Over the past six months our readers will have become accustomed to our scenario analysis chart.
The fact that we show six scenarios (as opposed to our historical three) illustrates the uncertainty that exists in markets today as a result of ten interest rate increases in Australia by the Reserve Bank of Australia (RBA), and the return of inflation that has shown itself to be irritatingly sticky.
Source: Zenith Investment Partners, Hamilton Wealth Partners
The grey box above is the more likely outcome based on the information to hand, and why we have a cautious approach to risk-based assets, however we are looking for the right opportunity to increase weightings in these asset classes and move from the current relative underweight or neutral tactical allocations.
It is important to point out though that we do see downside in the S&P500 before we get to this stage. We think the S&P500 could fall by up to 10 per cent from its current level of around 4,100. We also see the US 10-year Treasury yield ending this calendar year at 3.25 per cent, an approximate 35 basis point fall from current levels.
This reinforces our decision to add bond duration to portfolios in late December last year. If the longer-term path for official interest rates is lower this will support these positions. We remain cautious on diversified credit. Tighter financial conditions ensure we sit on the sidelines for now and this will be one of the last asset classes we expect to increase allocations to in this cycle.
We have now moved the red box in the table above to the least likely scenario. Whilst up to 10 per cent downside in equity markets would not surprise us and would provide a buying opportunity, the reason we have discounted the worst-case scenario is that we believe interest rates are at or near their peak and markets always look ahead.
We are not discounting the damage we are yet to see in the real economies from interest rate increases but markets and economies do not necessarily run in tandem.
Whilst there is still a laser like focus on inflation, we believe this is diminishing. As a result of the collapses of Silicon Valley Bank and Credit Suisse the focus is shifting from inflation and monetary policy towards the impact of the interest rate increases and the stability of the banking system.
As we have seen in previous cycles these are rarely unique events. Don’t be surprised if there are further bank collapses out there, and don’t be surprised if they are left to fail. Remember Bear Stearns in the GFC, where a facilitated takeover by JPMorgan occurred but Lehman Brothers was left to fail.
Treasury yields rallied following the global banking issues, as investors lowered their expectations for Central Banks to continue increasing official interest rates.
Additionally, the commercial banks have tightened lending conditions. This is equivalent to further interest rate increases, estimated to be somewhere between an additional 75 to 100 basis points.
Every cycle is different. What is unique about this cycle is the continuing low levels of unemployment and that this cycle is a liquidity crisis rather than a credit crisis as the GFC was, having been driven by the degree and speed of central banks tightening official interest rates.
We have only seen the early stages of analyst earning expectations being revised downwards. We believe that there is scope for these to decline further, reflecting the full effect of the interest rate increases on the economy, especially as this affects sectors such as US commercial property which is highly leveraged.
Watch out for those companies that are highly leveraged as this is where the pain will come, and it could send shockwaves as these businesses and sectors affect others.
As we often remind our clients, diversification amongst and within asset classes has provided outperformance and protected portfolios but we also do believe that opportunity does emerge in the time of crisis and we will be looking at how to capitalise on this.
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