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January looked like a great start to 2023, after the losses of 2022. The S&P/ASX200 index was up 6.2% for the month, similar to the 6.3% rise in the US S&P500 index. Share markets in Europe, China and Latin America were even stronger.

But appearances can be deceptive. The January rally was built on hope, not facts. Investors were betting that the Fed would stop raising interest rates and the battered tech sector would recover. For example, Tesla gained 40%, Bitcoin jumped 38%, and even the joke Dogecoin rose 32%.

 

What investors were doing is called bottom fishing: that is, they were buying the assets which had fallen the furthest in 2022, on the grounds that they must be cheap after such big price falls. For example, Meta Platforms (the disaster formerly known as Facebook) fell by 76.7% from peak to trough in 2022. In January 2023 it rebounded by 109.8%: simple arithmetic tells you that it is still down 51.2%, i.e. Meta shareholders have still lost half their money. Is Meta cheap? History suggests it isn't.

The investors who are buying beaten-down tech stocks in this cycle are usually too young to remember the aftermath of the 2000 dotcom boom. As PT Barnum said, "There's one born every minute." Older readers will recall that the tech stocks began to slip in April 2000, and kept sliding for the next four years. They did enjoy rebounds every few months, but these were all false dawns as the bear market persisted. The best of the tech stocks - think Amazon, Google, Microsoft - lost about 75% of their value from peak to trough. The rest of the tech stocks just disappeared altogether. In fact, if dividends are excluded, the whole US share market was no higher in 2007 than it had been in March 2000.

The January 2023 rally ended in early February as the Fed (and other central banks, including our own Reserve Bank) put an end to investors' fantasies by making it very obvious that interest rates were going higher and staying up for longer. Early reporting from US companies for the December 2022 quarter showed that in many cases profitability was falling short of expectations.

 

Arminius continues to believe that, even though we are now in the Year of the Rabbit, several of the tigers from 2022 are still hanging around, such as oil prices and the Ukraine crisis, and they have been joined by the problem of Congressional gridlock in the US. The biggest of these tigers is inflation, which is not going back to the sub-2% levels which was obtained in the peaceful decade before Covid.

At best, US inflation will abate from 7% to around 4%, but then it will get stuck. The tight US labour market is pushing up wages in key sectors, and companies are pushing through price increases in order to pass on increases in wages and input costs. Persistent inflation means that the Fed will not cut interest rates as quickly as the bond market is hoping.

At worst, US inflation will fall slightly then begin to rise again, e.g. because of external factors such as higher oil prices or higher commodity prices. Under these circumstances, the Fed may have to raise interest rates again ala the Ghost of Arthur Burns past.

The outlook for Australia is better than the outlook for the US, and we expect the Australian share market to outperform the US over the next three years. This has nothing to do with domestic Australian policies; if anything, it's in spite of. The main drivers of this positive outlook are China and the resources boom. The Chinese economy is not recovering as fast as the bulls might hope, but it will be back to pre-Covid levels by late 2023. In addition, the Chinese government is quietly stepping back from its unofficial bans on Australian exports from coal to lobsters.

Global de-carbonization is fueling a resources boom which will focus on the minerals used in batteries and clean energy generation, "critical minerals" such as copper, nickel, cobalt, graphite and lithium. This latest resources boom means that Australian investors will enjoy a rising A$ against most major currencies, which will also help to curb domestic inflation. US investors, by contrast, will see the US$ continue to weaken, which tends to mean importing inflation.

The single most important thing for investors to remember in 2023 is that the world has changed. We are not going back to the world of ultra-low interest rates because inflation is not going away, and the forty-year bull market in bonds ended abruptly and painfully in 2022. This paradigm shift means that investors need to question the habits which they have built up since the GFC, and adjust their investment strategies to a world of higher volatility, where real assets will outperform financial assets.

Source: AlphaArchitect

Australian equities will perform better than most of the world over the next three years, but the new paradigm of higher volatility means that the old strategy of buy-and-hold won't work very well in a world where commodities and resource companies lead share market performance. To cope with the coming turbulence, investors will need exposure to commodities and to long/short strategies - i.e. the ability to short shares as well as buying them.

The Arminius Capital "ALPS" strategy returned +21.67% in 2022, compared to negative -19% for the US S&P500 and negative 1.1% for Australia's S&P/ASX200. The 2022 return puts ALPS among the top 3 out of 39 alternative funds. The key factors behind the ALPS annual return of +21.6% were to invest in commodities and to invest long/short.

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Funds operated by this manager:

Arminius Capital ALPS Fund

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So, has inflation peaked or not?

Given the multi-decade high inflation levels of 2022 was the precursor to aggressive interest rate hikes, a key driver for the 2023 outlook is the direction of inflation. Throughout 2022 three core factors drove higher inflation; supply chain issues, amplified goods demand due to stimulus, and a commodity price shock. All three appear to have peaked.

Several economic indicators suggest that supply chain issues are behind us. The supply chain measure provided by the Federal Reserve has fallen, shipping rates between the US and China have normalised (refer Chart 1), and key global exporters such as Korea and Germany are now seeing export orders decline.

Additionally, the impact of central bank rate rises through 2022 should see consumer spending slow in 2023, as the fastest rate hiking period in the past 30 years quickly constrains household budgets.

In Australia, we expect to see mortgage costs rise anywhere from 20-60% (for the typical borrower), with those who borrowed on a fixed rate over the past 18 months will see a 60% increase in payments. After an era of cheap money and stimulus provided during COVID, this should take the sails out of the outsized goods demand over the past two years.

While geopolitical risk related to Russia dominated headlines in 2022, commodity prices have begun to fall. Oil is now flat on a year-on-year basis and commodities are declining. Commodity prices are one of the strongest predictors of inflation, and the more benign commodity prices, point to inflation falling away in 2023 (refer Chart 2).

Outside of these factors, several other lead indicators of inflation are beginning to decline. These include producer prices in China dropping to deflationary levels (refer Chart 3).

PMI surveys show that firms are now reporting that input prices are falling, and small business surveys show the number of firms passing on price increases has peaked (refer Chart 4).

While the indicators do not point to a deflationary environment, the speed with which they have shifted, combined with the central bank's aggressive hiking cycle, suggests that we could see inflation back within their target bands by the middle of the year. This would encourage central banks to keep interest rates high but remove their hawkish bias.

Signs pointing to rising recession risk

The second factor that is likely to determine interest rates in 2023 is related to recession risk. Historically, when a recession occurs, interest rates fall aggressively as central banks ease financial conditions to boost their economies. This has occurred in every recession over the past 50 years (refer Chart 5).

On average, following a recession, the cash rate dropped by 400 basis points, with smaller decreases only occurring when the cash rate hit the zero bound (refer Table 2). In no instance did the cash rate finish the recession higher or at the same rate it started.

If the US enters a recession in 2023, there will be pressure on the Federal Reserve to cut the cash rate. Currently, several recession indicators are starting to flash red and point to a distressing growth signal. These signals can be seen in the leading index of US growth, new orders, consumer expectations, and housing. For example, the leading US growth index has moved into contraction (refer Chart 6) and is now at a level indicative of a recession, as observed in all of the past eight occurrences.

A warning sign of recession can also be a result of falling indexes including new orders relative to inventories which have now seen the US yield curve invert across multiple maturities (refer Chart 7). Historically, this has preceded a recession by approximately six to 12 months, reflecting monetary policy has become too tight for economic conditions. As with the leading index above, curve inversion has not given a false positive and has preceded all recessions since 1970.

In addition, we are seeing recessionary signals such as a weak housing market and an extreme softening in consumer confidence.

While many may hope that the economy faces an unemployment-less recession, i.e., that unemployment doesn't rise as growth falls, this would be an extremely rare occurrence. Over the past 50 years, unemployment has never remained stable through a recession, rising anywhere from 0.6% to 3% higher over a six-month period. If the US economy does enter a recession, a rise in unemployment should not be far away.

The key takeaway is that we have not seen this many recessionary signals since 2007, creating strong pressure for central banks to ease rates should a recession occur.

Interest Rate Outlook - Inflation meets recession

These two forces produce two very different outcomes for central banks and interest rates. On the one hand, high but slowing inflation should encourage central banks to maintain their hawkish stance, hold rates high and ensure that inflation returns to its 2% targets. However, the deterioration in economic data would historically have seen a dovish tone being adopted by now. So which force should win?

The below chart shows that, historically, recession risk dominates. When recession occurred in the '70s, '90s, and '00s, rates fell even when inflation was high. Furthermore, in 1974 and 2008, the cash rate fell before inflation peaked and was still running at over 5%.

Despite this, the Federal Reserve continues to present an extremely hawkish message, expecting to make cash rate moves that take little consideration of the existent lags in monetary policy. The Federal Reserve dot plot (a chart that records each Fed official's projection for the central bank's key short-term interest rate) currently shows an expectation for cash rates to be around 5.5% in 2023.

Considering this, it may set up 2023 to be a tale of two halves; higher cash rates to begin the year and lower cash rates mid-year as the Fed acknowledges the recession risks. With this in mind, we believe rates will end 2023 lower than 2022, even if central banks continue to talk a hawkish message in the first few months of this year. If the recessionary indicators prove correct, then rate cuts of 400 points is the magnitude required to restart the economy, which would drag short-dated interest rates into a 1-2% range.

The Yield Curve - Flatter short-term, much steeper long term

The yield curve is one of the most consistent series in bond markets as both the driver of its changes and the levels it respects. While bond yields have fallen from 15% to 0%, the spread between the two and 10-year bonds has typically been range bound between -100bps and +250bps.

When looking at the two-component rates of the curve, it is easy to see that monetary policy direction is the key driver that determines both steepening and flattening. When the cash rate rises the yield curve flattens, and when the cash rate falls the yield curve steepens. This occurs as the 2-year yield makes larger moves with the change in the cash rate while the 10-year yield is slower-moving. Typically, the 2-year yield moves the fastest to cause large changes in the shape of the curve (refer Chart 11).

We can make two comments about the direction of the curve:

• If the Federal Reserve continues hiking the cash rate - the curve will flatten.
• If the Federal Reserve pauses or cuts the cash rate - the curve will steepen.

As such, we currently favour a steepening position for three reasons. Firstly, central banks can change their minds and we believe that the magnifying recession signals should not be ignored. If the recession risks are proven true, we should see dovish actions take place sometime in 2023 which will cause the curve to steepen. This idea is backed up by the fact that post-1970, curve inversion has signalled that rate hikes should be coming to an end.

Secondly, the typical flattening cycle occurs over multiple years, while the steepening period is usually far shorter, with the first 100 points of steepening occurring over 9-12 months.

And finally, the curve typically struggles to flatten through -50 to -75 levels that are now broken and take the inversion to historically stretched levels. As such, we are looking to position ourselves to capture the next 200-point move steeper, rather than the last 20-50 points flatter.

Is the RBA done with interest rate hikes?

While the majority of this outlook has focused on the US, as Australian and US long end rates are highly correlated, for short-dated rates it is important to consider whether or not the RBA has finished its hiking cycle. This is important as the differential between US and Australian short-dated rates is largely determined by the cash rate differential. When the Australian cash rate is higher than that of the US, then 2-year bond yields in Australia will be higher too. Since Australian short-dated bonds remain well below the US, the ability for them to move in a similar nature to the US will depend on the RBA's next action.

One of the key differences between Australia and the US is that the Australian mortgage market is predominantly a variable rate market, while the US mortgage market is fixed. This means the Australian household should feel the brunt of rate hikes faster and at a lower interest rate than in the US.

We determine how restrictive monetary policy is by estimating the percentage of disposable income allocated to repaying loans. This measure accounts not only for interest rates but total debt loads and income in the economy. As shown below, the current RBA hikes have already taken this measure to some of the tightest monetary policy settings we have seen in the past 40 years.

Since the Australian policy setting is becoming historically tight, and the global economy is slowing, we believe the RBA is approaching the end of its hiking cycle. If this is the case, 3-year bond yields should have already peaked for this cycle and are currently close to what we consider a fair value.

Whether or not short-dated bonds can rally in Australia in 2023 will depend largely on what the RBA does with the cash rate. In previous hiking cycles, if the cash rate can remain stable for 12 months or longer (1995 and 2010), then 3-year bond yields consolidated at those levels for an extended period (refer Table 3). However, when the cash rate held at its peak for only six months (such as in 2000 and 2008), bond yields rallied in anticipation of future cuts and saw yields materially under the cash rate.

Currently, it's too premature to tell whether the RBA will need to cut rates in 2023, as the lead growth indicators for Australia are not as weak as they are in the US. However, if the US and Europe enter a recession, we would expect Australia to follow.

Given we are likely near the peak of the cash rate cycle, this effectively sets up an outlook where two outcomes can likely occur. If the global economy avoids a recession, Australian 3-year yields should be somewhat stable and trade around 3.50%. Alternatively, if the global economy continues to slow, we should end the year with yields well below 3%. Therefore, we expect there is a strong likelihood that short-dated yields will end in 2023 lower than in 2022.

Author: Chris Rands, Co-Portfolio Manager of the Yarra Australian Bond Fund

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Tim Binsted from NovaPort Capital runs the ruler over this retailer's results and provides an outlook for the coming 12 months.

Specialty retail has been a tough place to operate over the past 12-18 months. Gone are the goldilocks conditions of the pandemic (at least from a retail perspective), where everyone was at home remodelling their living rooms and updating their décor. Replaced by an environment of higher interest rates, mortgage stress, and increased economic uncertainty.

The company we're focused on today has been savaged by the market on the back of its latest results, perhaps unfairly, suggests Tim Binsted from NovaPort Captial. 

I think it's not surprising that we've had some moderation, but the market's now extrapolating this going forward. It looks like a bit of an overreaction

The stock in question is Nick Scali (ASX: NCK) and whilst the company's results were much stronger than a year ago, with revenue and EBITDA up more than 50% each, written sales orders were down more than 12% on January 2022 - and that's what has spooked the market. 

The NCK share price performance has been solid since the June low, rallying from around $7 to north of $12 before today's results. Join me as I dive into the results with Binsted and get his take on the prospects for Nick Scali as it continues to navigate the post-Covid retail landscape.  1-year daily chart of Nick Scali (ASX: NCK), compared to the S&P/ASX 200. (Source: Market Index). 

Nick Scali (ASX: NCK) H1 key results and company data

• Revenue $283.9m, compared to $180.3m a year-ago (+57%)

• EBITDA $112.2m, compared to $73m a year-ago (+54%)

• Orders $210.3m

• Interim dividend 40 cps, fully franked; record 7-Mar, payable 28-Ma

• Source: Market Index

 

In one sentence, what was the key takeaway from this result?

It looks like the froth from the lockdown-driven boom in furniture sales has ended.

The stock is down 13% on the results. In your view, was it an overreaction, an under-reaction or appropriate?

I think it looks like a bit of an overreaction. I think we had the market jumping at shadows leading into the market lows with big fears about retail disaster. The whole sector sold off and then it rallied when trading was better than expected and it rallied quite hard into the result. Everyone was expecting that the boom in COVID sales couldn't last forever. I think it's not surprising that we've had some moderation, but the market's now extrapolating this going forward. I think it's jumped at shadows before, recovered and rallied. 

And then now we've had one month that's down from very high levels and the market's jumping again. It looks like a bit of an overreaction

We're there any major surprises in this result that you think investors should beware of?

No major surprises. We've all seen rising rates. We all knew there was a huge boom in sales during COVID per this category in particular, those comps were never going to last. 

I don't think it's surprising that this was going to ease a bit at some point. 

I mean, they're [sales] not falling off a cliff. They're still well up on pre-COVID. I wouldn't have thought there's a massive surprise in there. The main positive surprise would be how well they're executing on the Plush acquisition. 

Would you buy, hold or sell NCK on the back of these results?

RATING: Hold

Please note that NovaCapital currently hold this stock in its portfolio. 

What's your outlook on NCK and its sector over the year ahead? Are there any risks to this company and its sector that investors should be aware of?

You've got to assume there's going to be a continued easing in like-for-like sales just with the COVID heat coming off a bit. 

I think you'd also expect that rising rates will put a little bit of a dent in as well, but you've got very strong employment, so that should support sales to some degree. As long as unemployment is below 4%, wages are still strong. That's a mitigating factor. And then you should see them bank a lot of synergies from the acquisition of Plush, which is going really, really well. They've got one of the best management teams in the business executing that. They've got $20 million out already on a runway basis, and they're getting the margins up in that Plush business. There's 6-7% percentage points of margin that they're getting through there. 

I'd expect them to execute well on that and for that to drop through to the bottom line of the business.

I think the retail sector, generally, it is going to get tougher with rates going up. You've got a lot of fixed mortgages rolling off, it's been well flagged, that's going to hit consumers, but we're coming off a really high base and the valuations aren't that high for Scali and some of its peers. There's a few offsetting factors there, but you have to say sales would have to be a bit less rosy, but it just depends on individual stocks and how they're placed to manage that. There will be a little bit of top-line pressure, but it's well-run business with good margins and a great acquisition to deliver synergies.

From 1-5, where 1 is cheap and 5 is expensive, how much value are you seeing in the market right now? Are you excited or are you cautious on the market in general?

RATING: 2-3

I think you'd have to say it's pretty exciting. I think you probably have to say somewhere between a two and a three. And the reason that I've given you a range, I'd probably skew it more towards two. For cheapness, there is value, but we just haven't really seen the earnings pressures yet. We've had a very good period for market earnings. I think we've had the PE come down, bit of a de-rate with the interest rate rises, and we haven't seen the earnings pressure yet. Maybe we're just starting to see a little bit of that through pockets of the market. I think you want to see a bit more of an adjustment there. Plus, we've had a big rally over Christmas and into February reporting, so that's taken away some of the ultra cheapness out of the market. 

But there's opportunity. The market's rebased a bit and it's a good time to be investing.

10 most recent director transactions

Equity markets were stronger in January, as investor sentiment shifted toward a potential soft landing (ie. inflation moving back to acceptable target levels without a severe economic downturn). In the US, the S&P 500 rose +6.2%, the Nasdaq was up +10.7%, whilst in the UK, the FTSE 100 increased +4.3%. On the ASX, the All Ordinaries Accumulation Index rose +6.4%, with consumer discretionary and technology sectors outperforming, whilst utilities underperformed, as investors chased cyclical and higher risk exposure.

In bond markets, the US 10 year bond rate fell -31 basis points to close at 3.52%, whilst in Australia, the 10 year yield was broadly flat at 3.55%

Commodity markets were broadly stronger in January. Iron ore rose +10%, gold +6%, and copper +11%. After a very strong rise since mid 2020, thermal coal fell sharply (-35%) and has continued to fall in February month to date. Crude oil declined -2% in the month. The A$/US$ appreciated +4% to close at US$0.70.  

 

 

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Infrastructure is an enabler

Infrastructure provides heat, power, mobility, clean water, waste treatment and digital connectivity - all services that underpin a functioning society. It also has the potential to enable change: to improve livelihoods, reduce inequality, improve productivity and support environmental outcomes. When there's a societal imperative, infrastructure can provide the foundation for it to be achieved.

This is particularly true of our response to climate change. Economies must fully decarbonise globally by 2050 to give a reasonable chance of keeping the temperature rise below 1.5 degrees by the end of the century. This goal is a firm policy objective in many countries, including the UK and the EU.

The role of infrastructure in the transition

Using the UK as an example, infrastructure accounts for around 54%¹  of total annual emissions. The emissions that come from the construction and operation of infrastructure assets (capital and operational carbon, respectively) represent around 13% of the total. But by far the largest component, making up the remaining 41%, are emissions arising from using infrastructure - referred to as user carbon.

The carbon footprint of each business and citizen in the economy is highly dependent on the emissions intensity of the infrastructure they use - that is, the energy and physical resources they use, the data they consume, and the transport options available to them. Significant improvements have been made to the emissions intensity of some sectors since 2010. The energy and waste sectors, in particular, have been subject to ambitious policy packages over this period.

But progress isn't fast enough and other sectors like transport lag behind. The choices and behaviours of individuals can help, but without accelerated decarbonisation of the infrastructure services on which we all rely, the 2050 target will be hard to meet.

Without accelerated decarbonisation of the infrastructure services on which we all rely, the 2050 target will be hard to meet

Mobilising investment in the transition

This is a theme that came out strongly in the recent independent review of the UK's net-zero policies² and one that is central to the EU's Green Deal package³. An estimated £40 billion of annual investment in infrastructure is required over the next decade if the UK is to meet its net-zero commitment⁴. Across the EU, this figure is approximately €737 billion per year to 2030⁵.

These are substantial numbers that require unprecedented collaboration between policymakers and investors. Infrastructure assets are characterised by long construction lead times and decades-long operational lifetimes. If such investment is to be mobilised quickly and successfully, investors need a policy mix that provides sufficient confidence in long-term revenues and returns. This capital is required to develop new low-carbon infrastructure, but also to invest in decarbonising and repurposing existing assets that can play a role in the transition.

Many traditional infrastructure assets are inconsistent with the net-zero transition and lack a viable plan. In other words, high user carbon is locked in. For these assets, the clock is ticking on their functional life in the face of increasing carbon pricing, regulation and shifting customer sentiment.

Conversely, assets that are aligned with the transition and support reductions in user carbon will attract stronger policy support. This means they will not face the same functional obsolescence over time. As a result, they are likely to support stronger returns for investors over the long term.

Our role in the transition

We focus on small- and mid-market assets where we are either the majority shareholder or the significant minority partner, and we always have board representation. Small- and mid-market assets represent the majority of infrastructure assets - many utilities, energy generation, and fibre assets fall into this category. We take a long-term view that allows us to assess each asset's role in the low-carbon transition. And we position these assets to benefit from opportunities to create value. Our level of influence and proactive approach to asset management mean we can drive real change in this respect.

For example, alongside our investments in operational renewables in Poland and Norway, our Finnish utility Auris Energy has a strategy to phase out the supply of fossil-gas entirely by 2040. Additionally, our North Sea gas asset Noordgastransport has recently gained technical approval to transport hydrogen produced from offshore wind where the laying of electrical cables is not economical. In both cases, assets are being repositioned to support the low-carbon transition and to drive much-needed reductions in user carbon for their customers and the wider economy.

The vital role that infrastructure must play in enabling the low-carbon transition is clear. We believe our approach to proactive, long-term, direct infrastructure investment presents a unique opportunity to support the net-zero journey.

Author: Ruairi Revell, Head of Sustainability - Infrastructure