Crispin Murray’s weekly ASX outlook

Here are the main factors driving the ASX this week according to our head of equities Crispin Murray. Reported by portfolio specialist Chris Adams.

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EQUITY markets continue to bounce despite increasingly hawkish rhetoric from the Fed.

The S&P/ASX 300 gained 1.6% last week and is now up 0.8% for the 2022. The S&P 500 gained another 1.8% to be down 4.3% for the year. The NASDAQ is still down 9.3% in 2022 after gaining 2% last week.

It’s remarkable that this takes place against a sharp increase in two-year US bond yields, a surging oil price and a US dollar grinding higher.

These factors are usually headwinds for equity markets, as seen in late 2018.

There are several potential reasons for the ongoing recovery in equities. These include:

• Sentiment and positioning being too negative, leading to a technical bounce
• A poor outlook for bonds, driving rotation to equities
• Equity inflows remaining positive despite softer investor sentiment indicators
• Economic growth supporting earnings, underpinning a view that the market can de-rate without a bigger correction
• A belief that the pre-requisites for economic slowdown are being put in place and rates will not need to rise as far as the Fed is saying

We remain wary in the near term. The Fed needs financial conditions to tighten – and rising equities works against this objective.

Potential scenarios

We see three potential scenarios that are more likely than a continued strong equity market rebound:

1. The market consolidates and treads water for a few months as we gauge central bank ability to contain inflation. This would be consistent with the history of US bull markets, which shows that the third year is often lacklustre — particularly if the first two are very strong. As an aside, if we are near the end of the post-March 2020 rebound it would be by far the shortest bull market in US history.
   
2. The market falls back to set new lows reflecting falling liquidity, concerns over slower growth dragging on earnings and a lack of certainty. Slower economic growth eases inflationary pressure, allowing interest rates to peak at levels the market or Fed are currently expecting, without triggering a recession. This enables a market recovery. Fed chair Jerome Powell notes there have been similar “soft landings” in US monetary history in 1967, 1984, 1994 and 1998. Each involved the yield curve going flat, with the Fed funds rate subsequently getting cut.
   
3. Similar to scenario two — except we end up in recession due to policy error or as the only way inflation can be contained. History indicates that when you see oil rise more than 100% year-on-year it triggers a recession. So too does persistent inflation at current levels. 

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US monetary policy

Powell last week noted the need to move “expeditiously” back to a neutral rate setting.

This kind of language is usually a signal. It’s widely interpreted as an increased chance of a 50bps move in rates in May and possibly in June.

Powell also reiterated that the Fed would need to go above the neutral rate, which is currently estimated at 2.5%.

This is all about getting to the neutral rate as quickly as possible, since anything below that is still stimulatory. The challenge is doing so without prompting a financial shock.

As discussed last week, this rally in equities and credit is loosening the overall Financial Conditions Index. By some measures, it has unwound a third of the recent tightening. The Fed will need to engineer more tightening to achieve its goals.

The market is moving to a view that the Fed is worried real rates run the risk of being too low through 2022 — and therefore the best way to avoid a recession is faster near-term rate increases plus early quantitative tightening.  

Inflation outlook

There are small positive signs that freight rates may be easing at the margin. A slowing economy will help this process.

This is countered by continued pressure in commodity markets.

The focus is shifting to food inflation, where we see:

• A sharp rise in fertiliser prices, which are tied to gas prices. The Tampa contract (a measure of ammonia prices) is up 43% in April compared to February/March.
• Glyphosate prices are already high, affecting weed control
• The price of diesel — necessary to run equipment — has more than doubled in the past 12 months
• Labour shortages
• Propane storage levels are at their lowest levels in seven years. Propane is used in about 80% of grain dryers to reduce moisture and allow storage.

The UN Food and Agriculture Organisation’s Food Price index has hit all-time highs, eclipsing the previous highs which played a role in the Arab Spring. This is before many of the effects of the Ukraine conflict have flowed through. 

Europe

The European economy continues to weaken based on sharp falls in a number of sentiment indicators.

For example, the German IFO Business survey of future business conditions reported its biggest ever single-month decline. 

Sentiment indicators are not far off what was seen at the onset of the Covid pandemic.

We are now seeing some fiscal policy response, predominantly in the form of fuel subsidies. The latter may be more effective politically than economically, given they underpin demand in a supply constrained environment.

Despite fiscal moves the chance of recession in Europe is still priced at greater than 50%.

Australia

There is speculation the federal budget will include a temporary reduction in the fuel excise (currently 44.2c per litre). A 5c cut for six months would cost about $1 billion.

Infrastructure spending of up to $18 billion is expected. But it’s hard to see this flowing through quickly due to difficulties in executing projects and the tight labour market.

More broadly we reiterate our view that Australia is better placed than many other countries.

There is less need to raise rates, allowing them to remain lower for longer.

The economy is benefiting from pent-up demand as restrictions roll back. Australia is largely self-sufficient in key commodities and is a beneficiary of rising prices here.

This underpins our relatively positive view of the domestic equity market.

This is reinforced by the degree to which the Australian market has underperformed the S&P 500 since the GFC.

While recent outperformance has been material, it is a blip on a longer-term view. This gives us confidence in the potential for further outperformance.

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Markets

A continued rise in 10-year US government bond yields (up 33bps last week to 2.48%) has taken them back to the top end of a 30-year downward trend.

The consensus is bearish — with a view that yields rise to 3%.

Sharp moves such as last week’s are often followed by a period of retracement, so we wouldn’t be surprised if there was some relief in the near term.

The rise in 10-year yields signals that the US market is still not of the view that we are entering a downturn. This may explain why equities have been able to rally through this increase.

It is worth highlighting how rate-sensitive sectors have been affected in the US.

Homebuilders continue to fall on expectations of a housing downturn, as have consumer discretionary companies seen as tied to housing, such as Home Depot.  We have not really seen the equivalent of this in the Australian market.

Australian equities continued to grind higher last week.

Resources (+6.3%) and Energy (+5.3%) recovered from the prior week’s fall. Technology (+3%) began to bounce, but remains the weakest sector over 2022 to-date, down 15.5%.

About Crispin Murray and Pendal Focus Australian Share Fund

Crispin Murray is Pendal’s Head of Equities. He has more than 27 years of investment experience and leads one of the largest equities teams in Australia. Crispin’s Pendal Focus Australian Share Fund has beaten the benchmark in 12 years of its 16-year history (after fees), across a range of market conditions.

Pendal is an independent, global investment management business focused on delivering superior investment returns for our clients through active management. 

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