MARKET reaction to Russia’s invasion of Ukraine was more subdued than many would have expected, though there has been underlying volatility.
The S&P500 actually ended up last week, gaining 0.8%. This is possibly because the market had already priced in a high probability of conflict – alongside the underlying issue of higher rates.
Sentiment was cautious as a result. The view that sanctions would not cover key commodities and NATO forces would not engage on the ground tempered perceived near-term impact on the broader global economy.
A spike in gold, oil, wheat and other commodities unwound in the space of a few hours. This was a catalyst for recovery in parts of the market that initially fell the most.
The domestic market was hit harder than the US with the S&P/ASX 300 off 2.4%. This seems mainly due to anticipation of a more negative reaction in offshore equities.
This sentiment-driven fall overwhelmed a reasonably positive final week of reporting season, which underpinned the consistent message that the domestic economy looks set to recover well while cost pressures are building in certain areas.
Recent market caution could mean the late-week bounce continues, likely led by growth stocks.
But we remain wary this will persist given liquidity withdrawal has not yet started. Economic strength will probably also continue to underpin inflationary pressures, which could be exacerbated by the geopolitical risks triggered by Russia last week.
This makes the policy response even more challenging.
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This will be combined with a reappraisal of energy policy in the West. Significant sums will need to be invested to accelerate the energy transition and build resilience in the supply of energy and other critical commodities.
This reinforces this long-term theme of far higher levels of investment which underpin commodity demand.
Some are questioning whether central banks will delay rate hikes in response to the Ukraine crisis.
This is unlikely in our view — the level of inflation is just too high to delay action. The only small shift is that the probability of the Fed hiking rates 50bp in March has fallen.
Economic momentum appears to be building, particularly in the US. We have seen incomes remain strong, unemployment claims hit 52-year lows, Covid cases decline and strong capital goods shipments and house prices accelerate.
US personal income growth has now cycled through all the additional hand-outs people were receiving.
While it fell marginally below the growth in outlays for the first time since Covid struck, the savings rate remains in normal territory. This indicates households have been able to maintain spending without dipping into the excess savings built up over the past two years.
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The Citi Economic Surprise Index is on the rise again. This measures the difference between reported economic data and consensus expectations (it rises when the data is better than consensus).
Unlike the 2018 rate raising cycle when the Fed raised four times while data was starting to disappoint, this is not the case currently.
This will be a signal to watch as rates rise.
The combination of high volatility and a growing use of short-dated options by retail and institutional investors has exacerbated recent market moves.
This year we have seen rising volatility force investors to sell down risk. This can have a self-reinforcing effect due to the technical nature of options.
The sharp bounce at the end of last week shows this trend can operate in reverse — which may be supportive in the near term, particularly if volatility starts to subside.
Current volatility levels signal daily moves of 1.5% in US equities, so it is plausible this subsides. However in our view this would be a technical bounce and we are still working through a correction as liquidity becomes a headwind.
That said, we note that sentiment indicators remain at the more pessimistic end. US domestic equity fund inflows have still not reversed — though this will be something to watch as liquidity is withdrawn.
In terms of other assets oil is very hard to call in the near term.
There is still a potential for a deal between the US and Iran, which is probably worth $10-15 off the price in the near term. There is also the threat of releasing strategic reserves. But the medium-term fundamentals are supportive given low inventory, improving demand and potential supply disruption.
Soft commodities are the other key sensitive area to watch given the political consequences of high food prices. Wheat traded almost identically to oil.
Domestic market moves were dominated by the Ukraine news, which muted reactions to positive results such as NEC and exaggerated negative reactions.
Banks underperformed after a good run on initial concerns that the rise in rates may be slowed given geopolitical uncertainty. That narrative has quickly unwound.
The 32% bounce back in Block(SQ2) (formerly Afterpay) on Friday highlighted the potential for a positioning unwind in this market.
The underlying themes for reporting season have been constructive with regard to the domestic economy. Rising costs are an issue, the ability to price for it is key.
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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