BETTER-than-expected economic data and signs of Beijing winding back Covid restrictions are fuelling concerns that inflation may not fall as quickly as some hoped.
This has prompted a rebound in commodity prices. It’s also seen US 10-year bond yields rise 20bps to 2.94%, down from a peak of 3.19%.
The move in bonds triggered a sell-off in US equities late last week. The S&P 500 finished down 1.2%. The S&P/ASX 300 was up 0.8%.
Cautious sentiment was reinforced by JP Morgan CEO Jamie Dimon’s reference to the “hurricane… right out there down the road coming our way” as a result of higher rates and quantitative tightening.
Elon Musk’s “superbad feeling about the economy” and need to cut 10% of Tesla’s workforce did not help.
The S&P 500 has rallied 7% off its lows and many sentiment indicators have shifted back from “oversold” to more neutral.
The near-term market direction is likely to be driven by this week’s inflation data and the potential for earnings surprises.
We believe we are in a holding pattern for now.
Rate expectations have shifted materially. Whether they will moderate or go higher still will be determined by the economy over the next three months. It’s just too early to call.
Going back to 1929, the average US soft-landing bear market has been -26% — and for a recession
Here are the current scenarios for each of these “book-end” soft-landing and recession paths:
1) The path to a soft landing
2) The path to recession
The path should become more apparent in coming months.
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The risk-reward at this point favours caution. The Fed still cannot afford for financial conditions to loosen — which would be the case if equities rallied too far.
The key caveat is that Australian equities remain well placed in this environment and continue to hold up reasonably well.
Monthly US payroll data was solid — 390k new jobs versus 318k expected.
The rate of new jobs has eased from the 600k level, but it’s generally considered too high to be consistent with an easing of inflationary pressure.
The three-month moving average remains at 408k. The market believes a level of 100k-150k new monthly jobs is needed.
Participation picked up 0.1%, but this is not enough. This gap helps explain tightness in the labour market with unemployment at 3.6%. There is material deviation by age cohort, with participation rates in the 55-and-over range remaining stubbornly low.
Average hourly earnings growth of 0.3% month-on-month was a bit lower than expected. The annual rate of 5.2% remains too high, though the three-month moving average has fallen into the 4-5% range. We need to see it drop into the 3-4% range.
The latest ISM manufacturing data was too strong for the market, rising to 56.1 versus consensus 54.5. Services ISM was marginally softer at 55.9 versus consensus of 56.5, but this clearly remain the strong part of the economy.
The orders backlog component fell back to pre-pandemic levels, indicating supply chains are improving. This reflects the build in retailer inventory we have been hearing about from companies.
Overall there is nothing here to reduce the likelihood of back-to-back 50bp moves from the Fed in June and July.
It also reduces the likelihood of a pause in rate hikes in September.
Oil markets saw a lot of action last week.
OPEC+ announced it would bring forward an increase in oil supply. Initially this was seen positively as a thawing of relations between Saudi and the US.
But the more you dug into it, the more it looked like another hollow effort to make it appear as though something was being done about high US fuel prices.
OPEC is bringing forward a slated September supply increase to July and August.
This equates to an extra 200k or so barrels per day for two months — allocated across all of OPEC+, including Russia. Many of these nations are unable to produce the extra barrels, so not all of that will come onto the market.
It is also apparent that Libya and Venezuelan production has been weaker than expected. Any agreement with Iran to potentially unlock another 500k bpd is still forthcoming.
Russian supply is estimated to be 1m bpd less than pre-invasion. The prospect of China re-opening could add 1m bpd of demand.
The risk of fuel prices to the economy is high.
US inventories are low. Globally they are being propped up by strategic petroleum reserve releases, but this is not sustainable.
An extremely tight refining market caps all this off. The NYMEX 3-2-1 spread — the gap between a price of three barrels of oil and the two barrels of petrol and one of diesel which can be refined from it — is multiples of its historical average.
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This implies fuel prices at the pump are equivalent to US$175 oil. This is a challenge for the consumer and does not help the inflation outlook.
There is increasing focus on Australian power prices.
A combination of outages and supply issues at coal-fired plants — plus cold weather and a limited supply of solar at this time of year — have left the domestic market relying on gas to fill the void.
This comes at a time of limited gas supply and a high global price. Wholesale prices have surged in response. The NSW average price is $200 — almost double the previous highest prices over the past 15 years.
In the near term this affects only a few commercial buyers, since most are on contract.
Consumers are protected for now. The main effect is on power providers reliant on purchasing power on the National Electricity Market. Smaller players are looking to shed customers and load as a result.
However the medium-term effects could be material.
Some analysis suggests it could translate to power price rises of 9% in Sydney in FY23 and 30% in FY24. The situation would be worse in Queensland and marginally better in Victoria.
Clearly, this is politically unpalatable and raises the risk of intervention in the industry.
Understanding the flow-on effects for the economy and corporate earnings is key here.
The consensus view that peak inflation meant peak bond yields was challenged last week.
We remain wary of this view. History suggests that in most cycles rates end up rising above inflation. If the latter isn’t below 3% in a reasonable time frame we still may see rate and bond yields head higher.
The issue for markets remains that central bankers will want to be seen to be hawkish until it is clear inflation is beaten — which will not help sentiment.
Commodities maintain their defensiveness. This partly reflects the oil issue flagged above — but also the belief that China appears to be reopening. Copper remains the best proxy for this sentiment, and rose 6% last week. The Australian market continues its resilient performance with energy and resources leading the way. Financials and utilities fell last week, relating mostly to stock-specific issues.
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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