Last month we talked about the US Federal Reserve and their often-stated view that they are data dependent.
We have seen clear evidence of this in June as, depending on the day and the announcement, markets have reacted accordingly. For example, market expectations for interest rate cuts in the US were brought forward following positive inflation data in June, with the first US interest rate cut now expected in November.
We also mentioned last month that the focus on interest rates is perhaps overdone. Rates are at or near their peak and the next move is down. Market direction will depend on how much rates fall and how resilient growth remains.
In the US we saw inflation for May announced and rates held steady. US inflation was essentially flat from the month before and up 3.3 per cent from one year earlier. In April, prices rose 3.4 per cent. Core prices, which exclude volatile food and energy items, posted their mildest gains since 2021 and rose 0.2 per cent from April, below economists’ expectations.
Federal Reserve Chair Powell indicated there will be only one rate cut of 0.25 per cent in 2024 (remember the market was looking for 7-8 cuts at the start of 2024), and 100bp or 1.0 per cent next year, leaving rates at the end of 2025 at 4.125 per cent.
The market reaction showed that investors are unconvinced by the unexpected hawkishness of the Federal Reserve and there could be more than one rate cut in 2024. Powell does want inflation below 3.0 per cent and there are four more Federal Reserve meetings in 2024 in July, September, November and December but true to form, Powell mentioned it was down to the data, in other words we continue to be data dependent.
Domestically, GDP figures were released in June for the first quarter that saw growth below expectations at 0.1 per cent for the quarter ending March and 1.1 per cent for the year. If you adjust for immigration, Australia is experiencing a per capita recession, dropping 0.4 per cent for the quarter, the fifth consecutive quarter of negative growth and negative 1.3 per cent for the year.
Australia is experiencing a significant economic slowdown, and we are concerned about wage price inflation here, with abundant evidence that inflation is not under control. The May monthly data, released just last week, showed inflation jumping up to 4 per cent from 3.6 per cent in April. Whilst interest rate cuts are likely in the northern hemisphere, unfortunately another (final?) rate increase is now looking likely in Australia.
To conclude our macro view, we continue to see uncertainty in markets during the remainder of the northern hemisphere summer and then, as rates are cut in the northern hemisphere, we expect equity markets to continue to rebound.
We believe that equities in the US will keep outperforming those in the rest of the world, as economic growth is stronger there than elsewhere, and as a bubble fuelled by enthusiasm about AI continues to inflate, disproportionately benefitting the US stock market.
Equities
During quarter two we witnessed a continuation of the trends in equity markets that have been with us for some time now, with the US leading the way, followed by Emerging Markets and with Australia lagging.
Equity market composition explains much of the divergence and as we discuss above, the US market has much higher weightings in companies perceived to be AI winners, those being semiconductor manufacturers like NVIDIA or large technology businesses such as Apple and Microsoft.
The end of quarter correction in NVIDIA saw the company lose its short held title of being the world’s most valuable company. These corrections are healthy, and they help elongate the expansion phase, noting NVIDIA had gained 155% in the year to late June 2024.
Capital Economics increased their end of 2024 and end of 2025 S&P500 target during June, after the market briefly pushed through their long-held end of 2024 target of 5,500. This target was set back in mid-2023 on the view that growing enthusiasm about AI would lead to strong equity returns. Capital Economics note that valuations are not as stretched as they expected currently because returns to date have been supported by increases in earnings expectations and not just multiple expansion. Their revised end of 2024 and 2025 targets of 6,000 and 7,000, respectively, reflect “broadly similar price/earnings ratios to those they had previously anticipated, while accounting for the stronger-than-expected earnings outcomes so far.”
We maintain a marginal overweight to Developed and Emerging Market Equities as we enter quarter three.
Fixed Income
Government bond markets have also ebbed and flowed over the quarter in accordance with data releases, both the US and Australian bond markets trading within a roughly 50 basis point range along the yield curve. The key difference is that US bonds are ending the quarter towards the bottom of their yield range, as growth and inflation data has cooled, whereas Australian bonds are ending the quarter at the upper end of their range as inflation data has continued to disappoint.
Australian 10-year Treasury yields are now 10 basis points higher than US (4.40 per cent versus 4.30 per cent). Australian 2-year Treasury yields are lower than US (4.25 versus 4.70), reflecting the higher cash rate in the US, but this gap will surely be eliminated at some stage, when the US starts to lower its cash rate and Australia’s cash rate remains at its current levels, or possibly is raised one more time.
You will recall that we removed bond duration from portfolios in late March/early April and we remain marginally underweight Fixed Income overall.
Property
The domestic listed property market (AREITs) was broadly flat during the quarter, after recording substantial gains over the prior two calendar quarters. It is important to remember that the AREIT index is not reflective of the broader unlisted property market because industrial property developer Goodman Group (GMG) makes up over a third of the entire index. GMG has surged nearly 100% over the last year on anticipation that their shift into data centre development will help propel growth into an AI led future.
Unlisted office assets continued to experience further cap rate expansion during the quarter as high interest rates and vacancies, along with the sluggish domestic economic backdrop, weigh on valuations. One positive development we witnessed during the quarter was that certain subsectors, such as healthcare, managed to offset higher cap rates with solid rental growth.
We have seen a few interesting opportunities in industrial property transactions in recent months where deals to buy parcels of assets at a wholesale level and then divest them at a retail level make sense on a shorter-term basis. Extremely tight vacancy levels and strong rental growth support these strategies on a shorter-term demand/supply basis.
We maintain a Neutral weighting towards Property.
Alternative Assets
The domestic Initial Public Offering (IPO) market was tested for the first time in approximately three years in June with the float of fast-food business Guzman Y Gomez (GYG). Several market commentators were expecting a flop based on excessive valuations and ambitious growth targets, however GYG managed a successful listing, gaining over a third of its value on its first day of trading, valuing GYG at approximately $3bln. This could mark an important turning point and lead to increased activity during the second half – potentially freeing up liquidity for privately held businesses.
The lack of liquidity available across several Alternative asset classes in recent years has reinforced our strict process around how we classify illiquid assets and the level to which we are comfortable gaining exposure. We continue to witness structures restricting withdrawals across semi-liquid Private Equity, Credit, Infrastructure and Property.
Summary
We have often talked about the need for diversification amongst and within asset classes.
It also concerns us when we see investor complacency. Yes, we are optimistic on risk-based assets, however a recent comment by James Mackintosh of the Wall Street Journal is pertinent. He said “the bigger risk I see is that investors get too comfortable with the idea that there are no imminent threats. It means any surprise—whether on the economy, the AI theme, the Fed or geopolitics—will hit hard.”
In other words, nothing ever goes up in a straight line.
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