Hedge Clippings | Friday, 16 September 2022

In this edition: Inflation, Interest rates, and Recession

In November 1990 then treasurer Paul Keating famously opened a press conference by confirming Australia was in "a recession that we had to have."  

According to Wikipedia, former Reserve Bank Governor Ian Macfarlane said that policymakers did not "set out to have a recession in order to reduce inflation, but that the recession happened because of the unwinding of the excesses of the 1980s, the international recession of the early 1990s, and the high interest rates employed to slow the asset price boom of 1988-89."

It is often said that economic history does not repeat itself, but it often rhymes. We have certainly seen an asset price boom over the last decade, much of it powered by low, and even negative interest rates. What we haven't seen (as yet) is a stock market crash to rival that of October '87, which itself was triggered by an increase in interest rates in Germany and Japan. As a result, the Dow Jones dropped by 25% in a day, and the ASX by 40%. That market crash in turn triggered the global recession, which flowed on to Australia.

Where there is some similarity is the increase in interest rates, albeit not to the level of January 1990, when they hit 17.5%. This time around inflation, which has effectively been dormant in recent times, is the key, and central banks around the world, but particularly the US under Fed Chairman Jerome Powell, are prepared to do "whatever it takes", including triggering a recession, to tame it. The causes of inflation may be different this time, in part thanks to supply chain issues out of China, and energy prices, thanks to Russia's military exercise in Ukraine. However, central banks' only available economic medicine is to raise interest rates to curb consumer spending, all with a view of taming inflation.

Compared with 1990, the world is in a very different place, with the war in Europe, tension over Taiwan and the Pacific, and coming out of (hopefully) a global pandemic. A recession in the US and in parts of Europe seems almost inevitable, and whether Australia can dodge one remains to be seen.

In Australia, with unemployment at just 3.5%, and as yet with limited flow on to wages, inflation is running at an annualised rate of 6.1%, the highest since 1990. (There's that date again). Meanwhile in the US, inflation is 8.26%, admittedly down from an earlier peak of 8.6%, but a long way north of its average of just 2.3% between 1991 and 2019. In parts of Europe, (Portugal, Spain, Italy, and Greece for instance), inflation over the 2 years from Q1, 2020 to Q1, 2022 has ranged between 10 and 20%.

For signals that the US economy is either heading into a recession, or might almost be there, consider a couple of overnight news items: Firstly the yield curve between the US 2 and 30 year bond rates has inverted (generally a reliable indicator of a recession) with the 2 year rate at 3.85%, 38bps ahead of the 30 year rate to 3.47%, the deepest inversion for 22 years. Secondly, FedEx, the global transport giant, operating in an industry which acts as a canary in the economic mine if ever there was one, withdrew its previous earnings guidance, citing softness in its latest quarterly earnings, and foreshadowing further weakness next quarter.  

Meanwhile, the World Bank warned that the three largest economies - the US, China, and the Euro area - have been slowing sharply, and even a "moderate hit to the global economy over the next year could tip it into recession."

If all this seems like gloom and doom, remember there's a whole generation who have never experienced inflation, or higher interest rates, let alone an "induced" recession. Australia, as the lucky country, may just avoid one, but the signs for the US and Europe don't look as promising.

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McDonalds Story

Magellan Asset Management

August 2022

June 2022

McDonald's opened its first restaurant in 1948 and has since become one of the most recognisable brands in the world. The iconic golden arches were designed to draw attention to the company's pioneering 'Speedee Service System' that allowed McDonald's to serve its customers at speed, at lower cost and with consistent quality. It is this 'Quick Service Restaurant' design that enabled McDonald's to franchise. The company's reach has expanded to 36,000 restaurants in more than 100 countries that serve 63 million customers every day.

Given its size, McDonald's is exposed to numerous environmental, social and governance risks and opportunities, particularly in relation to the supply chain and labour management. It is important that these ESG risks are managed, to limit any threat to the company's cash flows and valuation. Communication of risks and how the company is mitigating them is crucial because transparency enables investors to better understand these risks. Key risks and opportunities for McDonald's include:

• Labour. McDonald's is one of the largest employers in the US. Staff are vital as customer service is essential to operations. Consideration for diversity, equity and inclusion are important to culture, business continuity and brand.
• Health and wellness. McDonald's needs to ensure the items on its menu meet the changing demands of customers including their quest for healthy eating.
• Climate change. According to the UN Intergovernmental Panel on Climate Change, the global food system is responsible for 21% to 37% of global greenhouse gas emissions. Cattle are the largest contributors due to the methane they give off and land clearing for grazing. Investing in sustainable farming techniques is an important step to reducing emissions and lowering vulnerability to climate change for McDonald's.
• Raw material sourcing (including animal welfare). Improving the sustainability of sourcing reduces the environmental damage from operations. Importantly too is that this is the ethical path.
• The 'circular economy'. The term, which extends to natural resources, refers to the long-term sustainability of society, where there is less waste and more recycling of waste. Given the reliance of McDonald's on natural resources for packaging and food, it is important that management implement strategies to reduce waste and increase recyclability.
• Governance. It is important for all companies to operate ethically and in the best interests of shareholders.

As the world's largest restaurant chain, McDonald's attracts much attention from the media and investors. The McDonald's annual general meeting this year was no exception. Prominent activist investor Carl Icahn contested some of the proposals subject to shareholder voting at the meeting held in May. A contested ballot is uncommon. Less than 1% of Magellan's investments were subject to a contested ballot in fiscal 2022.[1] Contested ballots can be a distraction to management, but they can be a reminder that communication is critical to risk management.

At this year's annual meeting, Icahn called for McDonald's management to focus more on sustainability. He requested two seats on the board to drive this change and submitted a shareholder proposal on sow gestation stalls - animal-rights activists say they are too small for pregnant pigs. Icahn had a tiny holding (just 200 shares) yet wanted director representation vastly greater than this ownership stake and out of proportion relative to McDonald's risks. 

McDonald's management improved disclosure ahead of the meeting. Specifically, McDonald's provided much greater disclosure related to the activist investor's shareholder proposal on sow stalls. McDonald's outlined its collaboration with industry, its targets related to sow stalls, supply  challenges due to covid 19 and progress to date. Although Icahn's proposal was voted down, it resulted in improved transparency, which is a good outcome for the industry.

The episode highlights that ESG risk management is important to asset owners. It is a reminder to asset owners that their vote matters and that asset owners can influence management. At Magellan, we value our right to vote. In this example, we reviewed the proposals, discussed the evidence, engaged with management and encouraged better communication. We concluded that McDonald's is managing the risk and this issue is of limited consequence to the investment case.

Sources: Company filings

Funds operated by this manager:

Magellan Global Fund (Hedged), Magellan Global Fund (Open Class Units) ASX:MGOC, Magellan High Conviction Fund, Magellan Infrastructure Fund, Magellan Infrastructure Fund (Unhedged), MFG Core Infrastructure Fund

Important Information: This material has been delivered to you by Magellan Asset Management Limited ABN 31 120 593 946 AFS Licence No. 304 301 ('Magellan') and has been prepared for general information purposes only and must not be construed as investment advice or as an investment recommendation.  This material does not take into account your investment objectives, financial situation or particular needs. This material does not constitute an offer or inducement to engage in an investment activity nor does it form part of any offer documentation, offer or invitation to purchase, sell or subscribe for interests in any type of investment product or service. You should read and consider any relevant offer documentation applicable to any investment product or service and consider obtaining professional investment advice tailored to your specific circumstances before making any investment decision. A copy of the relevant PDS relating to a Magellan financial product or service may be obtained by calling +61 2 9235 4888 or by visiting www.magellangroup.com.au.

Past performance is not necessarily indicative of future results and no person guarantees the future performance of any strategy, the amount or timing of any return from it, that asset allocations will be met, that it will be able to be implemented and its investment strategy or that its investment objectives will be achieved. This material may contain 'forward-looking statements'. Actual events or results or the actual performance of a Magellan financial product or service may differ materially from those reflected or contemplated in such forward-looking statements.

This material may include data, research and other information from third party sources. Magellan makes no guarantee that such information is accurate, complete or timely and does not provide any warranties regarding results obtained from its use. This information is subject to change at any time and no person has any responsibility to update any of the information provided in this material.  Statements contained in this material that are not historical facts are based on current expectations, estimates, projections, opinions and beliefs of Magellan. Such statements involve known and unknown risks, uncertainties and other factors, and undue reliance should not be placed thereon.

Any trademarks, logos, and service marks contained herein may be the registered and unregistered trademarks of their respective owners. This material and the information contained within it may not be reproduced, or disclosed, in whole or in part, without the prior written consent of Magellan.

Growing financial risks favour small and mid-sized global companies

Bell Asset Management

August 2022

Global equities boutique manager Bell Asset Management sees rising geopolitical and macroeconomic risks ahead and expects small and mid-sized quality companies with an international focus to offer the best value in the current market.

According to Ned Bell, Chief Investment Officer, Bell Asset Management (BAM), China's sharp growth slowdown will impact the global economy, especially emerging markets, while there are growing risks the world's central banks could hike interest rates too sharply in the battle against rising inflation.

"The global macroeconomic environment is changing dramatically, with economic growth slowing pretty quickly. And for the first time ever that slowdown is being led by China," said Mr Bell.

"What also worries us is to what extent central banks will be able to get on the right side of managing the inflation surge. The big risk is they do too much as the economy slows," he added.

Taking a more positive perspective, Mr Bell said the uncertain outlook was likely to bring plenty of buying opportunities for actively managed fund managers like BAM.

"As much as there are a lot of things to be worried about in the current market, these risks bring opportunities to the table," Mr Bell said.

BAM's investment approach focuses on companies that meet a high quality threshold, which includes financial strength, consistent profitability as well as a strong focus on Environmental, Social and Governance (ESG) factors. The asset manager then looks to identify mispriced companies within this sector or those stocks that display a disconnect between quality and current value.

SWITCH TO GLOBAL SMALL AND MID-CAP COMPANIES

As a result of the changing macroeconomic environment, Mr Bell said the Bell Global Equities Fund had cut its weighting in large global companies and increased its allocation to smaller and mid-sized (SMID) firms as they offer more attractive valuations.

"We've got 42% (of the fund's assets) in the SMID area. At the same time, we're probably the most underweight in mega caps that we have ever been," Mr Bell said. The benchmark MSCI World SMID Cap Index currently has a forward price/earnings (p/e) ratio of 15 times, compared to 24 times for the MSCI World Large Cap Growth Index.

Mr Bell noted that the Global SMID cap p/e ratio currently stood at a significant discount to the MSCI World Large Cap Growth Index and traded at a discount to the main MSCI World Index compared to an average premium of 12% over the past 10 years.

The COVID pandemic has given many global SMID companies a further boost with many forced to cut costs sharply.

Mr Bell explained, "They had no choice. They cut so much cost out of their businesses that the actual earnings for the SMID asset class is 70% higher this calendar year than the pre-COVID level in 2019. As a result, they are able to absorb what is happening now more than they otherwise would have been able to."

ESG INTEGRATED INTO INVESTMENT PROCESS

Adrian Martuccio, Co-portfolio manager at BAM, said the fund manager's focus on its global SMID strategy had also led to a lower carbon footprint for the Bell Global Equities Fund.

"Fundamentally we believe that if you have a portfolio with great ESG characteristics as well as meeting other quality metrics, then it's going to help you outperform. There is a very tight correlation between quality companies and good ESG outcomes," Mr Martuccio said.

"We believe having a quality bias does help because it means you generally steer clear of many of utility stocks and other stocks that aren't environmentally friendly, but you really have to have some positive selection and active portfolio construction to get a carbon intensity level as low as BAM's," he added.

The Bell Global Equities Fund and the Bell Global Emerging Companies Fund have ESG scores consistently above the MSCI World Index and the MSCI World SMID Cap Index, and a significantly lower carbon intensity.

Sector Spotlight: Mineral Resources

Airlie Funds Management

July 2022

Join Vinay as he discusses what makes Mineral Resources a unique business and how it's positioned for future growth.

Speaker: Vinay Ranjan, Equities Analyst

Funds operated by this manager:

Airlie Australian Share Fund

Important Information: Units in the fund(s) referred to herein are issued by Magellan Asset Management Limited (ABN 31 120 593 946, AFS Licence No. 304 301) trading as Airlie Funds Management ('Airlie') and has been prepared for general information purposes only and must not be construed as investment advice or as an investment recommendation. This material does not take into account your investment objectives, financial situation or particular needs. This material does not constitute an offer or inducement to engage in an investment activity nor does it form part of any offer documentation, offer or invitation to purchase, sell or subscribe for interests in any type of investment product or service. You should obtain and consider the relevant Product Disclosure Statement ('PDS') and Target Market Determination ('TMD') and consider obtaining professional investment advice tailored to your specific circumstances before making a decision to acquire, or continue to hold, the relevant financial product. A copy of the relevant PDS and TMD relating to an Airlie financial product or service may be obtained by calling +61 2 9235 4760 or by visiting www.airliefundsmanagement.com.au.

Past performance is not necessarily indicative of future results and no person guarantees the future performance of any financial product or service, the amount or timing of any return from it, that asset allocations will be met, that it will be able to implement its investment strategy or that its investment objectives will be achieved. This material may contain 'forward-looking statements'. Actual events or results or the actual performance of an Airlie financial product or service may differ materially from those reflected or contemplated in such forward-looking statements.

This material may include data, research and other information from third party sources. Airlie makes no guarantee that such information is accurate, complete or timely and does not provide any warranties regarding results obtained from its use. This information is subject to change at any time and no person has any responsibility to update any of the information provided in this material. Statements contained in this material that are not historical facts are based on current expectations, estimates, projections, opinions and beliefs of Airlie. Such statements involve known and unknown risks, uncertainties and other factors, and undue reliance should not be placed thereon.

Any third party trademarks contained herein are the property of their respective owners and Airlie claims no ownership in, nor any affiliation with, such trademarks. Any third party trademarks that appear in this material are used for information purposes and only to identify the company names or brands of their respective owners. No affiliation, sponsorship or endorsement should be inferred from the use of these trademarks.. This material and the information contained within it may not be reproduced, or disclosed, in whole or in part, without the prior written consent of Airlie.