Where the current opportunities lie

The Australian economy is experiencing a downturn that may see it experience recession in the coming 12 months. Fidelity International head of investments Paul Taylor points out opportunities for investors exist even in troubled times and identifies the companies toward which investors should turn their attention.

Since May, the Reserve Bank of Australia (RBA) has increased interest rates seven times, taking them from 0.1 per cent to 2.85 per cent. The United States Federal Reserve (Fed) has been more aggressive, with US official interest rates now sitting between 3 per cent and 3.25 per cent.

These initial interest rate moves have not yet had any significant impacts for either economy, with low unemployment and consumer confidence still riding high. But monetary policy is notoriously slow and it could be 12 months before the full effect is achieved.

The Fed seems determined not to repeat the policy mistakes of the 1970s and 1980s when it was criticised for being slow to act in the belief inflation was transitory. It now seems to be erring on the side of overaction.

The RBA, after receiving criticism for predictions it would not be increasing rates until 2024, does not want to be getting its monetary policy decisions wrong either.

With interest rates expected to keep rising, the likelihood the US and Europe will enter a recession in early 2023 is increasing, but it’s less certain if Australia will follow suit.

Australia is fortunate in that high energy costs, along with better conditions for commodities, should cushion the blow to the Australian economy, but future rate rises could do some damage. An official interest rate of 4 per cent has the potential to push mortgage rates to above 6 per cent, putting considerable pressure on a highly leveraged Australian consumer.

One of the best pieces of news out of the October federal budget was the forecast for growth to slow to 1.5 per cent in 2023/24 from a forecast of 3.25 per cent for this financial year.

That’s a big fall, however the government is not yet forecasting a detraction in growth and if Australia is able to avoid negative growth and a recession, that would be the best possible outcome.

But there is no denying times are about to get quite a bit tougher. While we can all tighten our belts personally and potentially cut back on our discretionary spending, there are also actions we are taking, and have already taken, when it comes to our investment portfolio to best position it for potential opportunities.

Essentials

It is currently a very noisy market and speculation of a global recession has intensified. This may not happen in Australia for the reasons outlined above, but even if it does, there will still be sectors and companies in those sectors that outperform.

We saw this in the initial panic of COVID-19 when essential businesses such as supermarkets did extremely well. They had to pivot and employ more delivery drivers and obviously had issues with supply (we all remember the toilet paper rush of 2020), but overall sales increased.

This is a good example of history demonstrating businesses that provide essential goods and services perform well through inflationary periods, recessions and other crises. By their nature they are essential and people continue to buy and consume these products and services regardless of market, economic or environmental conditions.

These types of businesses are also in a much better position to pass on higher input costs to consumers because they are indispensable. Inflation actually helps them grow.

Examples of essential businesses include supermarkets, consumer staples, healthcare, telecommunications and utilities. In this category, the Fidelity Australian Equities Fund has overweight positions in Coles, Ramsay Healthcare and Telstra.

Ramsay Healthcare in particular looks interesting. Private hospitals were negatively impacted by the coronavirus as elective surgeries were postponed and delayed and private hospitals focused on helping the public system through the pandemic. Elective surgeries can be delayed, but eventually need to happen so we should see strong pent-up demand for private hospitals. Ramsay is probably one of the highest-quality private hospital operators in Australia and with earnings currently depressed we think it is a great opportunity to invest in a quality asset with good long-term structural growth opportunities.

Cheap sectors

Economic and market uncertainty will invariably make some sectors, and companies in those sectors, cheaper. Essentially these are still good companies, they are just being undervalued by the market at this point in time.

Sectors with attractive valuations currently include energy, materials and insurance. The commodity sectors have very strong balance sheets and cash flows. In fact, it’s the performance of our commodity sectors that have managed to keep the Australian economy afloat and may prevent us heading into a recession.

These sectors are negatively impacted by recessions, but they also have the prospect of an improving China. The Chinese economy has been adversely impacted by its zeroCOVID government policy. But we believe this could turn in 2023 and unlike most of the rest of the world, China is now easing monetary policy.

It is playing catch-up when it comes to using fiscal stimulus to boost the economy post COVID, and the worse the fallout from its zero-COVID policy, the bigger this stimulus may be. These better prospects from China, combined with cheap valuations, start to move the odds in favour of the commodities sector.

In addition, we believe the process of decarbonisation is at an extremely metalintensive phase of development, as much of the infrastructure involved in the electrification of energy requires rare earth metals.

Solar panels, wind turbines, batteries and electric vehicles all require significant amounts of not just lithium, nickel, cobalt and copper, but other metals such as steel and aluminium. Decarbonisation will be impossible without the growth in production of most of these commodities.

So those companies with exposure to transition metals and energy sources such as nickel, natural gas, copper and lithium will be best positioned within the commodity sectors.

Clean energy-focused miner IGO is a good example of a mining organisation outperforming because of this exposure. It recently reported positive results as it benefited from increasing lithium prices and its results were led by a double-digit increase in revenue compared to the previous quarter.

IGO’s lithium joint venture with Tianqi Lithium Corporation, which it incorporated in 2021, is really paying off for the company. This joint venture contributed $177 million of net profit and $71 million of dividends to IGO in the first year of its ownership.

“We remain committed to further growth to continue to deliver a globally relevant diversified portfolio of clean energy metal products and to do this with a combination of exploration and disciplined mergers and acquisitions,” IGO chief executive Peter Bradford said when delivering the company’s financial results in August.

Speculation regarding Mineral Resources’ listing of its lithium business also buoyed investor sentiment in this sector.

The insurance sector is similarly extremely cheap and with premiums on the rise, we believe the general insurance sector is well positioned for growth. The Fidelity Australian Equities Fund has significant overweight positions in IGO, Santos and Suncorp.

Self-help

The third bucket of sectors and companies we think can outperform in a recession or rocky economic environment is what we like to call ‘self-help’. Perhaps a better explanation might be ‘help-self’ – companies that have made concerted efforts to change or improve their businesses to better adapt to existing conditions.

Suncorp, while an insurance company and cheap, is a good example of a stock that also falls within the self-help bucket. Suncorp has been simplifying its business and with the sale of the bank will become a very focused general insurance business.

When announcing the sale to Australia and New Zealand Banking Group in July, Suncorp said it positioned both the insurance and banking businesses for ongoing growth and success.

“Both businesses will benefit from a singular focus on their growth strategies and investment requirements,” Suncorp chair Christine McLoughlin said.

The market response at the time may have been mixed, but we believe this greater business focus should bring considerably improved valuation metrics for Suncorp.

The banking sector should also benefit in the shorter term from higher interest rates and a steepening yield curve, however, this will only be up to a point. Of course, higher interest rates will likely bring higher loan loss provisions and a decrease in borrowing.

While we are underweight banks in general, we have a significant overweight position in Commonwealth Bank of Australia (CBA) due to its strong balance sheet and superior technology platform. CBA also benefits the most from rising interest rates, steepening yield curve and improved net interest margins given its very significant deposit base.

Structural growth at cheaper valuations

We also believe 2023 may be the time to get on the front foot with Australian equities and some long-term good structural growth companies. The past year has seen many of these growth companies devalued due to rising interest rates. With now much cheaper valuations but still structural growth opportunities, 2023 may represent a good opportunity to get set in these quality businesses. In this bucket we would include companies like Seek, Domino’s, Siteminder, Domain and Macquarie.

Shutting out the noise

It is obvious we are entering a new phase in the economic environment. I don’t have a crystal ball, but as hopeful as I am we don’t enter a recession, it cannot be ruled out and we are preparing the portfolio for that possible eventuality.

To that end, I’m adopting a barbell strategy with the portfolio. This is where higher-risk assets at one end and low-risk assets or sectors at the other end balance out risk. In our portfolio we have commodities (higher risk) at one end and at the other end are companies selling the essentials and that have pricing power (lower risk).

The companies in the self-help category above are at various points in the middle of the barbell.

Our combined decades of investment experience at Fidelity helps us shut out the noise of markets, which can be hard to ignore in periods of volatility. This involves focusing on the long term, looking at facts and not being swept up by emotions (hard to do when markets fall repeatedly), and knowing what is important versus unimportant.

Personally, I find talking to companies and getting a 360-degree view of their operating environment much better for portfolio construction than being stuck at a desk watching the market go up and down.