EQUITY and bond markets trod water last week after well-received inflation data – and ahead of more US quarterly earnings reports, plus meetings at the Fed, European Central Bank and Bank of Japan this week.
The S&P 600 gained 0.7% while the S&P/ASX 300 was up 0.13%.
In US equities we saw a rotation from tech to banks.
There was some wariness of tech stocks ahead of results, given their big recent runs. Bank results are so far better than many feared. This rotation provided breadth to the market.
Positive surprises on inflation and economic resilience – combined with the AI thematic – have driven markets in 2023.
We now appear to be entering a phase of consolidation, rather than a major correction.
The improvement in market breadth is a constructive signal, as is an economy with little tangible sign of deterioration.
In Australia, strong employment data is a reminder of domestic economic resilience. It is hard to see how inflation falls sufficiently in this environment – but the market is waiting for this week’s inflation data before worrying too much about rates again.
At the start of the year we outlined six issues we thought most important for markets going into 2023.
It’s worth revisiting now to see how they’ve transpired.
In short, the key issues have evolved, but there haven’t been any definitive developments.
It’s worth noting the miracle of a soft-landing is now a real possibility – something no-one really believed six months ago.
Since then we’ve also added two new issues to keep tabs on:
1. The persistence of inflation – which will determine how tight financial conditions should be
Inflation has proven more persistent than expected for much of 2023, though in recent weeks it’s started to surprise on the downside.
Importantly, this recent change has begun without the economy showing material signs of weakness.
Despite the rise in two-year bond yields – US government bonds are up 42bps in 2023 and Australian yields up 61bps – 10-year bond yields have remained flat (down 4bps in the US and Australia so far this year).
Lower commodity and input prices along with improved supply chains have eased inflationary pressures.
The key area of contention remains services inflation, which is tied to wage growth and productivity.
Wages are trending lower.
Forward indicators such as the Indeed Wage Tracker are slowing materially, down from about 9% annual growth in late 2021 to 4.8% by June.
The Atlanta Fed wage tracker has seen the gap between overall wage growth and wage growth for job switchers narrow materially, as the latter has decelerated faster.
This suggests the worker shortage is dissipating.
The remaining concern is the continued strength of the labour market, which may make the Fed question whether wages will fall back as far as they need to.
Weak productivity is another reason to be wary of how quickly services inflation falls back.
The upshot is that there is still more to do.
Wages need to reduce to 3% or below to be consistent with 2% inflation. The latter is heading in the right direction and offering hope.
2. The scale of the economic slowdown in the US and other developed markets
The economy has clearly held up better than most expected.
The market was pricing a 65% chance of recession at the start of the year. We remain at the same level some seven months later.
Higher rates have not wreaked havoc as many feared. The debate has shifted to how long the potential lags in effect may be.
Bulls point to “total financial conditions” – a measure of changes in key indicators such as mortgage rates, credit spreads, equity markets and currency moves – having already tightened to a peak. Lead sectors such as housing are turning the corner and an inventory de-stocking phase is now slowing.
Combined with the better inflation data, confidence is building of a soft landing.
Bears continue to point to yield curves and other lead indicators as signs the economy will roll over.
The Fed has now released its own “total financial conditions” index (alongside others from the likes of Goldman Sachs, Bloomberg and regional Federal reserves).
The Fed’s index – which measures the expected impact on growth – shows total conditions as more restrictive than indicated by other indices, suggesting we may see a weaker economy by the year’s end.
That said, even the Fed’s measure of total financial condition tightening has peaked – and the expected impact on growth is waning.
The March banking crisis was seen as evidence of how tightening can affect the economy in unpredictable ways.
But it’s increasingly looking like the “all-in” policy response from the Fed and US Treasury has successfully stemmed second-order consequences.
The question remains: will we defy the “laws of economics” this cycle and avoid a recession?
The accumulated stimulus from the pandmic – combined with green investment, re-shoring and a deflationary China – may help pull off a soft-landing miracle. But there is still no clarity emerging.
3. The leverage of earnings to that downturn
With no sign of recession, there is no insight on the degree of operating leverage.
Earnings have proven more resilient than many expected, particularly in tech.
4. Whether markets have already priced in the downturn
In hindsight a lot of bad news was priced in at the start of the year.
Markets have done much better than expected, squeezing higher on cautious positioning and resilient outlooks for the economy and earnings.
The S&P 500 is up 19.24%, the NASDAQ 34.69% and the S&P/ASX 300 a more subdued 6.03%.
The bulk of this move is valuation re-rating. The S&P 500 has gone from 16.8x P/E to 19.6x.
This suggests less pessimism – but also less buffer in the case of an economic downturn.
5. How China’s economy performs as it exits Covid-zero
China has been a material disappointment.
Q1 saw a strong re-opening bounce, but it faded far more quickly than expected.
Housing has been weak. At best, it can be expected to stabilise.
Exports have suffered on slowing global growth – particularly in goods – although there are some signs of stabilisation.
Consumers remain cautious and this is more likely to be structural factors at play.
Q2 weakness was exacerbated by inventory de-stocking, so there should be some improvement in Q3 even without stimulus.
July’s Politburo meeting is usually focused on the economy. But the mail we are getting is not to expect too much.
The growth rate, while slower than expected, is still consistent with Beijing’s target. It is also unclear how effective stimulus would be.
So any measures are more likely to be specific industry-orientated actions, rather than a “big bang” type of stimulus.
6. Can the RBA engineer a soft landing in Australia?
Australia’s relative appeal has deteriorated.
When it looked like the rest of the world was facing a recession, our immigration-driven resilience was a relative positive.
Now with the rest of the world seemingly more likely to pull off the soft landing, the Australian economy is seeing more stubborn inflation due to higher population growth, combined with rising wage growth and weak productivity.
At the same time the much-anticipated mortgage cliff has not yet had a meaningful impact.
The latest employment data reinforced the strength in the economy.
The politicisation of the rate-setting process and an RBA flip-flopping between inflation hawkishness and social concerns also runs the risk of undermining confidence in policy making and de-anchoring inflation expectations.
So the risks here have risen.
The Fed, ECB and BOJ meet this week. To summarise:
US earnings season kicked off with a focus on banks – where results were not as bad as feared.
One of the key issues was margins, which did deteriorate but not as much as expected. Big banks retain strong liquidity and haven’t chased deposits, which seems to have helped.
The other concern was around exposure to commercial real estate, particularly office.
The positive news here was that reserves against this exposure had stepped up from 3-4% to 8-9% – but without a hit to capital, providing more of a buffer.
Heading into the main phase of earnings, revisions have been at the weaker end of the historic range. Clearly if this persists it will add to the argument for market consolidation, or even a pull-back, given the recent run.
It is also worth noting how low stock correlations have been in 2023.
They are now probably as low as they go, which would indicate macro factors may begin to re-emerge.
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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