Success breeds complacency. Complacency breeds failure...

Equity markets continued to drift higher over April, assisted by easier financial conditions and increased liquidity. Volatility has more than halved from the levels witnessed 12 months ago and the market continues to price-in rate cuts from as early as July. With inflation remaining elevated, and central banks hawkish, now is not the time for complacency. Our Chief Investment Office explains further.

Our view

For much of April, financial markets quickly readjusted to ‘life as normal’. The banking fiasco seemed to be firmly in the rear-view mirror, earnings season chugged along without any major disappointments, and headline inflation prints were apparently enough to assuage fears that the US Federal Reserve (Fed) and other central banks might need to hold even firmer for even longer.

Of course, when it comes to financial markets it can be foolhardy to become complacent. In our view, there is still work to be done by central banks, and likely more pain to be inflicted before there can be any declaration of victory over inflation. And it’s the continued mismatch between the market’s expectation and the Fed’s intention which provides us with the greatest level of discomfort.

Pleasingly, US headline CPI printed at an annual figure of 5 per cent last month, its slowest rate since 2021. This was somewhat expected and is likely to continue as strong base effects continue to roll-off until mid-year. Indeed, the fall in headline inflation from more than 9 per cent last June to almost half that level today might be considered the ‘easy part’. The next leg down towards 3 per cent will be more challenging and whether inflation can actually be pulled back to target in the medium-term remains debatable. After-all, at 5.6 per cent, 12-month core CPI is now higher than headline CPI; and despite falling modestly from its February level, the ‘stickier’ services inflation remains above 7 per cent.

Elsewhere, the troubled First Republic Bank came under renewed pressure late in the month before being scooped up by JPMorgan only days ago. Its failure is unlikely to be the last of this tightening cycle. The Fed’s decisive action and backstop has in large part stemmed most first order effects of the banking crisis; nonetheless, there will undoubtedly be further ramifications across other sectors as the cycle progresses. There have already been concerns surrounding the commercial property sector in the US, and it’s in these less-liquid parts of the market that some fault lines may take longer to crack. To clarify, we don’t envisage any GFC-style risks at this time; but to suggest the fallout from March’s events are finished would be naive. On the one-hand, further collapses would probably result in a continuation of tighter credit conditions, and this should make the Fed’s job easier by providing some disinflationary forces. However, it’s unlikely to get the job done on its own and assumes that the Fed prioritises financial stability over price stability. As we have mentioned for months now, we remain unconvinced this will occur unless any fallout is extreme.

The other risk that has gathered momentum over the past month is the US debt ceiling. At this stage, our primary concern isn’t whether a resolution will be reached, rather it’s the associated terms that come with any agreement. The passing of an increase to the debt ceiling through the House of Representatives was a positive first step towards raising the ceiling on time. Importantly, Congress is now debating ‘how’, not ‘whether’, to raise the ceiling and this is an important distinction. However, it should be assumed that any path to conciliation will come with austerity measures. Like the natural tightening of credit from the banking tremors, this could prove disinflationary to some degree but also weigh on the growth outlook. In the more immediate term, like the Fed backstop during the banking crisis, it might be the sudden withdrawal of liquidity once the legislation is passed that rattles markets.

US Treasury will continue to provide significant liquidity until the debt ceiling is raised, helping financial markets and possibly risk assets in the process. Perhaps counterintuitively, once the debt ceiling is raised these liquidity measures will be reversed – and alongside it, the support that risk assets have received over recent months.

Financial conditions have recently eased, providing support for equity markets

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Source: Bloomberg, PB CIO

In fact, it’s these easier financial conditions including increased liquidity, narrower credit spreads, lower volatility and a weaker US dollar that have helped equities to grind higher since the start of the year. Alongside bearish sentiment and light positioning across the market, this trend could continue for a little while yet. However, with inflation remaining stubborn, employment firm, and monetary policy likely to remain tight for some time, we see the upside for equities being capped. Moreover, across all three highlighted risks – continued banking fallout, the debt ceiling dilemma, and a market recalibration of Fed pricing – we see risks skewed to the downside for equities.

What this means for our diversified portfolios

This month, we retain our defensive positioning across portfolios given the stated risks and view that upside moves in equities are likely to be limited.

With an underweight to risk assets already in place across portfolios, we are comfortable with the level of downside protection in place and acknowledge that equities could continue to drift modestly higher in the near-term.

Across portfolios we have elected to modestly increase our exposure to global real estate investment trusts (GREITs), taking the position to a mild overweight from benchmark. The commercial property sector has come under renewed pressure in recent months, and this has been reflected in the significant underperformance of GREITs relative to global equities. This sharp fall in price has seen valuations become more attractive and the position adds some additional duration to portfolios. The modest increase was funded using cash.