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MOUNTING fears of stagflation — higher inflation and slowing growth — weighed on equity markets last week.
The S&P/ASX 300 fell 2.12% and the S&P 500 was off 2.19%.
Several factors are driving concern. These include persistent supply chain bottlenecks, the potential impact on export volumes from Chinese power shortages and a more hawkish tone on inflation from Fed Chair Powell.
OPEC’s decision not to add any additional supply to the oil market beyond already-planned increases — despite evidence demand is re-accelerating as the Delta Covid wave fades — added fuel to this fire.
In response to stagflation fears, equities and bonds have sold off, while commodity prices have risen.
In equity markets, higher bond yields have prompted a rotation away from growth stocks towards re-opening plays and companies offering protection against inflation.
At this point we don’t expect this issue to de-rail markets. But we wouldn’t be surprised to see the rotation away from growth continue.
Powell’s hawkish turn
After a relatively dovish tone on inflation at Jackson Hole, Powell was slightly more cautious in the September Fed meeting. He was more hawkish still in his presentation to the European Central Bank’s (ECB) Sintra conference last week.
This reflects inflationary data persistently coming in higher than expected and evidence that its drivers are shifting away from short-term factors.
In particular, the Fed Chair noted tension between the Fed’s goals on inflation and employment. He also noted “transitory” inflation may last longer than expected.
Powell later moved to soften the message, but the market is dwelling on the uncertain outlook.
The sub-plot is Powell’s likelihood of a second term.
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Some suggest this is in question due to the recent Committee trading scandal — and that the narrative has as a result shifted to the inflation risks to be addressed, rather than the story of growth.
Powell is regarded as one of the more hawkish potential leaders of the Fed.
Any shift at the top of the Federal Open Market Committee will reinforce market expectations that inflationary pressures will be accommodated.
The inflation question
The Fed’s favoured inflation measure — US Core personal consumption expenditures (PCE) — rose 0.3% for the month and is running at 3.6% year-on-year.
Notably, some of the “Covid bounce-back” categories are no longer big drivers. This is evident in the quarterly annualised growth of 2.7% in the Core PCE — the highest since 2008.
There are two broad forms of inflation to consider:
At this point we are witnessing the first form of inflation.
The hope is that it fades quickly as supply chains are restored and demand is fulfilled, easing inflationary pressure without any impact on growth.
The concern is that if supply chain issues persist too long and we get significant energy price spikes in the Northern hemisphere winter, it will drive a more severe impact on the global economy.
An additional fear is that current labour shortages in a number of countries — combined with central banks maintaining their current aim of higher real wages — would see inflation entrenched via wages.
For example the current wage negotiations at US equipment manufacturer Deere & Co will be worth watching, with employees threatening their first strike since 1986.
There is a long way to go, but risks have risen.
This all puts central banks in a tough position.
Either they react through tightening policy as we are seeing in countries such as South Korea and potentially New Zealand.
Or they hold the line as the US is doing, which risks fuelling continued strong demand, exacerbating the issue.
China’s inflation impact
The market has been focused on China’s role in the inflation question. The focus last week was power outages which have led to curtailed output in some industries.
There are three factors at play here:
Power shortages are flowing through to higher prices in inputs such as cement and aluminium.
They are also limiting output in a number of processing industries and retail suppliers, exacerbating supply shortages.
Beyond the role this plays in potential inflation, we need to be mindful of Australian companies with exposure to Chinese supply chains.
The current situation limits China’s ability to stimulate in response to slowing growth, with potential implications for the ASX’s miners.
Covid and vaccines
Delta seems to be waning as a market issue. New daily case trends are improving in developed and emerging markets. This is flowing through to better activity levels in countries affected by restrictions.
The main news was the approval of the Merck / Ridgeback oral antiviral pill which roughly halved hospitalisation and morbidity rates among Covid patients in trials.
Ease of use and manufacturing scalability make this a real potential tool in the response to Covid.
A similar product from Roche / Atea and also from Pfizer due to report trial results soon.
Markets
US 10-year bond yields were only 1bp higher last week, but rose 18bps over the course of September.
Commodities continued to climb higher. Brent crude was up 1.5% and iron ore 4.4%. Even without a material shift in yields, this was enough to support the continued rotation away from growth stocks.
As a result technology (-5.94%) and healthcare (-5.62%) underperformed. Concerns over China weighed on the miners, but the energy sector (+4.48%) showed signs of life on the back of a stronger oil price.
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.
Find out more about Pendal Focus Australian Share Fund here.
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