LAST week’s Fed statement was bland, but the press conference that followed was not.
Fed chair Jerome Powell did not deliver a soothing message and the more hawkish tone of his comments raised market expectations around monetary tightening.
The bond yield curve flattened, the US dollar rallied and the US equity market fell in response. However a rebound on Friday saw the S&P 500 finish the week up 0.8%.
The Australian equity market rode the same wave, with the additional distortion of BHP’s index re-weighting exaggerating swings. The S&P/ASX 300 ended down 2.8%.
We remain cautious in the near term. The withdrawal of liquidity combined with the Fed’s aim of slowing economic growth suggests there may yet be more downside.
But we also expect markets to be punctuated by sharp bounce backs as we saw on Friday. This is partly because selling is amplified by the effect of investor hedging, which then unwinds.
It’s important to keep a close watch on the trifecta of rates, oil prices and the US dollar. When all three are rising it usually means a stiff headwind for equities.
However the underlying growth environment remains strong and supportive of earnings. The selling has also been largely indiscriminate, ultimately driving good alpha opportunities.
Chair Powell struck a hawkish tone in his press conference, prompting a sell-off in two-year notes and a flattening of the yield curve. His key messages were:
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The market has moved to price in five hikes in response.
The March, May, June, September and December meetings are expected to yield rate rises. At this point the market expects quantitative tightening to begin at the July meeting, while the November meeting coincides with mid-term elections.
The market suspects there will be evidence of a slowing economy or inflation (or both) by that point.
The market is not used to such frequent hiking. But this should be considered in the context of the very low starting point and the fact that monetary policy is still likely to be stimulatory until we go beyond a 2% rate.
The Fed’s goal is to stop stimulating an economy that does not require it. It is looking to get rates back to a “neutral” setting of 2% to 2.5% and shrink the balance sheet from US$9 trillion to US$6 trillion (it was US$3 trillion pre-pandemic).
The essential question – and driver of current uncertainty – is whether this will to be too much tightening or insufficient to achieve the Fed’s aim.
One way to consider this is that the risk balance is asymmetrical.
Higher inflation is considered to be a greater problem than over-tightening, since it would de-anchor inflation expectations and could require a recession for resolution.
It would also condemn Powell and the board to history as the team that lost control of inflation after four decades.
Given this, the goal outlined above is the point at which the Fed will believe they are not making the inflation problem any worse. If it transpires that they have over-tightened and the economy slows too much, they can quickly fall back and pivot as they did in January 2019.
The upshot is that the “Fed put” that helped underpin market confidence has shifted.
The market was conditioned to expect a soothing message from the Fed after equities fell some 10%. Now the perception seems to be that it would take something closer to a 20% fall and widening credit spreads to prompt Fed intervention.
This shift in perception changes the mindset of the market.
One of the key questions is how quickly rate rises would affect the economy.
There is a view that the high degree of leverage means small rate increases will affect the economy quickly. But as Chair Powell detailed, this cycle is different to the last. Specifically:
Academic analysis suggests that when you net off the negative for borrowers with the positive for savers, the impact of rates is very mild and only kicks in with a lag.
The impact on investment intentions is also likely to be minimal. Lower rates did not trigger substantially more investment and higher rates are unlikely to choke it off.
There is plenty to underpin a resilient outlook for business investment.
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This includes the transition away from carbon, good pricing power, the need for more resilient supply chains, the need to deal with labour shortages and the effect of technology on business models.
The areas where tightening may have a disproportionate impact are sentiment and access to capital.
Aggregate financial conditions – how loose or tight an environment is – include not just the level of rates, but also money supply, equity markets, credit spreads, the US dollar and energy prices.
With the US dollar and oil rising as equities fall, we have already seen a meaningful tightening in financial conditions. In time this will begin flowing through to the real economy.
That said, we suspect pent-up Covid demand, the need for inventory re-build and tight labour markets will mean growth and inflation are more resilient.
Conditions also remain relatively loose in a historical context, compared to where we have been over the past decade.
Australia had its own wake-up call with worse-than-expected quarterly inflation numbers.
The RBA’s preferred trimmed mean measure hit the middle of the 2% to 3% target band two years ahead of forecast.
Since rents, grocery items and new housing prices are all rising and supply constraints remain, it is hard to see inflation easing back.
Wage growth is running at just above 2% and the RBA believes wages rising more than 3% are necessary to be consistent with inflation staying in the target band.
Given the rigid Australian labour market, wages should be slower to rise than in the US, possibly giving the RBA cover to delay a rate hike beyond the market’s expectation of May.
That said, surveys indicate labour shortages and with unemployment falling and higher headline inflation, it is likely we will see wages move higher and the RBA raise rates.
As flagged last week, Australia is in a better place than the US in terms of the need to tighten. Inflation and wages are lower and we didn’t have the same degree of stimulus last year.
Australia is also among the more defensive equity markets at this stage of the cycle, given:
Australian Covid-related mortality rates are at a high point, but the trend in new cases and hospitalisations is beginning to turn downwards. This is also the case in the UK and US.
In the latter, case numbers are down in 45 states. This is coinciding with evidence that retail and travel activity is beginning to pick up again following largely self-imposed lockdowns.
European cases are on the rise again.
Denmark, which was early into the Omicron wave, has seen a re-acceleration led by the Omicron Ba.2 sub-variant.
Early assessments suggest this sub-variant is about 1.5 times more transmissible than Omicron, but no more severe.
The UK has not seen a surge in the sub-variant yet. But if Denmark proves to be a lead for other countries, it will reinforce the disruption to the economy and supply chains.
The last leg of the US sell-off came with very high volumes, which signalled a degree of short-term capitulation as investors de-risked following a 7% drop.
Measures of the proportion of stocks declining are at extreme levels, suggesting the market may be oversold on a near-term view.
This could indicate a pause in the market, particularly given strength in recent economic data and what should be a constructive US earnings season.
We do not expect a sharp bounce-back at this stage and there is scope for further falls as rates begin to rise. At this point we remain wary of the degree of beta investors will want.
There was an interesting shift in equity markets last week.
As expectations around rates increased, long-duration growth stocks were underperforming. But as the Fed emphasised the goal of slower growth we saw more cyclical sectors hit last week.
In the global tech sector semiconductors had outperformed software by some 40% since October 2021. About a third of that move unwound last week.
Real-time surveys in the US highlight how consumers have become more cautious. Anecdotally this is also true in Australia, which could have a bearing on company outlooks in the upcoming earnings season.
This partly reflects the flattening yield curve but may also signal that the worst of the valuation de-rate in good quality software names is over.
A strong result from Microsoft highlighted strong enterprise demand for software as business models evolve. This is particularly material in the financial sector where the rise of the payment companies has sharpened the focus of banks.
The call between value and growth is more nuanced now.
Value’s outperformance over the past two months is in line with the vaccine-related rebound in late 2020 and early 2021.
But on a long-term basis the relative move still looks muted. Within value we are wary of the more cyclical end due to a backdrop of slowing growth and high leverage as credit spreads widen.
A final interesting observation: this is the first market sell-off to coincide with rising bond yields since the Quantitative Easing era started.
This reinforces the point Powell made about this cycle being different. It goes to the core issue that strategies that have worked in the past 11 years may not work this cycle.
There should be a lot of alpha opportunities in this type of market.
Largely indiscriminate macro-related selling means there has been little differentiation between stocks that are likely to reverse once strong fundamentals become evident, and those that will not.
We have been in a multi-year period where rating has been the dominant driver of returns. There is now the strong possibility that individual company earnings return to the fore.
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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