THE challenge for central banks — particularly in the US — is that the economy is growing well above trend, with little slack in labour markets.
They need to engineer a tightening of financial conditions to resolve this and at least slow the economy back to trend growth rates.
This is yet to be achieved, which means they need markets to adjust further.
This is why we remain wary of equity markets in the near term. We are not expecting a major bear market, but believe we remain in a correction phase.
We also remain mindful that Australian equities should fare better than the US, reflecting its sector mix and less need to tighten. The S&P/ASX 300 is down 3.2% year-to-date versus -7.2% for the S&P 500 and -11.8% for the NASDAQ.
US inflation data came in higher than expected last week. In combination with further evidence of wage pressure, this saw an increase in the number of expected US rate hikes this year.
Concerns over the Russia-Ukraine crisis also drove oil prices higher, adding to future inflationary pressure as well as geopolitical risk.
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The S&P 500 fell 1.8% and the NASDAQ lost 2.2% last week. Australia fared better with the S&P/ASX 300 up 1.3%.
This was partly a catch-up on the overseas rally in the previous week, but also reflected reasonable results in the local financial sector.
US inflation data came in worse than expected last week. Headline CPI was at 7.5% and the underlying core measure at 6% annual growth.
Current consensus is a peak of 7.9% headline and 6.4% core inflation in February. The latter would be the highest reading since 1984. It is then expected to ease as a result of base effects and easing supply chain pressure.
Prices of goods have been rising at 11% annualised, which has been the key driver of inflation. For example, of the 6% growth in core CPI, a disproportionately large 2.7% is coming from used cars and new vehicles.
The unwinding of components such as these are underpinning expectations of a deceleration in inflation after February.
However we are also seeing services inflation start to rise, reaching its highest levels since 2007. The pathway here will be something to watch.
There is also a broadening of inflationary factors. The median three-month CPI component is running at an annualised rate of 5.9% — its highest level since data was first recorded in 1983.
Key components such as rents (17% of the core PCE index) are yet to rise since measured rent is below signals of what spot rents are doing. For example, the Zillow measure of rents is up close to 14% versus the 4% in the PCE calculation.
This is all adding to concern that inflation may prove harder to contain.
Concerns over the threat of a wage-price spiral was reinforced by the Atlanta wage tracker, which moved over 5% annualised growth, the highest level in 20 years.
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The issue here is one of the pathway and changing expectations. The market is still implying that annualised inflation drops below 3% by the end of 2022. There are reasons to be wary of this expectation:
The key point is the size of the disconnection between policy conditions and the economic environment.
We can see this in the Goldman Sachs Financial Conditions Index which captures contributing factors beyond just rates. This remains at a 39-year low.
This stance is grounded in the view that inflation will fall as supply chains improve; high levels of debt mean the economy will be sensitive to small adjustments in rates; and the belief that real rates can stay negative.
This means central banks need to do more to drive bond yields, the US dollar and credit spreads higher and/or equities lower – since these are all contributors to total financial conditions. This means either tightening faster than expected or going higher than expected – or seeing signs that the economy is rolling over quicker than expected.
None of these scenarios are benign for any asset class, though within equities there is scope for variance in outcomes.
With real rates still needing to move higher, this remains a difficult environment for growth stocks. So shorter duration, cash generating names will be more defensive which we have seen in the Australian market this week.
Part of the reason equities can be a bit more defensive is that equity risk premiums have stayed at reasonable levels through this cycle.
A more positive data point was that Chinese loan growth was larger than expected. This reflected more issuance of local government bonds which are likely to underwrite greater infrastructure spend in China over the next few months.
The Chinese economy remains fragile, particularly the small-to-medium enterprise (SME) sector. However this should lead further easing of policy — with two key policy meetings towards the end of March — which can help underpin the resource sector.
Resources and financials helped the market last week. They are leading to an emerging theme of large cap outperformance.
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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