With a soft economic landing fully priced into equity and credit markets, any sign that interest rates could stay higher for longer on unexpectedly strong economic growth could push up bond yields and suppress equities, according to Zenith head of asset allocation, Damien Hennessy.
Mr Hennessy believes a cut in official rates in Australia is unlikely for the moment, with core inflation still hovering near 4 per cent. He said the core Consumer Price Index (CPI) would need to fall towards 3.5 per cent for the central bank to contemplate cutting rates, given its 2 to 3 per cent target band.
“Analysts that are calling for an interest rate cut soon from the Reserve Bank of Australia (RBA) are a little premature. We would need to see inflation with a ‘three’ in front of it for the RBA to cut rates and we would probably need unemployment to drift up more than it has. I don’t think we are there yet. We may get a rate cut in the later part of this year, but not in the near term,” Mr Hennessy said.
“If economic growth remains stronger than expected, a significant risk the share market faces is that interest rates don’t get cut as markets expect and instead, bond yields rise; this could see share markets pull back globally.
“The economies in the US and Australia have held up much better than expected, so perhaps rate cuts won’t come as soon as markets expect. If bond yields push up, that could undermine most asset valuations and that is the biggest risk financial markets face at the moment,” he said.
“The Australian stock market has run very hard in recent weeks and valuations have been expanding without being matched by expected earnings growth, which remains weak at about 2 per cent for the next 12 months. For example, banks are trading on a price-earnings (P/E) multiple of 15.5 times, which is close to a record high, yet earnings growth for the bank sector looks quite subdued. A large part of the Australian share market looks expensive right now,” Mr Hennessy said.
Other risk factors for financial markets stem from geopolitical risks, with war in the Middle East and supply disruption in the Red Sea potentially pushing up inflation. In addition, the ongoing conflict in Ukraine and the US election outcome add to economic uncertainties.
From a portfolio perspective, these factors are taken into consideration when Zenith constructs portfolios and determines asset allocations.
“We are focusing on those asset classes that aren’t as aggressively priced. In that basket, we put global small and mid-cap stocks, and some emerging markets that look reasonably attractive. While we maintain a slight overweight to credit and equities, we think quality, small caps and emerging markets aren’t as fully priced and are well placed for future gains.”
He said along with credit and small and mid-cap stocks, unhedged global equity investments are also a very efficient addition to portfolios.
“The diversification benefits are significant. A lot of investors adopt a 50:50 hedged versus unhedged ratio, but our analysis suggests that a 60 to 70 per cent unhedged exposure is a more efficient long term portfolio allocation.”
He said other sectors such as listed infrastructure and property trusts aren’t as expensive as other sectors of the Australian market, partly because they have been undermined by rising real yields over the past two years.
“They’re two areas that are of interest, as they’re not as fully priced and both look better placed on our long-term return expectations,” he said.
