Still on Track

Key Points:

• Markets have risen very strongly in the first half of this year; with tech companies being a key contributor.

• Though risks remain, we think the most likely scenario is a continuation of this relatively benign environment – one characterised by improving inflation, some interest rate cuts and good enough economic growth.

• The key risks to this scenario are the emergence of a major recession in the USA or a disappointment from technology company earnings. The US election will also likely add some volatility to markets.

• Reflecting this outlook and the signals from our Tactical Monitor, our portfolios are modestly overweight growth exposure, with a relatively style balanced exposure within equities and a large underweight to government bonds and overweight to corporate credit.

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In this month’s Market Insight, we provide an update on our outlook and how our portfolios are positioned. As the World’s major central banks pivot to easing from tightening, how will markets react? Though the risk of a major recession in the USA has faded, this has been reflected in the pricing of the biggest global companies, which continued to power ahead in the first half of this year. Can the Goldilocks environment continue indefinitely or will markets disappoint investors?

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Mission Accomplished?

The first half of this year didn’t provide much evidence that the USA economy has been derailed from its soft-landing path. After an interruption early this year, progress on disinflation has resumed, with monthly inflation now very close to target. Economic growth in the USA has drifted between a bit sluggish and pretty good (to use economist technical terms), but there is little sign of a capitulation (see below).

The unemployment rate in the USA has drifted a bit higher (as it has in most countries) but is not yet major cause for alarm. Unemployment benefit claims remain low, suggesting no mass layoffs, and employment growth is solid. Elsewhere, including Australia, progress on lowering inflation has been less impressive, economic growth has been closer to the sluggish end of the range and labour markets have generally deteriorated a bit more.

This generally benign environment has allowed equity markets to deliver strong returns so far this year. The Magnificent Seven have risen around 35% and the rest of the market is up around 10%.  The broadening in markets is positive. In 2023, developed markets ex the Magnificent Seven delivered around 10% for the full year compared with ~75% for the Magnificent Seven. So far this year the gap has been much narrower.

Fixed interest markets have more closely tracked the economic data so far this year. Bond yields initially rose as rate cuts were priced out on higher inflation fears. However, softer inflation and economic data in the June quarter reversed this course leaving bond yields and market pricing for rate cuts around where they started the year. Markets now expect all major central banks (except the RBA and Bank of Japan) to cut rates in the second half of this year. The European, Swiss, Canadian and Swedish central banks have begun their cutting cycles. Seeing few prospects for a major default cycle, credit spreads remain very well behaved, though the reward for taking credit risk, particularly in the high yield space, is low given how tight spreads are.

Can Benign Continue?

Equity markets traditionally perform quite poorly when central banks are cutting interest rates. Of course, this is a reflection of the environment in which rates are being cut rather than the rate cuts themselves. In fact, if you split policy easing cycles into two categories, featuring a recession and featuring no recession, the average equity market return in each category couldn’t be starker. The chart below shows some examples of this. The market drawdowns during policy easing cycles with a recession are plain to see. The Financial Crisis, Tech Bubble and major recessions in the mid-1970s and early 1980s were all pretty devastating for equity markets. Indeed, the average equity market drawdown during a recession is around 30%. However, the mid-1990s and mid 1980s easing cycles, which didn’t suffer recessions, were fantastic periods for equities.  

Suffice to say the biggest consideration for the year ahead with respect to market performance continues to be the risk of a major recession in the USA and other major economies. Without completely rehashing the debate we have covered many times in this publication, this risk has diminished considerably since early 2023, from very high (there had never been a tightening cycle of this magnitude before without a subsequent recession), to currently moderate (in our opinion). The reasons we think a recession can be avoided are:

• Fiscal spending in the USA offset a substantial amount of the pain from higher interest rates;

• Also in the USA, 30-year fixed rate mortgages have risen as a share of the total mortgage stock relative to previous tightening cycles;

• Demographic changes across all developed countries have reduced the interest rate sensitivity of their economies. The share of the population who are elderly savers has risen relative to young borrowers;

• In many high debt economies (Canada, New Zealand and Australia in particular), exceptionally strong population growth has papered over cracks in the economy (the individual is going backwards while the aggregate moves higher); and

• Expected interest rate cuts in the second half of this year should begin to support economic growth from early 2025, helping to head off any recession coming down the pipeline.

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Despite this, the increase in unemployment rates we have seen since 2023 is a concern, particularly if it intensifies. Sharply rising unemployment is terrible for corporate earnings and general market sentiment. So far, higher interest rates and slower economic growth have worked to reduce excess labour demand, returning exceptionally tight labour markets to something closer to normal. However, there is a point where all of this excess is removed and weaker demand for employment could translate into materially higher unemployment rates. Almost certainly this would meet most people’s definition of a recession if this occurs.

Just because we think we can avoid a recession doesn't mean we think equity markets will repeat the stellar performance of the past 18 months. Valuations have become very full and particularly dependent on ongoing earnings beats from mega-cap technology names. The AI driven capex cycle from big tech is supporting a lot of the positive sentiment in markets and is unlikely to be sustained indefinitely. At some point Nvidia will have sold enough H100 GPUs and forward earnings projections will come back down to earth.

Another wildcard is the high likelihood of another Trump presidency. Love him or hate him, he has a tendency to say things which create volatility in markets. Most recently, off the cuff statements around the potential defence of Taiwan sparked an overnight sell-off in global technology hardware stocks. Assuming he is elected (which the polls currently indicate), we expect potentially sizeable swings in markets and sectors. Whether markets are happy overall with a Trump presidency will probably depend on whether corporate tax cuts or tariffs win the day. Even if he isn’t elected, the period leading up to the vote could be volatile.  

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Portfolio Positioning

Our portfolios are modestly above neutral growth exposure. There are risks to the outlook, but in our view no more than usual. If we are correct and a recession is avoided, inflation continues to behave and central banks can pivot to supporting growth, the next twelve months should be reasonable for growth assets. Within equities, we are more balanced across style than we normally are. We like technology companies because of their ability to grow earnings. However, if growth begins to recover next year on interest rate cuts, small caps and more cyclically sensitive names could outperform. In this environment, we could see the relative performance differential between different styles continue to converge. In addition, after a such a solid run, we are mindful of the risk of a 2022 type style reversion away from big tech.

Within defensive assets, we continue to be underweight government bonds and overweight floating rate investment grade credit. If a recession is avoided, government bonds are unlikely to rally materially, even if central banks cut interest rates. Meanwhile, investment grade credit spreads are attractive in a high cash rate, low default, environment.

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