Katie Hudson
The key point is that while we had been expecting a drawdown in equity markets in Q3 and a decent rally in bonds, this was expedited by the US labour market triggering the Sahm rule and a poor ISM report.
While it’s hard to argue too much that the risk of recession in the US hasn’t risen somewhat – let’s call it to ~30% probability – it is not our base case and the key difference is that some of the key aspects that generate recession outcomes are not currently evident, in particular:
- Clear policy error: While I was surprised that Fed market pricing for a cut wasn’t higher for July, it’s likely that the Fed will be doing 50bp moves in Sep and Dec (US election may see a skip for the Nov meeting). The Fed has done a pretty reasonable job faced with the information they had available to hand. It’s clear they discussed easing in July and no doubt they sense a greater degree of urgency to act now to forestall a larger-than-desired easing of the labour market. As such, there is no clear policy error at this point that could lead to non-linear outcomes.
- A breakdown in credit provision: Credit was already tight heading into this market correction if you use the Fed’s Loan Officers Survey as a guide. There are risks that a financial institution of size gets into trouble as the carry trade unwinds, but at this point there is no evidence that a systemic threat to markets has been breached.
- Expectation shocks: This is the main mechanism that turns economic downswings into recessionary shocks. It’s important to note that the economic cycle was not coming in ‘hot’ to this event with high levels of enthusiasm and optimism. Instead, business and consumer sentiment are closer to their cyclical lows than highs, and prior strength in US economic growth was more sourced from fiscal stimulus rather than excess private demand growth. That is, an abrupt expectation shock in the private sector is less likely and, as such, a sharp retracement in activity growth is also less likely.
Of course, the starting point mattered. Equity markets had run ahead of the economic dataflow and the shift in the policy framework in Japan that prompted an unwind of Yen-financed carry trades has also been important in driving this correction. While it’s relatively easy to calibrate how much the market would need to adjust for the first of these factors, having any reasonable accurate gauge on the second of these factors is difficult. The movement in $/Yen suggests a further unwind is still likely in the carry trade, but as volatility settles back down you cannot rule out the reestablishment of some of these trades.
Has the correction finished yet? Well, we are closer to some technicals which will entice some buying, but the reality is that the macro landscape will still determine where the market lands in coming weeks. From our perspective, the US labour market is in a trend deterioration until late 2024 and this will be the rate determining step for risk markets. Until some lead indicators of the US labour market stabilise, it’s likely that risk assets will have trouble sustaining gains.
The good news is that we are about 50% through the adjustment in equity markets and that concerns over excess inflation can now be relegated to history. Rate cuts are clearly coming in size, and once the early signs appear that the easing is having its desired impact and the US election outcome is known, it’s likely that equity markets will be more focused on economic recovery than recession.
Comments By Tim Toohey, Head of Macro and Strategy
The market sell-off has been largely indiscriminate with little dispersion between sectors and stocks to date. Against that backdrop, we believe there are attractive opportunities to differentiate on fundamentals and take advantage of attractive opportunities.
In particular, we are seeing opportunities to build holdings in the small cap space across the following:
- Well-placed REITs which are trading at significant discounts to asset backing, despite valuations stabilising, and in some cases once again expanding.
- Industrial companies with good business models and strong management teams which have been sold off on cyclical concern.
- High-quality growth companies where valuation support is improving, albeit we are being more price sensitive in this area given the elevated starting point for valuations.
We will continue to exploit the volatility by focusing on the long-term fundamentals.
Comments By Katie Hudson, Head of Australian Equities Research