Solving the macro puzzle
Global Investment Insights
by Rob Tucker, Managing Director & Portfolio Manager, Chester Asset Management
The chief operating officer (COO) of our house recently decided that it would be a worthwhile father-daughter bonding session to enter a puzzling competition with our keenest puzzler. Remnants of the COVID era.
Little did the COO know (or let on) that we had been entered into the VJPA (The Victorian Jigsaw Puzzlers Association) annual competition. 120 pairs, all ages.
The sense of humour started failing as we were informed that this was a three-hour competition, not one-hour, as promised by the COO.
The VJPA rankings were determined by, first, the speed of completion, and failing that, the number of puzzle pieces (500 piece) that were completed at the end of the allotted time. All information we were learning in real time.
The first inkling we were in trouble, was when the winners were announced 45 minutes into the competition, before we had completed the bottom row (less than 50 pieces).
As more and more participants finished the puzzle, it became clear that this father-daughter combination were out of their depth.
Unfortunately our team recorded a DNF, we resigned our VJPA membership effective immediately and our puzzling career was over.
It wasn’t fun while it lasted.
Defining the pieces of the macro puzzle
We view all the pieces of the macro environment as a jigsaw puzzle. The intersection of inflation, interest rates, currencies, commodity prices, government deficits and, most importantly, monetary and fiscal policy.
Without question, the desire of central banks in the first half of 2022 has been to (belatedly) focus on fighting inflation. Jay Powell (Fed Chair) even admitted that risking recession was necessary in bringing inflation under control.
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We are in the middle of a co-ordinated Western world economic slowdown, to effectively crush the demand side of the inflationary debate.
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Price stability is key. The USD is driving much of the macro forces currently given the relative weakness in Europe. So we are in the middle of a co-ordinated Western world economic slowdown, to effectively crush the demand side of the inflationary debate. Realistically though, it has been the supply side (supply chain constraints, energy and food supply) that has been the major driver of the inflationary pressure.
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Supply side (supply chain constraints, energy and food supply) has been the major driver of inflationary pressure.
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This is a difficult puzzle, but maybe the commodity complex rolling over solves a piece of it?
Equity markets try to discount 6-12 months into the future. Considering the first half of 2022, it suggests a period of economic weakness ahead.
Historically, business cycles have tended to last 18 months or so. In today’s information driven age, where real time data is disseminated quickly, business cycles are shortening, lasting 9-12 months perhaps. This shows up in confidence indicators, capex intentions, forward orders and hiring intentions. The most relevant of leading indicators is purely M2 (or money supply), which at the end of 2020, had risen 25% or so year-over-year, and is now decelerating sharply. Combined with broad commodity price weakness, the economic landscape is changing rapidly.
The Fed (and to a lesser extent, the RBA) tend to focus on a dual mandate, inflation and unemployment. Both remain very strong, which suggests that the hawkish interest rate environment will likely continue for the foreseeable future.
Lead and lag indicators to monitor
Only when we see signs of inflation peaking and unemployment rising will we see a change in language from central banks. The problem with both inflation and unemployment is that they are both lagging indicators. Leading indicators (confidence, freight rates, new orders, inventory levels, hiring etc) are suggesting a far weaker outlook than the lagging indicators.
To that end, commodity prices themselves (led by copper) are also signaling economic weakness ahead. Thus, the bond market is taking instructions from the real time economic indicators, while the equity market is still grappling with the inevitable earnings revisions downwards over the coming months.
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Bond market is taking instructions from the real time economic indicators, while the equity market is still grappling with the inevitable earnings revisions downwards over the coming months.
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There are simply too many companies that face rising cost pressures, without the ability to pass on these costs, as demand is weakening.
These earnings revisions will create somewhat of a minefield through the July/August reporting season, and hence the key attribute we are looking for currently is earnings resilience. There will be some wonderful buying opportunities ahead.
So what could go right?
The market is heavily focused on earnings resilience (as are we), in light of significant cost pressure being felt by every business. We are also very mindful of higher discount rates being reflected in falling share prices.
In this context, significant economic weakness will be seen as good news for equities, as the prospect of the interest rate tightening cycle would appear to be peaking. In fact, the forward interest rate curve is starting to price in interest rate cuts in 2023, such is the changing economic landscape.
We have long been of the view that central banks (particularly the US Fed), cannot afford materially higher interest rates, given the amount of public debt held by central banks themselves. We go through this maths again inside, and you can read our full analysis here.
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Central banks (particularly the US Fed), cannot afford materially higher interest rates, given the amount of public debt held by central banks themselves.
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There has been the notion of the Fed put for the past 20 years, whereby the Fed runs to a 3rd mandate, which is equity market strength. This appears to be off the table for the time being, but should the S&P500 fall another 15% (thus down 35% from its peak), the notion of the Fed put may well be back on the table, with the most likely approach being yield curve control (YCC).
Forgotten in much of the current financial commentary is the ongoing Russian occupation of Ukraine and how disruptive this has been to energy markets and food supply. Whilst a long way from a base case, the prospect of a peace deal being brokered and oil falling significantly, in short order, should not be ruled out. As we approach a European autumn, the humanitarian crisis of heating and food will become critical for much of Western Europe (Germany), hence we would ascribe a probability to a peace deal being brokered in the next 3-4 months, as higher than zero. Markets would rally significantly.
Our philosophy with the Chester High Conviction strategy (distributed by Copia) remains to protect and then grow (what we hope to be) generational wealth. Protecting capital means a rigorous focus on asymmetric investing. What is the downside vs what is the upside of an initial investment?
We remain heavily focused on owning a portfolio of stocks that remain compelling on a bottom up cash flow basis, and by no means do we want to be overpaying for those cash flows.
We think the backdrop is favourable for finding unloved and underappreciated assets, where the risk/reward trade off is far more compelling.
This focus on fundamental investment drivers holds our philosophy in good stead over the next 2-3 years, as the significant dispersion in valuations unwinds. We still have a significant number of stocks in the fund that fall into the category of unloved, underappreciated or undiscovered. Equally as important is our portfolio construction framework, which has remained consistent for over 8 years and has ensured a diverse exposure to non-correlated sectors.
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Significant economic weakness will be seen as good news for equities.
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Rob Tucker, Managing Director & Portfolio Manager, Chester Asset Management
Rob founded Chester Asset Management in 2017. Prior to Chester, Rob spent 7 years at SG Hiscock and was most recently the portfolio manager of the SGH Australia Plus product, a 25-40 stock Australian Equity portfolio with a mid cap bias, that was run in the same manner as the Chester High Conviction Fund. Rob was also the Co-Portfolio Manager for the SGH20 unit trust and key mandates from 2010 until November 2014 when he became the primary portfolio manager from November 2014 until his departure. Responsibilities included: portfolio construction and management, stock selection, macroeconomic analysis, research and marketing.
Prior to joining SG Hiscock in 2010 Rob was Investment Director for Halbis Capital Management (formerly HSBC Asset Management) where he worked for 9 years as Portfolio Manager of the Australian Country Fund (2005-2010), Head of Research for Asia Pacific (2005-2007), and Portfolio Manager of the Asian Freestyle Fund (2008-2009). 5 of these years (2005-2010) were based in Hong Kong where he managed a large pool of money for a wide array of institutional clients. During his 5 years running the HSBC Australian Country Fund, the Fund delivered 4.3% outperformance per annum.
Between 2001 and 2005 as well as Co Managing the Australian Active Fund from 2003 – 2005, Rob was also Australian Equities Analyst across: Healthcare, Building Materials, Energy, Transport, Media, Retail, Food and Beverages sectors. Rob also previously spent time as an Analyst at Merrill Lynch.
Disclaimer
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