Written by Chief Investment Officer Scott Haslem

In this Special report, we take the opportunity to trim risk by moving underweight US equities and high yield credit, while adding back to cash and short maturity fixed income. We have strengthened our overweight to fixed income relative to equities and continue to favour government bonds and investment grade credit. We remain overweight domestic and emerging market equities.

While we remain constructive on markets relative to 2022, we now expect the period of volatility and potential equity market drawdown that was anticipated in early 2023 to extend into Q2. The path lower for inflation is being challenged by signs of ‘sticky’ services prices and resilient economic growth. Central banks appear to believe that they have more work to do in tightening policy. Compelling signs of macro weakness, which we anticipate over the next several months, are key to closing our equity underweight.Written by Chief Investment Officer Scott Haslem

Worse macro, better (or less bad) markets still the right call for 2023

We maintain our “worse macro, better markets” outlook for 2023. However, recent developments suggest the expected material slowing in growth in 2023 and pause in rate hiking by central banks around end-Q1 2023 (in turn supporting a more stable market backdrop) is slipping more into Q2. In short, risk markets have improved, and growth has been more resilient than expected during Q1.

• Markets have been relatively volatile during Q1, as expected, but macro data has proved more resilient than anticipated. Equities and bonds rallied through January on renewed soft landing hopes before retracing somewhat during February. In terms of macro data, there is no doubt that we can discount the strength of some of the recent prints. Labour market indicators are typically the last measures to show weakness, January’s strong US retail sales rebound comes after weakness through late last year. Still, the warmer winter in Europe and China’s reopening have improved the global growth outlook. Moreover, key purchasing manager indices have rebounded strongly in February, and particularly in the areas where inflation data is indicating already elevated inflation, like services prices.
• Interest rates appear on track to move higher than we expected in early December. Despite historically rapid hiking cycles in 2022 that have yet to be fully felt, as well as a passing peak in inflation, the resilience of the macro data and the still high level of actual inflation are causing central banks to view it necessary to tighten further and for growth to weaken more if they are to ensure a future where inflation is once again low. We expect both the US Federal Reserve and Reserve Bank of Australia to hike on two more occasions - to 5.25% and 3.85% by May respectively, which is 0.5% higher than previous estimates. 
• More evidence of weakness in jobs markets will likely deliver a central bank pause in Q2. We expect that coming months will show clearer evidence of weaker consumer trends and rising unemployment rates, as the lagged impact of rate hikes and higher debt servicing costs weighs. The extent of weakness in the macro data will be key to assessing the likely timing of future rate cuts, which are unlikely to be before early 2024.
• Equities have proved resilient, but US valuations have once again become stretched. While earnings have trended lower over recent months, as expected, the rally in equity markets have underpinned a deterioration in valuations. This is particularly true for the US, where price/earnings (P/E) ratios have risen to pre-pandemic peaks of approximately 18.5 times, and on earnings that appear challenged by the macro outlook. European valuations have risen to average levels, but earnings appear more elevated than in the US, as the European Central Bank is less advanced in lifting interest rates.Written by Chief Investment Officer Scott Haslem

What changes have we made?

We have adjusted our regional tilts, moving underweight US equities. From neutral, we are adding a modest underweight to US equities, reflecting the rally since early December and the rise in valuations. While our underweight to Europe has not been accretive over recent months, the market appears to have already more than adjusted for the modestly better macro outlook. Valuations in Australia and China appear relatively attractive, and together with the benefits associated with China’s reopening, we retain these overweights.

We have closed our cash underweight due to higher policy rates. Central bank policy rates are now expected to be 0.5% higher than previously forecast. Reflecting this, we have partially retraced our move from overweight to underweight cash on 1 December 2022, moving cash to neutral to reflect higher short-term yields. This remains a less defensive position than during most of 2022.

Fixed income yields appear likely to remain higher for longer. US 10-year bonds have retraced toward previous highs, rising from around 3.4% to 3.95% during February. We continue to expect central banks to pause hiking rates during Q2 and for markets to increasingly price policy rate reductions through 2024, supporting our overweight to government bonds. While there remains a risk of a policy-overtightening, we continue to view investment grade yields as compensating for a likely moderate widening in spreads. In contrast, we now expect higher-than-expected policy tightening to underpin a deterioration in the high yield credit market, with the potential for greater distress and dislocation. We have, therefore, moved underweight high yield credit, added to short maturity, which provides a clearer reflection of our long-held preference for investment grade over high yield. 

Source: LGT Crestone Wealth Management. Units refer to the percentage point deviation from strategic asset allocations. Investment grade credit includes Australian listed hybrid securities.

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