THE market seems increasingly convinced that inflation is last year’s problem and is falling faster than expected.
The focus has now shifted to the size of the economic downturn and the impact on earnings.
In that context, bad economic news now becomes bad for the market as it indicates a worse downturn. Good news, conversely, indicates less earnings risk.
Last week manufacturing sentiment indicators and retail sales flagged a weaker US economy, driving the market lower. However supportive comments from Fed officials boosted markets late in the week.
The S&P/ASX 300 ended up 1.7% for the week. The S&P 500 fell 0.7%, while US 10-year government bond yields dropped 19bps.
The market looks bound in a tight technical range for now.
Investor positioning has shifted away from a more defensive stance and is now more of a headwind. However the market’s breadth and resilience provide confidence that support levels will hold.
US quarterly earnings season have just kicked off. So far we do not have a strong signal either way.
Until we get more clarity on the economy, the S&P 500 is likely to stay range-bound between 3800 to 4000 with the flip-flop of sentiment set to continue.
In this environment stock specifics are set to become a greater focus locally and offshore.
Indicators such as the EVRISI employment costs and pricing power surveys continue to highlight that inflation is decelerating rapidly.
The question is whether inflation plateaus in the high 3% range and holds or continues to fall into the 2% range.
Friday’s market bounce came in response to a speech from US Federal Open Market Committee member Christopher Waller.
While considered a hawk on monetary policy, Waller said recent data was breaking more positively and the Fed might be less rigid regarding rate increases than the market feared.
Neither Waller nor Brainard tried to adjust market expectations for rates to stay below 5%.
This potentially means two more 25bp hikes, with rates peaking in March at 4.75 to 5%.
Waller said the Fed might stay higher for longer than market would like – to manage risk and avoid inflation picking up later in the year.
On the economic front a survey of economists reported an average 65% expectation of recession in the US in the next 12 months.
Manufacturing surveys, weak housing, softer retail sales, low savings rates and inverted yield curves all support the recession call.
The holdouts expecting no recession or a shallow downturn are quoting some combination of these reasons:
The bull-case scenario from here is that earnings-per-share (eps) for the S&P 500 holds at about US$220 and the market valuation multiple rises to 20x P/E as bond yields fall. This would equate to the S&P 500 index around 4400, or up roughly 10% from here.
The bear-case scenario is a drop in earnings of about 11% to around US$200 eps and a de-rating on uncertainty to 16x P/E. This could see the S&P 500 fall some 20% to 3200.
The US market multiple remains above its long-term average, in the 75th percentile. A weaker US dollar, a better outlook for Europe and Chinese re-opening should all be supportive for earnings.
We remain of the view that the market’s upside remains capped by earnings risk and Fed actions to contain financial easing.
However, the downside scenarios are looking more benign for now.
The US Treasury has technically hit a debt ceiling approved by Congress. But Treasury officials say they won’t run out of money until June at the earliest. There are lots of moving parts to this equation.
There will be no impact on bond issuance through to the end of February. From March, Treasury will start running down cash holdings, reducing bond issuance and the Fed’s liquidity.
This will reverse in April as tax receipts come in, then resume until all the cash is spent. The market is seeing late July/early August as the crunch time.
Some sort of last-minute compromise in Congress is the best-case scenario.
Some scheduled payments could be missed. This is likely to be social security obligations rather than bond coupons.
The risk here is that the market assumes a last-minute deal will be done – and doesn’t send a strong signal to Washington to solve the problem.
This could see a 2012-13-style scenario come July. However, it is not a major near-term market driver.
Some 10 per cent of the US market reported last week, with a skew to financials. Earnings continue to be revised down, with S&P 500 eps growth for the year now at -1% versus flat two weeks ago.
US banks had a good 2022, with return on tangible equity (ROTE) at 15% versus 11.5% the previous year.
This is the highest since the GFC and was driven by a roughly 20% increase in net income as margins rose and loans grew 10%.
So far credit losses are still only half 2019 levels.
The picture gets tougher as deposits fall and competition increases. This is reflected in the sector’s 16% fall last year.
The S&P/ASX 300 has returned almost 6% year-to-date, with good returns across most sectors.
Commodity prices remain supportive on the back of improved sentiment around China. Lower bond yields are helping REITS and growth sectors – notably healthcare.
A number of positive corporate updates last week reflect resilient earnings.
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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