Higher rates for longer and debate of a soft vs hard landing.

Key Observations:

• Interest rates expected to stay higher as an increased soft landing probability weighed by markets.
• Inflation had declined but core stubbornly above target. Not unusual to see a bounce higher here.
• Some signs of slowing in economy but employment remains resilient. Base case is for delayed downturn.
• Markets are weighing implications of higher short term cash rates and impact of higher long bond yields.
• Equity and credit markets wobbled in late September. Seasonality could drive a rally into year end though we remain cautious of weakness over the next year.

The September 2023 quarter finished weaker for equities and higher for bond yields as the Federal Reserve forecasts of bond yields in their ‘dot plot’ report caused a re-evaluation. For most of the quarter the soft landing narrative gained strength while expectations of Federal reserve policy cuts starting next year balanced the outlook. The business cycle as indicated by purchasing manager indices shows some signs of bottoming, although not conclusive yet. Liquidity measures are mixed with the perception of tighter conditions as the Federal Reserve and other central banks drain liquidity from the system. There is some debate on this as we have seen measures that indicate liquidity may be nearing a neutral and could be heading towards positive, that is more money is being released into the system. Factors at play including a shift in government policies over the medium and longer term to more net spending from trends including energy transition, building resilient onshore and near-shore supply chains, and higher spending on social measures. Seasonally we also tend to see weaker periods in equities during September and October followed by stronger periods in November through to January. Overall, we do expect some form of economic slowdown in the US and Australia, with weaker equities more likely, however we are balancing this against the implications of a soft landing scenario.

We see this cycle in markets and economies as a more normal business cycle in depth, rather than a financial crisis deep downturn. There is always a small chance of some systemic problem, such as a continuation of US regional bank weakness, collateral problems in derivatives markets, or higher government bond issuance causing a break in yields higher. However, if anything is seen as a systemic problem, we expect central banks to be on the front foot with policy measures and rate cuts to prevent truly systemic issues.

There are shifts in multi-decade secular trends such as the reversal in interest rates and move to more government fiscal spending which when overlaid with the very large changes in the Covid shock and recovery that make this cycle more difficult to project. Hence, we are actively considering a range of possible outcomes to help risk manage investment positioning. That said, we are positive on the long term future of economic value creation, capture of value by companies, and diversification across public and private asset classes. Parallels of this cycle appear closer to the late 1940s and late 1960s eras appear more relevant than the mid 70s.

Quarterly Market Performance (to 30 September 2023)

• Equity markets fell over the quarter in most markets.
• Government bonds in Australia and the US rose in yield and bond indices fell as Fed reduced forecasts for cuts.
• Credit spreads were sideways to higher balancing the impacts of soft landing with higher for longer cash rates.
• Currencies initially saw the USD weaker, then much stronger, with the opposite trends for AUD, JPY and EUR.
• Commodities were stronger, led by strength in oil with more modest strength in agriculture and metals.
• Volatility measures were sideways to down in equities, bonds, currency and gold.

Economies

Australia’s GDP rose by 0.4% for the quarter and 2.1% for the year to June, up for the quarter but declining for the year compared to prior readings. Inflation was 0.8% for the quarter and 5.2% for the year to June, declining from the prior quarter albeit the yearly pace picked up in the monthly measure to August. Unemployment rose to 3.60% in June, up slightly for the quarter and up from a low of 3.47% in December 2022. Forward looking indicators in the Purchasing Manager Indices (PMI) are weaker overall indicating contraction in the economy and no clear uptrend emerging yet.

The United States’ GDP rose by 0.5% (2.1% annualized) for the quarter and 2.4% for the year to March, slightly up quarterly while declining annually from the prior quarter. Headline Inflation declined to 3.7% in August, down from 4.0% to May, however there is an emerging bounce from a low of 3.0% in June and 3.2% in July. Unemployment moved up marginally to 3.57% in June from the 3.50% low the prior quarter and marginally down for the year. Forward looking indicators from the PMI indices for manufacturing may be establishing a trough, having picked up in the two months since June, however services are mixed with weakness and volatility more prevalent. Small business optimism was weak and continued sideways, while consumer confidence was weaker over the quarter.

The Eurozone GDP was flat at 0.1% for the quarter and slowing to 0.5% for the year to June, from a previous annual pace of 1.1% in the prior quarter. Inflation continued slowing at a 4.3% annual pace to September, down from a revised 5.5% in June, well down from the peak of 10.6% in October 2022. Unemployment was at 6.4% in July, down slightly over the quarter and the lowest level this year. Forward looking indicators from the EU PMI indices have moved sideways at low contractionary levels. Consumer confidence has declined in the last two months to September after rising consistently from the lows in September last year. Confidence in the manufacturing, services and construction sectors is still depressed and still trending down this quarter.

China’s official GDP rose 0.8% for the quarter and 6.3% for the year to June, weaker for the quarter but stronger for the year. Inflation remains subdued at 0.1% for the year to August, slightly down from the 02% annual pace to May. Unemployment was at 5.2% in August, no change over the previous quarter. Forward looking indicators from PMI indices for manufacturing and services were sideways to slightly up in marginally expansionary territory across business and services PMIs. Consumer confidence weakened over the quarter and is flat on the year having improved to March and subsequently declining in September.

Economic outlook

The overall economic outlook is mixed to contractionary given the composition of forward looking indicators. There are some signs of recovery such as in the US manufacturing PMIs but it is early days. The perception of a healthy economy is demonstrated through a resilient labour market in the US, Australia and globally while nominal GDP, company earnings and retail sales benefits from inflation. Labour advocacy for wage rises is gaining momentum, particularly with the US auto workers strike which has been robustly supported by the Biden administration. Wage rises have a slower but continued pass through from our enterprise bargaining system. We do see higher interest rates as biting the consumer and business as debt gets refinanced over time as higher nominal interest rates are reflected in capacity to spend. A shorter term rebound in oil price also takes money away from consumers and businesses while longer term effects in inflation still see an overall downtrend in inflation interrupted by shorter term factors. We haven’t seen businesses react by cutting jobs yet as labour hoarding is still a factor and businesses feel they don’t have to cut costs or capacity further at this stage. The implications for the financial markets are that they are attempting to look through the cycle and anticipate upside. However, we don’t see this as an easy call as there are still more negative influences in the underlying economy we believe are likely to impact financial markets.

Market Performance

Asset Class Performance and Outlook

Australian Equities

We believe there are risks to Australian Equities from very lagged effects from tighter monetary policy on businesses and consumers, and growing pressures on bank credit provision. While we see business insolvencies picking up to the highest levels seen in about 10 years, this is in selected sectors. There is a positive impact from higher migration however this has also impacted housing availability as supply is constrained. Defensive sectors are expected to do well alongside quality.

International Equities

International equities saw weaker performance for the quarter but a stronger USD drove outperformance for unhedged exposure. Large cap technology stocks have performed strongly for the year despite weakness in September as yields moved higher again, putting pressure on long duration equities. Both the MSCI World and US S&P capitalization indices had a similar pattern with large caps outperforming mid caps and small caps lagging both large and mid cap indices. The quality factor has also significantly outperformed for the year though this moderated in the recent quarter. We remain cautious as we would expect better relative performance in small caps and mid caps to confirm a new bull market but this is likely to require indications of improving economic growth.

Fixed Income

Bond markets were active over the quarter with a volatile but upward trend in Australian and US 10 year bond yields over the quarter surpassing the peak from October last year. The most recent rises in yield was influenced by the Federal Reserve’s Open Market Committee projections for cash rates which were revised up. Over the year credit spreads have trended down with the last two weeks of September some rises as risk associated with higher cash rates for longer were assessed. Most of the credit moves were in the credit default swap indices which move faster than bond indices. Overall bond index returns are down for the year given the overall rise in government and corporate bond yields. Yields remain relatively attractive on a medium term view but tight credit spreads drive our preference for quality.

Tactical Asset Allocation

Portfolio Positioning

This information is general in nature and is provided by Partners Wealth Group. It does not take into account the objectives, financial situation or needs of any particular person. You need to consider your financial situation and needs before making any decisions based on this information.