Some say its two quarters of negative growth. If that's the case, then the Atlanta Fed's GDPNow tool is predicting the U.S. is in a recession. Meanwhile, the U.S. National Bureau of Economic Research says a recession is a significant decline in economic activity that is spread across the economy and lasts more than a few months. If that's the case the 488,000 new jobs created in May would void any assessment of recession.

Elsewhere, given inflation is at nine per cent in the U.S., and growth is a far cry from that number, the real economy is going backwards, validating the person-in-the-street's perception of recession. And finally, the U.S. yield curve has just gone negative, confirming an economic slowdown.

Central banks are in a quandary

Even though economies appear to be losing momentum, inflation remains unacceptably high. And even though we might be near a peak in inflation, the decline is unlikely to be fast enough to placate Central Banks. Consequently, I agree with the idea downside surprises in inflation are the outcome of recession, not an indicator we will avoid one - whatever your definition of recession actually is.

The last time U.S. inflation was this high was 1981, but as analyst Ben Carlson points out the circumstances are very different. 

In 1981, savings accounts offered a 10 per cent yield (today they provide a one per cent yield). Mortgage rates then were 17 per cent, today they are five per cent.  In 1981 U.S. treasury bond yields were 13 per cent, today they are at three per cent. And finally, Robert Shiller's Cyclically Adjusted P/E ratio was just eight times in 1981. Today it's still at 28 times.

There are a multitude of differences today to any other time in history. Searching the past to discern what happens next may be a fools errand. 

Instead, I believe it is most important to look to liquidity. Giant swings in the availability of money, especially in modern debt-based financial systems, do more to explain the vicissitudes of markets than macroeconomics.

And on that front, Crossborder Capital's chart of the liquidity cliff in the supply of the USD worldwide, including off-shore, suggests a major credit crunch is ahead. 

Source: Crossborder Capital

And according to Michael Howell, "The economic cost of this big liquidity squeeze is world recession" adding "Central Banks are making a major error by hammering down too hard on the brake. World recession is inevitable."

Meanwhile the U.S. Treasury yield curve is seeing collapsing term premia. The term premium is the amount by which the yield on a long-term bond is greater than the yield on shorter-term bonds. Collapsing premia means short term rates are rising at a higher rate than long term rates. The mix of higher front-end rates raises cost of capital for corporates, while lower rates at the long end of the yield curve reflects meaningful demand for safe assets. In other words, no appetite for riskier corporate debt. In combination, it suggests a credit crunch is afoot. It's arguably much more important than whether we are heading for a recession - whatever your definition.

Author:  Roger Montgomery, Chairman and Chief Investment Officer

With the RBA tightening cycle firmly underway, the impact for Australian households is only starting to be felt.  Dwelling prices are falling most notably in Sydney and Melbourne where 39% of households reside but have 53% of total housing debt¹. The pace of rate hikes is at levels not seen since 1994 and combined with rising energy costs and higher food prices it is not surprising that consumer sentiment has fallen sharply as shown in the chart below.

What does this mean for consumer spending and is a recession on the cards? 

Relative to other developed markets, Australia's economy has been strong; boosted by high commodity prices, lower relative interest rates, a weak Australian dollar and solid household balance sheets.  A lower exposure to long duration technology stocks (which have been hardest hit) has also provided some insulation from the global equity sell-off.  For the six months ending June 30, 2022, the total return for ASX300 is -10.4% compared to -20% for the S&P500 and -20.3% for MSCI World.

Looking forward from here, vulnerabilities are apparent and none more so than in the housing market.  Having spoken to bank executives, real estate businesses and developers over the past year, we expect a contraction in the housing market.  The evidence is mounting even though price falls have been modest thus far.

• Higher mortgage rates have led many buyers to pause their plans.
• The time needed to sell a home has lengthened.
• There is a lower level of urgency amongst buyers.
• The HomeBuilder stimulus pulled forward demand and skewed sales.
• Foot traffic in display homes is a good indicator of where house sales will end up year on year and traffic is down 30%. This is already leading to lower conversion rates.
• Rising interest rates, higher material costs and supply chain issues are leading to higher prices for builders and developers.
• While there is a big backlog of work, a key risk ahead is bank financing in a rising interest rate environment.

However, in our view, the outlook is not as grim as media reports would suggest with a fall of 15% likely over the next 18 months.  This is due to the expected influx of immigration now that borders are open as well as the structural shortage of housing stock which puts a floor on house prices.

While a 15% fall in the housing market would be material, there is also a wealth effect to consider.  The magnitude of the hikes is massive at the margin.  Even for those who do not face mortgage stress, higher mortgage payments dent consumer confidence and spending.  The consequences are wide-reaching with impacts for the banking sector, construction, and ancillary businesses such as law firms and architects.  Further, there is a significant refinancing event looming in 2023 as a large swathe of fixed rate loans roll off and many households will face a 40% increase in their repayments as they move to variable rates (based on current rates).

History teaches us that tightening cycles usually lead to a de-rating of P/E multiples for the banking sector.  While steady interest rate rises are seen as a positive tailwind, with every 25bps increase leading to a 1-2bps positive boost to net interest margins, the sheer pace of the current increases creates a different outlook.  While the banking sector is already down by 10% since the start of June, and has underperformed the broader market, looking forward the downturn in the housing market will lead to lower credit growth, lower margins and higher bad and doubtful debts.  According to Jarden Research, new home growth leads bank share prices by approximately 3 months and bank share prices lead house prices by 5 months given the lag in house price data and the forward-looking nature of markets.

A de-rating of major bank share prices occurred in Australia during the 1999-2000 and 2009-2010 cycles when multiples fell by an average of 2.0x in the first three months after the first hike and 4.2x by the time of the last hike².  New Zealand, which is further ahead of Australia on rates is already experiencing a slowdown in credit growth. While Australian banks are well capitalised with very strong balance sheets, the medium-term outlook for their share prices will be negatively impacted by a housing downturn.

A slump in consumer discretionary spending is expected as households tighten their belts.  The question for investors is how much of this is already priced in?  Many stocks in this sector have already fallen significantly as consumers have shifted their spending from goods to services and earnings have normalised.  Despite this, in our view, the consensus forecasts for FY23 and FY24 are still too optimistic.  We have not seen earnings downgrades yet and this could occur in the coming weeks.  While reporting season is likely to show strong results on a historical basis, analysts will focus their attention on forward looking guidance for earnings - or lack thereof.

For retailers, in addition to the rising cost of debt, analysts will be watching inventory levels.  In many cases, inventory levels have been rising as supply chain issues ameliorate and are indicative of falling demand.  The US provides a good indicator of the outlook for Australia given their rate hiking cycle and emergence from pandemic lockdowns is about 6 months ahead of Australia.  What is evident is that retail is struggling with rising mortgage costs impacting consumers spending patterns.  This is most evident for furniture, electronics and hardware sales which are highly correlated with housing growth.

Whether or not we get a recession in Australia will depend largely on how aggressive the RBA is in raising rates.  A neutral rate of 2.5% for example would dramatically impact borrowing capacity.  Future inflation prints will determine whether the RBA stops there, and time will tell whether the current level of pessimism is overdone.  As shown in the chart below, the market is expecting rates to peak in May 2023 with softer economic growth leading to rate cuts thereafter.

We have assessed the implications of a downturn in the housing market and falling consumer spending for investee companies on a bottom-up basis.   We are underweight sectors such as financials and property trusts as well as those retailers more likely to be impacted by lower discretionary spending.  We have long been overweight healthcare, which has proven to be resilient in previous downturns.

After hiking for the fourth consecutive month, the RBA's tone has shifted to suggest a pause at the September meeting is possible, reflecting in part the troubling signals emanating from markets as the US teeters on the brink of recession and conditions continue to cool across the globe. 

As lead indicators continue to flash red - consumer confidence remains at alarming levels and housing is rolling over - can Australia's central bank successfully thread the needle and avoid an outright stalling of the Australian economy? 

Speakers: 
Darren Langer, Co-Head of Australian Fixed Income &
Chris Rands, Senior Portfolio Manager

Warren Buffett famously said that "only when the tide goes out do you discover who has been swimming naked."

We have been hitting lower tides in recent months as the world of 'free money' comes to an end, which is exposing 'naked' companies and assets that have crashed.

The low tide is however also highlighting great companies with strong management teams that are suited up to steer their customers - and investors - to safety during these difficult times.

Great management teams can navigate challenging periods like the present and come out stronger on the other side.

There are many examples of best-in-class management teams represented across our Global and Australian funds and several management teams that have specifically done a phenomenal job managing the increasing risks. Some Australian examples include Goodman Group, Super Retail Group, CBA, Medibank, and Orora Group. On the global side, we can commend the teams at McDonalds, PepsiCo, Diageo, and Waste Connections.

Below we look at 2 lesser-known domestic and global management teams.

1. Waste Connections (WCN) - Pragmatic & differentiated

Waste Connections is the 3rd largest solid waste services company in North America. They provide non-hazardous waste collection, transfer, and disposal services to millions of customers across the US and Canada. WCN was founded by the current Chairman and this entrepreneurial culture runs deeply through the organization.

WCN runs a decentralised structure where decisions and PNL responsibility is pushed out of HQ and down into the operating businesses around the country. You often see this type of management structure in Scandinavian capital goods companies, but we rarely see it in the US. If done well, it creates a dynamic and flexible business that can respond rapidly to a changing environment.

With the challenges that the waste companies have faced over the past 6 months, this approach has been a meaningful advantage for Waste Connections. We see the outcomes of this decentralisation through their industry leading margins and cashflow generation.

WCN has industry-leading profit margins

Source: Bloomberg

Further, the company generally seeks to avoid highly competitive, large urban markets and instead management target markets where they can attain high market share either through exclusive contracts, vertical integration, or asset positioning. WCN defines their markets as either "competitive" or "exclusive/franchise" based. Competitive markets are markets where pricing is a function of supply & demand and WCN deliberately focus on the underserved markets, which are less competitive. This affords WCN very strong pricing power and market shares. The remaining 40% of revenues are generated from markets they serve on an exclusive/franchise model basis, where pricing for contracts is done on a CPI-like or returns based basis.

Similar to its peers, WCN has faced numerous challenges of late, including input price pressures (fuel spikes), labour shortages/higher wages (with drivers and mechanics extremely sought-after) and truck shortages to name a few. Despite this, they are managing the business well and continuing to execute on their strategy. At their recent results management achieved very strong pricing outcomes, talked to building M&A momentum, and maintained their full year FCF guidance. Waste Connections is a stable, defensive grower with an enviable track record worth backing in our view.

2. Orora (ORA) - Optimise, enhance & invest

Orora (ORA) is an Australia-based company that provides packaging products and services. It manufactures glass bottles and beverage cans in Australia and manages a medium sized packaging distribution services in North America.

From China wine tariffs to old legacy IT systems to higher input cost pressures, the ORA team has not had a shortage of challenges to deal with over the last few years. In response, they have addressed each of their challenges in a logical and systematic way and announced a clear growth strategy for the next few years.

Over the last few years, ORA has done a complete SAP integration process in the US that after some significant implementation challenges are now resulting in improved operational efficiencies and management of input cost pressures.

They have also implemented a mix shift towards higher product-to-package ratios (for example the recent contract with Tesla for car parts) and enhanced their digital capabilities through an e-commerce custom design platform and diversified their product portfolio.

ORA -- A quality, defensive enjoying earnings upgrades

Source: Alphinity, Bloomberg, 28 June 2022

ORA has also been able to find low risk capacity expansion opportunities such as beverage cans in Australia. Following a thorough review of some poorly judged and executed acquisitions in the US by previous management the company believes they are now ready to look at new M &A opportunities. While not without risk we would back management given their conservative approach and successful management of the company since taking the reins. Finally, and importantly, ORA is pivoting investment towards more sustainable products and operations with a clear commitment and path to net zero greenhouse gas emissions by 2050.

Despite the tough environment, ORA has recently reiterated their guidance for FY22 EBIT to be higher than FY21. In combination with a robust balance sheet, meaningful returns to shareholders (both dividends & buybacks) and attractive Return on Capital (25%), we view ORA as a high quality, defensive company in safe hands.

Spending more time with management

When uncertainty increases and the environment becomes more challenging, we make a concerted effort to spend even more time with the management teams that are steering our investments, to understand their thinking and approach to ongoing and new challenges.

We meet with various members of the management teams across seniority levels, responsibilities, and divisions. Our due diligence process also includes site visits and meetings with the company's suppliers, competitors, and clients.

Through the ebb and flow of investment cycles, investors should continuously focus on identifying quality management teams that can perform well during high tides, but even better during low tides.

Author: Elfreda Jonker, Client Portfolio Manager

This information is for adviser & wholesale investors only

Origin Energy recently announced the early closure of its Eraring Power Station. This will reduce Origin's carbon emissions, whilst allowing the company to focus on obtaining low or no emission sources to replace capacity.

As an operator of a coal-fired electricity generator, Origin Energy is one of Australia's largest carbon emitters. While the company has long positioned itself to transition to clean electricity generation, the absence of policy direction from successive Federal Governments has seen this transition evolve more slowly than expected. As State Governments have taken the lead on energy policy, the transition is now progressing apace.

Despite reducing its emissions by c16% over the FY20 and FY21, Origin remains a significant carbon emitter. Data from the Clean Energy Regulator's National Greenhouse and Energy Reporting indicates that Origin was the fourth largest carbon emitter in FY21 (on a combined scope one and two basis). Notably, the top three are other coal-fired generators.

Of the company's c17mt CO2-e of scope 1&2 emissions in FY21, 86% of these emissions come from the Eraring Power Station. On February 15th, Origin Energy announced that it had informed the Australian Energy Market Operator of its intention to close Eraring in August 2025 - the earliest possible closure date given the required 3.5-year notice period.

While the closure of a coal-fired generator has obvious significant environmental benefits, there are social impacts to consider. Accelerated renewable capacity undermines the economics of baseload generators. The company explained that the reason for the accelerated closure was in part attributable to the economic impact of growing renewable penetration in the National Electricity Market (NEM).

Renewable generation, particularly solar, is most productive in the middle of the day. Growing volumes of generation from renewable sources have seen demand for grid electricity decline in the middle of the day.

Electricity prices at these times fall to low or even negative levels. Further, the NSW Government's Electricity Infrastructure Roadmap will drive an acceleration in the supply of renewable energy that will likely drive average prices lower still.

Increasing renewable volumes are reducing demand for coal-fired generation in the middle of the day.

The low or negative prices in the middle of the day result in financial losses for baseload generators like Eraring. Baseload generators rely on higher prices during the peak and shoulder periods of the day to recoup losses and generate an adequate return. Unfortunately, the introduction of capacity from Snowy 2.0 in the latter part of this decade may also pressure these peak and shoulder prices, further undermining the financial sustainability of baseload generators.

A significant reduction in Origin's emissions profile will result over time

When Eraring is closed, the company's scope 1 emissions will fall by an estimated 95%. How far the combined scope 1&2 emissions fall remains to be seen and will be dependent upon the sources of energy Origin accesses to replace the Eraring volumes.

The company has highlighted several potential sources of capacity that will compensate for the loss of Eraring and a number of these are low or no emission sources. These include a proposed 700MW battery at Eraring, the additional renewable assets being added to the NEM, the potential expansion of the Shoalhaven pumped hydro project, and Snowy Hydro capacity.

Additionally, the ambition to orchestrate 2GW through a virtual power plant provides further flexibility in the form of additional firming and demand management.

Ultimately, while purchases of coal-fired generation from the pool will remain a feature for some time, Tyndall expects Origin will deliver ongoing reductions in emissions intensity following the closure of Eraring. Importantly, over time we expect that this improving environmental footprint and leadership in the transition to clean energy will be reflected in Origin's share price with a progressive re-rating of the stock.

Social impacts front of mind for Origin

While the early closure of Eraring provides significant environmental benefits, this development will also have a material social impact on Origin's workforce and the local community.

The labour force directly impacted includes 240 Origin employees as well as several independent contractors that work at Eraring from time to time. On average, there are c200 contractors on-site on any given day. The workforce includes administration workers, multi-skilled engineers, boilermakers, and electricians. We would note that many of these skills have application outside of the generation industry.

Origin is highly cognisant of the implications for these workers and their families and recognises the role Origin must play in ensuring a just and equitable transition for them. Importantly, Origin intends to support its workers with reskilling and career support. The broad principles to apply here are individualised consideration of needs and preferences, in full awareness that different workers will have different priorities. The company will seek to transfer personnel within Origin where possible. Where this is not possible, Origin will assist in identifying external opportunities. Recognising the heightened impact the closure may have on apprentices, their needs will be prioritised.

The company has also stated that it will continue its existing community support programs such as local sponsorships and the relocation of the Myuna Bay Sport and Recreation Centre. Further, Origin has committed to invest $5m in local community support over the decade to 2032.

Our discussions with the company around these issues reinforce our belief that Origin operates with a high level of integrity. The company is acutely aware of the role it needs to play in ensuring that the energy transition is an equitable one for all the various stakeholders, including those employees that will be significantly impacted.

Environmentally compelling, socially aware

In conclusion, the early closure of the Eraring Power Station is a net positive for Origin shareholders in our view. We expect the market to reward the declining carbon emissions intensity over time. While the impact on the community and workforce is unfortunate, we note that Origin's intended efforts to retrain and repurpose its staff highlights the integrity with which the company behaves and the importance it attaches to its social licence to operate.

Author: Tim Johnston, Deputy Head of Equities

Global sharemarkets changed direction abruptly in mid-November 2021, with the trigger the 'hot' US inflation reading for October - it rose to +6.2% year-over-year, almost guaranteeing the US Federal Reserve would raise rates to prevent the number going higher (which it did).

It got worse. The Russian invasion of Ukraine put upward pressure on commodities: disruptions in oil, grain, fertilisers and some chemicals added new anxiety to a world still recovering from COVID supply shortages. Indeed, Shanghai remained in lockdown until last month. There is good news in the bad news - rising costs and tight supply are pushing prices to unacceptable heights for businesses and consumers, which of itself is slowing the economy and reducing upward pressure on interest rates.

As monetary policy tightened investors bailed out of cashflow-negative, longer-dated growth stocks. These companies, exposed as they are to an intentionally-slowed economy, declined in value materially. Without profitability today, the market is anticipating that such companies will be forced to find new funding with fresh debt or equity - but of course at significantly higher cost to existing shareholders, which is pushing valuations down further. Sharemarket indices dropped by -20% to -30%, but many former sharemarket stars were down by -50% to -90%. There was safety in quality, relatively, with the Loftus Peak portfolio outperforming the "concept" stocks, as the chart below shows.

The market punished companies that were not profitable

Source: Goldman Sachs, Loftus Peak. Data in AUD, indexed to 100 as at 30/06/21

For the 12 months to 30 June 2022, the value of the Fund dropped -23.3%, with most of this confined to the second half. This was underperformance of -14.7% relative to the benchmark MSCI All Countries World Index (net) as expressed in AUD from Bloomberg. The Fund closed out the month down -6.9% net-of-fees, which was underperformance of -2.1% against the benchmark.

Roku and Netflix, also hit in the second half, were among the worst performers, and cut -3.9% and -3.3% from Fund value respectively over the twelve months. Amazon cut -2.2%, Google -2.1% and Microsoft -1.2%, while AMD's negative contribution was -2.1% with Taiwan Semiconductor (-1.5%) and Nvidia (-0.8%) also off. Qualcomm, the Fund's largest position, cut -3.4% from the value of the Fund.

Streamers unspool

Netflix and Roku are two former market darlings needing neither debt or equity capital but which nevertheless were treated as if they did. The streamers, together, were the largest negative for the Fund in the financial year to 30 June 2022.

And yet it is difficult to find any informed industry participant who does not believe that all TV will be streamed by decade's end. Indeed, in 2022 streaming eclipsed cable TV in popularity across the US , as reflected in the chart below.

Source: Roku Company Filing, Nielsen

That streaming companies, which thrived in lockdowns only to stall when restrictions are lifted, has little bearing on pivotal questions around their room for growth at the expense of linear TV. We believe Roku's and Netflix's penetration has not reached saturation with both having differentiated but solid medium- to long-term growth paths.

Chip stocks weak, for now

The Fund has held investments in semiconductor companies including Qualcomm, Nvidia, Xilinx, AMD and Taiwan Semiconductor over a number of years. We invested because these companies are foundational to the disruption economy, though they do not command the same valuations as software-driven companies such as Facebook, Netflix and Google, which, along with many others, have boomed as applications for the networked, streamed economy were turbo-charged by the smartphone.

But in this tougher economic environment, when growth multiples are under pressure, the semiconductor stocks have provided significant shelter, while the outlook for them has materially improved as their usage, across virtually all industries (either directly or indirectly) increases.

For example, one very important announcement barely noted by financial markets was that Apple had failed to meet the deadline for the 2023 rollout of its own 5G modems in its newest phones. This is important because Apple's failure was preceded just two years earlier by that of the titan Intel to produce the same part - meaning that Qualcomm will continue to be the 5G supplier through 2023.

Qualcomm's technological superiority, coupled with its financial strength, create a formidable moat ensuring growth for several years for its 5G business. We hold Qualcomm not just for the phone business, but for the significant diversification it has engineered relative to its position a few years ago.

Source: Qualcomm Company Filings

Qualcomm's automotive revenues in the most recent quarter were up +61% on the prior year period, as the performance requirements of and higher demand for automobile intelligence is necessitating a huge increase in chip usage. The company's connected IoT (Internet of Things) business was up +41%. Even Qualcomm's 'mature' smartphone business showed growth of +56% year-over-year, driven by its dominance in 5G.

Another of the Fund's holdings, AMD, also has a sizeable moat - built by besting the incumbent, Intel (which the Fund does not hold) in the area of low power, high performance chips for the most discerning of end markets, data-centres - which, according to McKinsey & Co, represent the single largest and fastest-growing end market for semiconductors globally.

Why does McKinsey say this? Because datacentres are the hardware on which cloud computing runs, an evolving megatrend brimming with promise as the convergence point for the miscellany of remote work, connected supply chains, networks and more. These are areas targeted by Taiwan Semiconductor and Nvidia, which have, unsurprisingly, constructed formidable moats of their own, using deep pools of capital amassed by years of excellence in product execution. This is technology and disruption, to be sure, and not the commoditised kind, either.

The Blue Sky in the Cloud

Megacaps Amazon, Google, Microsoft, Tencent and Alibaba form part of the Fund's cloud exposure. It is possible that these cloud businesses may one day eclipse the legacy businesses of their parent companies (especially true of Amazon and Amazon Web Services). Information technology in business globally is moving to the cloud, but it is only a fraction of the way there. Building a cloud business isn't for the faint of heart - it is a scale game requiring tens of billions of dollars of investment.

This has led to a few large players reaping most of the rewards to date, which we expect to continue given the capital requirements. These companies now represent 73% of the global cloud infrastructure market by revenue. Amazon alone accounted for almost half, while Microsoft had the largest market share growth.

Silicon's cousin - the power semi-conductor

Beyond all this, the roll-out of electric vehicles along with increasing use of wind and solar power are driving the development of new specialised componentry for electrification known as power semis, typically silicon carbide. ON Semiconductor is a major player here, and is critical to the supply of componentry that facilitates this power transfer.

How to grow an Apple

Services - not just products - are a keystone of Apple's future growth. The services business, including Apple TV+, Apple Music, Apple Fitness+, Apple news+ and more notched double the annual revenue growth of the products business in the March quarter. One of these services, Apple Pay, is expanding quickly, and only a few weeks ago moved into the buy-now pay later space. The chart below tells the story of Apple's services businesses now accounting for almost 35% of gross profit, compared with 17% in 2016.

Source: Apple Company Filings

Looking ahead

We understand the market's concerns about recession and what that might mean for consumers and businesses. However disruption and the associated long-term secular trends continue through even the worst periods of recession. It is for this reason, along with the quality of our holdings, that we believe the companies held by the Fund are well positioned for any short-term economic headwinds and more importantly, for the medium and long term.