Investment strategy quarterly market update

Key developments

US economy resilient but growth is slowing elsewhere

The US economy showed surprising resilience in Q3, though this strength has come in marked contrast to the rest of the world. The Chinese economy has, at best, stabilised after an anaemic post-COVID recovery and ongoing concerns over its property market. Meanwhile, signs of outright contraction have started to emerge in Europe and the UK. Weakness outside the US suggests the pace of global growth will slow below trend in H2 2023.

Inflation eases as central banks lock in final hikes

Encouragingly, we have seen more broad-based easing in both headline and underlying inflationary pressures, as well as some signs that labour market tightness may be easing. Easing inflation has enabled most central banks in major developed markets to signal that they have reached the peak in their respective rate-hiking cycles in Q3 2023. However, central banks have also signalled an intention to hold policy at restrictive levels for an extended period, forcing markets to reckon with a further delay in potential rate cuts until H2 2024.

Markets deliver negative returns amid higher bond yields

A combination of robust US economic data, central bank signalling, and higher oil prices led to a significant rise in global bond yields in Q3 2023. The 10-year US Treasury yield rose to 16-year highs, reaching above 4.6%. This put pressure on most other financial assets and led to broad-based equity declines.

Equities

Global equity markets fell 3.7% in Q3 2023 after Q2’s strong 6.3% gain. The sharp rise in interest rates had the greatest impact on valuation-rich and longer-duration regions, such as the US.

The US S&P 500 index fell 3.7% (after a 8.3% rise in Q2), with high valuations likely to act as a headwind in the absence of accelerated earnings growth.

Concerns about sticky inflation and slowing growth saw Europe’s STOXX 600 index fall 2.9% after Q2’s 0.9% gain. For China, concerns about global growth and internal debt dynamics led the Shanghai Composite index 2.9% lower, extending Q2’s decline.

Domestic equities outperformed the US and Europe in Q3

The S&P/ASX 200 index outperformed US and European markets in Q3, falling 0.7% after rising 1.0% in Q2. Concerns over sticky inflation and higher bond yields proved a significant headwind—much like in other equity regions. Energy (boosted by sharply higher oil prices), consumer discretionary, and financials were the only sectors to post a positive return over the quarter.

The earnings per share (EPS) growth forecast for financial year 2024 for companies in the S&P/ASX 200 index is currently -8%. Within the index, there is a clear bifurcation, with the S&P/ASX 200 Industrials index forecast to see EPS increase 5%, while the S&P/ASX 200 Resources index sees it falling around 10%.

Source: Bloomberg

Lower growth in Q4 2023 as interest rates bite

The sharp rise in global bond yields and uncomfortable inflation pressures from higher oil prices are likely to weigh on sentiment and growth into Q4 2023. Still, the likely peak in cash rates and low unemployment globally support our long-held view that any global recession in H2 2023 will be relatively mild. However, we are cognisant of rising political and geo-political uncertainty as we move into 2024.

Australia should avoid a recession, but growth to be weak

Signs of slowing in consumer spending have strengthened the narrative that interest rates have reached their peak in Australia. The growth outlook has improved, given Australia’s high level of employment, the post-pandemic rebound in migration, as well as some stabilisation in domestic housing and the outlook for China. However, we still anticipate the lagged impact of policy tightening will lead to a further slowdown in consumer demand over coming quarters. This should keep the economy on a path of sub-trend growth into 2024.

Source: Bloomberg

Fixed income

Central banks maintained a hawkish stance in Q3, espousing higher-for-longer rates. This saw global yields rise to post-GFC highs, sparking broader financial market volatility. Despite this, the higher starting point for yields provided some income cushion. The Barclays Global Aggregate index fell only 2.0% in Q3, outperforming most global equity markets.

In the US, resilient growth and the US Federal Reserve’s shift towards reducing its expectations for interest rate cuts in 2024 saw US 10-year Treasuries rise 76 basis points to 4.57%, their highest levels since before the GFC. This dramatic move bled into most other major global bond markets, lifting yields globally. UK 10-year bonds were the major outperformer over the quarter. Downside surprises in inflation data allowed the Bank of England to unexpectedly hold rates in September, reducing pressure on the local bond market.

Source: Bloomberg

Currencies

The US dollar strengthened against most major currencies in Q3, supported by resilient US growth and higher US yields. The British pound was a key underperformer, with lower UK yields weighing on the currency.

The Australian dollar weakened against the US dollar in Q3, broadly in line with other major currencies. The Australian dollar is expected to stabilise from here, though CBA believes it is unlikely to rise to USD mid-70s before mid-2024.

Our outlook for markets

Global growth expected to slow as tight policy weighs

We may be approaching an inflection point where near-term macro risks are tilted to the downside due to restrictive

monetary policy and as the lagged impacts of prior monetary policy tightening flow through the economy. While the US economy is outperforming, we are cautiously monitoring for signs of vulnerabilities amid rising delinquency and default rates, weakening consumer confidence, and increasing political tensions in the run-up to the 2024 presidential elections.

Australia should continue to be supported by strong immigration flows and the recent stabilisation in housing, but weak labour productivity poses a significant longer-term challenge.

We retain a cautious outlook, favouring fixed income

We remain broadly neutral on the investment outlook, noting that near-term pressures on markets are increasing. We continue to favour returns in fixed income and alternatives, and believe they are well positioned to provide a ballast to portfolios, should global growth decelerate markedly. Within fixed income, we prefer the higher quality areas of government bonds and investment grade credit, and within alternatives we favour hedge funds and real assets, particularly infrastructure. For equities, we are broadly neutral, focusing on quality. We favour defensive sectors and non-US regions, including Australia and emerging markets.