Crispin Murray: What’s driving the market this week?

Here are the main factors driving the ASX this week, according to Pendal’s head of equities CRISPIN MURRAY. Reported by portfolio specialist Chris Adams

• US economy reaches tipping point, unemployment rate triggers “Sahm rule”
• Markets fear the US Federal Reserve is now behind the curve
• Find out about Pendal Focus Australian Share fund
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LAST week saw a significant shift in sentiment, prompted by signs that the US economy is slowing down faster than previously thought.

The rally in bonds (which saw US ten-year Treausry yields fall 40 basis points), as well as further falls in global equities and a sharp rotation away from tech, banks and cyclicals towards utilities, REITs and gold all suggest that the market was clearly not positioned for this.

The moves were exacerbated by US results, with the tech sector reporting OK but seeing no material upgrades, while other companies indicated some signs of slowing consumers.

Finally, the Bank of Japan (BOJ) surprised everyone with a rate rise, triggering a sharp rise in the Japanese yen and a fall in the Japanese stock market.

The common link with all these developments is that they are leading to the unwinding of crowded trades – this is important given the US market has rallied for eight and a half months and gained more than 35%.

Even if this growth concern proves a head-fake (as others have), there is room for a correction in the S&P 500 to the 5,000-5,100 level – reinforced by the weaker seasonals and election uncertainty. There is also likely to be material rotation as part of this.

We have been bracing for such a correction, with cash levels higher and positions reduced in some of the more economically leveraged stocks.

The S&P 500 fell 2.05% on the week, while the NASDAQ was off 3.34%.

The S&P/ASX 300 was up 0.28% for the week on the back of more benign inflation data, making a new high Thursday.

The move off the October 2023 lows is well below that seen in the US, but still roughly 20%.

The key issue is whether this is a “normal” bull market correction or will we see a more meaningful drawdown.

Two potential drivers of the latter could be:

• Flows and/or liquidity. ETF flows have been strong in recent months and there are no signs of them reversing, but if that happened it would reinforce the sell-off. Liquidity is unpredictable and needs to be watched. There appears no stress in the system at present and US funding requirements should be supportive short term as it gets skewed to the short end and funded from reverse repos.
• More significant economic weakness. Our view is that this will not be the case for several reasons: the global economy is holding up OK, we have not seen an economic shock, there is a lot of scope for rates to be cut (particularly given the stepdown in inflation), and corporate earnings and the AI/semi theme still looks well underpinned. That said, this can change and markets will remain focused here.

US economy: is it weakening more than expected?

Markets reacted to a string of negative data points, with a shift towards the narrative that the Fed may now be behind the curve – having not cut rates in last week’s meeting – and that the risk of recession has risen materially.

US employment data cemented this shift in sentiment, as July non-farm payrolls rose 114k versus the 175k forecast and the prior month was revised 29k lower.

The three-month trend rose from 168k to 170k, however, the underlying components looked soft – with 67k of the rise from healthcare.

Total services employment slowed from 125k to 72k, and the underlying measure of private sector jobs (ex-healthcare) dropped to 75k on a three-month annualised basis.

The 20 basis point rise (bp) in the unemployment rate – from 4.05% to 4.25% (versus the 4.1% expected) – caught the eye.

It is now 60bp higher than its low point and just triggering the “Sahm rule”, which signals that a recession has started when the three-month average unemployment rate rises 50bp off its three-month average low in the prior 12 months.

This increase was driven by the household survey seeing job growth of only 67k (on the payrolls-equivalent basis it fell 15k) and a continued rise in the participation rate from 62.59% to 62.7%, which added 420k to the labour force.

Hours worked data was also weak, declining 0.3% month-on-month. This series is now flat on three-month annualised basis.

Average hourly earnings were only 0.2% month-on-month (versus the 0.3% expected) and fell from 3.8% to 3.6% year-on-year

The fear is that we are at a tipping point in the US economy.

For the bears who have been predicting recession for almost two years, the payrolls data was the signal that validates these concerns, and the market is concerned that the Fed has misread the economy and is behind the curve.

While that may be the case this is only one data point, and there are issues with this month’s payroll figures.

The main caveat is the impact of Hurricane Beryl – the Bureau of Labour Statistics said there was no discernible effect from it, but this weather-related category for not being employed or working fewer hours spiked to 20-year highs suggest that there was an effect.

There is a very wide discrepancy between the payroll data and Household Survey data series, with each giving quite different signals.

There is a view that higher immigration is distorting the numbers. Normalising these numbers suggests that underlying payroll figures are not deteriorating as much as the headline would suggest. For example, Goldman Sachs estimates underlying July payroll growth of 147k, down from 148k in June.  

The rise in the unemployment rate has been driven more by the increase in the labour force, rather than an acceleration of layoffs. This means employment is rising, just slower than the rise in workforce.

This is a different profile to the rise in unemployment that has been seen in previous cycles. That said, ex-FOMC member William Dudley recently pointed out that this labour force supply was the trigger in the 1970s and the Sahm rule proved correct then.

US reporting season company commentary indicates that there has been no deterioration in corporate attitudes to employment and no sign of a step-change in the need to cut costs.

While these caveats indicate that we are not seeing a dramatic shift down in the economy, it does signal that the economy is softer than expected.

Economic risk has risen, with some lead indicators suggest a weakening in labour:

• Jobless claims have deteriorated. While this may also partly reflect some weather factors, it is stepping up and represents the best real-time signal on the labour market.
• The flow data of people losing their jobs versus getting jobs was worse in July than in June. This is first real sign of this changing; up to now, there has been no evidence of a pick-up in layoffs.
• Other lead indicators on employment, such as the ISM Survey outlook for employment, have also deteriorated.

So, the question is: does this signal a more rapid deterioration into a recession, or is a soft landing still more likely?

Our call is still for a soft landing, given:

• we still have job growth
• we are not seeing substantial layoffs
• the Fed has significant room to cut rates.
• commodity prices (particularly oil) are subdued, helping consumer spending
• corporate investment appears reasonably underpinned. 

In conclusion, payroll data and others last week indicate the economy is softening more than expected.

Given these caveats, it is too early to read this as an unambiguous change – but what it does mean is that cracks are appearing, and the Fed may be behind the curve. The August data will be critical to determining what the Fed does in September.

It also puts the market on edge regarding a deterioration in earnings trends. Given the extent of the rally and positioning, this is a catalyst for a further drawdown in equity markets.

Ultimately, our view is that growth can be maintained at reasonable level but could well require lower rates than originally thought.

US rates: what is the impact on policy?

The Fed July meeting came two days before the employment data and – as expected – it left rates on hold at 5.25-5.50%.

The messaging was dovish, with a shift from being “highly attentive to inflation risks” to being “attentive to risks to both sides of the dual mandate” – reflecting the improving inflation data from the most recent Personal Consumption Expenditures (PCE) and the employment cost index.

There is a widespread view that the Fed would have cut if it had seen the employment data and, therefore, it is now behind the curve.

As a result, the market is pricing in 70% chance of a 50bp cut in September.

However, economists are split – with some believing sequential 25bp cuts in the last three meetings of 2024 is more likely.

Whichever way it goes, rate expectations have materially shifted.

The market has shifted from pricing an implied 86bps to 166bps of implied rate cuts over the next 12 months.

Chairman Jerome Powell’s Jackson Hole speech on 24 August will be an opportunity to flag a more aggressive easing – similar to how he used his 2022 speech to warn on inflation.

Other US data

There were two positive data points on inflation, with the June core PCE up 0.2% and Employment cost index up 0.91%.

Unit labour costs are coming down as wages decelerate and productivity holds up. This is a good lead on inflation and gives the Fed plenty of room to cut rates.

The US manufacturing ISM was also sending a weak signal on economy.

It fell from 48.5 to 46.8, versus expectations of 48.8. The composition was poor, with new orders down 1.9 points and production down 2.6pts.

The employment component was the weakest since 2009.

Bank of Japan

A hawkish policy shift from the BOJ fuelled the unwinding of the yen carry trade and triggered de-leveraging of widely owned trades.

Rates were raised from a range of 0.0-0.1% to 0.25%.

The market only had a 30% probability of this, reflecting concerns over consumption.

The BOJ also announced a plan to gradually reduce JGB holdings over the next two years (which was expected) and its statement pointed to further rate hikes.

The hike reflected the broadening of wages growth in the economy as well as the risk to inflation from imports, given the weakness in the Japanese yen.

The market’s reaction was brutal, with the yen continuing its appreciation and the equity market falling 9% in two sessions.

The risk is that the yen was funding other trades and that this unwinding will force investors to shut down other risk – extending the de-risking sell-off.

Australia: inflation data better than feared, marketing swinging back to RBA cut

The headline Consumer Price Index (CPI) for Q2 2024 rose 1.0% quarter-on-quarter and 3.8% year-on-year.

This was in line with expectations. However, the RBA-favoured trimmed mean rose 0.8% versus the 1.0% expected, leaving FY24 at 3.9% versus the 4.0% forecast.

This is still too high, but low enough to leave rates on hold this week.

The monthly core CPI fell from 4.1% to 4.0% year-on-year.

Australia remains unique globally with inflation proving sticky.

Government measures on price relief have probably taken 0.7% off the headline rate, which reflects the greater resilience of our economy and the ongoing issue with rents and wage inflation.

Separately, we had household spending data – which covers two-thirds of GDP consumption – revised higher materially. While slowing, it is still up 3.1% year-over-year.

We also saw strong retail sales for June, with 2.9% growth – the highest since May 2023. Credit data was also firm.

None of this suggests that the economy is slowing sufficiently to allow inflation to fall to levels where rates can be cut. That said, lower global inflation and slowing growth will give the RBA time.

US Q2 earnings: holding up well, but surprises moderating

The challenge this reporting season has been a higher bar, making upside surprise harder.

There have been fewer positive surprises than recent trends, but still more than historical averages.

This suggests that earnings have not been a factor in the market sell-off – rather, they didn’t provide enough offset for the other headwinds of de-grossing and stirring macro fears.

The one negative is that the market is relying more on margin than sales to drive upgrades.

With 77% of the market having reported, revisions are running up 0.2% for FY24, led by financials and communication services. Energy, materials and industrials have been the weakest.

One area of focus has been the outlook for tech capex as this is a large component of overall capex and key to the trends on AI. 

The “hyperscalers” – Meta, Microsoft, Alphabet and Amazon – updated capex spending and guidance, with investments in AI infrastructure driving upside to 2024 expectations. Meta and Microsoft also guided to significant capex growth into 2025. 

This is supportive of the AI/semiconductor investment case over the medium term, but is unlikely to offset the current position unwinding.

Markets

The move in bonds is dramatic and highlights how much the market was caught off-guard.

This reinforces the point that investing is driven by the shift in probabilities of something happening, rather than the event itself.

The break lower in yields takes us back to the levels when rate cut optimism was at its greatest at the end of 2023.

That proved a head-fake – instead, we saw the economy hold up and inflation pressures increase.

Should the US economic growth hold in the 1.5% to 2.0% level – and we get rates falling to 4.0% –it is hard to see bond yields falling from here.

So, the question now is whether we do head into an economic downturn. If so, yields could drop to around 3.0%.

It is interesting that last week’s move led to an unwind of the inverted yield curve. This type of steepening is usually bearish for equities as it can be a lead on earnings risk.

One signal to watch is credit – this has not yet broken down despite the rise in volatility.

Credit as a signal is not as clear as it used to be as it has become more coincident with equities, but a widening of spreads could act as reinforcing factor in an equity selloff.

Another signal to watch on the US economy is the performance of discretionary stocks versus defensives.

This has broken lower, but so far looks like the false signal at the end of last year rather than the more material breakdown which coincided with the 2022 bear market.

The fundamental difference from 2022 is that rates had to rise then; this time, we have a material buffer of rate cuts to shield any slowdown and a very willing Fed.

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About Crispin Murray and the Pendal Focus Australian Share Fund

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.

Pendal is a global investment management business focused on delivering superior investment returns for our clients through active management. 

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