Q2 2022 Investment Market Update
Investment markets continued their decline throughout the second quarter of 2022, as both domestic and global markets trended lower. For investors, the largest challenge has been stomaching the rapid pivot in monetary policy globally and digesting inflation data which has proven to be more persistent than initially thought.
Throughout the quarter, the Reserve Bank of Australia (RBA) increased rates from 0.10% to 0.85% whilst the US Federal Reserve increased rates from 0.5% to 1.75%. We anticipate central banks will continue to follow an aggressive interest rate and tightening path throughout the remainder of 2022 until they reach a neutral policy setting.
Inflation has continued to challenge markets. In May, inflation in the US unexpectedly accelerated to 8.6%, this was above analyst expectations. This represents the highest level of inflation since 1981 and challenges investors to consider how a higher inflationary environment will impact underlying investment positions. In line with many analysts, it’s our view that inflation is likely to moderate throughout the 2nd half of 2022.
There has been a lot of talk about the risk of recession during Q2 which has spooked markets on a few occasions. Whilst this remains an uncertainty, we see the risk of a deep and prolonged recession being low, whilst a technical recession may be possible. Recession or no recession, it’s clear that due to changing policy settings there is likely to be downwards pressure on economic growth globally. This forces us to shift our focus to an environment where economic growth is likely to slow (albeit from a reasonably high base) which has implications around which sectors and asset classes are likely to perform well going forward.
From a portfolio perspective, our investment portfolios declined across every month in the second quarter, with the weakest performance coming in June. Returns across asset classes continue to be diverse which provides ample opportunity for active investment management. We continue to adjust the portfolios in line with the opportunities presented in front of us.
Below I’ve segregated the portfolio’s significant asset classes and will provide further insights on each one.
INTERNATIONAL EQUITIES
International Equities continued their decline across the June quarter returning -8.33% and were a detractor from portfolio performance. Our international equity allocation narrowly outperformed this as our China allocation provided excess returns.
Of late, the market has been rewarding lower-quality sectors of the market which hasn’t favored our positioning. We categorise these businesses as ones that have little control over their financial outcomes with externalities having a greater impact on financial performance. Typically this arises from cyclicality and leverage to the business cycle or rising commodity prices.
We maintain a bias towards high-quality businesses and are now seeking to capitalise on the poor sentiment across this space. From a forward looking perspective, we see quality as being highly favorable from two perspectives. Firstly, high-quality businesses are able to dampen the impact of inflation on profitability. Persistent Inflation will cause company costs to rise and companies that can increase their prices without impacting demand are in a stronger position to maintain margins relative to others. Additionally, we suspect in light of tighter policy settings both cyclical businesses and commodity prices may be challenged that may see a rotation back towards quality within markets.
During the quarter, we added to our position in international equities to retain the portfolio allocation at a neutral positioning. As the market declines, so does the allocation to equities within the portfolio so we considered it prudent to rebalance the portfolio. The new positions in equities were funded from the portfolio’s alternatives allocation which had generated positive performance throughout 2022.
We directed capital toward companies with above-average and sustainable growth characteristics. This is a sector of the market that has declined considerably throughout 2022 due to rising interest rates and valuation multiple compression. We believe the sell-off across growth companies this year has created some attractive valuation and investment opportunities for active managers.
Despite the changed macro backdrop, many of these companies still have strong growth fundamentals and long runways of market opportunity. Whilst it’s possible for markets to continue to trend away from growth companies, from a purely bottom-up perspective we can now seek comfort in the valuation of some popular growth names.
We also elected to increase the level of hedging across the portfolios. Throughout the quarter the US dollar strengthened quite significantly against the Australian Dollar we were able to dial up our hedges at a sub 0.70 level. We anticipate this to enhance returns if we see markets return to a risk on environment or there is an appreciation of the Australian Dollar.
AUSTRALIAN EQUITIES
Australian equities were worse off throughout Q2 returning -11.90%. Our Australian Equity allocation underperformed the benchmark for the quarter as our allocations across smaller companies were sold off more heavily than their larger counterparts.
Whilst Australian equities followed their global counterparts downwards throughout Q2, they have outperformed global equities year to date. The Australian market has been well supported in 2022, largely as an outcome of its sector composition that is skewed to banks and resource companies. In last quarters letter, I discussed this in greater detail that banks and resource companies are well-positioned for this environment.
I now believe this narrative is shifting somewhat and core Australian equities are becoming less attractive from a forward-looking perspective. As I touched on earlier in this note, commodity prices will likely face some downwards pressure as global economies slow. This could be offset in the short term as China re-opens, however could be challenged into 2023. Bank stock valuations appear fairly priced on face value so will require earnings upside to drive share prices higher.
Opportunities appear to be emerging across the mid and smaller companies of the Australian market. Quality growth names such as CarSales, REA Group & Xero have all seen their share prices decline dramatically from their highs. For many of these names, fundamentals remain relatively unchanged and may offer an appealing entry point for investors with a long term horizon. Depressed valuations across the market have also led to an increased amount of M&A activity which may be supportive of valuations across favorable sectors.
The Australian equities allocation of the portfolio went unchanged throughout Q2.
PROPERTY & INFRASTRUCTURE
Property and infrastructure assets were mixed throughout the quarter. Listed property declined by 17.68% whilst listed infrastructure rallied by 3.26%.
Our property allocation entering 2022 was positioned with a large bias to unlisted property. Unlisted property exposures performed very well throughout the quarter and generated positive returns for the portfolios. I anticipate active hands-on management of property portfolios will prove crucial in the coming months. For investors to continue to generate good returns across the asset class they will need to go beyond a buy and hold approach.
On one hand, the valuations of unlisted properties may face some pressure in light of central banks raising rates which may cause capitalisation rates to increase and property prices to decline. On the other hand, given the high inflationary environment, property managers may be able to aggressively increase rental yields should CPI-linked clauses be built into rental agreements. This increase in net operating income across property portfolios would dampen the impact of rising cap rates on valuation. However, without earnings growth & value creation, real estate may struggle in the coming months.
Infrastructure continues to perform well and outperformed the broader equity market throughout the quarter. Whilst we did trim the allocation back this year we still maintain an overweight position across listed infrastructure. The sector has been a major beneficiary of M&A in recent months as either unlisted infrastructure funds, superannuation funds or private equity have turned to publically traded infrastructure assets to put cash reserves to work. This would suggest that the sector remains attractively valued given that there are a number of buyers willing to acquire equity at a premium to market valuations.
Late in the quarter, we increased our allocation to Australian listed property as we believe that some opportunity has emerged across the asset class. The higher-than-expected jump in interest rate expectations and increased concerns over the near-term economic cycle has warranted some adjustment in the valuation of listed property. However, the magnitude of the change in listed property prices would appear to be excessive and belies the earnings profile of the sector, which is more stable and defensive than many others. This trade increases the portfolio’s exposure to listed assets which heightens the amount of upside potential.
PRIVATE EQUITY & VENTURE CAPITAL
Our private market exposures continued to be a source of diversification in Q2 and were relatively flat from a return perspective. Noting we are still awaiting the end of June valuation for some assets.
Currently, the outlook for this asset class is torn between new & old pools of capital. For new pools, there is a great opportunity to access companies at depressed valuation multiples. Speaking with many of our partners in the venture sector, we are hearing of founders and companies returning to the market to raise at cut-price valuations relative to where they were looking to raise capital only a few months ago. These lower entry valuations bode well for new investors.
As I touched on at the end of Q1, the flip side of this is existing portfolios that may have stale valuations or overvalued positions. We’ve seen examples of this begin to play out across the ecosystem with some notable examples including Klarna (A buy now pay later provider) who recently raised capital at a $US15b valuation, a somewhat more modest valuation compared to the $US46b the company raised capital at in June 2021. I expect this to continue to play out in the immediate future and remain very cautious around directing capital towards established funds.
During the quarter we reduced our exposure to private market assets. The asset class hasn’t experienced the same declines throughout the course of 2022 as we’ve seen across public markets. Due to this, the portfolios allocation to private markets has grown throughout the course of 2022. We anticipate valuations across private markets may lag their listed counterparts given the revaluation process is completed on an appraisal basis or the companies’ next funding round. Whilst we believe our private markets exposures can continue to add value to the portfolio into the future, considering the above factors we believe the allocation represents an ideal funding source.
FIXED INCOME & BONDS
Bond markets have undoubtedly been the most interesting asset class this year. Entering 2022 bonds were virtually uninvestable and warranted very little inclusion in an investment portfolio. Since, bonds have been viciously sold off. For reference, the Australian bond index has returned -8.70% throughout 2022 and -3.51% in the last quarter. Pleasingly our positioning has navigated this environment significantly better.
As bonds sell off, the forward-looking returns climb and as returns rise they become increasingly attractive. One of the biggest challenges for asset allocators in 2022 has been the correlation between stocks & bonds. Historically, bonds have shown a negative correlation with equities which means they have either risen or held their value as equity markets decline. This year we’ve seen both stocks and bonds decline concurrently which has meant the traditional portfolio of stocks & bonds has underwhelmed significantly and has limited the amount of rebalancing available to portfolio managers.
Fortunately, our philosophy has been a beneficiary of this environment. Its been a long-standing objective for our portfolios to achieve diversification by incorporating non-traditional asset classes such as direct property, infrastructure, hedge funds & private equity. These asset classes to date haven’t been subject to the same drawdown as bonds.
During the quarter we increased the portfolio’s exposure to short-duration bonds. We believe that short-duration bonds now offer an attractive return relative to their level of risk. Additionally, bond markets have potentially become dislocated from reality, which creates opportunities for bond investors. We assess the market as having attractive yields on a forward-looking basis caused by dislocated markets that are reflecting a cash rate profile that is unlikely to be delivered by the Reserve Bank of Australia (RBA) over the coming months.
We also note that the yield across Australian 10-year bonds has risen to around 4% per annum. This is a level that now challenges other positions in the portfolio that are targeting returns in 4-6% region with greater volatility and uncertainty. I suspect this will be an area of debate for the investment committee over the coming months.
CONCLUSION
Whilst the drawdown and performance throughout the first six months of 2022 has been disappointing, we remain very comfortable with how the portfolio is positioned. As I have mentioned a few times this year, the dispersion of returns across asset classes continues to provide great optionality for the portfolios and to execute on opportunities. The prolonged nature of this drawdown (relative to the relative V-shaped recovery in 2020) has also been beneficial given we’ve had larger windows to execute trades and reposition capital.
It remains our objective to have your portfolio’s structured to take full advantage of the eventual market recovery and leave all of our clients in a better position than prior to the start of this market downturn. Given the opportunity set that we currently see unfolding, we are very confident of achieving this objective.
Whilst equity markets have had a torturous start to 2022 many markets globally are now trading in line or marginally below their 10-year median valuations which represents an attractive entry point for investors who may be considering increasing their exposure to equities. Should we continue to see valuations compress throughout the remainder of the year, it’s likely we’ll consider taking equities to an overweight position within the portfolios.
Ryan Synnot
Associate Director, Investment Research & Solutions
Arrow Private Wealth