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The S&P 500 was flat in May but at the time of writing is down 5.8% in June and -22.9% ytd. Most financial assets are down negative double digits ytd: Nasdaq -31%, 10-year US Treasuries -15%, and Bitcoin -56%.

The growing volatility and uncertainty in the financial markets globally is being driven in large part by the overdue and somewhat chaotic reaction of Central Banks to persistent inflation. The US Fed hiked rates by 75 bps in June - the largest hike in 27 years. The 10-year US real yields soared 150 bps in 60 days and most other bond markets suffered - the Australian 10-year yield rose 57 bps in 2 days.

The persistent inflation, made worse by supply chain problems from lockdowns in China and war in the Ukraine, is starting to bite consumer spending and reduce economic growth around the world. In Europe, the 80% rise in the price of natural gas is one problem; the 50% reduction in deliveries by Russia is a worse problem. Europe may not be able to buy all the gas they need for next winter at any price.

Investors fearing more volatility may want to raise cash to be "safe". But if cash buys 8% fewer goods and services next year compared to this year, too much cash may not be safe. A well-managed Life Settlements strategy can contribute to investors' portfolios in these turbulent times: it will be non-correlated with the equity and bond market turmoil, and it offers a return that has a strong probability of keeping up with inflation.

PORTFOLIO CONSTRUCTION: THE ROLE OF LIFE SETTLEMENTS - The Role of the Laureola Fund in Portfolios of Private Clients and Family Offices

Last month we discussed the role of LS in institutional portfolios showing that, mathematically, a small allocation to LS could both reduce portfolio volatility (risk) and increase returns over most 5-year periods because of its diversification characteristics, even if single digits returns are assumed.

But there are other definitions of investment risk sometimes used by Private Clients and Family Offices. Some are simple and straightforward, but still very useful in analysis - maybe even more useful. Many strategies that promise diversification in bull markets fail to deliver the needed diversification in bear markets. But the Laureola Fund does.

The Fund has outperformed all asset classes (except for commodities) ytd in 2022 including hedge funds as measured by the Barclay HF index (-5.7% ytd). The Fund has delivered positive returns in 7 of the 10 worst months for the S&P since inception, and in 2 of the 3 months when both had negative returns the negative return of the Fund was insignificant. The Fund has helped investors keep up with inflation delivering 6.7% net over the past 3 years.

For once the theory and the practice align: The Laureola Fund can make a positive contribution to investors' portfolios in turbulent times no matter what analysis is used.

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There are a number of unique characteristics that make the insurance sector attractive in the current environment, including some company-specific factors which have led to valuation-based investment opportunities.

Valuing the insurance sector

Valuing insurance companies remains difficult due to the potential mismatch of estimated claims verses actual claims paid which may take years to finalise. Large catastrophes can take several years to be resolved—such as the New Zealand earthquakes—and injury claims can be stuck in the legal process for a long time. As a result, errors in claim loss forecasts can impact a company over many years.

As investors, we look at a combined ratio calculation to measure the profitability of insurance companies, which is the sum of operating expenses and claim losses divided by premium revenue. A ratio below 100% indicates profitable insurance underwriting.
Chart 1. below illustrates the 22-year history of natural disasters in constant dollar terms. The frequency of catastrophes has been higher over the last 10 years than the prior 10 years, yet the subsequent constant currency losses have yet to eclipse the 1990 insured losses from the Newcastle Earthquake.

Chart 1. Insured losses by Financial Years (in constant $2017)

The chart is a reminder that disasters happen, and that risk is why people buy insurance to protect them from the impact of a disaster.

A well-run insurance company prices risk appropriately. Insurance companies have accepted that there is an impact on the size and frequency of claims as a result of climate change, and premiums have increased to reflect this.
Insurance companies that manage aggregate underwriting exposures through price, category limits and by selectively purchasing reinsurance (insurance for insurers) will do well over time.

What makes insurance companies attractive in the current market climate?

The current market environment is characterised by rising interest rates, energy price spikes and higher inflation. This has led to a softening in economic growth and growing fears of recession. Stagflation or recession will negatively impact profit margins and valuations for companies.

One of the things that makes the insurance sector unique is that premiums are billed and collected up-front, delivering in a premium float before claims are paid. The float is usually large and is invested to generate additional returns on top of an underwriting margin.

Typically, this large premium float is invested in a mixture of cash and bonds, and possibly a small proportion in shares and other assets. Insurance companies aim to make an insurance margin which includes a return on the float that is akin to a leveraged investment return, since the return is earned on the premium float.

The insurance sector is one of a handful that benefits from higher interest rates, with a 1% increase in rates equating to 10-20% earnings upside. The insurance Industry structure in Australia is attractive, operating as a functional oligopoly with the two major domestic insurers—QBE and IAG—taking approximately 70% market share.

What makes the structure of insurance companies different?

The business service provided by insurance companies is the pricing and pooling of risk. It does not require an inventory of raw materials or finished goods, freight costs, or energy consumption.

Premiums are typically a function of asset value and rise with the insured value. The rate of return on insurance floats improves as interest rates rise, which is the opposite outcome experienced by most companies. Inflation can flow into claims costs, though insurers do generally mitigate this by adjusting premium prices upwards. Furthermore, insurers would face similar pressure and typically be less likely to compete in an inflationary environment.

Why are the insurance stocks undervalued?

The recent increase in the frequency of disasters and associated claims has weighed on investor sentiment, with concerns that estimated losses and exposure protection limits would be exceeded. To date, the measures in place have provided adequate protection.

In addition to claim frequency, a series of operating missteps have dented investor confidence. Most notably, QBE, IAG, as to a lesser extent Suncorp, were forced to raise provisions for Business Interruption claims relating to COVID-19 and to manage costs associated with insurance policy documents incorrectly referencing the Quarantine Act 1908 (rather than Biosecurity Act 2015). IAG was disproportionately impacted by this and had to raise equity. Litigation has so far favoured the insurers, which may lead to the future release of surplus provisions for claims.

Investor confidence in IAG waned further after the company suffered humiliating make-goods as a result of failing to apply group policy discounts and payroll errors. Accusations that IAG retained risk to the Greensill financial collapse proved unfounded, with the company clarifying that the business division that had this exposure had been sold and the risk transferred to the purchaser.

What are the signs that things are improving?

Consistent with IAG and Suncorp's February results commentary concerning premium rate increases, QBE released a performance update in early May which confirmed a healthy 22% growth in constant currency gross insurance premium revenue.

QBE indicated that after the increase in risk rates and a 9% reallocation into riskier assets, the expected running yield on the investment portfolio has almost tripled to an exit rate of ~2%.

The operating missteps of IAG and QBE have rattled investor confidence. Suncorp has fared better following its focus on cost reductions and dividends, and this has been rewarded by the market through share price gains.

We expect a recovery in market valuation and dividend payments from both IAG and QBE as: (i) the cost impact of remediation fades; and (ii) the industry-wide improvements in premium pricing are earned and higher running yields on the premium float are delivered.

The valuation, dividend profile, and sensitivity to rates, inflation, and the risk of stagflation leave IAG, QBE, and Suncorp well placed to outperform. And with high dividend payouts expected to persist, the Tyndall Australian Share Income Fund remains happily overweight the sector.

Author: Michael Maughan, Portfolio Manager, Tyndall Australian Share Income Fund

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Leaders indicators warn of global recession

Central banks state they are not seeing signs of a recession as they continue hiking rates to curb spiralling inflation. But with forward indicators flashing red across the board, low consumer confidence, declining forward sales, the US yield curve beginning to invert, and the continued drop in the global equities, markets are telling us they see slowing growth ahead.

Will the RBA pause in August, or will they continue to tighten at the fastest rate we have seen in 30 years and drive the country into a recession?

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

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For those who prefer to read, the transcript is below. In this episode, the focus is on energy transition in the Asia Pacific region and a look at opportunities versus challenges. 

 

SPEAKERS

Paul Diggle, Deputy Chief Economist
Jeremy Lawson, Chief Economist
Anna Moss, Climate Change Analyst

Paul  00:06

Hello and welcome to macro bytes the economics and politics podcast from abrdn. My name is Paul Diggle Deputy Chief Economist at abrdn, and today we are talking about the energy transition. It's a topic we have tackled a couple of times before on the podcast. But we're specifically going to focus on the energy transition in the Asia Pacific region in this episode. And that's because the region is a crucial battleground in the world's fight to decarbonize with many large emitters base there. And it's also a region replete with opportunities and challenges as part of that transition. So joining me in this discussion are Jeremy Lawson, our chief economist, and Anna Moss, our climate change scenario, analyst. And Jeremy and Anna have recently authored a paper on exactly this topic, so it's going to be great to get into it with them. So Jeremy, let's start with you. Perhaps you could start by laying out why the Asia Pacific region matters so much in the fight against climate change and the transition to clean energy. So I

Jeremy  01:10

think the simplest way to put it is that in the last 20 years, almost all of the net increase in global emissions has come from the Asia Pacific region. That's because you have reductions in emissions in the United States. Here are some other advanced economies, and modest increases in places like Latin America, Middle East and Africa. But they're broadly offsetting service, all of the aggregate increase, and you've got to the three world's largest emitters are based in the region, China and India. And then, as I say, other very large emitters, like Indonesia, and so there can be no energy transition, unless there's an energy transition in the APAC region, any chances of holding temperature increases to one and a half degrees above pre industrial levels, the rest on rapid decarbonisation in the Asia Pacific. And in fact, one of the really important reasons why we don't think that that type of pathway is likely, and even a blue two degree pathway is going to be hard to achieve is because the Asia Pacific region in aggregate, and almost all of the major countries within it are not on net zero trajectories themselves.

Paul  02:29

Brilliant. And AIPAC is, of course, a very big region very heterogeneous in terms of the stage of development climate policy in individual countries. Could you give us a sense of some of that heterogeneity that difference across countries?

Jeremy  02:45

Well, exactly. So think about it through the prism of net zero targets themselves. So we have everything from net 02 1015 targets in places like Australia, Japan, South Korea, then you have a number of countries on China has got a net zero 2060, objective, India's is net 02 1070. So governments very clearly signaling different different policy pathways. You have some of the wealthiest countries in the world in the region. And still some of the poorest, particularly of us sort of expand to include the Pacific Islands, but also parts of Southeast Asia, and parts of southern parts of southern Asia. The credibility of policy very significantly, funnily enough, China is actually the only country that really has a national carbon pricing regime in place through its emissions trading scheme, whereas actually, the advanced economies who look like they have more aggressive climate targets, have actually not managed to put those types of instruments in place. So actually, the credibility of their objectives is even more under question. And so it becomes very, very important to take these types of variation into account, manufacturing shares of GDP, renewable energy, intensity of the energy system, all these sort of things into account when sort of considering the nature of the risks and opportunities that are going to be facing investors looking to get exposure within the region.

Paul  04:18

So I know you're very closely involved in the climate scenario modelling work that you and Jeremy have undertaken. And this is a quantitative framework that we've applied to AIPAC, but also globally to understand different paths for climate change the energy transition, the fortunes of individual sectors and companies. Can you tell us a bit more about the modelling framework? How does it work? What have we done with the modelling?

Anna Moss  04:42

Yeah, so we're about to commence what will be our third year of climate scenario analysis. And I'd say that that really reflects the importance that we place on the potential insights that this type of analysis really can provide to us. And I'd say that also our unique approach Ah chi, that analysis also emphasises that commitment, because rather than relying on publicly available tools, and simply relying on off the shelf scenarios, which can typically have more simplistic assumptions that are built into, that they're built upon. And instead, we've created our own bespoke scenarios. And this allows us to input our sectoral and critically here our regional insights and research. And this means that we can create is more plausible scenarios, where regions and sectors are able to vary within a global pathway. So, as Jeremy has illustrated in his outlining of the importance of the APAC region, there are distinct and important characteristics between regions and between countries in those regions. And it's important for scenario analysis to be able to reflect these. So our approach means, for example, we can reflect China's that China's expanded policy commitments mean, it's likely to decarbonize more quickly than the average across emerging markets, or how the policy ambition and the timescales of that ambition for countries like Japan or Australia, for example, are significantly different to those of Thailand and India, for example. But as Jeremy pointed out, because we need to also the credibility of all those targets. It says right, in terms of the simple off the shelf approaches, these tend to focus on, if you like, the stress testing, approach to climate scenario analysis. So that means that they're concentrating on more the tail risks. And this will flag up the major risks and potential opportunities, but it doesn't allow you to consider what would be the more likely impacts of climate change. So instead, we've, we have a large suite of scenarios and that we apply probabilities. And that then provides us with a really good depth as well as the breadth. So this allows us to explore the differing impact impacts of, for example, limiting warming to the degree two degrees, more ambitious scenarios that are critically aiming for the 1.5 degrees, the hothouse world use of a continuation of work where basically current policy fails to scale up. And also the varying degrees in between, including our current view. That is that the likely figure is around 2.2 degrees in terms of global warming.

Paul  08:01

Brilliant. So we've got this set of bespoke climate scenarios. And our model takes into account alternative paths for climate change the energy transition emissions, the global temperature rise, and gives us impairments of individual sectors and companies that we might invest in. Jeremy, could you bring to life a little bit what the average scenario looks like? So there's the 2.2 degree temperature rise, but what else do we have in terms of technological path or regulatory path bring this to life for us?

Jeremy  08:34

Sure. So I think it's very important for the listing to understand how this framework is built. We have a baseline scenario, which really reflects what we think is priced into assets today across geographies and sectors. And this is a really important starting point for investing, because any investor always has to begin with the question of what is in the price of assets. Then what we do, as I said, we build this array of scenarios, which we think are more likely more plausible, because they build in technology and variation across technology and policy variation across sectors and geographies. And then the mean the probability weighted mean that we generate as a result, then that dictates the extent of the impairment that different securities are exposed to. And this is going to generate very different results than what a standard scenario analytical framework will sort of generate. So they give a couple of examples. We're able to build in the fact that for example, the European Palace sector is decarbonizing more quickly than the power sector in the typical emerging Asian economy. And it's going to matter a lot, because implicitly that means that the carbon price trajectory in Europe in the power sector is going to be higher than it is going to be in emerging Asia. That's also therefore going to significantly influence the after tax. Earning streams of companies differently. So all these things are going to matter quite a lot in terms of what is the demand for products look like? What is the carbon price sort of trajectory look like? How was the ability of companies to pass on changes in carbon prices. So effectively in this model, carbon pricing closes the system, it effectively generates a pathway that ensures that emissions drop in line with the overall sort of temperature, or emission sort of trajectory. And again, if we think about some of the key inputs around, for example, electrical vehicle penetration, or when does global oil demand peak, or how much coal is used in the future, each of these things is going to look a lot different in our main scenario than they do in those extreme tail scenarios. So there's gonna be a lot more fossil fuels use in our main scenario than in one and a half degree or below two degree Well, however, there's going to be a lot less used than in the current policy world says, say most investors, when they gauge a scenario analysis, they're going to get these types of risks that vary widely available, they're commonly used by just kind of precise enough. Ultimately, assets will be dictated by what happens in the real world, not in highly stylized scenarios that reflects the tail probabilities that are very unlikely. And so our The unique part of our framework is the ability to build that in as a feature. And so we're looking for example, for how is BHP Billiton affected by the energy transition, our framework will generate a very different impact than what are the frameworks will.

Paul  11:36

Brilliant and one of the findings of the modelling, Jeremy is that the typical aggregate equity market impairment from the transition is often quite small. There are lots of winners and losers. But you find the aggregate they largely net out at a global level. But that's not the case in a pack, is it especially not for some specific countries, say like India, where you find pretty large aggregate impairments to tell us what it is about Asia Pacific equity markets, that mean that you actually get some pretty big aggregate impairments from the energy transition, you're envisaging.

Jeremy  12:14

I think the simplest way to explain it is that if you look at, say, equity indices across the Asia Pacific region, for the most part, they had larger concentrations in the sectors that are negatively affected under the transition scenario we have in mind. So for example, energy materials, consumer discretionary, each of these sectors that on average, is negatively impaired in our main scenario. And so naturally, if those sectors have got a larger weight in the indices, that will drag the aggregate down in India's case, for example, in very significant weight to materials, but materials that are in some sense, brown rather than green materials. And so that has a negative effect on the aggregate results. But it is still very important to recognise that even though it's true, that the index level effects are a little bit larger, on average, across Asia, and across emerging economies than in the major advanced economies. That it's still the case that dispersion of the impacts of fair valuation impacts is predominantly a security level phenomenon. Right? So So knowing what country the firm is, in knowing what sector even a firm is, is in tells you relatively little about the true exposures, the different types of climate risk and opportunity.

Paul  13:37

And that's the great insight, of course, or of the framework you've built. It allows you to think about individual companies and their exposure to the energy transition, which as you say, Jeremy, varies considerably. And Anna, so a potentially surprising result of your modelling work within a PAC specifically is that Chinese indices actually have quite a low negative exposure to the energy transition. Could you explain why that is? Yeah, so

Anna Moss  14:07

as you say, it is quite a surprising result, given the carbon intensity of the Chinese economy. One of the reasons for this is that some of the country's most fossil fuel intensive firms are actually non listed state owned enterprises and that means that the energy sector which is the most negatively impacted sector, and she has a very small weight in the in the aggregate index, as Jamie pointed out, is quite critical that the weight of these sectors within their indices and that results in therefore a smaller set tall drag on valuation for China in comparison to some these other markets. But also, as Jeremy pointed out, this importance of the dispersion within a sector and whilst the the overall whilst overall the energy sector is very negatively exposed. There's still many firms which do show significant uplift in valuation in our mean scenario. And some of these are actually coal producers based in China, which again, is perhaps surprising to people. And that's because coal remains a dominant fuel type in China, under continuation of current policy, and even in the most stricter and early action scenarios, the projected role for coal actually remains a dominant figure for the dominant figure in terms of few types of much longer in China can compared to other regions. And if you add to that, the issue around carbon pricing so as Jeremy pointed out in although they do have this carbon price pricing scheme in place, it is projected the prices still projected remain pretty low in China across our scenario sweet. So those coal producers in the region have the potential to benefit from the continuing demand, whilst at the same time, their regional peers are potentially going to be hit by higher carbon prices. And along with this dwindling demand that they would face that would see them exiting, exiting the market sooner. So although this car, these coal producers do see a large downturn in net zero scenarios, the uplift from these other scenarios is enough to pull through a positive result in the mean scenario.

Jeremy  16:43

And it's just a Can I just pulled this out a couple of things to that that are probably work, you will help people sort of understand even more in any sort of asset pricing framework, you will have a discounting mechanism taking place, right, and so the further out, the change in earnings occurs generally will, the less weight it has in the valuation, because in emerging economies, including in China, a lot of the policy action, the most aggressive policy actions projected to take place, say after 2030, the biggest negative effects on fossil fuel usage are occurring in periods that are going to be more heavily discounted within the framework. So another way of thinking about that is if we rolled this all forward 10 years and we were doing the analysis, then those same companies might look quite poorly, they still had the same structure reliance on coal. The other one there's a sector element as well is that the Chinese power sector is definitely on a decarbonisation pathway that a lot of coal is used in the industry sector in China, and industry is the sector, it was one of the sectors that we think is going to decarbonize much more slowly, in part because alternative technologies aren't available didn't, then the sheer growth rate of China can sort of create sort of still healthy demand for coal through that particular channel. So again, it's the real importance of taking these nuances into account rather than sort of, say, coal bed renewables good. It's much more complex than that in terms of modelling.

Paul  18:14

Right. And and Or another nuance then is that individual firms can actually take measures to limit their impairment through the energy transition, can't they? So they can they can move to net zero, they can set carbon targets, can you tell us about the sort of measures firms might take that would mean, they they can do well, through the energy transition?

Anna Moss  18:39

Yeah, so I guess the the measures really fall into two broad categories. So limiting rising costs from their emissions, and also reducing the risk of, of losing market share as demand for their products and services declined. So sort of changing how they're the products changing the actual products that they're producing. And so the most common measures fall into that first category with companies announcing commitments to reduce emissions. So basically, as the carbon prices rise, they can improve their position relative to competitors by by basically reducing their costs. But also, there are companies that are announcing targets to adjust their revenue splits to move away from their high carbon products, and increased production of low carbon products. So they're not disadvantaged by these these changing demand dynamics

Paul  19:37

in the auto industry might be an example of that.

Anna Moss  19:41

Yeah, yeah. I'd say definitely the the auto industry is a important one to bring in there. And really, that's so if you consider in terms of the changing in the revenue split, particularly there, you're seeing auto companies announcing In their commitment to change their their split much more favourably towards electric vehicles. And I'd say a lot of the time the devil can really be in the detail. So there can be considerable variation between companies, not just in terms of addition, but also in terms of the the type of permissions that they're including within those targets. And also in terms of whether they're considering the milestones that they'll need to achieve, achieve those those targets. So if we look back at consider our analysis. So climate scenario analysis, although the the policy and technology pathways that underpin it are forward looking, we are working now to introduce a way to incorporate the kind of dynamic responses that individual companies are also likely to make. So we're exploring how to integrate those company level targets into the modelling. But we really do need to consider this this credibility issue. So just as we consider the credibility of targets at country levels, we also need to consider the credibility of these targets being announced by companies. So for that reason, we're also developing a credibility framework in house that can consider the track record in terms of decarbonisation of these companies, how detailed the targets are, and whether these they have these milestones to transition, whether they're operating in jurisdictions where the policy and the regulations, or perhaps like the hinder their plans. And also really crucially, this this issue that the Jeremy touched on earlier about the viability of the technologies that are actually needed to aid their transition, because a lot, a lot of the technological developments that are going to be needed to achieve net zero. In across, most sectors are yet to actually be proven at scale. And in many cases, they've not even made it to market yet. So if you consider going back to your question about the autos, so that's a sector where even where we have proven technology, we're already seeing companies falling short of the targets that that they've set, and majority of the world's car makers already lagging behind with regard to the necessary switch to electric vehicles,

Paul  22:50

right. So credibility is absolutely key when assessing individual again,

Jeremy  22:54

and again, to emphasise how unique this is because it's already the case in our standard work, we're able to take into account policy variation across sectors and geographies and technology variation way but other frameworks don't. But now our ability to take into account dynamic corporate strategies with a layer of credibility will take this work to the next stage in the next level. So it really needs to be thought of as an innovation that makes it even more relevant to investment decision making. And the framework already was and takes a long way beyond this, the standard risk based assessments that are that are mostly sort of prevailing in the industry.

Paul  23:33

And Jeremy, tell us how how we're incorporating this into investment decision making, ultimately, how are our portfolio managers changing their decisions, using this research, this great modelling framework that you and Anna have developed.

Jeremy  23:49

So it's very important to emphasise that the modelling the analysis does not dictate any investment decision. It's a model poll, you're very familiar with the strengths and weaknesses of different model their representation of the world, but never a perfect one. And we want to really emphasise that there are things that are going to be influencing asset prices over different frameworks, including the energy transition, you can never sort of fully capture in a single framework. But what it is being used for in large parts of the businesses is like a think of it as a as a screen as an input into decision making helps people sort of understand well, okay, so how exposed might this firm be? How does that weigh against other things that might be influencing you know, the company, how should I think about long term value compared to short term value? Maybe it can be used in the way where it's being used in the way we engage with companies. So a lot of corporates themselves do scenario analysis, but some of them cherry pick those scenarios to represent favourable futures and say, Hey, we're already on the right track. We don't need to do anything. But when we're armed with our own analysis, we can say, Oh, actually, when you look at it this way you're exposed Asia looks a bit different. How are you? You know, how are you counteracting that? So it's sort of it's, I sort of see it as, like any sort of good model as a way to make better decisions to influence the not dictate and make sure that we've just got a better way of capturing of avoiding risk capturing opportunity. Alongside the other things, they're gearing towards the value of companies and, and the way that we make investment decisions over short, medium and long term timeframes.

Paul  25:29

Anna Jeremy, thank you both for a fascinating set of insights. The full report on the energy transition in Asia Pacific and how we are using it in our in our modelling in our stock selection, portfolio construction, and company engagement can be found on abrdns website and we'll link to it in the show notes as well. Thank you to you for listening to macro bites, we'd love you to give a like or subscribe to the podcast on your platform of choice. But until next time, Goodbye and good luck out there.

26:08

This podcast is provided for general information only and assumes a certain level of knowledge of financial markets. It is provided for informational purposes only and should not be considered as an offer investment, recommendation or solicitation to deal in any of the investments or products mentioned herein and does not constitute investment research. The views in this podcast are those of the contributors at the time of publication and do not necessarily reflect those of abrdn. The companies discussed in this podcast have been selected for illustrative purposes only, or to demonstrate our investment management style and not as an investment recommendation or indication of their future performance. The value of investments and the income from them can go down as well as up and investors make it back less than the amount invested. Past performance is not a guide to future returns, return projections or estimates and provide no guarantee of future results.

Speakers:

Gerald Stack, Head of Infrastructure
David Costello, Portfolio Manager
Ofer Karliner, Portfolio Manager
Ben McVicar, Portfolio Manager
Jowell Amores, Portfolio Manager

Time stamps:
22.00 Infrastructure review by sector
45.00 Impact of inflation and interest rates
48.15 Opportunities and risks from the energy transition
58.46 Safe transition methodology
1.00.00  Conclusion
1.04.00  Q&A

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In this week's video insight Roger discusses what could be next for the stock market. We already know that P/E ratios have compressed considerably, and taken into account all of the increase in bond rates. What they haven't done, of course, is priced a very significant recession, nor have they priced the possibility of a financial crisis of any description. But what happens if rates stop rising, and if economies don't go into a recession, and we don't get a financial crisis?

Transcript 

Roger Montgomery:

Hi, I'm Roger Montgomery, and welcome to this week's video insight. Well, bearishness pervades almost every corner of the market at the moment. In my travels, in talking to brokers, other fund managers and economists, I don't find many people who are very bullish at all. In fact, most of them expect another leg lower in the stock market. Of course, for me, that starts to become optimistic because if everyone's already bearish, there's not many others left to become bearish. Those who are bearish have already sold, there's not many people left to sell, and so it may be that prices are now on the cusp of a bounce.

But rather than speculating about that, let's just think logically about what could happen next. We already know that P/E ratios have compressed considerably, and taken into account all of the increase in bond rates. What they haven't done, of course, is priced a very significant recession, nor have they priced the possibility of a financial crisis of any description. We'll address those two subjects in a moment.

But if rates stop rising, and if economies don't go into a recession, and we don't get a financial crisis, then there's a very real possibility that the indiscriminate selling that we've witnessed recently becomes something more discerning and buyers return to the market to look for downtrodden, high-quality growth companies. That's one possibility. The other possibility, of course, is that the deterioration in consumer confidence, such as what we're seeing in New Zealand at the moment, after five interest rate increases there, and a similar event here in Australia is a consequence of rising prices as well as declining property prices, could result in less funding being available to venture capital and private equity companies. If that happened, then that would mean a lot of people who are currently employed, thanks to the altruism of shareholders, could become unemployed.

There's also a more significant possibility that those people employed in construction, and remember construction is the third largest employer in Australia, there's a very distinct possibility that those people have less work on. And that's because falling house prices and rising costs make people defer or delay any alterations and additions that they might have conducted on their properties. And so it's significant to think about, or important, rather, to think about the possibility that we get rising unemployment from those sectors of the economy that are being funded by altruistic shareholders, those who have previously had very cheap money or free money to access to be able to fund startups, venture capital and private equity. Or there's a possibility that we see unemployment rising amongst those people in the construction sector.

Now, thinking through the transmission mechanism of that, if that happened, then we would get a much more significant decline in economic growth, and then the possibility of a recession goes up. But as I said earlier, in the absence of a recession and in the absence of a financial crisis, and I don't think any of those two things are very likely right now, then we're in a situation where we've had indiscriminate selling, pushing P/E ratios very, very low, and that of course means the possibility of better returns in the future. So if indiscriminate selling gives way to more discerning buying, we'll get an expansion of P/Es again, and that will increase the return available, that would normally be available, rather, just from the earnings growth.

So my suggestion now is to start dipping your toe back in. It's not a recommendation of course, but it's something that I'm doing myself. I don't know whether prices will rise from here or continue lower. It could be that the rest of my peers in the market are absolutely correct and we get another leg down. I just don't know. But I do know that there are some mouthwatering opportunities already appearing, and rather than try and predict what prices are going to do next, I'd rather start filling my portfolio with wonderful businesses at rational prices. That's all I have time for today. I look forward to speaking to you again next week, and in the meantime, please continue to follow us on Facebook and Twitter.

Speaker:  Roger Montgomery, Chairman and Chief Investment Officer

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A recession is commonly defined as two consecutive quarters of real GDP decline. It is characterised by falling economic activity, increasing unemployment and decreasing consumer and business confidence: with both groups being more cautious in their spending. Investment spending also slows. The GFC, between mid-2007 and early-2009, was exceptionally bad on all of these metrics, resulting in a significant fall in share markets - the previous peaks of which were not recovered for another five years. And yet, over those same five years, many disruptive companies outperformed the S&P 500 (quite significantly in some instances). How could that be?

Over the five years it took the S&P to recover its 2007 high, Netflix's share price grew +731%, Amazon +180%, Apple +164%, Alphabet +30%

Source: Bloomberg

Then, as now, there were a number of key disruptive trends working their way through the economy. Smartphones were becoming ubiquitous, e-commerce was in its infancy but growing strongly, online advertising was taking hold and streaming was beginning to benefit from faster download speeds. The simple answer is that the disruptive trends benefiting these companies were a greater force relative to the economic headwinds they faced.  

E-commerce and Amazon

For many decades, retail was a story of growing concentration, housed in a physical structure of some kind, from the early day 'mom-and-pop' shops to shopping centres. However, it was the advent of the internet in the 1990s that brought with it the ability for consumers to browse and shop online, a much more convenient solution. Even with logistics networks that were not yet properly built out, e-commerce took market share from brick and mortar retail each year. E-commerce's share of retail in the US still grew at the depths of the GFC between 2007 and 2008 (3.5% and 3.6% respectively), and the trend accelerated to the point until today (aided by superior logistics networks and same day delivery). 
 

E-commerce as % of Total Retail Sales in the U.S.

Source: U.S. Department of Commerce

Online Advertising and Google

There was also significant change underway within the advertising industry at the time of the GFC, fuelled by digitisation and the changes to consumer behaviour that it brought about. Time spent online increased, so advertisers needed to follow. This time, however, companies placing advertising had granular targeting capabilities the likes of which were never available for traditional media such as newspapers, magazines, radio and linear television. Once again, a better, more efficient solution had arrived. So while the global market for advertising declined significantly during the GFC (almost -10% in 2009), market share within the industry tells a very different story. 

% of Total Advertising Revenue by Category (Global)

 

Source: Magna

Some of the more inefficient means of advertising, where reach (the number of people who saw the advertisement) was also suffering, experienced declines of almost -20% at the low of the GFC (linear TV was the only exception, largely a function of increasing - but peaking - growth in pay TV households). These types of advertising never recovered. Meanwhile, online advertising grew +5% at a time when many businesses didn't know whether they would trade the following week. Online growth did slow from +20%, but given the overall market for advertising declined -10%, it resulted in some very large market-share gains.

Streaming and Netflix

There was also an interesting dynamic occurring in the lead up to and during the GFC in the entertainment industry. Pay TV households in the US were still growing, but streaming was also becoming an increasingly appealing option. It was a new and better way to consume content from the largest and best studios, although often with a slight delay, but without the $100-200/month price tag of cable. That it was a better solution was often lost on those working at incumbent entertainment companies. The head of Time Warner Jeff Bewkes famously stated in 2010 that Netflix was not a threat to media companies and that it was "a little bit like, is the Albanian army going to take over the world? I don't think so." We know how that played out. During the GFC Netflix managed to grow from 7.5 million subscribers to 20 million subscribers by the end of 2010 (a respectable +39%, 3-year subscriber compound annual growth rate).

Netflix Subscriber Growth from Inception to 2021

Source: Company Filings

Smartphones and Apple

The iPhone was launched at the beginning of 2007 and arguably kick-started the mobile revolution (although it wasn't the 'first' smartphone). The product launch came just a few months before early signs of financial stress and at a time when Nokia was king of the mobile market, with market share of almost 50%. But the iPhone was different. There was no stylus or keyboard, it provided access to the open internet in a way that smartphones of the past didn't and there was soon an app for anything and everything (especially functions previously performed by other devices). It was simply a better solution than its predecessors and it was because of this that Apple grew its iPhone sales from nothing in 2006 to 4 million in 2007 and 48 million by 2010. It wasn't just Apple iPhone sales either - smartphone sales showed significant growth, despite higher price tags and severe economic weakness:

Number of Smartphones Sold to End Users Worldwide from 2007 to 2021

Source: Gartner

There are many new disruptive trends happening right now that are unlikely to change course in the face of economic headwinds. Carmakers aren't going to go back to making more internal combustion engine vehicles, nor are they going to cut back on safety features like advanced driver assistance or digitised infotainment (all of which is powered by semiconductors). Business aren't going to turn back on their digital transformation plans. They certainly aren't going to cut back on their cybersecurity budgets either. 

And interestingly, many of the disruptive trends listed above still have a long way to go, even after more than a decade of progress: online advertising shows no signs of slowing, e-commerce is at under 20% penetration, streaming represents only 46% of TV viewing and smartphones are undergoing a 5G supercycle. 

Despite the potential of a recession, disruption marches on. 

 

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Invest in inflation. It's the only thing going up.

-- Will Rogers

Every day we read about higher costs of food, energy and property via higher interest rates, while our pay packets don't seem to be rising as fast as the cost of living. 

We're being told to learn to cut back on our quality of life and to expect lower returns going forward from our investment portfolios because of ostensibly more difficult business conditions and, prima facie, higher than typical stock valuations.

The spigots of 'helicopter money' opened by central banks all over the world are slowly being closed along with rising interest rates that make the traditional 'safe haven' of fixed income, riskier than recent historical experience would suggest. In addition, the spectre of war is a key risk as the probability of conflicts increases during poor economic times.

What is an investor to do? In an environment of low economic growth, high inflation (a situation known as stagflation) as well as tightening monetary and fiscal policy along with geopolitical risks.

A sensible thing one can do is to put more onus on tangible, hard assets versus the recent popularity (and erstwhile success) of investing in abstractions. In these adverse market conditions, we believe that it's prudent to get back to the basics.

Accordingly, factors such as positive cash flow, positive real returns (post-inflation), relatively low valuation multiples, returns to shareholders via capital initiatives and strong market leadership positions we view favourably. 

Which asset classes will be resilient?

We can use history as a guide in comparing similar environments in the past with the present day. The stagflationary environment in the 1970s is a reasonable comparable in some ways to the present day, with numerous 'oil shocks' experienced analogous to the global 'energy molecule' crisis being experienced today.

The sector that experienced the best returns over this decade was the energy sector, with the worst returns coming from the technology sector. Value and small-cap assets performed best throughout the decade, with growth assets and government bonds providing the worst relative returns.

Accordingly, we believe the most favour sectors to be going forward to be:

• Energy - unpopular and cheap due to ESG mandates with material operational leverage to higher energy prices going forward
• Agriculture - defensive, real asset class, albeit with typically lower returns
• Tangible goods and commodity producers - will benefit from the trend towards greater localisation and the unwinding of globalisation

It's important to observe that recent inflation has been driven by shortages and supply chain disruptions. Rising rates are unlikely to control inflation in the short term. Inflation has been labelled the 'silent tax' as it essentially measures the fall in a currency's purchasing power. It reduces the standard of living for the majority, which has the knock-on effect of reducing economic activity and increasing the probability of a recession.

Accordingly, it's imperative to invest with those stewards of capital that can outperform the rate of inflation earning a real rate of return, thereby preserving one's purchasing power and quality of life. Passive market exposure may not provide this however, we firmly believe that the appropriate actively managed funds in combination with other uncorrelated assets provide a higher probability of preserving an investor's wealth in real terms.

Since August 2018, the ASX200 Total Return index has compounded at an annualised rate of 8.79% per annum. Over the same timeframe, as an example, the Datt Capital Absolute Return Fund has doubled the index return: achieving 17.73% per annum (past performance is no guarantee of future performance) at lower relative risk, despite some of the most turbulent markets in living memory.

This demonstrates the importance and value of adding high performing active managers; with the ability to invest within the sectors experiencing tailwinds to a diversified portfolio as a potential hedge against inflation.

Author: Emanuel Datt