Will this time be different?

The US Federal Reserve has upgraded its growth forecasts and downgraded unemployment expectations. It’s told markets to expect an additional rate rise but more importantly for rates to remain elevated for longer. A soft landing just became more difficult. Our Chief Investment Office explains further.

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Our view

Over the first half of 2023 investors maintained conviction that this time would be different. Equities rose sharply despite the most aggressive tightening cycle in 40 years. The banking crisis was washed aside by liquidity poured into the financial system and a structural slowdown of the world’s second largest economy wasn’t enough to shake investor confidence.

However, over the past quarter, this conviction appears to have wavered. Bond yields have soared to pre-GFC levels, the S&P 500 registered its first quarterly decline in 12 months, and the Nasdaq, which seemed immune to rising discount rates over the first half, finished the quarter lower for the first time this year.

Even so, the falls have been somewhat modest in the context of the impressive gains registered over the first half of the year. And particularly so when considering they have come against a backdrop of more than 500 basis points of Fed tightening.

So, for markets, the question remains. Will this time be different? In our view, the answer is possibly but not necessarily as some may hope. Instead, we believe this cycle may simply be playing out in a manner and timeframe that most investors are unaccustomed to.

Indeed, we have already seen stark differences across this tightening cycle compared to those before it. Unlike the past 30 years, this phase of tightening has been driven by a need to bring inflation back to target rather than a desire to curtail growth.

And we have seen some idiosyncratic features amongst equity market performance too. Growth stocks have rallied in a rising rate environment and value stocks have so far underperformed.

Moreover, while small caps have underperformed large caps for a sustained period, a broad market downturn has yet to materialise – a feature that has typically followed small cap underperformance in previous cycles.

Perhaps most concerning for investors though, is that the negative correlation between equities and bonds has broken down and the relationship between the two is now more reminiscent of prior inflation fighting cycles.

Whether these differences are the result of structural changes unfolding across the globe is still to be determined. But we are undoubtedly reaching a new inflection point for the global economy.

For investors, remaining alert to the differences in this cycle, and considering these as part of portfolio positioning, is likely to be more important the further this late-cycle phase extends.

As to the outlook more broadly and one could argue things might be different this time also.

At the surface level, the current backdrop for equities might even be considered constructive, at least over the next few months.

Globally, labour markets remain tight and continue to support consumer demand; inflation is broadly moderating, growth remains reasonable, and central banks have indicated they are nearing, if not already at, the end of the tightening cycle.

Moreover, we have just farewelled what is historically the worst month for US equities on average. And should investors survive October, a month famed for historic market crashes, they should be able to look forward to December – traditionally, the most bullish month for equities, when positive returns have historically occurred almost 70 per cent of the time.

However, while the shorter-term outlook for equities appears reasonable, we remain sceptical that the medium-term will prove different this time. Rather, we believe it’s more likely that the impact of pandemic-related fiscal and monetary policy measures, alongside the increased returns on cash, have insulated household and corporate balance sheets, allowing the cycle to prolong further than it ordinarily might.

Over the first nine months of the year, investors have clung to the prospect of a soft landing and the hope that equities can continue to climb the wall of worry – something the Fed’s latest economic projections suggest is plausible. Although, as those same forecasts show, low unemployment and better than expected growth may only serve to see interest rates remain higher for longer – likely postponing, rather than stopping a potential market downturn.

In fact, when placing this year’s equity market rally in the context of a slightly longer timeframe, we can see the gains have been primarily concentrated to a five-month period from March this year. The latest pullback has taken the US market back to levels consistent with when the Fed began raising rates in March last year, while the ASX has failed to reclaim its 2022 high – just prior to when the RBA announced lift-off.

The Fed’s projections also suggest the final phase of bringing inflation back to target could be the most cumbersome, with core inflation not forecast to reach 2 per cent until 2026.

Indeed, the moderation in price pressures to date appears to have been led by supply-chain normalisation rather than a meaningful reduction in demand. Where goods price inflation has fallen sharply, services inflation remains elevated and sticky.

And although the US labour market is becoming more balanced, the ratio of job openings to unemployed remains inconsistent with the Fed’s inflation target.

Historically speaking, dampening demand without sharply raising unemployment has proven near impossible for policymakers. It has occurred once in the past 30 years and never against this level of tightening or inflationary pressure. And while this cycle is like few before it, it’s worth remembering that most hard landings look like soft landings until they’re not.

Hard landings often look like soft landings until they’re not

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Source: Bloomberg, ANZ CIO

Different or not, with the equity risk premium near 20-year lows and with real yields at levels not witnessed since 2009, the case for overweighting equities relative to fixed income has become an increasingly difficult one to mount.

What this means for our diversified portfolios

So, with the soft-landing narrative providing a potential platform for equities to drift higher into year-end, albeit with risks increasingly looking skewed towards the downside, how are we approaching the final quarter of this most unusual year for investors?

Over the past quarter we further increased defensiveness across portfolios, aimed at providing greater downside protection in the event of an equity market sell-off, while also making nuanced changes across our equity allocations with a view to providing better defensive characteristics and the opportunity to participate in short-term rallies should they transpire.

In fixed income, we cut our exposure to global high yield, taking our position to an underweight. Concurrently, we increased exposure to global fixed income, specifically investment grade credit and sovereign bonds, extending our preference for high quality assets in this late-cycle environment.

While there remains scope for yields to push higher, particularly if central banks are forced to become more hawkish, we would expect any upside moves to be capped given the tightening to date. Moreover, given recent yield levels, the addition of further duration to portfolios should be beneficial for portfolios over a medium-term horizon.

Across equities, we began to adopt a more balanced stance between regions, while we continue to look for further opportunities to increase beta across portfolios.

This included a reduction in emerging market equities, taking the position back to benchmark, while also closing our mild underweight to developed market shares – again seeking to provide portfolios with more quality exposure at this stage in the cycle.

Other tactical adjustments include a reduction in our mild underweight to Australian shares and a discrete allocation to the US tech sector, the latter increasing portfolio beta.

Risk is inherent with any investment strategy and portfolios will always be subject to short-term fluctuations. However, particularly during these late cycle environments, it’s critical that any risk is commensurate with the potential reward and that portfolios always remain true to their intended risk profile.

After all, ensuring you’re able to remain invested throughout the full market cycle is the most critical factor for compounding returns and long-term wealth creation.

With equities appearing expensive, yields on bonds at multi-decade highs and the economic backdrop remaining uncertain, we believe the risk/reward balance remains skewed in favour of fixed income as the final quarter commences.