ALTHOUGH the ASX is touching new highs, equity markets continue to grapple with a slowdown in economic growth and potential implications of the Delta variant.
The sell-off on July 19 reversed late last week as US earnings continued to show strength and M&A activity supported the local market. The S&P/ASX 300 rose 0.6% last week and the S&P 500 was up 2%.
Despite growing uncertainty, the underlying foundations of fiscal stimulus and abundant liquidity continue to win out.
British data continues to show a disconnection between the rise in new Delta-strain Covid cases and the resulting rate of hospitalisations.
Initial signs of a decline in new UK cases provide grounds for optimism, though new cases are expected to pick up as restrictions are removed.
There are also signs of stabilisation in new cases elsewhere — including Spain, Malta and Indonesia which have all experienced a surge in Delta infections.
On the negative side, it is becoming apparent that even well-vaccinated countries will experience a Delta-driven wave.
In the US we are not seeing a disconnection to the same extent as the UK. New cases are up 56% week-on-week and hospitalisations have risen 36%. This may reflect lower testing rates and a higher proportion of unvaccinated people. Data shows that fewer than 3% of hospital admissions are vaccinated.
The big issues are Delta’s effect on government policy, the potential for on-going restrictions and the need for booster doses. The reality is that we don’t have answers at the moment.
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We are seeing increased hospitalisations in Israel – albeit off a low base and well below the previous wave.
The sample size is small and there are complexities related to age, but this may suggest vaccines become less effective in terms of infection and hospitalisation over time. This could mean some restrictions will remain in place even after countries move to re-open.
The issue of “breakthrough” infections in people who have been vaccinated poses a difficult issue for Australia, given low political tolerance for any degree of community infection.
The concept of herd immunity is getting difficult to pursue and may require some pivot in approach. There remains potential for policy confusion and further delays in re-opening of borders.
In Australia the news has been mixed. There are signs that Victoria will be able to re-open to a degree, while Sydney is facing an extended lockdown.
The market is focused on economic implications. We may see the RBA signal an extension of tapering given the change in economic momentum. There will be a lot of focus on potential for government stimulus.
Some indicators suggest the second derivative of growth – the rate at which it is growing – has ticked over. This is unsurprising: the speed of economic recovery could not be maintained.
Nevertheless, this is some causing some concern in markets, particularly in combination with the Delta strain.
History suggests that when the second derivative of growth turns, this marks the beginning of a phase where disappointments are more likely and earnings revisions are negative.
But the unique nature of this cycle may offer a counter-argument.
Normally slowing economic momentum is a function of some form of policy action. For example in 2018 Fed tightening clearly prompted the slowdown. This time slowing momentum is a function of the unprecedented growth rate triggered by the Q1 US stimulus.
The bullish case for cyclical stocks says there is currently no policy tightening; no prospect of rates rising; and tapering is increasingly likely to be pushed into 2022.
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The bear case says the Fed will face a quandary with slowing economic momentum yet high inflation — and may end up tapering into a weaker economy.
We tend towards the bull case at this point. Slowing economic momentum would likely ease inflationary pressures as well. All the evidence of the past 18 months suggests governments are pro-growth and will react with more policy stimulus.
Clarity on this issue is unlikely before Q4 2021. By then we’ll have seen the end of the US summer break and unemployment insurance payments trailing off. At this point we’ll potentially see job growth reaccelerating.
Until then, we could see the current rotation to more defensive, quality, bond-sensitive stocks persist.
Equity markets continue to rise despite concerns over Delta and the slowing pace of growth, although breadth has narrowed.
Liquidity and low rates continue to act as backstops. The combined balance sheet of the Fed and European Central Bank continues to expand at more than US$100 billion a week.
US earnings season is good so far. Earnings revisions have the potential to shift the S&P 500 price/earnings ratio from 22x to 20x. The next two weeks will be important to watch in this regard.
Australia’s upcoming earnings reason will not be as buoyant as the US and guidance will be subdued. But the prospect of a weaker Australian dollar, delayed monetary tightening and potential for fiscal stimulus should continue to support the market.
Last week rotation continued into defensives and quality. Health care (+4.6%) led alongside Consumer Staples (+2.1%). Energy (-1.8%) and Materials (-1.1%) underperformed.
Altium (ALU, -9.4%) was the weakest on the ASX 100. Management rejected a takeover offer from US company Autodesk, which then withdrew the bid.
Gold miners underperformed despite the market’s more defensive bent, as the gold price came off 0.7%. There was some news flow in the sector. Evolution (EVN, -9.4%) was weaker on a quarterly update that signalled lower production and higher capex in the near term as they accelerate longer-term project development.
The stock fell, but rebounded as management raised capital to buy an asset from Northern Star (NST, -6.0%) which will help increase utilisation and extend the life of its Mungari mill in Western Australia. The deal makes sound strategic sense, though the timing of the capital raise could have been better.
Crown (CWN, -8.4%) continued to wallow in the wake of the Victorian Royal Commission. Last week Star (-1.4%) withdrew its offer for CWN. There is still logic to a merger, but the three-month wait until the Commission’s outcome makes it hard to value the company.
Santos (STO, -6.1%) proposed a merger with Oil Search (OSH, +3.1%) which also makes strategic sense, given the impact that ESG is having on capital available in the sector. A merger would address a number of issues depressing OSH’s valuation rating and would offer cost synergies. The implied 10% premium proposed by STO may not be enough for OSH shareholders at this point.
BHP (BHP, -1.2%) delivered a decent quarterly production update, in contrast to Rio Tinto (RIO, -2.7%) where operating issues remain. There was speculation that BHP would combine some or all of its Australian oil and gas business with Woodside (WPL, -1.9%) in some form. This is complex given the difficulty of estimating reserves and arriving at a valuation in areas such as Bass Strait.
Health care stocks benefited from the rotation to quality and defensives. Fisher and Paykel Healthcare (FPH, +7.6%) did best.
CSL (CSL, +5.7%) was among the strongest ASX 100 stocks last week. It has lagged for some time over concerns around plasma collection in the US. The outlook here is improving.
Retailers were strong with Wesfarmers (WES) up 4.8% and JB Hi-Fi (JBH, +4.6%). JBH provided positive guidance, but we are cautious. Unlike previous lockdowns there is not the same support for retail spending.
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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