THE US equity market is catching its breath, down 0.27% last week (S&P 500) with limited news-flow and waning recession fears.
JP Morgan joined Morgan Stanley and Bank of America in removing their recession forecasts.
Meanwhile, US post-result earnings revisions continue to come in better than expected.
Offshore bond yields moved higher, despite US CPI coming in slightly softer than expected. US 10-year government bond yields rose 12bps and two-year yields 13bps last week.
This led to some rotation away from tech towards healthcare in the US, exacerbated by a market that has been generally long the former and short the latter.
This may signal some mean reversion with a 33% relative outperformance in tech so far in 2023.
Energy was also stronger on fears of union-led strikes at three Australian LNG projects. European gas prices are up 30% this month.
Chinese CPI and PPI both went negative year-on-year for only the second time since 2009 (the other time was during Covid). Concerns around China’s economic outlook continue to grow.
Australian equities were also flat (S&P/ASX 300 +0.26%). Early results from reporting season are slightly favourable in aggregate.
Commonwealth Bank’s (CBA, +2.48%) result eased fears on bank margins while Suncorp (SUN, -5.02%) and QBE Insurance (QBE, -3.52%) flagged higher near-term claims inflation in Australia.
In combination, this led to some reversal in performance between banks and insurers. We don’t believe this will last too long.
James Hardie (JHX, +13.37%) and Nick Scali (NCK, +13.59%) were the pick of the results last week. Both these cyclicals are doing better than feared, with margins helped by lower input costs.
Finally, the Aussie economy has found another way to defy doomsayers with payments platform Airwallex estimating a $7.6 billion economic boost from the FIFA Women’s World Cup.
And that was before Saturday night’s result.
Core July CPI rose 0.16% for the second consecutive month, which was seen as slightly better than consensus expectations.
The breadth of inflation also continues to fall –‑ the percentage of CPI components with deflation has now increased to 25%.
Annualised headline CPI ticked a little higher –- largely the result of energy deflation starting to reverse.
If core CPI is adjusted for observed rents and the volatile component of used autos is removed, it is running at a three-month annualised rate of 2.2%, which is back towards the Fed’s target.
All this is positive and we are likely to see lowish CPI prints in September and October.
This view is expected to let the Fed hold rates steady in their September meeting. The question remains whether this is enough to remove the last hike they still currently predict.
Lower inflation reduces the risk of the Fed being forced to drive the economy into recession, since it suggests there needs to be less of a rise in unemployment to bring inflation back to target.
One caveat is that three current tailwinds are unlikely to be sustained:
On this basis, we could be back to 28-30bp monthly increases in inflation come the December quarter.
This would probably deter the Fed from cutting rates in the first quarter of 2024.
Inflation hawks are concerned that the recent easing of pressure has been exaggerated by the reversal of Covid-related distortions.
Wage pressure remains a key signal for Fed intentions.
While this is a lagging indicator, the employment gap continues to rise. This is not consistent with wages dropping enough to satisfy the Fed.
At this point it would probably take a much weaker US economy in early 2024 to change the view that the Fed does not starting cutting rates in Q1.
There is still a view that we could see a recession, with some pointing to the shift upwards in real rates, which can more than offset the recovery in real wages.
The US 10-year government bond yield has backed up and is approaching the 4.2% highs of last October and November.
This is interesting because inflation data has improved and the short end of the yield curve is also holding in.
This suggests yields are not being driven higher by an expectation of higher interest rates.
There are several theories on what is driving this move:
Whatever the reason, this remains an important issue to watch.
The risk is that if bond yields continue to break higher it may start to weigh on equity markets as the relative appeal of the two assets shifts.
There is no sign of this yet, although it may have acted as a drag on technology stocks in the last two weeks.
Last week we saw both Chinese annualised CPI and PPI turn negative for only the second time since 2009 (the other occasion was during the Covid lockdown).
This has coincided with weak export data (-14.5% in July).
At the same time China’s biggest private property developer Country Garden is warning of big first-half losses triggered by high levels of debt and continued weakness in Chinese property sales.
This is raising concerns over refinancing risks, potential default and the need to restructure debt.
This is not having the same contagion effect of last year’s Evergrande issues. But the combination of these signals reinforces concerns that structural factors are overwhelming Beijing’s ability to stem poor confidence affecting the economy.
The risk here to Australian equities in around commodity prices, which have so far held up on the expectation of policy support.
If confidence in a policy response wanes, this could see weakness in the Australian resource sector.
On the other side, there is still the possibility that policy makers change tack, launching a massive program to reflate the economy.
The price of gas inEurope moved 30% higher last week to about EUR37 per megawatt hour (mwh) on fears of a potential strike at Chevron’s Wheatstone and Gorgon facilities and Woodside’s North West Shelf –- all in Western Australia.
Combined, they represent 10 per cent of the global seaborne LNG market –- a reminder of the importance of Australian supply to global markets.
There are signals the strike may be a bargaining tactic rather than a true threat, but it does highlight the way gas markets pricing works.
In the event this supply is removed, that energy has to be substituted.
The first substitute is coal, which would require gas prices of EUR40-50/mwh.
If this was insufficient -– for example if we saw a cold Northern hemisphere winter -– oil would need to be priced as an alternative which implies EUR70-100/mwh.
This equates to an LNG price of US$20-30 per metric million British thermal units (MMBtu) as opposed to the recent price range of US$9-10 MMBtu.
Gas prices have remained lower than market expectations this year due to a lack of recovery in industrial demand — particularly in Europe -– due to ongoing inventory run-downs.
This boosted the European and global economy as it helps inflation and keeps power prices lower, supporting consumption.
Any disruption to this risks reducing growth expectations.
The market looks to be consolidating, with no major change in sentiment other than the liquidity overhang and a seasonally weaker time of year for equities.
One interesting sectoral point is the strong outperformance early cyclicals, driven by tech and homebuilders. This has left the sector near extremes in terms of historical outperformance of defensives.
The risk of some reversal here is high, given the shift in sentiment on the US economy has largely played out.
In Australia, performance was largely driven by results so far.
Retailers did better on more positive anecdotes, notably from Nick Scali.
Banks outperformed on CBA’s message that margin pressure has eased.
Insurers noted claims inflation in Australia remained very high –- running at about 15% in motor insurance due partly to higher repair costs.
The early theme in reporting season was a bounce among cyclical stocks with low expectations when market fears weren’t realised.
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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