FIVE factors combined to drag down equity and bond markets last week, while commodity prices also fell:
The combination of factors meant technology and cyclical sectors were both affected.
The S&P 500 fell 2.7% last week and is now down 10% year to date. The NASDAQ lost 3.8% last week and is down 17.8% for the year.
The S&P/ASX 300 (-0.7%) held up better, but the futures market suggests that effect will be lagged into this week. It is up 1.8% for the year.
Several paradoxes are facing the market, complicating portfolio positioning:
We remain wary of the near-term outlook in this environment.
As mentioned in previous weeks, the tighter financial conditions needed to tame inflation require equity markets to remain flat at best.
Meanwhile we are seeing the twin headwinds of uncertainty over Chinese growth and the market’s need to deal with what is likely to be back-to-back 50bp rate hikes in the US.
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A number of signs suggest US inflation has peaked:
We can conclude that at this point inflation is unlikely to get worse. But before declaring victory on inflation it’s important to note three things:
The key question is: if inflation rates have peaked, where do they fall back to? This comes down to two unpredictable factors:
The Fed maintains a hawkish message.
Federal Open Market Committee member James Bullard mentioned the potential need for a 75bp hike in some remarks last week. Again, there was talk of an “expeditious” need to get back to neutral.
At this point we think back-to-back 50bp hikes are more likely — with the potential for a third — as well as a start of quantitative tightening.
The market continues to price in further acceleration of rate hikes. The consensus is now 2.75% by the end of 2022, versus 2.5% previously.
It’s been a long time since markets have had to face such a rapid tightening cycle. There is still a question over the degree to which this is priced in. This underpins our near-term caution.
There is also a view that Fed tightening cycles will continue until something “breaks” — such as the 2016 collapse in oil prices, the 2012 Eurozone Crisis or the Russia/Long Term capital management crisis in 1998.
This is also making some in the market cautious.
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There has been a rapid deterioration in sentiment towards the Chinese economic outlook due to a combination of:
It is estimated that 44 Chinese cities are under some form of lockdown. This equates to 25% of the population and 38% of GDP — of which around 16% is in strict lockdown.
Estimates indicate Chinese growth could slow from 4.8% in Q1 to less than 2% in Q2.
This risk is emphasised by a sharp fall in road freight volumes (a reasonable indicator of Chinese economic health) and a backlog of ships off Shanghai.
There were hopes that policy easing would see a moderate pick-up in the housing market. This is not yet showing any sign of coming through.
The rise of the US dollar — against which the Chinese yuan is managed — has left China in a difficult competitive position given the relative depreciation in the Japanese yen and Korean won.
This exacerbates the existing pressure on China’s export engine from slowing global growth and a shift in consumer demand from goods to services.
This pressure seems to have forced a crack last week, with the currency breaking down relative to historical ranges.
It moved about 3% against the US dollar. While that may not be large in absolute terms, it is a four-standard-deviation event in historical terms.
The equity market was also pummelled. The rebound after the government’s comments in support of the market following concerns earlier in the year has proved short-lived, with some signs of outflows in foreign capital.
The policy response so far is regarded as too limited. The People’s Bank of China announced a 25bp cut in the bank reserve requirement ratio from April 25.
The immediate impact is concern around commodity demand, which risks being crimped by slower growth and a weaker currency.
We think the structural story in commodities remains attractive. But there is a sense it is a very long position among investors at the moment.
Aggressive Fed tightening — plus slowing Chinese growth and a devalued yuan — may see a sharp near-term unwind in the sector.
This is also materialising in some recent Australian dollar weakness.
Most asset classes weakened in response to all this.
Some are pointing to negative sentiment measures as a possible support. We are not so convinced by this — we are still seeing positive inflows into equity markets.
This is the key week for US earnings.
Last week saw two high-profile disappointments which dragged on sentiment:
Interestingly, despite a few major disappointments aggregate revisions to Q1 FY23 have been positive, reflecting what remains a strong economy.
For example, US airlines are seeing strong upgrades. At this point, earnings remain supportive of markets.
The ASX missed the big US fall on Friday, which is likely to emerge this week.
The local market was helped by the private equity bid for Ramsay Health Care (RHC, +30.6%). This supported the health care sector. Other than this, defensive sectors out-performed.
Mining was weak on a series of disappointing quarterly production report. Costs and production both disappointed, mainly due to the disruption associated with Omicron.
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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