Report Card

Our key messages from our last update were around a 1994/95 scenario when interest rates were 6% in the US and inflation was 3% and that saw economists fearful of a mild recession that never came. What unfolded as clocks rolled from 1994 to 1995 was a strong outperformance in equity, property and infrastructure markets. While it is not consensus, our view is that this could happen again as we move from 2022 to 2023. We liken much of the economic analysis dominating headlines to people who have been trained to use a hammer to fix physical problems… they tend to see nails everywhere! 

In taking a non-consensus view, we should note (and will talk in more detail) about the keys and risks to this view. The first key to our thesis is that the job market continues to cool, but not crash and that supply and demand for labour return to trend. Politics could play a role here as could any over-aggressive policy movements impacting the supply of credit (and follow-on impact to housing prices). The second relates not to interest rates (of which the path is reasonably well understood) but of the size of central bank balance sheets particularly the US Federal Reserve (the FED).  The FED is reducing the size of its balance sheet, but any signal around the rate of change here that is different to its current path would be materially negative for the availability of credit in the market. 
For the present however, the market is focused on:

• Inflation the path from 9% -> 3.5%: The December CPI figures in the US continued to fall, now at 7.1%, and more importantly below consensus.  Continuing claims figures, which is a proxy for unemployment in the US came in slightly better than consensus, so the Federal Reserve after a 50bp hike at their latest meeting used its hawkish rhetoric to further moderate the hopes of optimistic investors.
• Earnings: The biggest change in market consensus between our last update and the present for earnings is that analyst expectations in the US are at a -2.8% consensus for quarter 4 earnings. This accounts for the pull-back in equity markets since 30 November (and we should also note that Elon Musk’s ill-conceived takeover of Twitter is dragging down Tesla – a key index component, as he is forced to sell stock to fund his new toys).  It is likely that once again, sentiment is overly negative. 
  
  The reporting calendar is rather light this time of year, but some interesting companies in key sectors do report early.  Retailers Lululemon, Nike and Autozone all beat estimates, as did tech names in Oracle, and Docusign.  A key early reporter in the hardware memory space is Micron who beat on earnings but missed on sales. 
   
• In Australia, the RBA increased the official rate by 0.25% - largely because it is the last rate meeting until February. Their watching brief remains Christmas sales data, impact on property markets and a close eye on employment numbers. 
• We added to our table the Hang Seng Index (Hong Kong). This is up 20.7% since 13 October. The reason we added this is that China has clearly pivoted in terms of its Covid policy – the messaging is more consistent with cold & flu. Western Analysts are focusing on the short-term loss of productivity from Covid cases, however markets as they tend to do, focus on what things will look like in 9-12 months from now. Note the similar performance between China and the Australian Mining Index in the table. 

During the period since our last report, we have topped up our cash positions by taking profits selectively (with cash sitting between 8.5% and 16% at the time of writing). Much of our time has been spent working through our expected positioning for 2023 and the key drivers and signposts we expect to see during this year. We take you through our thoughts below. 


Sound of One Hand Clapping

The title of a book by Australian Author, Richard Flanagan, The Sound of One Hand Clapping is understood to be a Zen Koan from the 18th century Buddhist monk Hakuin, who was said to use this line to catch the attention of prospective students and force them to “slough reason in favour of enlightenment” (source: UVDavis.edu). Wikipedia describes it as a statement to provoke the “great doubt”. 
For us, either definition describes much of 2022 and could turn out to be an analogy for the remainder of the decade. As always, when the “great doubt” is being provoked, a return to a rational decision making framework is required.


Hail Comrade, the Return of the "Old" Economy as We Transition to the "New"

The Trump tariff wars with China got the de-globalisation (the old buzz word) ball rolling, and Covid’s impact turned the trickle into an avalanche of reshoring (the new buzz word) momentum.  “Just in time” inventory management has turned to “just in case” management at a national and ideological level. 
Politically, in most parts of the world, the pandemic resulted in a return to heavy government intervention, large (excessive?) fiscal policy responses and a resurgence to the labour (or Labor?) movement which comes at a time of profound demographic change. Equally, it gave the world a glimpse at a world with lower carbon intensity and the price paid that comes from weaning ourselves away from the old ways of doing things. 

Global supply chains are likely to continue to bifurcate along politically strategic lines in the coming decade.  As the western world’s farm, mine and LNG terminal, Australia will see continued impact with strategic investments by western allies in our resources.  Securing supplies of critical materials is a top priority after the supply issues of the last three years.  

These factors along with the strategic tilt of government spending is likely to see the return of the “old economy” with a vengeance. During the early 2000’s through to mid 2010’s, China became the world’s factory as a result of its relatively low cost of labour. The 2020’s will see a lot of this activity return to developed world economies in the form of highly automated manufacturing that is augmented by artificial or machine learning intelligence that is developed by programs that can self-write code.

From a portfolio perspective, our challenge will be understanding what to own as this change occurs and when. Specifically, we will need to understand:

• What role does old energy play as we transition to less carbon intensive energy and how will the disincentives for investment impact prices (see “classic underinvestment” below)?
• In an automated world, who makes the machines that will be in demand as part of the reshoring movement?
• As populations age and the demand for certain types of labour changes (AI, automation, wealth effect) what are the corresponding changes that will impact supply of labour, taxation policy (less working people / incentives for retirement age to work longer) and demand for services (wealthier retired cohort that is living longer).
   

Classic Underinvestment

The pandemic in 2020 showed us the impact of chronic underinvestment in materials and energy when plotted against starry eyed idealism and the cold hard realities of conflict. Extreme price responses immediately played out when supply shocks (e.g.: pandemic and war) stressed a system that was starting to prepare for the decarbonised decade but left itself vulnerable if every player in the game stopped sticking to the rules.  

We will be looking for situations where the impacts of underinvestment will be exacerbated by policy running ahead of itself. This almost always leads to a price response and either a change in supply or a change in behaviour via substitution (e.g.: renewables vs coal).


Inflation from 9% to 3.5%

With the world reshaping and reshoring supply chains, higher baked in inflation is a by-product. Swapping capital for labour to increase productivity and get inflation closer to the long term 2% target is likely, but it will take some time – we expect inflation to moderate quickly, but to sit at a somewhat higher level.  
Utilities get hit hard in the environment we describe (limited pricing power and slow regulatory mechanisms), but user pay infrastructure will be able to pass inflation to the top line, as will real estate.  
Sometime this year we expect the last interest rate rise to occur.  Estimates for the peak rate are currently 5.1% in the US and 3.6% in Australia as we sit at 4.5% and 3.1% respectively.  The rate of change has already slowed, and there are likely only one or two rate rises left before a pause.  Central Bank balance sheets are of course another story, and a turn to quickly reduce debt levels actively could upset the whole apple cart (see our section below on key risks).


Electrification

The generational shift is on for our power and transportation infrastructure.  Technology risk is always present in an area of rapid change.  New battery designs and chemistries are being developed every day, but behind these products is a sophisticated OEM (Original Equipment Manufacturer) cycle with tight tolerances and quality control on suppliers.  To get into these product’s supply chains can take years, and manufacturers are unlikely to switch technology or their sources quickly with the lead times required.  Big resource deposits of copper, rare earths, lithium and graphite are fertile ground for government and private investment dollars, even if it means greenfield expansion.

With this said, there is some near-term turbulence forming for battery materials, as Chinese subsidies are expiring, so order books are weakening.  At the same time a new lithium mine in Zimbabwe tied to a large resource with Chinese backers is set to open shortly increasing supply as demand falls.  We’ll be looking for any type of air pocket as an opportunity in this decade long trend and a looming shortage in the supply of graphite and copper to adjust positions in this area.


China

China has been uninvestable for much of the past 3 years. Many commentators will use this as justification for having no exposure. As the world’s largest economy with all the opportunities and significant challenges that come with it, this is simply nonsense.

Our view is that China needs to be looked at simply as the world’s second largest economy and (by number) one of the largest emerging middle classes. When China has problems (such as its response to Covid, stringent regulation of companies or declining productivity of its labour force), these problems have far reaching effects from small and incremental negative changes. The opposite is true when conditions emerge to allow positive change. In other words, the direction and rate of change is important to how you view China and where to invest. Our intention it to remain alert for these changes (of which signs are emerging) and the early flow of funds into these markets.


Technology and Artificial Intelligence

Avid readers would have seen plenty of column inches on the poor performance of tech companies in 2022 and many views on why this will continue.  We present a nuanced counterview.

Many of the largest companies in the world are tech companies with strong cashflows and business units that are integral to everyday life. They also grew (unsustainably) through large headcount and investment in research and development.  Last year is the catalyst for some moderation here with a much higher focus on productivity.

In 2023, you will see reductions in headcount for many tech companies and more stringent allocation of capital to internal projects (the same thing happened with mining, oil & gas and other industries with behemoth market positions in the past). Our view is that those companies with strong balance sheets and disciplined allocation of capital to projects in tech will rebound and continue to grow. Those that don’t… well they will likely not be around.

Below we have taken a snapshot from disruptive technology manager, Loftus Peak’s latest report, showing the difference in market performance between their portfolio of strong cash generative companies and those considered as unprofitable by Goldman Sachs:


 
There is another important nuance in investing in technology for this decade. The prior decade was characterised by huge investment in capital light (and in the US deductible from a tax perspective) development of intellectual property (e.g.: software companies). 

We believe that the outperformers this decade will be the tech companies that contribute to the productivity gain of spending capital to replace labour.  This will be semiconductor companies, tech that builds the machines that produce semis and enabling software such as AI. Look for leads from Government with regard to tax policy to drive this area. While the tech leaders are not reliant on tax support, it will certainly be an accelerant where governments take a strategic view about picking winners (look at the recent removal of FBT on electric cars up to $85,000 from the Albanese government).


A Few Words About AI...It Is Growing Up

One of the most profound changes we believe will impact this decade, is the advent of technology that will enable the rapid deployment of ideas into a technical environment and that can self-learn. In fact, if I was a software developer that had just graduated from University, I would be rapidly acquiring a new skill that I would hope would elevate me above my colleagues when they start reducing head count as tens of thousands of developers are replaced by a few conversant in code generating AI applications.  Over the last 20yrs it takes less engineers and geos to get more production in energy and mining from poorer grade rocks, coders are about to feel the same pressure as AI applications accelerate productivity in the dev space.
We asked the CTO of an artificial intelligence company, Tim Llewellynn of NVISO SA to explain what these new AI applications are capable of (an example is OpenAI’s recently released ChatGPT).

Mr. Llewellynn advised, “Think of it as the equivalent of “compound interest” for AI development.  As the generative AI gets betters - it not only reduces AI development costs but also leads to better AI results. E.g.: interest on interest.  Every time you iterate the cycle, you get compounding interest. The more you iterate the greater the advantage you get.  Everyone is still trying to get their head around the classical “simple interest” schematic for AI development so there is a first mover advantage here for smaller and nimble startups.
 
So yes AI applications directly translates into a) fewer developers required; b) higher quality outputs and c) faster development cycles.”

Still a long way to grow, but AI is growing up quickly.


Labour Markets and Demographics - Primary Risk #1 (Short Term) and a Medium Term Consumption / Tailwind / Inflation Driver

Labour Market Supply / Allocation & Availability of Labour
Covid restrictions on movement and the resultant curb in immigration created a large labour force supply shock that led to a short-term increase in wages and what would most correctly be described as a reallocation of the labour force. The drivers of these impacts have largely eased, and the labour market will need to absorb over the coming decade increasing migration, a change in the industrial relations environment, artificial intelligence and the strategic impact of reshoring.

From an Australian perspective more than any other developed market, the biggest short-term risk to prosperity remains a large increase in the numbers of unemployed persons. Unemployment is the second trigger to rising mortgage delinquencies and bankruptcies combined with rising interest rates / declining credit availability. This is a risk well understood by our regulators and our major banks, but there is complacency.  A policy mistake from government or central banks can have far reaching consequences that quickly spiral in the housing market and broader economy.
 
Changing Consumption patterns for Demographic cohorts
Western Nations are undergoing a key demographic change, which will have far reaching impacts on available workers, technology adoption / substitution, consumption patterns and taxation policy. These changes are key for decisions on where to invest. Barry Knapp from Ironsides Macroeconomics highlights the following for the US economy:
“In the ‘00s and ‘10s the second largest age cohort, baby boomers, were in prime savings years as they prepared for retirement. Now the largest cohort, Millennials, are in prime consumption years, and a much smaller cohort, Gen X, are in prime savings years. During the first 5 years of the ‘10s expansion, the combination of household sector deleveraging and demographics led to trend consumption of 1.8%, slightly more than half the post-war average rate of 3.4%. Beginning in 3Q14, household credit stabilized, and consumption averaged 3% until the pandemic ended the ‘10s expansion. We expect a modestly faster trend in the ‘20s.”

The conclusions are important:

• Firstly, there will be a great transfer of wealth occurring over the next 2 decades from Boomers to Gen X / Millennials.
• The largest cohort (Millennials) are reaching prime consumption age. This will be inflationary in and of itself. Knapp writes: “The low hanging fruit of incremental improvements in delivery of consumer goods, and increasingly services, has been largely exploited. Test this theory yourself: are products cheaper on Amazon or just more convenient to obtain?” This group, conditioned to convenience will likely accept a higher average price for this convenience going forward.
• The likelihood of a taxation policy mistake as governments seek to plug holes in budgets that see the retirement of Boomers and Gen X from the workforce in our view has increased.

Short Term Odds & Ends

• Watch for the “last rate rise” in the US, as markets and the risk on AUD could soak up the return to certainty and strengthen if rates pause. 
• For US markets (S&P 500) we’ve got an optimistic yearend 2023 target of 4500 that puts earnings ahead of current analyst estimates.  Right now, consensus has the next 12months flat for earnings, if we get a year that sees 8% growth in earnings and some multiple expansion as inflation outlooks move from this year’s 3.5% to a long-term return to 2 - 2.5% then we have got conditions to exit 2023 at 4500+. 
• At home the ASX200 has a consensus 15% drop in earnings forecast, a flat result from this year and positive inflation prints would push the ASX over 7700 (a record).  When you think of the companies that comprise our index and the tailwinds in cyclic sectors like energy and mining, it is not unreasonable to expect an upside surprise.
• China avoided stimulating their economy like the West did during the pandemic.  Recent protests have softened the ruling party’s Covid policy.  A big wild card for Australia would be return of Chinese demand.  When investing in China it isn’t as much about fundamentals, it is about being on the same side as the government and regulators.  A reflation in Asia could mean a very good year. Rate of change is important here.
• Sometimes you move further in a month than you did in three decades:
  •  Both Ai and fusion power feel closer today than they did a month ago with announcements from OpenAi ChatGPT that will change AI (go ask it to write you a screenplay, an essay or a line of code);
  • The US’s National Ignition Facility showing a 50% gain in energy output over energy input from fusion 
  • Wearable patches on skin can now power themselves more effectively from the moisture of your skin with technology out of Uni NSW.
  • Your Apple watch can tell you more about your immediate health than your doctor can without a battery of blood tests.