EQUITY markets bounced last week after overselling — but underlying news flow indicates further tightening, which remains a headwind for markets:
The S&P/ASX 300 gained 2% and the S&P 500 1.6% last week.
So far this year the latter is now down 5.5% and the NASDAQ has lost 9.8%. The S&P/ASX is down 4.5%, reinforcing our view that the Australian market should be more defensive in this environment.
The first three weeks of January saw hedge funds de-leveraging and the market cutting growth positions. This phase has played out for now. The market is likely to be more focused on earnings in the near term.
The bull case from here relies on slowing growth and easing supply chain pressure resolving the inflationary pressures without requiring a significant economic slowdown.
The bear case is that rates are still low, inflationary pressures are rising (oil, wages, rents, company pricing power) and the market begins to raise its view on where terminal rates are.
Last week’s news flow shifts probability to the latter. We think the market’s expectations are still playing out. Hence we remain cautious in the near term.
One CEO we spoke to last week said companies could not rely on the hope that inflationary was transitory.
They needed to act as though inflation was here to stay — which meant price increases.
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If most companies are thinking this way it means more inflationary pressure is in the pipeline.
The market also seems to be more discerning now the initial de-risking has played out.
We saw this in the divergence between Facebook and Amazon last week. Features such as pricing power, control over costs, earnings predictability, strong cash flow, low gearing and the ability to do capital management are likely to be rewarded in this environment.
This reinforces our view that in 2022 beta could be lower than previous years and alpha will be a major differentiator.
The key notion underpinning central bank thinking is the realisation that the combination of emergency policy measures, substantial fiscal expansion and supply chain disruption has triggered a significant rise in inflation — and they need to stop stimulating as quickly as possible.
This means normalising rates in a shorter timeframe than previously thought. The next step would be an increase in the terminal rates they are targeting, though we are not seeing this yet.
European Central Bank
President Christine Lagarde followed the Fed’s suit as the ECB made a sharp hawkish turn in tone. The bank removed references to rate increases this year being “highly unlikely” and emphasised the strength of the economy.
This is in response to year-on-year Eurozone inflation rising to 5.3% and a shift upwards in longer-term inflationary expectations 2%.
The fact that interest rates sit at -0.5% highlights the disconnection between policy and the underlying economy.
The consensus expects an announcement in March that Quantitative Easing ends from June. This suggests EUR200 billion less QE in 2022 versus 2021 and rate hikes to follow in September and December.
This triggered a sell-off in European bonds. German Bund yields increased from 0% to 0.2% and the Euro rose against other currencies.
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Bank of England
The BoE has been the most hawkish of the major central banks, raising rates 25bp with four out of nine members calling for a 50bp hike. It also announced quantitative tightening.
This highlights a policy of front-ending tightening and reflects the wage pressure that is already evident (it’s forecast to hit 5% for 2022).
The BoE is effectively prepared to break the economy’s strong growth to reduce the hit to real incomes form inflation and power price increases.
This is something to be mindful of for UK-exposed companies on the ASX this year. The GBP also sold off versus the EUR.
US payrolls came in at +467,000 new jobs versus +125,000 expected. This strong number was reinforced by material positive revisions to recent months and resilient average earnings data.
All this highlights that the Omicron wave has had limited impact on the economy and makes the Fed’s job of slowing inflationary pressures harder.
There was also a significant re-allocation of jobs in 2021. This reflects a shift in seasonal adjustments which meant the labour market was growing far more consistently through the year than previously thought.
Compared to previous recessions, the unemployment rate has returned to original levels far more quickly after the post-Covid shock. But the impact on the participation rate is far worse.
While the initial decline in participation was greatest in the 16-24 year age cohort, it is now evenly spread across all age cohorts.
It is impossible to isolate the drivers. But key contributors are considered to be rising wealth, a desire to change careers leading to re-training and education, health considerations and lifestyle choices. Whatever the reasons, it is creating a substantial labour bottleneck, driving wages higher.
Data released in the US last week shows civilian worker wages are up 4% from last year.
Another survey showed all private-sector wage growth of 5%, while leisure and hospitality wages were up 8.9% year-on-year. Wage growth is critical to watch. It is the factor that can turn supply chain inflation into more structural inflation
The bottom line is that pressures driving inflation are not yet showing any signs of abating.
New case number and hospitalisations continue to fall. The BA.2 variant appears to be 30% more transmissible, but no more severe.
The US has seen case numbers halve and hospitalisations fall 25%. Fatalities have fallen 80%, mostly due to immunity that has built up in the community from vaccines and prior infections. The death rate among those who have had vaccine boosters is 99% lower than the unvaccinated.
The ability for health systems to largely weather the Omicron wave is likely to reduce the use of restrictions in future waves. We should now see a re-opening boost heading into the northern hemisphere spring.
Brent crude rose 1.2% last week and was up after the “OPEC plus” meeting.
It is now at its highest point since 2014. The Australian dollar oil price is almost back to its 2008 peak.
Oil inventories are below pre-Covid levels.
It is hard to see what might change this, given continued demand recovery, OPEC sticking to careful supply increases, some concern they are limited in their ability to respond and the ESG overlay combined with a steep backwardation limiting new supply. All this adds to the inflationary pressure still in the economy.
The credit markets serve as indicators of stress in the economy. Spreads have widened but are nowhere near the stress we saw in the 2020 sell-off. This reflects good economic growth, cheap and available funding, and lower corporate gearing.
The market also watches the yield curve, which continues to flatten. Higher yields generally mean lower P/E ratings for equities and underperformance of growth stocks. This is a very different environment to what we have seen for the last few years.
In this vein, it was interesting to note the divergence in stock performance in the US last week.
The FAANGM stocks are longer performing in unison. Stock analysis and stock picking are becoming increasingly important since relentlessly increasing valuation ratings no longer overwhelm earnings trends.
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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