For the past two years, the central question for markets has been the feasibility of achieving the “narrow path” of controlling inflation while maintaining solid growth and labour markets. Historically, reducing high inflation without triggering a significant growth slowdown has been challenging. This task has grown more complex for central banks globally, yet the data suggests we remain on this path. Core inflation in major economies remains above targets, but the trend towards lower inflation persists, albeit at a slower pace. In the US, core inflation stands at 3.4%, down from two years ago. The Eurozone and Australia show similar trends, though Australia’s recent readings raise questions about its success. Despite restrictive rate settings, growth and employment data remain solid, reflecting strength in services even as manufacturing struggles in some developed countries.

In early FY2024, interest rate markets challenged central bankers by predicting near-term rate cuts. With inflation improvement slowing, there’s a risk of needing another push, jeopardizing growth. We believe further global rate hikes are unlikely but possible, particularly in Australia. This comes at a tricky time for markets, with valuations of risk assets stretched and upcoming elections in France, the UK, and especially the US adding uncertainty. Bond markets are factoring in potential tariffs and deficits, increasing volatility.

Furthermore, 2024 election outcomes have underscored a general increase in electorate unhappiness, with change being the operative word. Major Western democracies face anxiety over populist movements, whether from the Left, like the UK's Labour Party, or the Right, epitomized by Donald Trump's MAGA movement. Populist figures are poised to attract more support amid sluggish global economic activity, rising living costs, and widening socioeconomic gaps. These elections could profoundly influence ESG (Environmental, Social, and Governance) policies, especially in climate change mitigation. The recent COP28 underscored the pressing nature of the climate crisis, emphasizing the critical juncture at which we stand. While government spending may face headwinds, transition to cleaner energy will remain a pressing need and opportunity for growth. Our focus within infrastructure debt, transition commodities and technology have been attractive allocations in the portfolio. Active management within sectors focused upon the future economy will remain a key theme for our portfolios.

Additionally, AI is set to be a key driver for the foreseeable future, promising profound impacts on productivity akin to historical technological leaps like the Gutenberg printing press. While the printing press externalized information, AI externalizes intelligence. Current AI models now match or surpass human performance in tasks like image classification and radiology, highlighting vast productivity implications. This rapid progress, exemplified by OpenAI's GPT-4 with 1.7 trillion parameters compared to GPT-1's 100 million in 2018, underscores exponential improvements in computing, data, and algorithms over a short period. However, many technology stock valuations may be driven by momentum, and challenges like implementation and energy usage must be addressed before full-scale AI integration. Nonetheless, AI's transformative potential for productivity and the economy remains substantial. Active management will be crucial in managing risk, as AI's trajectory is likely to be more volatile than the past two years, not a straight line upward.

Sovereign bonds have cheapened, but inflation risks make us hesitant to overweight this sector. In credit markets, while yields are attractive, spread risk is no cheaper than equities and has asymmetric downside risk. Therefore, we prefer a modest overweight in equities, favouring international stocks. We continue to seek downside protection on these positions when volatility appears underpriced because, in an environment of stretched valuations, any market correction could be meaningful.

Portfolio and performance commentary for the Financial Year ended 30 June 2024

On a gross basis, the Balanced Fund rose 8.4% in the financial year ended 30 June 2024, underperforming its benchmark which rose 9.2%. Net of fees, the Balanced Fund (Wholesale) rose 7.6% and the Balanced Fund (Retail) rose 6.9% underperforming the same benchmark over the same period.

The fund underperformed compared to its benchmark due to below-market returns on equity holdings, especially in Australian large-cap stocks. Being underweight in financials coupled with stock specific detraction within materials, and healthcare holdings hurt performance. However, underweight direct property was beneficial as market valuations continued to be revised lower over the period. Active global fixed income and cash allocations outperformed the benchmark.

Despite the lower-than-benchmark performance of our equity holdings, all asset classes except property contributed positively to the fund’s total return. Equity markets saw strong double-digit returns for a second year, with the S&P 500 leading the S&P/ASX200, driven by large-cap momentum, particularly in the AI sector. Bond markets were mixed in terms of where they ended the year but overall delivered modest positive returns, helped by compression of credit spreads in the risk-positive environment.

Balanced (Wholesale) Fund Performance

As at 30 June 2024^*

^Benchmark: Australian Ethical Balanced Composite. Past performance is not a reliable indicator of future performance.

Inception date: 28/03/2018.

Balanced (Retail) Fund Performance

As at 30 June 2024^*

^Benchmark: Australian Ethical Balanced Composite. Past performance is not a reliable indicator of future performance.

Inception date: 16/10/1989.

Contributors and detractors

Contributors

• The International Financials sector outperformed the broader market, and due to the Fund’s relative overweight to the sector this contributed both to relative and absolute returns. Similar to the domestic market, we saw strong performance from insurers, such as Chubb Limited (+34%), Prudential Financial (+37%), and Manulife Financial (+46%), as well as consumer finance, such as American Express (+34%).

• Our international holdings in the Information Technology sector were a key contributor to total returns over the year, rising +34%. The sector overall was the best performing in the international index, driven mainly by the AI thematic, with holdings such as NVIDIA (+191%), and Microsoft (+32%). Our relative underweight to NVIDIA and Microsoft in the Fund, resulted in some underperformance at a sector level versus the benchmark.

• Domestic Financials continued to outperform the broader domestic market into the final quarter of the financial year, ending the year as the third best performing sector in the index. This was on the back of growing optimism for a soft-landing scenario in Australia helping bank stocks such as NAB (+45%) and Westpac (+36%), as well as a positive environment for insurers like Suncorp (+35%) and Insurance Australia Group (+29%), with solid premium growth and low claims. However, due to the exclusion of ANZ and relative underweight to CBA, this meant the Fund was not able to fully participate in this sector-wide outperformance.

The International Financials sector outperformed the broader market, and due to the Fund’s relative overweight to the sector this contributed both to relative and absolute returns. 

Detractors

• The Fund’s underweight to Domestic Materials at an allocation level was additive to returns due to the sector’s underperformance versus the broader domestic market. This was offset by stock specific holdings in the Fund which detracted from returns, particular those companies leveraged to lithium prices which has seen a dramatic fall over the year, such as IGO, Pilbara Minerals, Arcadium Lithium and Allkem.

• International Consumer Discretionary was by far the worst performer in the international equities benchmark, meaning the Fund’s relative underweight to the sector was a benefit to the Fund, despite on an absolute level detracting from Fund returns. Tesla, which saw a significant decline in its share price due to weak electric vehicle sales momentum globally, was a large driver of negative performance. However the Fund’s underweight to the stock contributed to the relative outperformance.   

• The unlisted property portfolio continues to face challenges, with higher rates and structural changes in demand for office assets, creating headwinds for the portfolio. Unlisted property was a detractor for the Fund in terms of absolute returns, although the combination of our portfolio holdings drawing down less than the benchmark, and our overall underweight position, reduced the impact somewhat.  

Our international holdings in the Information Technology sector were a key contributor to total returns over the year, rising +34%.

We continue to seek downside protection... because, in an environment of stretched valuations, any market correction could be meaningful.

Portfolio changes

Additions to the Fund

• Carbon Allowances – A position into EU Allowances (EUAs) was initiated over the quarter. Over the long run we believe that carbon allowances help form part of an efficient carbon market, putting a price on carbon and thereby providing an incentive to reduce emissions. Whilst we have been of this view for some time, we had been monitoring patiently, looking for a more attractive entry point which presented itself over the period.

Reductions from the Fund

• Copper – Having initiated a position in 2023, we took advantage of the sharp run up in copper prices in 2024 to take some profit.  We continue to retain a small exposure to copper and will look to add again at reasonable levels.  Over the long run we remain positive on the commodity given its role in the energy transition.