Q3 2023 Investment Market Update
The third quarter of 2023 saw a breakdown in the years' trend as market momentum was challenged. Global mega caps have provided a strong tailwind for performance year to date, masking many of the challenges seen across other asset classes and subsets of the equity market. This trend continued throughout July & August as positive sentiment lifted equity markets higher until a rally in bond yields saw steam come out of markets toward the quarter’s final weeks.
Inflation and the cost of living remain the central talking point for market participants. From an economic perspective, the inflation rate has declined from its peak, but pain is still being felt at the consumer level, where costs continue to rise. Central banks remained hawkish but switched their tools from hikes to words, recently becoming more hesitant with interest rate hikes. The Federal Reserve (FED) increased rates by 0.25% in July but kept rates on hold at its September meeting. Meanwhile, The Reserve Bank of Australia (RBA) kept rates on hold for the entirety of the quarter.
From a portfolio perspective, our investment portfolios climbed throughout July, marginally increased in August, and declined steeply during September, ending the quarter with negative returns between -1.01% & -4.10%, depending on the strategy. The investment committee made some changes throughout the quarter. Portfolios were positioned underweight equities and overweight cash at the quarter’s end.
ENHANCED INCOME
Australian bonds generated negative returns for portfolios, returning -0.13% in the third quarter. But the real story was within US Treasuries which returned -3.32% for the quarter in local currency terms.
Due to stickier inflation and more resilient economies, the market has now grasped the commitment of central banks such as the Fed and RBA to maintain elevated interest rates over an extended period, “higher for longer”. Consequently, the market's expectations regarding policy rates have undergone significant upward revisions in the past six months as the yield on the US 10-year Treasurys surged, reflecting changes in expectations, which generated negative bond returns. The 10-year Treasury yield increased from 3.8% to 4.6% during the quarter, standing at 4.7% at the time of writing, the highest level since 2007.
*Source Trading View
This is significant as the yield on the 10-year Treasury plays a pivotal role in shaping the discount rate and valuation for various asset classes. It is a benchmark for risk-free returns, representing the opportunity cost of investing in low-risk government bonds. When the 10-year Treasury yield rises, it typically increases the discount rate used to assess the present value of future cash flows for other investments. This, in turn, can lead to lower valuations for riskier assets like stocks and real estate, as their expected returns become comparatively less attractive.
Whilst traditional bond allocations continue to be a pain point in many investor portfolios, our positioning has been focused on shorter duration and floating rate investments such as term deposits, which haven't been subject to the same degree of negative returns as the benchmark. The outlook for many subsets of enhanced income investments continues to benefit as all-in returns rise in line with cash rates. For short-term investors, the highest rate we can access on a 12-month term deposit has reached 5.32% at the time of writing.
Outside of government bonds, other elements of the enhanced income universe, such as private credit and residential mortgage-backed securities, continue to perform well and offer very attractive risk-adjusted and consistent returns for investors, dampening the impact of volatility on portfolios.
We have been gradually ratcheting up the exposure to interest rate risk over the last few quarters and introduced exposure to US Treasuries in some portfolios during the most recent quarter. While there has been some short-term pain, we believe securing yields at these levels on defensive investments in 2-3 years’ time will reflect a clear buying opportunity to secure attractive long term yields.
INTERNATIONAL EQUITIES
International equities declined during the September quarter, returning -0.33% in Australian dollar terms, currency was a large contributor to investment performance as the U.S. dollar rose 3.64% against the Australian dollar.
In USD terms, international equities peaked at the end of July and have retraced nearly ten per cent, the equal-weighted version of the benchmark which strips out the impact of the “magnificent seven” AI-related stocks has generated only a 1.47% year to date. The AI rally lost some momentum waned during the third quarter. The Tech and Consumer Discretionary sectors underperformed the broader market, whilst the Energy sector notably outperformed, achieving double-digit gains thanks to the upward trajectory of oil prices.
*Source: FE Analytics
As referenced earlier, the primary cause of the decline can be attributed to the significant increase in long-term interest rates. Despite higher yields, we have not yet seen a major correction in valuation multiples. The rally experienced year to date has primarily been attributed to an expansion in valuation multiples, given that corporate earnings have not grown during 2023. The chart below highlights the disconnect between yields and valuations seen throughout 2023 that may leave forward-looking equity returns vulnerable should there be a valuation correction.
*Source: T.Rowe Price
During the quarter, there were some changes in the global equity allocation of the portfolio. We decreased the portfolio's overall exposure to international equities in early September, rebalancing to our tageted underweight position. Due to strong performance over the past few months, the allocations overall size of the portfolios had increased, and we considered it prudent to rebalance.
We also decreased the exposure to Asia. We were bullish on the reopening of China and Chinese equities at the start of the year, we viewed valuations within this market as attractive and thought their reopening would support equities given the reopening trade had been successful across many other equity markets. This thesis didn’t play out as anticipated, as the Chinese reopening has underwhelmed and we have since pulled back exposure. Exposure has been reallocated to global small caps and core positions.
AUSTRALIAN EQUITIES
Australian equities returned -0.77% during the quarter. Our Australian equity allocation outperformed marginally as a mix of strategies generated outperformance relative to the index.
A significant disparity was seen between the performance of various sectors during Q3. Energy, financials and consumer discretionary were the only sectors to outperform the benchmark during the quarter, energy was the stand-out sector during the quarter, generating returns of 11.16%. The healthcare (-8.59%) and Information Technology sectors (-5.81%) were two of the worst-performing sectors.
Corporations released their FY23 earnings reports during the quarter, and a pattern emerged across various industries. A common thread among these reports was the occurrence of unexpectedly elevated costs & a tougher consumer environment, resulting in downward adjustments to forward-looking earnings forecasts. Consequently, analysts made substantial revisions to their consensus earnings per share (EPS) estimates. In fact, the cumulative revisions to forward EPS have seen a significant decline, plummeting by more than 9% year-to-date. This decline in earnings revisions throughout the calendar year has placed Australian corporates in an unfavourable position when compared to their counterparts in other global markets.
One substantial change for the Australian economy during Q3 was the absence of rate hikes from the RBA. The RBA increased rates on 12 occasions from May 22 to June 23, taking cash rates from 0.1% to 4.1%. Whilst the RBA took no action, they stood firm with their words, refusing to rule out a further hike in the future. The third quarter also saw the end of Philip Lowes tenure as RBA governor, with Michele Bullock taking the reigns from 18 September.
There were no changes to the Australian equity allocation of the portfolio during the third quarter.
PROPERTY & INFRASTRUCTURE
Both property and infrastructure detracted from portfolio performance in the third quarter, listed infrastructure declined -4.19%, whilst listed property declined -2.93%. The unlisted counterparts of these asset classes fared better from a performance perspective and, in many cases, generated positive returns. Liquidity has become an issue in recent months, with many unlisted strategies deploying gates to limit investor redemptions.
These asset classes were arguably most impaired by the impacts of rising bond yields (outside of bonds). This effect is primarily due to changes in the discount rate used to determine the present value of future cash flows. This higher discount rate reduces the present value of future cash flows; assets with long dated & predictable cash flows, such as real estate, and infrastructure can be classified as bond proxies given they share similar cash flow characteristics.
Despite the sell-off, we maintain conviction in these assets, we believe that one of the most significant risks to markets is an unexpected resurgence in inflationary pressures, and this allocation offers inherent hedging against inflation. This is largely due to revenue generated from regulated assets such as toll roads, airports, and utilities being adjusted in accordance with inflation rates. The inherent characteristics of infrastructure assets offer resilience to economic downturns, setting them apart from many other sectors. Consequently, investors can find a higher degree of predictability in terms of projected income and earnings growth when considering investments in this sector.
The uncertainty surrounding the future of office spaces has cast a shadow of doubt and apprehension that extends into various sectors within the real estate market. Interestingly, this sentiment has spread across the entire market despite offices accounting for only 8.29% of the global Real Estate index. Notably, the Australian perspective on the return-to-office narrative diverges significantly from what is observed in other parts of the world, particularly the United States, where an increasing number of companies are actively implementing return-to-office policies. The truth is yet to be seen if the driver of return to the office enhanced productivity or an effective way to reduce headcount without laying off staff. Beyond the office, other property sectors, often referred to as "Eds, meds, beds, and sheds" encompassing Student Accommodation, Medical Facilities, Retirement and Residential properties, as well as Industrial spaces, continue to exhibit strong performance. These sectors have witnessed rental growth and have maintained high occupancy levels, which to date have been able to offset expanding capitalisation rates.
No changes were made to the property and infrastructure allocations of the portfolio.
PRIVATE EQUITY & VENTURE CAPITAL
All but one of our private markets exposures generated positive returns for portfolios during the quarter. Note that we are still awaiting the end-of-September valuations for some assets.
A critical development for private market investors was the IPO of Arm Holdings, a British chip designer, which marked the largest IPO of the year and a feeler for the sentiment around additional listing. The IPO markets has been largely shut since late 2021 with only 73 initial public offerings (IPOs) in the United States this year, which including Arm, have collectively generated $14.8 billion in funds raised. This amount represents only a small portion of the IPO activity witnessed in 2021, when a total of 397 companies managed to raise a significant $142 billion through their listings*. Arm’s stock soared 25% on the first day of trading but has since retraced close to the offer price of $51. The success of Arm’s IPO may lead to additional listings into the end of the year.
The secondary market continues to offer attractive investment opportunities as many investors have either lost patience with the quieter exit environment or are seeking liquidity from mature but non-realised investments to fund ongoing commitments to new private equity funds. For those providing liquidity and a degree of patience, healthy discounts continue to be made available, which we view as an attractive opportunity.
There were no changes to the private equity allocation of the portfolios during the second quarter.
*Source: Renaissance Capital
Looking forward, it continues to be our view that the full impact of tighter and continuing tightening of policy settings is yet to be felt by participants and the risk of a recession remains elevated. This would likely coincide with rising unemployment and a drawdown in corporate earnings as the consumer faces headwinds. We don’t believe that the valuations in equities markets, specifically global equities, reflect these risks. Stocks in recent cycles have peaked on average two months before the beginning of a recession but the period before that often saw strong returns.
Our portfolios reflect our views and are positioned in a defensive position underweight equities and overweight cash. Pleasingly, the alternatives to risk assets now offer significantly enhanced returns to what was available throughout 2021 & 2022 with cash-like solutions offering running yields over 4%, with any form of credit risk only enhancing returns from there.
As always, should you have any queries about any of the material outlined in this letter, please do not hesitate to contact me.
Kind regards,
Ryan Synnot
Associate Director, Investment Research & Solutions
