Testing times ahead
The individual components of the multi-asset strategy — including credit exposure and stock selection — helped protect the funds against bumpy Australian equity performance and tightening credit spreads this quarter. Its positioning also prepares it to react against activity from the US, either in politics, or markets.
The US economy continued to improve over the quarter, with strong jobs and wages growth, together with very optimistic survey results from both consumers and small businesses.
On many occasions we have commented on how markets look stretched, based on valuations, pointing to a low return outlook over the next three years. The other side of this coin is that markets are also more vulnerable to shocks — the more stretched valuations are, the greater the likely downside shift if markets are confronted with negative news. It is therefore prudent to scan the horizon for likely shocks that may destabilise markets. The most damaging of shocks would be a US recession. A typical shock will see greed turn to fear, and often leads to a 20%-plus fall in equity markets, like the European shock in 2011.
However, while terrible at the time, markets generally recover in a year or so. However a recession, while seeing a move from greed to fear, also sees a sharp deterioration in corporate fundamentals, often leading to a 50% fall and the recovery can take five years or more.
Unsurprisingly, we spend a great deal of time determining the risk of recession. Our modelling has found there are generally three phases leading into a recession. First, the economy begins to see signs of overheating — goods and labour markets are tight and inflation pressures start to build. This generally occurs one to two years before a recession. Then, the central bank responds by raising interest rates and draining liquidity out of the system. Policy becomes tight, and with a lag of six to 12 months, this leads to a recession. The last leg to fall is when we start to see it in activity, with investment and employment falling and consumers beginning to rein in on their spending. At the moment will only see signs of the first phase, which puts the probability of the US recession high, out past a year. Equity markets generally lead the cycle by six months, suggesting recession risk is not a near-term problem for markets.
More near-term risks are ones we have been discussing for a while now: rising US inflation and President Trump’s tariff war with China. We first commented on the risk of rising inflation in the US late last year. Our analysis was based on the non-linear relationship between the unemployment rate and inflation: i.e. the unemployment rate has little impact on inflation until it falls below a tipping point. The prime example of this phenomenon was the 1960s where the falling of the unemployment rate from 7% to 4% had little effect on inflation, but once it fell below 4%, inflation began to rise sharply. Once again, the unemployment rate is below 4% and inflation has begun to rise. As markets do not expect a further rise in inflation, should that happen it would be a significant shock, and would lead to a sharp rise in volatility.
We have argued that the path of least resistance is for a continued escalation in the US’s trade war with China. The mid-term elections will be won by the party that can energise its base, as voting is not compulsory, and President Trump is using the trade dispute with China to rally his supporters. So far, markets have not reacted much to the trade dispute, either assuming it will be resolved soon or will have only a minor impact on the strong US economy. While most analysis points to a modest impact from rising tariffs, it generally assumes it will be spread out. However, we think it will be concentrated in a short period of time, as supply lines get disrupted, and this will have a negative impact on business confidence. Also, with the political momentum for further escalation, we think it might take a reaction from markets to short-circuit this. So far, we have been right on the politics, but not on the markets. However, with significant tariffs having only just been implemented, we think the impact is still to be realised.
Diversified portfolios are most vulnerable in the lead in to recession, which our indicators suggest is unlikely in the near future. However, valuations are stretched, suggesting markets are primed for a very positive environment, and that the margin for safety is low. We see a couple of near-term potential shocks, and therefore believe our defensiveness will pay off and opportunities will present themselves – and as we have shown in the past, we will be quick to avail ourselves of them when they do.
This document is issued by Schroder Investment Management Australia Limited (ABN 22 000 443 274, AFSL 226473) (Schroders). It is intended solely for wholesale clients (as defined under the Corporations Act 2001 (Cth)) and is not suitable for distribution to retail clients. This document does not contain and should not be taken as containing any financial product advice or financial product recommendations. This document does not take into consideration any recipient’s objectives, financial situation or needs. Before making any decision relating to a Schroders fund, you should obtain and read a copy of the product disclosure statement available at www.schroders.com.au or other relevant disclosure document for that fund and consider the appropriateness of the fund to your objectives, financial situation and needs. You should also refer to the target market determination for the fund at www.schroders.com.au. All investments carry risk, and the repayment of capital and performance in any of the funds named in this document are not guaranteed by Schroders or any company in the Schroders Group. The material contained in this document is not intended to provide, and should not be relied on for accounting, legal or tax advice. Schroders does not give any warranty as to the accuracy, reliability or completeness of information which is contained in this document. To the maximum extent permitted by law, Schroders, every company in the Schroders plc group, and their respective directors, officers, employees, consultants and agents exclude all liability (however arising) for any direct or indirect loss or damage that may be suffered by the recipient or any other person in connection with this document. Opinions, estimates and projections contained in this document reflect the opinions of the authors as at the date of this document and are subject to change without notice. “Forward-looking” information, such as forecasts or projections, are not guarantees of any future performance and there is no assurance that any forecast or projection will be realised. Past performance is not a reliable indicator of future performance. All references to securities, sectors, regions and/or countries are made for illustrative purposes only and are not to be construed as recommendations to buy, sell or hold. Telephone calls and other electronic communications with Schroders representatives may be recorded.