What we liked

• Inflation is showing signs of easing, albeit slowly, with CPI for the year to July coming in at 3.5%, compared to 3.8% for the month of June. While positive in that it continues the disinflationary trend, it remains uncomfortably above the RBA target range of 2-3%.
• ISM services business activity in the US service sector surprised to the upside and returned to the expansion zone (above the 50 threshold) in July. The reading came in above consensus at 51.0 and reversed June’s 48.8 print. Services make up close to 80% of US economic activity.
• US weekly jobless claims, a lead indicator for the US jobs market, remains at historically low levels. This indicates that despite the economy showing some signs of slowdown employers are not cutting staff.
• The US consumer price index (CPI), a broad-based measure of prices for goods and services, increased 0.2% for the month, putting the 12-month inflation rate at 2.9%, its lowest since March 2021, continuing the disinflation trend.
• Advanced retail sales in the US accelerated 1% on the month. Economists surveyed by Dow Jones had been looking for a 0.3% increase.

What we didn’t

• The RBA in its meeting minutes maintained a hawkish (bias to higher interest rates) stance. This is despite many with large mortgages feeling the pinch from higher rates and pulling back on discretionary spending.
• Extreme volatility in markets at the beginning of August remind markets of the pitfalls of leverage. As the Japanese Yen carry trade unwound, many traders were forced to reduce risk and unwind market positions.
• US annual Non-Farm payrolls downward revision of 818K. While we anticipated a downward revision, this level of revision does take some of the gloss off what has been a very strong employment market in the US over the past two years.
• The German ZEW Economic Sentiment Index, a key indicator that gauges the expectations of financial experts, fell dramatically from 41.8 points in July to just 19.2 points in August. The falling sentiment reflects growing pessimism about the country’s outlook and highlights broader concerns for the eurozone economy.
• Japanese policy maker within the Bank of Japan surprised markets with a more hawkish view, raising the spectre of potentially raising interest rates more than the market had expected.

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 global economic data continues to come in mixed. While the U.S. remains the clear economic outperformer over the past two years vs the rest of the world, we may begin 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 thus supporting the economy and financial system, while risking local currency weakness, higher bond 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 slowing economic, progression towards the US Presidential election and entering a seasonally weak period for markets (September/October). Despite this, we expect that any volatility will lead to further liquidity injection from central banks to shore up the financial system. Positively, liquidity has begun to trend higher over the past month and is expected to continue to grow over the second half of 2024. 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.