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Crispin Murray: What’s driving Aussie equities this week

Here are the main factors driving the ASX this week according to our head of equities Crispin Murray. Reported by portfolio specialist Chris Adams.

A LOW point in the VIX volatility index last week proved to be the signal for a correction in the recent rally.

There was no specific macro news to prompt this. The weight of buying faded and the market shifted to a cautious position ahead of this week’s Fed meeting.

US ten-year government bond yields rose 9bps and the S&P 500 fell 3.4%.

Brent crude oil fell 11.1% and is now down for the year to date, as the market worries about a downturn in demand.

China’s re-opening appears to be happening faster than expected.

The iron ore price rose 9.6% as a result, and is helping underpin the Australian equity market. The S&P/ASX 300 was down 1% for the week. It has outperformed the S&P 500 by about 17% in 2022.

The RBA hiked rates 25bps, as expected, and struck a more cautious tone on inflation.

We also saw the federal government launch a new energy policy which at first glance looks under-prepared. The policy introduces price controls that would likely make the power problem worse in the future.

There are six big macro issues going into next year:

  1. The persistence of inflation — and how tight financial conditions will need to be in response
  2. The scale of economic slowdown in the US and developed markets. (Real-time signals are benign, but the yield curve is a very negative signal)
  3. The earnings leverage to that downturn — and whether nominal growth buffers earnings
  4. Whether markets have already priced in economic downturn. The bear view is that markets bottom during recession, not before. Bulls point to a falling oil price, a weaker US dollar and lower bond yields as evidence of lessening headwinds for equities  
  5. What China’s economy does as it exits zero covid
  6. Whether the RBA can engineer a soft landing in Australia
US inflation outlook

Inflation signals were marginally negative last week.

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After average hourly earnings surprised on upside — which market founds reasons to dismiss — the Atlanta Fed wage tracker indicated wage growth was staying elevated at 6.5%. (Though the series is believed to overstate by around 1%, relating to career progression effects.)

When measured against the Employment Cost Index, this suggests limited relief on the wage front.

The Producer Purchasing Index was also higher than expected, rising 0.3% month-on-month and 7.4% year-on-year, versus 8.1% in October. Core PPI was +0.3% and 4.9% year-on-year. The trend is still lower.

There is a view that if you hold good inflation flat and factor in the real-time rent inflation number (which is now close to zero), you can make a case for inflation tracking to 3.2%.

The question is whether this is sufficient for the Fed.

Since this number may still drag inflation expectations up, it may be seen as still too high, requiring a weaker economy and tighter monetary policy to bring it below 3%.

The Fed and the economy

The Fed meets this week, with the market clearly primed for a 50bp hike in rates.

There will be a few key issues to watch:

  • Whether the Fed signals any further slowing in the trajectory for rates at the next meeting. (This is unlikely given it’s not until the end of January)
  • Where the dot plots have moved to in terms of peak rates and duration
  • Any messaging on the long-term real rate assumption. (Again, we think this unlikely)
  • The tone of the Fed press conference, given Powell’s recent shift from a hawkish to a more benign stance.

The market is now expecting the Fed rate to reduce relatively soon after hitting its peak.

Total financial conditions — a measure of changes in key indicators such as mortgage rates, credit spreads, equity markets and currency moves — have eased considerably since October.

This has reduced the risk of the Fed over-tightening. But it may also result in the Fed thinking they need to do more.

One thing to note is that real US money supply (M2) has plunged from more than 20% a year ago to -7.2% in December. This is its lowest point in more than 50 years.

This is prompting a view in some quarters that policy is already more than tight enough.

The US yield curve is more inverted than at any point in 40 years, providing further fuel for the bears

Job openings are coming down — indicating a cooling labour market — but there remains a fair way to go.

Elsewhere, developed-market ISM manufacturing indices are deteriorating and moving into contractionary territory. This indicates a slowing global economy.

China

Beijing continues to move faster than expected on re-opening, with zero covid effectively dead as a policy from December 7.

The retreat from PCR testing means we won’t see a headline surge in case numbers. The issue will be hidden until it is potentially evident through pressure on the hospital system.

This suggests we are tending towards the “quicker re-opening” or “chaotic re-opening” scenarios.

This may not be good for the economy in the near term if it leads to absenteeism and possible supply disruptions,

Oil

The oil market continues to weaken despite crude inventories continuing to fall.

Inventories of diesel and petrol products built meaningfully last week. Some saw this as a sign that end demand is falling in the US. But it may just reflect a seasonally stronger production period for refineries.

One concern for the oil market is that the time spreads for oil futures in the front months have moved into “contango” (an upward sloping curve, indicating futures contracts are trading at a premium to the spot price). This means trading oil becomes harder and less profitable, which reduces demand.

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It may also signal weakness in the physical market, indicating softer demand.

We suspect oil will continue to be under pressure in the near term.

But the fundamentals relating to supply should underpin the medium-term outlook — as will demand recovery from China and when the market begins to look through any downturn in developed markets. 

Australia’s power intervention

There appears to be two elements to the Albanese government’s new energy policy.

The first is a near-term, stop-gap solution to try to get electricity prices lower. The second is draft legislation providing new powers for regulators and governments in the electricity and gas industry.

The near-term measures involve the government putting in a $12/GJ cap on uncontracted gas. It is unclear whether this is well-head or end-market including transport. There is also a A$125/ T cap on thermal coal, both contracted and uncontracted.

This means coal-fired power generation would break even at $60-65/MWH and gas power at $70/MWH.

The government is also committing to no coal or gas in the “capacity mechanism” — the structure that pays providers to have plants available to produce power when required.

The resulting lack of “firming capacity” — flexible supply to be called on when renewables are not functioning — would almost certainly lead to power cuts in the future.

In an effort to push it through before Christmas, the draft legislation is subject to only three days of consultation.

It involves a long-term price regime where gas is treated as a regulated utility.

Providers would be allowed an undefined “reasonable” price, based off an assessment of a fair return on the investment made.

The major flaw in this approach is that developing gas has a very different risk profile than traditional utility investment. The cost of developing gas projects can be a lot higher than planned. There are substantial operating risks and long-term pay-backs.

This means uncertainty around the pricing environment is likely to deter further investment in gas production and LNG import terminals, leaving Australia strategically short in gas.

The government is indicating it will introduce powers compelling companies to develop gas — effectively forcing private capital to invest against its will.

Unless changed, this demanding proposition could evolve into a battle like that over the mining tax under the Rudd government a decade ago.

From a stock point of view this may jeopardise the takeover offer for Origin (ORG).

It will also put pressure on AGL’s earnings, hampering its investment in the clean-energy transition. 

Markets

Resource stocks continued to outperform on the China re-opening theme. Fortescue Metals (FMG, +8.7%) was the best performer in the ASX 100 last week.

All other sectors lost ground and there was a clear defensive tilt. Tech and energy were the worst-performers sectors.


About Crispin Murray and Pendal Focus Australian Share Fund

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  

Contact a Pendal key account manager


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