Central Bank policy remains supportive for growth

August turned out to be another strong month for risk assets, with the ASX 200 index delivering 2.5% in total return and the S&P 500 index delivering 3% in US dollars (USD). This may have come as a surprise, considering that halfway through the month US economic data came in weaker than expected, leading to fears of a US economic slowdown. US retail sales fell 1.1% from June versus expectations of a 0.3% fall. Consumer sentiment hit the lowest level since 2011 and manufacturing PMIs continue to contract, falling 4.8 points from the peak seen earlier in the year. This occurred during the same month that the US experienced increased COVID-19 hospitalisations, the reduction of fiscal support as unemployment payments rolled over and the threat of Central Bank tapering of liquidity support hung over the market. It was enough to see the S&P 500 fall almost 3% peak to trough intramonth. However, investors quickly bought the dip in equity prices and Jerome Powell delivered a dovish speech at the Fed’s Jackson Hole Symposium, allowing the S&P 500 to close the month at all-time highs.

The question we need to ask ourselves is whether slowing economic data or the eventual tapering of US Federal Reserve bond purchases will be enough to break the bull market in equities. For now, we think not. There is no denying that the rate of change across most economic indicators is falling, however, that is mostly because they have been so strong and are now peaking at extremely high levels. US manufacturing PMIs are down 4.8 points from the peak but are still extremely elevated at 59.9 (anything above 50 is in expansion territory). US retail sales are softening but are 17.2% above pre-pandemic levels. Government unemployment support has rolled off in the US, but job gains are improving as are wages. This all points to a mid-cycle pause as opposed to the end of the upswing.

Model behaviour

Outside of commodity inflation, there is nothing in our recession models to suggest a recession is imminent. However, our two economic cycle indicators are starting to diverge. After being in expansion phase for most of this year, our faster moving “global wave” model is rolling over and is likely to enter the slowdown phase in the coming months. Typically, this creates a more challenging backdrop for equity markets. However, this contraction is mainly due to every indicator hitting highs and the mean-reverting nature of these inputs. On the other hand, our slower moving “output gap” model is still in recovery and likely to move into expansion phase in early to mid-2022. This phase is still supportive for risk assets, including equities and commodities. It is not impossible for the global wave model to move back into expansion as base effects roll over, but for now the two are diverging. To us this means the easy money is behind us and delivery of robust earnings growth will be even more important for the performance of equities in the near term as they earn their way into their high valuations. To us this means a shift towards quality within equities as opposed to de-risking the portfolio at the end of the cycle.

Tapering fears overblown

On the liquidity front, the experience of the “taper tantrum” of 2013 remains forefront in investors’ minds. When former Federal Reserve chairman Ben Bernanke first mentioned the prospect of reducing bond purchases it came as a complete surprise to the markets, which went from pricing one rate hike in 2 years’ time to 4 hikes. US 10-year treasury yields rose by 1.4% over the following months and global equities fell almost 10% in the following weeks. It’s only natural investors are concerned this time around. However, today the market is well aware the Federal Reserve is looking to reduce its bond purchasing program, and Powell successfully articulated the complete separation from tapering asset purchases and the decision to raise interest rates. As long as inflation does not force their hand on bringing forward rate hikes, we do not see tapering leading to a significant correction this time around. That said, equities are trading at far higher price/earnings multiples today than they were in 2013.

Emerging market risks priced in

The other ghost of 2013 was the flow on effect to emerging markets (EM). EM equities fell almost 20% and EM local currency government bonds fell over 13% in USD terms in the weeks after the 2013 tapering announcement. The rise in US treasury yields put immense pressure on countries with high levels of debt denominated in US dollars. Poor external balances, expensive real exchange rates and low central bank reserves were a recipe for disaster. EM central banks were forced to raise interest rates sharply to stop currency depreciation, at a time when their economies were already suffering. Today is a different story. External balances are far healthier, real exchange rates are more neutral and EM central banks have been raising rates preemptively (thereby maintaining their attractive interest rate differentials to the USD). Emerging market equities have been underperforming so far this year, particularly due to China’s regulatory crackdown. We believe the fear of both the taper and further China regulatory risk has now been priced into EM assets.

Portfolio positioning

Given our more sanguine view on the likely taper outcome and the recent value unlocked within emerging markets, we added 1% to both emerging market equity and Asian corporate credit allocations. Asian high yield credit spreads are now very cheap historically, particularly compared with global high yield spreads which are very expensive. While the regulatory crackdown in China is of concern, we believe this risk is reflected in the current spreads. The authorities have shown reluctance to overly hinder financial conditions by cutting the Reserve Requirement Ratio to arrest the economic slowdown. In addition, leading economic indicators remain well supported, mainly due to strong global trade and manufacturing conditions.  

We also reduced our UK equity allocation in favour of Japanese equities due to improved valuations in the latter, and added another 2% to US equities, bringing our overall equity exposure to 30%. Earnings in the US continue to be strong and margins have not only recovered to pre-COVID levels but surpassed them. We view this as a barbell approach of adding to more risky cyclical exposure that is offering value (emerging markets) and quality companies likely to deliver on their earnings expectations (the US).

For now, we believe equities continue to provide upside optionality, unlike some stretched credit markets. We continuing to hedge using duration, foreign currency exposure such as Japanese yen (JPY) and USD, along with put spreads in the S&P 500. As equities continue to earn their way into their valuations and our cyclical models are not suggesting the end of the cycle, we remain invested in growth for now.

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