Investment update with John Pearce - May 2023

John Pearce (JP): Hello, I'm John Pearce, Chief Investment Officer. Welcome to this investment update.

Today I want to explain what is driving the strength of the markets in the first four months of this calendar year. I’d then like to elaborate on recent developments that are sending new tremors through the market. And finally, I’d like to announce a very significant investment in a European digital infrastructure asset.

To the end of April this calendar year, every single investment option was recording positive gains. Our Balanced option, which is our largest being the default option, was actually up over 5%—effectively eliminating the losses that we saw in 2022.

You might be concluding that we have had a lot of good news. That's not quite right. The reality is that the news that we have received is not as bad as originally feared. Let's think about 2022 and there were three major concerns. One—China, the world's second-largest economy, was effectively in lockdown. Two—there was a fear of ever-escalating energy prices on the back of Russia's invasion of Ukraine in February of last year. And finally, there was a fear of ever-escalating inflation, the impact that would have on interest rates (particularly in the US), and then fears of that bringing on a severe recession.

How have things panned out? China abandoned its zero-COVID policy and now it's all-out growth. What about energy prices? It turns out if you think about the impact of the war in Europe—first and foremost, it is a humanitarian crisis, there is no doubt about that. However, the impact on the global economy via energy prices has been relatively muted. We think about gas prices—the market was right. There was a very significant escalation in prices, up about six-fold, looking at that graph. Today, however, gas prices have declined quite dramatically. We are still up, but we are about double where it was pre the invasion of Ukraine.

Image 1: A graph showing the price of gas peaking in 2022 at €300MWh megawatt hour before declining in 2023.

Oil is an even more fascinating story. As at today, oil is trading at levels below what we saw pre the invasion of Ukraine. What about inflation? Well, in June of last year, headline inflation in the US was printing at over 9%. September-October, it was still over 8%. Fortunately, we've seen a trend decline—it's now hovering around 5%. So, still high, but the trend is in the right direction.

Let's have a look at the language being used by the Fed relative to what was being used. In October 22 last year when inflation was around 8%, Chairman Powell said this about the rate hike cycle. “We will keep at it until the job is done… high rates will bring some pain.” That's pretty aggressive posturing.

We roll the clock forward to a few hours before this video was cut. Here's what he said. “We are close [to a pause] or maybe even there.” That's a huge difference. And we can definitely see some light at the end of the tunnel. And most importantly, there are no signs of a severe recession.

It's fair to say the market's worst fears have not played out. However, we have a new set of tremors to deal with. Yes, the market is going to be asked to climb another wall of worry.

Let's talk about the current concerns. Firstly, there's this thing called the US government debt ceiling. The US government cannot borrow in excess of $31.4 trillion. That's a staggering number. But think about this—within a month's time, US debt will actually hit that number. If Biden doesn't do a deal with Congress to actually raise that limit, the US will be prevented from borrowing any more money to pay its bills. This is a real concern, somewhat alleviated by the fact that since 1960, that debt limit has been raised no less than 78 times. So let's hope history repeats. The school of thought is that because of the poisonous relationship between the Democrats and Republicans, this time could be different. I'm no expert on US politics, but I am hoping that there'll be enough adults in the room so we can get to a sensible compromise.

The second big concern. Yes, there's another banking crisis and yes, the epicentre is the US regional banks.

Now, I'm sure many of you would have read about the failure of Silicon Valley Bank, or SVB. I haven't got time to go through the technical details as to why that bank collapsed, but let me summarise it by saying the leadership of the bank effectively bet the bank that short-term rates in the US were going to be at around zero for many years. It was a monumental error of judgment. I’d call it a rookie error, but frankly, even rookies would be embarrassed about the scale of this ineptitude. Silicon Valley Bank is no more—parts of it have been sold off, parts of it have been wound down. Most importantly, no depositors have lost any money. However, there is a crisis of confidence relating to regional banks in the US, and we've since seen more runs on banks.

I do use the word ‘seen’ a little bit loosely—it's old-fashioned. Runs aren't what they used to be. You remember Northern Rock? This is what the run on the Northern Rock looked like back in the GFC. Have a look at the crowd outside Silicon Valley Bank—more like a social gathering, taking pictures, because runs these days actually happen in cyberspace.

Image 2: On the left, a picture shows a large gathering of people outside Northern Rock during a bank run around the time of the Global Financial Crisis (GFC). On the right, a picture shows a small group of people gathered outside Silicon Valley bank in March 2023.

The rumours start in social media platforms, the Twittersphere—and then the run itself is done by way of keystrokes. So we didn't see much of that action but it happened—the bank collapsed. Unfortunately, I don't think we've seen the end of bank failures in the US among the regional banks. Most importantly, the large banks in the US are in great shape and it has no implication on Australian banks.

The Australian banking system is actually quite concentrated. Arguably this leads to less competition, but one thing for certain, we have a much more stable and secure banking system than the US.

And finally, we have a home-grown tremor. Last week, the Reserve Bank of Australia hiked rates by 25 basis points. This is after pausing in April. What's more, the governor signalled that more rate hikes could be in store.

This was not taken well by the markets. It got them by surprise, and we saw immediate sell-off in both share markets and bond markets. The question, though, is should we really have been that surprised? After all, unemployment is still very low. The labour market is very tight. And what about inflation? Well, have a look at this table.

Here's Australia's inflation rate. Look how it compares to many of these countries that we often compare ourselves to—one of the highest, if not the highest. You'd expect, then, our interest rates to be one of the highest, if not the highest. Well, it turns out that's not the case.

Image 3: A table showing Australia’s core inflation at the highest at 6.6%, followed by New Zealand at 6.5%, UK at 6.2%, US at 5.6%, Europe at 5.6%, and Canada at 4.3%. The table also shows that Australia’s official policy rate is one of the lowest at 3.85%, when compared to New Zealand at 5.25%, UK at 4.25%, US at 5.25%, Europe at 3.50%, and Canada at 4.50%.

As a matter of fact, our official cash rate is actually lower than most of those on the table. So we shouldn't have been surprised that the central bank was hiking rates.

The bottom line—it's a bit premature to talk about a pause in the rate cycle in Australia, but once again, I think we can see some light at the end of the tunnel. They'll certainly be a slowdown in the pace of rate hikes. So because of all those concerns I’ve outlined above, we remain cautious. That doesn't mean we haven't taken advantage of specific opportunities.

Speaking of special opportunities, I'm with Sandra Lee, who's head of our Infrastructure and Private Markets team.

Sandra's team is responsible for just closing a $1 billion deal to acquire an interest in Vantage Towers. Sandra, in a nutshell, can you give our members a high-level understanding of exactly what Vantage Towers is?

Sandra Lee (SL): Sure, John. Vantage Towers is one of the leading mobile towers businesses in Europe, operating in over ten markets with a portfolio of over 83,000 sites.

The anchor tenant and major shareholder here is Vodafone—Europe's largest market network operator. Vantage effectively signed a 32-year lease with Vodafone, providing the business long-term contract cashflows with inflation protection and committed growth. We like Vantage because it exhibits a lot of the Fortress asset qualities that we seek in larger investments.

JP: Some members might recall that we recently got out of the towers business in Australia. Why are we getting back in?

SL: You're referring to our previous investment in Axicom, John. It was opportunistic, and basically it came down to valuation. The bottom line is we were offered a price far in excess of where we held the asset at the time. We currently retain a very favourable view of the digital infrastructure sector and the Vantage opportunity emerged. We effectively bought a higher quality asset at a lower valuation.

JP: Sounds very sensible, Sandra. And maybe just a high-level view of what you're seeing in the opportunity pipeline?

SL: Given we are sitting on a fair amount of cash, we are looking at investments and assessing opportunities in various sectors, including in timberlands, transportation, renewables and private equity, and we're hoping to make an announcement in a significant investment in forestry in the near term. It's an exciting time.

JP: That concludes our update for today. In summary, yes, we are cautious, but we are seeing light at the end of the tunnel, and most importantly, we’re taking advantage of special opportunities when they arise.

Thank you very much for listening.