TIGHTENING monetary policy prompted further market falls last week.
The issue is not so much the rate hikes — which have been well flagged — but widespread scepticism that central banks can tame inflation without causing recession.
Inflation is presented as a material issue. But in the same breath central banks are saying rates only need to get back to neutral levels to contain it.
The market is concerned that the goal of a “soft landing” is wishful thinking.
Negative sentiment was compounded by the Bank of England warning of recession as they increased rates, raising the risk of stagflation. China’s reiteration of Covid-zero adherence also weighed last week, as did weaker US productivity data and the need to rebuild oil reserves.
The positive correlation between equities and bonds continued.
US 10-year Treasury bond yields rose 19bps, breaking through 3%. Meanwhile the S&P 500 failed to maintain a mid-week bounce, finishing the week down 0.2%. It is now off about 11% since March 29 and down 13.1% for the calendar year to date.
Growth continues to do worse. The NASDAQ is given up 17% since Mar 29 and 22.2% year to date.
The S&P/ASX 300 could no longer maintain its previous disconnection, falling 3.2% for the week as REITs joined growth stocks in underperforming under the weight of higher bond yields.
Resource stocks also declined as commodity prices weakened on concerns over future demand.
Confidence in the RBA’s inflation credentials appears low — 10-year yields rose 35bps to 3.47%, versus 1.6% at the start of the year.
We continue to remain cautious on markets in the near term.
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The US Fed raised rates 50bp and indicated moves of the same size at the next two meetings, with 25bp per meeting likely thereafter.
Chair Powell said a 75bp move would not be necessary. This initially reassured markets. But it was later viewed as an unnecessary constraint on the Fed’s ability to react to inflation, and bond yields continued to sell off.
Powell continues to soothe market concerns, saying he can bring inflation back to target without causing a recession. He noted the risk of recession was below what the market was pricing. He was also non-committal on the need to raise rates above the neutral level, which he puts at 2-3%.
However, the market is far more sceptical. There is a view – reflected in comments from recently retired Fed member Richard Clarida – that rates need to go well above neutral to reduce inflation.
Clarida estimates at least 3.5%. Others are saying 4%.
The way to think about policy is that financial conditions need to tighten to a level which brings growth materially below the trend of 2%.
Based on historic relationships this requires equities to fall further, higher rates, wider credit spreads and a stronger US dollar.
This is all consistent with weaker markets. As long as it remains orderly we are unlikely to see the Fed intervene.
Another way to think about this paradox is that unemployment is probably running 50bp below sustainable levels.
To dampen wage inflation unemployment needs to increase by at least that amount, which history indicates is consistent with a recession.
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The latest employment data was broadly neutral.
Payrolls were a touch better than expected at 428,000 new jobs versus 380,000 expected. However the previous two months were revised down 39,000, offsetting the gap. Average hours worked were +0.3% vs expectations of 0.4%. All this signals the rate of expansion in jobs is slowing.
The household survey saw a significant drop in jobs (-353,000) — but this needed to be -559,000 to be considered statistically significant.
The participation rate also declined, reversing positive signs of people returning to work in the last couple of months.
All up, none of this shifts the dial for the Fed in terms of resolving the fundamental problem of too few people available for each vacancy.
There are signs that inflationary pressures are beginning to moderate. Average hourly earnings are plateauing, some commodity prices (including copper) have stalled and money supply growth has decelerated.
This is not enough to dampen fears around the level of required tightening.
The market is also mindful of:
All this suggests markets will remain under pressure in the near term.
The positive correlation between bonds and equities remains, which encourages portfolio de-risking.
Looking at technical indicators, there is a lot of focus on sentiment being at levels consistent with a market low.
However we counsel caution on this view, since flows into the equity market have remained strong. This suggests we have not yet seen the capitulation on equities – particularly on the retail side – which could signal a true trough in sentiment.
We may need to see the FAANGs roll over for this to occur – and there are signs that this may be in train.
Australia participated in the sell-off. This was partly due to concern over the impact of slowing growth on commodity prices. The big move in bond yields also weighed on REITs and the growth names. Energy is remaining defensive, with oil prices proving resilient.
There has been large sector divergence across the ASX300 in the calendar year to date.
From the best-performed to the worst:
Last week we saw some bank half-yearly results and a number of company updates.
The bank results were reasonable, but cost pressures seem to be emerging as an offset to the benefit of higher rates. The issue going forward is that they are domestic cyclicals.
We do not expect a major bust in the housing market. A softer outlook is likely to weigh on sentiment but corporate updates were generally positive.
But the market is increasingly looking through the near term and focusing on the reality that the RBA — like the Fed — needs to engineer a material economic slowdown which will not be good for cyclical earnings.
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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