What we liked

• Inflation in Australia has declined to an annual headline rate of 4.1%. Economists were generally expecting the fourth quarter inflation figure to be 4.3%, so it has slowed down by more than predicted. This eases pressure on RBA rate rises, while increasing the odds of rate cuts this year.
• The number of available jobs in the United States unexpectedly rose in December to an estimated 9.026 million. While some other jobs data has shown signs of incremental weakening in the U.S. jobs market, this data exhibits a robust employment market.
• Spending at US retailers rose 0.6% in December from the prior month. That was a much stronger pace than November’s 0.3% gain, and it also beat economists’ expectations. This exhibits continued resilience amongst U.S. consumers.
• Economic activity in the U.S. services sector expanded in January for the 13th consecutive month as the Services PMI® registered 53.4 percent. The sector has grown in 43 of the last 44 months, with the lone contraction in December 2022
• German ZEW Economic Sentiment Index improves to 15.2 in January vs. 12.0 expected. The gauge measures the views of around 350 financial and economic analysts. This is because now more than half of the respondents assume that the ECB will make interest rate cuts in the first half of the year.
• China’s private Caixin manufacturing purchasing managers’ index (PMI) in December came in at 50.8, a four-month high, a signal of the recovery momentum of the country’s manufacturing industry. The index was up 0.1 points from November, remaining in expansion territory for a second consecutive month.
• The figure indicated a steady and stable recovery for small and medium-sized manufacturing enterprises, indicating stimulatory policy action may be gaining traction.

What we didn’t

• Escalation in conflicts globally, with the Red Sea crisis adding to global supply chain concerns.
• Inflation in the U.S. edged up slightly in December, as rising housing costs continued to put upward pressure on the Consumer Price Index. That said other indicators, such as the personal consumption expenditures (PCE), which is the U.S. Fed’s preferred gauge rose by 2.9%. This was lower than the 3% expected.
• Business activity in the US manufacturing sector continued to contract in January, albeit at a softer pace than December, with the ISM Manufacturing PMI rising to 49.1 from 47.1. This reading came in better than the market expectation of 47. Despite remaining in contractionary territory, the beat was a positive and may be a harbinger of an improving manufacturing demand landscape in the U.S.
• China’s consumer price index for January fell 0.8% year on year, steeper than the 0.5% drop expected by economists. While this provides scope for more aggressive stimulus from the Chinese government, it also places further pressure on an indebted property market.
• China’s consumer price index (CPI) fell by 0.3 per cent year on year in December, marking a third consecutive monthly decline amid fears of deflationary risks. Prolonged deflation is undesirable in highly indebted economies, such as China’s. A positive is that it provides scope for Chinese officials to increase fiscal and monetary stimulus to promote growth in the economy.

Base Case

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

73% Probability

A more sanguine view on global growth for the first half of 2024 prevails as economic data and supportive liquidity levels from central banks maintains economic momentum. While the U.S. has exhibited clear economic outperformance during 2023 vs the rest of the world, we expect to see other regions show relative improvement. That said with strong employment dynamics and robust household and corporate balance sheets, we expect the U.S. to also continue its robust economic growth over the coming months.

Our view remains that inflationary rates of increase are 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 earnings downgrades in some sectors, as lower inflationary pressures and impacts from higher interest rates put some pressure on company earnings.

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. We expect that continued liquidity injection from central banks to shore up the financial system will provide continued support for risk asset valuation over the coming months.

This scenario is likely to see us maintain a positive view on growth assets over the next few months. Despite this, we would expect bouts of volatility to emerge as market positioning and sentiment is strong, increasing the possibility of growth fears or exogenous shocks adversely impacting markets. As an example, some U.S. regional banks remain at risk of insolvency.

This will likely remain the investment stance until such time that we see employment leading indicators weaken, or we see central banks reducing their efforts to provide liquidity into financial markets. 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.

11% Probability

Global consumer demand for goods and services falls further than current constructive expectations as inflationary pressures and increased interest rates negatively impact discretionary spending. 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 as 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.

16% Probability

Economies across the developed world experience better than anticipated economic growth. 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.