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Nathan Hughes: Rate-cut bets may be wide of the mark

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A swift shift in market expectations toward rate cuts has underpinned equities recently. But inflation pressure persists, and market optimism may be getting ahead of itself, argues Perpetual’s Nathan Hughes.

Markets may be getting overly enthusiastic about the potential for interest rate cuts in 2024 – and a cautious approach to investing over the next few months would be prudent, says Perpetual’s Nathan Hughes.

Investors are pricing rate cuts of more than 150 basis points in the US over 2024 – a shift that has underpinned much of the equity market’s rally over recent months.

But despite optimism that inflation is in the past, there are risks ahead including strong jobs numbers, continued economic growth, robust corporate earnings and signs of an end to the inventory destocking cycle that has driven commodity prices lower.

“The expectations for rate cuts are remarkable,” says Hughes, who manages Perpetual’s ESG Australian Share Fund [GIVE:ASX].

“I’m asking the question: has the market got ahead of itself?

“There is evidence that inflation may be stickier and macro-economic data is holding up well. So why would you need to cut rates 150 points?”

The federal government’s changes to the long-planned stage 3 tax cuts – which redistribute tax cuts away from high income earners towards low-income earners – could also pose a risk to inflation, says Hughes.

“The tax cuts may not be directly inflationary – but they certainly won’t be deflationary given the higher propensity to spend amongst the beneficiaries of the policy shift.”

Inventory poses inflation risk

The key upside risk for inflation is the end of an inventory destocking cycle that began post COVID, argues Hughes.

During the pandemic, as demand spiked due to stimulus and lockdowns, many companies stocked up on inventory, moving from the typical ‘just-in-time’ production model to an overstocked ‘just in case’ approach.

As demand normalised companies began aggressively destocking this excess inventory, contributing to falling commodity and input prices as supply outstripped demand.

“In our conversations with companies there are indications that the destocking cycle is coming to a close,” Hughes says.

“That could have an impact on goods inflation as commodity prices – especially some of the metals –  may find a bottom.

“Destocking cycles typically only run for a certain period – usually not beyond 12to 18 months – because inventory finds a level.

“We’re talking to a raft of different companies in the industrials space and we’re seeing evidence of the cycle ending across a range of different industries, including spirits manufacturers, FMCG customers and packaging supplies.”

The end of destocking could put a floor under commodity prices, removing some of the downwards pressure on inflation, Hughes says.

“Metals prices – with the notable exception of iron ore – have been weak and the oil price has fallen over the last six months. The disinflation we’re seeing is underpinned by lower commodity prices.”

A note of caution

As a result, Hughes suggests investors take a cautious approach over the next few months.

“Be wary of chasing some of the rate-sensitive sectors – certain real-estate trusts, infrastructure, the higher-growth names that have longer duration and benefit from lower rates.

“Without wanting to sound overly bearish – because that’s not how I am – be a little bit cautious around market sentiment.

“We have had a big move off the lows and some of the riskier names probably benefited disproportionately.

“The message is cool your jets a little. Be selective, focus on company-specific issues, don’t forget about balance sheet strength, don’t get suckered into things where valuations are prohibitive.”

Domestically, Hughes says ASX industrial valuations are at the high end of their 20-30-year range, providing little valuation support for investors.

Long bond yields, a key input to valuations, have risen from December’s lows, making certain stocks less attractive to investors, he says.

The performance of local markets in coming months may pivot on the interest rate decisions of the Reserve Bank in February and March, he says.

“There is an open question as to whether the RBA lifts rates one more time in the next couple of months,” says Hughes.

ASX impact

A policy divergence between an RBA that is still tightening and a Fed that is cutting has a raft of implications for investors, says Hughes.

“There are a lot of big offshore earners in our market, particularly in healthcare, which could face a headwind from a rising Aussie dollar, while typically small caps do pretty well when the Aussie is rising.”

February’s ASX reporting season will provide investors with some important clues to how businesses and consumers are coping with higher rates, says Hughes.

“Some of the interesting questions we’re seeking answers to are whether people still have a propensity to continue traveling in a tougher macro environment. There was a bit of revenge spend after COVID – is that done?

“The supermarket results will be interesting too – especially the government risk.

“Bank earnings will also be topical. I think the bad debt cycle for banks is still far away but I think income growth is going to be a challenge given slowing loan growth, and higher expenses.”



About Perpetual ESG Australian Share Fund (ASX: GIVE)

GIVE is a unit class in the Perpetual ESG Australian Share Fund that is quoted and traded on the ASX as an active Exchange Traded Fund.

The Perpetual ESG Australian Share Fund is an actively managed fund, targeting long-term capital growth and income through investment predominantly in quality Australian shares which meet Perpetual’s ESG and values-based criteria.

Perpetual is a pioneer in Australian quality and value investing, with a heritage dating back to 1886.

We have a track record of contributing value through “active ownership” and deep research.

Find out about Perpetual ESG Australian Share Fund (ASX:GIVE)

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Nathan Hughes
Portfolio Manager, ESG Australian Share Fund, Income Share Fund
Nathan Hughes

Nathan Hughes

Portfolio Manager, ESG Australian Share Fund, Income Share Fund BCom, CFA

Years of experience: 18
Years at Perpetual: 12

Nathan is the Portfolio Manager for the Perpetual ESG Australian Share Fund and Income Share Fund, and an analyst.

Nathan joined Perpetual in September 2010 as a Research Analyst, before spending almost two years on the dealing desk at Perpetual working on all Australian Equity strategies as an Equities Dealer. Nathan was then appointed to the role of Equities Analyst covering small cap stocks in 2013. He was promoted to Deputy Portfolio Manager in May 2016, and took on responsibility for managing 50% of the Smaller Companies strategy in 2017.

Prior to joining Perpetual, Nathan spent 6 years in a Chartered Accountancy firm where he was responsible for the affairs of a diverse range of clients, including regular taxation compliance, financial reporting, Self-Managed Superannuation Fund audits and business advisory services.

Nathan holds a Bachelor of Commerce from the University of Wollongong and holds a Chartered Financial Analyst (CFA) designation.

This information has been prepared by Perpetual Investment Management Limited (PIML) ABN 18 000 866 535, AFSL 234426 as the responsible entity of the Perpetual ESG Australian Share Fund (Managed Fund) (ASX: GIVE) (referred to below as “active ETF”). It is general information only and is not intended to provide you with financial advice or take into account your objectives, financial situation or needs. You should consider, with a financial adviser, whether the information is suitable for your circumstances. To the extent permitted by law, no liability is accepted for any loss or damage as a result of any reliance on this information. The product disclosure statement (PDS) for the Active ETF should be considered before deciding whether to acquire or hold units. The applicable PDSs and Target Market Determinations can be obtained by calling 1800 022 033 or visiting our website www.perpetual.com.au. No company in the Perpetual Group (Perpetual Limited ABN 86 000 431 827 and its subsidiaries) guarantees the performance of any fund or the return of an investor’s capital.