It's time to hedge - the bear is here Watermark Funds Management June 2022 REVIEW The Australian share market saw a significant contraction in May with the All-Ordinaries Index down 3.0%, its worst month since January. The sell-off was once again led by Technology stocks with the sector down 8.7%. The Real Estate sector also performed poorly, down 8.9%, led by concerns of more aggressive interest rate tightening and associated impacts on demand.  After a soft April, the Materials sector resumed its outperformance in May, aided by expectations of more stimulus in China. In terms of factor leadership, value resumed its leadership over growth. The value factor has now outperformed growth by 20% over the last 6 months. MARKET OUTLOOK The secular bull market that ended for Australian shares last August emerged from the financial crisis and was a product of successive waves of liquidity led asset reflation, as central banks pushed real interest rates lower and lower and asset values higher and higher (Fig1). Figure 1: Successive waves of asset inflation Source: Bloomberg, S&P 500 Chart Asset inflation, of course, created excess demand, leaving product and labour markets acutely tight. Unemployment in Australia is now at its lowest in 40 years and with little immigration, the services sector is scrambling to find workers. Fair Work Commission awarded a 5.2% increase in the minimum wage, well above expectations. This policy led bonanza for asset owners was a consequence of systemic deflation. No one has a complete explanation for the root cause of this deflation which you can see clearly in the value of bonds which have pushed higher for decades (long term interest rates have been falling). The first phase took place in the 1980's with back-to-back global recessions that killed the inflation of that era. Then in the early 1990's with the collapse of the Soviet Union we had a rapid expansion of western democracies, a deepening of capital markets and the globalisation of trade. This spread of the neo-liberal 'rules based' order (capitalism) was deflationary allowing interest rates to fall and debt balances to accumulate. The spoils of this period where not spread evenly however, laying the seeds of its demise. Asset owners captured all the gains while labour's share of GDP has fallen sharply. We now have the first generation of citizens in the west who are worse off than their parents in real terms. The emergence of popularism and de-globalisation were the first phase of its descent. A new cold war between the East and West has manifested the next phase. With this reversal in these deflationary forces, the good times of ample liquidity and asset reflation have passed. Even before the health crisis, we were approaching the limits of these policies in driving asset values higher as bond yields in many western countries were already negative. On a hold to maturity basis, investors were guaranteed a loss, which of course is nonsensical. Then with the health crisis, policy makers doubled down on these same policies. The excess demand created from emergency stimulus and the associated supply chain disruptions have unleashed inflation which will be with us for years to come. Investors need to ask two important questions: Are the deflationary forces that persisted for so long still around or has their demise contributed to the inflation we are seeing today? Secondly, what has caused this inflation, is it established or transitory? How these inflationary pressures play out will determine the duration of this bear market. If the inflation hangs around for years to come as expected then we are in a secular bear, if it is transitory and the deflationary forces resume/return then potentially shares can make new highs in the years ahead. We are still early in this bear market. Until inflation moderates and central banks back away from hiking rates further, shares will move lower in the medium term. In the short term at least, share markets globally are oversold and sentiment is extremely bearish. In the weeks and potentially months ahead, we should see a decent bear market rally which investors should sell into as the big drawdown is still ahead in the second half of the year. Australian shares have proven remarkably resilient through this first phase of the drawdown given our economy's exposure to commodities which are the driving force behind the inflation we are seeing. In simple terms, the Australian economy is a good inflation hedge. The 'quarry and farm' may once again avoid another global recession. As we get into the 3rd quarter of the year however, around the US mid-term elections, western economies will be slowing quickly and the 'street' will be slashing profit estimates, pushing shares lower. This becomes a pivotal moment for investors as the policy response will determine the next move for shares. If the inflation data improves as everyone expects, Central Banks may 'pause' on any further policy tightening. Under this scenario economies slow but avoid recession and shares can stage a significant rally early into next year. However, an early pause only ensures inflation lingers for longer, leaving us with 'stagflation'. Alternately, Central Banks look to overshoot in tightening financial conditions further to kill inflation, only to push western economies into recession. Under this scenario shares obviously fall further into the first half of next year. The policy response as the economy slows, asset values fall, and inflation moderates will determine which path the market follows. Either way the medium-term outcome is much the same, shares will be lower. The emerging data is less than encouraging, with the May CPI report showing further deterioration, Central Banks are once again losing credibility as they were guiding to a moderation in the data. It seems they still have a lot more to do evident in the FOMC decision to increase the target interest rate by a full 75bpts (3 hikes in 1), which is unprecedented. With the broader offshore indexes down more than 20% we are now officially in a bear market for shares with investors seemingly still pricing in a soft-landing scenario (green line below in Fig 2). They have never tightened once shares have fallen into a bear market before (down >20%), a further demonstration of just how far behind the curve they find themselves. Given inflation has never been tamed once it gets above 5% without a recession, a recession more than likely beckons and we move lower (the red line in Fig 2). Figure 2: Market drawdowns with and without recessions Source: Stifel While we have seen some contraction in valuations (P/E's) already as financial conditions have tightened, we are yet to see any move lower in profit expectations. With the demand shock from the COVID stimulus, many public companies are over earning, profits have moved well above trend. In a garden variety recession earnings typically fall by a least one third Fig 3 below. Figure 3: S&P 500 Profit (EPS) drawdowns from prior peaks Source: Stifel If we are in a stagflation environment of lower growth and persistent inflation, then valuations may well move to the lower end of the historic range (P/E's are low during periods of inflation) which along with lower earnings leaves us with a share market that still has a long way to fall. SECTORS IN REVIEW The Consumer sector delivered a flat result for the month, with gains in supermarket shorts, offsetting losses in some consumer growth stocks. Our long position in the Fuel Marketers has been gaining momentum as fuel security becomes an increasing issue for Western Governments. Ampol (ALD) and Viva Energy (VEA) refining assets, historically loathed by the market, are now generating super returns and driving upgrades for both companies. This sector is under-owned and offers defensive exposure at a cheap multiple. As mentioned in the April monthly, the Agriculture sector is building as fertile ground for short ideas. Share prices have risen aggressively given the confluence of a strong domestic grain harvest, and sky-high soft commodity prices driven by supply-chain dislocation. We know however, as with all highly cyclical industries, that conditions are ever changing, and we should be careful extrapolating at either the top or the bottom of the cycle. Using a 'normal season' as the basis for valuation, earnings multiples look extreme. We see several catalysts, including the successful negotiation of a humanitarian export corridor in the Black Sea to correct over-inflated soft commodity prices. Financials had a flat month in terms of attribution. Our shorts in the Banks delivered returns, as we saw the beginning of a major sell off across the sector. Banks had held up well for most of the broader market volatility of 2022. This changed when investors came to appreciate the consequences of faster than expected rate rises. We have been highlighting for some time the nexus between bank returns and the property market. Offsetting these profits was weakness in our long position Macquarie Group (MQG), we continue to see good earnings prospects for Macquarie in the short term amidst the energy market volatility. Commodities trading remains a key driver of results. Technology delivered some modest positive returns. Largely from our short portfolio. The sector continues to be the most sensitive to higher than expected inflation outcomes. Which are then leading to higher interest rates expectation. Selling across the sector has been indiscriminate. The Building Material companies continue to come under considerable pressure as it has become clearer that interest rates will be moving a lot higher. This is the case not just for the local Builders but the US based ones as well James Hardie (JHX) and Reliance Worldwide Corporation (RWC). As manufacturing businesses these companies are also very exposed to escalating fuel and energy costs. In Media, cyclical business like Nine Entertainment (NEC) and Seven West Media (SWM) have come under considerable pressure on fears of a fall in advertising spending. NEC shares are starting to look attractive with a full recession now factored in. Contractors: We expect the resources sector to hold together relatively well even as growth slows elsewhere. Monadelphous (MND) an important contractor in energy and iron ore operating in WA should perform well in the years ahead, especially as energy investments picks up. The iron ore hubs are so large and established now, having doubled in size over the last 15 years, spending in this sector will remain elevated for years to come. As a defensive sector, Healthcare has held up relatively well in a difficult market, it's probably time to take profits here. Resources: The lithium sector has fallen hard following some negative research pieces suggesting the market is over supplied in the medium term as Chinese production ramps up. We have a balanced portfolio of attractively prices emerging producers/explores and a short portfolio of expensive explorers in preproduction. Producers of bulk commodities have held up very well in recent weeks, it's time to take profits in some of the iron ore miners in particular. The iron ore prices is still above $150/t and looks vulnerable here. Funds operated by this manager: Watermark Absolute Return Fund, Watermark Australian Leaders Fund, Watermark Market Neutral Fund Ltd (LIC)

Markets pivot from reflation to deflationary bust Watermark Funds Management May 2022 MONTH IN REVIEW The Australian share market saw a small contraction in April with the All-Ordinaries Index down 0.83%, much less than the 8.7% contraction seen in the S&P 500. The modest move in the index disguised material moves in underlying sectors. Sell-offs were concentrated in Technology and Consumer Discretionary, down 10.4% and 3.2% respectively, while Utilities was the strongest sector, up 9.3%, and continuing its strong run as a safe haven against inflation. For the first time in 2022 the Materials sector fell, down 4.3%, which is an important development for the Australian market. We discuss further below.  In terms of factor leadership, growth surprisingly outperformed value in April. While the Technology sector was week, 'growth' stocks in Consumer and Healthcare sectors traded better. The 'value' factor was also dragged down by the Materials sector which has now started to fall, as mentioned above.  While May has started poorly for share markets globally, the hedges in our portfolio have so far protected the fund from any drawdown. The strategy is very well suited for the environment we find ourselves in.    MARKET OUTLOOK In April capital markets pivoted from reflation to deflationary bust as investors started to factor in a recession next year. We saw this play out clearly as commodities and commodity currencies fell sharply, including the Australian dollar.  With this, late-cyclical sectors such as resources, which had held up relatively well, joining the rout in growth shares. The catalyst for this shift was a further tightening in financial conditions and lockdowns in China weighing on growth in the world's second largest economy.  China historically has acted as a counterweight to growth trends in the west, this was particularly evident coming out of the financial crisis. With low vaccination rates amongst seniors in their community they have resolutely stuck to COVID-zero policies. Rolling lockdowns are weighing on growth and further disrupting supply chains into western markets. This is unlikely to change in the medium term given the virulence of Omicron. With China already in a recession, it is unable to play its typical role of balancing weakness in the west.  The other major development last month was the breakdown in US mega-cap technology shares. This group of companies has led the share market higher in recent years. Together they account for one quarter of the value of the S&P 500. Until April they managed to escape the broader weakness in the NASDAQ.  The 'Generals' as they are often called, reported disappointing results for Q1 2022, with Apple, Amazon, Netflix, and Facebook either missing expectations or providing weak guidance. The NASDAQ and Russell 2000 having fallen more than 20% now, joining emerging market equities and growth sectors in a new bear market.  The Australian share market had been resilient through this earlier weakness in shares offshore only to fall sharply as commodities and mining shares broke down with the news out of China and broader concerns of a pending global recession. China almost certainly is already in a recession with growth in business activity and household spending in full retreat.  If you break down the Financial Conditions Index (FCI) into asset values (falling); interest rates across the term structure (rising); and the US dollar (rising), FCI is tightening quickly, and we are only just embarking on a tightening cycle.  The incidence of central banks tightening to combat inflation is the highest in many decades. This will likely end in recession in advanced economies. As these economies slow, profit expectations for public companies will fall along with valuation multiples as real interest rates continue to move higher. This is what a bear market looks like and we are almost certainly in one.  Bear markets don't end until policy reverses course and financial conditions start to ease. We are still early in this tightening cycle, there is a long way to go. Liquidity will tighten further as central banks become sellers of the assets they have accumulated through COVID emergency measures. Bear markets typically last 18 months to 2 years and don't end until the liquidity spigot is turned back on again. Central banks are fully committed to combatting inflation and will not reverse course until inflation comes back into their target range of 2%. There is no central bank 'put option' this time around - falling asset values only helps Central Banks in their crusade to kill excess demand.  While we are probably at peak inflation now and Consumer Price Index (CPI) and Personal Consumption Expenditures Price Index (PCE) will moderate in the months ahead as we cycle inflated data from last year, any moderation will happen slowly. Key components of the inflation basket - energy, food and shelter will remain under upward pressure for years to come. Labour markets remain acutely tight, employment needs to fall (recession) to reduce pressure on wages.  We are in a 'secular' bull market for commodities, resource security and de-carbonisation will ensure ongoing investment in the sector for decades to come. Australia should benefit from this. While activity will slow in Australia, particularly if our major trading partner China is in recession, our economy should prove resilient even if advanced economies move into recession. There is a good chance Australia avoids the recession bullet once again.  Having said that, commodities and mining shares are in a 'cyclical' bear along with other risk assets and will fall through the balance of this year.  Share markets globally are over sold short term, sentiment is extremely bearish, and positioning is light. Shares should recover in the weeks ahead, an improvement in COVID cases in China would be particularly helpful.  Any rally though should be used as an opportunity to reposition into defensive, quality names that will outperform in a slowing economy.  Volatility will remain high into the second half of the year as financial conditions tighten further. We are still to see an exodus of retail investors who invested $1.3 trillion globally in equities through COVID.  As markets fall in the second half of the year and investors come to realise, there is no central bank bailout this time around, a weaker tape could easily turn into a rout as we close the year. The bear is just getting started. SECTORS IN REVIEW The Consumer sector made a positive contribution for the month, with gains in Fuel marketing longs partially offset by losses on Agriculture shorts.  Our long position in the Fuel Marketers has been gaining momentum as fuel security becomes an increasing issue for Western Governments. Ampol (ALD) and Viva Energy (VEA) refining assets, which are generally loathed by the market, are now generating super returns and driving upgrades for both companies. This sector is under-owned and offers defensive exposure at a cheap multiple.  While coming at a cost to near-term performance in April, the Agriculture sector is building as fertile ground for short ideas. Share prices have risen aggressively, given the confluence of a strong domestic grain harvest, and sky-high soft commodity prices driven by supply-chain dislocation. We know however, as with all highly cyclical industries, that conditions are ever changing, and we should be careful extrapolating at either the top or the bottom of the cycle. To overcome this issue focus should always be given to mid-cycle analysis. Given decades of data on the Australian grain crop, we can predict with some certainty what mid-cycle earnings for companies like GrainCorp (GNC) might look like. On these mid-cycle earnings, current valuation multiples look extreme.  Financials had a disappointing month in April. The primary driver was our long position in EML Payments (EML). EML delivered a guidance downgrade two months after its result in February. Given the volatility in the market, earnings dependability is currently paramount. As such, unexpected downgrades are seeing stocks punished by investors, with EML nearly halving over the month. In March, we saw press coverage that EML was being stalked by Private equity player Bain Capital, this saw the price above $3.00. We are cautiously optimistic that EML is forced to negotiate a reasonable price, which we view as the best outcome for investors.  The TMT portfolio was a slight detractor of performance during the month. Our shorts in internet companies delivered as investors focused on deteriorating housing market drivers. They have also been caught up in a broader global technology sell off. Offsetting this was our technology portfolio, where losses were largely driven by our position in Life360 (360). 360 gave a quarterly update, where it reinstated guidance. We viewed the update as overall positive and were surprised to see the share price negatively impacted. We continue to see absolute and relative value in the name.  The Mining sector was hit hard in April on lockdowns in China. The best performers recently were impacted the hardest with lithium names in particular retracing recent gains. Commodity prices were also weaker with lithium chemical and rare earths prices falling off peak levels. Coal continued to perform with our investment in Stanmore Resources (SMR) making a strong contribution.  Healthcare: The medical device names are struggling with supply chain issues. Notably, ResMed (RMD) has had trouble locating components out of Asia.  Industrials: Defensive industrial shares outperformed with Amcor (AMC) and Brambles (BXB) leading. Elsewhere housing names continued to struggle as investors adopted a more bearish view of housing activity and the property market- the building material names in particular were weak. Funds operated by this manager: Watermark Absolute Return Fund, Watermark Australian Leaders Fund, Watermark Market Neutral Fund Ltd (LIC)

Mid-Cycle correction or a new bear market? Watermark Funds Management April 2022 The question everyone is asking, Is this a mid-cycle slowdown or have we moved into a new bear market for shares?  We are firmly in the latter camp.​ The balance sheet recession that followed the financial crisis was a powerful deflationary force. Households and businesses de-levered while governments exercised fiscal restraint allowing Central banks to reflate without creating inflation. Low growth with deflation was a 'goldilocks' era for risk assets, not too hot and not too cold. In Fig 1 below, you can see four very clear and discrete mini business cycles of four years each starting in March of 2009, as Central Banks' eased and then tightened policy. Together they make up the 14-year secular bull market in shares. The cycle has turned, the bear is here In each reflation episode, real interest rates moved lower and lower and 'financial assets' such as shares and bonds, moved higher and higher. At the same time as real interest rates turned negative, capital was re-allocated away from short-duration 'hard' assets such as commodities. The share market has followed each of these business cycles peaking on each occasion at the blue advance line in Fig 1 as it has once again in December of last year. As policy support is once again withdrawn we have moved into the next 'cyclical' bear. Market bulls will have you believe policymakers can engineer yet another soft landing, pivot, and reflate one more time. It's highly unlikely this time however as we no longer have these deflationary tailwinds, instead, we have inflation at the highest level in 40 years in many western economies.   In the last tightening cycle in 2018 (Fig 2), the US Federal Reserve started raising interest rates much earlier while the economy was still expanding rapidly (PMI was rising). They didn't even reach the neutral interest rate however where policy pivots from accommodative to restrictive (the dotted line) before economic activity fell sharply and they were forced to reverse course and ease rates again. Back then, inflation was barely at 2%, and the Fed was still trying to push inflation higher! US Federal Reserve Target Interest Rate This time will be very different, they are late and are tightening as growth slows. Furthermore, to bring inflation back under control, theoretically, policy must 'overshoot'. They need to move beyond the neutral rate (dotted line) to slow demand enough to stimy inflation. Goldman Sachs have suggested this overshoot may require interest rates as high as 4% or above to curb inflation. Interest Rate markets are clearly well below this level today and with an inverted yield curve, bond investors are already signalling a recession is ahead. Given central banks are late and tightening into a slowing economy and the need for a policy overshoot to curb inflation, the prospect of a recession in advanced economies next year is high. A soft landing and another round of asset reflation is equally unlikely. Not just any bear. A new secular bear. This will not just be a 'cyclical' bear market like the four prior episodes but the beginning of a new secular bear where shares move sideways for many years to come. As with secular bulls (the last one lasted 14 years), secular bears typically last 10-15 years​   A secular bear market Strategists often refer to the 1970's secular bear as a precedent for what lies ahead. You can see in Fig 3 above this was not a unique period. Inflation eventually kills most secular bull markets and that should be our base case this time also. It is dangerous to expect this time will be different. ​ Within this secular bear we will still have the four-year business cycle playing out as shares rise and fall, but within a broadly sideways trend.​ A new secular bear for bonds also With the return of inflation, it looks like the 31-year secular bull in bonds is also now complete. It is clear from the momentum signal in the bottom panel below the low for bond yields (the high for bond prices) is in. Most risk assets are priced off the long bond - the very low yield on these securities has led to a re-rate of other long-duration risk assets like shares. The P/E re-rate of shares and for growth shares in particular is an extension of the depths bond yields have fallen too. As commodities are an inflation hedge, secular trends in commodities have historically been negatively correlated with financial assets. You can see this indicated in red below. A new secular bull market in commodities has probably begun. Secular bear in bonds/a secular bull in commodities   US Treasury Yield % (10 year) Further confirmation of a reversal in bond prices is near to hand. In Fig 5 below you can see bond yields across multiple durations are pushing up against the 30-year downtrend as we speak. If yields break through here, we will be at a seminal moment for risk assets. The 30-year tailwind for share market valuations will have reversed. How it plays out for shares this year   Following the strong bear market rally in March, shares are likely to track sideways in the months ahead but will fall short of prior highs. It is still too early for a major draw, shares still offer decent profit growth this year and analysts are still upgrading profit estimates. Furthermore, with money pouring out of the bond market, investors have few alternatives other than to invest in shares. The next major drawdown in the share market is likely to occur later in the year as economies slow and the street starts cutting profit estimates. ​As shares start to move lower and investors come to realise there will be no Central Bank bailout this time around, share markets will fall hard led by mega-cap technology - the last and largest bubble still to burst.​ Closer to home, we may well see a replay of the Teck Wreck and the GFC where the lucky country once again misses the recession bullet given our exposure to a resurgent resources sector. Given our markets' heavy weighting to resources, the ASX may still make a new high in the months ahead. From here, I would advise thinking of the Australian share market as two discrete markets - the All Industrials share market which today is still 7% below the August 2021 high and a resources market which is making new highs as I write this piece. Don't chase it though, the initial advance in commodities is nearly complete. As late cyclicals, resource shares will also fall in the second half of the year as global growth slows.  Funds operated by this manager: Watermark Absolute Return Fund, Watermark Australian Leaders Fund, Watermark Market Neutral Fund Ltd (LIC)