What we liked

• Australian inflation surprisingly remained steady in January, supporting the case for the Reserve Bank of Australia (RBA) to begin cutting interest rates later this year. The consumer price indicator advanced 3.4% from a year earlier, below economists’ estimates of 3.6% and unchanged from December.
• U.S personal income grew 1.0% month-on-month in January, a sizeable increase from December’s 0.3% gain, and above market expectations for a 0.4% increase. This is supportive for consumer spending and household balance sheets.
• In February, the German ZEW index, which measures financial analysts’ assessment and expectations of economic and financial developments, increased for the seventh consecutive month to 19.9, from 15.2 in January.
• ​Japan’s labour market remains historically tight: the unemployment rate is low, labour mobility is rising, with a majority of companies report that they are struggling with a lack of workers. Although this is not yet reflected in headline labour cash earnings growth, underlying wage growth has been rising, to 1.6% annualised in December. The concern to this data is that it may bring forward interest rate increases.
• Japan’s seasonally adjusted Consumer Confidence Index increased in February compared to the figure seen the previous month, rising by 1.1 points to land at 39.1. This indicates potential for further growth upside in the Japanese domestic economy.
• Activity in China’s manufacturing sector continued to grow in January with a further recovery in demand. The reading came in at 50.9, versus 50.6 expected. A reading above 50 indicates expansion. While manufacturing data from China remains mixed, we continue to see signs of activity troughing increasing the likelihood of a pick-up in activity over the coming months.

What we didn’t

• The NAB survey’s business conditions index fell from 8 in December to 6 in January, its lowest level since early 2022. Respondents reported weaker trading conditions, profitability, and employment, but less pronounced weakness in forward orders. The survey, however, showed stronger price pressures, with its measure of quarterly change in labour costs, purchase costs, and retail prices all increasing at a faster pace.
• U.S. consumer prices rose more than expected in January amid a surge in the cost of rental housing. Figures showed US inflation cooled less than expected in January, to 3.1 per cent year on year. A positive is the pick-up in inflation did not change expectations the Federal Reserve will start cutting interest rates in the first half of this year.
• U.S ISM Manufacturing PMI declined from 49.1 in January to 47.8 in February, compared to analyst consensus of 49.5. This remains in contraction territory. While other indicators are showing signs of activity troughing and improving in the U.S manufacturing sector, this report is a negative indicator.
• Retail and food services sales in the U.S fell 0.8% from the previous month. Although economists expected sales to cool after robust spending around the holidays, the actual decline far surpassed the anticipated 0.1% drop. While a concern, this is tempered with the knowledge that January data has been historically volatile.
• China’s consumer price index (CPI) fell by 0.8% year on year in January, marking a fourth 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.