The Roadmap - July 2023 : simplebooklet.com

EVANS & PARTNERS5 Roadmap | July 2023This past quarter has been no less volatile in markets than in prior quarters, with the RBA hiking a further 25 pts in June, taking the cash rate to 4.1%, only to pause in July. Our view for the remainder of 2023 is to tread carefully, as you need condence in the valuations of assets you purchase.We expect the RBA will continue to push ahead with its hawkish rhetoric in the near term, placing pressure on bond yields; hence we favour investing in high-quality oating rate credit instruments. Higher interest rates have brought an entire asset class - xed income and bonds, back into investability, yet these remain underweight in client portfolios. The key question is whether ination is entrenched. Central to any investment portfolio should be the focus on taking as little risk as possible to achieve one’s stated investment and income objectives. We have been reiterating defensive positioning within investment portfolios. Equity valuations are approaching CY21/22 levels despite a materially higher risk-free rate and sluggish earnings outlook. However, the opportunity set available in defensive and income-oriented strategies is becoming increasingly attractive, with benchmark rates and risk premiums reaching new cyclical wides. Cash yields are now attractive and oer a true source of capital preservation (with no duration risk). Importantly, cash provides valuable optionality and liquidity to take advantage of oversold opportunities when they arise. We want portfolios to be poised for investment opportunities in private markets (private equity, private credit, infrastructure and direct real estate).Our Product Review Group (PRG), headed by Andrew Moir, has been focused on identifying investment managers/vehicles with full or partial liquidity. Private market exposure can lower volatility within a portfolio and enhance returns with valuations that are realistic in the current environment. You should explore these opportunities with your adviser.Risk assets rallied in June, buoyed by resilient global economies and falling headline ination. The focus for the Investment Committee (IC) this past quarter has been the client portfolio asset allocations with a particular focus on interest rate exposure. The Chief Investment Oce (CIO) group has been focused on constructing example portfolios based on dierent risk appetites to accommodate risk and age constraints. Considerable attention is paid to how the portfolios should be constructed to provide performance resilience and limited capital drawdowns during more volatile economic markets.Another key focus for the IC this quarter has been the REIT sector, with Robin Young (Executive Director – Research) presenting a detailed review of the sector and the valuation metrics. Asset valuation downgrades are not likely to be as signicant as implied by the current share prices. We again reiterate the need for diversication in equity portfolios and limited concentration to any one sector. In the Commercial Real Estate (CRE) debt space, we prefer institutionally backed property managers that have been through a rigorous due diligence process and have demonstrated managing assets through the cycle.This past month has seen the launch of our Not-For-Prot (NFP) Director Education series hosted by Will Hart (Director - ESG and Sustainable Investment) and the NFP advice team. We were delighted to see the client attendance at the governance seminar in Melbourne and Sydney despite being a dry yet necessary topic. Please reach out to your adviser to discuss attendance at future presentations. The feedback has been positive as it intends to provide a roadmap to governing an NFP organisation.Finally, I note that Australia and New Zealand will host the rst ever Women’s FIFA World Cup in the Southern Hemisphere. This will be very exciting as we all know that a national jersey number is not worn without a story behind it. Wins, losses, determination, and support are all part of the game. Approximately 94% of women in a C-suite position played competitive sports at some stage in their careers. There is an undeniable correlation between women’s participation in sport and business success. We hope you enjoy the series noting the discipline it takes to achieve the ultimate outcome. The same can be said of investing!

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EVANS & PARTNERS6 Roadmap | July 2023Tim Rocks – Chief Investment Ocer Robin Young – Executive Director, ResearchMax Casey – Director – Portfolio Strategist, ResearchMACROECONOMIC OVERVIEWThe economic outlook remains complicated. Economies around the world have proved remarkably resilient to the sharpest tightening in monetary policy in a generation. Consumers have high accumulated savings and enjoy record job creation and strong wage growth. A massive investment wave is also underway on electric vehicles, manufacturing relocation, defence spending and decarbonisation. The global ination threat lingers, however. The initial wave linked to COVID supply problems is over. Still, a second wave driven by rising wages, corporate margin repair and facilitated by higher ination expectations appears to have taken root. In our view, this will force central banks to raise rates by more than is currently expected by markets and keep them higher for an extended period. This is a recipe for more economic volatility and increases the risk of nancial strains in areas with high debt levels. Recessions or nancial crises cannot be ruled out, but their timing is dicult to predict. Similar dynamics are playing out locally. Accumulated household savings are particularly large, government spending remains elevated, record immigration is boosting demand, and our commodity sector will be a major beneciary of the green investment boom. Our ination outlook is worsening given the number of price rises in the pipeline from rents, electricity and a growing threat from wages. These also point to the need for interest rates to head higher still.This is mixed news for investors. The jump in interest rates will boost returns in interest rate securities and creates signicant opportunities in this asset class. Investors should ensure that they have adjusted portfolios to reect this major change. Conversely, equities are less attractive at present because indices have already run hard, and they are more vulnerable to some of the macro risks. Investors should ensure they have well diversied and defensive portfolios but should also be looking for opportunities created by any future volatility.

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EVANS & PARTNERS8 Roadmap | July 2023Tim Rocks – Chief Investment OcerMax Casey – Director & Portfolio Strategist, ResearchRobin Young – Executive Director, ResearchTHEMATIC ONE: EVS FIND A NEW GEARElectric vehicle (EV) adoption is at an inection point. EVs are following the same adoption prole as other consumer technology goods in the modern era, which points to an even greater take-up in the coming years. Government incentives underwrote the initial take-up, but economies of scale, improving product quality and expansion of charging infrastructure have taken over. It is fascinating that such a large, globally important industry is transforming so quickly. Global auto sales are around $US3 trillion (3% of global GDP). The next wave will have economic, political and market implications. ▪ Given the industry’s size and pace of the transition, the amount of investment is meaningful for the global economy. Investments in new car plants, commodity supply, battery production and charging infrastructure could total around $400 billion per year over the intense period of industry development. That alone is about 0.4% of global GDP or about 3% of global investment spending. ▪ Interest rates may have to go higher in the short term and stay higher for longer. The investment wave is adding to activity and demand for labour at a time when central banks are trying to dampen growth. In the longer term, while vehicles may fall in price, there could be higher ination from commodity prices and the broader energy transition. ▪ There are geopolitical implications. China has stolen a lead on the rest of the world and is now the world’s second largest auto exporter. China now also controls the battery production and lithium rening supply chains, making it more dicult for others to bridge the gap. Japan is the most vulnerable here, but the US will be uncomfortable with losing out in such an important industry. ▪ These recent developments conrm the compelling case for green metals over the next decade. Lithium is the stand out from the battery metals, while copper is the main winner from the traditional metals.

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EVANS & PARTNERS10 Roadmap | July 2023Tim Rocks – Chief Investment OcerMax Casey – Director & Portfolio Strategist, ResearchRobin Young – Executive Director, ResearchTHEMATIC TWO: WATCHING COMMERCIAL PROPERTYThe potential for nancial strains in the commercial property market remains a key macro risk. Property valuations are falling, and some owners will struggle with the higher cost and more limited availability of credit over the coming years.Higher interest rates are forcing a reassessment of commercial property valuations. In the US, prices have fallen 4-5% from their peak in mid-2022, and further falls are likely. For example, Capital Economics expects a further 18-20% fall from here. There are likely to be wide divergences by sector, with the oce sector expected to fall by around 30%. The oce sector has been aected by the trend towards working from home, particularly in the US.Another important question will be whether property owners can cope with signicant increases in the cost of debt. Many funds were locked in cheap debt when rates were low, so this eect will be delayed, but it may prove challenging and costly to renance this debt when it falls due. This is particularly the case in the US, where smaller banks have traditionally been major providers of funds, but these banks are now liquidity constrained.These pressures are most intense in the US, but they are also playing out in Australia to a lesser extent. Australian REITs have announced downgrades in asset values of around 3-6%, with Dexus being at the high end of that range, given its greater exposure to oces. Meanwhile, several large superannuation funds have downgraded oce tower valuations by 10-15%. Outside the oce sector, valuation changes have been small. Since most listed REITs are trading at discounts of 20-30% to current asset valuations, we see this risk as comfortably priced into the listed sector.A greater risk for Australian REITs is that their cost of funding will rise over time, aecting cash ows and the size of future distributions. The risk will vary by REIT depending on the level and maturity of its debt. The extent to which rents are linked to ination will also be an important factor for the size of future dividends. Overall, however, we need to be aware of the potential for lower dividends from the sector over time. Clients should consider switching funds to credit, where yields are rising, or other equity sectors, where dividends are likely more stable.

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EVANS & PARTNERS12 Roadmap | July 2023Tim Rocks – Chief Investment OcerMax Casey – Director & Portfolio Strategist, ResearchRobin Young – Executive Director, ResearchINTEREST RATE SECURITIESCREDIT OPPORTUNITIESThe jump in interest rates has improved prospects for interest rate securities. Expected returns are higher, and the opportunity set has expanded. Investors should be reviewing their allocations to this segment of the market. In many instances, interest rate securities now oer a better combination of risk and return to equities. In the US market, yields on investment grade credit now exceed the earnings yield on equities for the rst time in 15 years.The attractiveness of these securities could extend further. We have more conviction on the persistence of ination, which means central banks will have to li rates further. The structural deationary force of globalisation is reversing, the transition to clean energy is inationary and demographic changes are leading to a structural shortage of workers in most major developed markets. Higher rates have owed through to parts of the market in dierent ways. Floating-rate securities with shorter maturities have seen the biggest jumps in yields. This is behind our preference for investment grade credit. With the resetting of interest rates, these are now oering returns of 7-9% - around double the rate of a couple of years ago.Longer-term xed-rate government debt is currently less attractive since yields on longer-dated bonds have not risen as much and are at risk of mark-to-market losses if ination persists. Term deposit rates are starting to rise, and some oers are now around 5%. However, investors should be careful about locking away money for too long because ongoing market volatility could create opportunities for those with cash on hand. Returns for hybrids have risen in line with the increase in short-term interest rates such that current yields-to-maturity are around 7%. Further rate increases could push them up further. Investors should also consider some exposure to private credit. Some corporate borrowers are struggling to access funds because banks are less willing to lend, and listed debt markets remain eectively shut to new issuance. They are increasingly turning to private credit providers who can charge higher rates with more favourable terms. This is an opportunity for investors, but we should also be wary of the potential for rising defaults and ensure we invest with experienced managers.

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EVANS & PARTNERS14 Roadmap | July 2023Tim Rocks – Chief Investment OcerMax Casey – Director & Portfolio Strategist, ResearchRobin Young – Executive Director, ResearchAUSTRALIAN EQUITIES STAY DEFENSIVEMacro risks have increased in Australia as ination has become more embedded, and the RBA has continued to raise interest rates. The better news, however, is that valuations are less stretched than in the US, and there are some opportunities at the sector level.Some powerful forces are propelling the Australian economy, including record immigration and job creation, a jump in government spending, major capex programs, and households ush with excess savings. These have dampened the impact of rate rises to date. However, the ination outlook has materially worsened this year, forcing a response from the RBA and threatening an economic slowdown at some point. While the short term is uncertain, Australia is well positioned for medium-term expansion. The next global cycle appears set to be dominated by major capex programs in the energy, healthcare and manufacturing sectors. This should provide strong support for commodity demand. We are also on the cusp of a local construction wave driven by the Brisbane Olympics, a second Sydney airport, major road and rail projects and the rebuilding of the electricity network to accommodate the adoption of renewable energy.The Australian equity market is also less stretched in valuation terms than the US. The Australian forward price-earnings ratio has fallen by around 25% since its peak, meaning that much risk has been priced in. The adjustment to overall market valuations has not been uniform across sectors. Investors should continue to be wary of sectors that could be particularly aected by further weakness in the economy. Still, they should also have an eye on sectors with strong outlooks. Banks is one sector where caution is warranted. They have performed well because of strong dividends and expanding margins. But margins will soon peak as deposit rates rise, the cost of other funding increases, and they compete more aggressively for new business. There is also the risk of credit deterioration as higher interest rates eat away at borrowers, particularly those switching from xed rates.

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EVANS & PARTNERS16 Roadmap | July 2023Tim Rocks – Chief Investment OcerMax Casey – Director & Portfolio Strategist, ResearchRobin Young – Executive Director, ResearchINTERNATIONAL EQUITIESEMERGING MARKETS AND SMALL COMPANIES STAND OUTRemarkably, equity markets have had such a strong start to the year, given the backdrop of the sharpest tightening in monetary policy in a generation, heightened geopolitical tensions and some signs of nancial stress emerging. Instead, investors have been heartened by the recent resilience of economies, the fall in headline ination rates and hopes for an AI-led productivity boom.The surge in US mega-caps has pushed valuations to extremes. US tech captured most of the benets of the megatrends in the 2010s, such as e-commerce, social media and cloud computing. There is hope that AI will cause another such wave, but it is less clear that US rms will be as dominant in this new growth phase. Headline market strength has hidden signicant divergence in performance where many assets have lagged - this is where opportunities appear. Emerging markets have been neglected by investors even though prospects are improving. Smaller companies were also overly caught up in the market fall in 2022 and have not recovered.Emerging markets are the stand-out global region for now. Asia is still in the process of post-COVID reopening. Given lingering risks around the property sector, China’s economy has been slower to bounce, but a recovery is underway and will be further supported by policy measures throughout the year. China is also best positioned to benet from the green investment wave, given its dominance of the electric vehicle, battery and solar industries.

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EVANS & PARTNERS17 Roadmap | July 2023Europe has been surprisingly resilient so far in 2023. The industrial north has suered from a manufacturing recession, but this has been oset by the benet of returning tourism to the southern nations. In the short term, there are still risks from energy shortages and rising interest rates. We do not recommend increasing exposure to Europe at this time. Still, we are monitoring the situation as equity markets are not expensive, and holders of European assets will eventually enjoy a rebound in the Euro that has slumped to record lows.In the US, our preference is for smaller companies only. They have not seen the same valuation rerating as the mega-caps. The broader market is still vulnerable to macro risks, tightening margins and the possibility of an unwinding in the strength of the US dollar.Equity investors need to be more aware of the potential for currencies to drive relative performance going forward. It has been a remarkable run for the $US over the past decade, driven by US corporate dominance and structural challenges in Europe. This has le the currency overextended and vulnerable to reversal over the next cycle. Once US interest rates start falling, investors who ocked to higher-yielding US assets and high-quality US equities will look elsewhere in the world to nd better value. US VALUATIONS BY SIZESource: Renitiv, Evans & PartnersASIAN EMERGING MARKET EQUITY VALUATIONSSource: Renitiv Datastream, Evans & PartnersUS TRADE WEIGHTED INDEX DXYSource: Renitiv Datastream, E & P

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EVANS & PARTNERS18 Roadmap | July 2023Tim Rocks – Chief Investment OcerMax Casey – Director & Portfolio Strategist, ResearchRobin Young – Executive Director, ResearchALTERNATIVESFOCUSSED ON INFRASTRUCTUREAlternative assets serve several important roles in portfolios. There are two broad categories of alternatives: growth alternatives and defensive alternatives. Growth alternatives include private equity and venture capital. These typically provide exposure to parts of the economy that are either not or poorly represented in public equity markets. The private equity market has changed signicantly in recent years and, in our view, is now essential for investors seeking a well-diversied exposure to high-returning assets.Part of the reason for this is the changing nature of public markets. The number of listed companies in the US has halved since the golden days of the 1990s. Fewer companies are listing, and they are doing so later in their lifetime. They are more likely to be mature when they do so, meaning much of their rapid growth will already be behind them. Macro and market volatility have had a range of impacts on the private equity industry. Some established venture, growth and buyout funds might struggle in coming years because they bought assets at the peak of the cycle, and many have high levels of debt that will need to be renanced at higher rates. Meanwhile, newer funds might be able to take advantage of distressed situations and be well positioned to allocate money to growing companies at the start of a new cycle.Defensive alternatives include less volatile assets that should provide a more stable source of return over time or which are lowly or negatively correlated with traditional asset classes. This could include infrastructure investments, private credit, hedge funds, commodities, gold and long-short funds operating in equity or bond markets. Our preferred defensive alternatives are unlisted infrastructure and private credit. Unlisted infrastructure funds typically have large exposure to transport infrastructure, such as airports and freight terminals where volumes are strong as conditions normalise aer COVID. Many assets also have ination protection due to CPI-linked pricing, making them particularly attractive at present.

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20 Roadmap | July 2023EVANS & PARTNERSDisclaimerThis document was prepared by Evans and Partners Pty Ltd (ABN 85 125 338 785, AFSL 318075) (Evans and Partners). Evans and Partners is a wholly owned subsidiary of E&P Financial Group Limited (ABN 54 609 913 457) (E&P Financial Group) and related bodies corporate.This document is not a product of E&P Research (“E&P Research” is a registered business name of Evans and Partners) and is not intended to be a research report (as dened in ASIC Regulatory Guides 79 and 264). Unless otherwise indicated, all views expressed herein are the views of the author and may dier from or conict with those of others within the group. Where a reference is made to a recommendation from an E&P Research Analyst, it is merely a restatement, summary or extract of the most recent E&P Research report relating to the relevant nancial product and a copy of the original report may be obtained from your adviser or from our website at www.eap.com.au/services/research.The information may contain general advice or is factual information and was prepared without taking into account your objectives, nancial situation or needs. Before acting on any advice, you should consider whether the advice is appropriate to you. Seeking professional personal advice is always highly recommended. Where a particular nancial product has been referred to, you should obtain a copy of the relevant product disclosure statement or oer document before making any decision in relation to the nancial product. Past performance is not a reliable indicator of future performance. The information may contain statements, opinions, projections, forecasts and other material (forward looking statements), based on various assumptions. Those assumptions may or may not prove to be correct. E&P Financial Group, its related entities, ocers, employees, agents, advisors nor any other person make any representation as to the accuracy or likelihood of fullment of the forward-looking statements or any of the assumptions upon which they are based. While the information provided is believed to be accurate E&P Financial Group takes no responsibility in reliance upon this information.The Financial Services Guide of Evans and Partners contains important information about the services we oer, how we and our associates are paid, and any potential conicts of interest that we may have. A copy of the Financial Services Guide can be found at www.evansandpartners.com.au. Please let us know if you would like to receive a hard copy free of charge.

The Roadmap - July 2023

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