Still no clarity in sight

The market loves certainty. Despite talk of a ‘dovish’ pivot, political stability in China and the first signs of inflation rolling over, uncertainty remains as strong as ever. As a result, our Chief Investment Office maintains its mild underweight to equities.

Our view

Another month has brought no real clarity for markets. Investors continued to cling to hopes of a Fed pivot, only to be disappointed once more. Other central banks, including the RBA and Bank of Canada, stepped down the pace of tightening but appear poised to deliver further rate hikes this cycle. Earnings season in the US has seen downgrades, yet more are expected, and Xi Jinping has secured an historic third term, but China remains locked down. All this uncertainty makes for a difficult and likely volatile period before year-end.

On the flipside, since 1950, on average, November and December have been the second and third best performing months for stocks and the last five trading days of the year often bring what is known as the ‘Santa Claus’ rally. This ‘seasonality’, as its otherwise known, provides some support to the argument for a possible increase to risk assets, however, this year it comes against a backdrop of deteriorating fundamentals, an opaque outlook for the path of inflation and monetary policy and an earnings season that has seen results underwhelm relative to historical averages. Moreover, where we held onto a benchmark position to risk assets earlier this year due to sentiment being at record lows and an expectation that even the smallest amount of good news could result in a sharp rally, markets are no longer positioned in such a manner.

In China, Xi Jinping’s appointment as leader of the Chinese Communist Party for a third successive term will arguably make him the most powerful leader since Mao Zedong. This has ensured political stability in China but provides Xi a stronger platform from which to pursue China’s ‘reunification’ with Taiwan; and guidance on the abandonment of covid-zero remains non-existent.

As noted previously, elevated yields are increasing borrowing costs for corporates, and new funding for many companies is now close to three times more than that paid at the corresponding time last year. Indeed, the yield on a basket of 5-year high quality corporate bonds is at levels not seen since 2009. Furthermore, the yield on longer-duration government bonds has increased markedly since the start of the year, which alongside diminishing earnings expectations has resulted in the equity risk premium – the expected return from equities over risk-free assets – narrowing significantly.

Borrowing costs are challenging the outlook for corporates

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Sources: U.S. Department of the Treasury, 5-Year High Quality Market (HQM) Corporate Bond Par Yield [HQMCB5YRP], retrieved from Federal Reserve Bank of St. Louis

Earnings season is just about over in the US, and the S&P 500 is on track to report its lowest earnings growth since the third quarter of 2020 with both the size and number of earnings surprises below longer-term averages. Roughly 70% of companies have reported actual EPS above estimates, versus 77% and 73% for the 5 and 10-year average respectively. Not only is the number of earnings surprises lower relative to history but the magnitude of beats is down significantly also. In aggregate, earnings are 1.9% above estimates, paling in comparison to the 5-year average of 8.7% and significantly lower than the 10-year average of 6.5% – owing mainly to the number of companies reporting misses by unusually wide margins. These misses have been broad based with only four of the eleven sectors reporting year-over-year earnings growth. Of these sectors, Energy, is the standout, reporting the highest earnings growth at 134%. Concerningly, if Energy is removed from the equation, the blended year-over-year earnings increase for the third quarter falls from +2.2% to -5.1%. Moreover, analysts expect the Energy sector will only remain as a positive contributor to earnings growth for the next two quarters. Looking further ahead, for Q1 2023 and Q2 2023, analysts are projecting earnings growth of 2.3% and 1.5% respectively, with 5.9% growth expected for 2023. In our opinion, this remains too optimistic based on current headwinds.

What this means for our diversified portfolios

Sentiment and seasonality are trumped by fundamentals this month and as a result our mild underweight to equities remains. Duration is becoming increasingly attractive, however, with an expectation of further increases to yields we hold our position for now and may look to take advantage of equity bear-market rallies into year-end to fund increases to bond positions. We would expect a possible increase to sovereign bonds, to be followed by rotations into credit and possibly high yield in the months ahead.

For now, we hold our positioning. Within equities we maintain a preference for emerging market shares over developed markets equities, and global equities relative to domestic shares. Within fixed income we maintain our relative preference for Aussie bonds and have recently been adding to sovereign bonds over credit to extend our duration exposure