Policymakers will closely monitor incoming data to determine just how much the banking shock will adversely impact financial conditions via tighter lending standards, wider credit spreads and greater caution in hiring, consumption, and capital expenditures. U.S. Federal Reserve Chair Jerome Powell made it clear that he views the resulting tighter credit conditions as equivalent to additional policy tightening. In Australia too, the central bank paused for the first time in 11 meetings this month to assess the state of the economy and the outlook, in an environment of considerable uncertainty.
For investors, we believe it is more important understand the broad implications than to quantify the precise impact of the shock on financial conditions. The International Monetary Fund has trimmed1 its 2023 and 2024 global growth forecast by 0.1 percentage points to 2.8% and 3% respectively as higher interest rates cool activity. It also warned that a severe flare-up of financial system turmoil could slash output to near recessionary levels. Australia will not be immune, the IMF said. While the Australian economy expanded 3.7%2 in 2022, the IMF estimates the pace to show to 1.6% this year and to 1.7% in 2024.
Slower growth and tighter financial conditions could mean a lower terminal rate globally. It could also bring forward the timing of the first rate cut though we still expect rates to be in higher for longer on persistent inflation and don’t think central banks especially the Fed will be in a position to cut rates this year. That belief shapes our outlook for the Q2 2023.
- Our highest conviction allocation remains fixed income. We still see the yields on offer in short-dated Treasuries as compelling. We also see benefit in opportunistically adding to duration for ballast in the potential coming recession. Persistent inflation and falling real rates could benefit Treasury Inflation-Protected Securities (TIPS), and local currency emerging market (EM) debt also looks attractive.
- In US equities we end our preference for value and instead shift to exposures with quality characteristics to lead in a slowing economy. We also introduce a framework for identifying growth at a reasonable price, a screen that favors global tech and global energy.
- Our tactical overweight to EM equities is fueled by China’s reopening, a weaker dollar, and the potential for looser monetary policy in the region, though in the long run we see demographic challenges to growth and geopolitical tensions as a headwind.
- Both volatility and correlations in traditional asset classes have risen. Commodities can be instrumental in choppy markets characterized by high volatility and low visibility. We see tactical opportunities to help hedge portfolios using gold.