What we liked

• In Australia, the monthly inflation read came in at 3.4% over the year to February, showing further progress in the fight against inflation. This was against expectations of 3.5%. While the monthly read is less relied upon by policy makers, it does enhance the argument for the RBA to lower interest rates.
• U.S Nonfarm payrolls increased by 303,000 jobs last month in March, clearly above the 200,000 increase. This result exhibits continued strength in the U.S jobs market and is supportive of consumption and economic activity. This led to an unemployment rate of 3.8% versus the expectation of 3.9% unemployment rate.
• U.S. retail sales increased more than expected in March amid a surge in receipts at online retailers, further evidence that the economy ended the first quarter on solid ground
• The European Central Bank left interest rates flat at 4.5% and gave further indications that its next move would likely be a rate cut.
• The ZEW economic sentiment indicator for Germany demonstrated notable growth in April 2024, reflecting a significant increase from the values reported in the previous month, according to the latest survey by ZEW. The indicator, which measures the optimism that financial market experts have about the expected economic development over the next six months, climbed 11.2 points to reach 42.9.
• China’s economy grew faster than expected in the first quarter. The world’s second-largest economy grew 5.3% in January-March from the year earlier, comfortably above a 4.6% analysts’ forecast.

What we didn’t

• The reading of inflation in Australia has come in higher than expected, with prices rising by 1% in the March quarter significantly reducing the chance of rate cuts by the Reserve Bank this year. Annual inflation slowed to 3.6 per cent in the year to March, down from 4.1 per cent in the 12 months to December but remains above the RBA’s 2-3% target.
• U.S. economic growth slowed more than expected in the first quarter, and came with surprisingly hot quarterly Personal Consumption Expenditure inflation reading, stoking fears of stagflation (low growth/elevated inflation).
• Business activity in the U.S service sector, while continuing to expand in March, edged lower to 51.4 from 52.6. This reading came in below the market expectation of 52.7. Service activity has been a major driver of U.S economic activity, the silver lining being that it may provide greater impetus for the U.S Federal Reserve to cut rates.
• US consumer prices picked up again last month, to a 3.5% increase for the 12 months ended in March. This remains the Fed target of 2% inflation, reducing the likelihood of interest rate cuts in the short-term.
• China’s consumer inflation cooled more than expected in March, while producer price deflation persisted, maintaining pressure on policymakers to launch more stimulus as demand remains weak.

Base Case

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

75% 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.

14% 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.