In the month of May, central banks in Australia and the US decided to raise their official interest rates after a previous pause. While the necessity of these rate hikes can be debated, the accompanying statements from the central banks reveal their frustration with inflation and their determination to bring it under control.
With the latest interest rate increase and the release of the Federal Budget, which despite the government’s claims, is expected to have an inflationary effect, the focus now shifts to the possibility of further rate hikes. Capital Economics, a London-based research firm, suggests that while central banks’ tightening cycles are coming to an end, their impact on economic activity is yet to be fully realised. In other words, attention is now shifting from the rate increases themselves to their impact on economic activity.
Capital Economics offers the following insights:
- The global economy has shown resilience, with world GDP growth of approximately 1.5% in the first quarter of the year following a contraction of -0.4% in the fourth quarter of 2022.
- Inflation remains persistent, and although headline inflation has been trending downwards, core inflation has in fact increased.
- Central banks acknowledge that they may have done enough to bring inflation down to “more acceptable” levels by the second half of 2023.
Looking ahead, it is anticipated that the US will commence rate cuts by the end of 2023, while Australia’s rate cuts will proceed at a slower pace. This projection is based on Australia’s struggle to control wage price inflation and the anticipation that the US will be able to implement more aggressive rate cuts in 2024. Australian wage price inflation is expected to remain around 3.5-4.0%. This is expected to result in a higher Australian dollar.
Market indicators, such as two-year bond yields, suggest that the bond market is pricing in two rate cuts in the US this year and an additional five cuts in 2024, with a mild recession. While many developed market economies are bracing for recessions in the second half of the year, Australia is expected to escape such an outcome.
We retain a cautious stance on equity markets, expecting potential downside risk of 3,800 for the US S&P500 (compared to its current level of 4,130). We will look to reweight equity positions in market weakness, although such a correction is not anticipated until the second half of the year.
Our bond position, initiated in December, has contributed positively to portfolio performance. However, in hindsight, a more aggressive approach could have been taken. At a 3.0% long term bond yield or below, these positions become marginal and we would consider reducing exposure.
Source: Zenith Investment Partners / HWP
Readers will be familiar with our probability analysis. As illustrated the bear case we see as only a slim possibility. We continue to stress the importance of watching interest rate markets. Eighteen months of monetary tightening has raised the risk-free component of discount rates globally, which in turn lowered valuations and created a headwind for equities.
Whilst valuations have adjusted, we now see the headwind of decelerating earnings, again as the result of the impact of increasing interest rates. The question is to what extent are expectations of further falls in earnings factored in?
We see downside in equities with a bounce later in the calendar year. This, however, will see performance selective and divergent between sectors.
Conviction management is the answer as certain sectors will rebound in earnings and therefore valuations whereas many of the old “growth” companies that had revenue growth and little if any earnings we fear will be left well behind.
Login to …