Welcome to the December Quarter update. I would like to recap the journey a typical portfolio has endured over the past 3 years, how we read the market and adjusted your portfolio in response to these. Pleasingly, our portfolios have outperformed the benchmark due to our active review approach. We feel with the most recent adjustments, your portfolio is well positioned into 2024 and beyond (as things change daily, we don’t plan to get too far ahead of ourselves).

VOLATILE JOURNEY OF BENCHMARK MARKET PORTFOLIOS

Source: Sovereign Advisors, ASX, Vanguard Diversified Growth & Conservative Portfolios, prices as at 20 December 2023

We would like to begin by sharing the experience of a typical growth and conservative investor in the Australian market over the past three years. This will provide some reference and context for the journey of your own individual portfolio to date.

As you can see, 2021 was a positive year for the benchmark growth portfolio, which was up by +5%, but it was a negative year for the benchmark conservative portfolio, down by 5%. This was the year when inflation threatened to spiral out of control, and the strategy to hedge against inflation risk involved investing in growth assets, such as equities and gold, while avoiding long-duration bonds. By and large, we adhered to this approach.

Then came 2022, with high and entrenched inflation rates, leading central banks to aggressively raise interest rates. Both benchmark growth and conservative portfolios suffered, with growth portfolios declining by approximately -8% over the year and conservative portfolios faring even worse at -15%.

Moving forward to 2023, it has been largely a flat year for both benchmark portfolios, except for a rally in the last four weeks up to December 22nd, resulting in a recovery of approximately +5%.

DRIVERS OF VOLATILITY TO REMAIN

The volatility experienced by the benchmark portfolios over the past three years is rooted in some deep-seated transitional drivers. We have discussed some of these in past letters and will summarize them below for easy recall.

Let's remind ourselves that the upside risk to average inflation and interest rates remains, due to the two ongoing wars that show little sign of abating. Additionally, the ongoing tensions between China and the U.S. could easily lead to supply chain disruptions and a sudden spike in inflation. The aging demographic, which contributes to labor shortages, remains a key factor in driving wage pressures in advanced economies. The global transition to renewable energy infrastructure is likely to continue creating excess demand for key resources such as materials, labor, and capital. Military build-ups in a deeply divided world represent another area of increasing demand for labor and funding. Finally, burgeoning government debts globally are unlikely to find willing funding from debt markets at low rates with enthusiasm. Debt investors, including China, which is the third-largest lender to the U.S. and has been reducing its investments in recent years, are increasingly questioning the interest rates they require as adequate compensation.

USING VOLATILITY TO OUR ADVANTAGE - HOW WE PLAN TO INVEST IN 2024?

Our view is that the aforementioned risks will continue to be a source of greater-than-normal volatility across all asset classes.

Therefore, our focus has been, and will remain, on thoughtfully navigating these risks to manage volatility or fluctuations in your portfolios. We aim to capitalize on current income opportunities arising from high interest rates and ensure adequate positioning in quality growth opportunities that will yield capital gains when the markets are favourable in the coming years.

It is important to note that these risks also present unprecedented opportunities for capital gains over the medium to long term. Let us highlight these opportunities.

All of the risks mentioned above can be turned to our advantage. You will notice that we are positioning your portfolios not just for 2024 but beyond. Each of our individual recommendations to you are designed to align with these potential sources of future returns:

Higher average Inflation & Interest rate risks – you would have noticed that we have been recommending high quality credit funds and etfs for income, namely, Janus Henderson Tactical Income, Perpetual diversified Income Fund, QPON, SUBD, Ardea Real Outcome Bond Fund, and direct hybrids up to a point. Collectively, these funds are averaging circa 5-6% p.a. in income currently. We have taken out the guessing game of short-term movements in interest rates by investing in either variable interest rate paying credit or short dated debt. If interest rates increase over the medium term, these funds' coupons will adjust their payments accordingly. Similarly, if interest rates fall next year (a return to 2% interest rates is not anticipated), these income funds will decrease their coupon payments in tandem. We will pick up capital gains in growth parts of your portfolio due to a fall in interest rates.

You might have also observed that we have continued to minimize exposure to highly indebted businesses, mainly because they will face higher interest rates as funds become scarcer. A range of corporate borrowers will compete for debt alongside prolific government borrowers, and the general demand for capital will increase as retirement savings begin to fund pension payments to an ageing demographic.

Renewable energy transition – Given that measured global temperatures continue to rise, causing climate change and permanently impairing habitats for humans and wildlife, the shift to renewable energy is inevitable. This shift will likely occur rapidly at the last moment, reflecting human tendencies towards disagreement and procrastination. According to most credible sources, the demand for energy transition metals will outstrip supply. It is essential to position our portfolios to capitalize on these opportunities. That is why you are seeing, and will continue to see, us building positions in direct stocks (such Allkem & South 32) and funds that will be significant players in this transition.

Ageing demographic risk will mean demand for healthcare will be exponential – Australia, Europe, China, Japan, and to a lesser extent the US, have aging demographics. As a vast number of people enter middle age and their senior years, the need to preserve life and improve its quality will increase. Consequently, healthcare services, as well as manufacturers of drugs and therapies, will be in high demand. You will notice that our recommendations will align with this theme.

Disruptive technology presents both risks to existing companies and opportunities for investors to invest in companies that will shape future industries. You will see us recommending companies like Megaport, Wisetech, and Pexa listed on the ASX, as well as fund managers like T. Rowe Price, QUAL ETF, NASDAQ ETF, and other managers and stocks we have been doing due diligence on and will introduce to you next year. We believe these technology-focused managers and stocks are where double-digit returns can be expected in the next decade. Opportunities in digitization, cloud storage (including data centers, which are the real estate of the future), information processing (such as quantum computing), and analysis (AI), among others, are areas that we anticipate will continue to show compounding growth.

Emerging Markets – India is poised to be a standout economy in the coming years, in fact it was the fastest growing economy this year at over 7% with a booming equity market. You will see us engaging in this market directly through India-focused ETFs (like NDIA) or through skilful active managers such as the GQG Emerging Markets fund, who have intimate knowledge of the market. This represents another opportunity for double-digit compounding. You will also find us recommending taking profits along the way, especially when valuations seem stretched.

Australian large cap stocks – You will see us recommending Australian stocks primarily for seeking dividend yields and we will drive growth in your portfolios through rotating in and out of stocks in cyclical sectors like Consumer Discretionary, Industrials, Energy, Technology, Healthcare, and small caps stocks and fund managers. We intend to largely maintain our core positions in banks and consumer staples (such as Wesfarmers, Woolworths, Coles), Telstra, BHP, Rio, etc., as anchor positions that provide solid yield and steady growth.

Overall, we have been fortifying your portfolios for short-term economic headwinds while simultaneously positioning for medium to long term growth.

We wish you a peaceful Christmas and all the best for 2024!