The recent recovery in equity markets looks to be ending as the S&P 500 fell -1.2% and the NASDAQ -3.9% last week.
Australia remains more defensive in this environment, falling just 0.3% for the week. More hawkish comments from the Fed prompted the fall.
It signalled a 50bps hike in rates for May, absent any major new shock. It also reinforced the message that quantitative tightening is on its way. While this was known, it triggered a further sell off in long-dated bonds.
US 10-year Treasury yields rose 32bps for the week. It also took the yield curve back into positive territory.
This reinforces the key message that the Fed needs overall financial conditions to tighten sufficiently to cool wage inflation.
Surging equity markets loosen overall conditions, and the Fed is likely to try and prevent this.
China is also weighing on market sentiment. The situation in Shanghai appears to be deteriorating, with lockdowns potentially remaining in place into May.
This puts growth at risk but, unlike the US, Beijing’s desire to achieve its growth target is likely to see policy stimulus to mitigate the effect of lockdowns. This would be supportive of commodities.
The Fed remains focused on tightening financial conditions, as it tries to slow the economy enough to choke off wage inflation. The trick will be to do this without triggering a recession.
To this end, both Fed minutes and comments from Board member, Lael Brainard, last week suggested that quantitative tightening may proceed at a faster pace than expected. As well as implying greater risk to the upside for inflation.
Federal Open Market Committee (FOMC) minutes flagged a plan to shrink the balance sheet at a run rate of ~US$95bn per month, from May. This would comprise US$60bn in Treasuries and US$35bn in mortgage-backed securities.
This would enable them to reduce the balance sheet from US$9tr to US$6tr over 3 years. The technical aspect of how they would accomplish this was slightly more hawkish than the market expected.
The Fed also reiterated talk of moving ‘expeditiously’ towards neutral. This raised expectations of back-to-back 50bp hikes in rates.
These factors triggered the sell-off in bonds and led to slight steepening in the yield curve.
US 10-year Treasury yields are very close to a multi-decade trend line. This is being seen by some as the potential catalyst for a rally on bonds, as we saw for equities in May. Others see the potential for bonds to break the trend line, which could trigger a sell-off in equities and underperformance from growth stocks.
Any sustained rally in bonds would be contrary to the Fed’s goal of tighter monetary conditions.
We have also seen credit spreads tighten as fears around the US economy have eased. Hence the Fed remains hawkish on inflation and the need to tighten.
Former Fed official, Bill Dudley, noted in a Washington Post article that the Fed will only be able to achieve its inflation goals without increasing rates past 2.5% if;
His key point is that the Fed needs tighter financial conditions if their plan is to work. This requires bond yields to move higher or equities to be flat to lower.
We are at an interesting juncture. Lagging indicators such as labour remains very strong, and wages are also continuing to slowly climb, with the latest Atlanta Fed wage tracker data coming in at 6.0 vs 5.8% quarterly wage growth.
Q1 GDP growth will slow down dramatically, with estimates down 1%.
Much of this reflects a reversal in the inventory build that drove Q4 growth, however some lead indicators of growth are signalling slowing momentum.
Consumer spending remains critical to the growth outlook. Anecdotally, consumption remains resilient, despite the increase in mortgage rates and inflation.
The US consumer is helped by having record net worth and a strong balance sheet, with US$3.9tr in savings and wages growing strongly in nominal terms.
In addition, the rotation from goods to services is becoming more evident.
Trucking appears to be showing signs of slowing, which is typically a good lead on consumption, however airline sales are strong.
There are some signs of easing inflationary pressures. For example, the backlog of container ships is falling rapidly. So too are the pricing rates for freight.
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Shanghai’s streets are deserted, while attendance at the Melbourne Grand Prix was 420,000 over the four days.
This demonstrates how quickly things can change in the space of just a few months in the Covid era.
Official statistics suggest that the number of districts classed at “high risk” of Covid started declining last week. The share of nationwide GDP at risk also dropped from over 30% to under 20%.
However, there is more anecdotal evidence that the trends are not improving.
The situation in Shanghai has deteriorated. There are reports of food shortages as lockdowns and a reluctance to deliver to Shanghai is constraining supplies and leading to unrest.
This situation has the potential to affect supply chains. It is also relevant for specific industries. For example, Shanghai and Jilin, another city affected by Covid, provide 20% of China’s auto production.
The State Council noted the ‘especially difficult’ conditions facing a number of service industries and the desire to underpin growth this year. This is likely to lead to more stimulus which, given the limits on consumer spending, may have to come in the form of infrastructure spending. This would be supportive of commodities.
Australian Federal election and rates
From a market perspective there appears to be little at stake in this election. Given Labor’s ‘small target’ approach and the likely focus on issues such national security.
However, once the election is over it is likely that the RBA will be looking to move rates. The April meeting release removed the reference to ‘patience’ in terms of the RBA’s stance.
Recent comments have noted wages rising outside of fixed agreements and building wage pressure.
The effect of floods on construction costs, further supply chain disruption from China and the stimulatory effect of the budget have also been flagged.
All this signals the need to raise rates.
June is set to be the ‘live’ meeting, with a debate as to whether they move 15 or 40bp.
The market is implying a cash rate of 3% by June 2023, which at this point we think is a bit high.
The financial stability review released last week showed that the loan-to-value distribution in mortgages has improved significantly in the last two years due to lower rates and higher house prices.
While that signals a more resilient housing market, it should be noted that the proportion of people with more than 6x debt to income levels has risen significantly, which raises the sensitivity to rate increase.
Part of this sensitivity to rates is initially mitigated by a high proportion of people maintaining higher than required repayments in recent years.
Data suggests that 40% of households would not be affected by a 200bp rise in mortgage rates as their current repayments are already high enough.
That said, by the same measure 20% will see their repayments rise by more than 40%.
The added complexity this cycle is the higher proportion of fixed rate mortgages. This will defer the initial impact of rate increases but may cause issues 18-24 months down the line.
Overall, a 150bp move in mortgage rates would reduce capacity to pay by around 10%. It would also render consumer discretionary exposure, particularly in goods, vulnerable to a slow down.
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Renewed concerns over Fed tightening and uncertainty in China saw bond yields rise while equity and commodity markets fell.
Heading into US earnings season, headline revisions still look good. However, once the energy sector is stripped out, the effect of input costs, labour, supply disruptions and a slowing consumer is beginning to tell, with the rest of the market seeing revisions back to flat for the calendar year to date.
The other thing to watch is the US dollar, which continues to grind higher and close to testing its highest levels in five years.
The Australian market saw more defensive sectors such as utilities, energy, and staples outperforming, while tech and discretionaries lagged.
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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