Investor Letter - Q3 2022
The third quarter was very much a tale of two halves for investment markets. We saw a strong rebound in July from June’s lows, with markets rallying as much as 10% to late August, before erasing almost all the gains in the remainder of the quarter. Australian equities were marginally positive during the quarter, whilst international equities were marginally positive in AUD, however posted significant declines in local currency terms.
The market rally was due to an anticipation of a pivot in monetary policy as the street talked up the confidence of a slowdown in the interest rate hiking cycle. This would have been a positive result for equity markets given it would likely revise terminal discount rates downwards, benefiting equity valuations. However, it was not to be, as a hawkish Jerome Powell took the stand at the Jackson Hole Economic Symposium on August 26th, reiterating that the Federal Reserve will continue to act hawkish in its approach to combat inflation, even if it means that GDP and the stock market will fall.
Throughout the quarter, the Reserve Bank of Australia (RBA) increased rates from 0.85% to 2.35%, whilst the US Federal Reserve increased rates from 1.75% to 3.25%. We anticipate central banks will continue to follow an aggressive interest rate and tightening path throughout the remainder of 2022.
Inflation continues to be a major focal point. In August, the inflation rate in the US eased to 8.3%, the lowest in four months, however this was above analyst expectations of 8.1%. Inflation will continue to be the key driver of interest rate decisions, the negative scenarios would be if inflation proves to be stickier than anticipated, and therefore further interest rate increases would be required to reign it in. On the other hand, should inflation reside quicker than expected, policy settings could become more accommodating which would be supportive for equity markets. In line with many analysts, it’s our view that inflation is likely to moderate into the end of the year with a sustained period of disinflation.
We can identify three potential tail risks for markets. Much market narrative is currently focused on the first which is the potential of unintended consequences resulting from the rapid changes in monetary policy settings. The second is an escalation in geopolitical risks across either western Europe or the east. The third, which would be positive to the upside, is a sooner or larger than expected decline in inflation or economic data, triggering a quick resolution to expected Fed hawkishness.
International Equities
International Equities rose slightly during the September quarter returning 0.45%. Currency was very supportive of international equities as the USD rallied more than 7% against the Australian dollar.
To date, the drawdown has been primarily driven by a contraction in earnings multiples. Many markets globally are now trading in line or marginally below their 10-year median valuations. This has been most damaging across longer-duration pockets of the market such as technology, where multiples have fallen from a higher base. We believe the decline in multiples represents some opportunity for investors, however risks remain elevated in the short term.
Whilst earnings have remained resilient to date, there is an argument that rising costs due to inflation and higher interest expenses are yet to filter through to company earnings. Should this eventuate, the earnings side of the valuation equation may face pressure and markets could drift lower. We believe an emphasis should be placed on high-quality businesses that can both manage expenses and pass-through increased costs to end users.
Australian Equities
Australian equities rose slightly during the third quarter returning 0.39%. Our Australian Equity allocation performed in line with the respective benchmark.
The Australian economy is potentially better positioned than most when it comes to weathering a potential downturn. The inflation situation in Australia is not as severe as some of our offshore counterparts and our wage-setting framework will assist in limiting the potential for a wage/price spiral.
From a household perspective, the savings pool of the average Australian is larger than that of the average American which provides a stronger buffer against the impact of rising rates. Our government is also better positioned to provide stimulus following any potential economic shock given a lower proportion of debt to GDP relative to some other nations.
One potential risk for the Australian economy is if the interest rate differential between the US & Australia widens significantly over the next few months. This would occur if the RBA is unable to keep up with the amount of interest rate increases deployed by the federal reserve, which would be a negative outcome for the Australian dollar. The likely cause of this would be differences in the mortgage systems between the two economies. The US mortgage system largely comprises of fixed-rate mortgages whereas the Australian system is mostly variable. As a result, the average Australian is impacted more by higher rates which may mean we may reach a point where the RBA is unable to follow the federal reserve’s lead.
From an equity market perspective, we’re still yet to see any substantial impact from higher rates and dwindling sentiment, filter through to company earnings. We will be paying close attention to announcements in the coming months. Saying this we believe some sectors of the market are more at risk than others. More cyclical pockets of the Australian market, such as commodities, may face some pressure as global economies slow and the demand for raw materials fades. The same can be said for the consumer discretionary sector, where demand may dwindle as the belt tightens around the consumers’ wallet.
We continue to believe the best opportunities may be found across mid and smaller companies. We categorise these businesses as quality growers who will be able to grow independently of the economic cycle by riding a wave of innovation & long runways of growth. For many of these names, fundamentals remain relatively unchanged and may offer an appealing entry point for investors with a long-term horizon.
Property & Infrastructure
Property and infrastructure detracted from portfolio performance during the quarter. Australian listed property declined by 6.72% whilst global listed infrastructure declined by 5.18%.
It remains important to reiterate that our property exposure remains predominately unlisted. Unlisted property performed very well throughout the quarter and generated positive returns for the portfolios. We had positive communications with several of our direct property managers during Q3, who detailed a direct line of revenue growth across their respective portfolios over the coming years. This will continue to support both valuations & portfolio performance.
Listed infrastructure was sold off as bond yields moved sharply higher towards the final days of the quarter. Across the infrastructure asset class, there is little at a fundamental level that has warranted lower prices. There are several tailwinds behind the asset class such as decarbonisation & the US’s Inflation Reduction Act that we believe will provide support for the operational performance of these businesses over the coming years. Despite the sell-off, in the 12 months to the end of September, the asset class has delivered for the portfolio returning 1.32% vs broader global equities at -9.28% as investors have pivoted towards companies with stable and reliable cashflows.
Private Equity & Venture Capital
Our private market exposures continued to be a source of diversification in Q3 and generated positive returns for portfolios. Noting we are still awaiting the end of September valuation for some assets.
We currently find the secondary market particularly attractive. The secondary market allows private equity investors to make early exits, liquidate assets or rebalance their portfolios by selling their interest to another investor. Secondaries offer investors the opportunity to buy private equity assets years into their performance cycle, normally at a discounted price.
The volume in secondary market private equity transactions this year has been record-setting. Many institutional investors were at or near target allocations for private equity last year & given the magnitude of falls across both stocks and bonds this year many are now significantly overallocated. Some investors may have restrictive mandates and hard asset class caps that could result in forced liquidation. Given the size of such investors, this aggregate volume of sales has been significant. This has seen discounts in secondary markets widen which creates attractive investment opportunities for those providing the capital adequacy.
Across venture capital, we find new pools of capital particularly attractive. There is a great opportunity to access companies at significantly lower valuation multiples relative to where they were less than 12 months ago. We’ve recently approved a new venture capital strategy for our investors, so for those with a risk appetite, please reach out to your adviser for further information.
Fixed Income & Bonds
Bonds yet again provided little defensiveness for portfolios as Australian bonds returned -0.56% across the quarter.
During this period of rapidly rising rates, bonds have become increasingly correlated with equities which has reduced the allure of the asset class. Our portfolios have been underweight bonds throughout 2022 with a preference for other asset classes such as direct property, infrastructure, hedge funds & private equity.
Given the bloodbath across bonds & higher rates available on cash, defensive investments have become materially more attractive throughout 2022. This has also coincided with a period where growth investments have declined in value but also become more attractive from a valuation perspective, so for many investors it may not warrant an immediate switch. For context, here is the yield to maturity across a portfolio of bonds today vs 12 months ago. (At the time of writing)
Australian Government Bonds: 3.64% vs 1.48%
Australian Investment Grade Corporate Bonds: 5.35% vs 1.40%
Australian High Yield Bonds: 7.54% vs 4.42%
We assess the market as having attractive yields on a forward-looking basis with risks in the bond markets being substantially lower than where they were at the beginning of 2022. From a credit risk perspective, our allocation is very defensive which provides us with the opportunity to pursue riskier bonds with higher returns should the relative valuations look attractive.
The range of outcomes for markets and economies continues to be highly uncertain. Our investment committee is positioning portfolios for a range of economic outcomes ensuring we have assets that will be beneficiaries of varying outcomes. This is done by repositioning capital towards asset classes where the risk-adjusted forward-looking returns are most appealing whilst maintaining awareness of our desired long-term positioning.
We believe the decline in multiples represents an opportunity for investors with long time horizons. At these levels investors can invest in equities and benefit from multiple expansion rather than compression, should markets revert to historical averages. Saying this, in the short term there is an argument that rising costs due to inflation and higher interest expenses are yet to filter through to company earnings. Should this eventuate, the earnings side of the valuation equation may face pressure and markets could drift lower.
It remains our objective to have our portfolio’s structured to take full advantage of the eventual market recovery and leave our clients in a better position than prior to the start of this market downturn. Given the opportunity set that we currently see unfolding, we are very confident of achieving this objective.
As always, should you have any queries about any of the material outlined in this letter then please don’t hesitate to reach out to me.
Kind Regards,
Ryan Synnot
Associate Director, Investment Research & Solutions
Arrow Private Wealth
