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Crispin Murray: What’s driving ASX stocks this week

Here are the main factors driving the ASX this week according to Pendal’s Head of Equities, Crispin Murray. Reported by portfolio specialist Chris Adams

CHAIR Powell reiterated his message that the Fed will continue to tighten quickly, even if that threatens to trigger a recession.

This prompted market pain last week. The S&P 500 fell -4.63%, through a previous support level, and is now retesting year-to-date lows. So too are high yield credit spreads, the copper price and Australian equities (which fell -2.48%).

Elsewhere the US dollar index rose to year-to-date and twenty-year highs, US bond yields hit year-to-date and twelve-year highs, the oil price fell to its lowest point since the invasion of Ukraine, and both French and German equities broke to new lows for the year.

In the US, commodity prices, freight rates and used car prices are all falling. But service sector inflation continues to rise and the labour market has not cooled enough.

The market fears the Fed will break the economy, with rates rising too quickly. As a result, we appear to be entering the capitulation / liquidation phase of this bear market, where the orderly sell-off gives way to fear and more indiscriminate selling.

Currency appears to be at the nexus of this sell-off. There is less confidence in the British Pound and the Japanese Yen due to fiscal and monetary policies. This is driving strong flows into the US dollar, which causes stress on risk assets generally.

There is a circularity in FX markets. As the US dollar rises it increases inflationary pressure in other countries, forcing them to consider more rate hikes. The on-going sell-off in bonds, despite growing concerns on recession, also points to liquidity issues.

Bulls are pointing to extremely weak sentiment, that we are at peak inflation hawkishness and the belief that the support levels currently being tested can hold. It is also possible that the Fed may send some small signal to prevent the market becoming disorderly.

Overall, we remain cautious in the near term. However we are mindful that these episodes can present attractive opportunities on a medium-term view.

Find out about

Crispin Murray’s Pendal Focus Australian Share Fund

Policy and economics

US

While the 75bp hike in rates to a 3.0-3.25% range was largely expected, the Fed’s hawkish stance weighed on markets.

Powell’s comments that there “isn’t a painless way to get inflation down,” that “the housing market may have to go through a correction,” and that there will “very likely be some softening in the labour market” all point to a clear effort to change the market’s mindset and flush out any hope of pivoting.

This rhetoric, combined with the shift in “dot plots” of future hikes moved the expected rate profile higher. November is now expected to see another 75bp hike, with 50bps more in December and 25bps in February. This implies rates peak at 4.5% to 4.75%.

The Fed also increased their expected unemployment rate at the end of 2023 from 3.9% to 4.4%. Such a move would be consistent with a recession, suggesting that they are prepared to keep hiking rates into a recession.

The 2 year government bond yield rose 34bps to a cycle high of 4.21% in response.

One challenge for the Fed – and the market – is that the economic data is not looking that soft. It may also remain supported by the fiscal drag easing off and by pent-up demand in autos and services, while the backlog of unfinished homes will underpin construction in the short term.

In addition, the labour market remains tight. The difference between job openings and unemployed peaked at 5.9m, which is the highest ever as a percentage of the workforce. This creates pressure on wages.

Goldman Sachs estimate this has to fall to 2m to loosen the labour market enough to get to back to 3.5% wage growth, which is consistent with 2% inflation. So far, this has only dropped to 5.2m.  This makes it difficult for the Fed to signal a significant pivot in approach.

The market’s fear is that the pace of hikes is too quick to be able to assess their impact and the Fed is therefore making a significant policy mistake that sends the economy into recession and may trigger some form of financial shock.

In response, the Fed is saying this is not a mistake. Rather, it is what needs to happen to solve the inflation problem.

Either way creates risk to corporate earnings.

UK

The scale of fiscal stimulus in the new UK Chancellor’s “mini” budget went beyond most expectations.

The government will spend GBP45bn, equivalent to 1% of GDP. Most expected something in the order of GBP30bn. This comes on the heels of the energy pricing policy, which is expected to cost at least GBP60bn in its first year.

This largesse has been widely condemned on the premise that such strong fiscal expansion in an inflationary environment will only force the Bank of England to raise rates more aggressively.

UK government bond yields surged 35-50bps across yield curve in short order. The UK 5 year bond was yielding below 2% on 15th August and is now 4.15%.

The broader fear is loss of confidence in the UK. This is reflected in currency markets, where the GBP fell 5% against the USD over the week to reach record lows.

The Bank of England raised rates 50bps during the week, but would not have anticipated this degree of fiscal stimulus. The market is now pricing in a potential intra-meeting rate hike by the BOE, to try to protect the pound.

Japan

Intervention by the Bank of Japan on behalf of the Ministry of Finance to support the yen – for the first time in twenty four years – shows another source of stress in forex markets.

It came in response to the BOJ’s continued commitment to yield curve control and comments that there would likely be no need to raise rates for two years. While providing short-term relief for the yen, the market remains sceptical that it will ultimately prove successful, with Japan the only buyer. There is also the question of how deep are Japan’s pockets. It has US$1.3 trillion of forex reserves, but much of this is in US Treasuries, which it is unlikely to liquidate to fund intervention – although it does highlight some concerns regarding liquidity in the treasury market.


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Markets

Both the S&P 500 and the NASDAQ look set to test their year-to-date lows. There are plenty of negative signals at present, including:

  1. Bond yields hitting new highs for the cycle. The ten year yield is at decade highs for the first time in forty years, perhaps signalling a regime shift. Higher rates means lower valuation ratings and the US equity market is still sitting at higher-than-average P/E ratios. This means valuation is not a supportive factor.
  2. Key equity markets in Europe have already broken to new lows and may potentially lead the US.
  3. Major stocks such as Microsoft and Google – and key sectors such as semis and software are hitting new lows. Although at this point stocks such as Apple and Tesla haven’t broken to new lows and are helping prop the index up.
  4. Sectors such as energy which have held the market up are now seeing significant selling.
  5. Market breadth remains wide as the index falls. Typically trend shifts are preceded by narrowing markets, which we are yet to see.
  6. Volatility hasn’t yet spiked to levels normally seen near a market bottom.
  7. The option market – as measured by the put / call spread – is not positioned at extremes.
  8. Real rates (nominal rates minus inflation) have risen sharply, which has been required to anchor breakeven inflation expectations. One thing to note is that real yields have been the driver of the relative performance of growth versus value in recent years, which would indicate there is risk of further rotation away from growth.

Overall, this feels like the capitulation phase is beginning to kick in. This will present opportunities, but the lesson of prior bear markets is to be careful not to jump in too soon.

There is a risk the moves we are seeing trigger forced selling. We note that US households still have high holdings in equities and some foreign central banks may liquidate to get access to their reserves. There is also now a decent carry on cash and fixed income, offering an alternative to equities.  The counter-risk, mentioned above, is that the Fed steps in with some signal to calm markets.

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Australia

We continue to see the Australian market as more defensive. It trades on a P/E of 12x, versus the S&P 500 at 17x, while the economy is supported by higher savings, a less aggressive central bank, supportive terms of trade and immigration.

The issue for Australia is as much as the RBA may want to limit rate rise, there may be a limit to the gap between our short-term rates and those in the US, before it creates issues with the currency which would exacerbate inflationary pressures.


About Crispin Murray and Pendal Focus Australian Share Fund

Crispin Murray is Pendal’s Head of Equities. He has more than 30 years of investment experience (including 28 years at Pendal) and leads one of the country’s biggest equities teams.

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. 

Find out more about Pendal Focus Australian Share Fund 

Contact a Pendal key account manager here


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