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 As policy support is once again withdrawn we have moved into the next 'cyclical' bear.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. 

Vrimp, the vegan alternative to shrimp, is made from peas, seaweed and konjac root, a vegetable found in Asia. The vEGGie, a vegan egg, is a mixture of soy protein and omega-3 fatty acids. Wunda is a pea-based alternative milk. Offered too are the Vuna, a vegan tuna alternative, and vegan burgers, while an experiment is underway to make vegan chicken that comes with fake skin and bones. These products add to the plant-based dairy alternatives for chocolate, coffee, creamers, ice cream and malt beverages. Such are newest offerings of the Swiss-based Nestlé, the world's biggest food and drinks maker, as it responds to the latest twist in consumer demand.

The innovation drive extends to the staples that bring in so much of Nestlé's revenue, which reached 87.1 billion Swiss francs in fiscal 2021, a jump of 7.5% on an organic basis from 2020 and the fastest pace in 13 years.

Coffee (26% of fiscal 2021 sales) has benefited from the launch of Starbucks at Home, a tie-up with Starbucks and Nespresso, and a revamped approach to producing Nescafe instant coffee. Bean selection is now approached in much the same way as wine makers grade grapes and there's an organic option. Of note is that in 2021 Nestlé scientists discovered two novel plant varietals of the coffee tree that produces Robusta beans. The result is a jump in yields by up to 50%, lower carbon emissions and people can now enjoy a super-premium barista blend in their soluble coffee. And every second of every day, the world enjoys another 5,500 cups of Nescafé, including the premium Nescafé Gold.

The pet care staple (18% of sales) has become personalised (animalised?) and much science has gone into producing healthy high-end labels. In many parts of the world at production volumes that achieve economies of scale, Fido can receive a unique blend of dog food and supplements delivered to the home with his name stamped on the front. For house pets so inclined, there's a pet food line where insects and plant protein from fava beans and millet are mixed with meat. Pet carers are considered too. Improved online ordering means people don't have to lug home heavy packets.

The KitKat staple, which was revitalised by a marketing campaign in Japan in 2014 that exploited how the Japanese pronunciation of KitKat (kitto katto) resembles the phrase 'you will win' (kitto katsu), now has stand-alone stores. These 'KitKat bars' offer almost countless flavours including a vegan option (KitKat V) and let people devise their own recipes - 'create your break'.

Such is the revamp of a company with a history stretching to 1866 since Mark Schneider became CEO in 2017. Key drivers of success under Schneider include a switch into healthier products such as plant-based foods and vitamins and supplements, and a focus on novel products and faster times to market with the latest offerings. Schneider has reinvigorated the company's portfolio of assets by conducting at least 85 divestments and acquisitions over the past five years.

Nestlé shares are trading around the record high set in November last year because investors recognise that an overhauled company with great brands is enjoying a virtuous cycle kicked off by digitalisation. The enhanced consumer insights improve innovation, which leads to the creation and successful launch of better products produced at economies of scale that bestow an unassailable competitive advantage on the company.

What brands the company has. Nestlé has 31 'mega-brands' including Coffee mate, Haagen-Dazs ice cream, Maggi noodles, Milo, Nescafé, Nesquik, Nespresso, Purina pet care and San Pellegrino mineral water. Each has loyal consumers, which means these products command a premium price and superior access to supermarket shelves. Each generates global sales of more than one billion Swiss francs every year.

Nestlé, in all, boasts 2,000-plus brands that are sold in 186 countries and many hold the No. 1 or No. 2 positions in their categories. The brands are split across seven segments. These are in order of fiscal 2021 sales: powdered & liquid beverages (28%), pet care (18%), nutrition & healthcare (15%), prepared dishes & cooking aids (14%), milk products & ice cream (12%), confectionery (9%) and water (5%).

Nestlé's great brands mean the company has steady cash flow and earnings streams no matter the state of the economy. As such, the stock has a 'defensive' appeal, which is why it's held up better than most during the share slide so far in 2022. Since Nestlé is well positioned to achieve its sales growth target of 4% to 6% in coming years, the stock is likely to generate superior returns for investors for a long while yet.

To be sure, Nestlé products face ferocious competition. Some products (chocolate) are struggling to boost sales. But the success of coffee and pet foods make up for these laggards. The health push exposes the food processor to charges of hypocrisy because many of its goods are unhealthy and cannot easily be made wholesome. But the company is out to reduce that percentage and sales show junk food is popular enough. For all its global reach, Nestlé is overexposed to a downturn in the US, where it sources about 33% of its sales and profits. The company has warned that higher costs for its agricultural ingredients, packaging, energy and shipping threaten margins. Russia's invasion of Ukraine has intensified that challenge, especially that wheat and energy prices are rising. But as a third of sales come from premium products, Nestlé is better placed than most of its peers.

A business that has changed so much since two Americans established the Anglo-Swiss Condensed Milk Company 156 years ago (that eventually merged with a company Henri Nestlé founded to sell milk-based baby food one year later) is used to overcoming challenges. If Nestlé can make such a successful start to going vegan and vegetarian (sales of 800 billion Swiss francs in fiscal 2021), what can't it do?

Sources: Company filings and website, Bloomberg News and Dunn & Bradstreet.

Against a backdrop of economic and geopolitical uncertainty, rising inflation and rate hikes, Australian investors are searching for investments that can benefit from these evolving market conditions.

With credit spreads at attractive levels, now might be the opportune time to have exposure to hybrids and credit.

With minimal returns on cash continuing to underpin strong demand for hybrid securities, we anticipate demand for yield to remain robust throughout 2022, resulting in strong returns over the year for this asset class.

The upside of rising interest rates

Rising inflation, above average GDP growth and the unwinding of quantitative easing (QE) in 2022 has seen financial markets reprice interest rate expectations.

The rising rate environment will push the outright return on hybrid securities higher, without having a material impact on spreads given the strong economic backdrop. Given most hybrids are floating rate, investors will benefit via higher income from these rising short-term rates.

Strong balance sheets you can bank on

Australian banks are the largest issuers of hybrids domestically and their balance sheets are in fantastic shape, with capital ratios at historical high levels. COVID-19 provided Australian banks with access to cheap funding via the Term Funding Facility (TFF), which provided them with a degree of funding certainty and lower funding costs.

Following the withdrawal of the TFF in 2021, new bank issuance is coming to market at attractive credit margins, providing the ideal environment for active credit managers to identify the most positive risk adjusted opportunities.

For instance, bank senior credit margins are significantly off their TFF lows, which is leading to an attractive re-pricing across all bank capital issuance (refer to Chart 1). Overvalued growth sectors are likely to lead an equity market sell off similar to 2000 - 02, but are unlikely to impact credit market returns.

Chart 1: Bank senior credit margins - Well-Off their TFF 2021 lows

The higher the carry (running yield of an investment), the greater the protection it offers investors from adverse movements in credit margins. The carry for the Yarra Enhanced Income Fund is currently sitting at ~3.0% above cash.

Based on an average portfolio maturity of ~3 years, we'd need to see an extreme 1.0% move wider in credit margins to wipe-out the carry. However, given the robust economic backdrop in 2022, we expect credit margins to remain relatively stable throughout, adding to floating rate credit's income generating credentials.

This benign outlook is in contrast to the capital losses currently being observed in traditional fixed income due to the reset in interest rates and real yields. Usually, a rise in real yields will impact the value of everything long interest rate duration, from traditional fixed income to most equities. That's not the case with floating rate credit, since its short duration offers protection to portfolio valuations from rising interest rates. This is observable in EIF's outperformance compared to traditional fixed income (Bloomberg Composite Index) since February 2020 (see Chart 2).

Chart 2: Floating rate credit with carry continues to outperform fixed rate with little carry

Making the grade

In a world that seems to be getting riskier by the minute, investment grade hybrids look to be a safe haven for investors. Here's why:

• Investment grade hybrids appear to be fairly priced in an environment appearing increasingly more expensive, especially if real yields rise or normalise in a post QE world.
• Investment grade issuers remain well capitalised, making them more likely to be able to service their interest payments and repay debt.

• Most Australian investment grade hybrids are floating rate securities, which tend to pay higher yields if prevailing rates go up because they are based on a variable interest rate, rather than fixed. Not only does this mean more income when rates rise, but there is also no loss of capital.

Getting exposure to hybrids and credit

Being able to access fixed rate securities for floating rate portfolios remains a key competitive advantage for Yarra's clients. The Yarra Enhanced Income Fund invests in high yielding, floating rate credit and hybrid securities to deliver better returns than traditional cash management and fixed income investments.