EQUITY markets continue to bounce despite increasingly hawkish rhetoric from the Fed.
The S&P/ASX 300 gained 1.6% last week and is now up 0.8% for the 2022. The S&P 500 gained another 1.8% to be down 4.3% for the year. The NASDAQ is still down 9.3% in 2022 after gaining 2% last week.
It’s remarkable that this takes place against a sharp increase in two-year US bond yields, a surging oil price and a US dollar grinding higher.
These factors are usually headwinds for equity markets, as seen in late 2018.
There are several potential reasons for the ongoing recovery in equities. These include:
We remain wary in the near term. The Fed needs financial conditions to tighten – and rising equities works against this objective.
We see three potential scenarios that are more likely than a continued strong equity market rebound:
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Powell last week noted the need to move “expeditiously” back to a neutral rate setting.
This kind of language is usually a signal. It’s widely interpreted as an increased chance of a 50bps move in rates in May and possibly in June.
Powell also reiterated that the Fed would need to go above the neutral rate, which is currently estimated at 2.5%.
This is all about getting to the neutral rate as quickly as possible, since anything below that is still stimulatory. The challenge is doing so without prompting a financial shock.
As discussed last week, this rally in equities and credit is loosening the overall Financial Conditions Index. By some measures, it has unwound a third of the recent tightening. The Fed will need to engineer more tightening to achieve its goals.
The market is moving to a view that the Fed is worried real rates run the risk of being too low through 2022 — and therefore the best way to avoid a recession is faster near-term rate increases plus early quantitative tightening.
There are small positive signs that freight rates may be easing at the margin. A slowing economy will help this process.
This is countered by continued pressure in commodity markets.
The focus is shifting to food inflation, where we see:
The UN Food and Agriculture Organisation’s Food Price index has hit all-time highs, eclipsing the previous highs which played a role in the Arab Spring. This is before many of the effects of the Ukraine conflict have flowed through.
The European economy continues to weaken based on sharp falls in a number of sentiment indicators.
For example, the German IFO Business survey of future business conditions reported its biggest ever single-month decline.
Sentiment indicators are not far off what was seen at the onset of the Covid pandemic.
We are now seeing some fiscal policy response, predominantly in the form of fuel subsidies. The latter may be more effective politically than economically, given they underpin demand in a supply constrained environment.
Despite fiscal moves the chance of recession in Europe is still priced at greater than 50%.
There is speculation the federal budget will include a temporary reduction in the fuel excise (currently 44.2c per litre). A 5c cut for six months would cost about $1 billion.
Infrastructure spending of up to $18 billion is expected. But it’s hard to see this flowing through quickly due to difficulties in executing projects and the tight labour market.
More broadly we reiterate our view that Australia is better placed than many other countries.
There is less need to raise rates, allowing them to remain lower for longer.
The economy is benefiting from pent-up demand as restrictions roll back. Australia is largely self-sufficient in key commodities and is a beneficiary of rising prices here.
This underpins our relatively positive view of the domestic equity market.
This is reinforced by the degree to which the Australian market has underperformed the S&P 500 since the GFC.
While recent outperformance has been material, it is a blip on a longer-term view. This gives us confidence in the potential for further outperformance.
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A continued rise in 10-year US government bond yields (up 33bps last week to 2.48%) has taken them back to the top end of a 30-year downward trend.
The consensus is bearish — with a view that yields rise to 3%.
Sharp moves such as last week’s are often followed by a period of retracement, so we wouldn’t be surprised if there was some relief in the near term.
The rise in 10-year yields signals that the US market is still not of the view that we are entering a downturn. This may explain why equities have been able to rally through this increase.
It is worth highlighting how rate-sensitive sectors have been affected in the US.
Homebuilders continue to fall on expectations of a housing downturn, as have consumer discretionary companies seen as tied to housing, such as Home Depot. We have not really seen the equivalent of this in the Australian market.
Australian equities continued to grind higher last week.
Resources (+6.3%) and Energy (+5.3%) recovered from the prior week’s fall. Technology (+3%) began to bounce, but remains the weakest sector over 2022 to-date, down 15.5%.
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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