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Investment Perspective | 10 September

Equities are starting to come up against headwinds as the narrative of slowing growth and delta variant concerns start to bite, whilst emerging markets continue to fall on the back of regulatory concerns. This month, our new Chief Investment Officer, Graeme Bibby, shares his thoughts on the market and where we are heading.

Equities initially rose strongly in August, hitting record highs, before falling back with concerns over the Delta variant spooking markets. The ASX200 has risen roughly 1% and the US S&P500 index is steady over the month to the time of writing. Emerging markets continued with their recent underperformance with investor concerned about Chinese government market interventions and regulatory uncertainties in China.

The US had a very strong earnings season with close to 90% of companies beating consensus earnings expectations, and by a record average margin. Australian companies are midway through their reporting season and so far, and results have largely met high expectations. Investors have been rewarded by record dividends from some of our countries largest companies including BHP. The strong earnings reports go some way to justifying the strong run up in prices we have seen over the last 12 months. U.S. 10-year bond yields sit around 1.25% at the time of writing, whilst Australian 10-year yields sit around 1.10%, both down about 0.15% since the last update.

Commodities pulled back strongly from record highs, with iron ore falling significantly to USD$132 (China futures pricing) at the time of writing, from the highs seen in July of USD$220, after China ramped up its commitment to reduce emissions by cutting steel output amid a slowdown in global manufacturing. Copper prices have been more resilient pulling back slightly to USD$4.10. Brent Crude fell to USD $68 based on weak Chinese economic data and concerns regarding the impact of the Delta variant on energy demand. Gold pulled back slightly to USD $1780 on signs the US Fed may start tapering asset purchases before year end.

The Australian Dollar has weakened against the U.S. Dollar to 72 cents.

Economic overview

A worsening Delta variant outbreak in NSW, and now Victoria, has dashed hopes for a quick route out of lockdowns, with vaccinations now seen as the passport to freedom. Employment figures surprised with July’s jobless rate falling to 4.6%, the lowest since 2008. Delving a little deeper, the picture is less rosy – the figure was only so strong because thousands of people stopped looking for work altogether as lockdowns bite. Treasurer Josh Frydenberg has said that the economy will contract by at least 2% in the September quarter. Business confidence fell significantly, dropping into pessimistic territory for the first time since Victoria’s second wave last year. Consumer confidence has also fallen though has shown signs of recovery in the most recent weekly survey. On a positive note, experience over the last 18 months has consistently shown that the economy rebounds quickly after lockdowns end. Australia’s vaccine rollout is starting to hit its straps, with over three hundred thousand doses administered daily and Pfizer supply on the horizon for younger adults. Australia is now on track to meet vaccination thresholds set by the Government before years end. So, while the next few months will be tough for the economy, there is hope on the horizon.

In the U.S, economic data has remained strong though has continued to moderate to more normal levels. The most recent employment figures beat market expectations and the jobless rate fell to 5.4% and industrial production remains stronger than expected. However, US retail sales disappointed as consumer confidence looks to have fallen from recent elevated levels. Federal Reserve meeting minutes suggest conditions are likely to be met to begin tapering bond purchases by the end of 2021. Investors will be closely monitoring any announcement as this could be a headwind for equity valuations.

China released a five-year blueprint calling for greater regulation of vast parts of the economy, providing a sweeping framework for the broader crackdown. The document jointly issued by the State Council and the Communist Party’s Central Committee, said authorities would “actively” work on legislation in areas including national security, technology, and monopolies. Industrial production and retail sales data releases disappointed, raising concerns for the near-term outlook for world’s second biggest economy, especially with lockdowns recently re-introduced to deal with the emergence of the Delta strain.

The next year and ten years – a structured framework for investing

As new Chief Investment Officer, I bring a structured approach to investing for the long term.  The long term begins by building up from the short term and recognises current conditions and the corresponding cycles in the economy, government policy and markets. The very long term out to 10 years and beyond recognises that there are themes that will influence what investment strategies work, which ones are less effective, and strategies that help diversify and reduce risk. This is the mega-trend time frame where secular changes in the world are more apparent when comparing environments decade by decade. In the period from one to ten years we can have many cycles of economies, markets, political and government policy and flows of money to investment areas. In the short term from one month to one year we can track where the economic environment is with economic ‘nowcasting’. Assessing where the market narrative is versus the underlying realities provides opportunities to either go with the momentum of markets or position around potential turning points.

So where are we now? 

The market narrative is that the Federal Reserve has our back and is there to bail us out when markets drop – be that equities or bond markets. The Fed tends to react after large movements in markets occur, and have clearly stated they will provide support until inflation is visible sustainably at or above their target in reported inflation figures.

The coronavirus delta variant has some concerned but this has not prevented equity markets rallying to record highs in many countries around the world including the US, some European markets and Australia with the exception of China. Recent concern around the Federal Reserve’s stimulus tapering, with more clarity expected at the Fed’s Jackson Hole symposium has contributed government bond yields to fall.

Where are we going to?

The economic regime in Australia, the US and many other countries is transitioning from an accelerating GDP growth and inflation environment to a deceleration of growth, while inflation is likely to remain high due to lagging effects in inflation data. Some countries are further along in their economic regime, with China the first out of the initial pandemic wave, recovered quickly and has eased in their economic and inflation growth. Policy settings of central banks (monetary policy) and government budget spending (fiscal policy) is still very easy (i.e. low short term policy cash rates) and the level will remain very high for the next year even though the pace of stimulus eases slightly. As at the time of writing market participants are struggling to weigh up the impacts of a more meaningful economic slowdown.

What are markets pricing?

Equities are pricing through to the other side of any slowing economic environment in the next 1 to 2 quarters, while bond markets are more concerned about a mid-recovery slowdown, hence 10 year government bond yields are well down from their peak earlier this year. Policy makers have begun talk of tapering the level of central bank policy rates, and further government spending programs such as the US infrastructure bill could add between 1 to 3.5 trillion US dollars of budget spending. Short term market volatility can be expected in equity and commodity markets as narrative shifts between shorter term concerns and longer term look through. Capacity for further gains in equities is likely given the amount of cash and savings (liquidity) still on the sidelines around the world. Falling bond yields and credit spreads (yield above government bonds for companies and other non-government bond issuers) provide some limited additional returns as yields are already very low. Since the beginning of July, high yield bond spreads above government bonds have risen by around 0.4%, reversing a downward trend since the start of the year. This is an indication of a reduction in risk appetite and has been associated with a movement from high yield bonds to investment grade bonds and government bonds.

How do we position portfolios?

Our equity portfolios have a mix of styles that are expected to perform well through the cycles, noting that we would see some short-term weakness for the next one to two quarters in small capitalisation, and cyclical stocks with a rotation towards larger and quality stocks likely. The rotation in environment means that while equities are still likely to be positive, where the winning sectors is likely to shift in the next two quarters, then shift back as we transition again to a re-accelerating recovery. These shifts and shorter term concerns which is likely to see more volatile markets as market narratives ebb and flow between positive and negative.

Within our bond portfolios we take a more absolute return approach, choosing investment managers that can perform despite the very low levels of government bond yields, including a mix of credit and more broad market bond strategies. Selective high grade credit exposures are preferable to purely government bond strategies. We can expect some lower to moderate volatility in defensive bond portfolios as the economic environment transitions and markets price the evolving policy response of goverments.

Within our multi sector balanced and high growth portfolios the path will be smoothed by the diversification provided by defensive sectors compared to equity only strategies.

Style and sector rotation are expected to be a source of opportunity and risk for our managers and direct equity holdings. The value style tail wind is likely to fade for some time in the next six months, as is likely the performance of more cyclical sectors. Hence we have a preference for quality as a style in the next six months. Longer term quality and growth at a reasonable price are reasonable long-term styles while we think value will be challenged for the decade ahead. Value managers have a place as they select better stocks from within a value universe, and we still include them in our portfolio structures.

Want more information?

This perspective highlights that market sentiment on all asset classes is constantly changing. It is important for us to quickly recognise any threats, to preserve your investment capital or to identify early investment opportunities to maximise any return advantages. At Partners Wealth Group we don’t get complacent with the current state of play and constantly monitor investments and your portfolios.

If this article has raised questions regarding your personal situation, please contact your Partners Wealth Group advisor directly or on 1800 333 143.

This article contains information that is general in nature. It does not take into account the objectives, financial situation or needs of any particular person. You need to consider you financial situation and needs before making any decisions based on this information.

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