Investment update with John Pearce – February 2024

Hello. Welcome to this investment update, my name's John Pearce, Chief Investment Officer. Today, I'd like to explain why, in my opinion, the markets have rallied pretty strongly lately. I'd like to discuss how some of our investment options are performing. And finally, I'd like to address the question: has the rally been justified or is it irrational?

So in non-technical terms, the market has been ripping. Since the lows in October last year, the Aussie market's up about 14% and the US market is up about 18%. Why? Well, before I dive into the answer, I’d like to show you this graph. I'm sure some of you will remember as I presented it in November last year—it shows the performance of the Australian stock market over the course of 2023, and the graph depicts the rollercoaster ride that the market found itself on. And I said Mr. Market was in his usual mood swings and there were four distinct phases. We got off to a very good start for the year when the mood was very positive with the prospect of immaculate disinflation.

Then of course, we had the regional bank crisis in the US. You remember Silicon Valley Bank. Then, we had the market being gripped by euphoria around artificial intelligence (AI). And then Mr. Market got into a bit of a swoon because the bond market crashed.

Let's roll the clock forward to 31 January this year, and what do we see? Another sharp rally. Once again, I put it down to the prospect of immaculate disinflation.

Chart 1: A graph depicts the ‘rollercoaster’ performance of the Australian stock market over the course of 2023.

Is this justifiable? Well, firstly, let's define exactly what immaculate disinflation is. Disinflation is simply a fall in the rate of inflation, and the market is pretty confident that we're going to trend towards that magical 2.5%, 3% level that central banks are typically targeting. What's immaculate about this? It's all going to happen without having to crash the economy.

Central banks are not having to tighten to the point where we're forcing the economies into a recession. If you think about this combination, strong economies, low inflation—that is utopia for company profits and share prices. Before I get on to talk about exactly if it's justifiable or not, I'd like to spend a minute or so talking about how some of our investment options have performed, and it really is—if we look at this financial year—a case of two halves.

When I presented in October, things were not looking that good. If you look at our Balanced option, which is our default option and our largest by a long stretch—off to a tough start, a good recovery, and now well and truly in the black.

Our Listed Property option. Good news story here—really poor start, strong recovery, and now a really strong positive number. The listed property sector is very rate-sensitive so the prospect of rates being on hold really lifted that sector.

At the other end of the ledger, unfortunately, is our worst performing option, Global Environmental Opportunities, and not only is it our worst performing, it indeed is the only option that is recording a negative result for the financial year. Off to a really bad start, and unfortunately the bounce-back has not been strong enough, anywhere near strong enough, to get it into positive territory.

Chart 2: A table shows the performance of UniSuper’s Listed Property, Balanced, Global Environmental Opportunities, and Australian Income investment options between the following periods: July 2023 to October 2023; November 2023 to January 2024; the financial year to 31 January 2024.

Now what has been driving this? Firstly, the thematics underpinning this option are still strong. When you look at something like decarbonisation, that is a structural thematic that is here to stay. But no matter how strong an overall thematic is, it is not immune to cyclical headwinds, and there have been a few. And it's really important to consider that a lot of the companies in this portfolio were priced to perfection. What does that mean? Their valuations were such that the market believed nothing could go wrong, so when the slightest thing goes wrong, they come back to earth.

A few things. The rise in interest rates meant financing costs went up. We had a slowdown in demand in some of the sectors. We have even the prospect of a Trump election victory putting some doubts in people’s minds about the speed of the energy transition.

So with all these factors, a lot of these companies’ share prices have come back to earth. If you look at a company like Tesla, that was a market darling at one stage, its share price is off about 50% from its all-time highs. Is there light at the end of the tunnel for this option? I believe there is. Firstly, structural tailwinds are still there. In terms of valuation, we see now a much more rational pricing in the market. Whereas before this portfolio was priced at extreme premium to the broader market, now on average it's back down to in line with the broader market. I'm not suggesting that means it's going to necessarily rally, but I do think there's optimism that we've seen the worst of the underperformance.

Just quickly on another option, this our Australian Income option that’s proving to be particularly popular amongst our retirees—you see there a really steady return, 4.7%. Now consider that this option does not contain any growth assets, it’s all defensive assets, so 4.7% over seven months is a pretty good outcome.

Chart 2: A table shows the performance of UniSuper’s Listed Property, Balanced, Global Environmental Opportunities, and Australian Income investment options between the following periods: July 2023 to October 2023; November 2023 to January 2024; the financial year to 31 January 2024.

So let's get back to that question: is the market rally on solid grounds or are we experiencing just another bout of irrational exuberance?

Market commentators love being pessimistic and negative about things, but let me give you three reasons why I think the market could indeed be on solid ground. Firstly, the concept of disinflation is real. Take a look at this graph showing core inflation in both Australia and the US. It's all heading down. Contrast where we are today to where we were in January last year when we experienced this bout of euphoria. Inflation in the US was around 6.5%, it's now closer to 3%—inflation in Australia was around 7.6%, it's now getting closer to 4%, so all very much heading in the right direction.

Chart 3: A graph compares core inflation in Australia and the US from 2020 to 2024.

Point number two, and this is really important—the Federal Reserve, the most important central bank in the world, really important for other developed countries as well—look at the pivot that the central bank in the US has undertaken.

And to give you an idea of the speed of the so-called Fed pivot, I'd like to refer to the comments made by Jerome Powell, the all-important chair of the Fed Reserve. It was not that long ago, in November of last year, that the chair was basically saying, “Hey, we're still going with these rate hikes—watch out, market”. Then in December, “Hmm, we believe that is room for a pause”. Then in January, two months after November, he's basically saying, “There are grounds for rate cuts this year, but March is probably too early”. Wow. That's a hell of a pivot in a very short period of time. I would have ruled out any possibility of rate cuts if you asked me in November last year.

So they’re three reasons why the market could indeed be on solid footing. Of course, what could go wrong? And once again, there's no shortage of risk factors that people will allude to. Let me talk about the three most common risks that commentators like to talk about.

First, geopolitical conflict. Now, I've been around long enough to beware of fund managers parading as geopolitical experts, and what I can say in my four decades or so of working in markets, I can't recall a time when the world was totally at peace, when there was no conflict, and frankly, I don't see much difference today. And what's more, when there is an outbreak of hostilities, historically, it tends to be a good buying opportunity. Second, the prospect of a hard landing. Now we can have an exogenous shock such as a pandemic, we can't stop that from happening. But hard landings are typically driven by policy, and given the current posturing of central banks, I don't think a hard landing is a high probability.

The one that I am concerned about is the possibility of reacceleration of inflation. So the market at the moment is saying that inflation indeed will trend down to that 2.5%, 2% mark and we're going to get rate cuts.

And if we don't get that, well, the market could get into a bit of a tailspin. I'm not so sure. Firstly, I'm not sure what's so magical about a 2% inflation rate versus a 3% or 3.5% inflation rate. Also, I don't believe that we necessarily need rate cuts to sustain the current market rally. However, it does change if we get a reacceleration in the rate of inflation.

Could that happen? It could, but I won't be blaming central banks if it does, I'll be blaming governments. To me, economies are really strong at the moment. Governments around the world should be printing large surpluses. They are not—many governments are still printing large deficits. It's imprudent, and I hope that they will become more prudent. What about the prospect of a Trump victory? Well, the election happens in November, there's plenty of time before then so we'll leave that for another day.

As we sit today, if you ask me what do I think about the current state of the economic and financial world, I say it feels about normal and that's not a bad place to be. Thank you very much for listening.

This video provides general information and may include general advice. It doesn’t take into account your financial situation, needs or objectives. Consider your situation before making financial decisions, because we haven’t, as well as the PDS and TMD relevant to you at unisuper.com.au/pds, and whether to consult a qualified financial adviser. Past performance isn’t an indicator of future performance. Information is current as at 7 February 2024. UniSuper’s portfolios have been designed to suit UniSuper, and may not be appropriate for others. Prepared by UniSuper Management Pty Ltd (ABN 91 006 961 799, AFSL No. 235907) on behalf of UniSuper Limited (ABN 54 006 027 121) the trustee of UniSuper (ABN 91 385 943 850, AFSL No.492806) the fund.