Markets have remained relatively resilient this year despite periods of volatility driven by geopolitical uncertainty.

However, beneath the headline performance, the underlying character of markets continues to shift.

Here’s what caught my eye…

We are increasingly seeing a more selective environment, one where returns are becoming less synchronised across sectors, asset classes and investment styles. Economically sensitive sectors such as financials, industrials and resources have generally led returns, while more defensive assets have been less consistent. Even high-quality businesses have experienced sharper periods of volatility.

Importantly, we do not currently interpret this as deterioration in underlying market conditions.

Rather, it appears more consistent with a market regime where valuation support from falling interest rates is becoming less reliable, increasing the importance of earnings resilience, balance sheet strength and pricing power.

A Reset in Expectations

At the core of this shift is a repricing of several key assumptions that markets had become comfortable with over recent years.

In particular:

• Interest rates are likely to remain higher for longer,
• Inflation is moderating post covid highs, but remains structurally stickier than many expected, and
• Economic growth is holding up, although with a narrower margin for error.

This matters because markets are now adjusting to a world where investors can no longer rely as heavily on falling interest rates and long-term growth assets to drive returns. 

The gap between stronger and weaker assets, both in quality and performance, is widening. 

Historically, environments like this tend to reward thoughtful portfolio construction and diversification, rather than simply relying on broad market exposure to drive returns. 

What We’re Currently Testing at the Investment Committee Level

Ahead of our upcoming Investment Committee meeting, much of our focus is not on reacting to short-term market commentary, but on pressure-testing whether the underlying market structure is genuinely changing.

Three areas remain central to that discussion.

1. Bond Markets Continue to Matter

I was always taught early in my stockbroking days that “bond markets never lie”.

While perhaps not entirely true, bond markets often provide one of the clearest signals around how investors are assessing inflation, economic growth and future interest rates.

The yield curve, essentially the difference between short and long-term interest rates, plays an important role in shaping investment conditions, because it influences both the returns available today and market expectations for the future.

Bond markets are currently sending a more nuanced message than equity markets alone would suggest. Government bond yields have continued to move higher as investors demand greater compensation for inflation uncertainty and rising government debt levels.

None of this necessarily points toward immediate stress.

However, it does suggest a backdrop where markets may be more sensitive to policy mistakes, inflation surprises or growth disappointments than they were during the exceptionally low interest rate environment that underpinned markets for much of the past decade.

That distinction is important.

2. Australia’s Domestic Position Deserves More Attention

While much of the global narrative remains centred on the United States, we continue to spend considerable time assessing the Australian backdrop, hopefully through a reasonably unbiased lens!

From our perspective, Australia faces several overlapping structural challenges:

• Weak productivity growth,
• Elevated household leverage,
• Expanding state and federal debt burdens, and
• A policy mix where elevated government (“fiscal”) spending is working against central bank efforts to slow inflation.

Individually, these issues are manageable. Collectively, however, they increase the economy’s sensitivity to slower growth and sustained higher interest rates.

This does not imply a base-case recession scenario.

But it does suggest the range of potential economic outcomes is widening, and that portfolio resilience remains important.

3. The Source of Returns Is Becoming More Important

One of the clearest implications of the current environment is that the source of returns may matter more over the next few years than it has through much of the post-GFC period.

If markets continue along the current path:

• Simply owning the broader market may become less effective as a return driver
• The difference in returns between sectors, investment styles and individual businesses is likely to become more pronounced
• Risk may not be rewarded as uniformly as investors have become accustomed to

In practical terms, this increases the importance of:

• diversification quality,
• risk management,
• liquidity,
• and selective capital allocation.

This thinking is already reflected in some of the positioning adjustments we have made, including modest reductions in Australian equities and a greater emphasis on diversified core exposures over narrower exposures tied heavily to particular investment styles or themes.

Interpreting the Bearish Commentary

There has been no shortage of bearish press recently, particularly around:

• Higher rates interacting with elevated debt levels
• Geopolitical tensions and supply-side inflation risks
• Fiscal uncertainty, particularly in the United States

These are legitimate considerations.

Where views often diverge is around timing, transmission and magnitude.

At present, several underlying indicators remain more constructive than the broader narrative would suggest:

• Labour markets continue to hold up
• Corporate earnings remain relatively sound
• Financial conditions have tightened, although not yet to levels that would typically signal broad stress across the economy or markets

Accordingly, we are not currently positioning portfolios for an immediate recessionary or crisis style outcome.

Rather, we continue to operate under the assumption of a more fragile equilibrium.

One where markets can still deliver returns, but where the margin for policy error, valuation error and the risks associated with portfolios becoming overly concentrated in a narrow group of assets or themes are materially higher than they have been in recent years.

Looking Ahead

We have several highly regarded external contributors joining next week’s Investment Committee discussions to challenge and refine our thinking further.

As always, we look forward to sharing our key observations and conclusions with you. For those who would like to continue to explore the usual commentary and source material behind much of our market observations, you can click contact me to request a link to our latest Macro Tones update.

What Caught My Eye is intended to highlight the issues we’re spending time thinking about, not to predict outcomes, but to better understand the environment we’re operating in. Remember any advice in this blog is general in nature. Always seek out professional financial advice before acting on anything personally. 

Cheers 

— Scott