In our recent market update, our Investment Committee (IC) shared their perspectives on the market volatility that we have experienced so far this year and key factors that drove that volatility. The IC also discussed elevated equity valuations, the bond market and macro factors contributing to global markets.
As expected, we have experienced a volatile year, what has been driving this volatility so far?
Year-to-date there have been numerous pockets of volatility, with the extreme being the tariff announcements in April. There are however signs that volatility is waning. Despite the level of rate cuts that are required in the U.S., there is resilience in the economy, particularly with the extraordinary amount of reinvestment into AI, at magnitudes that haven’t been experienced before. That, combined with several share buybacks, has been driving core equity markets/bourses higher and considering the high yields at present, spreads on fixed income investments are moving lower. With the way the market is heading, there are signs of a late-stage cycle slowdown and that is why risk assets appear to be expensive. Essentially, the market is looking through short-term volatility, whilst acknowledging that there are likely to be rate cuts ahead, with large investors continuing to deploy capital. It has been a rewarding year for investors that have been long conventional risk assets.
In general, we saw volatility as investors became concerned with the impact of tariffs and lack of progress on interest rate reductions, particularly in the US, which then abated as a result of strong corporate US earnings. How sustainable this is over the next 12-24 months remains to be seen. Inevitably there will be a slowdown in that growth trajectory, and investors may experience some discontent with the price they’ve had to pay for those earnings in the not-so-distant past.
How long do we continue to expect valuations to keep pushing higher?
The US is in its fourth year of double-digit EPS growth year-on-year, which is extraordinary. Due to the amount of revenue that has been spun out of some of the big tech names and at the same time the extraordinary amount of capex that is being reinvested in these companies, is why valuations are above long-run historical benchmarks. From a global macro perspective, there is no recession in any significant economy, albeit there has been consistent weaker domestic demand (excluding their strong export sector) coming out of China. Current valuations may appear to be expensive, however, we are all participants and benefactors of this rally, so we remain invested and look for opportunities to add more to risk assets from any pullback.
That said, there are still opportunities out there in assets that are not fully priced, and therefore, Family Offices or investors, that are not large institutions (who need to position themselves quarter to quarter), can benefit from diligent allocation to undervalued quality assets.
What other growth drivers outside of the U.S. might be interesting for clients to consider?
The two biggest growth drivers outside of the US (despite their resilience and late-stage slow-down), is core Europe and tariff influenced trade changes. In Europe they adjusted the Maastricht Treaty allowing member countries to borrow more and increase defence spending from 2% to 5% of GDP. In aggregate, that is a significant amount of debt and bond issuance that has to be rolled out to the market and absorbed to spend in the economy. The second biggest driver is the redirection of trade due to tariffs brought in by the US, where the GCC (Gulf Cooperation Council) ports are likely to benefit from goods being shipped to the US.
What is the outlook for bond markets (considering US government bonds are often a proxy for the risk-free rate)?
Bond yields reflect what buyers are demanding of sellers in terms of pricing the return that they’re looking for. The strength of buyers and sellers in this market changes over time. The point is, it’s not as simple as it being about supply and demand, it’s a lot more complicated than that. The bond market is driven more by sentiment than you might expect and now, we’re seeing a lot more commentary around the fiscal position of the larger economies in the world. The problem with bond yields is what happens to valuations on a relative basis. If you can earn a 5% yield on a 10-year Treasury, why would you want to own an equity that in theory will yield you 3%/4% and then you also have to factor growth into that. For example, if you consider the growth on that equity over the long-term is 7 to 10%, is that a realistic and sufficient premium relative to a bond considered to be risk-free?
In the Western World, the government bond yield is the risk-free rate which financial engineers use to price assets. There are nuances and moving parts however at the longer end of the curve, the 10/20/30-year tenors are increasing in yield more so than tenors on the shorter end of the curve, for obvious reasons—central banks are cutting rates, which is why the curve is steeper. This implies that the economy should be able to withstand the amount of issuance on the shorter end of the curve, as it is more expensive to borrow at the longer end. Hence, the U.S. and larger central banks are going to focus on the shorter end of the curve and issue a lot of debt into that part of the market and investors that are averse to risk, will absorb that debt. There has been recent concern in the media around the amount of debt that large economies are issuing, which is largely hype. There are eleven countries globally that are AAA-rated, Australia for example, whose economy is backed by a strong export sector (energy and materials), and financials (banking), backed by the export sector. Hence, the Australian government can opt to issue more debt and likely drop down one notch in rating to AA+. We expect that there will be more countries that will likely see their rating drop from AAA out of this cycle.
How might equity and bond markets react to an interest rate cut in the US?
The US Federal Funds rate is 4.25-4.5%, the ECB’s cash rate is at 2.0%, which is a gap that is too large and hence the Euro has rallied at the same time, which is a big headwind to the short end of interest rate markets. Financial markets are pricing in three rate cuts over the next nine months in the US and if these aren’t delivered, markets may hiccup. The smaller rate cut in the US is positive for the equity market and for small to mid-cap companies (e.g., the Russell 2000 index). However, that aside, major central banks are unlikely to lower their cash rates to the historical lows we experienced pre-pandemic. Hence, rate cuts are likely to be shallower than the historical lows we experienced prior to Covid.
What are your thoughts on equity markets, earnings season and macro themes in Australia, US, NZ and UK/Europe?
For Australian equities, the recent reporting season revealed that the Australian banks met earnings expectations which was in part driven by the shape of the Australian Government yield curve. This steeper yield curve influenced the banks’ large balance sheet, creating a positive net interest margin. Further, there was cautious guidance across industrials and small-cap companies. Additionally, the main Australian Index is dominated by 20 companies and there is a valuation gap between the banks and some of the energy and materials companies that are larger constituents of the index which is concerning because this valuation gap is at extreme levels. Earnings guidance is soft, however, with a 3.6% cash rate and potential rate cut coming, combined with a positive boost in economic activity given record migration into Australia, we believe this is a positive tailwind for GDP.
In the US, whilst there’s a lot of talk about tariffs, political changes, immigration etc., underlying economics seem to be relatively unchanged. Tariffs are not biting yet, the deportation of a significant number of undocumented workers has not started to flow through in price inflation. However, there are early warning signs of unemployment rising and inflation ticking up higher than it should and a likely battle emerging with the US Federal Reserve and the political influence of the central bank. This has all largely been ignored by markets and the reality is the underlying engine which has driven US growth is largely intact— innovation, flexibility in the labour market, which are tailwinds. However, the headwinds are workers in low-income industries being deported and jobs not being created, hence the early warning signs. The economic policies of this administration will not be fully understood for another five to ten years, particularly the defunding of significant research efforts in the medical sphere, which has driven significant value in US companies and the economy over the last 70 or 80 years.
In New Zealand, we’ve still got a problem with inflation even though it is within the target range at 2.7%, the OCR is currently at 3.0%, and the RBNZ has signaled another cut. Jobs are also a problem, particularly in the retail and hospitality sectors which are hurting. We are currently in a deeper and longer “recession” than what was experienced during the GFC in New Zealand. Term deposit rates were between 5-6%, which are now rolling off and being renewed at 3-4%, so net of inflation and taxes, you’re going backwards on a real basis. The market in New Zealand has been relatively lacklustre and given we are strategically underweight to Australia and New Zealand, has been a tailwind in client portfolios. We are still deploying capital into markets, over a period of time to mitigate volatility. In the UK and Europe, the big news in European economies is the lack of willingness of governments to deal with the fiscal realities of the promises they’ve made. Both the UK and French governments are not willing to cut welfare spending and live within their means if that is indeed the right test. Over the next 12-18 months either something gives in that governments come to realise that there is little more tax revenue to raise from their populations for existing governments to be reelected; or, governments cut costs which broadly means cutting the welfare state, a deeply unpopular path to take particularly with the left leaning institutions currently in power in the UK and France. These are political decisions which can be changed overnight with politicians willing to make the tough calls.