Brenton Saunders: What you should really be watching as markets rally

Recent market rallies are a sign the market is looking for a slowdown in rate rises, but investors should resist trying to pick a pivot point, says Pendal’s Brenton Saunders.

• Wait for hard economic data
• Watch jobs data and earnings downgrades
• Find out about Pendal MidCap Fund

RECENT share rallies are a sign the market is looking for a slow-down in rate hikes. But investors are better off waiting for hard economic data rather than trying to pick a pivot point, says Pendal’s Brenton Saunders.

Global markets lifted in October on hopes that central banks may start to slow or pause rate rises after the Reserve Bank of Australia became the first major bank to slow the rate of monetary tightening.

But with labour markets still strong and inflation rising, it is likely too early to suggest that central banks are changing their approach, says Saunders, who manages Pendal MidCap Fund in our Australian equities team.

“It’s quite hard to understand the motivation for the rallies,” says Saunders.

“Many of the drivers of inflation continue to run hot and more importantly headline and core inflation remain strong — stronger than expected.

“Anecdotes around the edges might give you an insight into timing at best. But until central bankers have done enough to feel like they have inflation beaten, they’re likely to keep raising rates.”

The US Federal Reserve kept up the pace at its November meeting, lifting interest rates by 0.75 percentage points and signalling rates might have to peak higher than originally anticipated.

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“The Fed has been incredibly clear in terms of their objectives of getting inflation under control.

“We have no reason to doubt them. It just feels like the market is trying to trough a little early.”

Look for an earnings downgrade cycle

Typically, for sharemarkets to find a bottom through an economic downturn or recession they need to go through an earnings downgrade cycle, says Saunders.

“We’re starting to see earnings downgrades but only recently and so far in a very diluted form. It’s very early days.

“Retail and housing are the obvious sectors where it would show up because of the flow-through of interest rates. Now we’re starting to see more broad-based earnings pressure.

“Even resources companies that still have strong commodity prices are seeing margins squeezed largely because of higher-than-expected cost inflation driven by poor labour availability, high fuel prices and the cost of raw materials.

“But the declines in earnings expectations we’ve seen so far are quite modest. We’d expect to see that continue to escalate over the next couple of quarters.”

The outlook for inflation is still concerning, especially as Europe enters winter amid government programs to protect against gas shortages, he says.

“The reason European gas prices are so low is quite simply because they have run out of storage.”

Strong signal from jobs data

Persistent strength in employment – partly fuelled by slower migration – also indicates the rate cycle has a way to go.

“The biggest head scratcher is just how strong labour markets are.

“I keep coming back to the fact that that’s just going to mean that central bankers have to do more work with interest rates to get inflation under control.

The message for investors?

“You just have to be very balanced in your approach. We’re trying not to cater for only one eventuality – resisting the temptation to pick a bottom.

“You’ve got to be balanced despite the temptation to try and pick the eyes out of the volatility.”