Asset Allocation Strategy
22 April 2024
Weighing up the Recent Equity Correction
Goldilocks Showing a Few Wrinkles

Equity markets have pulled back in April but remain well up on levels of 12 months ago. 

As we have discussed recently, a correction was looking overdue given the pace of the advance over the past year, particularly in respect of the US equity market.

The primary correction catalyst has been a significant shift in US interest rate expectations in response to stronger-than-expected growth and renewed signs of sticky inflation. A rise in geopolitical tensions (Israel and Iran) has also contributed to the recent risk-off tone.

The correction is still relatively minor in an historical context (~4.5% as at April 19) and US valuations remain elevated, so the pullback could quite conceivably extend further. 

Figure 1: The US equity rally has finally faltered as bond yields continue to push higher
Figure 2: Individual US investor sentiment had become very elevated

However, our base case is that the correction proves relatively minor (less than 10%) and that the equity uptrend resumes over the next few months. 

We retain a neutral (12 month) view on global and domestic equities despite some short-term caution. Our view of moderately positive returns for equities over the coming year is premised on the assumption that global growth continues to expand and global inflation cools further. Australian growth should improve over the coming year in response to moderate fiscal and monetary stimulus, while domestic inflation should continue to ease. The Australian market will likely remain captive to US market volatility in the near term but an improved earnings growth outlook for FY25 is shaping up as supportive for at least moderate gains.


The US Economy: Too Hot for the Fed?

The US economy continues to defy consensus expectations with surprisingly resilient growth. Recent key data signposts include a stronger-than-expected employment report for March and last week's strong March retail sales print.

Figure 3: The US labour market (non-farm payrolls report) continues to surprise to the upside

The Atlanta Fed estimate for US first quarter gross domestic product (GDP) stands at 2.9% growth after 2.5% in 2023. This compares to the long-term trend in US GDP growth of around 2.3%. Clearly, the US economy remains a long way from the widely expected recession scenario that was dominating headlines 12 months ago.

Figure 4: US GDP continues to track at an above-average pace

US reporting season is now moving into full swing, with the market eager to see if US economic strength will translate to strong earnings performance. After the market’s strong run-up in recent months, the bar is set reasonably high (which raises short-term risks). However, solid results and outlooks may act to allay recent market jitters, so the near-term outlook is delicately poised from an earnings perspective. Ultimately, we see earnings as a bullish support for the US market. We continue to see good prospects for US earnings over the next few years led by the dominant US technology sector.

While US growth has been resilient, a less positive development has been a run of higher-than-expected US CPI prints. This has caused a significant repricing of Fed rate cut expectations and seen a sharp lift in bond yields.

Equities had been ignoring this lift in rates for much of this year but have begun to weaken over the past couple of weeks in response to this interest rate recalibration.

The core personal consumption expenditure (PCE) reading (the Fed’s preferred inflation measure), set for release on April 26, shapes up as the next key inflation litmus test for the markets. We expect this to be a more benign print than the recent consumer price index (CPI) reading, helped by a much lower weighting to housing related inflation (primarily rents). Recent housing inflation reads in the CPI have been coming in stubbornly high. 

Figure 5: The gap between the CPI and PCE measures of core inflation is unusually wide

Sticky US inflation remains a short-term risk, though we doubt inflation will experience a genuine sustained reacceleration. Our medium-term view remains for a further downswing in inflation as the labour market cools and housing related inflation measures catch up to real time estimates of housing related inflation. This should ultimately allow the Fed to ease policy later in the year, which will be a positive support for equities.


Geopolitical Temperature Rises

Geopolitical tensions have bubbled up again in recent weeks. Iran’s retaliatory attack on Israel last week, which followed Israel’s attack on the Iranian consulate in Syria a few weeks ago, has heightened tensions. The Iranian attack risks a significant escalation depending on how Israel responds. This could threaten Iran’s 3-4% of world oil production and potentially the broader flow of oil through the Strait of Hormuz, through which roughly 20% of world oil production flows. 

Another sharp spike in oil prices would be a threat to the economic outlook as it could boost inflation again and risk adding to inflation expectations. This could potentially result in higher interest rates and act as a tax hike on consumer spending. 

However, this is a risk case scenario rather than our central case. While equities are jittery and risk barometers such as the VIX (thus US implied volatility index) have lifted, the global oil price has so far been remarkably calm in the face of Iran’s attack. Oil had been moving up in recent months due to both rising geopolitical fears and fundamental (supply/demand) dynamics. The failure of oil to spike following the Iran attack suggests the market does not expect a significant conflict escalation, although tail risks remain.

Figure 6: The US market implied volatility index (the VIX) has spiked off low levels but is not particularly elevated
Figure 7: Oil has been pushing higher this year but did not spike following Iran's recent strike on Israel

While the US has vowed to protect Israel, it has also called for restraint and said that it would not participate in an attack on Iran. It is still possible that Israel decides to go at it alone and launch another strike on Iran, although it will probably stop short of making a full-scale declaration of war.

Historically, geopolitical skirmishes and indeed outright wars have more often than not only caused temporary corrections in global equites, though we note there is a large range of outcomes when we look across the past 50 years. The oil shocks of 1973 and 1979 (both linked to middle eastern geopolitics) stand out as the clearest examples of geopolitical events that had profound impacts on the global economy (and inflation). This, in turn, had significant negative implications for equities beyond a purely short-term impact. 

In summary, while geopolitical risks are high, our base case is that we will not see an escalation of the conflict into outright war. Nonetheless, the situation remains fluid.


Medium-term Market Prospects Look Constructive

In conclusion, after a period where equity markets had become relatively complacent, equities are now pulling back as they contemplate risks around the goldilocks macro central case, as well as risks in respect of the geopolitical backdrop. The correction remains a minor one in the context of the recent advance, so the correction could quite possibly extend. However, we continue to see the macro backdrop as conducive for further gains in global and domestic equities over the next 6 to 12 months, as inflation cools, policy rates are eased and the global and domestic economic growth cycle continues.

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Written by

David Cassidy, Head of Investment Strategy

David is one of Australia’s leading investment strategists.

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