The Road Ahead
At the precipice of a new financial year, Damian Cilmi assembled a panel of investment experts to discuss what lies ahead for markets. Discussing key topics like demographics, deglobalisation, the energy transition, and the persistent issues of inflation and interest rates, this podcast brings the future into focus.
Drawing upon the wisdom of Tim Toohey (Head of Macro Strategy at Yarra Capital) John Mulquiney (Portfolio Manager/Analyst on the Global Listed Infrastructure and Global Equity Franchise teams at Lazard) and Blake Henricks (Deputy Managing Director and Portfolio Manager for Firetrail's Australian High Conviction Fund), it delivers a comprehensive understanding of the factors that could be driving the 2024 market while helping to unravel the complex challenges and opportunities that lie ahead.
Whether you are trying to understand the impact of shifting birth rates on the bond market or comprehend the implications of deglobalisation on Australian equities, this podcast leaves no stone unturned. Listen now for practical insights into the road ahead.
This transcript has been edited for clarity and brevity.
Welcome to the 2024 Key Market Driver webinar, the third in our series aimed at helping you navigate the coming period through portfolio ideas and examination of critical issues likely to affect capital markets. The start of 2023 has already seen notable developments such as persistent inflation, rising interest rates (up to 5% in some jurisdictions), failures of Credit Suisse and US Bank, the US Fed ceiling, AI advancements, fluctuation between value and growth, all set against a backdrop of geopolitical tensions. Let's introduce our esteemed panel, experts in Australian equities, global equities, economics, and the bond market.
First up, we have Tim Toohey, head of macro strategy at Yarra Capital, with over 25 years of industry experience. Tim is one of Australia's most respected economists, advising Yarra on financial markets and asset allocation. Before Yarra, Tim was the chief economist at Ellerston and spent 15 years as chief economist and head of Macro at Goldman Sachs, where he was named Australia's top economist for 13 consecutive years.
Next, we have John Mulquiney from Lazard who will discuss global equities. John is a portfolio manager and analyst on the global listed infrastructure and global equity team with over 25 years of experience. Before joining Lazard in 2005, John worked at Tindall covering stocks in various sectors. He was also part of the Asset Infrastructure group at Macquarie, involved in transactions and valuations across various sectors.
Lastly, we have Blake Henricks, the deputy managing director and portfolio manager for Firetrail's Australian High Conviction Fund. With over 20 years of experience investing in equity markets, Blake co-founded Firetrail after a 12-year stint at Macquarie Group, where he co-managed the Macquarie High Conviction Fund. Welcome, panelists.
Today's discussion will cover three key topics: demographics and deglobalisation, the energy transition, and inevitably, inflation and interest rates. Let's begin with demographics and deglobalisation. Over to you, Tim. Can you discuss its impact on the bond market?
Thank you, Damian, glad to be here. While demographic changes tend to be slow-moving, they are crucial to understand. In 2021, a significant shift occurred when China released its census data, revealing a precipitous drop in its birth rate. This accelerated the timeline for when China's population would start to decline, and ignited discussions on similar demographic issues in Western economies.
Suddenly, we could run projections based on a Chinese birthrate of 1.3 or 1.4 and envision a shrinking China. The situation inevitably led us to consider the after-effects of the stimulus-induced recovery. What would the 'other side' look like?
Economic growth essentially boils down to demographics and productivity. Productivity data appears rather static while demographic forecasts for the next 20 years look challenging. This does influence portfolio construction, particularly bonds. Lower demographic growth likely means lower real expected growth rates and thus real interest rates.
The debate on whether weaker demographics are inflationary or deflationary leans towards the latter in my view. Despite potential wage increases for skilled and unskilled workers catering to an aging population, overall slower growth suggests a more disinflationary trend.
The other aspect to consider is the massive inter-generational wealth transfer accompanying these demographic shifts. In Australia alone, about 400,000 people are expected to retire in five years, and another million baby boomers will retire over the next decade. This represents a huge wealth transfer to Generation X, many of whom are nearing retirement themselves. This could continue to drive demand for safe assets like bonds.
Interestingly, bonds are currently yielding returns not seen for a long time, making them an attractive option amidst these demographic shifts.
Thank you, Tim, for that insightful analysis on demographics and GDP. Now, let's switch gears to Blake. Could you talk about deglobalisation and its impact, especially from an Australian equities perspective? How are shifts in production and location impacting companies?
Thanks, Damian. The big picture is that deglobalisation could enhance the value of traditional assets. Deglobalisation, led primarily by governments, is driving companies to diversify away from the lowest-cost jurisdictions unless significant government incentives are in place. Take the Inflation Reduction Act, for example. It's subsidising up to 80% of CapEx for onshore facilities, leading to a surge in onshore investments worldwide.
This has two major implications. First, there's a strong CapEx impulse occurring globally across sectors like engineering, construction, and manufacturing. Companies like Worley Engineers have stated they've never seen conditions like this in their 25 years on the market.
Second, costs are likely to increase. For instance, Ampol, an Australian company, is poised to benefit from deglobalisation and the upcoming Minimum Stockholding Obligation (MSO). As of now, importers must maintain a 22-day diesel stockpile for emergencies. From July 1, this requirement will increase to 30 days, a roughly 50% hike in storage, leading to a surge in government-subsidised storage construction. Ultimately, the consumer will bear these additional costs, adding to inflationary pressure. Although the effect might be minor on an individual basis - perhaps 1.5 cents per litre of fuel, if repeated across sectors, it becomes significant.
In this new world order, 'old world' assets, such as Ampol's refinery, once on the verge of shutting down, can become valuable investment opportunities. This is one of the many implications we foresee due to deglobalisation.
Thanks, Blake, for your perspective on deglobalisation and its potential benefits for Australian assets. Now, over to John. Can you share your insights on global equities, considering demographic shifts and the influence of deglobalisation?
Certainly, Damian. We consider demographics as part of our overall macro view. As Tim mentioned, real growth stems from productivity and population growth. Therefore, a shift in the working population generally implies lower growth rates. We've particularly noticed this trend in Japan.
We don't invest directly in China, but in places like Japan, we see demographic changes leading to slow growth rates. This demographic information sets the macro context for our investments. The goal is to identify specific opportunities within these macro changes. Despite the market growth being in line with our projections, we see certain sectors that stand out.
Healthcare, for instance, is one such sector where demographic changes are creating lucrative investment opportunities. Our portfolio includes significant healthcare stocks, primarily from the US. For example, Fresenius and DaVita, the two leading kidney dialysis providers in the US, are set to benefit from an aging population and the increased incidence of kidney disease.
However, in order to make it into our portfolio, these companies also need to be financially appealing. Both are facing short-term inflationary pressures affecting their margins, and they're still in the process of passing this increased cost back to their customers. But this situation allows us to buy robust, stable stocks that should provide solid returns in the future at bargain prices.
Another company we're keeping an eye on is CVS, the largest retail pharmacy chain in the US. They've vertically integrated their operations by acquiring a healthcare insurer and a pharmaceutical benefits scheme, leveraging their retail presence throughout the health space.
Thanks, John. Now a quick question for both Blake and John. Do you see these demographic reductions and shifts in Western countries as inflationary or disinflationary?
I'm somewhat neutral on this. The impact largely depends on immigration policies, which can act as an 'escape valve.' In Australia, for instance, sensible immigration strategies have somewhat counteracted demographic changes. However, countries like Japan, with lower immigration rates, are more or less committing to a lower growth scenario. It's difficult to give a definitive answer as it also varies by industry. Certain sectors may see increased demand and, coupled with deglobalisation, could lead to higher wages and inflation. However, reduced productivity could result in overall less demand, so as Tim mentioned, it's not a clear-cut situation.
Considering the recent focus on productivity and wage inflation, how do you perceive the argument that demographic shifts could be inflationary, Blake?
To be frank, we haven't seen demographics significantly affecting our investment strategies within a 3 to 5 year horizon. However, we've noticed an interesting trend on the ground in terms of inflation. As central banks globally and the RBA have raised rates to temper demand and control inflation, it has ironically incited inflation in some areas, particularly in the technology sector.
Companies that could previously afford to offer inexpensive, even free services, while operating at a loss, are now striving for profitability and aggressively increasing prices. A clear example is the Australian company MilkRun. They initially offered very low-cost, sometimes free, 5 to 10 minute deliveries. However, when they tried to raise prices, they lost their customer base and eventually had to shut down. Woolworths acquired it from receivership and almost immediately raised delivery prices. So, the exit of competition from markets can indeed be inflationary. However, when it comes to the role of demographics, we don't hold a clear view as we haven't observed a direct impact within our investment timeframe.
Thank you, Blake. Let's move on to the second topic of energy transition. Do you have any comments on the previous responses?
I agree to an extent. When trying to profit from the energy transition, it's relatively easy to predict demand, but it's more challenging to determine who will make money. It boils down to competitive dynamics and who has the ability to enter or exit the market.
Resource projects needed for the energy transition are struggling to secure funding due to environmental concerns, whereas other areas like battery materials and lithium are receiving significant government funding. Hence, we think the resource sector could be promising, given the sustained demand.
However, we diverge from the hardline decarbonization views in one respect. We believe that gas, as a source of energy, will remain crucial for at least the next two decades. Completely eliminating all fossil fuels from the energy chain seems highly challenging. For instance, a large company we recently spoke to was planning to use hydrogen to decarbonize away from gas and oil. But with Australia now effectively putting a price on carbon through the safeguard mechanism, this company and others have to move away from coal and onto gas, which produces half the emissions. Therefore, we see gas as a realistic, albeit not perfect, solution for the next two decades.
On the topic of hydrogen, what do you believe the timeframe is for it to become commercially scalable?
Most discussions around hydrogen as a fuel source involve green hydrogen, which is created using wind and solar power. However, conversations we've had with several stakeholders, including Japanese customers, suggest skepticism about the economic feasibility of hydrogen, especially on a cross-border basis.
Transporting hydrogen involves significant challenges and costs. For one, you need to create an entirely new fleet of ships capable of maintaining temperatures 100 degrees Celsius cooler than those required for LNG, which is already at minus 180 degrees Celsius. So we're looking at maintaining temperatures of minus 280 degrees Celsius, which is a huge logistical challenge.
In addition, you'd have to replace all the existing pipelines to accommodate hydrogen, which also incurs considerable costs. While domestic usage of hydrogen might be viable, the concept of cross-border export seems quite far-fetched. I wouldn't go so far as to call it a pipe dream, but it's certainly bordering on that, from my perspective.
Remaining on this topic, Blake, how are you addressing the energy transition within your portfolio?
We see Worley as a big winner in this energy transition. After attending their recent Investor Day, we're impressed by their productivity; they have 50,000 engineers operating at very high utilization rates. They're being inundated with projects, from carbon capture and storage for oil and gas companies to hydrogen in Europe, batteries, and the renewable economy.
Their strategy has been to let go of clients not willing to pay for their engineering services and to focus on higher-value projects. Thus, our portfolio has an overweight emphasis on gas, with significant investments in companies like Santos, and of course, Worley, where we anticipate both robust top-line growth and margin expansion.
So, would you say Worley is the "picks and shovels" of 2023?
Absolutely. The largest risk, however, is if governments suddenly decide to stop funding these initiatives. While the sector has great potential, relying heavily on government support is also a risky strategy.
John, considering your global equity and infrastructure investments, how are you approaching the energy transition, especially with regard to assets like poles, wires, and generators?
While we operate an infrastructure fund, the energy transition doesn't impact us as significantly because we screen out many energy and commodity producers. We perceive these sectors as highly risky and difficult to forecast. Consequently, we don't include energy or resource companies in our franchise universe.
However, there are opportunities for higher growth within our infrastructure portfolio. One thing to note about infrastructure is that a company's growth rate doesn't significantly influence its valuation. The majority of infrastructure companies are regulated, with returns on capital often dictated by a regulator, aiming to balance the cost of capital with the return on capital. As a result, the growth rate doesn't greatly affect the valuation.
Take National Grid, for example, the largest electricity transmission business in the UK and one of our significant investments. Despite increasing demand to connect new solar and wind opportunities to the grid, the higher growth doesn't necessarily translate to higher returns for investors due to stringent regulation.
However, we've seen a different trend in the U.S., especially with the Inflation Reduction Act's stimulus for energy transition. U.S. utilities are moving forward aggressively in this area. Unlike in Australia, the UK, and Europe, where the allowed return equals the cost of capital, in the U.S., each dollar of invested equity is worth about $1.25 because the regulator permits a slightly higher return. This difference means that a higher growth rate, achieved through more capital expenditure, can indeed be value accretive.
Ironically, integrated utilities in the U.S., those with both poles, wires, and generation assets, are creating value by replacing their coal-fired power stations. The regulatory landscape and the overall equation make this possible. However, navigating these specifics can be complicated, which is likely why many find the energy transition complex. There are indeed two particular areas where this transition has significantly impacted our infrastructure fund.
Thank you. Tim, could you share your views on these developments in the energy transition and their implications for inflation, interest rates, and the bond market?
Indeed. This is a key area demonstrating clear structural changes that can lead to inflation. What we're observing is substantial reduction in capacity, particularly in sectors that have closed power plants, transitioning towards cleaner energy options. This has been done primarily for environmental reasons, but it comes with economic costs.
The transition requires significant capital funding, some of which is currently provided by government incentives. Companies too are reacting, but there's a need for large-scale investments over the next decade to come close to net zero.
The bond market, particularly green bonds, will play an essential role in this process. The green bond market is relatively new but rapidly growing. Several funds have begun setting up their own green bond portfolios, with some even issuing official Commonwealth government securities. Corporations and individuals are increasingly investing in this area, which offers enormous potential. However, my concern is that the penalties for bonds not meeting their environmental targets could be stronger to ensure they're effective.
The investments required for this transition are comparable to the rise of the BRICS in terms of scale. It will be interesting to observe how these government, institutional, and social directives affect the global economy, especially given the potential inflation implications.
Let's switch gears to discuss interest rates and inflation, though we've touched on some of these impacts already. Tim, how do you see the year ahead in terms of inflation? Will your approach be more defensive or geared towards growth?
It's a complex picture. Current inflation appears high, and central banks worldwide seem to be struggling to manage the rate cycle. There's a clear shift in their approach and communication regarding rate adjustments, primarily due to concerns about productivity and rising costs.
Interestingly, the Reserve Bank of Australia (RBA) suggests that about 85% of inflation is driven by labour costs, with the remaining being influenced by changes in employment rates. However, the current rise in labour costs is more due to increased working hours rather than growth in wages, without a corresponding increase in output. Therefore, a hasty decision to increase interest rates could potentially harm the economy.
This lack of correlation between increased hours and output is because we've induced a significant economic slowdown due to the most rapid period of interest rate hikes ever deployed. As the economy slows down, productivity decreases. It's crucial not to misinterpret this as a labour cost and productivity cycle. The retail, housing, and industrial sectors all show signs of a rapid slowdown due to restrictive financial conditions. This isn't the stage of the cycle for slowing down; central banks should be aligning their actions more closely with high-frequency data.
Globally, a similar trend can be observed. For instance, Europe appears to be on the brink of a recession, as suggested by negative indicators in real retail volumes and industrial production. Central banks need to be wary of overemphasizing services inflation, as much of it is driven by government administration prices, and wage growth appears to have peaked in many developed economies.
Thanks. Now, Blake, could you discuss what your portfolio's implications might be for Aussie equities, especially considering factors such as discount rates and valuations? Additionally, are there any sectors that you anticipate benefiting from higher inflation and interest rates?
Indeed. Our Firetrail Australian high conviction portfolio leans towards defensives like healthcare, and also includes rate beneficiaries like insurance. We're also looking at energy. People usually avoid energy in recessions because its performance tends to align with GDP and consumption. However, if you delve deeper into energy, you'll find it to be quite resilient. Also, with China reopening, that's a factor not typically considered in recession planning.
I echo Tim's comments. Frankly, it's hard to envision rates climbing much higher in a sustainable way. We're receiving weak high-frequency data from the retail market. The Australian consumer started to decline around March, April. It's clear that the recent rate rises are starting to pinch, and I predict the data for the next four months leading into the September quarter will reflect a significant consumption downturn. Even Baby Bunting reported a 20% drop in sales over the last two weeks.
As for investment ideas, Domino's has piqued our interest, and we've been increasing our holdings recently. Despite taking hits from inflation in food and labour costs, we believe that Domino's, with better economics than its pizza industry competitors, can weather the storm.
Do you think that some of the retail numbers might be obscuring a shift in consumer behavior, such as trading down to lower price points?
Definitely. There's a distinct disparity among consumers. Companies like Uber are reporting continued top-line growth and an influx of new drivers. Qantas also reported strong demand, particularly at the higher end. However, the lower-end brands are struggling. This dichotomy reflects the pressure currently experienced by the bottom-end consumer.
Agreed, agreed. John, turning to you now, how are you adjusting your portfolio in response to the persistent inflation and high structural interest rates we've been seeing?
From our perspective, the key long-term consideration is aligning our GDP and interest rates assumptions. A few years ago, the market seemed to get ahead of itself. It was expecting a 4 to 5% GDP, but simultaneously projecting a structural interest rate of only 2%. We thought this was impractical. Our core assumption follows the "Golden rule", which proposes that in developed countries, GDP and interest rates should be approximately equal. We have successfully managed our portfolio with this assumption for the past decade, consistently outperforming most of the growth market.
Currently, we have seen 5% interest rates in the US for a sustained period, and we don't anticipate this changing in the near future. So, the first crucial point is to look beyond market chatter about the Delta and concentrate on the fundamental value of stocks.
Secondly, we're observing that interest rates and inflation are impacting different companies at different stages of the cycle. This supports Blake's point. For instance, Fresenius, which I mentioned earlier, has limited pricing power due to a 2 to 3-year repricing timeframe on their contracts. On the other hand, Tapestry, the owner of the Coach handbag brand, has been flourishing over the past two years, thanks to a strong demand for handbags, especially in the sub $5,000 market.
These different macro impacts on companies provide opportunities for value investors like us to take advantage of market overreactions. The short-term changes and their potential impact on the outlook should be discussed more because they are what create opportunities for us to exploit.
To build on that point, and acknowledging there's a potential conflict of interest in this next question, I'd like to discuss the role of active management versus passive instruments and beta. Given the disparities we're seeing across industries and companies with regards to the impacts of demographics, inflation, etc., are you more excited about the market now than you were, say, five, six, seven years ago?
We continue to see the market as quite expensive, especially in the niches we focus on which include infrastructure stocks and monopolistic, franchise-type businesses. When we evaluate these businesses for their value, only a small handful emerge as opportunities, despite the market fluctuations of the last few years.
We believe we can still generate franchise returns greater than our 10% performance objective. However, this is not a reflection of an overall inexpensive market. I'd caution anyone considering shifting to a passive strategy right now, as it's potentially the worst decision to make given our general outlook of the market. There are times when passive strategies offer value, but now is not one of those times.
Fair enough. Blake, what are your thoughts?
I completely agree. When you invest in the index, you're essentially investing in the largest companies by market cap. Often, these companies are also some of the highest valued ones, meaning you're essentially employing an anti-valuation strategy.
While I can't speak for the entire market, I can speak for our approach. One of our biggest competitive edges is our ability to take a genuine 3 to 5-year view, to take risks others might avoid because they're concerned about the next quarter's performance. Opportunities arise from this short-term focus, and they're becoming more frequent.
I believe the rise of computer algorithms that buy upgrades and sell downgrades is contributing to this. Sometimes companies are worth much more, but they're navigating temporary headwinds, and that's where we find significant opportunities to add value in the medium term.
Thank you. And Tim, with regards to the dispersion in bond markets, is it providing more opportunity, or perhaps more volatility, than what you've observed in recent times?
There are several aspects to consider for this question. When we look at fixed income markets, some unique opportunities have emerged in an environment where bond markets, like equity markets, are influenced by passive money, which generally reduces turnover. If you're prudent and realize interest rates are rising, you can raise more short-term capital on a safe portfolio of securities, achieving a yield of over 6%. This has been the case for the past couple of years, and I see it as a great opportunity. However, if you're following a passive approach, you won't achieve these returns.
In the fixed income space, there's a strong case for active and selective investing, rather than just following the index or zero-inequality space. If we decompose these large global ETFs with significant risk, I think you might be surprised by the limited diversity you actually achieve in your stock portfolio.
We haven't even touched on AI and whether there's a bubble there either. Let's move on to a couple of audience questions. I believe this one is probably for Blake: Do you foresee your organization benefiting from the growing need for kidney dialysis?
That's an insightful question. CSL, which acquired V4 last year, operates in the kidney space. We've also done extensive research on Fresenius, which John mentioned earlier. Reports suggest roughly 30% of the global population is iron deficient, a figure that likely skews towards emerging markets and Africa where diets often lack sufficient iron. We believe CSL can significantly increase sales of V4’s product.
During a site visit in Switzerland earlier this year, I observed a stockpile of iron ore they convert into injectable and oral supplements to restore iron levels. We believe this represents a significant opportunity over a three-year horizon, as CSL can bring a strong sales focus to V4's high-quality product range.
Thank you, Blake. The next question is likely for John and pertains to the energy transition. Specifically, how do you foresee APA and AGL performing in the near future?
As investments, we don't currently consider AGL, and we find APA to be quite expensive, so it's not included in our portfolio. We do have other gas pipeline investments, specifically Snam REIT, an Italian gas transmission network. They're currently expanding their network to diversify away from reliance on Russian gas, and the related capital expenditure has been quite beneficial for them. Regarding APA, we see it as overvalued.
Okay, excellent. Thank you. I think it's time to conclude to ensure we finish on schedule. I want to express my gratitude to all of our panelists for this illuminating discussion on key topics for this year.