter monetary policies in the major economies (except Japan) are dampening demand as intended, but they are yet to slow inflation. The difficulty surrounding monetary policy is that tightening of financial conditions will invariably hurt economic growth but calibrating this is imprecise. Central bankers are seeking to engineer a gentle slowing in growth – a ‘soft landing’ – while taming inflation. Given the mandate central banks have, it is almost impossible not to expect inflation to be brought down to acceptable levels, let’s say low single digits. But we do not expect this to happen quickly even in the absence of further shocks (such as more sanctions against Russia, supply cuts of energy in Europe, or sustained lockdowns in China with its zero-covid policy).

Inflation still accelerating

“with inflation still accelerating, the risks of a bleak outcome remain large.”


This brings us to the ultimate question for investors. How bad will the demand destruction need to be for this to be achieved? Does it mean a gentle economic slowing with a few low- or no-growth quarters; or does it require a sizeable recession in all or many major economies to kill off inflation? For now, with inflation still accelerating, the risks of a bleak outcome remain large. While the extent to which growth slows is debatable, we know from history that slower (or negative) growth leads to conflict over resources. Eurozone members are bound to fight over how high interest rates should go (Germany high versus Italy stay low). Creditor nations are likely to argue with debtor nations over income transfers needed to support economies in any downturn. They are likely to clash over any program the European Central Bank devises to help hold down bond yields of key indebted nations (Germany not needed, Italy yes please). European harmony and collaboration are likely to be tested yet again.

Emerging countries as well as China are hurt by higher US interest rates as a stronger US dollar makes it more costly to meet US-dollar-denominated debt repayments. On top of that, emerging countries face their separate challenges. China’s pursuit of a zero-covid policy and resulting lockdowns, as well as a struggling housing sector that is the store of wealth for many Chinese, mean the government must add economic support via looser monetary and fiscal policies. While we expect Beijing will stimulate its economy in a restrained manner and note some encouraging Chinese vaccine developments, we see China’s economic and political risk as elevated as President Xi Jinping seeks to cement his grip on power.

So, how do we navigate the uncertain and unbalanced world to protect capital? We remain focused on investing in only high-quality companies that can cope with the challenges the world faces. We are seeking companies that we expect to be resilient during the tightening of financial conditions and those that can benefit from such conditions. This means companies that are protected from rising and high inflation or indeed can benefit from high prices. In terms of the portfolio, a world of rising interest rates has prompted us to scale back our holdings of energy utilities that had risen on their bond-proxy allure when rates were low. We avoid growth (but not cash-generating) companies that are susceptible as valuations are deflated by higher discount rates and we exited those similarly vulnerable due to low cash generation now. Our concerns about China prompted us to exit Chinese-domiciled stocks. We added banks that are likely to enjoy higher margins as interest rates return to more normal levels. We have added high-quality defensive companies with pricing power and minimal commodity and labour-related cost pressures.

The second issue likely to determine the fate of economies and investment markets is that inequality seems to be reaching its political limits. A pushback against inequality has driven many policy changes of late in countries from China to the US that act against investment returns. In the US, for example, the backlash against inequality has led to higher minimum wages, the rising influence of business-unfriendly progressives within the ruling Democratic Party, instructions for the Federal Reserve to take account of people on lower income and minorities when conducting monetary policy, and more onus on companies to justify their social licence (a bigger risk in the age of smart phones and social media). Beijing’s drive to improve ‘common prosperity’ by eliminating poverty and social inequality is another example. The risk for equity investors is that any lowering of the corporate profit share of national income will weigh on overall equity returns. Rising social-licence risks contributed to our decision to reduce our holding in Meta Platforms (formerly Facebook).

The third issue confounding the economic outlook and financial markets is that geopolitics has become more unstable. Russia’s invasion of Ukraine in February is a pivotal event because it is fanning a decoupling of the West and its competitors (foremost China) due to concerns about national, health, economic and energy security. The invasion is likely to cause rifts in Europe’s ‘security architecture’ because countries nearer to Russia are seeking to help Kyiv while Western Europe is more aware of the economic costs of doing so. The risk now is that Europe will trigger a downturn to break its reliance on Russian energy. This could herald another financial crisis as threatening as the one from 2008 to 2012 – another risk spurring our caution on Europe.

Among the last things Europe or elsewhere needs is another energy upheaval. But the world intends to pivot from Russian hydrocarbons towards Gulf energy sources. The risk is that global economic security could be used as a bargaining chip in Iran’s nuclear negotiations or become a vulnerability for the West if Iran were to retaliate to any attack.

In Asia, Taiwan remains a flashpoint. Economic interdependence and nuclear weapons reduce the likelihood of a Chinese invasion of what Beijing regards as a renegade province. But economic cooperation is being eroded by the decoupling of China and the West. Expect standoffs or ‘incidents’ involving Taiwan. But as Russia’s invasion of Ukraine showed, large military deployments take time to organise and can be observed. A lack of surprise could deter a Chinese invasion.

The investment implication of heightened geopolitical risks is that benefits of globalisation are reduced. That means slower economic growth and stalled increases in living standards. Unhappy voters reinforce the risks around inequality because people might support populists promising to redistribute income and wealth to the masses. Some companies might be caught up in such political developments.

The fourth issue holding sway over economies and investment markets is the energy transition to renewables and to electrification. This is of paramount importance to us as citizens as well as for our fiduciary responsibility as we aim to strengthen our portfolio returns by analysing the implication of the changes needed. Much is yet to happen, and government policy, regulatory frameworks, reporting requirements and corporate strategies are in flux as the world navigates its way to Net Zero. Implications will be far-reaching and will present outsized opportunities and outsized risks as new economic models and new technologies arise. Huge addressable markets will be created and destroyed and vast sums of capital will be spent to find solutions to our deteriorating climate. So we are enhancing our understanding of the changing competitive landscape, and return prospects of companies exposed.

“The investment implication of heightened geopolitical risks is that benefits of globalisation are reduced.”

Investment implication

What then is the central economic case stemming from tightening monetary policy, fiscal contraction, efforts to address inequality, ongoing global political tensions and steps to mitigate climate change? The global and US economies are already slowing quickly, asset prices (equities, bonds, property) are either deflated or no longer rising, while price inflation is remaining doggedly high. But herein lies the silver lining. As demand destruction continues, technology and innovation deliver productivity, labour markets benefit from renewed international flows and some other supply disruptions unlock, we believe there is a good prospect that inflation drops back to 3% or so. Signs of this will add confidence back to financial markets and companies. Whether it happens quickly enough to allow major economies to avoid recession remains difficult to gauge. Even with the engineering of conditions by central banks today, the cycle lives on.

 

This too shall pass

What might this central economic case mean for global share markets? Equity markets have declined from record highs in January because investors have brought forward their expectations of when, and increased their assessment of at what height, central banks’ policy rates will peak.

the dominant driver of equity market returns

“the dominant driver of equity market returns is likely shifting from interest rates to earnings.”


Assuming no more shocks, the dominant driver of equity market returns is likely shifting from interest rates to earnings; in particular, downgrades to earnings expectations. This is a natural sequence when higher rates slow economies.

Earnings estimates for S&P 500 countries have been resilient so far this calendar year with this number especially buoyed by the booming energy sector and any company benefiting from rising commodity prices. European earnings could be susceptible to downgrades; Chinese earnings expectations have already been downgraded. We expect more downward pressure on earnings outlooks through the balance of this year as companies review guidance. Broad capitulation of negative earnings revisions is normally a prerequisite for a bottoming in equity markets.

As such, the global portfolio is holding a cash level moderately higher than usual. We will seek to use this money to buy high-quality companies at great prices as we navigate the volatility induced by the uncertain backdrop. We remain confident that the portfolio is positioned to benefit from longer-term investment thematics and secular growth tailwinds to above-GDP growth in many segments of industry. These include digitalisation trends across our lives – in payments, in enterprise processes, in advertising, entertaining and retail spending – as well as the energy transition and electrification and rising usage of data analytics via increased computation speeds. We are working to ensure our investors benefit from today’s inflationary pulse and the return to more-normal social engagement and community activity, including travel.

While the visibility of daily share prices makes volatility appear risky and uncomfortable, proper due diligence and concentrated investment in high-conviction opportunities are the ways we take advantage of the opportunity this brings for strong future returns. We do not invest in overtly risky market segments such as unprofitable emerging companies or commodity-linked companies.

This quality-focused portfolio, aligned to the opportunities presented by the macroeconomic backdrop, has generally stood the strategy and our clients in good stead. We will persist with the robust process behind our absolute-return, lower-risk objectives and we remain focused on seeking to deliver outstanding performance over the economic cycle to you, our valued clients.

 

Arvid Streimann
PM Magellan’s Global Strategy

Nikki Thomas
PM Magellan’s Global Strategy

July 2022

0.25 CPD hours