Hurricanes Harvey, Irma and Maria may have devastated parts of the US in 2017 but the Janet Yellen-led Federal Reserve was determined to persist with an unprecedented way to tighten monetary policy. The central bank in October that year commenced selling the assets on its balance sheet, to unwind eight years of on-and-off quantitative easing.[1]

The 'taper tantrum' of 2013 showcased the risks. In that year, comments from the Ben Bernanke-led Fed that it would reduce its monthly asset purchases sparked financial turbulence. Such turbulence, the Fed backtracked. No tapering worthy of the name occurred and by 2015 another round of quantitative easing was underway.[2]

Investors were thus wary of the quantitative tightening of 2017. What would happen when the Fed shrank a balance sheet that had swelled to US$4.4 trillion from US$900 billion in 2008? How would investors react when the Fed refrained from reinvesting as much as US$50 billion in bonds that matured every month, even if it was the most conversative approach to shrinking a balance sheet?[3] Some turbulence eventuated. But the 'balance sheet normalisation' went smoothly enough for a Fed led by Jerome Powell from February 2018. Until it didn't.

On 16 September 2019, when the Fed balance sheet had contracted by about US$600 billion to US$3.8 trillion, strains in the repo market spilled into the money market and the secured overnight financing rate jumped from 2.43% to above 5%, an event the Fed described as "surprising". To provide enough liquidity to ensure short-term interest rates behaved, the Fed restarted asset purchases.[4]

Investors nowadays might keep this episode in mind when the Fed restarts asset sales accompanied by at least one other major central bank. On January 26 this year, Powell announced the Fed would "in a predictable manner"[5] reduce its balance sheet that has swelled by US$4.5 trillion since the pandemic struck to US$8.9 trillion now.[6] Eight days afterwards, the Bank of England announced it would reduce "in a gradual and predictable manner" the 895 billion pounds worth of debt it has purchased since 2009.[7]

To understand what might happen when the biggest buyers of debt become the biggest sellers, it helps to revisit what happens when central banks undertake quantitative easing. Under the non-conventional policy invented by the Bank of Japan in 2001, a central bank creates money (electronically) as an asset on its balance sheet and buys financial securities in the secondary market with interest-paying reserves. The purpose is to reduce long-term interest rates.[8] Quantitative tightening, as the name suggests, is the reverse process.[9] Once central banks 'destroy' money, long-term interest rates should be higher than otherwise.

The first question to ask is: Why do central banks need to reduce their balance sheets? A valid answer is they have no need to. The bloated balance sheets are not causing financial instability, even if pumping them up came with side effects such as asset inflation and excessive risk-taking and is a culprit behind consumer inflation.

But central banks are intent on shrinking their balance sheets. (The Bank of England in February started monthly sales of 20 billion pounds worth of corporate bonds.) Why? The main reason is that central bankers are worried that an overstuffed balance sheet could shake the financial system. At some level, the public might lose confidence in the value of their fiat money. Central banks fret that, if circumstances were to change, the market-based rate of interest they pay the holders of their reserves might not be attractive enough to stop these sums being lent out and inflation might accelerate. They worry too the policy option is, in Powell's words, "habit forming".[10]

Powell, by this comment in 2012 when as a member of the policy-setting board he opposed Fed asset buying, meant it's another 'Fed put'. This is slang for the moral hazard whereby investors take more risk because they are confident the Fed, in a quest to protect the economy, will act to cut their losses.

Another reason for quantitative tightening is political. Quantitative easing stirs charges that central banks make it easier and cheaper for governments to run fiscal deficits. Reversing the process would depower those accusations and reassert central-bank independence.

One motivation for the Bank of England for selling assets appears to be that higher short-term interest rates could turn central bank profits into losses for government budgets.[11] If short-term rates rise enough, the interest central banks pay on their liabilities on their balance sheets will exceed the interest they earn on their assets. The bigger the balance sheet the bigger the losses.[12] It means too that a large balance sheet could restrict how high the Bank of England and others could raise key rates.The Fed would be aware of the political storm created if it were to become a loss-maker for Washington.[13]

It's notable that the Fed and Bank of England talk of undertaking quantitative tightening in a "predictable manner". That's probably because so much surrounding the stance is unknown. No central bank has ever reversed its asset buying over the medium to long term.[14]

The danger today is that central banks want to shrivel their balance sheets when they are raising their key rates to combat inflation. Whereas in 2018-2019, inflation was tame, the Fed now must contend with inflation at 7.9% in the 12 months to February, the highest since 1982. The Bank of England must suppress inflation at 5.5% over the 12 months to January, the highest in three decades. No one knows how high bond yields might rise as central banks raise their key rates and shrink balance sheets, especially if inflation accelerates further.[15] Nor does anyone know how high bond yields could rise without triggering the financial mayhem that occurs when investors anticipate a recession.

But the bigger menace of quantitative tightening is that it might show the Fed is not serious about curbing the inflation it dismissed as "transitory" throughout 2021. Even though all US inflation gauges have exceeded Fed comfort levels for months, the Fed is buying assets until the end of March. A Fed that couldn't immediately end asset purchases when inflation first reached 5% mid-last year (for the 12 months to May) is unlikely to allow asset sales to destabilise markets.[16] It's likely that come trouble the Fed would cease asset sales or even resume asset buying - aka QT1. With the cash rate close to zero, quantitative easing is the best Fed put around. Don't be surprised if it resumes.

To be sure, the pressure is mounting on the Fed to control inflation, especially as energy and food prices soar after Russia's invasion of Ukraine. But adjusting the key rate will be the means to curb price rises, not asset sales. A Fed balance sheet at double the size of 2018-2019 must be riskier to puncture without mishap - so even timid asset selling could stir trouble. The risks would increase if the Bank of Japan and the European Central Bank were to join the Bank of England and the Fed in shrinking their balance sheets. An inflation outbreak that required an abrupt tightening of monetary policy could escalate the risks of doing nothing about a swollen balance sheet. A recession that prompted more quantitative easing might make it harder to envisage that central banks would ever reduce their balance sheets to pre-2008 levels.

Amid the uncertainty, best to frame the Fed's balance sheet as a tool to ensure today's asset bubbles don't burst. The longer-term problem, of course, is that one day the Fed put will be kaput. Investors might confront a hurricane.

The kaput put

On 19 October 1987, the US share market dropped on opening by about 10%, to follow a 5% decline the previous Friday. Fed chief Alan Greenspan convened a meeting of the Fed's policy-setting board. No action was proposed though one board member urged Greenspan not to fly from Washington to Dallas that day to give a speech.[17]

But travel Greenspan did. On arrival in the Texas city, he asked a Dallas Fed official who greeted him at the airport how the stock market had gone. "It was down five zero eight," came the answer. Greenspan felt vindicated in travelling, given the stock market had lost only 5.08 points. "What a terrific rally," Greenspan said.

But the man from the Dallas Fed looked pained. Greenspan realised the man meant the Dow Jones Industrial Average had plunged 508 points, nearly 25% of its value and the largest single-day loss in history.

Amid concerns the Chicago Mercantile Exchange could collapse due to the events of 'Black Monday', Greenspan ensured the Fed on the Tuesday issued a one-line statement. It said the central bank reaffirmed "its readiness to serve as a source of liquidity to support the economic and financial system". In the first hour of trading, the Dow recouped 40% of the previous day's losses. The 'Greenspan' put was born (as was Greenspan's reputation as 'the maestro').

The Greenspan/Bernanke/Yellen/Powell put has lived a healthy life since. The Fed put has generally manifested itself as rate reductions. But it takes the form of emergency liquidity facilities. It comes in soothing comments (though none as effective as Mario Draghi's 'whatever it takes' of 2011 even if the Greenspan "irrational exuberance" comment of 1996 was a prescient warning).[18] And the put takes the form of quantitative easing.

Fed leaders have acted to support asset prices because falling markets can destablilise the financial system and hurt the economy. Declines in asset prices can make consumers feel poorer and can batter their confidence, and thereby restrict the consumer spending that drives about 70% of the economy.

The biggest risk with the Fed put is that it cultivates asset bubbles. In 1959 when Greenspan was under the influence of philosopher Ayn Rand, he presented a paper that argued bubbles were recognisable even when investors were irrational. Investors who bid risk premiums close to nothing have taken leave of their senses because they were forgetting the limits "of what can be known about future economic relationships," he said.[19] In his PhD thesis of 1977, Greenspan warned how rising incomes and rising financial prices fed into each other to create asset bubbles that would eventually burst, a contrary view in the heyday of efficient-market belief.[20] Yet as Fed chief from 1987 to 2006, Greenspan acted to ensure bubbles never burst.

Greenspan biographer Sebastian Mallaby encapsulated this doublethink in his book title: The man who knew. Mallaby argues that Greenspan knowingly acted carelessly as Fed chair - usually under the cover of aiming for full employment - because "he calculated that acting forcefully against bubbles would lead only to frustration and hostile political scrutiny".[21]

The political pressures are unlikely to have changed. The biggest flaw surrounding the Fed put is that it's only credible if a central bank can muster up some sound action. The danger is that one day the Fed might run out of credible emergency measures.[22] A US cash rate close to 0% means rate cuts are no recourse. (The Fed is against a negative key rate.) At some point, a swollen Fed balance sheet might hobble the Fed's ability to inject money into the economy. It's likely the dangers and higher interest rates stemming from quantitative tightening will prevent the Fed shrinking the balance sheet so much quantitative easing can safely restart to prop up asset bubbles.

Come the day when the Fed is powerless to respond to bursting asset bubbles, maybe the storms that tear through financial markets can be called Hurricanes Alan, Ben, Janet and Jerome.

Author: Michael Collins, Investment Specialist

Federal Reserve of St Louis. FRED economic data. Shaded areas signify recessions.

Source: fred.stlouisfed.org/series/WALCL

THE INVESTMENT ENVIRONMENT - Volatility, Uncertainty, and War

The S&P 500 dropped 2.6% in February and by mid-March was down 13% on the year. Other markets did even worse: Euro Stoxx ( -16.9%), Nasdaq 100 (-21.3%), and China CSI 300 (-31.4%). All markets were volatile, but the commodity markets were the worst with the LME suspending Nickel trading due to a 250% rise in two days. China based Tsingshan Holding Group Co is rumored to have a huge short position backed by JP Morgan and other banks and could not meet margin calls. Oil traded as high as $130 a barrel. European fertilizer makers have had to cut production due to the high price of natural gas and European steel manufacturers are cutting operations due to record prices for power.

The war in Ukraine intensified with millions of refugees, hospitals and schools bombed, and over a thousand casualties so far. Investors' thoughts will clearly be with the Ukrainian population as they resist, but any analysis of the range of potential economic and political outcomes can only be speculative. The future is more uncertain than ever with even more pressures on inflation, supply chains, commodity prices, and food production - projected slower economic growth and higher inflation.

Investors were already struggling to analyse the potential effects of the unwinding of 13 years of unprecedented QE and ZIRP policies and now the uncertainty has been compounded. Markets are likely to remain volatile and future investment value harder to gauge than ever. 2022 may be a good year to be invested in Life Settlements.

THE LIFE SETTLEMENT MARKETS - LS Markets Stable; News from a European Investor Conference

The Life Settlement markets remained stable albeit with lower volume and a gradual shift in favour of the buyers, contrary to the past two years which favoured the sellers.

The Fund Managers attended an Investor Conference in Amsterdam in early March and it was an interesting study in contrast compared to similar conferences in the USA. There was a strong focus on ESG related issues including the need to be ESG accredited and have ESG Directors in house to ensure ESG rules were being followed in all investment decisions. The majority of the attendees and panelists had jobs that were ESG related.

No one actually defined ESG precisely - it seems to be similar to a successful political slogan and can mean different things to different people. The emphasis on ESG and its impact was astonishing given how little attention was paid to the recent invasion of Ukraine, the scale of the conflict, and its potential consequences on investments in all asset classes.

One of the more interesting non-ESG investment topics was the ability of different strategies to perform in the current investment climate with the unwinding of ZIRP, the war in Ukraine, and the forecasted lower growth and higher inflation scenario. Here there was a strong case for the Laureola Life Settlement strategy, which (for the record) has been given the ESG accreditation by the UN PRI on account of its contribution to solving social issues.

Written By Tony Bremness

Apparently, Confucius did not say "One Picture is Worth Ten Thousand Words" after all. It was an advertisement in a 1920s trade journal for the use of images in advertisements on the sides of streetcars. Even without the credibility of Confucius behind it, we think this saying has merit. Each month we share a few charts or images we consider noteworthy.

The extent of the new "Tech Wreck" is highlighted by Societe Generale with 60%+ of stocks in the index down more than 25%, including 20% down more than 75%. But bonds have not delivered on their promise of safety as Bespoke and The Irrelevant Investor highlight. Back in Australia, Wilsons counts only 47 earnings downgrades in total for FY22 (so far), which is similar to FY21 but well below pre-Covid years. Wilsons also shows an unusually large spread between growth in small and large caps. The correlation of bitcoin with the more speculative parts of the equities market has been mapped courtesy of The Daily Shot. Finally, Bloomberg highlights that Australian polling indicates a change of federal government is on the cards.

Nasdaq's latest "tech wreck"

Source: Societe Generale, @jsblokland

US equities (S&P 500) v long-term bonds (iShares 20+ Year Treasury Bond)

Source: Bespoke

Bond market drawdowns: US equities (S&P 500) v Vanguard Total Bond Market ETF

Source: The Irrelevant Investor

Number of ASX downgrades per financial year

Source: Wilsons

ASX large cap growth less small cap growth

Source: Wilsons

Bitcoin correlation with "meme" stocks

Source: The Daily Shot, Dantes Outlook

Australia's election polls pointing to change in government

Source: Bloomberg, Newspoll

Steve Johnson and Gareth Brown are in Chicago for an episode of 'Stocks Neat'. They taste-test an American bourbon and recap their research trip in the US. Tune in as they reflect on the impacts of inflation and supply chain disruptions on businesses in the US, and the potential impact of the war in Ukraine on the Australian economy.

Key Takeaways

• As expected, accelerating inflation forced the hand of the Federal Reserve (Fed) to initiate its first 25 basis point (bps) rate increase of this cycle, thus ending the pandemic-era zero-percent interest rate policy.
• In our view, high inflation has placed the Fed on a narrow path and increased the risk of policy error, with two potential outcomes - slowing growth and embedded higher inflation expectations - vying for supremacy.
• With our expectation that U.S. monetary policy will ultimately prove to be more dovish than many expect, we believe longer-dated bonds remain at risk to continuing inflationary pressure.

In a well-telegraphed move, the Federal Reserve (Fed) raised its benchmark overnight policy rate by 25 basis points (bps) on Wednesday (March 16) to a range of 0.25% to 0.50%. Perhaps more importantly, the U.S. central bank's own forecast for the future path of rate hikes - as expressed in its "Dots" survey, which records each Fed official's projection for the federal funds rate - increased to seven hikes for this year and four for 2023. In the December survey, these expectations were for three hikes in each of these years.

While some may interpret this as a continuation in the shift toward a hawkish bias, we are more circumspect. We believe that the seven 25 bps rate increases the futures market is pricing in for this year very much represent an upper limit of potential hikes and that this scenario is unlikely to materialize. Also, the current Dots survey comes with a considerable caveat: There were fewer voting members at this week's meeting due to the ongoing transition in the Fed's leadership composition and none of President Biden's nominees have taken their seat. Importantly, we believe that eventual new members will lean toward the dovish camp, reinforcing our view that the market's expectations have gotten ahead of reality. It's worth recalling that throughout Chairman Jerome Powell's tenure, when given the choice between two paths - and having not been mugged by multi-decade highs in inflation - he's opted for greater accommodation.

About that Inflation

The reality that Chairman Powell has been unable to avoid is that inflation remains on the march. In February, both the headline and core U.S. consumer price indexes reached multi-decade highs - 7.9% and 6.4%, respectively. Market expectations for price increases to drift toward the Fed's preferred 2.0% long-term range look slim. Inflation is expected to average 3.6% over the next five years based on the U.S. Treasury Inflation-Protected Securities (TIPS) market. For the 10-year horizon, the average is a modestly less ulcer-inducing 2.95%. We interpret these elevated levels as the market's growing recognition that the Fed will be more tolerant of a pace of inflation seldom seen in the U.S. over the past three decades.

Yet the Fed faces a conundrum. Much of the current upward lurch in prices is due to supply constraints. The global pandemic famously caused supply disruptions in semiconductors and other important industrial inputs. Labor shortages have led to upward pressure on wages, which feed directly into inflation, especially in service-based economies. Unfortunately for the Fed, the blunt instrument of rate hikes tends to be less effective in combating inflation driven by supply factors than it is in quelling periods of accelerating prices driven by full-throttle demand.

A Narrowing Policy Path

The nature of this bout of inflation, which has been exacerbated by recent geopolitical events, amplifies our concerns about the potential for monetary policy error. Policymakers must perform a perilous balancing act. Should the Fed overtighten, the U.S. economy could slip into recession. If it falls behind the curve and higher inflation expectations become embedded, bond valuations could come under pressure as higher discounts are commanded to compensate for the diminished value of future cash flows.

Caution Merited

The expected template of a methodical pace of rate increases in 2022 has been turned upside down. We believe that every Fed meeting has the potential to be "live," meaning that a rate hike is possible. While it would likely be well-telegraphed per Chairman Powell's modus operandi, we cannot rule out a 50 bps hike at some point.

The forced shift in the Fed's stance, however, means that the period of "peak policy uncertainty" has likely been extended. Our view is that the Fed will make every attempt to proceed with caution. Yet, this same caution could lead to even more volatility in longer-dated rates as the risk of higher-than-trend inflation becomes fixed in investors' minds.

Consequently, we believe investors should treat interest rate exposure - or duration - with caution. Longer-dated bonds, in our view, appear most vulnerable to elevated volatility. And given the relative flatness of the yield curve, the incremental return for holding farther out maturities may not be worth the higher risk. Lastly, the geopolitical uncertainty emanating from events in Ukraine further reinforces our view that now is not the time to take on any undue risk in one's fixed income allocation.

Basis point (bp) equals 1/100 of a percentage point. 1 bp = 0.01%, 100 bps = 1%.
Duration measures a bond price's sensitivity to changes in interest rates. The longer a bond's duration, the higher its sensitivity to changes in interest rates and vice versa.  

This information is for adviser & wholesale investors only

That's not a peak……

I still remember the time I thought I'd hit "peak technology". I had a new Nokia 3310 in my hand and after making a call and sending an SMS I found a game called Snake that helped to pass time in the cab while the driver fumbled through a UBD street directory to try and find my hotel. I was also carrying a new digital camera to document my trip and an MP3 player with music I'd burned from my existing CD's. And when I hit my destination all I needed to find was a telephone port to be able to connect back to the work files I needed to finish a presentation for the morning. What a time to be alive….…

It would have been impossible at that time for me to envisage what life would look like 20 years later. The phone I use is now a phone, internet, camera, music and TV device all in one, with the capability to run my entire life off a 6 inch by 3 inch screen. That cab I was in? Well now the guidance systems mean never pulling into a McDonalds to work out directions ever again, let alone the incredible advances in safety features and entertainment. Then we stand at the front edge of the electric vehicle migration while peering at autonomous driving looming on the horizon. Those files I need? Well now I can access them from anywhere and on any device as data migrates to the cloud. The changes to the way we live, and work have been astonishing and are accelerating.

While it is almost impossible to imagine what the next 20 years may look like, one thing we do know is that as technology marches ever forward, so does the required intensity of computing power. It is quite a leap from having a "snake" made of clunky pixels moving on a basic screen to cars that need to observe and assess all factors around them then calculate and execute the best course of action in fractions of a second. Let alone what other currently unimaginable technology extensions will emerge.

Imagination and semiconductors - driving technological advancement

Underpinning this march in computational advancement have been semiconductors. It is advances in semiconductor technology that facilitates this rapid escalation in compute power while also keeping a restraint on device size.  And it isn't just the complexity of the compute but the expansion in use cases that underpins the importance of semiconductors in the technology supply chain. Taking auto as an example, not only are the semis more advanced, but they have proliferated into almost every element of the car, from power to entertainment to guidance systems. The semiconductor company ONSemi estimate the content value of semis has lifted from $50 for an internal combustion engine with no advanced driver assist systems, to a future state of $1,600 for an electric vehicle approaching full autonomy.

Source: ONSemi Investor Day (Aug 21)

This expansion of content value is occurring across a range of industries. From cars to phones to datacentres and our homes, content per unit is expected to lift by 50-100% when moving from 2020 to 2025. Smartphones are continually adding more functionality, datacentres are adding capacity to underpin advances such as AI, machine learning and the metaverse while compressing speed, and our homes are moving towards a degree of connectivity for almost every device.

Source: UBS (Jan 22), Applied Materials (April 2021)

What does this mean for the semiconductor industry?

This acceleration of technological development has driven a step change in semiconductor industry growth rates, with demand rising from a historical growth rate of 3-5% p.a. to an industry forecast to grow at 6-8% p.a. out to 2030, taking total industry revenue beyond $1bn. Where demand used to rise and fall with smartphone and PC demand, there are now much broader demand drivers, with particular areas of strength expected across autos, industrials and datacentres.

Source: ASML Investor Day (Sept 21), Gartner

How do we invest in this opportunity?

There are many ways to invest along the chain in semiconductors. From the equipment manufacturers (ASML, Lam Research, Applied Materials, ASMI) to the main manufacturers (TSMC, Samsung, Global Foundries, Intel) to the semiconductor companies exposed to different elements of end demand spanning data centre (Nvidia, AMD, Marvell), auto (ONsemi, IFX, Texas Instruments) and memory (Micron, Samsung, Hynix) to name just a few. Each discrete exposure brings with it a nuance to overall semiconductor cyclicality and underlying demand strength.

Our goal is to balance end market demand strength, company positions and financial return metrics with a degree of resilience in the face of an ever present (and sometime violent) semiconductor cycle.  Among the swathe of opportunities, our preference currently lies with:

• ASML (equipment manufacturer): the market leader in lithography driving semis manufacturing to ever smaller parameters. The drive for semiconductor supply chains to be brought back to home countries such as the US and Europe is underpinning a wave of equipment investment that will last towards the end of the decade.
• ONSemi (autos and industrial semi manufacturer): ONSemi has reshaped their business towards the key automotive and industrial semiconductor markets, while focusing on value added products within these segments to drive margin improvement.
• Nvidia (GPU and CPU manufacturer): Nvidia is a leader in graphics processing units for gamers which are also being used as datacentre accelerators. Nvidia is also creating semiconductor platforms overlayed with software to drive further opportunities across autonomous driving and the metaverse.

Life in 2040?

The changes to tech have been stunning in the past 20 years and it is difficult to imagine what the next 20 years will bring. But one thing we do know is that compute will advance, and semiconductors will be the key linchpin in assisting this drive forward. As such the future looks bright and the return profile compelling for those that can carve out a market position exposed to these key tech growth trends.

Author: Trent Masters, Global Portfolio Manager

This information is for adviser & wholesale investors only

To understand the challenges facing the automotive sales industry, it is often helpful to examine a particular company, as Roger Montgomery did earlier this month.

Autosports Group (ASX:ASG) operates car sales outlets in Sydney, Melbourne, Brisbane and the Gold Coast. Its share price has been on a rollercoaster ride since floating in 2016 and currently sits below the $2.40 listing price. ASG is profitable and reasonably priced, but investors should be mindful of the threats facing its business model.

Established in 2006, Autosports Group owns and operates 40 retail businesses, including 23 luxury and prestige motor vehicle dealerships, two used wholesale motor vehicle dealerships and two specialised collision repair facilities in Sydney, Brisbane, the Gold Coast and Melbourne. Autosports Group represents Original Equipment Manufacturer (OEM) brands including Alpina, Aston Martin, Audi, Bentley, BMW, Jaguar, Lamborghini, Land Rover, Maserati, McLaren Mercedes Benz, Mini, Rolls-Royce, Volkswagen and Volvo. ASG offers new and used vehicles, finance and insurance, and back-end parts and servicing, including collision repair.

Currently, car dealers are operating amid a veritable storm. Deliveries of new vehicles are hampered by a semiconductor chip shortage and the shuttering of manufacturing facilities due to COVID-19 associated isolation requirements.  Booming demand for vehicles however is undiminished, thanks to consumers unable to travel, and flush with cash (e.g., a booming construction sector lining the pockets of builders and tradies). The eroded appeal of public transport is also driving demand for private transport.

Unable to purchase a new car, buyers have turned to the used market where prices for many used vehicles have risen beyond their original purchase price of several years ago.

The agency threat

Meanwhile, in the background, the ever-present threat of OEMs moving to an Agency Model (Mercedes AG have already announced the change and are in court with dealers fighting for $650 million compensation) poses a revenue hazard to dealership revenues, putting investors on edge.

Under the current dealership model, a brand retailer buys a vehicle from the OEM as inventory at a wholesale price. Typically the vehicle is only paid for by the dealer when it is sold. A margin for the dealer to cover costs is added and the salesperson then negotiates a transaction price with a customer.

OEMs including Mercedes and Honda have expressed frustration with the traditional dealership/OEM relationship because dealer promotions including special offers, run-out deals, discounts and end-of-the-month sales all lower resale values and accelerates depreciation rates.

But it hasn't all been the dealers' fault. Dealers note they have had to pay for manufacturer 'mistakes', overproduction on their floor plan charges, incorrect build combinations and obsolescence. This is the reason for the "race to the bottom" on new-vehicle margins.

Under the Agency Model, dealers are paid a fee for a vehicle sale. For Honda dealers in NZ, this ranges from four per cent to seven per cent depending on meeting sales targets and customer satisfaction scores. Elsewhere, the customer places their order directly with the OEM and nominates a preferred delivery dealer. The price and dealership mark-up or commission is set by the OEM.

The positive spin put on the agency model by OEMs says dealers aren't limited to selling just the cars allocated to them. They are free to sell any vehicle model in the brand's stable on order nationally. Dealers have access with access to the full range without incurring floorplan costs.

The OEM owns all demonstration stock at the dealerships and all the new-car stock. New vehicles are held for sale at a national distribution centre and sales are made directly to the customer. The dealer therefore no longer finances an inventory of vehicles for sale, and all floorplan or finance costs are borne by the OEM. In Volkswagen's electric vehicle agency model in Europe, the dealer is offered a lease program for demos and loan vehicles.

Across the globe, the use of agency models is more widespread.

Mercedes-Benz has already introduced agency models in South Africa, Austria, Sweden and it will transition to one in Germany as well. Volkswagen is rolling it out for selling electric vehicles in Europe and Honda has been running the model in NZ since 2000.

Back to ASG

Navigating this tumult is a challenge attested to by a 30 per cent decline in ASG's share price since its high of $2.74 last June.

Autosports Group reported its first half FY22 results recently noting the solid margins of the previous financial year continued, driving profit before tax to beat some estimates by more than 10 per cent.

The company however reported revenue of A$911 million, which grew 0.8 per cent year-on-year (yoy) but missed consensus estimates for $1 billion. Revenue was down four per cent when adjusted for acquisitions, which contributed $44 million.

EBITDA grew 27 per cent yoy to $48.6 million, beating some estimates by 10 per cent.  Adjusted profit before tax of $39.2 million was up 35 per cent on the previous corresponding period and beat consensus estimates for $33.8 million by 16 per cent.

Revenue for the sale of new vehicles was unchanged on the same period a year ago at $564 million, thanks to an inability to obtain sufficient stock. A combination of strong demand, and that inability to deliver new cars, has also resulted in the company's new vehicle order book doubling from a year ago. New orders written in the first half exceeded deliveries by 22 per cent.

Over in the used car department, vehicle revenue of $209 million was also flat yoy but strong growth in the final quarter of the calendar year was implied by the fact the first quarter was down 12 per cent yoy due to lockdowns.

The services department generated $59 million in revenue, which was nine per cent higher than the previous corresponding period and parts generated $60 million of revenue up 13 per cent yoy.

The growth in profit, which exceeded revenue growth, was the result of higher selling prices (on less stock) and therefore improved margins. Gross margins of 19.2 per cent was an improvement on the 17.8 per cent generated in in the second half of FY21.

The company's outlook remains clouded by a comprehensive lack of clarity about when deliveries will return to normal. Supply constraints are expected to last the remainder of the calendar year at least. Demand should therefore continue to exceed supply. The Used vehicle, Service and Parts divisions are expected to generate revenue growth of between six and ten per cent. Longer term the business model remains under the cloud of threats from OEMs moving to an agency selling model.

Author:  Roger Montgomery, Chairman and Chief Investment Officer

Economy-wide events dominate the headlines

Big inital swings are a typical reaction to a change in the macro-economic outlook and are not cause for us to react. This movement was primarily driven by the largest swing towards value stocks in over 20 years. 

As at the end of February, the 'value' style category fell -2.8% CYTD with 'growth' styles falling -12.5%, according to JP Morgan. The lesser known 'quality' style category where Insync resides is neither value nor growth, although we tend to hold stocks the market categorises as Growth. 2022 marked the 5th worst start for S&P 500 since 1927. Inflation fears have the market pricing in 5-6 interest rate rises this year, precipitating the heavy swing initially, with Ukraine's invasion by Russia creating price spikes in both energy and commodity prices as well. Markets hate uncertainty.

It's no surprise then that material and energy stocks were the best performers in February (Insync has zero exposure to these sectors due to their low ROICs through the cycle). It's highly probable that the negative macro factors will slow economic growth. This in turn, will then favour a move back to profitable growth companies (rather than growth stocks overall). These are the type of stocks we hold. Thus, we liken the current portfolio to a coiled spring. When investors soon refocus on company fundamentals, the share price performance of quality businesses then rebound quickly and sharply. This usually 'surprises' commentators and investors alike. Earnings growth across the portfolio continues to compound strongly despite macro shifts, with valuations becoming more attractive.

Governance factors are why Russia and its peers don't appear with Insync

Russia's invasion of Ukraine is one of the greatest tragedies of our lifetime. We have no direct exposure to Russian equities and virtually zero indirect exposure. The simple reason is that Russia is a Kleptocracy run by a ruler who has used his poitical power to systematically steal billions of dollars of its national treasure owned by its people. When there is no rule of law - and therefore no shareholder rights - valuations do not matter. The risk of near total loss of capital is too high. Companies with strong governance nearly always do the right thing and also deploy capital wisely.

Why we are confident that sustainable growth companies are poised to perform strongly

Almost every big slowdown in the past has been preceded by a rise in energy prices and Federal Reserve rate hikes.Going forward then, markets will likely start shifting focus to the prospect of weaker economic growth and refocus on investing in businesses with durable, sustainable earnings growth and profitability.

This economic backdrop propels precisely the kind of stocks we hold. Overlaid with identified megatrends, it enables these companies to thrive irrespective of higher rates or slower growth.

Meantime, in the near term expect ongoing volatility in markets and most equity funds as well including our own. 

Indicators suggest that the market may be surprised on the upside

We have often discussed the difficulty and danger of market timing. The probability of getting it right more often than wrong is extremely low. Right now, investor sentiment is very bearish with the AAII investor sentiment survey at its lowest point since April 2020. Fund managers overall reflect this view, holding the highest level of cash since the covid lows and at the bottom of the GFC.

This is why we remain fully invested when markets swing wildly as one would expect in these moments of macro-economic uncertainty. For good reason we didn't react in previous occasions such as now, and we won't in future ones either.

This is also why we remain fully invested unlike many of our peers. Should timing be desired in the hope of avoiding the dips and riding the peaks, then we believe this is a decision for the investor and their adviser. 

We continue with our usual rifle-like approach of investing in the most profitable companies with a long runway of growth fuelled by megatrends. We refrain from trying to time these shifts, as this lowers risks and, longer term, aids returns. 

Do valuation multiples matter? There's broadly two schools of thought - one that purchase price dictates your future return and the other that good companies will deliver growth in time to drive value higher, whatever the current price is. 

Buying a stock on low multiples is no guarantee of either future multiple expansion or earnings growth. Outside times of panic you can expect there is some logic driving the sellers of those low multiple stocks.

But an excessive price today can burden a company with implied growth expectations that it just can't meet. In a different era, former dot-com darling Sun Microsystems' CEO, Scott McNealy, expressed it well:

"At 10 times revenues, to give you a 10-year payback, I have to pay you 100% of revenues for 10 straight years in dividends. That assumes I can get that by my shareholders. That assumes I have zero cost of goods sold, which is very hard for a computer company. That assumes zero expenses, which is really hard with 39,000 employees. That assumes I pay no taxes, which is very hard. And that assumes you pay no taxes on your dividends, which is kind of illegal. And that assumes with zero R&D for the next 10 years, I can maintain the current revenue run rate."

Size is an important factor  - Sun was "at scale" with >$US10 billion of dollars of annual revenue and its ability to grow into its valuation was limited. A microcap today on 10x revenue that is just beginning to penetrate its market with a competitive advantage may well be able to prove it was a bargain retrospectively. So multiples only mean something with context and analysis.