WE continue to face the combined challenges of geopolitical risk, Covid, inflation and rising rates.
This is creating an intractable policy dilemma — the need to raise rates at a time when risk premiums are elevated, coupled with the risk that a commodity shock will lead to an economic downturn.
We didn’t see any sign of this dilemma easing last week.
The conflict in Ukraine intensified, US inflation data was no softer than expected, the Fed’s tightening bias persisted, the ECB was more hawkish than expected and China was facing another Covid outbreak, potentially causing disruptions to growth and supply chains.
As a result equity markets were mixed. The S&P500 fell 1.6% and the S&P/ASX 300 was down 0.4%. European equities bounced 3.7% (Eurostoxx 50) after previous sharp falls.
The market is struggling to build on any bounce despite the S&P 500 being off 12.4% from its early-January peak.
Our key observations are:
Oil and wheat prices peaked early last week and then fell back, despite growing signs of self-sanctioning.
One key debate is whether Russian oil will be locked out of global markets or find its way in via alternative channels.
At this point there is an expectation that some of that oil will find a home. But this will extend trade routes and it’s unlikely all will be placed.
At this point there are about 2.5 million fewer barrels per day (bpd) in global markets, compared to before the invasion. There are a number of potential sources of new supply to replace this:
There is also a persistent risk that Russia may itself disrupt supply, given its importance as a bargaining tool.
Pendal Focus Australian Share Fund
Now rated at the highest level by Lonsec, Morningstar and Zenith
The US is working with the likes of Saudi, Venezuela and Iran to bring other barrels back into the market to alleviate inflations.
Any success there will mitigate some of the pricing pressure. But we suspect we will be looking at US$100+ oil for at least a few months.
The market is starting to factor in the risk to economic growth. For example, Goldman Sachs cut its expected US GDP growth in Q2 2022 from 2% to 1.75% compared to Q4 2021.
This is driven by the impact on income and spending as a result of higher food and fuel prices.
Financial conditions continue to tighten as the US dollar and bond yields rise and equities fall. This adds to the headwind to growth in Q2 onwards by 0.3-0.4% of US GDP
We do not believe this will translate into a recession due to:
In combination this should enable growth to continue, providing earnings support for the market in time.
The good news is that the US CPI data was in line with expectations for the first time in eight months, rising 0.8% month-on-month and 7.9% year-on-year in February.
The not-so-good news is it’s the highest rate in 40 years.
Digging into the numbers we see food, energy and auto are driving almost two-thirds of the year-on-year figure.
These should unwind over time. But there is also a broadening of the number of components where prices are rising.
Fund Manager of the Year
For example, the proportion of CPI components with deflation has fallen from more than 25% at the start of 2021, to about 5% today. This breadth issue is a concern for policy makers.
Rent is one component seeing a strong rise. This is likely to continue, slowing the normalisation of overall inflation.
We had been seeing shipping freight rates start to fall as supply chain issues improved. However this has stalled as shipping needs to be re-routed as a result of the sanctions on Russia and growing Covid issues in China.
On wages, the Atlanta wage tracker rose from 5.1% to 5.8% annual wages growth, countering the more positive signal that came with last week’s household employment survey
So the challenge for the Fed is that a number of key drivers of future inflation are signalling that the problem is not resolving itself.
This explains its hawkish stance, despite the wider geopolitical concerns.
The European Central Bank signalled that rate rises could come sooner than the market is currently pricing – potentially as early as July, though September is looking more likely.
The key point is they are signalling a greater preparedness to tolerate weaker growth to fight inflation.
If there is a risk of stagflation it is centred on Europe, given its greater sensitivity to energy prices and higher exposure to Ukraine and Russia.
There is talk now of a fiscal policy response to this threat, which could allow monetary policy to focus on inflation.
We are watching two issues here.
First, an emerging new variant looks to blend some characteristics of Delta and Omicron. At this point it’s not expected to be any more transmissible that Omicron, so may not supersede the latter’s dominance.
Second, we are watching rising cases in China – particularly in north-east provinces – and a potential headwind for economy activity.
We saw a snap-back in European equities — the German index made its seventh-biggest single-day jump.
But history indicates such volatility is more often than not seen in a downward trend.
From a technical perspective we still haven’t seen enough breadth of selling to indicate a low has been reached.
Bonds sold off despite concerns over growth — a very different reaction to what we have been used to in recent years.
The number of rate increases priced in by the market have marginally increased for the US, so the need to fight inflation is seen to take precedence over growth concerns.
Bonds remains a good signal on what’s happening in the economy.
History indicates 10-year yields peak towards the middle or end of a rate cycle — rather than near the start. This suggests further to go on bond yields. If this is not the case it would indicate more economic risk in US.
The other signal to watch is 2-year yields, which have not yet peaked. A peak in 2-year yields is a reasonable proxy for potential recession risk.
There is also a debate around whether commodities are peaking in terms of relative performance. While they have run hard, the relative move has been minor compared to past commodity cycles in the early 2000s or 1970s.
These moves can be sustained over longer periods than we have seen so far.
The final signal worth noting is a continued decline in the Chinese tech index.
This was the first part of the growth universe to roll over in February 2021 and is now down 75% from its high. Recent pressure relates to the risk of forced de-listings from the US.
It suggests the more speculative end of the growth cohort is still yet to find a bottom.
In Australia it was a pretty quiet week overall. Resources corrected from their recent run, while rising bond yields saw a rally in banks. Elsewhere the defensive rotation continued, with technology down and consumer staples up.
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.
This information has been prepared by Pendal Fund Services Limited (PFSL) ABN 13 161 249 332, AFSL No 431426 and is current as at March 14, 2022.
PFSL is the responsible entity and issuer of units in the Pendal Focus Australian Share Fund (Fund) ARSN: 113 232 812. A product disclosure statement (PDS) is available for the Fund and can be obtained by calling 1300 346 821 or visiting www.pendalgroup.com. The Target Market Determination (TMD) for the Fund is available at www.pendalgroup.com/ddo. You should obtain and consider the PDS and the TMD before deciding whether to acquire, continue to hold or dispose of units in the Fund.
An investment in the Fund or any of the funds referred to in this web page is subject to investment risk, including possible delays in repayment of withdrawal proceeds and loss of income and principal invested.
This information is for general purposes only, should not be considered as a comprehensive statement on any matter and should not be relied upon as such. It has been prepared without taking into account any recipient’s personal objectives, financial situation or needs. Because of this, recipients should, before acting on this information, consider its appropriateness having regard to their individual objectives, financial situation and needs. This information is not to be regarded as a securities recommendation.
The information may contain material provided by third parties, is given in good faith and has been derived from sources believed to be accurate as at its issue date. While such material is published with necessary permission, and while all reasonable care has been taken to ensure that the information is complete and correct, to the maximum extent permitted by law neither PFSL nor any company in the Pendal group accepts any responsibility or liability for the accuracy or completeness of this information.
Performance figures are calculated in accordance with the Financial Services Council (FSC) standards. Performance data (post-fee) assumes reinvestment of distributions and is calculated using exit prices, net of management costs. Performance data (pre-fee) is calculated by adding back management costs to the post-fee performance. Past performance is not a reliable indicator of future performance.
Any projections are predictive only and should not be relied upon when making an investment decision or recommendation. Whilst we have used every effort to ensure that the assumptions on which the projections are based are reasonable, the projections may be based on incorrect assumptions or may not take into account known or unknown risks and uncertainties. The actual results may differ materially from these projections.
For more information, please call Customer Relations on 1300 346 821 8am to 6pm (Sydney time) or visit our website www.pendalgroup.com