A look back at last month and an outlook for the months ahead

What we liked

• Australian consumer price inflation accelerated in the June quarter, but a downside surprise in core inflation led markets to abandon all thought of further rate hikes and wager on an easing as early as November. Most importantly, a closely watched measure of core inflation, the trimmed mean, rose 0.8% in the second quarter from the previous quarter, below forecasts of 1%.
• Australian employment jumped well beyond expectations in June, yet the jobless rate still ticked higher as more people went looking for work, a mixed report that leaves open the question of whether interest rates need to rise further. Net employment climbed 50,200 in June from May, topping market forecasts for 20,000. Full-time employment rose 43,300 for a second month of strong gains.
• Inflation in the U.S. continued to moderate in June, as low gas prices and falling prices for new and used vehicles contributed to the first monthly decline in the Consumer Price Index since May 2020. Core inflation, which excludes volatile food and energy prices, came in at 3.3% in June, which is also the lowest since April 2021.
• US real gross domestic product increased at a 2.8% annualised pace in the second quarter, above the 2.1% forecast.
• The eurozone economy grew slightly more than expected in the second quarter, as continued growth in France, Italy and Spain offset yet another disappointing quarter in Germany. Overall growth was steady at 0.3% in the three months through June, and at 0.6% compared to the second quarter of 2023.

What we didn’t

• The U.S. unemployment rate jumped to near a three-year high of 4.3% in July amid a significant slowdown in hiring, heightening fears the labour market was deteriorating and potentially making the economy vulnerable to a recession. The increase in the unemployment rate from 4.1% in June marked the fourth straight monthly increase.
• A measure of U.S. manufacturing activity dropped to an eight-month low in July amid a slump in new orders. The manufacturing PMI dropped to 46.8 last month, the lowest reading since November, from 48.5 in June. A PMI reading below 50 indicates contraction in the manufacturing sector, which accounts for 10.3% of the economy.
• The economic sentiment gauge for Germany, which reflects financial experts’ future expectations, fell more than anticipated in July, marking its first decline after eight consecutive months of increases. The ZEW Economic Sentiment Index for Germany eased from 47.5 to 41.8 points, below the expected 42.5.
• Following an unrevised 2.9% monthly jump in May, UK retail sales gave back more ground than expected at quarter-end. Volumes declined 1.2% on the month, three times the market consensus and their third fall in the last four months.
• China’s economy grew much slower than expected in the second quarter as a protracted property downturn and job insecurity knocked the wind out of a fragile recovery, keeping alive expectations Beijing will need to unleash even more stimulus. The world’s second-largest economy grew 4.7% in April-June, official data showed, its slowest since the first quarter of 2023 and missing a 5.1% forecast in a Reuters poll.

Base Case

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

74% Probability

A more cautious view on global growth over the short-term prevails, as economic data globally has recently shifted to the downside. While the U.S. has exhibited clear economic outperformance over the past two years vs the rest of the world, we are beginning to see other regions show some relative improvement.

Our view remains that inflation is expected to continue moderating, although to remain above 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 weaker earnings in some sectors, as lower inflationary pressures and impacts from higher interest rates put some pressure on company earnings and lower income household balance sheets.

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, higher yields and inflation or continue to fight inflation and risk more severe economic weakness and potential bond market/banking stress. The actions of policy makers to move in either direction will be a large driver of financial market performance over the coming months.

The sequencing of these events will be important. We continue to expect heightened market volatility due to slower economic growth and as we move towards the US Presidential election. Despite this, we expect that volatility will lead to further liquidity injection from central banks to shore up the financial system. This is expected to provide continued support for financial markets over the medium-term.

This scenario is likely to see us maintain a positive view on growth assets over the medium-term, although more defensive sector weightings may be warranted over the coming few months. As previously stated, we expect bouts of volatility to emerge as market positioning and sentiment has been very strong, increasing the possibility of growth fears or exogenous shocks adversely impacting markets. As an example, some U.S. regional banks balance sheets remain at risk, should interest rates and rate volatility remain high.

Further weakening in employment leading indicators, or if we see central banks reducing their efforts to provide liquidity into financial markets would lead to this more defensive positioning. Overall, asset allocation will retain a bias to growth assets, with short-term tactical positioning to be guided by macroeconomic developments and central bank actions.

Bear Case

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

13% Probability

Global consumer demand for goods and services falls further than expected, with US growth faltering and the rest of the world showing no sign of improvement from tepid recent growth. Inflationary pressures and elevated interest rates negatively impact discretionary spending, further placing pressure on economic activity. A reversion to bank stresses seen earlier this year would be expected to further tighten bank 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 and energy prices, further exacerbating inflationary pressures and placing greater pressure on central banks to tighten monetary and financial 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 when the economy is weakening. Additionally, an untimely withdrawal or reduction of central bank liquidity into the financial system 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. Such a situation would see us move rapidly and meaningfully into cash at the expense of equities. 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.

13% Probability

Economies across the developed world experience better than anticipated economic growth rates. If then combined with waning inflationary pressures, as supply chain bottlenecks ease and productivity levels improve, we would expect a virtuous pro-growth asset environment as interest rate pressures subside. Additionally, current global conflicts remain contained. In this scenario disposable income for consumers would increase as inputs costs for corporates reduce. The result would be resilient earnings growth for companies as economic growth accelerates and costs are contained.

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 very 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.