EQUITIES continue to rally even as bond yields rise on the back of the Fed’s “hawkish pause” which held rates steady but added in a second rate rise by the year’s end to the “dot plot”.
The market is not convinced of the need for that hike, with CPI data indicating inflation is coming down.
There has been some good news recently.
While it has been a relatively narrow cohort driving the market’s momentum, we have seen some broadening in recent weeks. For example, the Russell 3000 index of US small caps is up 5.8% in June.
The S&P 500 gained 2.6% last week and has broken through the 4350 resistance level, with technical investors suggesting it could now retest the highs of January 2022 at about 4800.
The economy also looks to be holding up, with industrial companies like Honeywell signalling things are not as dire as some would suggest.
All that said, complacency is high.
Markets can enter the doldrums in the Northern Hemisphere summer. The liquidity environment may turn negative as the US Treasury rapidly refill their coffers, having run them down during the debt ceiling stand-off.
This could prompt a decent retracement in equities.
The S&P/ASX 300 gained 1.8% for the week, helped by a 3.06% gain in the resource sector as people hope that Beijing will blink and pull the traditional property and infrastructure stimulus lever in response to a disappointing economic recovery.
While there are myriad ways to measure inflation, the overall trend is one of incremental improvement on signs that underlying inflation is falling.
The headline US Consumer Price Index (CPI) rose 0.1% in May and is running at 4.0% annualised. This was broadly in line with expectations.
The impact of food and energy has swung about from driving about 4% of inflation in mid-2022, to now having zero impact in aggregate.
The breadth of inflation across different categories is also moving in the right direction. The number of categories growing at greater than 5% has fallen from almost 75% in mid-2022 to roughly 40% now.
Core CPI rose 0.4% month-on-month and on a three month-moving-average basis remains stuck in the low 0.4% range.
This is still higher than the Fed wants to see.
However the market is taking a sanguine view, expressing confidence that inflation will head lower in coming months, driven by:
1. Used car prices falling back. These added 15bp in May, but auction prices are falling. Auto assembly is also ramping up, which means more new car inventory, more competition and reduced margins, helping inflation.
2. Rents are set to drop. Owner Equivalent Rent is stuck at 0.5% month-on-month on the lagged effect of previous rent rises. But this has largely played out now, according to Cleveland Fed. Owner equivalent rent should fall materially based on leading indicators.
In combination, there is a view that these trends can shift annual core CPI from 5.3% to 4.2% by the end of 2023.
As an indication, inflation ex-rents and used vehicles is running at a three month annualised rate of 2.8%.
Personal Consumption Expenditure (PCE), which the Fed place emphasis on, could fall from 4.7% to 3.7%. It is declining more slowly due to the effect of higher health care and financial services representation in the basket.
Finally, the University of Michigan survey of inflation expectations showed that the median expectation of inflation in one year had dropped by 0.9% — more than was expected — to 3.35%.
The ten-year median fell by 0.1% to 3%, which was in line with expectations.
The Fed’s meeting was described as a hawkish pause.
Chair Powell kept rates unchanged, as previously flagged, but simultaneously sent a more cautious message via the commentary and dot plots.
The FOMC is now signalling two more hikes this year, versus only one back in March.
In his commentary, Powell suggested he is considering moving to hikes in alternate meetings. This is relevant because it would mean a hike in July – as the market expects – but then a second in November.
This is a long time away and a lot could change by then. So while the market moved, two year yields only rose by 12bps.
The Fed’s statements and actions appear to be at odds. Why pause when you are also raising the amount of hikes you believe are required to bring inflation into range?
The logic could be:
1. Having pre-committed to a pause, they didn’t want to do an about-face
2. With inflation falling, the Fed may see risk-reward as more balanced between inflation and recession, so can be more patient
3. The Committee may be more hawkish than Powell and this statement was the quid pro quo for a pause
4. The Fed is concerned the market would react too positively to the pause, leading to looser financial conditions
US bonds have rallied from March, fuelled in part by concern over the economic impact of the banking crisis. However the economy has held up better than feared and, while inflation is falling, it remains sticky at around 3.5-4.0%.
So the current yield curve suggests the market is no longer looking for rapid easing in 2H 2023.
The reason the Fed remain wary is that while the momentum of the economy is slowing, the absolute level of activity remains high.
This is reflected in a tight labour market and stubbornly high wage pressure, manifesting in unit labour costs and wage expectations.
The Fed’s six-monthly monetary policy report (MPR) was released to Congress.
It noted the labour market remains “very tight”, despite some signs of easing, versus the “extremely tight” of the previous report.
They therefore believe that core services inflation “remains elevated and has not shown signs of easing”.
It does indicate that they still expect some impact from credit tightening post the bank failures. It also included the imputed level of rates based on the Taylor Rule, which would be 6%.
The European Central Bank raised rates 25bp to 3.5% and signalled another hike in July, blaming resilience in employment and inflation signals surprising to the upside.
The market is pricing in an 80% chance of a further hike in September.
There is a lot of chatter around potential stimulus in China, which did see a small rate cut in its seven-day reverse repo rate last week, signalling the direction of policy.
Issues such as youth unemployment rising to 20% are seen as driving the requirement for Beijing to act, with commodity plays strengthening in response.
Good employment data validated the message from the RBA that more rate hikes are needed.
Australia is in a different place to the US, reflecting accelerating wage increases, poor productivity, rising house prices and strong immigration underpinning the economy.
The domestic bond market woke up to this last week with some big moves in yields.
The net result is that the ten year versus two-year yield curve has inverted for the first time since 2008.
This is a negative signal for the economy, although we note that the curve first inverted in mid-2006 and equities continued to rally through to late 2007.
So this is not necessarily a flag for near-term falls in equities.
The S&P/ASX 300 continues to rally and is up 4.89% CYTD, versus 15.78% for the S&P 500 and 31.35% for the NASDAQ.
Miners led the market last week on hopes of China stimulus, with Resources up 3.06%. They are now outperforming the S&P/ASX 300 over CYTD, up 7.19% despite the price of iron ore being flat and lithium falling about 30%.
Information Technology continues to run, up 4.26% for the week, following the US lead.
Healthcare (-5.69%) was a laggard, largely down to a downgrade from CSL.
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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