THE market is seeing signs of inflation easing, the economy slowing and policy having an effect.
As a result, concerns over the extreme tail risk of substantial central bank overtightening may be receding.
It remains a challenging environment. The key questions around where inflation settles, the path of rate hikes and the economic impact are still unanswered.
Energy remains a wildcard. But at this point there is a reduced probability of some of the most negative projected scenarios.
The market bounce continued last week.
The S&P 500 gained 2.6% and the S&P/ASX 300 3.6%. This was despite more bad news on economic growth and the European Central Bank (ECB) striking a more aggressive stance than expected with a 50bp rate hike.
At this point bad news is seen as good news. Weaker growth is seen as helping drive inflation lower, bringing forward an expected peak in rates and bond yields.
US 10-year government bond yields are now 66bps lower than the June high, which is helping support the equity market. The S&P 500 is up about 8% from its lows. We are also seeing a rotation back to longer-duration sectors.
Oil prices, bond yields and the US dollar all remain tightly correlated and a key driver of markets. Recent falls in yields and oil and a pause in US dollar gains are all helpful for equities.
Early US corporate earnings signals are supportive. It was interesting to see Netflix bounce about 25 per cent despite weaker subscription numbers.
It is too early to call whether we have seen a bottom or if this is another bear market rally.
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Technical measures of market breadth and volumes are not indicating a sustainable turn in sentiment.
Seasonally, August and September are typically soft months for equities.
That said, a market moving higher on bad news suggests some stale positioning and the squeeze could continue.
Bear markets don’t tend to end until policy direction shifts. It would also be unusual to see markets bottom before the extent of any earnings recession is known.
The challenge is that bear market rallies and squeezes can be large.
The average NASDAQ bear market rally since 1985 has been 30% — and the NASDAQ is only up 11% from its recent low.
The S&P/ASX 300 is now down 7.2% for the year to date. Technology is off 27%, consumer discretionary is down 17.6% and REITs has lost 16.8%. This leaves plenty of scope for these sectors to squeeze higher during reporting season.
This week will bring a lot of new information including a Fed meeting, the US Q2 GDP print and a raft of US earnings results.
The ECB raised rates 50bps — the first hike in 11 years — in response to a worse-than-expected inflation print of 8.6% year-on-year. The market was not expecting such a big move, only ascribing a 25% chance.
The market’s reaction was positive.
This could be partly because the ECB stated there was no change to the ultimate expected terminal rate. There was also likely some relief that the bank was catching up to the reality of dealing with inflation.
Given the likely slump in the European economy, there is a view the ECB has only a small window politically to raise rates — and therefore they are better to front load.
The ECB also provided the latest “tool” to manage the “fragmentation” risk of bond spreads blowing out in the periphery and creating the next Euro crisis.
The Transmission Protection Instrument (TPI) represents a form of Quantitative Easing in an era of rate tightening and Quantitative Tightening. The purpose is to prevent the upcoming recession from putting pressure on the Euro.
It is said to have no budget limit on the purchases or periphery bonds (refers to being “proportionate”) or any need to negotiate some economic reform package.
There is no stated threshold for use, which will be determined by the European Council. It will also likely relate to circumstances beyond the country’s control, so the current Italian political crisis is unlikely to trigger its use.
As with most European tools, this is deliberately vague. We suspect the market will want to test this at some point.
It is almost unanimously expected that the Federal Reserve will hike rates 75bps this week. Speculation about a 100bp hike has dwindled along with the latest inflation expectations data.
The Fed is maintaining a hawkish tone.
We suspect they would rather wait for more firm evidence of slowing inflation over next two months – remembering they do not meet in August – than ease up too early and risk another embarrassing U-turn.
The curve of expected future policy rates shifted down 15bps last week. It now has rates peaking at the end of 2022, rather than the previous end of Q1 2023.
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This is a big shift from where we were a month ago. It is likely the economy will need to be a lot weaker for this to happen.
Elsewhere there were limited data releases last week.
Regional Fed manufacturing indices were soft. But the Flash US Manufacturing PMI was better than expected at 52.3 vs 52.7 in June.
Interestingly the Services PMI was weak at 47 vs 52.7 in June, with the pricing component notably lower.
Overall, it painted a constructive picture of inflation easing.
Gas resumed flowing through the Nordstream pipeline from Russia to Europe after maintenance, calming some fears.
It is running at 40% capacity. This enables Germany to build enough reserves for winter – but only just. It remains vulnerable to any change in the Russian approach.
We now have the perverse situation where the West has imposed sanctions to constrain Russia’s ability to sell oil, but is desperately hoping Moscow keeps supplying gas.
Germany suffered the ignominy of asking the rest of Europe to reduce gas consumption 15%. Greece and Spain refused. The latter drew on Germany’s own Euro crisis era rhetoric noting that “unlike other countries, we haven’t been living above our means in terms of energy”.
Oil and gas will be key to determining whether sentiment around inflation continues to improve.
The growing consensus is that weak global growth will see oil prices fall below US$90, relieving pressure on headline inflation and consumer inflationary expectations.
This would allow softer Fed rhetoric perhaps as early as September.
The alternate view is that supply constraints, an end to strategic petroleum reserve (SPR) releases and Chinese re-opening could drive energy prices higher even as the global economy slows.
This would leave central banks facing an impossible choice.
Chinese equities have rallied since May on the easing of Covid restrictions.
However sentiment has turned more negative.
This is partly driven by the mortgage strike in relation to unfinished homes and also by the lack of any meaningful stimulus. Measures enacted recently really only serve to offset the negative impact from housing weakness.
At this point, it appears growth with be sluggish for the next few months. It is hard to see China as a big driver of any improvement in sentiment towards global growth in the near term.
The US dollar continues to drag the Chinese Yuan (CNY) higher, affecting its ability to compete with Korea and Japan. There is a risk we may see another step down in the CNY, which would likely be negative for commodities.
Last week’s broad ASX rally was led by tech (+7.3%), financials (+4.5%) and small caps (+5.8%).
Small cap resources had a good bounce (+6.9%) after a sharp fall in recent weeks (about -33% since April).
This is symptomatic of being oversold and the market chasing beta into the bounce, rather than a shift in fundamentals.
We are seeing small signs of rotation from consumer defensives to discretionary. This was helped by an upgrade from JB Hi-Fi (JBH, +10.1%).
This will be something to watch in reporting season. We note Nine Entertainment (NEC) as a good example of stock that has been heavily de-rated without any sign of earnings softening.
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.
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