With consensus that a soft-landing is imminent and markets are pricing in this outcome, there are complex geo-political risks that could impact the actual outcome, says Zenith Investment Partners head of asset allocation, Damien Hennessy.
“What we saw recently was an ‘everything rally’. Markets ended 2023 strongly on the basis of better-than-expected inflation results and signs that policy rates had not only peaked, but were likely heading lower,” he says.
“This allowed markets to rally. Asset classes that had been hit hard by rising rates and bond yields were amongst the best performing sectors - small caps, parts of emerging markets, REITs and infrastructure - but pretty much everything rallied.”
Fast forward to January 2024, Hennessy says that performance has been more mixed across asset classes. Bonds have also had a reassessment, with the continued strength in economies weighing on already optimistic rate cut expectations.
“Somewhat unexpectedly, even though bond yields have risen, equity markets have generally held up. It could be that equity markets believe the better inflation data will allow some easing and that solid growth will support earnings.”
However, while a ‘soft-landing’ may be imminent, Hennessy says it will be a fine balancing act for markets to contend with various geo-political risks and inflationary headwinds.
“There are a range of potential risks at play at the moment. The first relates to markets downplaying the ‘higher for longer’ risk which was front and centre in October. The prospect of lower inflation and rate cuts could easily be sideswiped by geopolitical events. An escalation of the conflict in the Middle East and associated supply disruptions could add to inflation again, with estimates that 80 per cent of the swings in inflation in recent times have been supply-related. That’s quite significant.
“An additional risk factor is the US election outcome. Donald Trump has fared strongly in the Iowa and New Hampshire primaries and could possibly be facing-off President Biden in November. A Trump victory is viewed as more protectionist and fiscally expansionary, so it may elevate uncertainty around the US attitude to the conflict in Ukraine and tensions between Taiwan and China. This is a potentially more volatile and inflationary backdrop.”
Hennessy also highlighted the continuing property meltdown in China as another risk factor that needs to be considered.
“New builds in China are down 50-60 per cent from the peaks, while transaction volumes overall have dropped by a third. In the meantime, China’s exports seem to be recovering, particularly in areas such as automotives and renewable energy, including to countries outside of the US. Recalibrating its economy and implementing measures to nurse the economy while it weans itself off a reliance on property and infrastructure spending is positive for the long term, but not without risk in the near term."
From a portfolio perspective, Hennessy says these risks and opportunities are important factors taken into consideration when Zenith constructs and positions its portfolios.
“We are currently positioned for a soft-landing with a modest overweight to equities and credit, but we are selective within these areas, with global small caps and mid-caps being favoured. However, the pace at which markets changed over 2023 means that these positions need to be constantly reviewed. Some positions are more longer term while others may not have the same attractive risk/return trade off.
“As always, it’s important to remain focused and nimble to ensure we deliver robust portfolios that deliver strong outcomes for our clients,” he said.