The hike that sounded like the last one in this mini-cycle?

The Reserve Bank lifted the cash rate 25 basis points to 4.85% on Tuesday and then spent the rest of the week being read as dovish. The vote was 6–3, the three dissenters placing more weight on downside risks to growth, and the Board dropped its explicit reference to raising rates further if required. Three-year yields fell around 10 basis points on the day and the Australian dollar slipped below 70 US cents. That is not the all-clear: Governor Bullock called inflation broad-based with risks still skewed a little to the upside, and the Bank nudged up its assessment of domestic capacity pressure, which means more inflation for any given unemployment rate. Private household building approvals fell 5.3% in September, the largest monthly fall since March 2024, though August was revised to +5.4%; household spending rose 0.6%, above consensus. Third-quarter GDP lands  just before the December meeting.

The week the index stopped being the market

The more interesting story was underneath the indices. A larger Democrat sweep than polls implied took the perceived odds of escalation in Iran sharply lower; Brent fell roughly 9% in a session to near US$94, close to 20% below its late-October high. Then investors worked through what Democrat-controlled state houses mean for data-centre approvals, and the AI complex repriced: the Nasdaq fell 5% in Thursday's US session, Nvidia 8.7%, Micron 15%. What that produced was not just the very visible sell-off in the largest companies in the world but a rotation below the surface. In fact the dispersion inside indices was remarkable in the last five trading days and builds on a trend that we have seen over the last few months. Locally, the Small Ordinaries returned 1.6% having been up by 4% atsome mid-week while the big miners and banks were flat.  Ex-20 ex-resources strategies were up by more than 3% which is where the local version of the rotation trade appears to reside.  

Offshore, the gap was wider still. Emerging market equity as an index  fell about 2%, dragged by a Korea exposure that lost over 10%; yet active emerging market managers that we follow closely and who are at ostensibly opposite ends of the style spectrum, deep value and quality growth alike, returned between 3.5% and 5.7%. What they had in common was minimal exposure to AI. The same pattern held in global small companies, where quality-biased strategies that were dramatically out of favour earlier this year during the Saaspocalypse, were also up around 3% while tech focused peers  were down by a similar amount. There was another contemporary element to the turmoil in US markets last week in that the initial sell down was prompted by skittish leveraged retail investors and propagated by hedge funds who increasingly seek to pre-empt and profit from what they think the retail investor is doing. Other investors can choose how much they  want to participate in or just observe this merry go around but all investors have to account for the dispersion, changing correlations and volatility that this entails. 

So, overall, this episode can be seen as a taste of what concentration in indices looks like when the concentration unwinds. The other side of the coin is that the diversification benefits of doing something different are both impressive and difficult to quantify (which is ironic given that investors tend to think of diversification (correlation) as a numbers game). 

Bonds did their job, too

On the other hand traditional portfolio construction also made a comeback and defensive assets behaved as the textbook says they should. Australian government bonds and US Treasuries both rallied modestly as yields followed oil down. For Australian investors currency markets also saw a resumption of normal service as the Aussie Dollar depreciated against the USD, providing another cushion against falls in the US tech titans. One oddity was the strong performance of global high yield as aggregate spreads narrowed. Credit spreads compressing  as equities fall is not text book stuff but we suspect that is another facet of polarised markets where the crowding out effect of data centre related debt issuance has been reversed, providing relief to the rest of the market. Perhaps. We will investigate further. 

In summary

The week has been a live demonstration of the thing diversification is for. A portfolio that owned only the headline index had an uncomfortable Thursday; a portfolio that owned small companies, genuinely active international managers, bonds and basically some less flash investments did pretty well. The uncomfortable question is whether a "diversified" portfolio is in fact a single bet in several guises — a question worth asking before the next repricing, not after it. It is also worth noting that volatility around midterms is routine and has historically been a poor reason to go to cash. The really positive message is that the boring, apparently diversifying stuff, is not only proving to be less volatile but, on our maths, offers superior expected returns. Week ahead: US payrolls detail, RBA commentary and the run-in to  the December Board meeting.