GLOBAL EQUITY markets remained soft last week. The S&P500 fell 0.5%, bringing month-to-date performance to -1.9%.
In Australia the S&P/ASX 300 was flat, though there was some meaningful sector divergence. Metals and Mining came off 4.4% while Energy was up 3.5%.
There were two key drivers of this performance:
Covid and vaccines
Domestic news has been generally positive.
NSW Covid cases peaked at a lower level than feared and vaccine penetration has continued to grow solidly.
Take-up rate for the first dose has risen to 82.2% — up 3.7% compared to last week. This rate has been holding up well. That’s important since a higher rate will help relieve potential strain on hospital systems in future outbreaks and reduce the likelihood of future lockdowns.
The seven-day moving average for second-dose vaccinations is close to 61,000 this week — up from about 50,000 last week.
If this trend continues we might get to 80% full vaccinated — and further relief from lockdowns — before October 18.
Globally case numbers continue to improve, albeit marginally in the UK and the US.
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Return-to-school impact can be seen in the higher ratio of kids in case numbers. Though this is tending to sustain case numbers rather than increase them.
Hospitalisation numbers have been slowly improving in both counties. This is leading to some evidence of improved sentiment in the US.
Economics and policy
Tension has been building for weeks around Evergrande, China’s (and the world’s) most indebted property developer.
Evergrande’s bond interest payments are due on September 23. The question is whether the market will see a bankruptcy or some form of debt restructure.
More importantly, people are contemplating whether this will have a cascading effect on China’s other property developers and the economy more broadly.
Weakened sentiment contributed to the precipitous drop in iron ore over the week.
We see great uncertainties around how this will eventually play out. There is a good chance a default is possible with the Chinese government choosing to send a strong message on property speculation.
But we think the outcome will be something the government can manage, since Evergrande is not a state-owned enterprise and is not as systemically important.
That said, we will reach a crescendo of concern over the next couple of weeks.
Outside China, the focus has been on renewed concerns that inflation is set to be persist for longer, leading to faster tapering and potentially an earlier move in rates.
Inflation fears in the US have come mainly from a combination of labour shortages and unemployment insurance (UI) payments coming to an end. The next few weeks will be an important test of the durability of labour tightness.
Recent pricing power surveys clearly indicate that US companies are pushing through pricing increases in a number of sectors. This reflects input price pressures, constrained availability of product and higher labour costs.
Also, gas prices continue to remain far higher than we have seen for years in the US and Europe.
Inventories are low heading into winter. There is a 70% probability of a La Nina weather event, which may lead to a colder winter. There are concerns elevated gas prices will persist, which has already led to higher electricity prices in the US and UK.
All eyes are on the Fed’s September meeting this week.
The market will closely watch how they signal the pacing of tapering and their quarterly update on the dot plots. The dots are expected to have shifted forward again towards the median rate rise around the turn of 2023. The other focus will be on the number of rate rises through to the end of 2024.
Similarly, there was media attention on unpublished forecasts by the ECB, which could see inflation rising 2% by 2025. This may lead to rates rising in 2023.
All this has added to the market’s wariness on the inflation impact on central bank policies.
The market saw a continued drop in iron ore price. The seaborne benchmark fell 22% last week and is now down 37% for the calendar year-to-date. In contrast the oil price was up by 3% and 45% in the same periods.
The main reason for this disconnect was iron ore’s reliance on Chinse demand, compared to oil’s link to global demand.
The fall in iron ore has been driven by a number of factors.
It had an over-extended starting point, driven by surging steel production in China in 1H21.
The production surge was then met by a dramatic slowdown starting from 2H21: steel production was down 18% in July and a further 10% in August.
The Chinese government has an aggressive rhetoric around holding down steel production through 2H21 for environmental reasons and trying to keep production growth flat for the full year.
These restrictions are expected to continue limiting steel production through to the end of the winter Olympics in late February next year.
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At the same time the Chinese government has introduced policies to maintain controls of the property sector, which is a key driver of steel demand.
Fears for the overall sector have been exacerbated by the Evergrande situation.
Also weighing on demand, the Chinese economy has been generally softer recently due to rolling COVID lockdowns. More stimulatory policies on local government bond issuance that funds infrastructure spend are unlikely to kick in until 2022.
Lastly, the deteriorating relationship between China and Australia may have led to other measures impacting on the commodity price.
Where to from here? The debate is not so much whether iron ore bounces much, but rather whether it can hold in the US$100s or if it continues to move towards a longer term price of US$70.
The Evergrande final resolution may mark a sentiment low in China and its property sector.
Consequently, some measures to support the economy may be introduced such as the RRR cut.
We should still expect relatively subdued demand from China, but the real-time indicators on the economy look to be near their lows.
Global demand for steel remains strong, as evident from the very high global steel spreads, suggesting there are still cyclical tail winds.
Supply disruption also continues to emerge, with Vale announcing this week its iron ore production next year will be lower than expected.
Overall, this week could be the crescendo in negative sentiment before investors start to rebuilding confidence slowly.
Against this backdrop, equity markets overall are re-testing support levels.
There could be support in early evidence that the US economy is experiencing a re-acceleration as Covid cases start to stabilise and fall. And liquidity from Central Banks remains abundant.
Lastly, we note the rotation of value to growth has been mirrored by fund flows. Inflows to tech and outflows from cyclicals look to be at extremes.
As such, we continue to see cyclicals holding better from here.
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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