4D podcast: interest rates, inflation and infrastructure

4D Infrastructure

August 2022

Funds operated by this manager:

The content contained in this article represents the opinions of the authors. The authors may hold either long or short positions in securities of various companies discussed in the article. This commentary in no way constitutes a solicitation of business or investment advice. It is intended solely as an avenue for the authors to express their personal views on investing and for the entertainment of the reader.

Is the sky really falling in?

Insync Fund Managers

July 2022

A different message for the year's mid-point...

Each month we show how we invest practically by focusing on a Megatrend, then one or two stock examples in support. Given we are halfway through the year and with so much negativity about after the last 5 months of stock price volatility, we thought a closer look at these negatives is warranted.
 
We will assume you are already well versed with 'the sky is falling in' commentary and opinion from elsewhere. All good decisions however come from looking at both sides.

Negativity Bias: We notice the bad far more than the good. It's why commentators lead with bad news. It gets our attention.

Cognitive Bias: We're more aware of, and seek out, information supporting our view or assessment, even if we can't point to why we have that view. As an extension, we often then block or discount information to the contrary.

Time bias: The immediate and near term has a greater weighting in how we respond than further out; even if it is counterproductive to achieving what we are seeking.

Straight Line Bias: We assume most lines and trends will continue as they are now, unabated. For example, today's inflation rate combined with negative headlines is interpreted as inflation will keep increasing.
Fear Bias: We tend to emphasise and process negative information ahead of positive information. So much so that positive news is often received with cynicism or suspicion. Fear beats positivity every time.

Inflation, recession, high interest rates.......

Commentators have espoused many things in the last 5 months, the general message swinging between ongoing crippling inflation, high interest rates, and recession. We have noticed 5 common assertions they often use, and for our investors benefit we felt it worthwhile examining each one carefully. What we discovered may surprise you, and so, remember those 5 genetic biases.

The inference is that investing in growth assets will be a risky decision and thus growth managers will face hard times. As a Quality Style manager, we are not convinced of these inferences, as what we found suggests otherwise. The details behind our reasoning can be found in our recent White Paper on this subject (on our website).

Common Assertion 1: Carbon prices will continue to rise.

• Supplies globally can easily meet demand (the potential temporary exception of gas to Europe accepted). OPEC sees oil and gas price pressures as 'transient', and not worth the expense or risk of lifting output creating oversupply.
• Net Carbon Demand continues to drop as Oil Intensity in our economies also falls (has been for the last 15 years).
• The Russian war will end, with bad news outcomes mostly factored into its price already.
• Longer term, carbon demand growth overall will be offset by green energy, emerging energy storage solutions and shrinking populations in developed nations.
• Scant evidence supports a sustained price rise above the present US $100-$120/ barrel trading range, especially as the US reopens shale extraction.

 
Given this, prices are not likely to either significantly increase or decrease. As carbon energy is the PRIMARY driver of key inflationary factors, should it trade around where it is now, it will fail to drive inflation further.

The red line in the graph shows the general basket of major commodities. They too are falling and earlier than carbon energy has. Indeed, this might not only point to a fall in inflation but to the prospects of a recession. We will address that further on.

Common Assertion 2: Global shipping supply chains are crippled and expensive.

The problem with this is that shipping capacity and efficiency is rapidly improving and prices are falling. These facts and more below.

• Next 2 years the equivalent of an additional 25% of all TEUs (6 Mn+ 20ft containers) shipping capacity in the world today will enter the water.
• Those ships are bigger and more efficient. They consume less fuel per TEU, with a very large proportion of new ships over a whopping 14,000 TEUs in size. (the largest carries 21,000 containers)
• Bottle necks are evaporating as a vaccine driven Covid BAU takes hold.
• Container costs have averaged under $2k/TEU for over a decade - Covid increased this temporarily to $10k/TEU at its peak last October.
• It's now already falling DESPITE high fuel costs.

Covid is an event based disruption- not permanent. Life resumes, blockages unblock. This is already occurring.

Common assertion 3: Reshoring back to the West means higher prices

A UBS survey of American CEOs had 90%+ intending to move production away from China. Already 6 massive multibillion dollar chip manufacturing plants are already underway in Texas and Arizona. It comes down to what's being re-shored. Goods being re-shored are mainly higher value/complex goods (e.g. technology intensive). Let's look at some further current facts:
 

• Multiple US tariff wars, Covid, Taiwan, Hong Kong, and now Russia - CEOs are adjusting their risk/reward calculations en masse. (There's been exponential increases in both the number of corporations both acting and planning moves).
• Re-shored goods by in large face lower transportation costs and delays, and less logistical complexity.
• Higher technology inputs utilising higher skilled labour means wage price differentials are less than previously assumed in financial models.
•  White goods are already being made in the US at prices as if they were made in China (Ironically in one example Haier from China is the plant owner)
• Automation of new plants is reducing manufacturing- based wage pressures.
• No one is yet certain how much will return to major consumption centres (beyond strategic goods such as chip manufacturing and rare-earth mining) but indications are clear that it's a significant amount.

 
There are emerging spin-off benefits, not previously factored in, that offset nearshoring or reshoring costs; for example massive construction activity for rehousing all this manufacturing, along with the support industries providing the new equipment for them. US facility construction soared 116% in the last year, dwarfing the 10% gain on all other construction combined.
 
This move may will assist western economies increased resilience to geo-political events of the future (meaning more stable prices and supply).
 
Common assertion 4: The US economy is faltering, and now from the Russian war, the EU is too.

There are several arguments entwined in this, and so we shall try to be brief, knowing we have a fuller answer contained in our White Paper.

That red circle in the graph shows a critical historical disparity. The market has overshot the negative and is out of kilter with the 300 odd critical US businesses purchasing managers that this reliable benchmark survey covers. Investors are already expecting the US economy to contract, yet importantly not to the extent that it did during the pandemic, the GFC or the 2000 recession.

Despite all the news headlines, US hourly wage growth is exceeding the inflation of goods and services (ex food and energy). Real wages are growing at (a moderate) 1.7% pace, maintaining a healthy demand for labour and not too much of a concern for the Federal Reserve. Given the low labour participation rate, there is little chance that we see wages driving inflation. This is what would concern the Federal Reserve, as unit labour cost growth is the real source of endemic inflation.
 

Until the Russian war ends the EU is in for a bumpy ride- short term no doubt, but there will be positive surprises as is already evident.

Common assertion 5: Ever increasing interest rates.

Bond markets basically set the future of interest rates and particularly in the US. So, let's take a closer look at what they are telling us. Their expectations after allowing for inflation, energy and commodities prices, geopolitics etc. says the next 5 years will top at 2.55% and the 5yr-10yr expectation at 2.14%.

Let's say that again... 2.55% and 2.14%.

From this we can gauge the expectations for 10 years which currently stands at 2.35%.

Clearly interest rate rise expectations, are actually rapidly declining. This has implications for how much more the Federal Reserve is likely to tighten. Whilst there is sound basis to argue that the Fed Fund Rate is too low, it is unlikely to be lifted more than 3.5% due to the combined effect of slowing GDP growth and peaking shorter term inflationary expectations. Long term inflation averages a little over 3%, yet in the last 10 or so years, we got used to a once in a lifetime decade of ultra- low rates. Life, markets, consumers and companies adjust. This level of inflation is not bad for growth assets.

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.

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Four in five advisers have consulted clients about 

inflation in the last six months

abrdn

July 2022

Funds operated by this manager:

Aberdeen Standard Actively Hedged International Equities Fund, Aberdeen Standard Asian Opportunities Fund, Aberdeen Standard Australian Small Companies Fund, Aberdeen Standard Emerging Opportunities Fund, Aberdeen Standard Ex-20 Australian Equities Fund (Class A), Aberdeen Standard Focused Sustainable Australian Equity Fund, Aberdeen Standard Fully Hedged International Equities Fund, Aberdeen Standard Global Absolute Return Strategies Fund, Aberdeen Standard Global Corporate Bond Fund, Aberdeen Standard International Equity Fund , Aberdeen Standard Life Absolute Return Global Bond Strategies Fund, Aberdeen Standard Multi Asset Real Return Fund, Aberdeen Standard Multi-Asset Income Fund

Methodology

Survey of 424 UK-based adult financial advisers, conducted by Censuswide on behalf of abrdn in May 2022.

Notes to Editors

At abrdn, our purpose is to enable our clients to be better investors.

abrdn plc manages and administers £542 billion of assets for clients, and has over 1 million shareholders. (Figures as at 31 December 2021)

Our business is structured around three vectors - Investments, Adviser and Personal - focused on the changing needs of our clients.

For UK wealth managers and financial advisers, we provide technology, expertise and support to make it easy for them to run their businesses - and to deliver the outcomes their clients want.

We offer content and experiences that can be personalised to suit every type of business and client, giving advisers powerful data and insight to make better decisions.

We're the number one adviser platform business in the UK for assets under administration and gross flows (Adviser AUA: £76 billion as at 31 December 2021).

We're also the first UK adviser platform provider to receive and retain an 'A' rating from AKG for the financial strength of our platforms (AKG financial strength reports 2021).

Hedge Clippings | Friday, 12 August 2022

Following last week's rate increase of 0.5% by the RBA, and the inevitable flow-on from the big banks, various sections of the media made a song and dance about how much higher mortgage rates are likely to go, and how much stress that's going to put on homeowners, and thus push the economy into a recession. This week therefore, it is worth taking notice of comments by the CEO's of the CBA and ANZ, both of whom are more optimistic than the economic doomsayers. Given that between the two of them they have their fingers on the pulse, or at least the numbers of the bank statements of half the population, they should know.

ANZ's Shane Elliott thinks an Australian recession is "extraordinarily unlikely", while Matt Comyn doesn't believe there will be widespread mortgage defaults within CBA's home loan book.

Given the sensitivity to any interest rate increases from the record lows of the past few years, the facts would appear to support Comyn's view that the RBA will only need to raise official rates twice more, once by 0.50%, and a final 0.25% before Christmas. 40% of CBA's mortgage customers have fixed loans, and most won't be affected for another 18 months. Added to this almost 80% of CBA's borrowers are ahead with their payments, and around one third are two years ahead. Finally, the CBA, along with other banks, have been tightening mortgage eligibility for a while in anticipation of higher rates.

As we see it, the biggest risk for homeowners is that property prices fall significantly (say more than 20%), whereupon banks, who have a habit of wanting an equity top up from their stretched borrowers, demand just that. Hopefully this time around prices won't fall that far, or if they do, banks will hold their nerve.

Meanwhile, the above scenario (official rates to be limited to 2.75% or say 3% as a maximum) relies on inflation peaking and therefore falling into the RBA's "transient" category. It's well accepted that to date, rather than being wages driven, much of the inflationary pressure is either climate based (fresh fruit and veg for example), caused by supply chain disruption, and/or energy prices, thanks to the war in Ukraine.  As noted last week, there's probably a number of opportunistic price rises by some businesses being slipped in there as well.

As a result, Australian equity markets have continued to rally after their EOFY sell off, which particularly hit last year's winning peer group of small and mid cap managers, and their funds, which judging by the results below rebounded strongly. Even cryptocurrencies have stabilised, which has seen Bitcoin back above $24,000 from below $19,000 in early June. Equity markets seem to have ignored the war in Ukraine, as they did with this week's ramping up of action, and rhetoric, by the Chinese leadership over Pelosi's visit to Taiwan.

Coupled with the effects of climate change in Europe, which is threatening further supply chain disruption as the Rhine and Danube rivers become un-navigable in places, macro issues such as the threat of an all out war between China and the US (and allies) would put everything more in perspective.  Except that the markets, by and large, seem to be ignoring the storm clouds.

At their peril.

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