Rob Tucker, Managing Director of Chester Asset Management, shares his thoughts on three key macro questions that help shape the Chester High Conviction Australian Equity strategy.
What has been the main theme driving markets in the most recent quarter?
Globally, the first quarter of 2022 was overshadowed by the Russian invasion of Ukraine. Perhaps the Russians underestimated the sense of tribalism of the Ukrainian people in defending their homeland. The world has significantly changed in the past 8 weeks, as this conflict has bought into sharp focus the delicate balance between economic trading partners and autocratic leaders with ulterior motives.
The overreliance of Europe (Germany in particular) on Russian energy highlights the risks surrounding a lack of self sufficiency in primary production (both food security and commodity security). The lack of short term alternatives puts much of the European population at significant risk of fuel and heating shortages come winter. Australia as a significant exporter of both food and energy is blessed with an abundance of primary production. The lucky country. This enviable position cannot be underestimated over the next decade.
What are the longer term implications of countries adopting greater self-sufficiency in their economies?
This shift in thinking amongst global policy makers around self sufficiency (or localisation) has been talked about for the past 2-3 years, but has significantly accelerated over the past 6 weeks. Shifting semi conductor manufacturing out of Taiwan, localising defence spending, reducing reliance on crop protection ingredients sourced from China, to ensuring rare earths are sourced from western nations, this thematic has only just started. It will play out over the next 3-5 years as many of the decisions taken this year, will really only come into play by the middle of the decade.
Our most significant takeaway from the tragic events in the Ukraine, outside the humanitarian crisis is that globalisation is very much a thing of the past. Companies and consumers will willingly be paying higher prices for the security of supply rather than the lowest cost of supply, which of course only plays into the notion that the 2020’s will incur higher inflation than the preceding decades.
How real is the inflation threat and how is Australia positioned?
Geopolitics aside, the current narrative around inflation is well and truly the biggest dilemma for policymakers. Cost inflation is rampant and a level of demand destruction is needed to reign in inflation expectations, so much so that market expectations for US interest rates have risen from 3-4 hikes in 2022, to 8-9 hikes this year. Adding balance sheet contraction (QT) to the mix suggests that financial conditions are tightening very quickly. Credit spreads need to be watched closely for broader financial market stress, but this is not apparent yet.
While the bond market has reacted to the change in interest rate expectations, we are not so sure the equity market has. It appears to us the RBA has decided to let the upcoming Federal election play out over the next 6 weeks before changing monetary policy course, whereby interest rates will be going up. The key variable obviously becomes “for how long?”. With the prospect of financial conditions getting tighter in 2022, the focus will be very much led by stock specific earnings drivers, hence the most in demand stocks will be those that have earnings, dividends or cash flow tailwinds, valuation support or very strong pricing power. Outside commodity producing tailwinds, earnings strength looks far tougher from here, while Australia looks to be a wonderful place to allocate capital from a global perspective.
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