Investment opportunity exists despite a likely tough year ahead
Investors are rushing to “look through” the global economic downturn but we believe the optimism remains largely unfounded.
We’ve been surprised at how quickly many investors have shifted their monetary policy expectations, particularly from the US Federal Reserve, toward easing of rates instead of aggressive tightening.
We think that’s probably too optimistic…we’ve also been surprised at the extent of the rallies in equities, those more credit-sensitive parts of the fixed-income market, and even in government bonds.
Markets have probably got a bit ahead of themselves in terms of how quickly the cavalry –the central bank pivot – is actually going to arrive. That leaves us more cautious than markets at this point.
And on Australia, more specifically, we believe it’s certainly too early, given the strong employment data here, to be talking about a rate cut.
But the above scenarios, alongside our outlook for a weaker US dollar, also create opportunities in some large global markets.
In the following video and the edited transcript below, I detail where we see the best opportunities ahead and how our portfolios are positioned to take advantage.
What is your outlook for this year?
After a very tough 2022 for markets, we do think the outlook for '23 is going to be more constructive. On a 12-month view, there's certainly a reason for some optimism. But we think there's still a bumpy road ahead for the global economy, so we see a need to prepare for some tougher times and market volatility.
We've been surprised at just how quickly some investors have jumped at that opportunity to pivot their views as it relates to the Fed's monetary policy, and whether it will move from very aggressive tightening to even easing.
We think that's probably a bit too optimistic. We've also been surprised by the extent of the rallies in equities, those more credit-sensitive parts of the fixed-income markets, and even government bond yields, which have also joined that feel-good party.
Has inflation peaked?
Certainly, to our mind, particularly if we're speaking about the US's peak, there's no question about that. But we're less convinced on exactly how far and how quickly that inflation is going to come back. We shouldn't forget about the US's importance to global markets. US inflation is still around three times higher than the Fed's target rate of around 2%.
Unemployment levels in the US are also at or near historic lows, wages growth is fairly solid. Policymakers have been quite clear about their concern about wage pressure and what that can do to inflation.
Putting all of that together, we think markets have probably got a little bit ahead of themselves in terms of how quickly the cavalry, in terms of that central bank pivot, is going to arrive. That leaves us probably more cautious than markets at this point.
What is your outlook on Australian policy rates?
Here in Australia – like the US from the perspective of the unemployment rate – is at near historic levels. It's well below the levels that the central banks deem to be full employment. In that environment, we think it's way too early for markets to be talking about an RBA pivot and starting to think about rate cuts.
We think it's more likely we'll see at least one, 25-basis point hike. That's probably our base case, but maybe two, pushing that rate another 50 basis points in total. But it's certainly too early, we would suggest, to be talking about a rate cut.
How likely is a soft landing?
So, if there is one concern for us, it really is around slowing economic growth. I think a recession is widely anticipated and as we've often spoken about, markets are forward-looking. Our concern is that there is very much a narrative around a soft landing that's going to play out.
We are less convinced that that is the case. We've seen some of the most aggressive rate hikes in decades and this is against the backdrop of a highly indebted world. And that's not only governments and corporates but also individuals who are carrying enormous amounts of debt.
We're not certain a soft landing is how things are going to play out when the pain really starts taking hold. These things do happen with a lag and sometimes those lags can be quite extended. We're a bit more cautious and we think if there are risks, they're probably risks to the downside in terms of economic growth at this point.
What’s one bright spot?
I think China is a bright spot in this gloomier economic outlook. What we have seen is really a 180-degree by the powers that be there in terms of COVID policy. We absolutely believe that is going to be beneficial. As that economy starts opening up, it should provide some offset to the weaker growth we expect in places such as the US and Europe. Now, it might take a little bit of time for this to play through. As economies open up and COVID spreads – we know, we've been through that – there are some starts and stops. But ultimately, if we think about the year ahead, to us, China probably looking on a much more positive trajectory than was the case when we last met last quarter.
It's also become clearer that the US dollar has probably peaked. That should be a good thing for emerging markets, with US dollar-denominated debt – mainly being able to service that debt. That's a good thing for the region.
As I mentioned, we're obviously more positive about China. I think that will have knock on impacts for parts of the Asian region more broadly. The combination of those things leads us to believe that being overweight in that region, so Asia or maybe emerging markets more broadly in preference to the US, still makes sense. Our portfolios are positioned accordingly.
Against this more cautious view in terms of economic growth, we’re still concerned by the expectations for company earnings. Our view on US earnings still looking too optimistic is something we’ve raised in recent updates.
We struggle to see how we can reconcile positive earnings growth expectations in a recessionary environment, even if that is not a deep recession. We think earnings are going to have to be revised downwards, which we believe will weigh on share prices.
It’s also worth noting – given that we are probably a little more pessimistic in terms of the earnings outlook for equities, particularly in the US – that we are comfortable holding a bit more cash in portfolios. It provides capital stability and the yield we’re getting on cash now is reasonable. It also allows us to act nimbly if the opportunity presents itself.
Following a tough 2022, we are more constructive on '23. But that said, we think markets have acted too optimistically in their expectation of rate cuts. We don't think central banks are going to come to the rescue quite as aggressively as I think markets are expecting.
We believe the economic backdrop is still likely to be tough. The risks are to the downside in terms of economic growth, so some level of caution is warranted.
Elston Asset Management's investment solutions range from a core Australian Equities Large Cap model through to full risk-based multi-asset class models. To find out more, visit their website.
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Leon de Wet is a Portfolio Manager and Shareholder in Elston Asset Management (“Elston”), a high conviction manager that adopts a team based approach. Leon joined Elston in December 2009 and has direct portfolio management responsibility for both...
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