76 days to go: What to expect for the rest of 2023

The September 2023 quarter saw the ASX 200 return -0.8% (q/q), with global equities declining a more weighty -3.5% (q/q) if you were hedged against the Australian Dollar’s fall (or flat if you weren’t).

In his preview of the December 2023 quarter, Tim Toohey (Head of Macro and Strategy) looks at the recent dramatic changing picture for US bond supply, explains why expectations for a rapid series of cuts from the Fed in 2024 have disappeared, and names the best opportunities coming into the end of 2023.

Transcript

Hello everyone, welcome to our December Quarter Outlook. If it seems like there was a longer than usual gap between our quarterly update then you are correct. Our September quarter outlook was recorded more than two weeks before the end of the FY so the gap actually closer to four months rather than the traditional three months.

September quarter summary

We concluded that September quarter Outlook with the statement;

“From an equities perspective, the narrow nature of the global rally and the ongoing negative EPS trend leave us unconvinced in the rally will sustain itself in 3Q. At best, we are expecting a pause for equities in Q3”.

As it turned out the September quarter returned -0.8%qoq for the ASX200 and global equities declined a more weighty -3.5%qoq if you were hedged against the A$’s 3.5% fall or flat if you weren’t hedged. Of course, the first few days of the December quarter suggest a more meaningful correction is now setting in, but more on that later.

The last quarter also validated our views on the RBA and the Fed, with both banks remaining on hold for the past four and three months respectively. Both remain on watch against any unfriendly inflationary pressures, but both continue to signal that they think they may have done enough to return inflation towards target over the forecast horizon.

Even our cautionary tale on gold appears to have moved in the right direction with gold prices declining 3.6% in the quarter, with much of the move occurring in the past month.

So far so good. Where our prognostications from mid-June really fell down however, were the returns from bonds. We suggested that bonds may finally be set up for a better quarter only to see global bonds decline 3.6% in the quarter, albeit domestic bonds declined a far more modest 0.6% in the quarter. Indeed, with solid contributions from Bills and corporate bonds, Australian fixed income declined just 0.3% - a very modest beat compared to domestic equities but not the type of quarter that we were expecting.

The changing US picture

Indeed, not long after we published the September quarter outlook we had a material change of mind and cut our bond overweights but towards neutral due to one key data point – the refunding statement by the US Treasury dramatically changed the picture for the supply of US bonds in 2H23 thanks to unabated US federal spending. This sharp increase in the supply of loanable funds together with further evidence that the US would likely escape a recession was more than sufficient for us to cut our overweight bond positions.

Indeed, the movement in bonds has been the story of the past quarter and looks to be the dominate theme in the quarter ahead. There is no question that some of the movement has been repositioning. The main recession trades embedded in markets were steadily removed upon each statement by the Fed that the odds of achieving a soft-landing were increasing and with each data point that showed some signs of economic resilience.

The refunding statement may have been the catalyst for the selloff in bonds but it also crystalised that the massive blowout in the US federal government deficit - equivalent to a fiscal impulse of 4% of GDP over the prior year – was not about to retreat any time soon. Whether this was adept counter cyclical policy (Janet Yellen may yet be a more effective fiscal manager than a central banker) or more likely that everyone underestimated the impact of the military build-up, the energy transition spending under the IRA and automatic stabilisers kicking in during a slowing economy, the reality was that government spending was providing a much bigger support than widely discussed.

In retrospect, this is the major reason why the US managed to avoid a modest recession. Yet two other powerful forces were also pulling in the same direction.

The first is something we had remarked upon previously, that is, financial conditions have moved into the restrictive zone in the US but for the past 12 months the level of financial conditions essentially held steady as tightening by the Fed in 1H23 was offset by higher equity markets and narrower corporate bond spreads. In other words the change in financial conditions had gone from a major headwind to future economic growth to something that is more of a neutral impact for economic growth over the next 12 months.

The second is that despite concerns that the US consumer still absorbing the lagged twin impacts of prior rate hikes and having now depleted the build up in savings during the COVID period, the more important data point is that US incomes are now growing faster than inflation for the first time since 2019 and at the end of the day it is always real income growth that drives the vast majority of consumption growth.

Making sense of the ‘downturn’

So after the most overly anticipated slow motion economic recession in modern history that never seemingly arrived we are left with a downturn that has created very little spare capacity in labour and product markets. Indeed, this is the main reason why rates markets are having to look deeply into their soles are realise that expectations for 5-6 rate cuts in 2024 in the US were never going to happen. At the time of recording there are now less that 3 rate cuts priced in the US. We may well see markets continue to give up on the likelihood of interest rate cuts in 2024 and this will continue to reverberate through risk assets that had already banked a series of rate cuts in 2024 into market valuations.

All of this means that the path for bonds remains problematic. Virtually all of the rise in yields is due to real bond yields, which can be interpreted through the prism of better economic prospects and greater supply of bonds, yet we are also seeing the term premium becoming reestablished. Negative term premiums are in part a reflection of the ZIRPs of recent years and the reckless deployment of QE. So positive term premiums should actually be welcomed, but we are not yet at normalised levels for the term premium so its possible that bond yields continue to drift higher.

Moreover, if financial markets are indeed coming around to the idea that the worst of the economic slowdown may be more behind us than ahead of us then the steepening of the yield curve could continue as the yield curve returns to its standard shape during modest expansion periods.

Are we actually in recovery?

What is of particular interest to me is that while most of financial markets remain locked in debate over bond yields and the prospects for the US, evidence of a broader economic recovery in the global industrial cycle had been accumulating for several months.

Our aggregation of industrial production data country by country had revealed that developed market economies are contracting modestly in recent months in annual terms, however, a recovery in emerging market industrial production commenced 4 months ago is of sufficient strength to drag global industrial production into positive growth. Countries such as India, Vietnam, Mexico and parts of Eastern Europe are expanding at sufficient pace to offset weakness in the West. Part of this may well be attributed to supply chain diversification from China providing an uplift for other developing countries, but it seems broader than just this effect. Indeed it’s not unusual for EM countries to lead economic upswings. It happened in 2001 coming out of the global recession and it even happened in 2016 which is now retrospectively attributed to the “Trump-bump” but in reality the recovery commenced six months ahead of Trump’s election led by Emerging Europe and Emerging Asia. The simple fact is emerging countries are further up the supply chain and tend to see shifts in the cycle ahead of the West.

Indeed, it’s of interest that this EM led recovery is occurring despite the surge in the USD. Typically, bouts of USD strength lead to crises in dollar linked EM countries, but we seemed to have dodged that phenomena this time around and instead we are seeing signs of resilience which not only bodes well for the global economy continuing to gain some positive momentum in the current cycle but also for future cycles as well.

Of course, one wonders how markets will respond should China deliver a more meaningful monetary and fiscal injection in the final months of the 2023. My base case is that they will. Not least because the vast majority of Chinese annual economic growth came in the September quarter of 2022 which will soon fall out of the annual growth rate. Recent months seemed to reach new highs in peak pessimism on China, despite the economic data being more mixed. It would be of particular interest for financial markets if China stimulates simultaneous improving ex-China EM growth and signs of improvement in the West.

Outlook for 4Q23

So turning to the outlook for the December quarter, the key question will be at what point will bond yields stabilise and the valuation downdraft that it has opened up for equities cease. The start of the quarter has continued to see significant de-risking and equity valuation declines escalating. However, if the root cause for the rise in long dated yields is the avoidance of recession, some signs of improved global growth already in place and the core thematic of easing cost pressures is still in place then equities will begin to stage a recovery in coming weeks. Indeed, our leading indicators for 12mth forward EPS suggests negative EPS revisions should now largely be complete and we can now begin to cautiously trust forward multiples again.

Our preference is to avoid long duration parts of the equity market, as they suffer the dual challenge of higher bond yields and the rotation from the historically narrow leadership of mega cap tech. Quality industrials and base metals should be better places for large cap exposure and if economic growth, including Australia is in economic upgrade mode and in particular, the bigger opportunity into the close of 2023 and early 2024 could actually be in small caps.

Best of luck everyone in navigating the rest of year and see you in the New Year.