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THE MARKET is at an interesting near-term juncture.
The S&P 500 has lost ground seven weeks in a row and is now off about 20% from its peak. It has re-tested and held recent lows.
Expiring options may reduce volatility and we may see some month-end rebalancing towards equities in a low-liquidity environment due to next Monday’s US Memorial Day holiday.
A near-term bounce may be possible and counter-trend moves can be material.
However we don’t think we’ve seen the low point for this cycle. The market is yet to work through the effect of a slowing economy on corporate earnings.
The S&P 500 fell 3% last week as the market continued to worry about the potential for recession.
This was compounded by some poor earnings results out of US retailers. The issue here was not weaker consumption, but the mix shift from goods to services and a rising cost impost.
This emphasises the market’s vulnerability should a slowdown occur and begin to affect earnings.
US 10-year government bond yields fell 14bp. The positive correlation between bonds and equities appears to have broken down as the focus moves to risk aversion and a flight to safety.
We also saw a fall in the US dollar. This was probably a consolidation after a big run. It helped commodities and resource stocks, as did more signs of Chinese easing.
Australia again remains the market for these times.
The S&P/ASX 300 was up 1.2% for the week. It’s down only 2.5% for the calendar year to date, versus -17.7% for the S&P 500 and -27.2% for the NASDAQ.
We see two primary issues driving the outlook for markets.
The first issue is whether the US economy slows down or slips into recession.
Looking at recent bear markets, a recession has tended to lead to bigger drawdowns – such as in 2000-2002 and 2007-2009.
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Current investor surveys indicate a 50-55% probability of recession.
This comes down to views on what the Fed sees as acceptable inflation and what they will need to do to achieve it. There are two scenarios here:
The second major issue is whether the Chinese economy deteriorates or sees a policy-driven rebound.
Again, there are two scenarios:
There is a lot of debate about whether we have seen peak inflation and peak bond yields.
Official data such as retail sales is signalling that the consumer remains strong, though there are signs the economy is slowing. For example, the Economic Surprise index – which shows the degree to which economic data is beating or missing estimates – is deteriorating in most countries. Consumer confidence is also weak and is at 40-year lows in the UK.
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The combined effects of higher mortgage rates and fuel prices have reached levels consistent with previous consumer slowdowns. This indicator tends to lead by around 12 months.
Total financial conditions – which includes rates, equities and credit spreads – have tightened to a reasonable degree and should lead to a headwind of 1.3% of US GDP growth by Q3 2022.
We are also seeing signs that corporate pricing power – while still at high levels – may be easing.
There are signs that consumers are under some stress – particularly at the lower income end – with credit outstanding rising rapidly. This may support current consumption but is unsustainable.
Freight shipping rates are beginning to drop and there are early signs of a fall in US trucking rates.
That said, the freight rate may be a misleading signal due to a drop-off in Chinese exports. It’s unclear how much of this is a genuine de-bottlenecking of supply chains.
All this indicates the economy is responding to tighter financial conditions. It is slowing down and this is beginning to reduce inflation pressures.
This belief can be seen in forward pricing of inflation, where both break even yields and the 5-year inflation swap have rolled over since late April.
This could be positive for the equity market since it’s in line with the first scenario outlined above.
However there are still two key unknowns:
Fed Chair Powell has stressed that the labour market is resilient enough to weather tightening policy.
While this sounds reassuring, the question is whether a resilient labour market is consistent with inflation falling to target levels. If it is not, policy needs to tighten even more.
The labour force is very tight and this is driving wage growth. Some measures suggest we need to see employment decline by at least 1% to reduce wage pressure.
Economic surveys indicate the Chinese economy is weak. Q2 GDP is expected to decline 1.5% to 2%, with growth for the year coming in between 3% and 4%.
Beijing has responded with a larger-than-expected cut in its 5-year loan prime rate.
China bears see this as a move to prop up private developers who are facing a funding squeeze, thereby preventing deterioration rather than providing stimulus.
The more bullish view is that while this may not be a sizeable move, it is a very strong signal that the government will support property, similar to November 2014. Then it was the precursor to a big bounce in Chinese growth sentiment in 2015.
We remain cautious on a China recovery.
The property market appears to be deflating, but prices remain very high and developers are still too leveraged. At best the market stays flat, but the risk is to the downside, so any infrastructure related stimulus will only be offsetting this.
The other challenge is the lack of transparency over the extent of Covid and the real level of restrictions.
The ECB struck a more hawkish tone in response to poor inflation data. The market is now being primed for a first rate rise in July, with a possible 50bp move straight up. This is unlikely, but helped the Euro bounce off its lows against the US dollar.
There is little to read into the election outcome at this point. A majority government provides more clarity than a minority.
We are also likely to see more emphasis on reducing carbon emissions in coming years, which will have an impact on corporate disclosures and investment.
Overall quarterly earnings were good. Full-year earnings lifted from about 5% to 11% growth.
However the outlook looks overly optimistic, with 9% eps growth expected in CY23 despite a slowdown.
Last week demonstrated the impact earnings headwinds can have. Broadline retailers missed earnings expectations as a result of freight costs and the mix shift in consumption.
Walmart and Target have joined Amazon in highlighting material gross margin pressure.
Underlying sales have not been particularly disappointing. But the impact of the unexpected mix shift caused problems as spending moved away from home, consumer electronics and sporting goods to travel, toys and luxury goods.
Inventories are also building in areas such as home furnishings and consumer electronics, while unit demand growth is dropping. This crimps a company’s ability to push through price rises.
The share of “private label” sales are rising. This is partly due to improved product availability as labour issues improve. It may also indicate consumers are “trading down” as real income falls – potentially a signal of softer consumption.
The overall impact were large hits to stocks in the previously defensive consumer staples sector.
This highlights the difficulty in identifying defensive pockets in this environment
We may be seeing a near-term low in the US equity market.
Historically, bear market bounces average a 15% gain over 30-40 days.
This does not signal the market has hit its lows for the cycle. Most technical signals have not indicated a degree of panic or capitulation. For example put/call ratio data has not yet moved into 99th percentile level – a usual indicator of capitulation. Nor have we seen high volumes in stocks being sold down.
Retail investors are yet to give up on the bull market.
The triple-leveraged NASDAQ ETF is still seeing large net inflows – despite being down over 60% year-to-date. Interestingly energy-related ETFs – among the best performing year to date – are seeing negligible inflows by comparison.
The high proportion of “buy” ratings on the market leaders of the past few years is another sign that we are yet to see capitulation.
We see scope for short, sharp bear-market rallies, but remain defensively positioned overall. We don’t believe it is yet the time to reload on high beta, illiquid names.
The Australian market last week saw a good bounce in the resource sector (+3.8%) on China optimism. The Technology (+5%) sector bounced as Xero’s management clarified a post-result message and emphasised confidence in improved margins and cash flow over time. Consumer staples (-3.3%) lagged, following the US lead.
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.
Pendal is an independent, global investment management business focused on delivering superior investment returns for our clients through active management.
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