MEDIA RELEASE: Many of the favoured reflation trades have come under pressure in recent months, with the possibility of a period of peak growth, policy and liquidity combining to create the perfect storm for equity markets, according to Heuristic Investment Systems head of asset allocation, Damien Hennessy.
However, Hennessy believes an elevated equity risk premium – the extra return for investors above the risk-free rate – together with lower-than-expected bond yields, provides a buffer for equities as long as inflation and wages growth remain muted.
“It seems to be all about the second derivative…the change in the rate of growth. We saw the best of everything throughout 2020 and early 2021 – the lift in growth and earnings momentum, coordinated rate cuts and central bank balance sheet expansion.
“However, it is seemingly peak everything at the moment. Often, an initial slowdown in growth momentum is viewed as a pause in the cycle and historically, it remains a reasonable equity return environment.
“Other events are also now conspiring to raise the risk of a more pronounced slowdown and that phase is often the worst for equities, including extended lockdowns and weaker Chinese growth. The missing ingredient as to why it is not all bad news for equity markets is that monetary policy will remain accommodative and nimble. Central banks seem committed to running the economy hotter at this stage of the cycle than they would normally and equity markets are proving to be the beneficiaries,” Hennessy said.
Equity markets have been underpinned by the V-shaped recovery in growth and earnings, fuelled largely by monetary and fiscal settings. The Australian equity market rose 1.1 per cent in July, taking the 12-month return to 28.6 per cent after achieving the strongest financial year gain since 2006-07. The equity market rally from the March 2020 low, driven by the better than expected economic and earnings recovery from the depths of the pandemic, now amounts to 63 per cent.
Hennessy said the key question for investors is whether the current loss of growth momentum – which typically happens following a rebound from recession – develops into a return to the secular stagnation environment of the past ten years, or whether it is a pause in the solid economic recovery.
“We anticipate the recovery to be more enduring, although less robust than the 2020-21 recovery, but an ongoing recovery that is reflected in solid performance of equities and modestly higher bond yields.
“This will, however, depend on a number of factors, including higher debt levels constraining spending and investment, and the extent to which households spend their amassed savings in the face of ongoing uncertainty,” he said.
Even when global vaccination rates reach the required levels for economies to fully reopen, monetary policy accommodation will need to be maintained for an extended period.
“The US Federal Reserve and other central banks will be wary of the uncertainty around what the so-called neutral cash rate level is, and cognisant of the need to target full employment in order to achieve the wages growth sufficient to meet higher inflation objectives. They will therefore be keen to avoid a policy mistake,” Hennessy said.
Zenith Investment Partners acquired Heuristic Investment Systems in March this year. As an asset allocation consultancy, Heuristics leverages off its proprietary StrategyEngine platform, providing data-driven asset allocation services to institutional and wholesale clients.