The economic outlook is uncertain and striking similarities to the period leading up to the 2001-2002 downturn have appeared, raising concerns, and prompting investors to tread cautiously.
There are several key factors reminiscent of the earlier period, these include:
- Extreme sector concentration in the stock market.
- High valuations in growth stocks.
- Tight labour markets.
- Perceptions of an everlasting business cycle.
- Presence of financial asset bubbles.
Another notable similarity lies in United States Federal Reserve’s monetary policy, where a tightening cycle followed by a prolonged phase of yield curve inversion has been seen.
Furthermore, a smug complacency seems to have taken hold in the market, with the recurring question of “where’s the recession?” echoing as the year unfolds.
The potential impact of the Fed’s policy decisions looms large on the economic outlook, and while the Fed kept rates on hold in June, the futures market is now expecting there will be more hikes to come.
The Fed is unlikely to stop until inflation is under control, and this is likely to drag growth and corporate earnings down with it. Only once we see the slowdown eventuate can the economic outlook swing towards an easing cycle. The question is how much damage is done to growth between now and then?
Are bonds performing?
Both the Reserve Bank of Australia (RBA) and the Fed are expected to hike interest rates two more times this year, according to NAB Group Economics. However, the impact of those hikes on the 10-year rates are harder to predict, that is because while central banks have a direct influence on short-term interest rates, they have little influence on long-term rates which are decided by supply and demand dynamics based on growth and inflation expectations.
Since late last year, short term rates have increased much more than long-term rates, as central banks have continued to hike rates despite markets expecting a slowdown in growth. This expectation has created an inverted yield curve where long end rates still are more muted compared to the front end of the curve. In fact, the peak in 10-year rates occurred in the fourth quarter of 2022 and has only recently retested those levels despite the aggressive rates hikes that have occurred since then.
What is becoming clear is that an economic outlook featuring a ‘soft-landing’ is becoming an outlier. The Reserve Bank of Australia’s response to rising wages, unit labour costs, and inflation indicators has been to increase the rhetoric for further rate hikes to achieve the required economic slowdown. A consequence is an anticipated rise in the unemployment rate, and it has prompted a more defensive approach to Australian equities and credit.
Are equities out of touch?
Similar issues offshore should have led to downward pressure on US and international equities, but recent price action has not aligned with expectations. The strong performance of US equities has been fuelled by increasing confidence in the Fed’s ability to engineer a soft landing, and a desire to increase exposure to Artificial Intelligence (AI) and mega-tech companies.
However, concerns persist about the Fed’s readiness to further raise interest rates, which could affect the likelihood of a soft landing.
Consequently, despite recent gains a cautious stance on equity markets prevails. Potential negatives include whether we are going through a temporary reduction in price inflation, and the tightening of financial conditions, which may influence the outlook for monetary policy. Additionally, the projected real returns for US equities over the next five years are projected to be relatively flat.
In conclusion, the key views have generally held up, except for the performance of US equities, which have defied expectations. The overall cautious stance on equity markets persists due to concerns about the macroeconomic and policy environment.
Crossing swords with recession
Real Gross Domestic Income (GDI) has already provided a recession signal, underscoring the importance of monitoring economic indicators closely. With the potential for further developments in the macroeconomic landscape, investors must remain vigilant and adaptable to navigate potential shifts in market dynamics.
While caution may dominate the sentiment, it is essential to acknowledge that the market is a complex and dynamic entity, capable of surprising even the most astute observers. The performance of US equities, contrary to expectations, serves as a reminder of the inherent uncertainties and intricacies involved in investing.
Amidst these uncertainties, the attractiveness of fixed income investments becomes more pronounced. Investment grade corporate bonds offer a potential refuge, especially given their recent relative cheapening compared to equity markets.
However, it is important to emphasise that market conditions and economic circumstances can evolve rapidly. Investors and market participants should closely monitor developments in the global economy, monetary policy decisions, and key economic indicators. Adapting investment strategies to align with the evolving landscape is essential for capital preservation and potential gains.
In conclusion – Stay vigilant
Parallels between the current economic outlook and the period leading up to the 2001-2002 downturn warrant caution and a vigilant approach to investment decisions, as well as flexibility and adaptability.
Fixed income investments are highlighted as an attractive asset class, particularly considering the recent relative cheapening of sovereign bonds compared to equity markets. As we progress through the third and fourth quarters of the year, these periods will prove crucial in determining the trajectory of the economy and validating existing views.
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