We maintain an overall NEGATIVE view of equities.
Macro indicators continue to soften with many consistent with economic contraction. The US has entered a technical recession after two quarters of negative real GDP and composite PMIs have dropped below 50 in the US and Europe. While there is evidence that headline inflation in the US is peaking (supported by the moderation in oil prices) it is less clear when it comes to core. The US Federal Reserve raised cash rates by another 75bps to reach their neutral rate of 2.5% but we expect further tightening and a relatively hawkish Fed stance until they are confident that US core inflation is tracking back towards its medium-term targets. Given the gap between current inflation and target, this will likely require both weaker labour markets and clear evidence of a moderation in the trend in core inflation. Equities have rallied recently but we see this as largely a bear market rally reflecting short covering supported by the idea that weaker data increases the chance of a Fed pivot.
While profits (ex-energy) have started to moderate, we believe further weakness in company margins (reflecting higher input costs including wages and weaker demand) will lead to earnings downgrades. We expect this to start to impact more significantly in September quarter outcomes but more likely in the December quarter numbers given the lags between policy, demand, and profits. We believe a ratcheting down of earnings and an affirmation of more hawkish central banks will lead to the next de-rating lower in equity markets. That said, positioning and sentiment is still extremely low, pointing to the potential for the bear market rally to extend for a few more weeks.
From a valuation standpoint, while multiples have moderated, they remain in most cases well above levels consistent with both elevated inflation and the expected profit outcomes. Typically bear markets in US equities (for example) end with multiples in the low to mid-teens. Current multiple at close to 20x are well above this. We prefer value to growth from a style perspective. While our medium-term return forecasts favour Australia, Japan and EM equities there are clear near term risks in each of this markets.
We maintain an overall CAUTIOUS view of credit.
Our cautious view on credit is underpinned by our view on corporate earnings. Most fundamental metrics like Net Debt to EBITDA and Interest Coverage are likely to come under pressure as earnings roll over, especially those who have to refinance at significantly higher rates (although many IG corps have termed out their borrowings over the last two years). Our views on recession also point to the start of a new default cycle which is not yet fully priced. That said, certain pockets of the market are starting to show some value, especially in investment grade credit where we believe spreads are pricing in a recession. Australian IG credit looks particularly attractive after spreads widened above 180bps, exceeding the 170bps seen during the Covid sell off, whereas both global IG and HY are at about half the spreads seen in 2020.
Adding to our caution in high yield is that we see this as the market segment where recession and rising defaults could trigger tail-risks if the sell-off becomes disorderly. During a stressed credit selloff, illiquidity can cause spreads to widen substantially and price in far more dire expectations, like the pricing of a depression in 2020 and 2008. Therefore, we remain cautious overall on credit, but have been adding to Australia. We expect some distress before a clear buying opportunity emerges once recession and earnings fears are realised.
We have a NEUTRAL view of Sovereign bonds / Duration.
We remain neutral on duration but continue to see risks to yields in both directions, albeit still slightly skewed to the upside (in yield terms) given the disconnect between nominal growth, policy tightening and the level of bond yields. That said, our models point to US 10-year government bonds as being around “fair value” and slightly cheap for the Australian equivalent. We have trimmed duration slightly in recent weeks and are now slightly below neutral duration positioning.
Our fair value models are influenced by longer run cash rate projections so are vulnerable should inflation prove more persistent and cash rates need to risk more than currently anticipated. However, as the Fed’s balance sheet will contract in coming months, this will serve to help tighten monetary policy and moderate the overall extent to which rates would need to rise. While market pricing already reflects some easing in 2023, we see this as premature even though the market has moved towards our recession base case.
We continue to watch inflation momentum, energy prices and growth with any sign of moderation being a potential catalyst for a rally. We prefer Australian duration as we do not believe the economy/housing market can handle the level of rates being priced in and given how aggressive the Fed has been relative to the RBA, the world could roll over into a recession before the RBA reaches their terminal rate.
We have a POSITIVE view on the USD and the JPY.
This reflects our overall defensive positioning and believe the USD is the safest currency in this environment and that the JPY is cheap and a typically a good hedge in a risk off environment. We do see EM currencies as a helpful diversifier with upside risk should China stimulate significantly and Asian markets turn, but this offset by a short CNY position.
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