The contours of the global outlook have been changing as the European and UK economies avoid recessions for now, and debate about a more delayed downturn in the US intensifies. Growth is proving more resilient than many expected. And while the data support further slowing in H2, that will likely still render 2023 at the milder end of global recessions.
Yet, the corollary of more resilient growth and still tight jobs markets is that inflation, while falling, remains stickier for services prices. While we believe central banks are at or near their peak for policy rates, there’s insufficient evidence for them to commit to a pause. Any ‘skip’ in tightening during June and July could give way to further hikes should inflation not move lower over the next few months. At the very least, hopes for a typically quick easing of policy in the months ahead now almost certainly appear likely to be disappointed.
In this month’s Core Offerings, we highlight the outlook for central bank policy, as markets now delay hoped-for rate cuts until early 2024. Persistently higher rates will continue to support fixed income returns (where we have tactically added to investment grade credit), while limiting the extent that equities can break higher. Staying underweight equities as rates and inflation peak is not without angst. Yet, adopting a more ‘risk-on’ stance is difficult until inflation falls more clearly and a base in the US growth cycle is within view.
The contours of the global outlook have been changing as the European and UK economies avoid recessions for now, and debate about a more delayed downturn in the US intensifies.
The contours of the global growth slowdown have shifted as we have moved through H1 2023. The near-consensus recession forecasts for the UK and Europe have now given way to flat growth profiles that have softened the global slowdown to date (though clearly risks remain). Easing supply chain shortages and falling energy costs have underpinned stronger industrial activity, including better trends for exports and business capex.
For the US, the anticipated H1 weakness in growth looks more distant, now expected to be revealed more convincingly in H2 2023. A tight jobs market has kept consumer spending resilient, led by strong demand. With manufacturing activity (in the US and globally) now showing some softening, the lagged impact of credit tightening (see the chart below) will be key. This is a feature that is also likely to weigh in the UK, Europe, and Australia.
For Australia, the mid-year mortgage reset, record low consumer sentiment, and tentative signs of a softening jobs market suggest, like the US, growth should be more clearly on a slower trend through H2 2023. Interestingly, this could see both countries on a much weaker profile than other key economies in H2 2023, some of which (e.g., China and Asia) may be entering modest recoveries. Still, few forecasters see Australia entering a recession, given the uplift in migration, a tight jobs market, and China’s pick-up.
These shifting contours – together with the ‘as yet’ quite uncertain magnitude of the credit and liquidity tightening in H2 – suggest there’s further slowing ahead in global growth. The data to date still support our long-held view that, while the journey is not yet over, this will be on the milder end of global growth downturns. Yet, this view is not unanimous.
Yet, the corollary of more resilient economic growth and still tight jobs markets is that inflation, while falling, remains ‘sticky’ at a core level.
While UBS has recently lifted its global growth forecasts for 2023 from 2.0% to 2.6% ahead of a pick-up to 2.8% in 2024, Société Générale (SG) sees the US entering a recession in 2024 that drags global growth lower than in 2023. Such a result would be a significant headwind to equity earnings and corporate margins over the coming year.
The IMF suggests inflation is unlikely to return to target until 2025. Of course, proximity to target may be clearer by early 2024, giving central banks scope to contemplate cutting from then.
Over recent months, inflation has continued to fall at a fairly healthy clip (see left-hand chart below). In the US, it has dropped from 9.1% last year to 4.9% in April, while in Europe, it has fallen from 10.6% to 7.0%, and in Australia, from 8.4% to 6.3%. However, much of these falls reflect the impact of retracement in rapidly rising food and energy prices in 2022, significantly due to the outbreak of the Russia-Ukraine war.
But the corollary of more resilient economic growth and still tight jobs markets (as noted above) is that inflation, while falling, remains ‘sticky’ at a core level. It is also well above central bank targets and above the level where they likely feel comfortable to start an easing cycle. Core inflation in the US fell to 5.7% late last year but remains at 5.5% four months later. As shown below, core inflation is not falling sharply – largely due to persistent services prices inflation (reflecting resilient consumer demand) – and in the case of Europe, it is still rising.
In its April World Economic Outlook, The International Monetary Fund (IMF) suggests inflation is unlikely to return to target until 2025. Of course, proximity to target may be clearer by early 2024, giving central banks scope to contemplate cutting from then.
The errors of the 1970s are mostly to do with easing too soon, and these appear to be errors central banks are focused on avoiding.
While falling headline inflation eases central banks’ concern on inflation expectations and gives them hope they have done enough on lifting rates, the stickiness in core inflation is giving them little room to reverse that tightening, even as unemployment rates start to rise (which is usual). The errors of the 1970s are mostly to do with easing too soon, and these appear to be errors central banks are focused on avoiding. As BCA Research notes, “repeated attempts to conquer inflation during the 1970s and 1980s led to abrupt policy pivots. Given this experience, the Fed may attempt to avoid prematurely easing policy by staying on hold for longer this time around“.
As discussed below, the market has moved to begin pricing in further rate hikes over coming months from central banks in the US, Europe, and the UK.
US Federal Reserve (Fed)–Policy is currently at 5.00-5.25% (see table below). Fed Chair Powell has backed a ‘skip’ in June, but comments from Fed officials suggest further hikes are still being debated. Futures markets, having at one stage priced 1.00% of cuts by end-2023, now have a partial further hike priced this year, with the first full cut delayed to mid-December, ahead of further cuts in early 2024. While CBA sees no Fed cuts this year, UBS is the outlier, with 1.0% of cuts still slated for this year from September.
Reserve Bank of Australia (RBA)–The RBA increased the policy rate to 3.85% in May. After ‘skipping’ in April, and likely again in June, RBA Governor Lowe warned against generous wage gains, stressing he had “no tolerance for high inflation lasting a long time”. Markets, having at one stage priced 0.50% of cuts by end-2023, now have a partial further hike for this year, with no cuts in 2023 and only 0.50% of cuts priced by mid-2024. CBA expects 0.50% of cuts this year, but UBS sees another hike, delaying forecast cuts until 2024.
European Central Bank (ECB)–The ECB raised the key policy rate to 3.25% in May, but officials say they debated a 0.5% hike. According to SG, “they also say that they are not done yet with rate hikes, are not committing to cutting rates at any time, and can hike rates even if the Fed pauses.” The key concern for the ECB remains sticky core inflation, which remains elevated and above 5%. The futures market is priced for two more hikes this year, while neither CBA nor UBS expect cuts until 2024.
Bank of England (BoE)–The BoE raised the policy rate to 4.5% in May, its twelfth consecutive hike. Despite little change to their forward guidance, UBS believes the BoE’s tone “was, on balance, somewhat hawkish”, given comments around the moderation in inflation being slower than expected. UBS expects one further 0.25% hike to 4.75%, while CBA has recently added two further hikes, taking the cash rate to 5.0% by August. However, market pricing is for a further 1.0% of hikes to 5.5% by end-2023.
Bank of Japan (BoJ)–The BoJ has retained an aggressively easy policy stance, with rates unchanged over the past year at -0.1%. Notwithstanding a surprise hawkish decision last December to widen the band on its 0% 10-year bond yield target from +/- 0.25% to +/- 0.50%, there has been no further change. According to UBS, the case to unwind the yield curve control “continues to build”, given solid growth, rising inflation and rising wage growth. Markets do not anticipate an exit from negative rates until 2024.
Emerging markets–Central banks in Asia, in contrast to elsewhere, are seen to be in a better position to cut policy in H2 2023, given inflation has begun to surprise significantly weaker. This has been led by falling food and energy prices, with potentially ‘sticky’ services prices a smaller weight in the inflation metrics. However, the extent of any easing will be impacted by currencies and may be more limited if the Fed remains on hold.
While being modestly underweight equities is not without angst, given peak inflation and peak policy, we continue to favour fixed income returns over equity returns for now.
We remain constructive on the investment outlook. And while being modestly underweight equities is not without angst, given peak inflation and peak policy, we continue to favour fixed income returns over equity returns for now:
For now, equities seem to be pricing in a path of both lower inflation and resilient growth. Should this be maintained, it is possible that equity markets will remain rangebound through mid-year, as they have been since May 2021.
Although there has been a slight near-term recalibration in interest rates higher over the past month in Australia and the US, equity markets have generally proven resilient in the face of this. Additionally, as noted, 10-year bond yields have moved higher, by 40-50 basis points (bps). With inflation expectations falling, this has meant that real interest rates have actually pushed higher. Typically, as we saw in 2022, such a move in interest rates would have been a headwind for equity performance, especially the longer-duration segments of the market, such as Technology. However, more recently, equity markets have been able to absorb these headwinds, perhaps focusing on the more resilient near-term growth outlook.
The near-term challenge through mid-year is that, firstly, stronger growth may further inhibit a slowdown in core inflation. This would lead to a more extended period of elevated interest rates than the market is expecting. Secondly, while the path to a “softish” landing is perhaps somewhat more plausible than appeared previously, the impact of credit tightening globally has yet to be fully judged. The tightening in lending standards, already in motion before the collapse of several US regional banks, will limit credit availability and may impinge growth over H2 2023 into early 2024 (especially in the US).
For now, equities seem to be pricing in a path of both lower inflation and resilient growth. Should this be maintained, it is possible that equity markets will remain rangebound through mid-year, as they have been since May 2021. However, we believe absolute upside remains challenged by 1) absolute equity market valuations that, in the main, remain expensive outside of the post-COVID 2020-2021 bubble period; 2) the fact that a more resilient growth outlook also implies stickier inflation and more time may be needed to accept that inflation can approach acceptable levels without further central bank tightening; and 3) returns in competing assets, where the earnings yield from equities is not far removed from yields on risk-free government bonds or investment grade credit.
Regionally, this leaves us with a value skew towards Australia and emerging markets. The 12-month forward P/E ratio for the S&P/ASX 200 index is just 14.3x, 1.2 standard deviations below its 10-year average. Against stellar year-to-date performance of US and European markets, the ‘flattish’ emerging market result is painfully weak. But there are several reasons why this year could be a year of emerging market outperformance. Firstly, emerging market earnings per share (EPS) growth is forecast to outperform developed market EPS over 2023 and 2024. Secondly, emerging market valuations are now 2 standard deviations cheaper than their average discount to the MSCI World index. Thirdly, emerging market economic growth is expected to exceed developed economy growth by over 3%, an extent to which in the past has led to emerging market equity outperformance.
The US equity market remains challenged by extremely rich valuations and a banking sector dealing with deposit flight and a significant tightening in lending standards. European equities are now back to average valuations, with the lagged impact of tighter monetary policy still to be felt. Importantly, the European Citi Surprise Index has now turned negative (data is coming in worse than expected) and there is a reasonable relationship between the relative performance of the US versus Europe, depending on the direction of the economic data. Despite peaking growth momentum, the ECB is likely to stay hawkish due to persistent inflation. This implies that the outlook from here is more challenging.
However, we believe absolute upside remains challenged by 1) absolute equity market valuations that, in the main, remain expensive; 2) a more resilient growth outlook that also implies stickier inflation and more time may be needed to accept inflation; and 3) returns in competing assets, where the earnings yield from equities is not far removed from yields on government bonds or investment grade credit.
Equity markets continued to grind higher in May, helped by solid earnings and margins, despite slowing growth and jobs markets in Australia and the US. After pausing in April, the RBA raised rates to 3.85% and the Fed hiked to 5.25%. Both central banks are likely now near the end of their respective rate-hiking cycles. Reflecting our cautious view of markets, we have increased our fixed income overweight. In the short term, we expect fixed income to outperform equities under various scenarios.
Inflation volatility is likely to persist—Inflation continues to fall, though services inflation remains sticky. However, fading impacts of globalisation, structurally tight labour markets, and geo-political impacts on supply chains suggest less deflation and more inflation.
A return to ‘normal’ interest rates—Peaking inflation is likely to foster a near-term peak in central bank hikes. But stickier inflation than over the past two decades is likely to limit a return to near-zero interest rates.
Geo-political volatility likely to be enduring—Russia’s invasion of Ukraine has ended a long period of benign globalisation. Ongoing decoupling of leading-edge technology, political and trade alignment, as well as military and energy security, are all key potential drivers of growth and profits.
Diversification matters —In a world of heightened volatility and fewer long-cycle trends, it is important to maintain portfolio diversification, avoiding over-exposure to individual markets, sectors and other specific return drivers. Unlisted investments are likely to grow in favour.
The energy transition—As the world faces a trade-off between net-zero commitments, cost, and energy security, this is setting the scene for both old and new forms of energy to play a role.
Sustainable investing—As the world becomes more connected, it is also becoming more socially aware. The intersection of finance and sustainability will govern a reallocation of capital.
The search for income—The exit of ‘zero-bound interest rates’ has resulted in a resetting of income expectations across all asset classes, including equities, fixed income, and income-generating unlisted assets.
Deglobalisation—Brexit, trade wars, COVID-19, and Russia’s invasion of Ukraine have up-ended a relatively harmonious world order, with impacts spanning geo-politics, military spend, supply chains and demographics.
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