Q1 2023 Investment Market Update
The first quarter of 2023 continued on the previous quarter’s momentum as markets climbed to start the year. Early in the quarter, the market gained confidence in central banks executing on a soft-landing scenario however this sentiment deteriorated as a series of hotter-than-expected inflation prints and systematic issues in the banking sector hit the headlines. International equities generated strong returns for the quarter outperforming Australian equities. Currency markets remained volatile as the US dollar appreciated approximately 1.5% against the AUD.
Throughout the quarter central banks continued to fight inflation. The Reserve Bank of Australia (RBA) increased rates from 3.10% to 3.60%, whilst the US Federal Reserve increased rates from 4.5% to 5%. We suggest that we’re now approaching the latter end of this rate hiking cycle, the RBA paused in April but this does not rule out future interest rate increases should circumstances demand such. Australian terminal rates otherwise known as the peak of the cycle declined during the quarter from 3.79% to 3.66%. Largely due to the disruption throughout the global banking sector which some market participants suggest is the equivalent of a 0.25% hike.
From a portfolio perspective, our investment portfolios climbed throughout January, declined in February, and rose in March ending the quarter up between 3.33% & 4.39%, depending on the strategy. The investment committee was active across the portfolios during the first quarter which I will detail later in this note. The portfolios ended the first quarter underweight equities, overweight property, infrastructure & cash.
INTERNATIONAL EQUITIES
International equities rose during the March quarter returning 8.79% outperforming Australian equities. International currency was a contributor to performance as the US dollar rallied around 1.5% against the Australian dollar. There was a substantial performance from longer-duration equities such as technology stocks that benefited from a fall in bond yields. Our international equity allocation underperformed by roughly 1.7% during the quarter as our currency hedging and defensive strategies underperformed relative to the index.
In mid-February, the investment committee elected to reduce the portfolio’s exposure to international equities. We believe the magnitude of the rally across equity markets has pushed valuations into optimistic territory. The market had converged to a “soft landing” scenario where inflation simply resides without any material ramifications to the economy.
There are two predominant risks to this consensus, the first being an economic slowdown or recession which has been flagged by several leading indicators such as an inverted yield curve and low PPI numbers. This may result in a recession and a contraction in corporate earnings for a period of time which would likely coincide with lower equity markets. The second is if inflation proves to be stickier and reduces slower than anticipated, this will result in interest rates needing to stay higher for longer putting further pressure on the economic outlook.
The objective for central banks is to increase the policy to a level until something breaks, ideally, this is demand & inflation however there are risks to corporate profitability and the broader economy. The central bank rate increases seen throughout 2022 were unprecedented given both the magnitude and velocity of increases. The RBA increased rates from 0.1% to 3.1% (a 3% increase) whilst the Federal Reserve increased rates from 0.25% to 4.5% (a 4.25% increase). This change brought the close to a period of “free money” which we continue to believe will challenge several market participants, particularly those impacted by the increased cost and reduced avaliability of leverage.
Come March, headlines of the banking sector dominated the news throughout as a Silicon Valley Bank collapsed following a run-on liquidity. Customers of the bank withdrew over $42b over the course of a single day (over a million dollars a second), which left the bank scrambling for liquidity ultimately leading to its demise. In the subsequent week, we saw Signature Bank collapse & a somewhat forced merger between Credit Suisse and UBS following negotiations with the Swiss government. The events highlight growing stress in the banking system. In the coming weeks, US corporates will report Q1 earnings which should provide greater insight into if stress has been contained to only the banking sector.
AUSTRALIAN EQUITIES
Australian equities also rose during the first quarter returning 3.46%. Our Australian equity allocation outperformed by 0.25% as our core large-cap strategies generated strong levels of outperformance.
Australian companies reported results throughout February that were generally underwhelming. Inflation was the key theme as companies discussed rising interest expenses, pivoting consumer behaviour, and the rising costs of retaining staff but also appointing new employees. More alarmingly the growth in company expenses outpaced the growth in company revenues leading to falling profit margins across the index. Looking forward there are no immediate catalysts for the corporate environment to improve as further rate hikes are expected along with a fixed mortgage cliff that will likely have a significant impact on consumer spending.
Despite this, M&A activity on the ASX has ramped up as there were several offers made for businesses that suitors clearly viewed as undervalued. At the large end of town, Newcrest announced a merger with Newmont, Brookfield’s takeover of Origin gathered pace and Albemarle made a bid for lithium miner Liontown. Midcaps also attracted interest as Invocare, United Malt & Estia Health all received offers from suiters at significant premiums to current valuations. This goes to show that even in challenging market conditions attractive opportunities are available for those willing to look.
In line with International Equities, we reduced the portfolios allocation to Australian equities during the quarter.
PROPERTY & INFRASTRUCTURE
Property and infrastructure both added to portfolio performance during the quarter. Australian listed property returned 0.52% whilst global listed infrastructure returned 3.89%.
We have begun to see some price revisions across portfolios of commercial real estate available to our investors. Capitalisation rates have widened throughout the last few quarters as investors consider alternative ways to generate yield such as bonds or corporate debt. The performance of property will likely be proliferated by sector. Sectors such as industrial, multifamily or value add strategies that are able to grow income & rents over time will likely outperform from here.
We have some concerns about the office sector as it appears the hybrid working dynamic may be here to stay. Anecdotally, we’re hearing corporates are needing to either upgrade their existing office space by either relocating to newer buildings & more modern fit-outs to entice employees back to the office. However, in this process continue to lighten their overall demand for office space. This is creating a flight to quality in the sector as demand for A-grade office space has remained robust whilst demand B & C grade buildings may be dwindling.
We still retain an overweight position to both listed infrastructure & property assets as we believe the assets are trading at sound valuations and should provide defensiveness and income consistency to the portfolio. However, we do recognise there are alternatives to property & infrastructure for yield today, relative to what there were 12 months ago.
PRIVATE EQUITY & VENTURE CAPITAL
Our private market exposures generated positive returns for portfolios during the quarter. Noting we are still awaiting the end of March valuation for some assets.
Our private equity partners continue to report strong operational results from the underlying businesses they own and operate. The buyout process does ultimately allow private equity funds to access an additional source of return through implementing and aggressively pursuing operational enhancements in the companies they invest. This lever is not generally available to public market equity investors. This has allowed private equity investments to better manage their profit margins over the past twelve months which has been a contributing factor to the stronger performance of our private equity positions. Private Equity managers have also benefited from holding companies at lower starting valuations, investing in businesses with structural tailwinds and leveraging informational advantages not available across public markets.
One of our highest conviction investments currently is within late-stage venture which was one of the most disrupted pockets of the investment landscape last year. Investment will be focused on late-stage, innovative high-growth companies, backing already successful companies with established market share, strong management boards and proven products. This strategy is not accessible within the managed accounts so if you have an interest, please reach out to your adviser directly.
There were no changes to the private equity allocation of the portfolios during the first quarter.
FIXED INCOME & BONDS
After a 2022 to forget, Bonds started the year strongly returning 4.30% during the quarter. Whilst the bond market remains volatile, the sector has benefited from a higher starting coupon rate and a rally in prices following the shock to the banking system.
Bonds were a beneficiary of the disruption to the banking sector in March as yields fell by around 1% over a couple of days as investors rushed to re-evaluate central bank policy. All in all, this led to a significant rally in bond prices.
Riskier bonds didn’t fare so well as credit spreads widened when investors lost confidence in the ability of corporates to meet their debt requirements. The hardest done by were owners of Credit Suisse AT1 bonds who were hit by an unprecedented decision by the Swiss Regulator FINMA completely write down the value of their investment awarding capital to equity investors over the bondholders.
Many Australians who locked in fixed rates on their mortgages during the pandemic will feel some pain over the coming two quarters as around a third of these mortgages will transition to the current variable rate. By our estimates, this will equate to around a 3-3.5% increase in a borrower’s mortgage rate which will translate to an extra $800-$1,000 in repayments per month (based on a $500,000 mortgage). For a large proportion of these borrowers, the increase in repayments will be significant and will cause borrowers to change their spending habits. The extent and impact of these changes are yet to be fully felt by Australian corporations.
Late in the quarter, we took some profits on our shorter-duration bond positions. The three-year part of the yield curve moved substantially in March settling at ~2.80% toward the end of the quarter, substantially lower than the current cash rate of 3.6%. The committee elected to reallocate capital to a defensive position that would perform better should bond yield rise from here.
Looking forward, it’s our view that the full impact of tighter and continuing tightening of policy settings is yet to fully be felt by market participates and the risk of a recession remains high. This would likely coincide with a period of rising unemployment and a drawdown in corporate earnings as the consumer faces headwinds, likely leading to lower equity markets.
The disruption seen in the banking sector will only lead to further tightening of lending standards, further restricting liquidity in the system. We’ve seen both economies and inflation continue to surprise the upside which may result in further and unexpected increases in rates. All of which would be negatives for risk assets.
Whilst we’d happily be wrong and see a soft-landing scenario unfold which would bring continued positive performance. For now, our portfolios reflect our views and are positioned in a defensive position. Pleasingly, the alternatives to risk assets now offer significantly enhanced returns to what was available throughout 2021 & 2022 with cash-like solutions offering running yields close to 4%, with any form of credit risk only enhancing returns from there.
As always, should you have any queries about any of the material outlined in this letter then please do not hesitate to reach out to me.
Kind regards,
Ryan Synnot
Associate Director, Investment Research & Solutions