Given how resilient the global and local economies have been, negative developments may have a larger impact on investors than consumers.
Green shoots of optimism are increasing hopes that we are through the worst of this cycle – both here and offshore. A more rapid mid-year decline in inflation, without an obvious rise in unemployment, has emboldened those looking for a “soft landing” – the so-called immaculate (pain-free) disinflation that avoids higher rates and recession.
It’s hard to know just how much of this pain-free fall in inflation reflects the trade and post-pandemic shocks that are reversing. Or how much of the job market’s resilience to one of the most rapid tightening of interest rates in history is due to pandemic cash handouts that have insulated consumers from higher debt costs.
Eminent US economist Paul Krugman wrote last month that “it’s still too soon to be sure that we’ll manage to pull off a soft landing, but the prospects for getting inflation under control without a recession have never looked better”. Even Jay Powell, US Fed chairman, noted late last month that “given the resilience of the economy recently, [the Fed is] no longer forecasting a recession”.
Even we have closed our underweight to equities at the start of this month, noting that falling inflation and the approaching end to the rate cycle make it harder to hate equities. Valuations make it challenging to love US equities too, where we remain cautious and continue to focus on encouraging strong exposure to fixed income and some unlisted assets.
The good news on inflation has also led major central banks in the US and Europe, and the Reserve Bank of Australia at the start of the month, to shift to a more data-dependent position – i.e., so long as inflation keeps moderating, they are largely finished increasing rates.
Even if you accept that interest rates may be held higher for longer, or come down more slowly than in the past, this has been quite the shift from “glass half empty” to “glass half full” over the past month.
Yet, it’s worth remembering that the outlook does not always mean smooth sailing, and we should reflect this in maintaining diversified portfolios. Things can still go wrong. Given how resilient the global and local economies have been, negative developments may have a larger impact on investors than consumers.
First, consumers could still “hit the wall”, albeit a “discretionary” wall. Interest rates have risen quickly, and there’s still probably some belt tightening to come. Retailers are only now flagging a sharp slowing in non-essential spending as households adjust to interest rates that are three times higher than a year ago.
There’s also that uneasy feeling that the oft-derided concept of money supply growth may just have its renaissance, as it drops sharply on the back of central banks lifting rates and removing liquidity. If that’s too ethereal, remember that rising interest burdens are not the only channel of monetary policy. The ability to earn 4-5 per cent in “cash” here and offshore is likely to dent at least some enthusiasm for spending over the coming year.
Second, there’s geopolitical risk which could well re-appear in the months ahead. One key focus should be the war in Ukraine. Some expect a ceasefire toward year-end, though this is likely to require escalation around a Ukraine offensive. Too great a victory could increase the chances of irrational actions from Russia.
Another key area is Iran, seen by BCA Research as “one of the most underrated geopolitical risks”. With the Iran nuclear deal inactive, Iran has the capacity to enrich its stockpile of uranium to weapons-grade levels, with some estimates suggesting it could create multiple nuclear weapons within a month. Early 2024 brings Taiwanese elections, an event that both China and the US will be watching closely.
Finally, valuations are not without their challenges across a range of asset classes. Consumers may have been able to adjust to higher rates through wages growth and cash handouts. But asset valuations may still have some further adjustment. Equity valuations may not be compensating investors enough for risk, given a likely higher future trend in inflation and interest rates. Similarly, valuations in private equity are only just moving through their adjustment phase, while not all assets in real estate appear to have adjusted to higher rates and shifting demand.
More defensive fixed income investments, including government and corporate bonds, appear primed to perform strongly through most of the likely scenarios. However, at best “acceptable” valuations for many riskier assets make them more vulnerable to any disappointment, should things go wrong with the soft-landing thesis.
