Zehrid Osmani – Market Update

Market Update

Hello. It’s Zehrid Osmani, Portfolio Manager of the Martin Currie Global Portfolio Trust with an update on the first six months of our financial year.

There have been two supply shocks since the start of the year, both of whom have exacerbated the situation. The first one, the Russia-Ukraine conflict, pushing commodity prices, notably energy prices up strongly, which has fed into stronger inflationary momentum.

And the second one, which has been a pandemic relapse risk in China, with China's zero tolerance on COVID, leading to partial shutdowns of sizable regions, which have again exacerbated the supply chain bottlenecks that we have seen previously - as well as creating some production disruptions, all of which has again exacerbated the inflationary pressures.  As a result, we are also seeing leading indicators slowing down. Economic leading indicators, both on the manufacturing and the services side, losing momentum quite rapidly across most of the key regions.

China has been a volatile one, has sharply deteriorated in the current Q1/Q2, has recovered since then but have rolled over again. So as a result of those leading indicators deteriorating, we believe that we are entering a sharp slowdown within the economic cycle away from expansion. 

As a result of this slow down and deteriorating macroeconomic momentum, we are facing a very negative cocktail of leading indicators slowing down and the economic cycle moving towards a sharp slowdown at a time when monetary policies have to focus on the stronger and longer-lasting inflation and therefore have to hike more rapidly and more significantly than previously expected.

So we are looking at a year, 2022, which was already looking like a year of low growth, which is now turning into a year of no growth in our view. As a result, consensus estimates will, in our view, need to come down and therefore focusing on companies that can either deliver or overdeliver or can resist the earnings downgrades more than the market is going to be an important focal point.

And it's easy to understand in periods of earnings downgrades, investors will favour companies that have resilient and consistent growth profiles that are facing long term structural growth and have solid balance sheets and that can therefore deliver on earnings expectations, but also resist in periods of sharp slowdown or recession.

At the same time, in addition to obvious criteria, we like to focus on companies that have pricing power. Given the stronger and longer lasting inflation that we have seen and the companies that we typically focus on have strong pricing power and are operating in industries that have favourable pricing dynamics typically. And as a result, we believe that margins of the companies we are investing will be relatively more protected during this abnormally high frictional inflation.

On the inflation side, we've talked about it in the past, the importance of wage inflation is critical, and we believe that inflation has become an important top-down focus. All eyes in the market are on inflation and a stronger inflationary prints will lead to upward adjustment to rate expectations and equally, the reverse could lead to some respite in terms of direction of interest rates.

For us, wage inflation is critical because typically it accounts for over 80% of inflation in the medium term. And there is some contrasting aspects to highlight here. In Europe, typically there is still limited wage inflation from what we can see, whereas in the U.S. wage inflation is accelerating and that's reached a level over 5% in the official print.

We believe that that increase in wage inflation has the potential to feed into a more structural inflation. So the importance of continuing to focus on inflation momentum will be an important aspect both in the second half and into next year.

Portfolio Activity

On the holdings, the importance of our process is also worth highlighting. Firstly, we constantly reassess conviction in all the stocks in the portfolio, especially in periods of underperformance as we have seen in the first six months of the year.

Secondly, we also assess reasons for underperformance and assess the operational momentum - and broadly speaking, the companies that we've been holding in the portfolio have tended to deliver or overdeliver on our expectations.

And for those who have been more cyclical and that have been seeing downgrades, those downgrades have been less significant typically than the rest of the market,

Generally speaking, therefore, the companies that we are holding are delivering strongly or are delivering in line with our expectations. And at the same time, our conviction is remaining solid and therefore we have made very little change to the portfolio year to date.

The only change that we have made has been a switch out of TSMC into ASML, keeping our exposure to the semiconductors on which we are positive in the long term, but moving into a company that is further up the value chain within that ecosystem that is positioned in a stronger, quasi-monopolistic position that has a similar growth profile (both in revenues and profits to TSMC) but where the ROIC (Return on Invested Capital) profile is significantly higher and, importantly from the geopolitical point of view, that has got a somewhat lower exposure to the Taiwan/China geopolitical risk - and ultimately that we believe benefits from the production line fragmentations within the sector that we are seeing with TSMC looking to open plants throughout various important geographic locations over the next 4-5 years,

We have had one stock that has disappointed us in terms of conviction in the healthcare space. That stock has been Masimo.

Masimo has decided to look at acquiring a company in the consumer electronics space and therefore diversify away from what was the single focus on the healthcare side to the medical technology side, selling into hospitals in a market that is strongly consolidated and therefore is facing good dynamics, with two players well-behaved generally, benefiting from an attractive and predictable growth profile and high return on invested capital (ROIC).

That move towards the consumer electronics space is effectively moving the company towards a much more competitive segment of the market with an unproven track record, which is therefore impacted the share price and has impacted on the performance on the trust.

Other areas of challenge this year have been our exposure to luxury goods. Luxury goods, which are companies that have actually been delivering strongly operationally, despite the various headwinds that have happened since the start of the year, notably the Chinese partial lockdowns, with the Chinese consumer being an important consumer of luxury, accounting typically for a half of the consumption of luxury goods globally and not being able to travel, but also having some partial lockdown restrictions have led to some companies that are highly exposed to those names in the luxury goods, but also in the sports apparel segment, to perform weakly and the share price performance has therefore impacted the performance of the Trust.

Finally, in the healthcare space, we have most of our exposure to sector that we have positive, long-term expectations in terms of structural growth exposures.

That exposure is mostly medical technology companies rather than large cap pharma and year to date, in an environment where the market has been worrying about potential risk of recession, large cap pharma companies have been performing strongly, whereas some medical technology companies have been caught up in the sell-off of the technology sector as have year to date as well. So that has impacted us from that point of view.

Again, we continue to prefer our exposure to the medical technology companies for various reasons. Firstly, they have higher growth profiles. Secondly, they have higher returns on invested capital (ROIC) profiles and operate in segments that have structural growth opportunities with lower competitive pressures.

Finally, the other aspects of the underperformance have been sectors that we have not held. We focus on companies in the quality growth space that have high growth, high returns, solid balance sheet, strong pricing power, and that have solid franchises. And instead, year to date, the market has been favouring companies in the Value space.

Energy has been the strongest performing sector, partly in relation to the flare-up in geopolitics and therefore the higher oil prices feeding into higher share prices in that sector. We have no exposure whatsoever to that sector, just as way of illustration.

Outlook and Opportunities

Our research continues to focus on finding undervalued companies operating in industries with high barriers to entry that have dominant market positions, or the potential to become dominant that have strong pricing power, which should serve them well in their higher and longer lasting on inflationary environment.

The disruption risk will have long term structural growth opportunities that generate high returns on invested capital, that have strong balance sheets and compounding cash flows, and on the side that have good corporate culture, quality management and sustainable business models that position them well in a world transitioning towards net zero.

Our industry megatrends of: Demographic Changes, Future of Technology and Resource Scarcity give us the opportunity to find businesses that are exposed to long term structural growth opportunities and are well positioning within a world transitioning towards sustainability. Indeed, Demographic Changes is about sustainable living. Future of Technology about decarbonization and Resource Scarcity is about climate change.

Within the three megatrends we find attractive long term thematic opportunities, of which the eight mid-term thematic opportunities that we've highlighted in the past, which are: 1) green and alternative energy, 2) greener and more energy efficient infrastructure 3) Healthcare infrastructure, 4) electric transportation, both electric vehicle and high speed railways, 5) 5G Telephony, 6) Cloud Computing and Cybersecurity, 7) Robotics and automation and 8) Metaverse and Quantum Computing. All of these thematics give us exposure to attractive, long-term structural growth opportunities within a transitioning world.

On valuation, equity valuations have come off significantly since the start of the year, given the market sell-off and despite the recovery that we've seen in the market levels in the last six weeks. When we look at valuation, notably in terms of cyclically- adjusted P/E (price earnings ratio) we find that European and Asian equities offer very attractive exposure for long-term investors.

US equities, whilst more attractive than they have been 12 months ago, remain less attractive on a relative basis to these geographies. This explains why we have and continue to have a significant underweight position to the US equity market. This is because we find more attractive opportunities outside the US, notably in Europe, where we have a sizable overweight in Global Portfolio Trust.

Just generally speaking, our quality growth style give us an ability to find very attractive companies that are already profitable, giving us exposure to structural growth opportunities that have sustainable earnings growth profiles and that have solid balance sheets, as well as strong pricing power to be able to navigate through what are very difficult macroeconomic environments in the near term, both in terms of higher and longer-lasting inflation as well as a potential risk of a sharp slowdown in the economic cycle.