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The big question remains: will Australia follow the Fed's lead or stick to its current path?

In Episode 51 of The Rate Debate, Co-Head of Fixed Income Darren Langer and Investment Manager Jessica Ren unpack the Fed's recent decision, explore the chances of rate cuts before Australia's next federal election, and debate the importance and reliability of employment data for the RBA. They also take a closer look at inflation pressures, from petrol prices and energy rebates to rising service costs.

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Jay Sivapalan, Head of Australian Fixed Interest, discusses the current state of credit markets and explores how active management strategies, mixed with nuanced credit investing, can lead to positive returns for investors.

As monetary policy works its way through various economies reducing final demand it has, by design, the dual outcomes of softening labour markets and lowering corporate profitability. The world has changed, and the price of money, in our view, is now at much healthier levels whilst the availability of credit becomes more discerning.

Funding costs for corporates have normalised, not just from the abnormally easy conditions during the pandemic, but also versus the decade of cheap money between the Global Financial Crisis and the pandemic. For investors, the late stage of this economic cycle has arrived and this brings the normal advent of rising delinquencies, re-structures and defaults. Whilst ordinarily this phase of the cycle would spell caution for investors, we believe ultimately it is a healthy development and that taking a nuanced approach to credit investing will likely deliver investors strong risk adjusted returns over the period ahead.

Key considerations for investors include:

• The starting point for corporate fundamentals matter
• This cycle is different despite the policy playbook not being new
• Not all corporate debt is made the same, a nuanced approach is required
• Outsized prospective returns for credit investors still exist, and
• Cheap ways to hedge for the unlikely left field events are available.

Starting point matters

As the economic and business cycle nears the latter stages, any slowdown in economic growth, softening of labour markets will inevitably impact corporate earnings adversely. This cycle will be no different. However, the starting point is worth assessing for different segments of the corporate debt market. To provide some context, corporates in Australia and abroad were healthy, making adequate profits prior to the pandemic. During the pandemic, these very companies shifted upward to making abnormally high profits, aided by both monetary and fiscal policy as well as a resumption of demand. Inflation on nominal revenues also assisted the larger, stronger companies in gaining market share and achieving margin expansion. Meanwhile, highly-levered consumer cyclical and small-medium enterprise (SME) segment survived and in some cases temporarily thrived during the pandemic. However, this segment was never fundamentally strong nor sustainable and is now facing the reality of falling demand and higher funding costs.

A different cycle

For the most part investment grade companies today remain well funded with debt termed out and highly profitable. From a fundamentals perspective, they remain relatively resilient to an economic growth slowdown. We see profits as moderating rather than falling precipitously. The same cannot necessarily be said for the SME segment. Nor for highly leveraged and/or cyclical, consumer centric businesses. A default cycle has commenced in loans, and pockets of high yield and private credit across the globe. Domestically this was most visible in SME delinquencies. It was initially centred around the property construction sector, but is now widening to hospitality, domestic tourism, recreational goods and services, and other consumer segments. Business models reliant on ongoing cheap debt or easy re-financing with little or no revenue is in the grips of a reality check, likely with harsh ramifications.

A nuanced approach to credit investing

Not all default cycles end in a crisis for credit markets. This cycle would suggest that defaults in investment grade companies should remain quite low by historical standards, but may be elevated in higher yielding segments. Importantly, rather than a uniform spike of defaults, we are more likely to see a rotation of defaults from industry to industry within lower quality credit. This will, in turn, keep the default rate rolling over multiple years. Recovery rates in these lower quality segments are being realised at lower levels than the past. Of course, market dislocations can occur with concerns around defaults lower down in credit markets, and cause mark to market underperformance in higher quality credit segments. We would assess these events as opportunities to add to investment grade credit without fear, rather than one to be cautious about.

Outsized credit returns available

Overall, higher quality credit in the investment grade space remains the sweet spot for delivering healthy yields. However, to assess relative value, the sticker yields of lower credit quality, higher yielding segments need to be adjusted down for defaults and loss. The relative value of higher beta segments of the credit market currently remains less compelling in our assessment but a widening of credit spreads in this area would be valuable entry points for investors.

Source: Janus Henderson, Bloomberg as at 31 August 2024

With the exception of a left field event, the most probable scenario points to strong prospective relative performance of credit, with investment grade credit being the sweet spot for investors on a risk adjusted basis. For the brave, the loans segment is potentially shaping up to be an opportunity, albeit security selection will be critical given the expected higher defaults and lower recoveries. A beta exposure is not recommended.

Cheap ways to invest in credit and hedge tail risks

Tail ends of economic and market cycles have always been volatile, with investors seeking duration, quality risk-free assets and high compensation for default risk. Liquidity can also become fleeting in an environment of uncertainly.

In order to preserve capital and also extract good returns in this environment, one must not passively sit on the sidelines; this is the wrong part of the cycle to be beholden to benchmarks. To ensure portfolios retain their defensive attributes, levers such as active management of duration, yield curve positioning and credit protection through the Credit Default Swap (CDS) market can be invaluable.

We are confident dislocations will occur and opportunities will emerge. Again, actively utilising the full spectrum of inflation linked bonds, bond/swap and bond/semi-government spreads, corporate and asset backed betas (such as global loans, high yield and emerging market debt) can further drive return outcomes. Individual industry positioning will become important if markets dislocate more meaningfully. Today, both CDS protection and duration are cheap and effective tools that can be relied upon whilst fully utilising the prospective value in investment grade credit. We assess this as a great way for investors to enhance overall portfolio outcomes on a risk adjusted basis.

Author: Jay Sivapalan, CFA

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Tech IPOs - there have been very few of them lately - but the unlisted world is bursting with "unicorns". Now that the Fed has cut rates in September, what's next? The market is not only oscillating around interest rate expectations but is also exhibiting volatility in the short time between the rate cut announcement and the press conference. We check in on PE multiples relative to historical levels by geography and sector, consider market moves in relation to risk premiums, then the performance of "AI" stocks. Finally we turn to the ASX's recent reporting season and look at the average sector-based consenus revisions to nano-to-mid caps plus the stream of dividends flowing into investors' accounts this month and next.

Technology IPOs

 

Source: Dealogic, PAC Partners

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The number of active unicorns

 

Source: FT, PitchBook, European Commission

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US Fed rate expectations for the Fed's November meeting

 

Source: CME FedWatch

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Changes in time to US Fed rate expectations for the Fed's November meeting

 

Source: CME FedWatch

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Fed cuts, employment & inflation

 

Source: Endeavour Equity Strategy

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US equity and bond markets change direction between release of FOMC statement and Fed Chair press conference

 

 

Source: Mohamed A El-Erian, Bloomberg

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MSCI regions' 12-month forward PE multiples relative to the last 20 years

 

Source: Goldman Sachs Investment Resesarch

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MSCI world sector/style 12-month forward PE multiples relative to the last 20 years

 

Source: Goldman Sachs Investment Resesarch

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S&P 500 actual v level consistent with expected return range

 

Source: Hussman Strategic Advisors

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Artificial Intelligence (AI) US equity baskets since 2023

 

Source: Bespoke

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Changes in consensus estimates - average across sector - during month of August for ASX "FIT" nano-to-mid cap ASX listings

Source: Equitable Investors, Koyfin

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Weekly value of all ASX dividends to be paid in September & October 2024

Source: Coppo Report

September 2024 Edition

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Q1: Does the AI investment theme still offer significant long-term potential?

When we are confronted with truly significant change, we can often react in ways that are not entirely rational. If the change represents a perceived threat, our fight or flight response can be triggered, leading us to resist the change or ignore it in the hope that it might go away. While there are clearly risks, resisting the opportunities presented by artificial intelligence (AI) and ignoring its development would seem to be dangerous for investors.

Bill Gates has been quoted as saying that the impact of new technologies is often overestimated on a two year view but greatly underestimated over time periods of ten years or more. When we view technological development in its long-term context, the change it represents can become less overwhelming and we can see patterns from history which might give us a clue as to where we stand today, what might happen next and who the big winners might be.

It should be fairly obvious to investors today that we are in the middle of a very strong, AI-driven cycle for IT hardware as the infrastructure for an AI based platform of computing is being developed at a rapid pace. Yet, obvious questions remain, such as "how long will this last?" and "are we once again overestimating the short-term significance and underestimating the long term impact?" To put this in context, it might be useful to look at previous hardware cycles and their characteristics as the various computing platforms have evolved over the last 60 years or so.

Chart 1: The evolution of computing platforms

Source: Jeffries Equity Research

Chart 1 above shows the evolution of computing platforms since the 1950s. We can see that each era lasts around 10 to 15 years and with each passing cycle, the number of devices connected to the network has increased tenfold. As a result, technology has penetrated more and more industries and been applied to more and more aspects of everyday life. What is less clear from the chart is that in each era, there has been one or two companies that have typically captured 80% or more of the hardware value chain. IBM in the mainframe era, DEC in mini-computers, Microsoft /Intel in PCs, Nokia and then Apple in cell phones and so far Nvidia in the parallel processing/IoT era powered by an AI datacentre at its core.

It's probably fair to assume that we are likely in the early stages of the AI-related infrastructure build, perhaps at a point equivalent to the mid-1990s when the internet was still being constructed. While this rapid growth phase for hardware is likely to slow down, there is still a long runway of adoption to go if prior cycles are any guide. One significant difference between the AI infrastructure boom and the growth in fixed and mobile internet infrastructure is the fact that the internet rollout was largely financed by debt raised by telecom companies and IPOs raised by often loss-making early stage companies. Today's AI infrastructure, however, is being built using cash flows from large and very profitable businesses. This factor alone may give the hardware cycle more longevity than its predecessors.

In terms of applications and profitable use cases for AI, it appears that we are in a position similar to the mid-to-late 1990s when the internet was being developed. Back then, we expected navigation, entertainment and e-commerce would likely become the main applications for the internet. It took a further decade for the smartphone to reach the mass market and fully enable the potential of the network, allowing companies like Apple, Meta Platforms, Alphabet, Amazon and others to flourish. AI may yet be applied to new industries and revolutionise the competitive landscapes therein. Drug discovery, self-driving cars, media content production and software code writing could all become the main applications for AI in the longer term. However, it is too early to make definitive predictions.

The emerging risk of a classic hype cycle seems fairly clear. If profitable use cases are not delivered soon enough, this may slow the infrastructure boom. This was certainly the case in the late 1990s early 2000s. However, back then the internet infrastructure collapsed under an unsustainable mountain of debt, which was paid out in the form of expensive 3G licences. During this period, Apple disrupted the telecom value chain with the power of iTunes and then the smartphone. This time, the spending is funded by cash flow and earnings, and while it may slow down, it seems unlikely to collapse any time soon.

In conclusion, the impact of AI clearly has the scope to be far-reaching and is likely a factor investors will have to contend with for a long time to come.

Q2: Will the market leadership broaden beyond technology names into other sectors?

The possibility of stock market leadership broadening beyond technology names and into other sectors, in our view, depends on several factors. These include economic conditions, the level of real rates, sector-specific earnings, cash flow developments and investor sentiment.

In general, market leadership so far in 2024 has been driven by upgrades in earnings and cashflow. Five mega-cap AI stocks--Nvidia, Alphabet, Amazon, Meta and Microsoft--have accounted for almost all of the market's return. However, value stocks in areas such as energy, banking and insurance have also performed well, while defensives such as consumer staples and healthcare have largely underperformed. The market seems to be assuming that we are in the middle of a business cycle of indeterminate length--all underpinned by a gradual disinflationary environment. It is only natural to question if this is a fair assessment. Does it all add up? How should we construct portfolios in this environment?

So far in 2024, changes in earnings have had a greater influence on the market than changes in real interest rates (Chart 2). The chart shows how much of the returns can be explained by changes in earnings. Rather ominously, similarly high readings were seen just before major market events, such as the Asian financial crisis of 1998, the dot.com bust of 2000, and arguably, the Global Financial Crisis (GFC) of 2007/2008 and the European debt crisis of 2012.

Chart 2: Proportion of S&P 500's large-cap stock returns attributable to changes in earnings

Large capitalisation stocks' share of the return dispersion explained by the dispersion in earnings surprise measured over nine-month windows from 1993 through mid-May 2024. Past performance is not indicative of future performance.

Source: Empirical Research Partners

Naturally, investors are wondering if there is something equally damaging around the corner which may cause this benign central scenario to unravel. If we examine each factor, listed below, we may be able to draw some conclusions.

1. Sustainability of the AI boom and technology valuations

   As mentioned in the answer to the previous question, we are still relatively early in the roll out of the next generation of a global computing platform with AI data-centres at its core. Given that the capital expenditure is largely being funded via cash flow and operating earnings, there doesn't seem to be a reason for the spending to come to a juddering halt any time soon. There may be disappointment over the lack of profitable applications (similar to the experience during the internet boom), which may cool investor sentiment. However, so far, the improvements in earnings and cash flow appear sustainable and are certainly far more attractive than those being produced by many other parts of the economy.

2. Is the disinflationary consensus appropriate?

   It's been over four years since the pandemic stopped the global economy in its tracks. The unprecedented economic standstill and the incredible degree of stimulus that supported the recovery meant that these circumstances were truly unique. But is this still the case? There are clear signs that we are approaching a new normal. The US labour market is coming back into balance following the large-scale retirements of baby boomers during the pandemic and low immigration levels, which led to the tightest labour conditions since World War 2. Now, a recovery in net migration and higher female labour participation has brought the jobs market into balance, leading to a cooling of wage inflation.

   In addition to a modest cooling in labour conditions, the shelter component of the CPI is also beginning to moderate. The increase in mortgage rates has caused homeowners in the US to stay put, as moving could result in mortgages being repriced to unaffordable levels. This has dramatically cut the supply of single-family homes in the market. However, the number of apartments under construction is now at highs not seen since the 1970s; vacancy rates are normalising, suggesting the pressure on the CPI from the shelter component should continue to ease.

   The relative health of the jobs market has also helped offset the drawdown in consumers' excess savings, which are now nearly exhausted. Despite the rapid tightening in monetary policy by the Federal Reserve, consumers, in general, have remained in reasonable shape. Conditions have undoubtedly been tough for those in the lowest parts of the income distribution, but even here, wage growth is at least keeping pace with inflation in necessities and debt service costs. In addition, consumers in the top quintile of the income distribution, who account for nearly 40% of all spending, actually benefit from higher rates.

3. What are the prospects for other sectors?

   If our central scenario suggests that we are in the middle of a cycle where corporate earnings power is beginning to accelerate as the economy achieves a soft landing, then we must consider the prospects for other sectors and the longer-term level of real interest rates when we think about these opportunities.

   Given the context of challenging geopolitical conditions, trade barriers and the prospect of a heavy supply of US Treasuries (USTs), it may be prudent to assume that the level of real rates should be higher in the next decade than it has been for the last 10 years. If this is the case, then the prospect for cyclical value sectors could be quite positive, provided that credit quality remains strong. Banks, insurers, some industrials and potentially energy sectors could see their earnings prospects fare relatively well in this scenario. Given the compelling valuation starting point, earnings upgrades for these industries could be accompanied by rising share prices. If this were to occur during a slowdown in the AI boom, these industries could take the lead in the market.

4. But what about defensives?

   In 2024, sectors historically correlated with the fortunes of the bond market have proven something of a disaster as their yield advantage has been eroded. The valuations of these sectors, such as consumer staples and healthcare, are now arguably reaching levels where the risk-reward looks very attractive. For this to bear fruit however, we need a major dislocation in the market from a growth perspective and for the economy to endure a hard landing. This seems unlikely today but given the tense state of geopolitics and the major election cycle currently taking place, the benefits of diversification should not be underestimated over the longer term.

Q3: What are the main risks and challenges equity investors may face in the remainder of 2024?

Whether it's about the level of the CPI, the direction of economic growth, credit quality in the consumer and corporate sector, the housing market, supply of USTs, elections, geopolitics or even an outright stock market bubble, the list of investor worries and concerns seems as long as one can remember. Yet the market continues to push higher. Are we headed for a fall or are we in an economic sweet spot with moderate growth and declining inflation that could go on for some time?

Like any journey, to really understand the benefits of the destination, we should also understand our starting point. Taking a long-term view makes this a little more straightforward and likely helps us draw some better insights, given the myriad of potential outcomes which exist in the short-term. The last 15 years have been characterised by unprecedented fiscal and monetary stimulus to keep the cost of money low following the GFC and more recently to support economies during the pandemic. The low cost of capital reached a pinnacle in a 2021 stock market bubble of money-losing growth stocks, which burst spectacularly as the cost of money increased.

The next 15 years seem unlikely to be a repeat of the last 15, with the direction of real rates being the primary concern for investors. Our best guess is that we are now faced with a sustainably higher cost of capital than the abnormally low level we witnessed following the GFC. A number of factors contribute to this, including (but not limited to) the high forthcoming supply of government debt to fund a burgeoning fiscal deficit, the impact of geopolitics on trade restrictions and the inflationary implications of the energy transition.

If real rates are indeed set to rise over the next decade or so, this will have implications for stock picking as immediate profits become more valuable to investors than the hope of potential profit a decade from now. This might explain why the companies in the market related to the AI theme are performing so well, as they are also experiencing sharp increases in earnings and cash flow. This contrasts sharply with long-duration growth stocks, which continue to lag the market as the anticipated earnings for 2035 or beyond remain just that--hope.

Yet, perhaps the biggest risk to investors with time horizons of 10 years or more is missing out on the opportunities a well-diversified portfolio of global equities can offer. As a smart investor once said, "time in the market is far more important than timing the market". This seems as true today as ever. We are on the verge of a further breakthrough in productivity, enabled by the ongoing evolution of computing platforms, and we stand ready to tackle arguably the most pressing challenge in human history--climate change. Throughout history, equity investors have benefitted from maintaining a long-term view and an optimistic outlook on humanity's ability to prevail in the face of adversity. This might once again be the case, meaning that the biggest risk might be not having exposure to the highest quality earnings streams through a diversified portfolio of global equities. Perhaps we have already mentioned that we know professionals who can be of assistance in such matters.

Global Equity strategy composite performance to June 2024

Important disclaimer information
Please note that much of the content which appears on this page is intended for the use of professional investors only.

 

Past performance is not a guide to future returns.

*The benchmark for this composite is MSCI ACWI Net Total Return Index. The benchmark was the MSCI ACWI ex AU since inception of the composite to 31 March 2016. Inception date for the composite is 01 October 2014.

Returns are based on Nikko AM's (hereafter referred to as the "Firm") Global Equity Strategy Composite returns. Returns for periods in excess of 1 year are annualised. The Firm claims compliance with the Global Investment Performance Standards (GIPS ®) and has prepared and presented this report in compliance with the GIPS. GIPS® is a registered trademark of CFA Institute. CFA Institute does not endorse or promote this organization, nor does it warrant the accuracy or quality of the content contained herein. Returns are US Dollar based and are calculated gross of advisory and management fees, custodial fees and withholding taxes, but are net of transaction costs and include reinvestment of dividends and interest. Copyright © MSCI Inc. The copyright and intellectual rights to the index displayed above are the sole property of the index provider. Any comparison to a reference index or benchmark may have material inherent limitations and therefore should not be relied upon. To obtain a GIPS Composite Report, please contact [email protected]. Data as of 30 June 2024.

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Trend Following: An Attractive Investment Strategy in Uncertain Markets

In the ever-evolving landscape of financial markets, uncertainty is a constant companion. Economic fluctuations, geopolitical events, and market sentiment can create an environment where predicting outcomes becomes increasingly challenging. In our view, trend following is an attractive investment strategy and particularly so amid this unpredictability. Its appeal lies in its simplicity, adaptability, and effectiveness in capturing market movements, especially during turbulent times.

1. Simplicity and Objectivity in a Complex World

One of the most significant advantages of trend following is its straightforward approach. The strategy is based on a simple premise: buy when prices are rising and sell when they are falling. This objectivity helps remove emotional biases from the investment process. In times of uncertainty, where emotional reactions can cloud judgment, trend following provides a systematic method to navigate the market. By relying on clear, predefined signals--such as moving averages or momentum indicators--investors can make decisions based on current market conditions rather than speculative predictions. See also our previous post "Remembering Daniel Kahneman".

2. Flexibility to Adapt to Changing Conditions

Market conditions can shift rapidly, especially during periods of uncertainty. Trend following excels in this regard due to its adaptability. Whether in a bull market, bear market, or a phase of high volatility, trend-following strategies will dynamically adjust to the prevailing conditions. This flexibility allows investors to pivot and stay aligned with market trends, with the strategy remaining relevant as circumstances evolve.

3. Capitalising on Emerging Trends Amidst Volatility

Volatility and uncertainty often lead to the emergence of strong trends. While other strategies might struggle with the noise of unpredictable markets, trend following focuses on capturing significant price movements that align with established trends. This ability to harness the power of volatile conditions enables trend followers to benefit from market inefficiencies and seize unexpected opportunities.

4. Built-In Risk Management for Uncertain Times

Effective risk management becomes paramount when navigating uncertainty. Trend-following strategies incorporate rigorous risk management practices, such as setting stop-loss orders. These mechanisms help limit potential losses and preserve capital, providing a buffer against unpredictable market movements. In times of heightened uncertainty, these tools are essential so that one adverse outcome does not derail the entire strategy.

5. Robust Historical Performance in Uncertain Markets

Historically, trend following strategies have demonstrated resilience in volatile and uncertain markets. The success of trend followers during periods of market upheaval underscores the strategy's effectiveness in navigating unpredictability. For instance, during financial crises or economic downturns, trend followers have often avoided significant losses and even capitalized on market declines. This empirical evidence highlights trend following's robustness and reliability, making it an attractive choice for investors facing uncertainty.

At our website and our YouTube channel you can view our video "Academic Research Support For Trend Following", in which ECCM's founder and CIO, Adam Havryliv, and Strategy Ambassador, Richard Brennan, talk more about the academic research on the effectiveness of trend following. 

Conclusion

In our view, trend following offers a compelling investment strategy due to its simplicity, adaptability, and potential for long-term gains, especially in uncertain market conditions. Its systematic approach reduces emotional bias, while built-in risk management ensures disciplined investing. Supported by historical success, in our view, trend following is an attractive strategy for navigating the complexities of financial markets - both seeking to capitalise on emerging trends and helping to protect against adverse movements.

At ECCM, our educational foundations are in finance and psychology. With extensive trading experience and long-term dedication to quantitative trading systems, we seek to provide our clients with our carefully developed approach to navigating the complexities and vagaries of markets.

Wholesale clients can find more information on ECCM and our flagship ECCM Systematic Trend Fund at our website and Australian Fund Monitors.