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Despite positive signs, diversification still key among growing uncertainty

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By Keith Ford
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4 minute read

Investors should maintain a diversified portfolio as a dependable and protective shield against any conceivable market scenarios in the upcoming financial year, a professional has said.

Although globally, there are positive signs in the economy, especially in the US where earnings estimates, housing, and consumer sentiment have all improved, Zenith’s head of asset allocation believes investors still need to protect against all possible market scenarios.

According to Damien Hennessy, the potential investment market scenarios for the 2023–24 financial year span from a favourable outcome of lower inflation and no recession — which he deemed as highly probable given recent market performance — to a worst-case scenario of “stagflation risk”.

“Equity markets have held up reasonably well, while credit spreads have tightened a little bit. Markets are starting to price in a soft landing, with inflation returning to the 2 to 3 per cent range in 2024–25,” Mr Hennessy said.

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Another scenario, he said, is that the US Federal Reserve and Reserve Bank of Australia maintain their fixation on cutting inflation and tightening monetary policy too aggressively, increasing the chance of a recession occurring over the next 12 months.

“The Fed absolutely doesn’t want to be the central bank that lets inflation get out of control, so they’re prepared to go so far in tightening monetary policy,” said Mr Hennessy.

“Ultimately, it’s good for bonds and probably good for cash, but risk assets would struggle.”

But the most likely scenario, according to the asset allocator, is a period of higher-for-longer cash, which means ongoing risks of a mild recession. Mr Hennessy called this the “muddle through” scenario, which would see inflation fall but remain higher than central bank targets.

“In this scenario, bond yields at least provide yield and recession diversification. Investors need to be selective within equities, underweighting those priced for soft landing while seeking to overweight those assets and sectors already factoring in pessimistic outcomes,” he said.

Mr Hennessy also acknowledged that a number of analysts are still favouring the “doomsday” scenario of stagflation, or high inflation and stagnant economic growth.

“In this scenario, the Fed and other central banks feel they can’t do anything about a slowing economy because they’re still fighting the inflationary war,” he explained.

“The probability of this happening is low but it’s certainly one that needs consideration.”

Given these uncertainties, Mr Hennessy assessed that maintaining a diversified portfolio remains the most effective defence for investors.

“Bonds have a place in portfolios, perhaps more so than they have for quite a few years now. Yields are in the 3 to 4 per cent range — not exciting, but they provide a bit of protection to investors for those more pessimistic scenarios,” he said.

“Cash and other short-dated investments that provide returns in that 4 to 5 per cent range can also provide a bit of flexibility for investors.

“The range of outcomes is so wide and broad, and investors need to respect the uncertainty that currently exists.”

Although the long-term outlook suggests that inflation will gradually decrease to a more manageable level, with the May CPI coming in at a lower-than-expectation rate, the majority of economists anticipate another interest rate hike during the upcoming meeting of the RBA.

One of them is AMP’s chief economist Shane Oliver, who said last week that: “We expect that the RBA will raise the cash rate again on Tuesday by another 0.25 per cent taking it to 4.35 per cent.

“We continue to think that the RBA has already done enough with inflation already falling and is not paying enough attention to the lags with which monetary policy impacts the economy,” Dr Oliver added.

Westpac, too, is convinced the RBA still has a way to go, with its economist adding on Friday that tight labour markets, limited progress on reducing core inflation, and a pivot in the board’s reaction function align with Westpac’s forecast for a rate increase in July.

Dr Oliver does, however, acknowledge the growing risk of a recession.

Much like other economists, he now puts the risk at 50-50, and believes that what Australians are currently witnessing is “a classic case of the economy being OK until it’s not”.

Despite positive signs, diversification still key among growing uncertainty

Investors should maintain a diversified portfolio as a dependable and protective shield against any conceivable market scenarios in the upcoming financial year, a professional has said.

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