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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THE reluctant rally continues with the S&P 500 up 3.3% last week and the S&P/ASX 300 gaining 1.4%. They are now down 9.3% and 3.7% respectively for 2022.

The US market is now up more than 15% from its low and the rally has lasted 32 days.

Key drivers include:

• Positioning: Systematic and institutional investors have been sitting on their biggest equity underweights in years.
• Lower volatility: This leads to increased participation by systematic investors
• Better sentiment: Job data has helped quell the view that the economy is facing imminent recession.
• Strong US earnings season: Hasn’t validated the pre-season market de-rating
• Lower commodity prices: Particularly in US gas which is helping dampened inflation expectations
• Early signs of goods inflation slowing as supply chains free up

A small shift in fundamental view — that things are not as bad as feared — has prompted a material shift into equities by various systematic approaches. This caught institutional investors off-guard.

This is the nature of bear market rallies — sharp and often short. We now find ourselves at a key point.

In the short term we’re likely to have a quiet couple of weeks ahead of the Jackson Hole central banking conference on August 25-27.

We suspect the market will be range-bound given it is high summer in the north, there are limited new data releases, we are near a large technical resistance level for the S&P 500 and it appears the sharp move in systematic investors has played out. 

Beyond that there remains a wide distribution of outcomes:

1. Inflation rolls over, the economy has a mild recession at worse, earnings declines are limited and the easing cycle starts at the back-end of 2023. In this scenario the market may consolidate, but ultimately moves higher.
2. Inflation proves more persistent, driven by tight labour market and higher energy prices as the economy runs too hot and China re-opens. Central banks need to continue to tighten into the downturn and earnings decline more significantly, taking equities lower.

There is probably enough evidence to indicate the latter scenario does not take us to new lows.

The key to the call remains the main drivers of inflation: the job market (particularly job ads and wage pressures), corporate pricing power and commodity markets.

Economics and policy

US year-on-year CPI (8.5%) and PPI (9.8%) were lower than expected.

But one month does not create a trend — and there was enough in the data for both inflation bulls and bears to validate their outlooks.

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Core CPI (5.9%) was 0.3% month-on-month, a lot lower than recent months. But it is at 0.5% excluding the more idiosyncratic categories such as used cars and airline tickets.

Core goods inflation is falling away reasonably quickly. Energy represents 34% of current inflation and is heading down as petrol prices drop.

Forward indicators of inflation — including the Crude Non-farm Materials ex Energy PPI which is a directional indicator for the Finished Goods (ex-energy and food) PPI — are moving in the right direction.

Freight rates also continue to decline.

All this underpinned more positive sentiment in market last week.

But in the medium term, categories such as direct rent and owner’s equivalent rent become more important. While these have begun to decelerate, it is marginal at this point and is still running above 8%.

Unit labour costs also remain too high, while there is no sign of a turn in the Atlanta wage tracker.

This means the Fed has had to re-iterate its vigilance on inflation.

China

There is some hope that cumulative stimulus measures will begin to drive economic recovery, particularly as we head into Autumn when construction activity should pick up.

We are cautious on calling this too soon. Some key lead indicators remain negative, notably property stock performance.

Credit data continues to be weaker than expected, reflecting low demand given the zero-Covid policy.

Australia

The market continues to grind higher, helped last week by BHP’s (BHP) bid for OzMinerals (OZL) which fired up the resource sector.

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Small caps also continue their recovery, outperforming the S&P/ASX 300 by 8% QTD. This is helped by a combination of short covering and a position squeeze.

There is an emerging view that the government and RBA are looking to deliver a soft landing by allowing inflation to run a bit hotter than normal — on the premise that commodity prices should stop rising, and immigration can ultimately resolve labour shortages.

In this context banks don’t face downside risk on bad debts and some of the consumer-exposed stocks may now be pricing in too much downside.

As in the US, this is contingent on commodity prices staying subdued and labour markets loosening.

Markets

It was interesting that US bond yields couldn’t break the 2.51% low of August 8 in response to the lower CPI number.

June’s hot CPI number coincided with the peak in bond yields (3.5% on June 14). Since then we’ve seen a 100bp move down, before a 33bp rise, closing the week at 2.83%.

Bonds could trade back towards 3% for several reasons:

• Economic data is surprising on the upside. The Fed is likely to be uncomfortable without further slowing, given inflation remains too high.
• The Total Financial Conditions index has begun to loosen, reflecting more confidence in the economy. This works against the Fed’s goals, which may lead them to signal rates stay higher for longer.
• Quantitative tightening beginning to kick in, which will potentially act as a headwind to lower yields.
• Yield curve inversion is implying too quick a reversal in US rates, particularly given economy and FCI trends

Given this, we do not expect to see bond yield moves lower — and they may move higher within a trading band.

This does not necessarily mean bad news for equities, but it makes further moves higher harder.

Given the moves seen so far we expect a period of consolidation coming soon.

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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