Whilst the seasons might be changing, for financial markets it was more or less the same. Themes discussed in the last newsletter remain dominant today – we sound a bit like a broken record repeating ourselves.
Central banks and their actions continue to wield an outsized influence on the direction of equity, bond, and currency markets. Over the quarter, asset allocation performance has been flat relative to the strategic asset allocation. Size of positions were small in-line with the cautiously positive overall outlook.
Figure 1: Allied Wealth Asset Allocation Performance – 3-Months to 30th September 2022
| 3-Months to 30th Sept 2022 | Moderate | Balanced | Growth | High Growth |
| Asset Allocation | -1.6 | -1.7 | -1.8 | -1.9 |
| Strategic Asset Allocation | -1.6 | -1.7 | -1.8 | -1.8 |
| Excess Return | 0.0 | 0.0 | 0.0 | -0.1 |
Source: Allied Wealth, Morningstar
Performance over the September quarter was characterised by a strong equity market rally in the first half followed by a fall in the second half. What stood out overall was the strength of the US dollar relative to most developed market currencies, which supported the relative outperformance of unhedged relative to hedged international equities.
Figure 2: Asset Class Performance as at 30th September 2022
Source: Allied Wealth, Morningstar
On the economic front, more data points have emerged to suggest that aggregate demand is softening, while higher interest rates have started to weigh on consumer and corporate spending.
Supply chain disruptions and the energy crisis, which were major themes early this year, have started to rectify themselves. Cost of shipping has fallen since the start of the year, while factory manufacturing activity has slowed. Natural gas prices have been volatile but current levels are much lower compared to previous peaks.
Figure 3: Natural Gas Prices in USD 2022 Year-to-Date
Labour conditions remain robust, but we believe it is a matter of time before the reduction in demand translates into weaker wage growth. As with all these data points, timing is the greatest uncertainty!
As the song goes – Why Can’t We Be Friends?
Putting aside economic indicators, we highlight longer-term structural trends from the evolution of the US-China relationship. So far into 2022, the US government has imposed further trade restrictions (on China), particularly as they relate to technology exports forcing a growing divide between global companies choosing to work closer with China, or with the US.
Over the quarter, we observed on-shoring or friend-shoring activity (mostly relocation of factories away from China to the US or jurisdictions friendly to the US) as companies look to build out supply chains more resilient to geopolitical risks.
Consequently, China has experienced a substantial outflow of foreign capital. Discussions with asset owners and managers indicate majority of remaining investments in China today reflect opportunistic positions rather than core long-term holdings. We are not surprised by this given the success of Xi Jin Ping in consolidating power and winning a precedent-breaking third term as party leader. The world is bracing for further escalation of geopolitical conflict.
What Does This Mean for Our Portfolios?
Developed market central banks have continued to tighten monetary policy. At the current pace we see an increased probability of a recessionary scenario as bankers have focused primarily on headline inflation. Equity market valuations look attractive on a historical basis – equity markets have generally fallen in-line with changing expectations of interest rates.
China whilst still considered a large part of the global growth engine, is expected to play a reduced role over the longer term. We expect to see other countries benefit from this and in turn should lead to a more diversified global growth profile.
Liquidity conditions have continued to tighten due to a combination of higher debt costs (reducing transaction volumes) and reticence of asset owners to deploy capital into a volatile market.
Over the long-term, we continue to expect earnings recovery as companies readjust to more challenging market conditions. Over the short-to-medium term, we see a situation where a mild recession triggered by central banks are met with static monetary policy as bankers look to retain ammunition against future systemic risk events.
In-line with this view, we retain the marginal growth bias across all risk models. Positions today remain appropriately sized given the range of expected outcomes both on the upside and downside.
Figure 4: Asset Class Summary and Portfolio Stance
| Asset Class | Portfolio Stance | Commentary |
| Domestic Equities | Neutral | Valuation continues to look cheap. Asset class has been supported by the slower pace of monetary policy as well as a substantially weaker AUD (relative to USD). |
| International Equities | Overweight | Proposed overweight is marginal given the distribution of near-term risk. Earnings recovery is likely over the medium to long-term. |
| Property and Infrastructure | Neutral | Rental outlook for the sector remains broadly challenged, particularly for the Retail and Office sector. Industrial property continues to trade expensively in contradiction to the reduction in demand. Infrastructure as a sector has continued to trade expensively. |
| Fixed Interest | Underweight | Interest rates have risen materially over the year-to-date in-line with global policy rates. Economic conditions have moderated further, although market uncertainty around terminal rates implies that rate volatility is likely to continue over the short-term. |
| Cash | Underweight | Cash yield have risen but remains less attractive over the medium-term compared to growth assets given the potential upside. |
Bottom-Up Market Observations
Over the next twelve months, we expect that the two key factors driving equity markets will be rising interest rates and a weaker Australian dollar, both of which will be positive for many of the companies in the Portfolio.
This year we saw the end of near-zero interest rates, unprecedented over the past five thousand years of human commercial transactions, below previous low points of 4% in Ancient Rome in 1 AD and 1.12% from the Republic of Genoa in 1619! Rising or, more accurately, normalizing of interest rates will present a challenge for many newly listed tech companies. Often these companies have business models that require low-interest rates, accommodating bankers and equity markets willing to finance losses.
This year has been a tough for high-priced tech stocks with minimal to no earnings today and only the promise of large profits in the distant future. In an environment of close to zero interest rates, investors are willing to pay very high prices for large distant future profits, which have a present high value when discounted using a rate close to zero.
Rising rates make the “boring” profits and dividends of companies such as Amcor, Ampol and Transurban look more attractive than a tech company promising large “blue sky” cash flow in 20 years. This occurs as the present value of profits delivered today or next year are worth more than profits that may be generated in 10 of 15 years.
Additionally, the Portfolio is constructed to be well hedged against rising interest rates due to either earnings being linked to increasing rates or the company having pricing power to pass on higher costs to their customers. Our positions in insurance companies, toll roads and banks will benefit from rising interest rates.
One factor that is currently being ignored by the market is the impact of a falling Australian Dollar. Over the past year, the AUD has declined by 16% against the USD to sit at US 64 cents. The last time that the AUD was consistently at this level was in early 2009. While this is bad news for those planning ski holidays in Colorado at Christmas, it is good news for many companies in the Portfolio that either have significant operations outside of Australia, or export goods that are sold in USD with costs incurred in AUD. For example, chemical company Incitec Pivot benefits from a falling AUD in two ways. Firstly, the profits Incitec earns in the USA from selling ammonia and explosives are now worth more when translated into Australian Dollars. Secondly, the fertilizer that Incitec manufactures in Australia is priced to compete with imports. A falling AUD makes imported fertilizer more expensive, thus allowing the company to increase their prices and expand their profit margins.
Currently, around 44% of profits generated in the Portfolio will see a positive impact from a falling AUD, with the bulk of these profits earning in USD. Suppose the current weakness in the AUD is maintained. In that case, Atlas expects a significant increase in AUD-reported profits and AUD dividends for the companies held in the Portfolio in the February 2023 reporting season. This occurs because one US dollar of earnings has increased by 16% for Australian-domiciled investors.
May the odds be ever in your favour! It’s been an exciting Melbourne Cup week and the race has left us with great memories but lighter pockets!
Yours faithfully,
Allied Wealth Investment Committee