Cross-currents

Markets are being buffeted by conflicting forces. The end of the global tightening cycle appears in sight, inflation is moderating, and the jobs market remains strong for now – the soft-landing narrative propelling markets higher. Still, earnings are trending lower, borrowing costs remain elevated and economic growth is meagre. Eventually these headwinds are likely to become too strong. Our Chief Investment Office explains further.

Our view

Over the past fortnight, the central banks of Japan, US, Europe, and Australia have all convened. While outcomes varied, the overwhelming sense across markets is the end of the tightening cycle has been reached or is within touching distance.

Global inflation has continued to moderate, and despite central banks leaving the door ajar for further interest rate rises, the consensus view is it’s time for an extended pause to assess the impact of the tightening to date.

That central banks have brought inflation back from 2022 extremes, without crushing economic growth or sending unemployment higher, has been remarkable – the concept of ‘immaculate disinflation’ has gathered momentum and the ‘soft landing’ narrative has helped propel markets higher.

That demand remains reasonably firm, while inflation continues to moderate, suggests that inflationary pressures were predominantly supply side driven. Still, central banks will want to see further moderation in demand and weaker labour markets to be confident that inflation won’t reaccelerate.

Yet this combination of solid employment, economic activity and above target inflation suggests the beginning of any easing cycle remains a distant prospect. And it’s this factor that is yet to be priced into equity markets.

Valuations are already stretched across many markets, and the US reporting season suggests another quarter of negative earnings growth is likely – the third in a row. We are closely watching corporate profit margins which appear to be contracting for what would be the sixth straight quarter of year-over-year declines.

While the moderation in inflation has been welcomed by the market, corporates have arguably benefitted from the ability to pass on higher labour and debt costs to consumers – even if this has meant less goods sold at higher prices.

Assisting this has been the rude health of US household balance sheets, flushed with excess savings from the pandemic period. These excess savings are on track to run out by early next year.

Further moderation in inflation, without a commensurate fall in the cost of debt and labour presents an unpleasant backdrop for corporates. Particularly at a time when consumer balance sheets may no longer allow for them to carry this inflation burden.

If rates remain elevated well into 2024 and the tightness in labour markets persists, then the significant amount of corporate debt due to mature, alongside ongoing wage pressures, is likely to weigh heavily on corporate margins.

US consumption has been helped by savings – so far

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Source: BCA Research

So, if a ‘soft landing’ can be achieved, do equities now look attractive?

With the earnings yield on equities less than the yield on cash or high-quality corporate bonds for the first time in decades it’s a difficult case to mount.

At current levels, the US stock market trades on more than 20x forward earnings. If earnings continue to decline, then this will only look more stretched unless there is a rerating.

Then why remain invested in equities at this point? Herein lies the difficult part. Timing.

With economic data remaining solid, this cycle could well continue into next year and so too equity market resilience. In recent cycles, equities have peaked on average two months before a recession began. However, as we’ve seen already, this cycle is like few before it.

Nonetheless, even if this remarkable rally continues for a few months yet, when a five per cent return on cash and bonds is available, investors need to be able to make a case for a double-digit equity returns to justify the risk of being overweight stocks. We continue to find that difficult to do.

What this means for our diversified portfolios

While the rally could continue for a few more months, we remain cautious about the current market exuberance. We continue to believe that recession is probable over the next 6-12 months and that this is not currently priced in.

Moreover, already this reporting season we’ve seen small misses or downgraded guidance result in sharp pullbacks across some sectors of the market.

While we maintain a rather sombre outlook for equities in general, and US shares in particular, we recognise that investors may continue to muddle through this late cycle phase for some time and that equities could also continue to drift higher as well. As such, we have made the decision to rebalance sector exposure across the equity bucket this month, ensuring we are able to participate in upside rallies while becoming more defensive across portfolios overall in the event of a pullback.

We have adjusted positioning within the developed market equity bucket – neutralising sector underweights to Information Technology, Communication Services and Consumer Discretionary.

In fixed income, given the current stage of the economic cycle we maintain a preference for high-quality fixed income assets. We have further downgraded high yield to an underweight with the proceeds invested into global investment grade credit and sovereign bonds.

While our base case remains for a more modest recession, if investors become more concerned about a hard landing, and risky assets become more vulnerable, then global bonds should offer good diversification to portfolios.