JULY’S more positive tone was tested last week by a combination of:
The first two points saw bond yields gain 34bp at the short end and 18bp for 10-year Treasuries. The yield curve is now more negative than it was in 2007 and the US dollar has started rallying again.
Despite this, equities ground out small gains, led again by growth stocks.
The S&P 500 rose 0.4% and S&P/ASX 300 gained 1.1%.
This resilience is surprising. We suspect it has as much to do with the market’s previous negative positioning and sentiment as any fundamentals.
The recovery has prompted some breaks in the previous bearish consensus.
We have seen a highly rated US technical analyst turn positive on the premise that the oil price and bond yields have peaked.
Energy is critical to the outlook.
A bounce-back in the oil price would kick-start stagflation concerns; a continued fall would help drive bond yields lower.
Locally, the focus will shift to stock specifics as reporting season kicks off this week.
US payroll data and household survey came in well ahead of expectations.
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This suggests the job market remains strong despite weakening lead indicators, a technical “recession” signal and headlines about tech companies laying off workers:
There are early signs that the ratio of job openings to the number of unemployed is rolling over. But we have a long way to go to normalise and reduce pressure on wages.
These are all co-incident or lagging indicators.
It’s highly likely a weakening economy will start to flow into jobs in the next few months.
But the starting point is higher and the amount of slack needed is rising. This makes the Fed’s job harder.
Some outer members of the Fed worked this week to rectify the interpretation of Powell’s press conference, re-iterating the priority of fighting inflation.
Combined with the employment data this moved the short end of the yield curve in particular.
The market is back to pricing an implied 67bp rate hike for September.
The Fed’s initial plan is to slow growth below trend — which should loosen the job market, leading to lower wage growth and inflation.
It’s important to remember that equity markets form part of the overall total financial conditions index, which has an impact on the pace of economic growth.
The Fed had shifted this sufficiently to be consistent with 1% GDP growth — in line with the aim of a soft landing.
However the reaction to Powell’s press conference last week meant total financial conditions were beginning to ease.
The Fed needed to check that move to keep conditions conducive to below-trend growth.
This US$430 billion bill — intended to fight climate change, lower drug prices and raise some corporate taxes — has been further amended and is now highly likely to be passed in next few weeks.
The most relevant component is an emphasis on clean-energy investments, including increased subsidies for electric vehicles.
This is tied to requirements that companies source components from countries with free-trade agreements with the US, to prevent reliance on China. This should be a boon for the Korean battery industry.
It remains to be seen whether the capacity to deliver this exists. But for the moment sentiment towards electric vehicles and battery materials has improved.
The UK highlights the policy conundrum that emerges as stagflation takes hold.
The Bank of England now predicts five quarters of recession with inflation peaking above 13% this year and remaining above 9% next year.
The need to quash inflation takes precedence, so the BOE raised rates 50bps despite predicting recession.
The UK is facing a crisis in power prices, which is not the case in the US or Australia.
This is a reminder that energy prices are a critical factor in determining where all markets go.
Markets remained relatively sanguine around the tensions attached to Speaker Nancy Pelosi’s visit to Taiwan.
The view among most geopolitical experts is that Beijing is not confident in the success of any invasion and will not yet start to impose a blockade — the likely first step.
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That said, there is a widespread view among western military experts that neither Taiwan nor the US is sufficiently prepared for any cross-Strait attack.
This is quite different to the preparation that had been happening in Ukraine for the past few years.
Pelosi’s visit and the Chinese reaction may be a catalyst for action to rectify this — which may also trigger Beijing to act before those preparations are in place.
This remains the single biggest long-term geopolitical risk for markets.
The big debate is whether the market’s rebound is a bear market rally or whether we have put in the lows for this cycle.
At this point the rebound is almost bang on the average bear market rally (in terms of rebound and length) in the S&P 500 since 1950.
The market breadth of the rally is not yet consistent with a change in trend.
The rule of thumb is you need to see 90% of stocks above the 50-day moving average to signal a change in market direction. We are at 73%. However this could continue to climb.
The yield curve is also sending a negative signal.
Its inversion is signalling recession, which would lead to a decline in earnings and pull the markets lower.
The challenge to this perspective is the unusual speed and scale of the increases and the market’s current confidence that inflation will be brought back down, which is reflected in long bond yields.
The bull case for equity markets is:
The importance of oil
The positive case is underpinned by the view that oil prices won’t bounce back.
We see this as a potential negative surprise for markets. There are several reasons why oil could behave differently in this cycle:
This may not play out for a few more months, given US SPR is still being released, China is set to run with zero covid for another few months and the global economy is slowing.
For time being the weaker oil/lower bond signal could remain in place, but it is something to watch.
The S&P/ASX 300 is now down only 4.1% in 2022. This followed a US rotation to tech, away from energy last week.
Defensive sectors such as staples continue to perform as cash is put into market reluctantly.
We continue to see a bounce-back in small-cap performance which appears correlated to market direction.
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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