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Soft, hard, shallow or postponed?

Private Bank

2023-09-08 04:30

Analysts are increasingly downgrading the prospect of a recession this year. Talk of a hard landing, soft landing and no landing have been spoken of at length. So too has the possibility of a postponed recession. Irrespective of outcome, the medium-term outlook appears skewed in favour of bonds. Our Chief Investment Office explains further. 

Our view

In our August House View, we spoke about the conflicting narratives jostling for market attention. While the soft-landing story had been propelling equity markets higher, pushing back against this was the impact of elevated yields and deteriorating corporate earnings.

As it turned out, over August, the narrative soured altogether as the impact of higher yields and concerns surrounding China weighed heavily on markets. The former pointed to an economy (responsible for approximately 20 per cent of the world’s GDP) with an incredibly tight labour market and a central bank indicating rates may need to be left higher for longer. The latter was indicative of an economy (responsible for roughly 18 per cent of global GDP) that appears to be in increasing trouble.  

News flow from China has disappointed since the Q1 GDP print, and analysts continue to downgrade growth forecasts – ANZ Research recently cut its growth outlook for China from 5.4 per cent to 4.9 per cent for 2023 and 4 per cent in 2024. While this is hardly diabolical by global standards, it does represent a structural slowdown for the world’s second largest economy.

That said, for markets, the performance of Chinese shares is dictated less by economic growth and more by sentiment. Whether these downgrades matter for the long-term performance of Chinese equities is questionable. Of greater immediate consequence, is the confidence crisis plaguing investors; not just in relation to equities, but also the property sector, and a shadow banking industry that offers wealth management products.

These wealth management products have historically been viewed as a safe place for Chinese citizens to park their cash – promising returns above typical deposit products. However, last month Zhongzhi, one of China’s largest shadow banks, stopped making interest payments on some of its wealth management products – sparking fears of contagion risk from the ailing property sector in which Zhongzhi invests. With a significant amount of China’s household savings tied up in such products, should these issues spread, there are concerns this could further dampen Chinese consumption.

Attempts by the Chinese government to reignite the stalling economy through a range of targeted measures have so far failed to arrest this unease. And without some form of ‘irrigation style’ stimulus, it’s difficult to see a sustained bounce in equities. The Chinese government has stated it is trying to rebalance the economy away from its reliance on construction-led growth; and so far, President XI is trying to stick to this narrative.

In the US, economic activity has remained resilient – despite 500 basis points of monetary tightening – yet it continues to display a weakening trend. Whether the Fed hikes again is arguably less important than how long policy remains restrictive for. Nonetheless, bond markets have readjusted to the prospect of higher interest rates, and yields hit 15-year highs mid-month.

Against this backdrop of rising yields, negative earnings growth and moderating inflation, the equity risk premium hit a 20-year low in August, and real yields rose sharply to more than 2 per cent for the first time since 2009.

As we’ve been saying for some time, historically (and relatively) high yields should eventually weigh on equity market returns – and we began to see evidence of this last month.

Real yields hit 2 per cent in August


Source: Federal Reserve Bank of St. Louis, ANZ CIO

Even despite the healthy correction in August, equity markets still appear positioned for a soft-landing. With central banks indicating we are nearing the end of the tightening cycle, inflation continuing to moderate, and economic activity remaining reasonable, it’s not outrageous to suggest equities could make modest returns in the near-term. Although, even if a soft landing can be delivered, the scope for equities to make outsized gains while rates remain at (or near) current levels, seems unlikely.

Conversely, the bond market appears priced for a harder landing with forward curves showing a reasonable amount of rate cuts from early next year.

So, which is correct? Like all good stories, the truth probably lies somewhere in the middle, and this is helping shape our positioning within portfolios.

In our view, the current level of rate cuts priced for 2024 appears overdone given the economic resilience to date. We believe some will likely need to be removed if the postponed and shallow recession is to prove correct. We are currently positioned for such a scenario within portfolios but stay alert to potential downside risks.

If the current level of cuts priced for next year is to be realised, and the Fed is forced to make multiple rate cuts over the first half of 2024, then we would expect a sharper economic downturn to materialise first. In this event, on the balance of probabilities, we would expect equity markets to first suffer (as earnings begin to reflect a recessionary environment), and for bonds to outperform prior to a more sustainable rally in equities.

While there remains scope for yields to lift higher, we believe such moves should be capped given the current economic backdrop. And in the event inflation does prove stickier, and central banks are forced to lift rates further, we would expect the hard landing narrative to gather momentum, equities to become weaker and duration to prove a good source of diversification across portfolios.

We continue to favour bonds relative to equities as a result.

What this means for our diversified portfolios

Following the recent spike in yields, we have upgraded our preference for global fixed income again this month, with increases to sovereign and investment grade bonds across portfolios – the purchases funded from cash.

Although we expect a fall in the short end to lead the curve steepening in the period ahead, on a relative and outright basis, the entry point to add further duration to portfolios remains attractive.

Across risk assets, given the continued negative news from China we have modestly downgraded emerging market equities this month, reducing the position to benchmark. We acknowledge that the recent level of downside economic surprises has been comparable with the GFC, and therefore it’s not unreasonable to assume that any upside surprises – either economic or stimulus-related – could spur short-term rallies in the months ahead.

As such, despite the downgrade this month, we remain very modestly overweight China and have redeployed the proceeds into Australian shares. Given the relationship between Australia and China, we would expect the Aussie share market to benefit from any upside surprises in China while not suffering to the same extent should downside surprises continue. 

ANZ investment strategy positions – September 2023


Developed Markets – Regional Performance

Source: Bloomberg, ANZ PB CIO as at 31 August 2023


Emerging Markets – Regional Performance

Source: Bloomberg, ANZ PB CIO as at 31 August 2023


ASX 20 vs. ASX 300 ex-20 – Performance.

Source: Bloomberg, ANZ PB CIO as at 31 August 2023


Global Infrastructure vs. Global REITs vs. Global Equities

Source: Bloomberg, ANZ PB CIO as at 31 August 2023


Bloomberg Global High Yield – Option Adjusted Spread to Treasury

Source: Bloomberg, ANZ PB CIO as at 31 August 2023


10-yr Australian Government Bond Yield (%).

Source: Bloomberg, ANZ PB CIO as at 31 August 2023


10-yr Australian Government vs. US Treasury 10-yr (%).

Source: Bloomberg, ANZ PB CIO as at 31 July 2023


Growth environment a common backdrop to stronger DXY

Source: Bloomberg, Macrobond, ANZ Research

Soft, hard, shallow or postponed?
Chief Investment Office
Private Bank

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