Hedge Clippings | 08 November 2024

It's been a big week for markets, central banks, mainly due of course to the clear-cut US election result, which seemed to surprise everyone it seems, except Trump and his die-hard supporters. While we know there's never a dull moment, this week might take the cake--or at least a sizable slice of it.

Trump's Victory: What It Means for Australia

Well, it's official. While Donald Trump won't actually be back in the White House until January, the ripples are being felt globally. As expected, the initial market reaction was a mix of higher US Treasury yields, a stronger dollar, and a predictably unpredictable response from equities. For Australia, the implications are numerous and, unfortunately, somewhat clouded by uncertainty. There's been plenty of chatter, not least from our friends at the RBA, on what a Trump presidency could mean for us.

What does this mean for investors here? Perhaps the biggest takeaway is uncertainty. Tariffs could impact Australian exports indirectly via China, US policy changes might affect currency markets, and there's a general sense that volatility could remain a dominant theme for a while yet. Shane Oliver at AMP summed it up neatly: Trump's policies may give a short-term productivity boost in the US, but at the risk of stoking inflation and leading to a global flow-on effect. Expect more of the same - and a nervous RBA.

Cash Rates: RBA Holds Steady as the Fed eases 0.25%.

If all the election noise wasn't enough, this week also saw major central bank decisions on both sides of the Pacific. The RBA held its cash rate at 4.35%, as most expected, while the US Fed opted to lower its rate by 0.25 basis points--a more dovish move aimed at balancing a "generally eased" labour market and still-high inflation.

RBA Governor Michele Bullock, speaking at the Senate budget estimates, noted that there's plenty of speculation, but no one really knows for sure. The combination of potentially higher tariffs, larger budget deficits, and fiscal changes in the US could lead to higher global interest rates and, ultimately, increased inflationary pressures here at home. If that sounds familiar, it's because we've seen this movie before--last time Trump was in office, his tariffs hit global trade and pushed costs up across the board. The RBA is right to be cautious.

The RBA Governor was clear that, while she acknowledged inflation has eased, the RBA is not ready to take its foot off the brake just yet. The message remains consistent: inflation is still the main game, and the RBA wants to see clearer signs of it being under control before even contemplating rate cuts. Bullock was equally clear in her warning to Albanese and Treasurer Chalmers - higher government spending, and further pre-election cash-splash promises, are inflationary.

So, what's the upshot for Australia? In the immediate term, not much--but with the US easing and Australia staying put, we could see increased pressure on the Aussie dollar. And with markets now contemplating the chances of no RBA cut until mid-2025, the gap between US and Australian rates could widen further. But then again, if there's one thing we know for sure, it's that predictions can easily be thrown out the window--particularly when Trump's involved.

No Time to Be Predictably Predictable

As always, uncertainty is the only certainty. We've got an unpredictable US President, an RBA sticking to its inflation-first mantra, and markets that are trying to make sense of it all. For investors this is a time to stay vigilant, diversify where possible, and, as always, keep one eye firmly on the bigger picture. The RBA might be on hold, but the world around us certainly isn't.

Until then, keep your powder dry--and perhaps a glass of pinot handy. We'll all need it.

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Artificial Intelligence will change the world (eventually)

Alphinity Investment Management 

October 2024

"The risk of underinvesting is dramatically greater than the risk of overinvesting" (Sundar Pichai, Alphabet CEO, 23rd July 2024).

This quote from the Alphabet CEO during the Alphabet 2Q earnings call amplified investor concerns around the current Artificial Intelligence ("AI") investment landscape. The technology industry appears to be engaged in a high-stakes race to develop AI infrastructure, while the potential returns on these massive investments remain ambiguous.

Given the substantial market share and valuation premiums now commanded by AI-focused companies, there's mounting pressure for these firms to demonstrate tangible returns on their AI investments. Investors are increasingly looking for concrete evidence that the massive capital inflows into AI infrastructure and development will translate into sustainable revenue streams and long-term profitability.

Despite market impatience, we are observing encouraging signs of AI's impact starting to emerge from both the revenue and expense sides of businesses. Substantial returns will however take time to materialise. Given the current market dynamics, we remain nimble with our AI exposure in the short term, but unequivocally convinced on the longevity and scale of the AI opportunity over the long term.

Where are the returns?

Market concerns around overinvesting in AI are not without precedent given the technology sector's history of several technology boom-and-bust cycles: From the 1990's internet era exuberance leading to the dot.com crash, to the recent hype around the metaverse (virtual worlds), Web 3 (decentralised internet vision), and even non-fungible tokens (NFT's). These examples serve as cautionary tales, illustrating how technology hype can outpace real-world applications, leaving a trail of poor returns and crushed share prices in their wake.

Current investment levels into AI architecture are extraordinary. Hyperscaler (Microsoft (NASDAQ: MSFT), META (NASDAQ: META), Alphabet (NASDAQ: GOOGL) & Amazon (NASDAQ: AMZN)) capex will rise more than 40% in CY24 and is expected to rise further in CY25 to levels 2.5x what they were in CY20. This level of investment is starting to have an impact on financial returns for these companies, both in terms of cash flow returns and on margins as higher depreciation flowing from this investment begins to bite in the P&L.

Hyperscaler Capex ($bn)

Returns take time to materialise

In any major technological transition - be it internet, cloud computing, or the current wave of generative AI, there is a consistent pattern: infrastructure development precedes widespread application and the realisation of value. The internet evolution provides a compelling case study, where the true value from end applications and the resultant share price movements only started to emerge after 3 years and really gathered momentum after 5 years.

Internet Cycle Stock Performance

We can see a similar phenomenon play out with generative AI. Cloud AI services are beginning to inflect, as evidenced by recent results showing a reacceleration in cloud demand but several cutting-edge AI applications such as Edge AI, Smart Robots and Multi-Agent Systems are still in development and yet to reach widespread commercial deployment.

Where are the end applications?

Contrary to the notion that end applications of AI are not yet visible, we're witnessing a robust proliferation of AI-powered solutions across various sectors already emerging just ~20 months after the emergence of GEN AI.

While these applications are in their initial phases and will take time to scale, their market potential is substantial. Take for example the M365 co-pilot example: a US$30 subscription fee per month across their 160m high value commercial users, could add $58bn revenue annually (a +23% lift to FY24 revenue). Expansion to the remaining 200m commercial users and integration into broader product offerings offer additional upside.

Returns from "efficiencies"

The impact of generative AI on business efficiency and productivity is emerging as a transformative force, with potential returns far exceeding initial revenue gains. This trend, while significant, remains underappreciated due to public concerns about AI-driven job displacement. However, real-world applications are already demonstrating substantial benefits across diverse industries. Companies are implementing AI with measurable success. For example:

• Uber (NASDAQ: UBER) is using gen AI to enhance customer service and marketing efforts;
• Mercado Libre (NASDAQ: MELI) is optimising capacity planning and fulfillment operations;
• Wipro (NASDAQ: WIT) is using it to boost software development through code assistance & documentation;
• Best Buy (NASDAQ: BBY) is deploying AI-powered trouble-shooting assistants.

Importantly, companies are beginning to qualify these benefits well beyond the bounds of tech:

• Walmart's (NASDAQ: WMT) quantified generative AI's contribution to catalogue creation in their recent results call with the CEO stating that: "without the use of generative AI, the work would have required nearly 100 times the current head count to achieve what we did using generative AI"
• Pfizer (NASDAQ: PFE) is leveraging AI as a key component in a $4bn operating expense reduction initiative;
• American Express (NASDAQ: AXP) is realising a 30% higher response rate on corporate offers through AI assistance; and
• L'Oreal reported a 10-15% boost in advertising productivity, by spotting trends (using "Trendspotter") early and marketing to online shoppers.

The list goes on. The adoption of generative AI is rapidly expanding, with companies across various sectors reporting emerging and expanding use cases.

How to quantify these returns

Quantifying the actual returns from generative AI can be a difficult exercise. For example, disaggregating how much of the Meta revenue acceleration comes from product enhancement due to Gen AI is complex, as is product augmentations flowing from its application to existing capabilities.

Stepping back to a broader economic perspective, McKinsey undertook a study trying to piece together the incremental value that generative AI could bring. The total value was $6.1tr - $7.9tr annually across specific generative AI use cases and general productivity.

Taking specific use cases, McKinsey's comprehensive analysis of generative AI applications provides a detailed roadmap of its potential impact across various business functions. McKinsey identified activities within business functions where generative AI could be applied and then calculated both the efficiency impact (as a % of functional spend) and the aggregate size of the opportunity. Remarkably, 75% of the generative AI impact was across a handful of functions spanning sales, marketing, product R&D, customer operations and software engineering, estimated to be a c$400-500bn impact across each function.

Interestingly, we are beginning to get validation of some of these data points in our conversations with company management teams, for example in software engineering the efficiency/cost boost figure of c. 30% is now being discussed. Looking ahead, we will continue to monitor validation points of this return profile, but if this current trajectory of efficiency gains persists across various business functions, it suggests that the substantial investments in AI infrastructure are likely to be more than justified.

Funds operated by this manager:

Alphinity Australian Share Fund, Alphinity Concentrated Australian Share Fund, Alphinity Global Equity Fund, Alphinity Global Sustainable Equity Fund, Alphinity Sustainable Share Fund

Debunking a myth about fossil fuels

and sustainable fixed interest

Pendal

October 2024

Exclusion of fossil fuels presents minimal challenges for sustainable bonds compared to other asset classes, writes Pendal head of credit and sustainable strategies, GEORGE BISHAY

SUSTAINABLE funds typically screen out industries such as fossil fuels, tobacco, weapons, alcohol, gaming, pornography and uranium mining.

This is generally with a revenue threshold, where companies with a certain level of revenue linked to a particular activity are screened out.  

Different asset classes have different potential exposures to fossil fuels.

Fossil fuel companies typically make up a large part of equities indices (about 15 per cent of the ASX 300 in July 2024).

By contrast, issuers involved in fossil fuel extraction, exploration or refining are a small component of the Australian fixed-income benchmark.

Chart 1 below shows these issuers make up only about 0.1 per cent of the Australian fixed income benchmark, according to the rules applied to Pendal Sustainable Australian Fixed Interest Fund (see Chart 1 footnote below).

However, there can be variations in the exclusions of different funds.

For example, in Australian equities a fund's revenue threshold can dictate whether a company such as BHP (at about 9% weight in the ASX300 index) is included or not.

BHP's revenue includes coal mining. Other iron ore miners such as Fortescue Metals and Rio Tinto are not typically excluded.

Notwithstanding these variations in exclusions, active performance in the average sustainable equity fund is influenced by changes in oil prices.  

As a result of these differing levels of benchmark exposure, sustainable fixed-income portfolios in Australia are less sensitive to the movements in oil prices than equity counterparts.  

What drives the active performance of Pendal Sustainable Fixed Interest Fund?

Active credit management is the main driver of excess returns in Pendal Sustainable Australian Fixed Interest Fund.

The green circles in the chart below highlight periods when the manager's active de-risking and re-risking of its credit exposures process led to strong outperformance.  

These returns are driven by active management and are delivered despite rising oil markets.

The black circle highlights a period of rising inflation concerns due to Covid supply chain issues driving goods inflation and central bank hiking fears.

This led to a risk-off event in credit markets which saw most active fixed-income funds underperform the benchmark. 

Given the volatility of oil markets, Pendal Sustainable Australian Fixed Interest Fund has delivered consistent returns, outperforming its benchmark in 75%¹ of months since inception to July 2024.   

The chart below illustrates the number of excess return months under different buckets of excess returns.

Social and environmental benefit + portfolio diversification benefit

Many sustainable fixed-income investors are attracted to ESG-labelled bonds which aim to address green, social and sustainability issues.

The proceeds of these bonds are usually ring-fenced for specific environmental or social projects to support climate stability and/or the underserved in society.

The Australian ESG labelled fixed-income market was valued at some $A124 billion in August 2024, constituting 7.6% of the total Australian fixed-income benchmark.

The ESG-labelled bond market offers sustainable Australian fixed interest managers exposure to an additional opportunity set beyond traditional fixed income - environmental and social projects across varying sectors, credit qualities and tenors.

These labelled bonds can complement an overall fixed-income portfolio, bringing added diversification benefits.

The credit spread on these bonds may not directly follow the credit spread on an equivalent vanilla bond issued by the same issuer. This arises from the different technical supply and demand factors affecting these types of bonds.

These bonds are desirable and often in greater demand than vanilla counterpart bonds.

The Australian fixed interest market has ESG labelled bonds in 13 of its 14 sub-sectors (transport is the only missing sector), providing investors with the ability to diversify across numerous sectors.

In August 2024, the Pendal Sustainable Australian Fixed Interest fund held more than 66% in ESG-labelled securities.

Sustainable fixed income as part of your core fixed income allocation

Unlike sustainable equities, which may underperform during periods of rising oil prices, Australian sustainable fixed-income exhibits minimal sensitivity to oil markets or any other screened activities.

This differentiation allows investors to integrate sustainable fixed income into their overall core fixed interest allocation with minimal additional benchmark risk.   

By incorporating Australian sustainable fixed income alongside other traditional assets, investors can achieve a robust portfolio while also supporting climate stability and/or the underserved in society.

Author: George Bishay

Funds operated by this manager:

¹ Pendal Sustainable Australian Fixed Interest outperformed the Bloomberg AusBond Composite 0+yr in 72 of 96 months from inception (Aug-16) to July 2024, gross of fees.  

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

Anticipating the Future of Luxury

Insync Fund Managers

October 2024

Investing is more than data; it requires anticipating future trends. This is why relying on past performance is often risky. Generational shifts, rising geopolitical tensions, and evolving consumer behaviours demand excellence in trend spotting.

Luxury goods, where China's rising affluent class is undergoing significant changes in spending preferences is  a case in point. Whilst luxury has historically been a secular growth story, we believe that more nuanced factors are at play, making active stock picking essential.

China's economic challenges have slowed luxury market growth. A notable shift is the rise of "quiet luxury"-- discreet, minimalist products reflecting a reluctance to display wealth. A recent survey revealed that 24.8% of Chinese consumers find Western brands less desirable, with younger generations increasingly favouring niche, culturally aligned local brands. Their younger demographic is now prioritizing experiences over luxury goods. Spending on travel, concerts, and cultural events are taking precedence. Whilst Luxury's long-term growth is supported by global affluence, future affluent consumer's evolving preferences make investing here more complex. China accounts for 23% of global luxury sales today, and 30%-40% of sales by 2030, so understanding their mindset is crucial in identifying the winners.

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.

Quarterly State of Trend report - Q3 2024

East Coast Capital Management

October 2024

Funds operated by this manager:

ECCM Systematic Trend Fund

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Hedge Clippings | 01 November 2024

The RBA finds itself in a bind yet again. Inflation has eased somewhat, with the September quarter number just 0.2%, or 2.8% annually, down from 3.8% in the June quarter, and taking it to a 3.5-year low. However, it's still running hot enough to make the RBA think twice about cutting rates. When the cash rate decision is announced next week, most experts are expecting rates to stay steady, much to the dismay of borrowers hoping for a bit of early festive cheer, and the Treasurer Jim Chalmers, desperate to claim the credit and hopefully another three years in office come election time next year.

The RBA won't be fooled either by the overall number, or Jim Chalmers desire to claim "mission accomplished" George Bush style. Prices for most goods and services rose, offset by large falls for electricity and fuel. The trimmed mean number, which excludes both, was still 3.5%, albeit below June's 4.0 percent. Only government spending is keeping the economy in positive territory, and it's only government handouts that are seriously impacting inflation - for the present. Despite the overall figure, prices of essential items like rent, childcare, and insurance have kept upward pressure on households, with many services demonstrating a particularly stubborn streak.

The RBA wants to keep inflation under control without being seen as stifling economic growth, but it's no easy feat. With inflation hovering in a state of "not dead yet," the central bank is likely to maintain its cautious approach. The possibility of a rate cut before year-end remains slim, and if that's the case, borrowers, and the Treasurer, will have to wait until February for any hope of a reprieve.

Meanwhile if you hadn't noticed, the United States is gearing up for Election Day next week, with seemingly the rest of the world mesmerised by the spectacle, confused by the process, and concerned about the outcome. From where we sit, it's been a bizarre lead up, with Biden slipping up (literally) and then stepping down, Trump as popular as ever among the MAGA set, in spite of - or maybe because of - multiple indiscretions and crass behaviour or reminiscences from the golf club locker room.

We have no idea based on the dead heat polls, but suggest voter turnout is expected to be the key factor when the dust settles (assuming it does). Historically, US voter turnout has fluctuated between just over 50% and 62.8% over the past six presidential elections. However it is unlikely to be the overall voter turnout that will determine the result: Most states are already won or lost, thanks to the winner take all approach by every state except Maine and Nebraska, leaving the result hinged on a handful of votes in the battleground or swing states. But given the personalities and issues at play, it's not the overall turnout that will determine the result.

How big a part will Roe vs. Wade play? Or the situation in Gaza, Lebanon, and Israel? And even more recently, to what extent might the Hispanic turnout sway the result?

For financial markets and global stability, the stakes are high, and the outcome will not only determine the next leader but also affect the ability to govern effectively, given the divided state of US politics. Questions surrounding inflation, federal debt, and the broader economic outlook have only added to the uncertainty. Yet amazingly, the result may come down to some little known, so-called comedian's off joke.

Closer to home, in political news, Prime Minister Anthony Albanese has been hitting some turbulence (apologies for the pun) following claims that he sought free upgrades from Qantas. The story, which began with whispers, has escalated to full-blown denials, with frontbenchers clarifying that Albanese did not make any requests by phone, email, or any other means of communication. The whole affair has probably been blown out of all proportion - of course airlines upgrade politicians, and Qantas made an art form of it to curry political favour. The issue is not the upgrades or perks that are handed out - it is what influence is sought or exerted in return. In this case, what input did Albo or Albo's office have on the government's decision to block Qatar Airways application for an additional 28 flights a week into major Australian airports?

A decision that massively benefited Qantas' traffic, passenger loads, market dominance and profitability, at the expense of the Australian traveling public.

Alan Joyce's greed and arrogance eventually cost both he and his chairman their jobs. Might it also claim his old mate Albo's come election time?

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Australian Secure Capital Fund - Market Update

Australian Secure Capital Fund

October 2024

Funds operated by this manager:

ASCF High Yield Fund, ASCF Premium Capital Fund, ASCF Select Income Fund