THE S&P 500 gained 6.2% last week, recouping half of its year-to-date decline.
This was most likely a combination of:
The Australian market was less leveraged to this bounce, but still gained 3.3% (S&P/ASX 300). It is now down only 0.8% for the calendar year to date.
Bond markets were not as optimistic as yields continued to rise. US 10-year government bonds rose 16bps to 2.15% and the 10y–2y yield curve flattened further to 21bps.
We still see the recent bounce as a counter-trend rally.
Policy makers are treading a difficult path to resolve inflation without sending the economy into a downturn. This is driving uncertainty which we expect will weigh on markets in the near term.
This is exacerbated by the removal of liquidity.
In this vein, the Fed’s rate hike this week has not tightened the overall Goldman Sachs Financial Conditions Index, given the offsetting effect of stronger equity markets.
To put this in context, conditions have only tightened half as much as in the previous cycles of 2015 and 2018 — yet we are at a far looser starting point and inflation is a much bigger problem.
To resolve the inflation problem financial conditions need to tighten further, which is likely to act as a cap for the market.
The Fed raised rates 25bp last week as expected. It was an 8-1 vote with one dissenter wanting 50bp. The overall message was seen as hawkish, with strong rhetoric on inflation.
It is worth noting the signals from changes in the Fed’s median forecasts from the meeting:
Year-end inflation expectations have effectively risen 1.4% since December, yet expected rates are up only 1%. So real rates will still be -2.2% at year-end, versus an implied -1.8% in December 2021.
Chair Jerome Powell said the Fed would devise a plan for quantitative tightening at their next meeting (May 3-4), to be implemented shortly thereafter. They have previously signalled this will equate to a 25bp rise in rates.
It is also worth noting that the Fed’s balance sheet has continue to expand even in the last week, as Quantitative Easing has only just come to an end.
Powell’s messaging was hawkish and conveyed a resolve to beat inflation akin to Mario Draghi’s ‘whatever it takes’ speech.
He noted the Fed was “acutely aware of responsibility to bring inflation down” and that real rates could be marginally positive by the end of CY23.
This provided some reassurance to markets.
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Despite the Fed’s current view that rates will peak at 2.8%, the market is implying a 2.3% peak in 2023. This highlights how the market is still shaped by the post-GFC policy experience.
However there is an inconsistency in the Fed’s messaging. Its own forecasts indicate inflation will fall with no rise in unemployment (which remains at 3.5%).
The Fed does not see rates needing to rise above 3% this cycle — ie no need to go above “neutral”. This is despite inflation running far hotter and labour markets tighter than in previous hiking cycles.
To reconcile this inconsistency we need to believe the supply side resolves the problem and dampens inflation and that the corporate sector will be able to resist efforts by labour to recoup the erosion of real wages.
The equity market appears to believe this — as reflected in its bounce.
In our view the Fed really has no idea what rates will need to rise to.
The current plan is to get back to neutral — just more quickly than previously expected. At that point the Fed will have a better idea of how sensitive the economy is to rising rates.
There is a wide range of potential outcomes.
There were nine hikes in the 2015-2018 cycle and 17 between 2004-2006.
We can gain a different perspective on US rates through application of the Taylor rule. This looks at the GDP deflator and slack in the economy to assess where interest rates should be.
Even adjusting for one-off factors driving inflation the implied interest rate is 5%. This is effectively double where the market expects rates to peak.
There are many reasons why this may not play out. But it highlights potential uncertainty on the path for rates in this environment.
The Bank of England also raised rates last week. But it sent a far more dovish signal, indicating the economy will not be able to absorb the number of rate increases currently priced in.
The only way rates will rise that much is if we see a substantial fiscal stimulus in the upcoming budget.
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European Central Bank president Christine Lagarde changed the previous week’s more hawkish message. There is now greater emphasis on watching the economy data before acting.
The market is ascribing a 50% chance of recession in Europe by the end of the year, reflecting the already slowing data.
Chinese equities were extraordinarily volatile last week — technology particularly so. This is worth watching since it’s been a lead for the rest of the tech sector.
Chinese tech had fallen 80% from its peak — akin to the NASDAQ bust of the early 2000s.
The sector fell almost 30% in the previous week before bouncing 50% last week and gaining about 30% in a day.
The catalyst was a statement from the head of the Financial Stability Committee which addressed five of the key issues weighing on the market.
In nutshell it emphasised:
Concerns over Covid diminished somewhat as case numbers appeared to be brought under control.
We saw substantial volatility in commodity prices last week. Oil dropped from US$113 a barrel to US$98 before rebounding to US$108.
Price volatility is being driven primarily by:
Volatility will continue to be high, but we expect prices to trend higher again due to the low level of spare inventory, the ongoing threat of further sanctions and the risk of an unexpected act threatening supply.
The data remains supportive, but it’s worth watching some softening (from a high base) in the trucking survey which is a decent lead indicator. There is also a slowdown in sales from European-facing companies.
Housing signals remain positive. Prices are up 15% year-on-year. The supply of houses on market remains at historical lows — and well below the levels seen running into the GFC.
There are also positive signals from US airline carriers. Air traffic is rising above previous expectations, though the market remains wary of the effect of oil prices.
While equity markets have bounced, we have doubts this can be sustained for the reasons above.
In our view the bounce lacks the conviction seen in March 2020 and Dec 2018, suggesting markets may still fall back.
From a technical perspective the breadth of the market rebound was reasonable, but not compelling. Also, the put/call ratio in option markets, as an indicator of fear, never rose to extreme levels.
Markets are running into technical resistance levels. This will be another thing to watch.
The Australian market was driven by technology, financials and healthcare last week. The headline return was decent given the decline in the resource sector and energy being flat for the week.
Rising yields and fewer concerns on some form of global financial shock helped the financials. Stock moves were mainly driven by a reversal — ie the names that had performed the worst bounced back the most.
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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