While a soft economic landing has been fully factored into equity and credit markets, Zenith has cautioned that bond yields may remain elevated, potentially dampening equities, should interest rates persist at higher levels due to unexpectedly robust economic growth.
With core inflation still hovering near 4 per cent, Zenith asset allocation lead Damien Hennessy believes that the Reserve Bank (RBA) is unlikely to contemplate rate cuts and will likely await a consumer price index (CPI) reading with a “three” in front of it.
“Analysts that are calling for an interest rate cut soon from the Reserve Bank of Australia are a little premature,” Hennessy warned.
“I don’t think we are there yet. We may get a rate cut in the later part of this year, but not in the near term.”
He posited that a significant concern looming over the market is the possibility that interest rates won’t be slashed as anticipated, leading to a rise in bond yields. Such a scenario could trigger a global downturn in share markets.
“The economies in the US and Australia have held up much better than expected, so perhaps rate cuts won’t come as soon as markets expect. If bond yields push up, that could undermine most asset valuations and that is the biggest risk financial markets face at the moment,” Hennessy explained.
“The Australian stock market has run very hard in recent weeks and valuations have been expanding without being matched by expected earnings growth, which remains weak at about 2 per cent for the next 12 months. For example, banks are trading on a price-earnings (P/E) multiple of 15.5 times, which is close to a record high, yet earnings growth for the bank sector looks quite subdued. A large part of the Australian share market looks expensive right now,” Hennessy said.
Other risk factors for financial markets, Hennessy noted, stem from geopolitical risks, with war in the Middle East and supply disruption in the Red Sea potentially keeping inflationary pressures afloat, while the ongoing conflict in Ukraine, and the US election outcome adds to economic uncertainty.
As such, he said that Zenith maintains a focus on asset classes that aren’t as aggressively priced, prioritising global small and mid-cap stocks, and some emerging markets that look “reasonably attractive”.
“While we maintain a slight overweight to credit and equities, we think quality, small caps and emerging markets aren’t as fully priced and are well placed for future gains.”
Noting that unhedged global equity investments are also a very efficient addition to portfolios, he said the diversification benefits are “significant”.
“A lot of investors adopt a 50:50 hedged versus unhedged ratio, but our analysis suggests that a 60 to 70 per cent unhedged exposure is a more efficient long-term portfolio allocation.”
Two other areas of interest for the investment manager include listed infrastructure and property trusts, which remain less expensive than other sectors of the Australian market, having been undermined by rising real yields over the last two years.
“They’re not as fully priced and both look better placed on our long-term return expectations,” Hennessy concluded.
