The market is focused on two issues right now.
Both issues have the potential to depress bond yields. Confidence that the Fed will take action to control inflation can support the bond market. So too can another Covid wave if it suppresses economic growth.
This is reflected in the equity market with a rotation from cyclicals to growth and defensives.
Equity market returns were muted last week. The S&P/ASX 300 fell 0.47% and the S&P 500 gained 0.36%.
We think sentiment on these two issues presents a risk to markets — but more in the way of driving material rotation rather than a sustained sell-down.
Abundant liquidity, decent economic growth and stimulatory policy all remain supportive of the overall market.
Only about two-thirds of Austrians are fully vaccinated. But even in The Netherlands, where almost 74% of people are fully vaccinated, there is a surge in new cases.
The acceleration highlights the seasonal element of Covid (as the northern hemisphere heads into winter) and the importance of increasing vaccine penetration.
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In the US, both new cases and hospitalisations have increased.
The market is concerned a new wave will result in a repeat of the economic hit in June and July.
At this point we think two factors can support a less severe outcome:
That said, the market will need convincing — and trends are likely to be negative in the next few weeks. This would support continued rotation from cyclicals to growth and defensives.
The key will be whether countries such as Germany and the US follows a UK-like path, where cases are at moderately high levels, but hospital numbers are manageable.
We’ve also seen agreement at US agricultural equipment maker John Deere and Co, which experienced its first strike for wage growth in 30 years.
Workers agreed to a six-year deal including a 10% rise in the first year, sign-on bonuses and a return of cost-of-living adjustments. Yet another sign of the wage pressure coming through.
There is a view building that the Fed is likely to signal a more hawkish shift on rates in its next meeting on December 14-15.
Previously, the Fed’s line has been that it was comfortable with higher inflation because there had been a period of lower-than-target inflation. This could act as a buffer for inflationary pressure.
No matter how transitory you believe current inflation to be, this buffer has now gone.
The Fed can continue to argue it is tolerating higher inflation to support employment goals. But the notion that inflation can run hotter to offset previous muted inflation no longer holds.
The market is also increasingly aware that some of the more structural drivers of inflation are flowing through and will be difficult to hold back. For example, leading indicators of housing rents suggest this will pick up materially over the next 12 months.
At the same time, the outlook for growth remains reasonably strong, despite the potential for another Covid wave, as discussed earlier.
To put some context around the combination of growth and inflation on nominal GDP, we are set to see levels in Q4 not seen since the early 1980s.
Nominal GDP is a reasonable proxy for corporate revenue and should underpin corporate earnings growth into CY22.
The risk comes if it also forces central banks to apply the brakes more aggressively.
This combination of higher growth and the flow-through of property-related inflation saw three members of the Fed signalling last week that the topic of faster tapering will be discussed at the December meeting.
There are two broad schools of thought on inflation at the moment:
In this regard, the two key issues to monitor in upcoming months are US labour market participation and how prepared central banks are to anchor inflation expectations.
On the latter point, a decision to replace Fed Chair Powell or appoint him for a second term with be important. Lael Brainard is seen as an alternative. Powell remains the favourite, but his odds have fallen in recent weeks.
There have been signs in recent weeks that Beijing is looking to ease policy in response to slowing growth.
This is not straightforward. The same cocktail of factors dragging on growth also make an effective response difficult. These include:
Recent statements from Premier Li Keqiang and the People’s Bank of China suggested an emphasis on constraining credit was diminishing and there was a need to safeguard exports.
A shift in policy direction will help limit the slowdown. Concerns around the Evergrande issue have also receded. However we do not see this as the time to be too bullish on China-sensitive stocks.
Beijing faces headwinds in its effort to combat slowing growth. Covid remains a challenge. So, too, do poor consumer sentiment towards property, rising inflation, weakening exports and constraints on local government funding for infrastructure due to falling land sales.
Meanwhile China has imposed environmental-based constraints on growth ahead of the Winter Olympics in March.
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While we are likely to see cuts in reserve ratio requirements for the banks, increased credit growth and some fiscal measures, these will probably be incremental in nature.
They will also take time to flow through.
We can reasonably expect concerns over China’s growth to remain in place for the first quarter of 2022.
Rising Covid, combined with a stronger US dollar, has led to a rotation away from cyclicals and back towards growth.
It’s worth noting that within tech, large cap is performing better than small cap in the US. This reflects rising volatility in the macro environment, which favours the more stable names with stronger earnings.
Oil prices were weaker as the US released some strategic energy reserves. There was talk that Washington was lobbying China to do likewise to help ease energy prices, though this is unlikely to work in the medium term.
In Australia the banks have given up their market leadership for 2021 (year-to-date) on the back of an update from Commonwealth Bank (CBA, -9.54%). Financials have returned 26.09% YTD, versus 33.33% for Communication services and 27.91% for Consumer Discretionary.
Growth names did best last week. Technology (+3.08%) and Health care (+2.82%) led. Financials fell 3.22%, Energy was down 1.57% and Materials lost 1.48%.
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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