As we look back at the September quarter, the market has become more optimistic that a “soft landing” or, at worst, a shallow recession can be achieved in the US and possibly also in Australia. While there are signs that high interest rates are starting to bite on economic activity, employment remains strong and growth forecasts are being upgraded. Inflation has peaked but it is hard to determine how quickly it will fall towards central bank targets and high oil prices are further muddying the picture.
Central bank comments at the end of the quarter made it clear that interest rates will remain high for some time yet but there is no doubt that interest rates are at or near their peak.
Source: Zenith Investment Partners / Hamilton Wealth Partners
The change in sentiment and outlook for interest rates is reflective in our scenario analysis above.
The market is now comfortable that tighter monetary policy has dampened economic activity and tempered inflation – the outstanding question is to what extent.
In late July we neutralised our underweight to Developed Market equities. Heading into the final quarter of the calendar year, our only underweight amongst risk-based assets is Australian equities. We discuss this in further detail in the equity section below.
In mid-September Capital Economics in London revised up their year-end projections for both the S&P 500 in the US and the US 10-year Treasury yield.
They still expect the S&P 500 to fall from its current level but not as far as they had previously predicted. They see it ending 2023 a few percent lower at around 4,200.
Capital Economics however remains bullish on the S&P 500 for 2024 and 2025, looking at 5,500 for end 2024 and 6,500 for end of 2025, or approximately 52 per cent above current levels. The positive forecast is due to an improved US growth outlook and the tailwinds provided by AI or artificial intelligence.
Equities
Mega-cap US technology companies that rode the AI wave higher during the first half of the year gave back some of these gains during calendar quarter three. The energy sector partially offset these losses due to higher oil prices, following reduced supply from OPEC members, with major oil benchmarks heading towards US$100 a barrel. The S&P500 ended quarter three down approximately 3%, with our domestic market following a similar pattern and ending down approximately 2% for the quarter.
The US Federal Reserve kept interest rates on hold at a range of 5.25 to 5.50% during September, as expected, although hawkish comments and raised forecasts for the future path for interest rates dampened investor sentiment, with markets now expecting a ‘higher for longer’ scenario which doesn’t anticipate rate cuts in the US until later next year.
We neutralised our Developed Market Equity underweight during the quarter based on recent data which supports the view that inflation can get closer to objectives without a significant economic downturn. This increase came via an allocation to global small caps, which haven’t participated in the equity rally to date and where valuations are closer to recessionary levels.
We remain underweight Australian Equities, as key sectors in financials, materials and commodities face headwinds. Banks are entering a period of peak earnings and rising housing and household balance sheet risks, whilst materials are expected to continue to struggle in the short term, as global growth slows. Softer commodity prices dampen the outlook for the mining sector. Domestic wages growth has lagged rates seen offshore however risks remain to the upside, and a collapse in productivity remains a key challenge for the local economy looking forward.
We remain underweight domestic equities and neutral developed market equities as we enter quarter four.
Fixed Income
The improving growth outlook, larger than expected US Treasury Bond issuance and hawkish central bank rhetoric caused bond yields to move higher over the quarter. US 10 Year Treasury Bonds started the quarter at 3.85% and ended around 4.6%. Australian 10-year Treasury Bonds moved from 3.95% to around 4.45%.
The 2-year/10-year yield curve remains inverted, indicating a recession in the US but, as the likelihood of recession eased later in the quarter, it “flattened” from 110 basis points to around 53 basis points. While short term bond yields are likely to remain high as cash rates are kept high, we think longer bond yields will eventually start to fall as the economy slows and interest rate expectations adjust downwards, albeit they may not fall as far as the market was anticipating.
Capital Economics points out that the US 10-year Treasury bond mainly captures investors’ expectations for the Federal Funds rate over the next decade, as indicated by US overnight index swaps (“OIS”), which are currently suggesting a fall in this rate from 5.5% now to 4% by the end of 2025.
Capital Economics foresees a faster and larger reduction in interest rates to 2025 as they expect the economy to be considerably weaker and core inflation to fall more quickly than the US Fed is projecting. They therefore see a rally in bonds to 3.75 per cent at the end of calendar year 2023 and 3.25 per cent to the end of calendar year 2024.
Property
In our July insight we touched on the lack of transactions that we had observed within unlisted property and how this was leading to an underwhelming level of price discovery. This changed during quarter three and we started to see an increase in deal flow from managers, with commercial property changing hands at levels not seen in some cases for over a decade. We think it is still too early in the domestic commercial property down cycle and believe investors will be rewarded for their patience, as we expect more attractive entry points to present themselves in due course.
Listed property or REITs took the valuation pain much earlier than unlisted property, with the Australian REIT index (S&P/ASX 300 AREIT) falling just over 20% in 2022. Listed REITs have traded mostly sideways during 2023 and sold off approximately 3% during the quarter, as a ‘higher for longer’ interest rate narrative put pressure on the highly interest rate sensitive sector.
We remain neutral property as we enter quarter four.
Alternative Assets
Our focus this quarter is on Diversified Credit.
With cash rates and bank deposit rates now offering between 4.5 per cent and 5 per cent, the minimum “risk free” return available has lifted. This higher risk-free rate should also be reflected in diversified credit returns, as here the return for the risk you are taking becomes critical.
The move by banks to reduce their exposure to traditional lending has resulted in the expansion of non-bank or direct lending.
This has come out of the shadows over the past decade and targeted institutional and sophisticated investors.
Given the new rate settings and changing market condition, direct lending has also expanded into the retail market, on the back of investor demand.
What’s more, the so-called “democratisation” of assets has led to an explosion in funds available in this space.
Our concern is that investors do not appreciate the risks in the underlying asset class, especially as these are heightened in some areas of direct lending.
An example can be seen in Australia with property-based credit. It has become popular especially in pooled returns – and the risks in the underlying assets have risen.
Returns are based on a premium over the cash rate. We would argue that returns in this sector have increased from approximately 8 per cent when cash rates were near their lows to a running yield now of 10 to 10.5 per cent.
So, given the increase in the cash rate, the margin has actually decreased as the risks have increased.
While this market can’t be compared to what we saw prior to the GFC we have nonetheless seen a transfer of risk.
In the first instance, that’s come from the shift from the highly regulated banking sector to the funds management sector.
In Australia, investment vehicles with full or partial liquidity in private or direct lending for wholesale investors and advised retail clients have been with us for some time.
For the right clients, this debt exposure has both lowered volatility and enhanced returns. However, right now, there is less need to chase yield and we are concerned that some investors may not appreciate that they may not be receiving an adequate return for the risk they are putting into their portfolio with this kind of asset class exposure.
Summary
We believe the worst of inflation and interest rate rises is now behind us.
The risk of recession has fallen but not gone away completely. Interest rates will remain high for some time yet, but we believe cuts will commence in the US by the middle of next year, likely later in Australia as services inflation remains sticky here.
With the exception of Australian Equities, we have neutralised our underweight positions in risk-based assets. The next move will be a tactical move to overweight.
Whilst interest rates will eventually fall, they will not be returning to the record low levels of the COVID years therefore asset allocation and conviction management will remain very important.
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