Are we Entering Goldilocks?
In June 2023, we entered a period of growth, but will earnings be resilient? Where inflation was up and growth down in May 2023, in June 2023 we entered a 'Goldilocks' stage where inflation went down and growth up.
Figure 1: The Economic Pulse
Figure 2: Stock Market Movement Scale
Recession - Interest Rates, CPI
There seems to be a dichotomy in the interest rate trajectory of the two countries. We have been seeing CPI numbers in the US coming off its peak in the last couple of data points. It’s now called “disinflation”. However, for Australia its CPI expectation is one of possibly stubbornly high. See chart 1.
Chart 1: Aust Inflation Expectation, RAM Jun23
The two key challenges are Australia’s wages growth and the not-cooling housing market which remain the RBA's headache. The housing market is balancing the demand from increased migration (to handle wage rise) which at the same time pushes up demand for goods and services (and in turn inflation). There remains the risk of over tightening by the RBA (and for that matter the Fed) pushing Australia (and the US) into recession.
Goldilocks - Earnings
Where market participants are expecting continued earnings - not just resiliency, but growth. This shall be proven either way very soon - mid July when US earnings season begins. Similarly encouraged by fund managers’ relatively high cash levels, with some on bearish tilt, chasing equities exposures on any lack of negative economic news. Whilst any positive news on the CPI-front, drives equities markets even higher (the story of July currently)!
Recession - Bonds
Bonds (like fixed or floating rate securities, government bonds or Treasuries or Corporate bonds) as an asset class have traditionally been a good hedge (or providing some downside protection) to investors in a recession. However, in June our multi-asset portfolio manager observed that international bond prices had been rising in tandem with Equities. This is abnormal to their traditional inverse relationship. See Chart 2.
Chart 2: Bond Equities Correlation, RAM Jun23
Note: Bond prices have inverse relationships to interest rates and equities, which gives it its protective characteristics should equities fall. This relationship can also be explained by bonds going up in price when economies are expected to go into recession, which generally drives the equities market (stock prices) lower.
Hence we are not seeing value in International Bonds compared to Australian Bonds, especially the inflation linked ones, are providing better value.
Goldilocks - China
China’ s stimulus which started in Jan 2023 carried much recovery optimism with it. By June though, they had waned and lost momentum. See chart 3.
Chart 3: China Caixin Manufacturing PMI Jun23, Trading Economics
As observed from Chart 4, the Dec22/Jan23 “Go-go China” period brought (up) with it our material stocks.
Chart 4: China and Material Stocks
Since then, we are seeing an even wider gap between MSCI China and S&P 500 and S&P/ASX200. See Chart 5.
Chart 5: MSCI China
The characteristics of these three economies that are dissimilar in some respects (deserve more writing space in the future) creates an interesting flavour for portfolio diversification.
Goldilocks - Small Caps
Goldilocks' environment is positive for Small Caps' catch-up in the US and Australia. See chart 6a and 6b.
Chart 6a: Aust. Large vs. Small Caps, VanEck 2Jun23
Chart 6b: S&P Large vs. Small Caps, Yardeni Research 3Jul23
Recession - Valuation
Australian equities’ forward P/E ratio (30 June 23) at 15x appears slightly lower than that of the US. See Chart 7 and 8. Australian equities may be a good downside buffer should US valuations revert.
Chart 7: Australian equity valuation, FactSet, S&P, JPM
Chart 8: US sector earnings and valuations, FactSet, S&P, JPM
We remain agile in portfolio tilts and not quite celebrating rallies, as lurking at the back of these happy days, may see Goldilocks going back to sleep whilst the "bears" are out to play!