Simon Doyle, Head of Fixed Income and Multi Asset, discusses the impact of a dithering FED and the downside risks to equities and other interest sensitive securities.
The month of August was an unremarkable month. Equities declined modestly, bond yields edged higher and the Australian dollar has remained by and large range bound. Consistent with this, the Fed continued to dither with the Jackson Hole get together seemingly confirming the Fed’s reluctance to adjust US monetary policy. Overall market volatility remained very low and the critical questions on the minds of investors remained unanswered. That said, some of the pressure points we have been highlighting in recent months have shown some tentative signs of bubbling to the surface and need to be watched carefully.
We remain of the view that the Fed’s intransigence with respect to US monetary policy is a key cause of suppressed asset price volatility and the mispricing of risk in global asset markets. The much anticipated Jackson Hole conference proved a non-event, with the Fed providing more evidence that it simply painted itself into a corner with respect to US rate adjustments. The preconditions they seemingly require (a stable global backdrop, limited market volatility and strong US data – especially payrolls) immediately preceding an appropriate FOMC meeting may not ever occur. US data in August was pretty good (sure the manufacturing ISM and payrolls were on the softer side) but the things that had been muted in Q2 have rebounded. Consumption remains solid and production is recovering. A rebound in US earnings in coming quarters would start to make the gap between rates and the economy even wider than would seem justifiable with upside risk to bond yields.
On this point, it is worth highlighting the poor performance of A-REITs in August (-2.8%) amid a relatively small rise in bond yields. We maintain that interest sensitive securities are particularly vulnerable should bond yields rise (even moderately) and these are areas we think should be avoided (or at worst limited) in a medium term context. The flip side of this was relatively good performance of the materials and energy sectors in August.
These factors have been particularly relevant in our thinking around portfolio construction and in particular our overall appetite for risk. Specifically, we believe valuations for equities in general are “full” in a cyclical context, but not stretched. While this implies moderate future returns and some limits to the upside, from a valuation perspective at least they are not overly vulnerable. The downside risks to equities though are threefold. The first is that valuations are being elevated by low discount rates and extended valuations in bond markets. This makes them susceptible to rising yields, both in an aggregate sense and especially for those sectors that have benefitted the most from a yield based revaluation. Secondly, and related to this is the fact that central banks generally have used both policy (action and inaction) as well as rhetoric to suppress volatility in markets. This has worked so far because growth has been moderate (positive but moderate) and inflation low. Any change to this dynamic (particularly via higher inflation) should prompt a re-pricing of risk (appropriate in my view). The biggest risk though is invariably recession, either at a macro-economy level or in profits specifically. While this is not the most likely scenario in our view, the risks of this scenario unfolding are not low.
The bottom line is that while we think there’s some upside to equities there’s plenty of downside. In an objective based environment where downside risks matter, a cautious approach is warranted.
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