The adjustment of interest rates and interest rate expectations has been significant with the recent credit downgrade of US sovereign debt and a sharp pick up in US Treasury issuance (to fund budgeted spending deficits) adding impetus to the upward trend in yields. In the midst of the COVID-19 pandemic, the 10-year US Treasury yield hit an all-time intraday low of 0.3%. Since then, we have experienced an astonishing turnaround with 10 year yields now standing at 4.6%, and it’s worth remembering that the annual rise of c. 2.3% over 2022 was already the biggest yearly increase since 1788.

Long duration growth assets such as technology shares, which had been the driver of returns earlier in the year, felt the brunt of the pain. Conversely, higher crude oil and energy prices resulted in the energy sector outperforming the rest of the market by 15%. While the US economy appears resilient, softening economic data elsewhere, particularly in Europe and China, has led to growing concerns about the near-term global growth outlook and negative revisions to corporate earnings.

The rise in crude oil prices and higher bond yields raises particular concerns for investors as these factors will weigh negatively on the growth outlook, while at the same time, fueling stubbornly high inflation in the near term. Central banks have little option other than to keep interest rates higher for longer, increasing the risk of some form of financial/ asset dislocation as credit conditions continue to tighten and cheap debt is refinanced at even more costly levels.

As shown above, over the past 50 years equities tended to rise when the interest rate hiking cycle was not followed by a recession. This only occurred three times; 1984, 1995 and 2018. For every other cycle, where higher interest rates resulted in a recession, equity markets experienced a correction of at least 20%. In addition, it is also interesting that the global economy experienced a sharp downturn whenever interest rates increased by 300 basis points or more over a rolling 12-month period.

Every economic and business cycle is however unique, and the sharp downturns experienced in the global economy since 2000 were accompanied by either an asset bubble (2000 dot.com) and/or periods of extreme risk taking (2008 global financial crisis). Our baseline view is that the global economy is unlikely to enter a period of recession given healthy balance sheets across households and corporates, significant increase in households net assets and a tight job market which has for the first time in many years supported real income growth for employees. However, we believe risks remain tilted to the downside given the extent of monetary tightening (higher interest rates) since 2022, with the lagged effects to the global economy still to play out, reduced fiscal support, tightening credit standards, high oil price (sticky inflation) and unfavourable geo-political developments between China and the Western economies. The current economic cycle would appear to be quite mature in nature and unlikely to reaccelerate until monetary authorities decide to ease interest rates again, an event that has been pushed back until next year.

Global Equity – Underweight

Head: Global Equity
Justin Maloney

After an initial surge in equity prices during the first half of the year, underpinned by China’s reopening, downwardly trending headline inflation and resilient macroeconomic data, equity market valuations adjusted to the reality that interest rates will continue to be a headwind for the global economy, and that monetary relief has been pushed out to the second half of next year increasing the risk of a financial dislocation as the global economy loses momentum. The sell off in global bond yields means that the discount rate used to value equities has increased materially, which requires an adjustment to prices and most likely earnings growth over the next 12 months as corporates adjust to higher for longer interest rates.

Outside of the technology and energy sector, equity markets have largely been trading rangebound this year, given that certain leading economic indicators are pointing to some softness ahead. Banks have been tightening their lending standards which has resulted in both credit extension and credit demand slowing materially. In addition, corporate bankruptcies this year have reached the levels last seen during the global financial crisis. Outside of the US and Japan, global equity markets have in fact been trending sideways and down (in USD) since reaching their peaks in February as the outlook for earnings growth has been adjusted lower. Consensus expects earnings for 2023 to be marginally down on last year.

We remain underweight the asset class due to the following reasons:

• The full effect of higher interest rates still needs to play out. It can take up to 2 years before the economy fully responds to tightening monetary policy. Higher interest rates combined with tightening credit standards, and a decline in money supply have in the past always resulted in a recession (not our base case).
• Interest rates are not expected to decline in the near term. Core inflation remains elevated given a buoyant labour market and is not expected to decline to levels that will allow central banks to cut interest rates until next year.
• Equity markets have historically not reached a bottom prior to the end of the interest rate tightening cycle and have tended to only bottom after the first interest rate cut. The risk is that monetary authorities overtighten in their effort to curb inflation.
• From a valuation perspective, equities are not overly attractive on a risk adjusted basis, and even less so when compared to the interest rates on offer for cash and government bonds. Expected returns over the next 12 months are in line with that of cash and fixed income.
• An environment of higher for longer interest rates and elevated inflation is unlikely to result in higher valuation multiples from current levels.
• The outlook for company earnings remains uncertain and given peak profit margins and an expectation that inflation and volumes will slow earnings growth could provide a challenge for many companies to sustain in the short run.
• Equity valuations are not extreme, but a soft landing is arguably already priced in which provides little to no cushion for any disappointment.