Equities have made a strong comeback in FY23, with global stocks on track to deliver ~20% returns in AU$ terms.

Australian equities have delivered a more moderate but still strong ~15% total return for the financial year.

There have been a number of key macro drivers behind the global equity rally that has played out since the October 2022 lows: (1) peaking (US) inflation; (2) emerging stability in long-term bond yields; (3) hopes for an imminent end to central bank rate hikes; (4) better-than-feared economic and earnings outcomes.

Cautious equity market positioning has also likely played a role in the upswing. Positioning is now less cautious than at the start of the year but is still far from bullish.

The outlook for inflation, central bank policy rates and the economy remains the central debate for both equity and bond markets.

US inflation remains our key focus and we see good prospects for a faster decline in core inflation over the second half of the year. This should be a supportive development for equities.

US core inflation has been stickier than headline inflation, although close examination of core consumer price index (CPI) trends highlights that inflation is now being held up by 2 components: used car prices and the heavily weighted “shelter” (housing) component.

Our analysis of real time indicators for these 2 components suggests lower prints are likely in the near term. This suggests core inflation should decelerate significantly in coming months, all things equal.

The market is pricing for one more Fed hike, while the Fed is guiding to at least 1 more, and quite possibly 2 more.

We back the market’s view that the Fed is very close to done, with a late-July hike still probable. However, this is likely to mark the end of the tightening cycle in our view.

We expect relatively benign CPI readings over the next couple of months to entrench the notion that the Fed rate cycle has peaked, helping equity markets push higher.

After a promising bounce in the first quarter, the China recovery has lost momentum in Q2. This has weighed on the emerging markets (EM) share-market recovery that was previously unfolding.

We expect the Chinese authorities to defend their 5% growth target for 2023. As a result, we would expect more economic stimulus measures to flow from the upcoming party conference in July, or possibly even earlier. This, along with a likely depreciation in the US$ on a peaking Fed, should renew interest in EM trade. EM continues to stand out on a price-for-growth basis. We retain our overweight but are watching developments over the next month or 2 closely.

The Australian economy is at an important juncture, characterised by a mix of softening activity indicators, a tight labour market and sticky inflation.

The tight labour market and sticky inflation has dragged the Reserve Bank of Australia (RBA) into a more hawkish policy position in recent months. The cash rate has now pushed up to 4.1%, with another rate hike more than fully priced.

Sharply rising interest rates, against a backdrop of high household gearing and maturing fixed rate re-sets, are creating the risk that the RBA might tip the domestic economy over the edge into recession. This is not our central case but risks have risen in the last few months as cash rates have pushed through 4% and terminal rate expectations have pushed higher.

The Australian economy still has a degree of underlying resilience, as evidenced by ongoing labour market strength, very strong migration flows and robust terms of trade position. This is why a domestic recession is not our central case. However, risks of a policy misstep are rising. Recession risk, which appeared relatively low at the start of the year, is increasingly clouding the outlook for the Australian equity market and increasing the appeal of domestic fixed interest.

As a result, we have edged down our domestic equities weight to neutral and edged our fixed interest weight up to slightly overweight. We will continue to monitor our positioning closely.

Consumer spending prospects face challenges as household cashflow is crimped, and business survey indicators are now pointing to an emerging slowdown.

While we would be cautious in placing too much weight on the somewhat experimental monthly inflation series, the latest, below-expectation print for May should keep the RBA on hold in July.

We lean towards the view that the RBA will execute one further rate increase, to 4.35%, with the most likely timing being August, following the June quarter CPI release.

We would expect significant slowing in growth over the coming year, though growth should still stay marginally positive avoiding a worst-case recessionary outcome.

This should be a supportive environment for high quality domestic fixed interest, with 10-year government yields close to 4%. With the 10-year very close to 4%, we see the risk return trade-off on Australian fixed interest as reasonably good.

Domestic bond yields appear to have entered a range trading environment after the violent selloff of 2022. This is similar to the pattern that has emerged in the US. We see long-term fair value for 10-year yields around the 3.5% area. A return to fair value over the coming year would see a total return on government bonds in the order of 7%. A cyclical overshoot to 3% on a weaker than expected economic outcome would see total return closer to 10%. We feel bond yields are now placed to fulfil their traditional role as a portfolio diversifier.

Moving marginally further out the risk curve to high quality investment grade, issuers see yields in the 5-6% area, which we also see as attractive. High quality floating rate instruments are yielding an attractive 5% to 6.5%.

From a share-market perspective, the corporate earnings cycle is weakening across a number of fronts. The largest downgrades of late have been from lower commodity prices and cost pressures. Demand-related downgrades have been less prevalent but are starting to creep into the equation, with downtrends more likely to emerge in coming months. We note Australia’s earnings momentum has recently been inferior to global equities. In part, this is a function of our sector mix toward banking and resources. Australia is showing positive returns in 2023 but the local market is bringing up the rear in terms of calendar-year-to-date performance (see Figure 11).

Australia’s sector mix and our belatedly hawkish central bank pose challenges for performance of Australian shares, at least in the near term. On the positive side of the ledger, China stimulus could buoy the mining sector in coming months, although the medium-term trajectory for the iron ore price is still likely to be down in our view. The heavyweight banking sector looks to be running into stiff headwinds, with relief on the interest rate front seemingly a fair way off. We still expect the local market to push moderately higher this year (~3-5%), dragged higher by further gains in global equities. The Australian dollar has been choppy in recent months but seems to be forming a bottom. We see moderate upside in the next 6-12 months, aided by China stimulus and a Fed pivot. This appreciation will drag somewhat on the performance of global shares from a local investor perspective, so we retain some partial hedging on international portfolios.

Overall, we see three key takeaways for equity investors: (1) be active in Australian shares to outperform an index that has a less-than-ideal sector mix; (2) be adequately diversified into global equities; and (3) consider some partial hedging for global equity portfolios as the A$ regains some lost ground.