What we liked

• The Australian consumer price index rose at annual pace of 6.8% last month. Economists had expected the annual rate would have dropped to about 7.2% from January’s 7.4% pace. This is positive as it reduces the pressure on the RBA to raise interest rates.
• Economic activity in the U.S. services sector expanded in February for the second consecutive month with a read of 55.1. The sector has grown in 32 of the last 33 months, with the lone contraction in December. While a positive, a strong services sector pricing dynamic has maintained pressure on the U.S. Fed to maintain a restrictive monetary policy.
• US February core PCE inflation ran at 4.6%, which is a tad lower than the economists’ consensus of 4.7% and a sign of easing inflation pressures. The lower inflation numbers will diminish the Fed’s urgency to hike, even as banking conditions improve.
• China annualised inflation came in at 1%, below the market consensus of 1.9%. This provides ample room for the Chinese authorities to continue stimulus measures with the aim of promoting economic activity.
• China’s March Official PMI Manufacturing arrived at 51.9  vs. the expected 51.5 while Services came in at 58.2 vs. the expected 54.3. Figures show expansion is ahead of expectations as China emerges from COVID lockdowns.

What we didn’t

• Global bank stress, with three banks folding over the month. The fast rise in global interest rates has been a concern of ours for a while as it tends to lead to financial system pressures. While we do not believe the issue will become a credit or systemic issue, it does highlight the elevated risk dynamic in economies and the financial system caused by the combination of high inflation and an aggressive rate hiking cycle.
• The economic activity in the US manufacturing sector continued to contract in February, albeit at a softer pace than it did in January, with the ISM Manufacturing PMI edging higher to 47.7 from 47.4. This reading came in below the market expectation of 48. A number below is indicative of contracting manufacturing activity.
• US retail sales fell in February after a surge in the prior month, suggesting consumer spending, while holding up, is getting challenged by high inflation. The value of overall retail purchases decreased 0.4% after a revised 3.2% advance in January.
• U.S. federal data on Friday show new orders for manufactured durable goods declined again. Durable goods such as washing machines require more of a capital commitment from buyers, showing the metric serves as an indicator of current economic conditions as well as future expectations.
• The German ZEW headline number showed that the Economic Sentiment Index worsened in March, arriving at 13.0 from 28.1 in January, missing the market expectation of 16.4. After some stronger than expected readings February’s survey surprised to the downside, casting some doubt on a resilient European economy.

Base Case

Our view of the most likely scenario for markets over the coming months, for which our portfolios are currently positioned.

70% Probability

Global economic activity is expected to continue moderating, despite recent data generally surprising to the upside. Slowing consumer discretionary spend, inventory builds, and margin compression are anticipated to remain strong themes over the coming months, adversely impacting company earnings.

Our view remains that inflationary rates of increase are expected to slow, although to remain above historical averages from the past decade. In isolation, this should be supportive for credit markets as well as valuations of growth assets and manifest in greater financial market stability over the medium-term. This is likely to be mitigated by earnings downgrades, as a slowing global economy combined with high input prices, negative operating leverage and currency volatility are expected to dampen company profit margins.

The current environment leaves central banks, particularly the U.S. Federal Reserve, in a difficult position. Developed economy central bank choices appear to be to ease financial conditions and support the economy and financial system, while risking local currency weakness and higher yields and inflation or continue to fight inflation and risk more severe economic weakness. The actions of policy makers to move in either direction will be a large driver of financial market performance over the coming months. For this reason, diversification and a defensive positioning through sector allocation and moderate cash holdings remain prudent.

This scenario is likely to see us maintain a neutral medium-term view on growth assets. Capital preservation will be the primary objective through increased cash levels and appropriate company/sector allocations to those companies and sectors that are resilient earners in a weakening business cycle and are able to maintain pricing power. This is likely to favour defensive industry sectors, such as healthcare and consumer staples at the expense of more cyclical sectors such as industrials and consumer discretionary. This will likely remain the investment stance until such time that we get a clearer macroeconomic trend emerge or we see central banks reducing their efforts to tighten financial conditions. Overall, asset allocation will retain a neutral bias, with short-term tactical positioning to be guided by macroeconomic developments, central bank actions and market positioning.

Bear Case

Our worst-case scenario for the coming months, which we are prepared to position for should conditions deteriorate.

14% Probability

Global consumer demand for goods and services falls further than expected as inflationary pressures and increased interest rates negatively impact discretionary spending. Recent bank stresses are expected to tighten lending standards also. This could act to place pressure on the currently very strong global employment conditions.

Geopolitical tensions could act to negatively impact supply chain bottle necks, further exacerbating inflationary pressures, placing greater pressure on central banks to tighten monetary conditions. Additionally, wage pressures and higher cost of lodging become more systemic as employees successfully lobby for wage increases. This will lead to a deterioration in company profits as increased input costs, and debt servicing costs (from higher interest rates) combined with lower demand converge to crimp company earnings.

Such a scenario would result in a tightening of financial conditions, while inflationary pressures remain elevated. This could see central banks continuing to withdraw monetary support (through higher interest rates) at a time as the economy is weakening. Additionally, an untimely withdrawal or reduction of central bank liquidity (through quantitative tightening) could derail financial markets, which have become accustomed to liquidity support. When combined with reduced government expenditure, due to elevated indebtedness, this may cause consumer confidence and spending to fall, as prior government support is not fully replaced by gainful employment income.

Rapid escalation in geo-political tensions or a significant or systemic credit default, due to over-indebtedness in an environment of rising bond yields and elevated volatility in financial asset prices, could see a liquidation of risk assets within a compressed period. Further to this, the recent stresses seen in globally systemically important banks could lead to more bouts of liquidity events, which would be expected to have a pronounced negative effect on economic growth.

Above scenarios will see us take a more defensive position and reduce equity exposures replacing them with defensive assets, such as cash. The accelerating bond yield scenario would require a more nuanced shift toward companies and sectors that would be the greatest beneficiaries of such a move. Focus will be on a more defensive posture with capital preservation being the primary objective. A further shift towards defensive sectors such as healthcare, consumer staples and utilities would combine with higher cash levels in this scenario.

Bull case

Our most optimistic view for markets over the coming months.

16% Probability

Economies across the developed world experience better than anticipated economic growth with economic activity exhibiting resilience. Combined with waning inflationary pressures, as supply chain bottlenecks ease, this would like lead to synchronous global economic growth as interest rate pressures ease on lowered inflationary expectations and financial conditions continuing to loosen. In this scenario disposable income for consumers would increase as inputs costs for corporates reduce. The result would be more resilient earnings for companies as economic growth accelerates.

Fiscal support from governments could combine with sound cash levels on household and corporate balance sheets to accelerate the speed of the global economic recovery. In the event central banks resume measures aimed at suppressing interest rates below inflation levels and potentially adding further liquidity enhancement measures to support financial systems, we would expect this to further fuel asset prices.

This scenario would be positive for financial markets as improving financial conditions act to fuel demand for growth assets in a low to negative real interest rate environment. We would act by ensuring a growth asset bias with low cash levels. Additionally, if leading economic indicators began surprising to the upside a net shift towards cyclical sectors leveraged to economic growth would occur.