Jason Todd
It’s been a volatile period for equities. From record highs in mid-February, developed equity markets fell to within a whisker of a bear market by early April, only to recover almost the entirety of these losses by mid-May. The consensus narrative has not fared much better, as it jumped onto the recession/bear market call only to jump off this path a few weeks later.
In early April, we took the view that we were past peak trade-related uncertainty, and that despite rising growth uncertainty, markets would bounce their way higher as the bear case was slowly removed from expectations. We don’t profess to have any unique skill in forecasting what US President Trump will do next, but we thought that a pause and time to negotiate trade deals would be a significantly better outcome for markets than trying to bludgeon trade partners to death using shock-and-awe tactics.
While this view proved prescient, it’s fair to say that equities have rallied much faster and certainly further than even we had anticipated back in April. But that’s all hindsight now, and we are happy to bank the gains (or be labelled the dumb money, if that makes the smart money feel better). The more pertinent question is: where do we go from here, and as investors, what should we do?
We think the equity market outlook is constructive despite ongoing uncertainty around trade and growth. We believe the US can now avoid a recession, and that in and of itself should account for a lot of the recovery in equity markets, regardless of whether there is a wide confidence interval around final tariff outcomes and where economic growth settles.
Equity investors will still need to deal with a slowing US/global economy, the potential for slightly higher inflation, a modest earnings downgrade cycle as tariff impacts are either absorbed via lower profit margins or via lower sales, as well as the uncertainty that results from US President Trump running policy through social media announcements. But these are not insurmountable problems.
Similarly, we are not overly worried about the recent spike in long bond yields due to fears that US debt growth has reached unsustainable levels or for a period of hard data catching up to soft data – provided it does not begin to signal a more severe growth slowdown. No doubt, equity markets will continue to lurch from one concern to another, but a deep beta-driven sell-off is unlikely to occur outside of a return to recession fears. We realise this might appear optimistic given the recovery seen to date and where equity market valuations are now sitting. But there are several factors that support our constructive view:
Positive (Incremental) News Flow
Equity markets work off incremental news flow relative to a baseline. This baseline turned bearish in early April, and while the outlook is still for slower growth and higher inflation, led by the US, this is a step up from recession and a bear market. While it is harder to justify how fast or far equity markets have recovered, they have been buoyed by better-than-expected news around tariff rates and the willingness of US policymakers to make concessions. Although soft data is still pointing towards some “catch-up” in hard data over the coming months.
Slowing but Growing Global Economy
The global economy is slowing but still expanding at a healthy clip. Significant uncertainty remains, but there is also scope for increased policy support to underpin risk assets depending on how the economic landscape evolves. We know the Fed will cut rates if growth risks rise, and we take as positive the expectation that this might not be necessary until late 2025/early 2026, given the US economy is on a modest glide path lower.
A Relatively Insulated Australia
Australia remains largely sheltered from the direct impacts of a global trade war, and the RBA has only just embarked on its rate-cutting cycle. With inflation no longer an impediment to further policy easing, the A$ at favourable levels, and the equity market largely domestically domiciled, we are not as surprised by recent outperformance as many market commentators have been. Markets move off expectations, as they are far from dire, even if there are hints of complacency creeping in.
Bond Yields Unlikely to Unwind Risk Assets
We think the fear around US long bond yields undermining risk assets is overdone. Since the end of the GFC, private sector debt has fallen meaningfully in the US (from 290% of GDP down to 210%), while government debt has doubled from 60% up to 120%. Thus, while the composition has changed, leverage has remained relatively steady at ~3.4x GDP. In addition, the US economy has been growing sufficiently fast to offset this debt.
It’s possible that a rising term premium pushes yields moderately higher, but we see limited risk that bond yields detach from growth-driven fundamentals in the near term – particularly with short-end rate cuts on the cards later in the year.
Summary
Markets are approaching early-year highs, yet macroeconomic conditions have unquestionably deteriorated. This does create a conundrum for investors: do you bank the gains, or do you weather some volatility in the hope that equity markets can look through these headwinds? Arguing that markets will encounter volatility versus arguing that there is meaningful downside are two different things. The first is a certainty, given the long list of risks. The second is less certain, and we don’t think this is something to position for.
Growth risks are elevated, as are equity valuations. In addition, fixed income markets are behaving badly at the long end. But zooming out from these concerns, and excluding a US recession, we don’t think the picture is that dire. The US economy, while slowing, is doing so gradually. Most financial markets have experienced a tightening in liquidity, but debt markets are functioning, and financial conditions are not onerous.
Closer to home, Australia remains well-insulated from the global trade war and stands to benefit as China ramps up policy support to offset trade headwinds. In addition, the RBA is in the fortunate position of facing fewer severe trade-driven inflation fears, which should open it up to a more aggressive easing path if conditions warrant. At present, market expectations are for an additional 75bps of easing by year-end (down to 3.10%). We think this is the minimum rather than maximum level of easing likely to take place before the cash rate bottoms for the cycle.
We understand concerns around equity market valuations, with the ASX200 now trading at 19x forward earnings. However, if institutional investors are still catching up to the rally, then we doubt further positive news flow will prevent the market from trading higher. However, the “beta” rally, which has driven all stocks higher, is likely to be replaced by an “alpha” rally, where upside is driven by stock specifics. This will see upside momentum slow, but rather than folding at the first sign of trouble, we think the market can stare down economic softening risks and finish 2025 higher than current levels.
By Jason Todd, CIO
