Interest rate hikes, inflation, geopolitical tension… Portfolio Manager Anshu Sharma discusses semiconductors (chips) and why we think they are so important over the next three to five years.

As the second quarter ends, investors are licking their wounds from negative asset returns as policy withdrawal corrodes asset values around the world.

Investor sentiment has swung wildly throughout the year but now seems firmly entrenched in Kubler-Ross's famed five stages of grief - denial, anger, bargaining, depression and acceptance.

Make no mistake, things do not look good in the near term for economies as central banks raise rates the world over, lifting interest servicing costs and reducing discretionary spending. Bond markets have already priced in the most substantial and violent rate hiking cycle in generations - far beyond the 2.5 per cent US Federal Reserve rate hiking cycle peak of 2018 that crashed the corporate credit markets (and ultimately the equity market). As investors are entering the bargaining phase of grief, perhaps there is some glimmer of hope emerging, as inflation data and the inventory cycle (the bullwhip effect) can help ease the pathways into 2023.

It is very likely there will be some depression as the markets continue to adjust (illiquid assets need to play rapid catch-up to listed assets) and finally an acceptance that our new geopolitical world order requires a vast recalibration of energy and labour markets that will have far-reaching effects, add risk premia to asset classes in higher volatilities and crimp the lofty growth valuations seen in the last cycle.

Government bonds led asset underperformance, correctly signalling tougher times ahead for the economy as reopening inflation was turbocharged by the Russia-Ukraine conflict and further China lockdowns.

Early in the year, many investors seemed in ''denial'' that markets could fall abruptly, despite the early warning signs from the bond market that funding interest rates would be moving significantly higher, tightening the economy at significant pace despite the economy opening the year in great health.

No doubt significant ''anger'' has been experienced as many risk assets followed the lead of bonds over the second quarter, playing catch-up and slingshot in a spectacular fashion (the US Nasdaq is now down 29 per cent).

The cult of crypto has been forced to stare into the abyss and contemplate life without self-reinforcing feedback loops, amid nasty infighting among the tribal communities. Australian equities have thankfully been well insulated from larger global declines to date, thanks to heavy commodity exposures which have outperformed significantly so far in a supplyconstrained world. This requires some investor consideration should growth fall substantially, as commodities can flip from leader to laggard very quickly despite supply constraints - in the Global Financial Crisis of 2008, oil fell from $140 a barrel to $44 in a matter of months.

Are we somewhere around the ''bargaining'' phase currently - looking for pathways that can deliver a soft economic landing? There are certainly signs that goods inflation has significantly abated in the US - major retailers such and Walmart and Target have reported a surge in inventory accumulation and expect consequential goods discounting as a result. Supply lines are healing, and freight costs have fallen - this is known as the ''bullwhip'' effect, where inventory can flip from deficit to surplus almost instantaneously.

Many businesses perhaps over-order inventory, knowing their order may be scaled back, but as supply lines heal one day the entire order arrives and they find themselves overstocked, leading to poor inventory turnaround times. This may also be the result of changing consumer demand, but either way discounting occurs and inflation pressures ease as a result until the excess inventory is cleared to restore equilibrium.

This should help inflation begin to moderate, along with a more stable energy complex (oil peaked at $US130 after the outbreak of the Russia-Ukraine conflict; now $US106).

However, services inflation is still expected to rise in the near term, leading to an ongoing, volatile series of outcomes in the inflation data. We expect that inflation will moderate over the balance of the year which will help central bankers find a change of narrative towards a ''pause'' of policy from the highly restrictive settings they are currently embarking upon.

Sadly, while this improvement in inflation will help lift the angle of decay, we still have some difficult times to navigate as interest rates rise over the balance of the year, as expected by the bond market which has fully priced these expected outcomes. And so the ''depression'' phase may remain ahead as a ''pause'' of policy may help alleviate the declines, they will not bring back the financial asset lunacy of 2021 (anyone for a digital ape drawing for a few hundred thousand?). Assets are finding new valuation ranges for a post-Covid geopolitical world.

This is probably a world where inflation can oscillate from inflationary (supply disruptions from war) to disinflationary (capitalism solves the problem) as secular forces clash and government policy stimulates or destroys demand, chasing inflation mandates.

Investors must finally find ''acceptance'' that the pandemic uprooted a rule-based system, led to the great resignation, accelerated working from home - essentially it threw the economic and social jigsaw puzzle into the air and pieces have landed all over the place. Incredible government policy saved economies from their stark realities at that time, but the entropy of that volatility has returned and will leave us with a more unstable world.

Part of that acceptance will be to realise that asset allocation is paramount for investors, who will be reminded that some equity is worthless, some dividend policies are best endeavours only, some credit will default, and many boring and and conservative assets play a critical role. In combination, strong and diverse asset allocation will generate good outcomes through the uncertainty we continue to face.

Contractually and legally binding bond coupons from highly rated governments are close to certain for income investors (unless you think the governments will not exist in time to repay you).

They might find growing acceptance in a world where the only certainties are death and taxes.

Market commentary June was a very weak month for equities globally, driven by continued investor concern around the quantum and pace of interest rate increases and a weakening US (and global) economy. Central banks (correctly in our view) appear committed to reducing inflation via aggressively increasing interest rates, even if it means reducing economic growth in the short term. 

In the US, the S&P 500 was down -8.4%, the Nasdaq fell -8.7%, whilst in the UK, the FTSE fell -5.8%. In Australia, the All Ordinaries Accumulation index fell -9.4%, whilst the Small Ordinaries Accumulation index was down -13.1%. On the ASX, the best performing sector was consumer staples, whilst resources was the worst performer, impacted by lower commodity prices and growth concerns regarding the Chinese economy. The underperformance of small/mid cap stocks vs large cap is not a new situation and has indeed occurred in all of the months in the last five years where the ASX has seen large falls. 

Whilst we agree that inflation, interest rate rises and weakening economic growth are all valid current concerns for investors, we also believe the falls in stocks across the board have been quite material and hence from a stock specific basis, there are now some very attractive investment opportunities for investors willing to take a 2-3 year view. 

As always during periods of market stress, it is very important to take a long term view and think about how long the current negative conditions will be in place over the medium term. Whilst concerns around an economic slowdown are warranted currently, we believe in 12-24 months time, this risk is likely to have reduced as central banks are further down the path of interest rate hikes. 

It is also important to remember that on average, bear markets last for 12-15 months, hence the current challenging conditions will not be in place permanently. Also, we would stress over the next 12- 18 months, whether Australia and/or global economies actually have a recession is not the key issue (even though it will generate a lot of media discussion). Rather for investors in the Fund, the key issue is the investment opportunities that are thrown up from the sell-off in equities, that can provide the basis of investment returns over the next 3-5 years. 

It should also be noted that as the stock market is very forward looking, stock prices historically fall well ahead of any economic downturn, in particular small/mid cap stocks on the ASX. 

Revenue multiples have returned to pre-2020 levels for high growth software companies, based on Octahedron's index. The downturn in valuations was accompanied by a 23% year-on-year decline in March quarter VC funding for late-stage and technology growth funding, crunchbase calculated - although it found seed and angel investment held up better, growing 9% year-on-year. The Information found VC firms buying listed tech stocks, meanwhile consensus data from FactSet shows the tech sector is not expected to have been among the strongest growth areas of the S&P 500 in the June quarter - energy and materials stocks have the most expected of them. Kailash Capital shows that price growth for the S&P 500 in the 2017-2021 period has doubled the long-term average return. Finally, Bloomberg charts the rise of self-employment in the US.

Octahedron Growth Software Index (EV / NTM Rev)

Source: Octahedron

Global Venture Dollar Volume by quarter

Source: Crunchbase

Global Seed and Angel Investment by quarter

Source: Crunchbase

VC Firms Buying Publicly Listed Shares

Source: The Information

S&P 500 Revenue Growth Expectations

Source: FactSet

S&P 500 historical average returns

Source: Kailash Capital

Americans increasingly shifting to self-employment

Source: Bloomberg

July Edition

The downward trajectory of global equity markets continued in June as central banks displayed a willingness to hike rates aggressively in the near term to fight inflation. This hard stance increased concerns of a swift contraction in global economic activity.

The US Fed delivered a 75bp rate hike in June, the largest rise since 1994, after May's CPI accelerated at the fastest rate since 1981 (8.6%). Chair Powell signalled another large hike in July to fight inflation "expeditiously." Likewise in Australia, the RBA surprised markets with the largest rate hike in 22 years (50bp) to bring the cash rate to 0.85%.

Small resources retracted by 22% on weaker commodity prices and shrinking demand concerns. The price of copper, a 'bellwether' for the economy, dropped below $US8000 for the first time in almost 18 months and is now down 17% year to date. Developers and explorers were sold off more heavily than producers, albeit no one was immune.

As a slew of earnings downgrades and profit warnings started to build momentum across the market, outperforming in the month were defensive portfolio holdings. Litigation financer Omni Bridgeway (+5%) highlighted the benefits of being uncorrelated to the broader economic environment at present, as well as announcing the launch of an 8th Fund.

With signs of economic fragility proliferating, investors finished the month speculating how quickly central bankers will change their tune. Last week, the closely watched Atlanta Fed's GDPNow estimate of real GDP was slashed to -2.1% in the second quarter, highlighting the prospect that the US economy may already be in recession. As a result, bond markets are now trimming their expectations for future rate hikes and investors are betting the deteriorating consumer and business confidence will be enough for central bankers to call a pause or slow their hiking cycle.