Where to now?

The US easing cycle is fast approaching, and investor focus has switched from inflation fears to growth concerns. Equities have been wobbly, but we believe the macroeconomic backdrop remains constructive with opportunities ahead. Our Chief Investment Office explains further.

The start of August was characterised by a brief selloff. So far, September has followed suit. Recession fears and stretched valuations have been the catalyst on both occasions. While economic indicators have softened, there is still no sign of capitulation. Indeed, the macro backdrop appears more Goldilocks than the three bears.

The US economy expanded at a 3 per cent annual rate over the second quarter and inflation is returning to target – core PCE (the Fed’s preferred inflation measure) has declined to 1.7 per cent on a three-month annualised basis. Moreover, after looking decidedly frothy prior to the declines, market sentiment and positioning have been delivered a healthy sense check.

We remain in the soft-landing camp and expect the US Federal Reserve (Fed) to commence an easing cycle with a 25-basis point rate cut later this month, followed by seven further quarter point reductions over the cycle, taking the federal funds target rate (FFR) to 3.25-3.50 per cent.

The risk to this outlook is US unemployment. The labour market has softened considerably. Indeed, the number of job openings fell to 7.7m in July vs a downwardly revised 7.9m in June – well below expectations. Job vacancies are now at the lowest level since the start of 2021 and the ratio of job openings to available workers has fallen to 1.1:1 from a peak of close to 2:1 in July 2022. For context, that compares with the 0.9:1 pre-pandemic 5-year average.

Providing some comfort is that labour market weakness has so far been led by a reduction in hiring and an increase in the participation, rather than a sharp rise in layoffs. However, a more meaningful decrease in the hiring rate would be cause for concern.

Fed Chair Powell has confirmed that employment is now front of mind, “the Fed is not seeking, nor does it want any further cooling in labour market conditions,” he said at his post Jackson Hole briefing last month.

We are watching incoming labour data closely also. For now, we expect the cycle to resemble a mid-cycle slowdown than anything more sinister. Still, a sharper deterioration in data between now and the September FOMC meeting would open the door to a 50-basis point cut to start the easing cycle. A super-sized cut would suggest the Fed has been caught behind the curve and increase fears of a hard landing.

We expect this uncertainty to be a key driver of market direction over the coming months. Indeed, equity market analysts expect double-digit earnings growth over each of the next two years. Yet, at the same time, market pricing suggests almost 250 basis points of easing should be delivered before the end of 2025. Historically, rate cuts of this magnitude have not reconciled with this level of earnings growth.

So, while equities look priced for a soft landing, forward curves are suggestive of a sharper deterioration, meaning any weaker than expected economic data in the near-term is likely to lead to sharp risk-off moves and increased volatility. These moves could also be exacerbated by seasonality, with September historically the worst month on average for equity market returns.

Still, with inflation returning to target, an easing cycle in sight, and liquidity expected to remain supportive ahead of the US election, volatility may also present reasonable short-term opportunities for investors. At this stage of the cycle, where and how to position for these opportunities is increasingly important.  

In our view, valuations across some segments of the US equity market look particularly stretched and the potential upside appears modest. Furthermore, unlike more recent tightening cycles, this one has been led by a need to control inflation. As a result, performance has been atypical throughout. Cyclicals and growth stocks – typical laggards during tightening cycles – have outperformed. For these to continue outperforming during the easing cycle (as is usually the case) investors will need to accept even richer valuations. As seen in early August and September, these valuations may prove challenging to digest.

During this type of environment, risk-adjusted market participation is best achieved through a multi-asset framework, providing the ability to hedge against downside risks while overweighting segments or regions where opportunities have been identified.

Once the easing cycle is underway, provided the soft landing materialises, we believe there will be greater opportunity for more broad-based participation.

September is historically weak for market returns

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What this means for our diversified portfolios

This month we have continued to make tactical adjustments to portfolios, reducing our unhedged global equity exposure in favour of hedged global equities. This is due to potential US dollar headwinds, including the fact that some segments of the US equity market appear susceptible to further pullbacks and volatility over September.

This volatility includes currency markets, where the US dollar has typically displayed weakness heading into an easing cycle and immediately following the first cut. The US dollar has already retreated in recent months, and given this weakness is generally frontloaded, much of the unwind may have already occurred. Nonetheless, should recession fears accelerate, US dollar safe-haven status may deteriorate as rates are cut more sharply than currently priced.

With risks evenly balanced, we maintain our mild overweight to defensive assets, with an overweight to long duration as a hedge against recession risks, while remaining at benchmark to equities overall.

At this stage of the cycle, provided fundamentals remain reasonable we may look to use equity market ‘dips’ as a buying opportunity, targeting sectors and regions where valuations are more appealing. Any addition to risk assets in the near-term would likely be accompanied by a lengthening of duration, increasing the hedge against recession risks.