Staying the course — A timeless lesson

On behalf of all our team at EWL Private Wealth, I would like to personally thank you for your continued trust in 2022. We understand that trust is earned, not given, and can be stretched in negative years like the one we have just had. While these years are inevitable, they can be very uncomforting. There is nothing more important to a successful relationship than trust – in our people, in our investment philosophy, our process, and your confidence that we will always put your needs first.

When we design a portfolio, or strategy for each family – it anticipates volatility. The reality that we will face positive and negative years together. On average, there will be a negative year every 4-6 years of between 15-30%. Irrespective of these levels of volatility, share markets have still returned, on average, a positive 9.50-11.60% per annum over the past 30-years. Those 30-years have encompassed booms and busts, global conflict, global financial crises, various geopolitical environments, recessions, and expansions. What’s important is that for those who need to draw upon their portfolio, they have liquid assets that can fund these withdrawals without having to sell more volatile ‘growth’ assets at a loss. These buffers are there to weather volatility and uncertainty.  

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Even more important is that investors trust their plan and stick to their strategy. Most of the families we work with have owned or operated a business. When something is underperforming in their business, they take action to improve the outcomes. It’s not surprising that when portfolios have a down year, investors want to act. To ‘sell out before the portfolio falls further,’ to ‘time the top’ and then to ‘reinvest when the market is recovering.’ The truth is, navigating short-term market fluctuations is near impossible. While it’s human instinct to want to react, good companies, with good leadership are doing exactly that. Making decisions on whether to cut or increase staff, managing their inventories, level of R&D spend, CapEx, OpEx. For businesses in an excellent financial position, deciding on whether to be opportunistic – acquiring businesses that sit within its supply-chain or buying back shares. Staying invested in quality businesses is what an investor does. Trading, timing for predicting short-term events is speculating, not investing.

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Volatility is much more normal than it feels…

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As mentioned above, the ‘average’ historical return for the S&P500 is about 8-10% per annum. Despite this average, the S&P500 has only gone up by 5.00-10.00% six out of the last ninety-four years. Returns, both positive and negative more commonly tend to over or undershoot this average significantly. Returns of positive 10-30% occur 42% of the time. Returns of 0.00% to -20% occur about 26.00% of the time. Across the dataset, returns are positive two-thirds of the time.

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While years like 2022 are uncomfortable, this type of volatility is completely normal. Every 4-6 years, a negative return should occur, causing assets to fall by most commonly up to 20%. What is not normal, is the universal repricing of all asset classes in 2022, due to positive correlations.

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Diversification – 2022 was a year of positive correlation.  

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What about your adviser – isn’t their job to reduce risk further than this? Yes. What an adviser should do for you is build a mix of assets, each with a different risk/return profile. The saying don’t have all your eggs in one basket – you should diversify your assets, their earnings, their exposure to risks. That exposure should be broad. Encompassing Australian, global, and emerging market equities, government and corporate bonds, property, infrastructure, private assets and so on.  

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In a normal environment, these assets should have different correlations. By that, I mean that over time, different companies, different types of industry and different economies should carry different risks and opportunities to one another. By managing these allocations, and the weighing or size of each allocation, your adviser can usually reduce risk and more consistently achieve a target return.  

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The different characteristics of assets usually provides an adviser with a toolkit to manage market risks. Not to avoid them, but to minimise them. 2022 was different. All asset classes moved to a point where they have positively correlated returns. Bonds, which would normally rally when equities fall, moved in tandem with equities (down 15-20% peak to trough). They offered investors no defensive cushion. Cash was deeply negative adjusted for inflation. All investors were pushed into higher equity allocations and alternative assets such as property, infrastructure, or private equity – from big industry funds, Australia’s sovereign wealth fund the future fund, and our own investors. Point being, the available toolkit narrowed, so portfolio volatility increased.  This wasn’t normal.

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This year will likely end negative for all asset classes, other than commodities and commodity-related miners or producers. Whilst some private equity assets will finish flat or positive, many haven’t been marked to market to reflect the higher interest rates that all publicly listed asset have since adjusted to.

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As a firm, our investment philosophy deters us from having large standalone allocations to commodities.  Commodity producers are price-takers. Their businesses are subject to global pricing, with little to differentiate their product relative to a peers, other than commodity grade or price. As a result, earnings are macro-driven, cyclical and unpredictable. Despite standout year to date returns, many major mining, resource and energy producers only reached the same share price levels in 2021-22 as where they traded 10-15 years ago.

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Admittedly, being underweight this exposure has led to some underperformance this year. Those with a greater bias to Australian equities did better, inherently because of this (as our local market is skewed almost entirely to resources/financials). Over the long-term, we believe this decision will be the right one.  

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2022 – knowable vs. unknowables

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As advisors, we are tasked with making recommendations with incomplete information. This rings especially true for financial markets and investment advice. Unfortunately, we have no crystal ball. We cannot predict the future, nor do we know what events will unfold in the coming quarters.

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This reality applies to all investors. What is knowable is the price we pay for an asset. How well capitalised that business is, and the general financial health of it. How much that asset currently earns or offers investors. How those earnings compare to other available assets. Then we make decisions on the relative resilience of those earnings, as well as their potential for future growth.  

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Macro forecasts, while interesting, are unknowable. They are simply big narratives that make it easier for investors, traders, finance professionals, economists, or journalists to digest what’s occurring, or speculate on the future. Think about recent examples. How high will inflation go? Will inflation remain higher forever? When might central banks stop lifting rates? Will the war in the Ukraine end in 2023? Will China invade Taiwan? Will governments or central banks intervene in a recession? Will corporate earnings decline in 2023, and if so, by how much? Is this inevitable?

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Are any of the above narratives knowable? Or at least knowable with a degree of specificity to make them useful to an investor? Is that narrative different to what other investors would be thinking to make it valuable, or uncaptured, unpriced by the market?  In almost all cases, the answer will be no – at least, not in the short-term. Over the long-term, these issues have little to no impact on returns.

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Short-term vs long-term

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It should be emphasised that in the short-term, earnings resilience, or earnings growth do not drive share price returns. Sentiment does. However, over the long-term, earnings are the main driver of returns. 2022 has not been driven by earnings, but instead interest rates and multiple compression.

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Let me highlight this disconnect:

• Over the long-term the S&P500 has seen earnings growth on average of 8-10% per annum. Interestingly, the index has averaged price returns to match this, of about 8-10%.

• But what about the short-term? This time in 2021, consensus among stock market analysts and strategists from large sell-side firms predicted earnings growth of 10.00% or about $230 for the S&P500 in 2022, but price growth of 8.00%, (discounting for a few rate rises).

• Upon reflection, earnings for the S&P500 will finish at $222-225 for the year. Remarkably, despite all the events and volatility this year, actual earnings will only be a few dollars less than anticipated. But what about price? This should match earnings growth, right? Wrong. Instead of being positive 8.00%, the S&P500 is down 18.78% or 26.78% below forecasts!

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Earnings growth for companies that make up the S&P500 will end the year with earnings growth up approximately 9.50%, almost exactly in line with Wall St consensus predicting an 10% rise for the year. None of these groups anticipated central banks reversing course as aggressively as they did, or a major conflict.

What factors determine an assets price?

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Predicting a future asset price usually requires two estimations:

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1. The cashflow, or earnings an asset will generate over a given time horizon; and
2. The valuation multiple or interest rate, the market will ascribe to that cashflow.

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The longer the horizon, the more certainty we have over the above two factors. For example, for a company like Apple, using longer-term data, we may be able to model the expected number of iPhone sales for a given year, sales growth, their margins, and indicative earnings from that product. However, in the short-term if factories in Apple’s supply chain go into lockdown because of a 1-in-100-year pandemic, and this impacts production – can we predict this? Should investors have sold out prior to the pandemic and purchased back in after? Of course not, it’s unknowable – and lower supply increased iPhone demand and pricing. What about point 2 – interest rates? In October 2021 the RBA and rhetoric of Central banks globally was that interest rates would remain low until at least 2024. Did we believe them? No – we expected 3-4 rate increases, but certainly not 10-12 or more. On the topic of inflation driven rate rises, it’s worth adding further context:

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Global inflation has fallen since the early 1980’s because the growth in the total demand for goods and services has lagged total supply. This demand growth deficit resulted from a combination of factors, including aging populations, technological progress, globalisation, and concentrated wealth. The gap in demand and supply has been closed by increasing debt – household, corporate, government and central banks (i.e. QE). In 1970 total global debt was 100% of GDP. Today it’s 400%. Immediately before Covid-19 arrived, central banks are wrestling with deflationary forces, undershooting their target range consistently. Long-term inflation was falling rapidly around the world. The RBA and US Fed began QE and cutting rates in late 2019 – prior to knowledge of covid.

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The reality is long-term inflation is in structural decline. Productivity and population growth are the two primary drivers of inflation. Population growth rates are declining; and technological productivity is improving. Inflation will fall from current levels over the long-term, but short-term distortions will elevate levels in the near-term. Covid-lockdowns and subsequent reopening, the Russia-Ukraine conflict, and governments onshoring or friend shoring production that is necessary on national security grounds, have driven this. These short-term drivers were again, unknowable. We continue to expect long-term inflation to decline to pre-pandemic levels of 1.50 – 2.50%. This would mean the RBA’s long-term cash, ‘neutral rate’ should settle at a similar level of 1.50-2.50%.

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A reflection – EWL perspective on 2022

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What we knew – October 2021:

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• Equities were the only asset that offered investors the potential for positive ‘real’ returns.
• From an income perspective, equities paid investors more than bonds or cash.
• Central banks, like the RBA had assured investors that rates would remain low until 2024.
• Underlying inflation was running at 1.75% in Australia, and
• The global economy was reopening post Covid, corporate earnings remained resilient.
• Economic growth was recovering, unemployment levels falling – sentiment was positive.

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What we didn’t – 2022:

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• Central banks would abandon earlier policy, increasing rates the most aggressively in history.
• Inflation would accelerate to the highest levels in approximately 40-years.
• A global conflict would emerge between Russia and the Ukraine.
• Sanctions against Russia would cause disruption to global energy and food supply.
• The moderate 60/40 equities-bond portfolio would have its worst return in history.

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Actions we took in 2022.

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We have built a reputation in the industry for delivering positive outcomes for clients that have regularly been above the market. However, 2022 was not a year that reflected this. As a team, we are accountable to you our valued client. For your, and our own reflection, I wish to share commentary on the decisions we made, the economic environment, and our performance.

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The environment over the past 24-36 months has been unusual. In 2020, Covid-19 was the first global pandemic the world has seen in approximately 100-years. The world went into mandatory lockdown. Production was cut and supply-chains screeched to a halt. The businesses that thrived were technology led. E-commerce replaced instore consumption out of necessity. Australian and global listed property saw double digit declines. Australian shares ended the year negative – largely because of the ASX’s large exposure to mining and resources which suffered, while the US and international ended positively due to more diversified exposures in technology and healthcare.

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In 2020-21, The global economy entered a short, sharp recession. The corresponding action from central banks and governments were unprecedented. Record amounts of stimulus and aggressive interest rate cuts dramatically reduced the cost of capital, encouraging activity. Fixed income assets offered investors little or no incentive to invest in them, trading negative in real ‘inflation adjusted’ terms. As a result, all investors were encouraged to move higher up in the risk curve to achieve their desired returns. A common mantra ‘there is no alternative’ or ‘TINA’, took hold of markets. Investors had no choice but to invest in growth assets for positive ‘real’ returns. As the cost of capital fell, real estate valuations soared. Central bank stimulus made borrowing much more affordable. Interest rates more than halved. Those with $1,000,000 mortgages at 4.00-5.00% could now afford $2,000,000 + at 1.75%-2.00%. Similarly, more money flowed into equities pushing valuations higher. Almost all asset classes delivered positive returns in 2021, except for Australian and international bonds, given their relative unattractiveness – low, or negative real returns, expectations that rates would inevitably rise, causing the mark-to-market value (capital value) of those bonds to fall.

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In 2021-22, we entered the year with conflicting sentiment. Central bankers, including Philip Lowe – the current RBA governor, assured investors that interest rates would remain on hold, at or near their record low levels until 2024.

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The message was clear – the RBA Board will not increase the cash rate until inflation is sustainability within the 2-3 per cent target range.

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“The Central Scenario for the [Australian] economy is that this condition will not be met before 2024.”

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Fast forward to December, and the RBA’s commentary on rising inflation remained consistent.

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“it is still low, at 2.1 per cent…a further, but only gradual pick up in underlying inflation is expected. The central forecast is for underlying inflation to reach 2.50% over 2023.”

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The ensuing environment and consequential actions of the RBA in 2022 were starkly different to the guidance provided to consumers and markets. The result was reputational damage for the central bank and an unprecedented public apology from the governor himself.

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Similar statements were shared in the US and globally. Households were encouraged to consume, and to borrow, on the premise that the cost of capital would remain low. As criticised by Former U.S Treasury Secretary Larry Summers [of Fed Chair Jerome Powell], “the return to humility, the abandonment of forward guidance as a policy tool is entirely appropriate.”

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Investors were incentivised to continue taking risk, given bonds or cash offered a negative real return. This sentiment continued from October 2021 through to April/May of 2022. As investors begun the 2022-year, equities were one of the few – if only places that offered the possibility of a positive real returns. Particularly given elevated inflation was (and is) running at the highest values in recent decades. Even ignoring total return, yields in Australian and global equites were mostly higher than available cash or fixed income options. So, on a relative basis, equities appeared favourable.

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Despite Central Bank rhetoric, we didn’t believe that rates would remain on hold until 2024. We anticipated higher inflation, and higher rates, but we didn’t anticipate the velocity and quantity of increases (nor did most peers – or the RBA itself). We did look to de-risk earlier in the year with a view that valuations were above their long-run average. However, we were also comforted by corporate earnings growth which remained above analyst expectations (and largely continued to be this year), and strong corporate and household balance sheets that built up over covid lockdowns.

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In January to about April, cash paid close to zero and in fact was deeply negative adjusted for inflation. Surprisingly, in most cases cash is still negative adjusted for inflation. In a rising rate environment, we knew bonds (fixed income) would lose money because they devalue when new bonds are issued at higher rates. Equities, irrespective of volatility, offered earnings of 1-5% per share, so were relatively attractive at the time. We diversified the type or ‘style’ of recommended equity investments. We started recommending a partial rotation from ‘growth’ managers, and instead, to ‘quality’ and ‘value.’

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Growth/Quality/Value – what do they mean?

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‘Growth’ shares are ones that refer to businesses that reinvest heavily into future growth. This is at the expense of paying higher income/earnings out to shareholders today – in the hope of delivering a higher return on investment over time. Growth benefits in a low-rate environment but underperforms in a higher one. Why? Because the cost of forgoing returns today is greater in a higher rate environment. Investors demand a higher return to compensate them in a higher rate environment.

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‘Quality’ refers to businesses that have a stable, established brand. They are typically market leaders and their competitive advantage gives them the ability to pass on cost increases to their consumer. Think of Apple – whereby consumers will pay what they need to, when replacing their phone. They have brand loyalty, so a higher rate environment shouldn’t impact these types of businesses as much as the broader market in an inflationary environment – because higher costs can be passed on to consumers. Quality companies, have sound balance sheets. In the case of apple – $50 billion in cash with little to no debt maturing in the near term. Higher rates should have little impact on these types of business from a cost of capital perspective.

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When we say ‘value’, some investors define this simply by how high or low the price to earnings multiple (P/E) is. However, we define this as the opposite of growth. Value businesses tend to favour paying out earnings or buying back shares, instead of reinvesting this into its business. Common examples could be banks/financials or energy companies. Historically, we have not invested in ‘value’ style businesses. We prefer businesses that reinvest their earnings to grow, instead of paying out high levels of income. We view equities as a ‘growth’ asset – not typically an income asset and in our opinion, income should sit with fixed income, real estate, or cash assets.

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If we reflect on a few examples of ‘value’ type investments, perhaps we can illustrate why we are generally under-weight in our exposure to these. In Australia, our big banks often trade on a lower multiple relative to the rest of the index. They pay out a high amount of their profits, in fact most of shareholder return has come from income – not growth. An allocation to Australian banks over the last decade (using MVB.ASX as a proxy), would have earned you a price return p.a of 2.26% (which is slightly below the average inflation rate of ~2.50% for the decade). The income return, however, averaged 5.19%. Yet, if you were choosing to invest for income – there were other, arguably safer options. The very same T2 bank bonds, which rank higher in priority than common equity, could have paid you a similar or equal return. Certainly now, with yields rising dramatically year to date, fixed income offers investors attractive income above the ASX, above big banks and most ‘value’ shares.

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Product innovation – how the strategies we launched performed relative to market

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Accounting for all asset classes, 2022 has been the worst year for markets in the last 50 years. To put things into perspective, markets were broadly considered to be ‘safer’ for investors during the 2008 Global Financial Crisis, as bonds and equities were uncorrelated.

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In the midst of this year’s macroeconomic chaos, we brought several strategies to market for our client portfolios. Whilst the benefit of these strategies has been muted by broad valuation drawdowns, in time, these inclusions will serve to enable portfolios to deliver their long run return objectives.

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The Clearbridge Infrastructure SMA was the first of its kind in Australia and has been one of the best performing equity strategies since we launched it in 2021. For 2022, Clearbridge has again been recognised as the best Infrastructure manager in Australia.

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We have also launched the T. Rowe Price Global equity and Lazard Global Franchise SMA’s. These have helped de-risk portfolios from their growth tilt and broadened our exposure to well capitalised, profitable, and growing companies.

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Closer to home, we launched the Fidelity Australian Opportunities SMA to complement our existing Australian equity exposure. This enabled us to benefit from the near-term tailwinds of Australia’s commodity/material driven economy, whilst retaining our strategic long-term allocation to Australian ‘growth’ companies.

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Most recently, we have launched an Australian first global property SMA in partnership with UBS & CBRE, seeking to capture a historic opportunity in listed property, which currently trades at a 20-40% discount to private equivalents. We expect this to provide clients with a meaningful return over the coming years. Looking ahead to 2023, we have several other innovations in development to enhance our access to private markets and traditional fixed income.

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Business developments for 2023  

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Everything we do at EWL is done in the pursuit of providing better outcomes for you. Whilst this is predicated on achieving positive long term investment returns, we strive to deliver an evolving and holistic financial service experience. With this in mind, we have developed a new partnership that will enable us to provide lending solutions across 80 institutions, spanning retail lending and private lending. This service will be complimentary to EWL clients in 2023.

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Similarly, we have further built out our capacity to access and negotiate term deposit and cash management solutions for clients in consideration of higher cash rates. For our clients who want to put retained cash on balance sheet, or short-term liquid cash to work, we can access more competitive rates than offered directly by major banks. For larger balances, we can negotiate across all major institutions for a rate. This service will also be complementary and attracts no advice fee.

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Together, having truly global and institutional investment access, the ability to source or build new investments, offer lending solutions to clients across all major institutions, and cash management solutions across all leading banks, we can provide clients with an unconstrained private bank type service.

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Today, despite the market challenges of this year, we are a substantially bigger business than at our predecessor firm. Our headcount is three times the size and growing, with more planned hires in 2023. We are proud to have opened the doors to our beautiful new office in Martin Place last week, with Craig and Charles making the move to Sydney to offer our NSW clients a full time, on the ground presence.

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From an operational perspective, we proactively surveyed clients this year – choosing to do this in an uncomfortable environment to gauge your honest feedback. Our takeaway was that in volatile periods we need to communicate more regularly and more personably, outside of your formal investment reviews. In 2023 we will be scheduling more frequent discussions – irrespective of portfolio changes, so we can keep all clients involved in our thought process.

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We have also launched a podcast called The Exchange, primarily to bring you into the conversations we have with fund managers, economists, and other professionals throughout the year. In addition to our annual client events, we plan to host several smaller ones, connecting you with thought leaders more regularly. In our client notes, these are often focused on behavioural mistakes (because they can be one of the most important risks to manage – within our control), but in 2023 we will publish more content on actionable insights/opportunities for those who wish to be more tactical. We hope that all these initiatives will enable us to provide the highest level of service possible.

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Final word

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Consensus leading into 2023 amongst investment houses appears to be that a global recession is all but a foregone conclusion. A bad year for the economy, but a good year for markets. We have no doubt that the next year will bring on its own challenges, but as we put 2022 in the rear view, we remain optimistic about the opportunity that lies ahead.

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As market functions normalise, inflation moderates and the economy slows, we believe that it will be a better market to allocate capital in. Certainly, one where correlations reduce, and investors and advisers have a broader toolkit available to manage volatility. For those who wish to de-risk, there are now meaningful alternatives outside of growth. We are starting the new year with valuations seemingly fair, if not below historical values – but uncertainties do remain for Q1 and Q2.

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“The psychological temperament of an optimist is not a sunny disposition or a Pollyanna delusion that everything is ideal. Rather, optimists believe that bad things are produced by temporary causes that can be overcome, while pessimists believe bad things always happen, and if anything, good happens, it’s temporary.” – Kevin Kelly (Founder, Wired Magazine)

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Yes, companies will face a tougher operating environment when central banks are ultimately successful in their pursuit against inflation. However, firms with strong competitive advantages and solid balance sheets will emerge from this period bigger and better.

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We remain confident in our investment process, our philosophy, and the ability of our carefully selected investment managers to ensure the viability of portfolio companies through a variety of economic conditions. Our portfolios are built for the future, with an alignment to structural growth trends predicated on major societal and industrial changes – these will play out consistently over time, and long run return objectives remain in sight for all of those that stay the course.

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On behalf of our team at EWL, we wish you a wonderful holiday season and a successful and Happy New Year!

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Warm Regards,

Ryan & Charles

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