What we liked

• Consumer prices in the U.S rose 0.3% from March to April, down slightly from 0.4% the previous month. Following some stronger than expected readings, the weaker read was a welcome indicator for the market as it relieves pressure on the U.S Federal Reserve increase or maintain higher interest rates.
• New orders for key U.S.-manufactured capital goods rebounded more than expected in April and shipments of those goods also increased, suggesting a moderate improvement in business spending on equipment early in the second quarter. Durable goods orders gained 0.7%, with shipments up 1.2%
• Consumer prices in China rose at a faster pace than expected, with the consumer price index in April recording a 0.3% increase year on year. China has struggled to produce inflation on weak demand, causing some concern of a debt/deflation spiral. In this context, we see the higher inflation print as positive.
• China’s factory output topped forecasts in April, helped by improving external demand. Industrial output grew 6.7% year-on-year in April, accelerating from the 4.5% pace seen in March and above the 5.5% increase tipped by analysts.
• German investor morale improved more than expected in May, reaching its highest level since February 2022, when Russia invaded Ukraine, according to the ZEW economic research institute. The economic sentiment index rose to 47.1 points from 42.9 in April. Analysts polled by Reuters had expected a May reading of 46.0

What we didn’t

• Australian retail trade figures were slightly up in April, but spending was still flat for the year, as Australians continued to keep an eye on what they spend. While up 0.1% for the month, this benign rise was below market expectations of 0.2%. this signifies continues pressure on Australian households battling with higher interest rates.
• Australia’s monthly inflation reading came in higher than expected at 3.6% versus the market expectation of a 3.5% rise. This read maintains pressure on the RBA to maintain higher interest rates at higher rates for longer.
• Americans unexpectedly paused their spending in April from March as inflation continued to sting and elevated interest rates made taking on debt more burdensome. Retail sales were unchanged, coming in well below economists’ expectations, and follow a revised 0.6% pace in March. This is further evidence of a slowing in demand from the U.S consumer.
• U.S ISM manufacturing purchasing managers index for May fell to 48.7 from 49.2 in April. This was below the median estimate and of 49.6 and indicates contracting U.S manufacturing activity. This shows a slowdown in the U.S economy is gradually taking hold.
• Chinese retail sales rose just 2.3%, the slowest increase since December 2022, off the 3.1% increase in March and far short of the forecast 3.8% rise expected by analysts. While positive, it shows the challenges for regulators in China to reinvigorate domestic consumer demand.

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 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 are beginning to see other regions show relative improvement, as has been expected. That said with strong employment dynamics and robust household and corporate balance sheets, we expect the U.S. to also continue its economic activity 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 and some 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. We expect that continued liquidity injection from central banks to shore up the financial system will provide continued support, although this support may weaken over the next 2-3 months, potentially increasing market volatility.

This scenario is likely to see us maintain a positive view on growth assets over the medium-term. 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, should interest rates and rate volatility remain high.

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 with US growth faltering and the rest of the world showing no sign of improvement from tepid growth recently experienced. 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 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.

15% 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.