Transition to late cycle
At the time of our most recent Australian equities model portfolio review in August 2021, we noted that we had quickly transitioned from an early to a mid cycle business cycle environment. With the initial phase of the economic recovery (supported by the rollout of vaccines and the twin supports of extraordinary monetary and fiscal stimulus) from the COVID shock passing, we were transitioning to a period from where most sectors and individual stocks were lifted by the rebound in activity to one whereby greater dispersion would become evident in different parts of the market. Consequently, this would call for a move from directional market trades to a greater emphasis on active management given the expectation that not all companies would flourish in this phase.
While we held this expectation that we would begin to see an elevated level of sector dispersion over the course of 2022, year to date the moves in markets that we have witnessed have been more extreme than typical, though consistent with a period of continuing to progress towards later cycle, where macro events and risks have taken on a much greater importance for investors.
The year has been notable for three significant macroeconomic developments – a persistently high inflationary environment which has triggered a considerable repricing of monetary policy tightening; the Russian invasion of Ukraine in February, which added to inflation risks and the tightness of a number of commodity markets; and lastly, increasing concerns around economic growth slowing into the second half, exacerbated by China’s rolling lockdowns as it perseveres with a ‘COVID-zero’ policy.
The conclusion that we can thus make is that we have now entered late cycle and can expect economic and corporate profits growth to slow from here, which has been reflected in our recent tactical asset allocation trade to move to an overweight duration bond position.
Table 1: Recap of the business cycle and sector performance
Early Cycle: There is a clear divide between the winners and losers. Directional tactical asset allocation tends to perform well. The more cyclically sensitive sectors such as consumer discretionary, financials, materials, industrials and real estate tend to perform best. Defensive sectors such as health care, energy and utilities tend to perform worst.
Mid-Cycle: The divide between the winners and losers is less clear so fewer tactical asset allocation opportunities. The focus should be on making slight portfolio allocation changes to protect the downside and quality manager selection within active funds.
Late Cycle and Recession: Directionality returns as does opportunities to add value from tactical asset allocation. Defensive and inflation-protected sectors tend to do better.
Australian equities sector exposures
Looking at the composition of the Australian equity market, it is clear as to why it has performed much better than most international markets through the first months of 2022, with the ASX 200 outperforming global equities by ~8%. The two largest sectors of the Australian market are financials and materials. Financials have been among the most leveraged to a rising rate environment, as a steepening yield curve leads to margin expansion; however, this effect is dissipating as the yield curve flattens in response to slowing growth. Meanwhile, materials have been buoyed by the strength in commodity prices. This tilt became more pronounced in January as the index’s weighting to BHP rose by around 5% after the unification of the company’s shares upon the collapse of its dual listing structure.
Equally important has been the significant negative valuation impact on the higher growth sectors of the market (particularly IT) as nominal and real rates have normalised. The Australian market has a lower allocation to these sectors than many international markets, which again has aided in relative performance through 2022. The following chart illustrates the composition of our model equities portfolio by sector.
Chart 1: Australian equities health check
In January, we made a number of changes to our model Australian equity portfolio in order to adapt to this changing environment. The key changes we implemented were to:
(i) reduce the exposure to more growth-orientated managers who were more exposed to valuation risk as bond yields rose; and
(ii) add to large cap managers that have greater flexibility around style or exposed to sectors more defensive in nature
While we do not have any value-specific large cap managers that would have fully capitalised on these market conditions, the more balanced portfolios of Pendal and WaveStone would have captured some of these themes. Our more growth-orientated managers have a lower capacity to make wholesale changes to their portfolios, however, the focus has generally been one of gravitating towards companies that have pricing power, thus reducing the earnings risk in this period of higher inflation.
Chart 2: Australian equities CIO model and managed funds
Australian equities health check
In the table below, we again present the sectors of the market, split into cyclicals (green), economic sensitive (beige) and defensive (blue) in terms of the relative weight compared to the benchmark ASX 200.
Chart 3: Relative positioning
In a late cycle environment, the sectors that perform best include materials and energy, while defensive sectors consumer staples and health care also do relatively well.
Our model is underweight the materials sector and neutral energy. The materials sector was key in underpinning the initial recovery out of the COVID crisis period, as is typical in the early phases of an economic recovery. While earnings momentum weakened into the second half of 2021 as more developed countries took the baton from China in driving the global recovery, the sector has returned to favour again through the first part of 2022 as the most important in driving the relative outperformance of the Australian equity market this year.
The economic reopening theme has continued to push commodity prices higher as a consequence of elevated demand and tight supply (the latter a consequence of a period of several years of limited capital investment in new supply by the industry). However, the more significant catalyst has been the Russian invasion of Ukraine, which has placed further pressure on tight commodity markets.
While our model portfolio has not fully realised this commodity price tailwind given its aggregate underweight position to materials, we responded to the development by implementing a tactical asset allocation relative trade of an overweight position in resources (implemented via ETFs) and underweight to European equities. The trade allowed a quick response to this key geopolitical development, but equally allows the trade to be closed if our investment thesis is invalidated for any reason. At this point in time, the most likely reason that would trigger the trade to be closed out is further evidence of increased risks around a sharper economic slowdown than anticipated into the second half of 2022, whether it be in response to much tighter monetary policy and/or weaker growth from China as it stoically maintains its ‘COVID-zero’ policy.
Presently, the portfolio has a modest overweight to health care and consumer staples. The health care sector is a key sector of the Australian market and most of the larger companies are among the global market leaders in their fields. Many of the key stocks did suffer varying degrees of interruption to their business through the COVID crisis and thus face improving conditions as demand normalises once again over the course of 2022.
In late cycle, the two sectors which typically do poorly are consumer discretionary and information technology.
However, consumer discretionary has remained the largest overweight position in the model, which was the case at the time of our last review. Presently, of the six managers in our model portfolio, five are overweight the consumer discretionary sector, and so this high weighting will continue to be monitored given these companies are more likely to struggle as the cycle matures. A feature of this cycle has been the contrasting environments faced by the so-called ‘COVID beneficiaries’ (i.e. those that saw an increase in demand through the lockdown periods, such as retailers with a strong eCommerce model) and companies more services-orientated that suffered disproportionally though this period. This latter group is expected to experience a significant rebound in pent up demand as the reopening continues, with reduced downside risk compared to the COVID beneficiaries. Pleasingly, our model has several of these as large positions across gaming (Aristocrat Leisure), education (IDP Education) and travel (Flight Centre and Corporate Travel).
The model has also retained a slight overweight to information technology, though this has been reduced with our recent portfolio changes. Assessing the large information technology exposures of Xero, Technology One and Iress, each have a high proportion of recurring software subscription-based revenue streams, providing some degree of downside risk in late cycle.
As we have witnessed through the first few months of 2022, the greater risk around companies that are either marginally profitable or yet to be cashflow breakeven is one of valuation (many of which are found in sectors such as IT), particularly if they are not self-funding in nature and have a near-term requirement for additional capital funding. Looking at our model portfolio, there is currently just over a 2% exposure to companies not expected to be profitable in the next 12 months, hence this risk is not material. Nonetheless, future changes to our portfolio are likely to reflect our preference for a lower allocation to the sector.
In late cycle, other sectors of the market are less likely to be influenced by the macro environment.
Financials is a key sector of the ASX 200 and comprise 18% of the model portfolio, though the sector is the largest underweight relative to the benchmark ASX 200. The sector typically has a low representation among more growth-orientated managers such as Selector and Bennelong, along with a lower allocation among small cap funds.
As noted, financials are a key cyclical sector that typically benefits from a steepening yield curve, a factor which will become more of a headwind in late cycle as the yield curve flattens. In this monetary policy hiking cycle in particular, there are risks around the pace and number of hikes (short and sharp) being made with a prevailing high level of household debt. Hence, this poses risks around a slowdown in the housing market, reduced economic growth and rising bad debts. Therefore, a somewhat more cautious approach is reflected in our managers’ exposures.
The structure of the Australian market has been key in leading to strong outperformance of global markets so far in 2022. However, we are cognisant of the risks as the cycle matures, and this will be reflected in both our asset allocation and within our model Australian equities portfolio as the environment and outlook evolves.
Given the relatively concentrated nature of the Australian market among the largest constituents, it is of no surprise that our largest three portfolio holdings have remained since the last review, albeit in a different order.
BHP Billiton is among the largest and most diversified companies within the global mining industry. Its suite of long-life, low-cost mines ensures robust returns and margins relative to its peers through the commodity pricing cycle. In more recent years the company has pulled back from a more profligate capex spending program that contributed to the prior downturn in commodity markets and instead focused on balance sheet repair, optimising its portfolio via the sale of non-core assets and maximising its returns to shareholders. A further rally in commodity prices in 2022 has provided a boost to its short term earnings profile, though some mean reversion is still expected over 2023/24 as markets adjust to a maturing global growth cycle. The company’s ESG credentials have also been enhanced this year with the recent approval to divest its oil and gas assets to Woodside, accelerating its strategy to reduce its exposure to fossil fuels. While BHP is the largest holding in our model portfolio, the stock is actually underweight relative to its ASX 200 benchmark weighting of 11%.
CSL remains a key holding across our four large cap funds. The company has been a core long-term investment for many domestic large cap managers thanks to its enviable track record of capital allocation, strong management, high returns on its investment and operational performance. The stock has underperformed though much of the COVID crisis, with its business disrupted through reduced traffic at its plasma collection centres in the US, though this outlook is improving as economies reopen. Additionally, its medium-term earnings profile is enhanced by the synergies expected to be realised from its recent acquisition of Vifor Pharma.
Commonwealth Bank is the largest of the four major banks and is typically seen as the highest quality of the group. The four major banks have all followed a similar strategy over the last several years of exiting the more peripheral parts of their businesses, such as wealth management, which was in part borne out of their shortcomings that were revealed in the banking royal commission. As with the other majors, the primary impact of COVID on Commonwealth Bank was a sharp rise in bad debt provisions – which are now being written back as the economy recovers on the back of fiscal and monetary support. Commonwealth Bank has historically traded at a healthy premium to its major peers (which is presently the case), which is attributed to its market leading return on equity and retail franchise. Reflecting this valuation differential, the stock is actually the largest underweight of the four major banks in the model (relative to the ASX 200).
Table 2: Top 10 positions
Table 3: Top holding in each sector