Banks, interest rates and opportunities in the finance sector

Magellan Asset Management

June 2023

Alan Pullen, Portfolio Manager, discussed the recent bank defaults, the impact of interest rates on banks in general and where he sees opportunities in the financial sector.

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

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Risk-adjusting small-cap upside 

PURE Asset Management

June 2023

Those investing in smaller companies will appreciate the difficulties faced by this market segment since early 2022. Central banks have raised interest rates in unison, with liquidity and confidence evaporating as a result. The unfortunate outcome is that share price appreciation has been a mirage for most emerging businesses. When compared to large cap peers, the chart below illustrates the degree of such underperformance. Since January 2022, small cap equities have experienced their own 'GFC'.   

A key adage we live by at PURE is that share prices are not always reflective of underlying operational performance. Market sentiment and liquidity can savagely impact small cap valuations, and while painful for existing equity holders, create phenomenal opportunities for astute new investors. The risk is that equity prices remain under pressure for longer than an equity investor can stomach, resulting in further losses. Our key takeaway from the above chart, it that strong outperformance has always followed underperformance. When small cap share prices appreciate, they do so quickly. The unknown here is timing. 

While no investors have certainty on timing, hybrid investing is a unique way to 'risk-adjust' this variable. Hybrid investments involve entering a transaction via a credit instrument, yet retaining exposure to equity returns via a conversion mechanism. The outcome being sought is to remove downside equity volatility, yet retain exposure to upside equity volatility. This entails swapping some equity upside for capital structure protection, security, and a consistent interest income stream. Getting 'paid to wait' in the form of interest income ensures a cash yield is received as each investment thesis materialises.    

Today's conditions are extremely attractive to deploy capital via hybrid structures. Many borrowers are unable to access debt markets, with most dissatisfied with their cost of equity. The result is a strong negotiating position for deal originators, as value drivers (interest rates / conversion premiums) are being agreed from a position of power. If capital preservation can be achieved as a secured creditor, upside potential from this cycle low should be self-evident. 

While an attractive way to invest, hybrid deals are are difficult for investors to source as they involve a direct negotiation with the Borrower. PURE's funds were established as a vehicle to provide exposure to this form of investing, a strategy which remains unique to this day.

Have you considered hybrid investments as a way to risk-adjust your exposure to emerging companies? 

Funds operated by this manager:

PURE Income & Growth Fund, PURE Resources Fund

Hedge Clippings | 23 June 2023

Rate Rises and Inflation - what else?

The RBA started the tightening process just over 12 months ago in an effort to firstly contain, and then to subdue inflation. The timing was broadly in step with central banks in the UK and Europe as inflation was global. Given they're still increasing rates, or threatening to, and consumers seem reluctant to respond, one has to ask how successful they've been - or possibly how much worse inflation would be if central banks had sat on their collective hands?

This week in his twice yearly appearance before politicians trying to make a point, US Fed Chairman Jerome Powell said it was a "pretty good guess" that US rates would increase twice more this year as he tries to subdue inflation back to the 2% level while avoiding higher unemployment, and thus a recession. In the UK, the Bank of England is facing the same issue, increasing rates by a further 0.5%, stating "The economy is doing better than expected, but inflation is still too high (8.7%) and we've got to deal with it."

Unfortunately, "dealing with it" involves inflicting pain on consumers, as pointed out by RBA deputy Governor Michelle Bullock in her speech this week, giving Philip Lowe a break from the firing line. In spite of widespread anecdotal evidence of consumer pain being reflected by retail sales, particularly for big ticket and electrical goods, strong employment statistics, not only in Australia but also in the US and UK, are spoiling the objective of higher rates.

Bullock pointed out there needs to be a balance. With the RBA's current forecast of inflation returning to target (2-3%) by mid 2025, and unemployment increasing to 4.5% by the end of 2024, which they estimate still equates to "full employment," they judge that the balance between supply and demand will be achieved.

As Philip Lowe frequently points out, that balance can also be described as a "narrow path" between inflation, higher rates, and recession.

Meanwhile, equity markets continue to confound and confuse. The ASX All Ordinaries has risen 10.5% in the 12 months since 23rd of June, 2022. Wind the start date for that 12 month period back to 31st of May, and that 12 month performance becomes negative. Stock and sector selection, plus of course timing, has been key. On Tuesday next week, we are holding a further Sector Review, this time focusing on the resource sector. Register here for our manager round table webinar, where we will be joined by three Australian specialist resource managers to get their views on the opportunities and risks for the sector.

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Japan - Back in Vogue

Redwheel (Channel Capital)

June 2023

Funds operated by this manager:

CC Redwheel Global Emerging Markets Fund, CC Redwheel China Equity Fund

Sources: 

[1] MSCI World and Developed World, Citi Research, MSCI, Factset, March 2023

[2] Mizuho Securities research, 30.05.2023

[3] Goldman Sachs Research, 30.05.2023

[4] Bloomberg data

[5] Market reports JPMorgan, Schroders, Citi Wealth, SocGen, Deutsche Asset Management, Invesco, AXA, T Rowe Price, January 2023.

[6] NLI Research Institute, May 2023

[7] JPX January 30, 2023

Key information:

No investment strategy or risk management technique can guarantee returns or eliminate risks in any market environment. Past performance is not a guide to future results. The prices of investments and income from them may fall as well as rise and an investor's investment is subject to potential loss, in whole or in part. Forecasts and estimates are based upon subjective assumptions about circumstances and events that may not yet have taken place and may never do so. The statements and opinions expressed in this article are those of the author as of the date of publication, and do not necessarily represent the view of Redwheel. This article does not constitute investment advice and the information shown is for illustrative purposes only.