The risk of a US recession has dropped markedly since US President Trump first announced widespread tariffs in April, with a soft landing now the more likely outcome, according to Head of Asset Allocation, Damien Hennessy.
"For us, the only indicators at this point in time that are pointing to very high or elevated recession risk in the US would be consumer sentiment. There's currently a lot of distortion in much of the data due to the impact and uncertainty of tariffs and we think it pays to look through that. And generally, when you look through a lot of that data, the US still seems in a reasonable shape," he says.
Shifting market dynamics: The bond-equity correlation inverts
There's also an investment regime shift occurring with the usual negative correlation between bonds and equities, which obviously aids the diversification benefits of bonds, inverting itself.
"In this more inflation-prone environment, we've seen a positive correlation develop between bonds and equities. You really have to go back to the 1960s and 70s to see a similar period, and then a little bit during the early 80s. It's in stark contrast to what occurred during the last 10 to 15 years, where you had a quite strong negative correlation," Hennessy says.
A soft landing scenario still in play
"There'll be periods where the negative correlation resumes, but by and large, I think we're in an environment where we're more likely to see inflation spikes from time to time creating this sort of positive correlation."
Even with these changes in the investment regime, we expect a soft landing to be the more likely outcome in the US with most of the hard data fitting in with this outlook.
Such a scenario would reflect tariffs averaging between 10% and 15%, a slowing in growth to below trend of around 1.5%, and inflation at 3%. You could call this “slowflation”, where the economy is softening but inflation stays higher for a period. It would also have the Fed looking through the tariff impact on inflation and cutting twice to 3.75% by early 2026. The US dollar would be steady or fall slightly, and bond yields would sit at around 4 to 4.25%.
Where to look: Global opportunities & mid-caps
"In that sort of environment, we still feel that there's enough there for investors to search out beyond those parts of the market that have led over the last two years," Hennessy says.
Countries and regions that could do well include Europe, Japan and potentially some emerging markets. China and the UK are also looking better from a valuation perspective.
"Small caps can offer value to some extent and the mid cap space would probably be a preferred area for us, and then also areas like global REITs, which is a sector that we've nominated as being well placed and having reasonable value," Hennessy says.
Strategic asset allocation: Favouring Australia & infrastructure
In terms of high-level asset allocation decisions, sectors where investors may want to consider overweight positions also include, Australian credit, the Australian dollar and infrastructure.
Infrastructure and Australian credit investments represent defensive positions in the current environment.
"The Aussie/US dollar seems to be pretty good value to us. It's about 10 per cent cheaper on a Purchasing Power Parity basis," Hennessy says. "We have an overweight to Aussie dollars at the moment, so we think there's a bit of room for the Australian dollar to move higher."
What to watch: Underweight credit & cash
At Zenith, we're wary of global credit - both investment grade and high yield - where it has meaningful underweight positions. It's also underweight cash.
"In terms of information within the credit market, the quality of credit is a lot better than what it has been in the past within the high yield market, but I still think they're way too optimistic," Hennessy says. “High yield is also an asset class that comes up as being quite expensive at the moment."
