Why I think tech and small caps could rally this year

Montgomery Investment Management

May 2023

With inflation finally coming down, it looks like the U.S. Fed Reserve could soon stop lifting interest rates and start cutting, possibly as early as this year.  That's great news for equity markets, which tend to rally when rates are lower. And it's particularly good news for technology stocks and small caps.

U.S. interest rate markets currently reflect investor expectations for a rate cut by the Federal Reserve before the end of the year, and more than three rate cuts by the end of January 2024. That's just seven months away! Clearly, the market is rather bearish about the prospects for the American economy, but earnings season doesn't appear to lend any credence to predictions of an economic collapse.

With earnings season now well underway, only a third of companies have yet to report. Of the two-thirds that have reported, earnings growth has come in at negative three per cent year-on-year, according to JP Morgan. The result, thus far, is significantly better than the negative nine to twelve per cent hitherto anticipated, and suggests some reappraisal of rate expectations might be necessary.

Last week we saw the U.S. indices rally after a stronger than expected jobs report. In the not too distant past, news of strong jobs would be met negatively amid expectations of consequent rate hikes. Now, it seems, equity investors are enthused by strong jobs that a recession is less likely.

Last Wednesday, Federal Reserve Chairman, Jerome Powell, reminded those investors expecting early rate cuts that the labour market remains robust if not hot. He also submitted the prediction that there will not be a recession in calendar 2023. Judging from the current reported results from corporate America, it certainly seems the Fed Chair is right. 

The Bloomberg chart in Figure 1. reveals current consensus rate expectations and confirms the noted expectations of at least three cuts before the end of January next year.

The magnitude of the divergence between Powell's comments and the market's expectations is unusual.

Figure 1. U.S. Rate cut expectations

Source: Bloomberg

So, what needs to happen for the market to be right? While anything is possible (another pandemic perhaps?), it seems the requirements will be difficult to achieve before the end of January 2024.

For example, inflation would need to fall to the Fed's target of circa two per cent relatively quickly. That's not out of the realms of possibility as the annualised rate of U.S. CPI over the past six months is just 3.6 per cent.

Incidentally, we have frequently reminded investors that deflation is very good for innovative growth stocks. The fall to 3.6 per cent annualised consumer price index (CPI) is very positive for equities and explains the 20 per cent jump in the Nasdaq since January 1st, this year.

But the path from 3.6 per cent to two per cent is not guaranteed. The strong jobs market and strong earnings from corporate U.S. suggest there will be bumps and delays to the Fed reaching its target.

And presumably, even if the Fed's target of two per cent inflation is achieved, it won't immediately start cutting rates unless that CPI print is associated with weakness in the economy, in corporate profits and consequently, the jobs market.

So, the next question might be, could the labour market weaken from here? Layoff data has now risen to its highest level in two years. (From 2019 onwards we began warning investors that when the spigot of Private Equity and Venture Capital money dried up, layoffs would be seen in the "profitless prosperity" sub-sector of the tech industry - the sub-sector NYU Professor Scott Galloway referred to in 2019 as suffering from "Consensual Hallucination".  See the article How soon till we see the collapse of profitless prosperity¹ and From Private Equity to Zombie - The ABC of Capitalism.²

So, can the labour market weaken quickly enough to justify multiple rate-cut expectations by January 2024? While the media is now breathlessly reporting the not-so-widely-anticipated layoffs in profitless technology businesses, there would have to be a much broader and more dramatic increase in unemployment to produce the necessary weakness that would validate significant rate cuts.

The final question then, can the U.S. tip into a deep recession this year if the jobless rate doesn't accelerate quickly and inflation doesn't drop to said target of two per cent?

First, it is worth keeping in mind that some experts believe that current two per cent real rates are not as "restrictive" as the Fed chairman has asserted. If they are accommodative, then the economy might just side-step a recession altogether.

The tumult in the banking sector may be a precursor to some credit tightening, and perhaps that is the source of economic weakness, but there are lags associated with such transmission mechanisms, not least because regulators will do everything in their power to avoid it. And let's not forget that the inverted yield curve means long bond rates are accommodative and therefore supportive of investment. 

If the market's investors have the rate cut scenario wrong, it could mean their predictions of a recession are also wrong. In the event, investors conclude the economy is growing and disinflation remains in place, equities will continue to rally and potentially strongly. Further gains in the Nasdaq and perhaps even small companies would not surprise remembering, since the 1970s, the combination of disinflation and economic growth has been very good for innovative and growth stocks.

Author: Roger Montgomery

Funds operated by this manager:

Montgomery (Private) Fund, Montgomery Small Companies Fund, The Montgomery Fund

¹ https://rogermontgomery.com/how-soon-till-we-see-the-collapse-of-profitless-prosperity/

² https://rogermontgomery.com/from-private-equity-to-zombie-the-abc-of-capitalism/

ESG Policy: The real-world impacts

Magellan Asset Management

May 2023

Elisa Di Marco, Portfolio Manager - MFG Core International and Core ESG Fund, discusses ESG-linked government policies, the real-world impacts of these policies and the importance of proxy voting

Funds operated by this manager:

Magellan Global Fund (Hedged), Magellan Global Fund (Open Class Units) ASX:MGOC, Magellan High Conviction Fund, Magellan Infrastructure Fund, Magellan Infrastructure Fund (Unhedged), MFG Core Infrastructure Fund

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Meta Platforms - AI Winner

Insync Fund Managers

May 2023

Excluding China (where US social media companies are generally excluded) Meta Platforms Family of Apps are used monthly by a staggering 90% of the world's connected population.

Meta has a long history of investing into AI. For years, Meta has employed a world-class AI research team that has been publishing industry-changing research. Even though we can't see it, Meta has, for years, used AI to recommend posts in our feeds, moderate content, and target ads behind the scenes in Instagram and Facebook.

Source: Netbasesquid.com

Meta is currently incorporating AI more visibly into his company's products. They are deploying AI technologies to assist advertisers optimise their spend across different mediums with the company saying it's improved its "monetization efficiency," or how much the company makes off of ads they sell on Reels, by 30-40 percent on Instagram and Facebook.

Insync significantly increased the Fund's exposure to Meta when shares were trading below US$100 in November 2022, as investors were fretting over how much the company was spending on the Metaverse. What was not appreciated was that 80% of their investments was spent on their core business including AI. Meta shares are today trading in excess of US$200.

Meta Platforms has 80% gross margin, over 19% net margins (which includes an expense/deduction of R&D spend of $35.4bn), and returns on invested capital in excess of 25%. It is an extremely profitable business which is in a strong position to benefit from the exponential deployment of artificial intelligence

Funds operated by this manager:

Insync Global Capital Aware Fund, Insync Global Quality Equity Fund

Disclaimer
Equity Trustees Limited ("EQT") (ABN 46 004 031 298), AFSL 240975, is the Responsible Entity for the Insync Global Quality Fund and the Insync Global Capital Aware Fund. EQT is a subsidiary of EQT Holdings Limited (ABN 22 607 797 615), a publicly listed company on the Australian Securities Exchange (ASX: EQT). This information has been prepared by Insync Funds Management Pty Ltd (ABN 29 125 092 677, AFSL 322891) ("Insync"), to provide you with general information only. In preparing this information, we did not take into account the investment objectives, financial situation or particular needs of any particular person. It is not intended to take the place of professional advice and you should not take action on specific issues in reliance on this information. Neither Insync, EQT nor any of its related parties, their employees or directors, provide and warranty of accuracy or reliability in relation to such information or accepts any liability to any person who relies on it. Past performance should not be taken as an indicator of future performance. You should obtain a copy of the Product Disclosure Statement before making a decision about whether to invest in this product.

Hedge Clippings | 02 June 2023

Phillip Lowe had a subtle shot at politicians this week, and Treasurer Jim Chalmers in particular, when fronting a Senate Estimates hearing in Canberra, asking the Senators to consider whether fighting inflation should only be left to the RBA?

"In a perfect world, you'd have a different set of arrangements," Lowe proposed. "The other way you could reduce aggregate demand at the moment is to increase taxes or reduce government spending." Of course that might involve some of the senators in question losing their jobs, which they'd rather not do. He could also have added something about the government not supporting wage rises, but sensibly kept away from that, even going so far as saying he didn't think the budget was adding to inflation, but actually reducing it.

It's still unknown if Lowe will keep his job when his term (or time) is up in September, and Chalmers has given no hint of support, suggesting that he won't. Whether he does or not is unlikely to change his successor's focus on inflation, and therefore the upward direction of interest rates, even though Lowe's claims that the 11 rate rises over the past year are working. The Fair Work Commission's 5.75% increase in minimum wages awarded to 2.6 million workers, and 8.6% for 180,000 on the lowest rate, won't be helping when the RBA announces the outcome of next Tuesday's board meeting. As a result, a bevy of bank economists are forecasting a further 0.25% rise, with some now suggesting that a peak of 4.6% - or three more increases - is not out of the question.

Not only are interest rates a blunt instrument with which to manage inflation, their effect on the economy is a lagging one. As a consequence, when the results show up in the statistics the RBA use in their monthly determinations, the tipping point in the economy has already occurred. Hence rates inevitably rise (and fall) too far. For many people - those under mortgage or rental stress, or minimum wages - that tipping point has already occurred, so if a cash rate of 4.6% is on the cards there'll be some serious pain, and certainly Lowe's increases will have worked.

Even if he's not going to be there to take the credit - or the blame - when or if inflation returns to the 2-3% target, and rates gradually follow suit.

On Tuesday afternoon next week at 4.15 we are holding the next in our series of Fund Manager Round Table Webinars, this time focusing on the Hybrid Credit sector. Register here to join Ben Harrison from Altor Capital, Nick Thomson from AquAsia Funds Management, and Patrick William from Rixon Capital for their take on the opportunities and risks for the sector.

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April 2023 Performance News

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Are we still catching cold when America sneezes?

Pendal

May 2023

Investors concerned about the banking crisis and recession fears in the US may be missing out on finding investment opportunities in other parts of the world, says Clive Beagles.

MARKETS are watching the US closely as its banking system reels from the impact of higher interest rates on regional bank bond portfolios.

Three US banks have been shuttered during the rolling crisis and regional bank shares have been volatile as markets weigh up the prospect of further failures.

But the crisis has also swept up banks and markets outside the US, which may offer opportunities for investors who can keep calm amid the noise.

Last week Pendal's Samir Mehta argued that the US regional bank turmoil shouldn't discourage investors from considering Asian bank stocks.

Clive Beagles, a senior fund manager at Pendal's UK-based asset manager affiliate J O Hambro, has similar things to say about British bank stocks.

"Many of the UK banks are posting returns on equity of close to 20 per cent in the first quarter," says Beagles.

"But they all trade at a discount to book value -- some of them at 0.4 or 0.5. That includes big names like Natwest and Lloyds.

"Discounts to book value for that kind of return on equity just look silly."

Beagles says the US market is acting like a "rotating firing squad" that seems to be picking a different name every other day to sell off.

But he believes the banks that are failing in the US are smaller players which are not globally significant.

"The differential between how the US has been regulating their banks and how the UK and Europe are regulating banks is becoming ever clearer -- which is frustrating because they have been dragged down a bit by the noise.

Is everyone else still catching cold when America sneezes?

Beagles says the underlying concern many investors have is of a global recession triggered by a downturn in the US.

"There's an old assumption that when the US sneezes everyone else catches a cold. But I do slightly wonder if it's going be different this time.

"If this is a crisis, it's the first one we've had where the US dollar is going down rather than up.

"Normally, you head to the dollar for safe haven status."

Beagles believes the US dollar weakness indicates something different is going on from the usual global contagion. It could point to a period where the US is one of the slower-growing economies in the developed world rather than its traditional role as one of the fastest.

"The banks are just a microcosm of that -- they will need more capital and need to be more tightly regulated in a slower US."

Beagles also cautions against comparisons to previous banking crises.

"In 2008, UK banks had tier-one capital ratios of 4 per cent. Today they have tier-one ratios of 14 per cent."

Tier-one capital refers to bank's most reliable and highest-quality capital. A higher tier-one capital ratio generally suggests a bank is better equipped to absorb losses and maintain its financial stability.

"In 2008, there were something like £400 billion more loans than there were deposits -- today it's the other way around.

"The UK as an economy is under-geared rather than over-geared."

Author: Clive Beagles, Senior Fund Manager 

Funds operated by this manager:

This information has been prepared by Pendal Fund Services Limited (PFSL) ABN 13 161 249 332, AFSL No 431426 and is current as at December 8, 2021. PFSL is the responsible entity and issuer of units in the Pendal Multi-Asset Target Return Fund (Fund) ARSN: 623 987 968. A product disclosure statement (PDS) is available for the Fund and can be obtained by calling 1300 346 821 or visiting www.pendalgroup.com. The Target Market Determination (TMD) for the Fund is available at www.pendalgroup.com/ddo. You should obtain and consider the PDS and the TMD before deciding whether to acquire, continue to hold or dispose of units in the Fund. An investment in the Fund or any of the funds referred to in this web page is subject to investment risk, including possible delays in repayment of withdrawal proceeds and loss of income and principal invested. This information is for general purposes only, should not be considered as a comprehensive statement on any matter and should not be relied upon as such. It has been prepared without taking into account any recipient's personal objectives, financial situation or needs. Because of this, recipients should, before acting on this information, consider its appropriateness having regard to their individual objectives, financial situation and needs. This information is not to be regarded as a securities recommendation. The information may contain material provided by third parties, is given in good faith and has been derived from sources believed to be accurate as at its issue date. While such material is published with necessary permission, and while all reasonable care has been taken to ensure that the information is complete and correct, to the maximum extent permitted by law neither PFSL nor any company in the Pendal group accepts any responsibility or liability for the accuracy or completeness of this information. Performance figures are calculated in accordance with the Financial Services Council (FSC) standards. Performance data (post-fee) assumes reinvestment of distributions and is calculated using exit prices, net of management costs. Performance data (pre-fee) is calculated by adding back management costs to the post-fee performance. Past performance is not a reliable indicator of future performance. Any projections are predictive only and should not be relied upon when making an investment decision or recommendation. Whilst we have used every effort to ensure that the assumptions on which the projections are based are reasonable, the projections may be based on incorrect assumptions or may not take into account known or unknown risks and uncertainties. The actual results may differ materially from these projections. For more information, please call Customer Relations on 1300 346 821 8am to 6pm (Sydney time) or visit our website www.pendalgroup.com

The maths of commercial real estate lending - April 2023

Challenger Investment Management

May 2023

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So much of financial analysis is comparative. We look for allegories; similar themes and narratives that could inform us about our current situation.

In part due to the significant exposure of US regional banks to commercial real estate, risks in real estate lending markets have been front and centre of investors' minds. The obvious question is whether the stress in US commercial real estate markets could also emerge in Australia.

And there is stress in the United States. As discussed in our recent quarterly review of markets the office sector is facing nationwide vacancy rates of 20%. In San Francisco, office vacancy rates are 30%, up from 3% in 2019. Average rents are almost 20% below the peak in 2019. In April, the Wall Street Journal reported on an office tower in San Francisco which was valued at US$300 million in 2019 is expected to be sold for US$60 million, an 80% decline in value over 4 years.

Adding to this stress is higher interest rates and wider credit spreads. The drop in operating income and increase in cost of debt is resulting in much weaker debt serviceability. As shown below, a loan written in 2019 will struggle to cover its interest bill if current levels of interest rates and credit spreads are sustained. The maths doesn't work which is why rating agencies are downgrading deals and defaults are picking up.

US Commercial Real Estate Serviceability (Office)

Here we have used the ICE BofA US Fixed Rate CMBS Index to estimate movements in interest rates and credit spreads. If interest rates increase another 100 basis points or the net operating income on the asset declines another 10% the interest coverage ratio on the loan will drop below 1 times.

To get to a passing ICR for a bank loan (which we define as starting of 1.75x), new equity needs to be contributed to the deal. We estimate up to 50% of the original equity cheque would be required to right-size the bank loan. If the deal slips into the non-bank market where a passing ICR might be more like 1.15 times but the debt cost is significantly higher which reduces the required equity cheque to more like 20% with little in the way of post interest earnings available to equity.

These findings tie into research from Deutsche Bank and Cohen and Steers which showed around one-third of 2023 maturities have a DSCR of less than 1.25 times^[1]. Serviceability is very tight.

Before we turn to Australia, it is worthwhile firstly to highlight some key differences with the U

Australia Commercial Real Estate Serviceability (Office)

Again, for Australia, to get to a passing ICR for a bank (which we still define as starting of ICR 1.75x), new equity needs to be contributed to the deal. We estimate up to 20% of the original equity cheque for a bank deal. This is much better than the US in large part due to the fact that credit margins have to date held up in the bank market in Australia and rents have been stable as opposed to declining.

However here if the deal slips into the non-bank market where funding margins are much wider (by >2%), Australia starts to look a lot like the US with significant equity contributions required to pass minimum ICR thresholds.

So, what happens from here?

It's abundantly clear there are serviceability issues in the United States and Australia. Absent equity contributions we think lenders will respond in the following ways:

1. Extend and pretend: if banks accommodate a minimum ICR of 1.5 times, the required equity contribution goes from 20% to 5% of the original equity cheques. In Australia we think many loans will go down this path, with banks recognising that we are likely close to the peak in interest rate but potentially with equity kicking in a small amount to deliver the deal slightly as well;

2. Senior/junior structures: for deals where banks aren't budging on senior leverage, some of the difference between equity and bank debt can be bridged with junior debt. In the case where an additional 20% of equity is required, half could come from a non-bank lender without materially impacting the overall serviceability;

3. Non-bank senior with a twist: clearly non-bank lends with minimum ICRs of 1.15 times are unlikely to work at scale and even if they do there is likely a cheaper bank loan available. But lower ICR covenants may be possible if accompanied by structural enhancements such as distribution stoppers or pre-funded interest reserves.

The upshot of all of this is that equity valuations will likely need to come down. We all know this. The vast bulk of the market cannot be sustainably financed on existing capital structures at the current level of interest rates. But domestically we do not see a catalyst that will force a sharp revaluation across the market - as sales start to emerge through 2023 then valuations will start to adjust. This is not the not the case in the United States where the regional banking sector, a significant lender to US commercial real estate, is experiencing a meaningful tightening in financial conditions. The extend and pretend option is far less available as an option as regional banks clearly need to reduce the size of their portfolios. Nor is it available to the CMBS market which needs to be refinanced.

Looking forward, we expect defaults to be heavily weighted towards deals originated during the low interest rates of 2021 and 2022 which will come due in the next couple of years. Not all the defaults will occur in the next couple of years; lenders and borrowers will extend for as long as they can see a path to recovery but the seeds for the losses have already been sown. New deals completed today will reflect the new reality of interest serviceability which at least in part will result in lower loan to value ratios and lower risk and a much improved risk return outcome. The next couple of years could well prove to be the best CRE lending opportunities since the post-GFC period.

Author: Pete Robinson Head of Investment Strategy - Fixed Income

Funds operated by this manager:

Challenger IM Credit Income Fund, Challenger IM Multi-Sector Private Lending Fund