MOST equity markets held their recent gains or advanced incrementally last week, despite bond yields rising after a big move lower the previous week.
The S&P/ASX 300 gained 0.1% and the S&P 500 lifted 1.35%.
Recent equity market resilience has been driven by a combination of:
However, these factors were offset last week by:
Despite this more negative tone, there was resilience in equities. This can be attributed to short-covering by systematic funds which were bearishly positioned and caught out by the prior positive reversal.
Investors were also possibly mindful of the market moving into what has historically been a positive part of the year for equities.
Due to the technical nature of the bounce, it was concentrated in the mega cap “magnificent seven” of the S&P 500, with breadth not as supportive.
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This could suggest price action from here will be more subdued. Though we expect to see a continued grind higher given prior bearish positioning, unless fundamentals change.
Oil continued lower with Brent crude down 5.7% last week, which also supported equities.
The rate hike in Australia was well anticipated and therefore had limited market impact.
Dovish RBA commentary helped support equities and led to a sell-off in the Australian dollar.
We have often referenced the importance of positioning both at a stock and market level. This has been recently demonstrated again.
Systematic strategies such as commodity trading advisor (CTA), risk parity and volatility-controlled funds are often the marginal dollar in the market.
Going into November they were very underweight US equities with CTAs at their lowest exposure since 2018.
This coincided with historically the most positive seasonal period of the year, encouraged by reduced tax loss selling and the resumption of buy-backs.
A reversal in bond yields provided the catalyst for systematic strategies to cover their position in equities. The rush to cover led to an initial sharp move which has subsided.
But the current equity exposure is still low and vulnerable to any squeeze into market, which is why it could be supportive.
From here, there are two disparate views on the medium-term outlook:
The bears expect material weakening or recession in the US in 2024.
This view points to the effects of monetary tightening lagging more than usual due to longer debt duration, though still flowing through.
Recent weakening in economic data and continued tightening in credit conditions are taken as early signs of this.
In this scenario unemployment might rise materially, affecting consumption.
This could result in rate cuts sooner than expected in response to economic weakness. Though lingering inflation concerns could still cause delays.
In this scenario we could see a fall in corporate earnings and a de-rating in equity markets.
The bulls believe the peak in tighter financial conditions has passed and presents a lighter headwind going forward.
In this scenario, core inflation has fallen more quickly than feared. Unemployment has stayed low and GDP growth resilient, reflecting a different kind of cycle tied to the distortions of the pandemic rather than a classic ‘overheating’ cycle which requires a recession.
This view sees the recovery in labour force participation enabling wages to ease off, consumption to remain supported and real disposable income growth improving.
Should inflation continue to fall, this could facilitate potential rate cuts, providing protection against a slowdown.
The global picture on current market valuations is mixed.
The US looks expensive at 18.5x 12-month forward price/earnings versus a 20-year median of just under 16x.
However this is distorted by mega-cap tech. Without these stocks, the market is at 16x, versus a median of around 15x.
Asia and Australia are around the 20-year median point while the UK and Europe are looking cheap by historical standards.
With almost 90 per cent of the US index having reported quarterly earnings, EPS growth is coming in at 4% year-on-year, versus 0% in Q2 2023. That reflects a stronger economy. (Ex-energy EPS is +10%.)
Despite this, expected earnings have fallen 4% for Q4 and 1% for the calendar year so far.
Q4 expectations indicate margins are set to fall, suggesting the market is reasonably cautious in terms of outlook.
There were four factors to take note of in the US last week:
Powell’s IMF speech struck a more hawkish tone than a week earlier. This was likely due to the risk of prompting too much optimism and becoming counter-productive. He said there was still a long way to go to get inflation sustainably down to 2%, while also noting previous “head fakes” on inflation.
Powell also toned down comments on the impact of improved supply chains versus. The benefits from supply might now wane, requiring tighter financial conditions to reduce inflation.
He also didn’t cite the impact of higher bond yields as a counter to recent strong growth, effectively recognising the rapid fall in bond yields has diminished this economic brake.
A lot of the bears focus on this Federal Reserve quarterly series. The latest survey reinforced the idea that conditions remain as restrictive as they were in the prior release — which usually signals slowing credit growth.
This is understandable given the cost of debt has risen close to 10 per cent for small-to-medium enterprises.
The US relies less on bank lending than any other economy given alternatives such credit and private credit. So it may not be as negative a signal as in previous years.
US consumer sentiment deteriorated for second consecutive month, according to the latest University of Michigan survey on inflation expectations.
Expectations one-year forward shifted from 4.2% to 4.4%, having risen from 3.2% in September’s survey.
Five-year forward expectations rose from 3% to 3.2% — a 12-month high.
While an important signal for the Fed, this series has some caveats given a smallish sample and the historic influence of energy prices.
That said, it reinforces the Fed’s need to strike a balanced line on policy messaging and ensure expectations remain anchored.
There was no major shift in this signal on US wages. The three-month moving average of median wage growth was at 5.2%, but it did validate a recent move lower.
This measure is typically about 1% ahead of other measures of wage growth, which suggests they may be in the low-4% to mid-3% range.
This is closer to being consistent with 2% inflation.
There was little newsworthy from China last week. But it’s worth noting some of the real-time trackers of the economy deteriorated again in October, reinforcing the need for ongoing stimulus.
Property is still not bouncing off depressed levels and confidence remains weak.
The Reserve Bank raised rates 25bp to 4.35% but softened its language regarding the need for further hikes — perhaps to dampen down reaction to the hike.
The RBA is effectively indicating it will not raise rates again unless the data demands it.
The RBA’s updated forecasts for inflation suggest why it remains more benign on the outlook for rates.
The actual rise in CPI forced it to raise forecasts. But it’s now expecting CPI to return to a previous forecast by mid-2024 — so it’s seen as six-to-12-month phenomenon.
A lower CPI forecast comes despite higher GDP growth, driven by stronger net exports and private and public investment.
Higher employment growth and lower unemployment is expected. But wage growth is anticipated to fall as higher award wages partly offset moderating wage growth in IT, professional services and construction.
The RBA therefore seems optimistic on inflation fixing itself, as has been the case in US.
The logic is that we may be just beginning to see the first signs of consumer slowing, while falling global inflation should also help.
The RBA’s six-month stability report and quarterly monetary statement highlighted the resilience of households and businesses.
Households have taken on extra work, reduced discretionary spend and drawn on savings. Businesses have been helped by large cash buffers.
Employment income growth has been strong, particularly at the lower-income levels, even as real base wages have declined. This reflects household ability to add extra sources of income.
For the lowest quintile of households by wage real (ie inflation-adjusted) employment income has grown more than 10 per cent.
Spending remains supported by savings buffers, which are only being run down slowly and still represent more than 15 per cent of household disposable income.
The RBA stability report noted some early signs of emerging financial stress. For example:
We are approaching the end of the fixed rate re-pricing peak, with two of the eight peak months left to go.
Mortgage principal plus interest payments is now reaching the threshold of percentage of disposable income that households have historically paid, when they were making voluntary payments over and above principal and interest.
This means mortgages are now starting to eat into disposable income.
Negative equity is not near to being an issue given the loan-to-value ratio distribution.
This shows that in the event of a 10% fall in house prices there would be almost no losses for the lender — even if a portion of borrowers could no longer service mortgages.
This all highlights that the economy, households and the financial system are under strain, but have so far absorbed the rise in interest rates and the headwind of tighter financial conditions.
These headwinds may begin to fade and we may see some support from higher real disposable incomes as inflation falls relative to wages.
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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