A protracted cycle increases risks

Recent economic data has proven more resilient than many expected. Yields have pushed appreciably higher, and the global tightening cycle is looking increasingly protracted. With the prospect of any easing now unlikely until 2024, downside risks are rising. Our Chief Investment Office explains further.

Our view

At the start of the year, we outlined three broad possible scenarios for financial markets in 2023.

In the first, inflation would recede, and growth would falter. However, because of easing price pressures, central banks would have the luxury of being able to cut monetary policy to support growth.

The second, saw inflation remain sticky, forcing central banks to continue increasing interest rates. In this scenario, the tightening cycle would become protracted and even though growth might remain steady in the short-term it would ultimately be undermined to an even greater extent as policy became overbearing. With inflation remaining stubborn, any opportunity for central banks to ease monetary policy would be limited and so too any rescue package for markets.

The final, and in our view most unlikely scenario, highlighted the possibility of inflation receding somewhat, employment remaining robust and growth not faltering as expected. Under this scenario, we noted that the Fed might engineer a soft landing while holding the cost of funding at elevated levels.

Less than two months later and the first of these scenarios already appears much less likely. Inflation has remained sticky and growth slightly more resilient than expected, leaving the most benign scenario for markets but also the most damaging. In our view, although economic activity has surprised to the upside early in 2023, it is still trending lower over a longer period, and we remain dubious as to whether this resilience is sustainable given the backdrop of higher funding costs for corporates and the squeeze on consumers’ disposable income.

In the US, while we expect inflation has peaked, several indicators have suggested it is unlikely to be a smooth path back to target. The February US PCE deflator rebounded strongly; added to falling unemployment, more resilient PMI data and durable goods orders that suggest economic activity remains reasonable, one can assume price pressures may continue to be stubborn. While previously celebrating the step-down in the pace of monetary tightening from 50 basis points to 25 basis points, many analysts are now calling for the Fed to revert to ‘super-sized’ 50 basis point rate hikes. Despite this, the S&P 500 commenced the week almost 6 per cent higher on a year-to-date basis. This, while US 10-year yield was close to 4 per cent and the 2-year/10-year curve inverted by more than 90 basis points. With the Fed indicating there is likely to be at least two more interest rate rises, we expect yields to shift higher still. However, some areas of the yield curve are increasingly attractive and credit spreads remain appealing.

The recent reporting season in the US has seen earnings fall more than 4.5 per cent (the first decline since Q3 2020) and we expect further downgrades in the months ahead. Even if a GDP recession can be avoided in the US, we continue to point to the likelihood of a profit recession over the coming period. Rising real yields traditionally weigh heavily on stocks, particularly when PEs are high, and EPS isn’t depressed from a recent recession. The forward 12-month P/E ratio for the S&P 500 is more than 17.5, and while below the 5-year average of 18.5, it remains elevated versus the 10-year average (17.2).

At this stage in the cycle, continuing to aggressively tighten policy increases the risk of a hard landing. On a risk/reward basis, particularly when compared to the US equity market where valuations remain stretched, bonds continue to look more favourable.

On the domestic front, following the Q4 Consumer Price Index print that showed inflation accelerating, the Australian economy has become an outlier of sorts. Unemployment has risen and wage pressures continue to undershoot expectations. Spending has also begun to show signs of weakness. We believe it’s far too early to call an end to the tightening cycle here, after-all the most recent monthly CPI indicator rose 7.4 per cent in the year to January 2023. However, with inflation yet to reach peak levels experienced in the US and Europe, and economic activity showing signs of easing, the RBA may have greater optionality as it attempts to engineer a soft landing. Alongside the tailwind from the China reopening, this points to better opportunity in domestic equity and bond markets, relative to global peers in the near-term.

The US Treasury 2yr/10yr yield curve has recently inverted by more than 100bps

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Source: Federal Reserve Bank of St. Louis

What this means for our diversified portfolios

In our 2023 Global Market Outlook, we noted the medium-term outlook for the Australian shares looked more positive than the one facing global shares. We also highlighted the fact that we expected to increase exposure to bonds in favour of equities as the year progressed.

After retaining our positioning at the first Investment Committee meeting of the year, we have now elected to adjust portfolios following the solid start to the year for equities, sharp rise in yields and continued determination of central banks to quell inflation. Within portfolios we have trimmed unhedged global equities and redeployed capital into Australian shares, global fixed income (specifically investment grade credit) and Australian bonds.

We remain positioned with a mild underweight to equities and are underweight risk overall.