Elise McKay: What’s driving equities this week?

Here are the main factors driving the ASX this week, according to Aussie equities analyst and portfolio manager ELISE MCKAY. Reported by portfolio specialist Chris Adams

• Markets are pricing in a 22% chance of an RBA hike in August
• ‘Substantial’ market moves saw small caps (+1.7%) outperform last week
• Copper was down 8% and near-term downside risks remain
• Find out about Pendal Focus Australian Share fund

THE market saw big moves last week, driven by a collision of shifting central bank expectations, an improved growth outlook, overbought technicals, rotational pressures, and increased odds of a second Trump presidency.

While the S&P 500 was down 1.95%, there were some violent rotations within the market that led to leadership completely reversing.

Most stark was the outperformance of small caps, with the Russell 2000 up 1.73% for the week and the mega-cap tech-heavy NASDAQ down 3.65%.

This move was fundamentally driven, with small caps benefiting from economic sensitivity to lower rates and tariff protection. But it was exacerbated by extreme market positioning, as systematic investment strategies moved rapidly to close shorts and go max long.

From here, the near-term risk of a market wobble is more elevated given we face a seasonally weak period of the year, the Fed’s first cut is still two months away, and the US presidential election is not until 5 November.

Earnings expectations are high and there is plenty more data yet to drop, which could threaten the soft-landing thesis near term.

But the longer-term bull market remains intact, and in our view, a market consolidation could present a buying opportunity.

We continue to position the funds for a wide range of potential market scenarios.

Globally, we should see a coordinated central bank cutting cycle, with Australia remaining the exception.

Here, the S&P/ASX 300 gained 0.13% last week.

Domestic employment rose by a solid 50k month-on-month in June, well ahead of expectations for 20k. But despite this increase, the unemployment rate also rose from 4.0% to 4.1%, with the labour force participation rate increasing from 66.8% to 66.9%.

This print suggests that demand for labour is not quite keeping up with labour supply. Conditions are slowly softening but remain tight overall relative to full employment.

This is consistent with the view presented by the RBA in June’s meeting minutes.

The Q2 Consumer Price Index (CPI) data out on 31 July is likely to play a key role in the RBA’s decision on whether to raise or leave rates on hold.

The market is pricing in 22% chance of a hike in August.

Meanwhile, the Chinese Communist Party held a largely anticlimactic Third Plenum of the current Congress, which is traditionally focused on economic reform.

While leadership appears increasingly concerned about near-term economic weakness – with Q2 GDP decelerating from 5.3% to 4.7% versus CY24 targeted growth of 5% – there has been no meaningful step up in stimulus efforts.

This remains a headwind for resource stocks.

Finally, an update from Crowdstrike crash millions of computers globally on Friday. We are not expecting meaningful exposure for portfolio holdings.

US politics

It was a busy week for US politics, with the Trump assassination attempt and pressure heaped on Biden, which culminated in him stepping aside over the weekend.

This has meaningful policy and market implications, with a variety of outcomes still ahead.

The Trump assassination attempt increased odds of him winning the election.

Pollster 538 is forecasting a 51% probability of Trump winning compared to about 40% back in April, while the odds have increased to 63% for a Trump victory based on PredictIT data.

The chances of a Republican sweep also looks more probable, which could result in a meaningful change in policy direction.

Trump’s big three macro ideas of higher tariffs, lower immigration and tax cuts point to lower growth and higher inflation. This is a negative read-through for Aussie resources.

We could also see significant sector-specific policy changes ,including a boost for traditional energy providers, some negative moves for EVs, and financials potentially benefiting from an easing regulatory regime.

The consequences for healthcare and big tech are mixed but may be good for emerging Trump supporters, like Elon Musk.

US macro

Last week saw the release of several macro data points, which further supported the view of a soft landing and the increased expectation of a first rate cut in September, first stoked by lower CPI print the week before.

Retail sales

Retail sales data was well ahead of expectations for June and also saw May revised up.

Headline sales were flat month-on-month in June versus consensus expectations of -0.3% and May was revised up 20 basis points (bps) to +0.3%.

Control-group sales, which excludes autos, gas, building materials and restaurants, were also well ahead of expectations at +0.9% month-on-month versus consensus at +0.2%.

Strength was broad across all categories, with the exception of motor vehicle sales (-2%) due to a cyberattack on auto dealers which prevented the finalisation of some sales.

This data suggests that the US consumer is holding up pretty well – even showing signs of recovering – and is supportive of overall growth.

On the other hand, it was also the second hottest June since 1895, which may have contributed to strength in goods sales like building materials, garden equipment and hardware.

This means we need another month or two of data to show a clear trend, though there was enough to suggest nascent signs of recovery for the US consumer are emerging. This is positive for discretionary retail and payments companies such as Block (SQ2).

Further signs of recovery were seen in the housing starts data, with homebuilders buoyed by the tentative signs of recovery.

Housing starts

Housing starts rose to 1,353k in June which is up 3% month-on-month and 4% ahead of consensus expectations. 

Building permits rose to 1,446k, up 3% month-on-month versus flat expectations. 

The recovery is coming from multi-family housing. Conversely, single family homes remain under significant pressure – a trend that is expected to continue with the inventory of new single-family homes for sale relative to current sales well above the long-term average.

We saw a decent step up in the AtlantaFed’s GDDNow forecast from 2.0% to 2.7% as at 17 July, reflecting the stronger retail sales and housing starts data from the week.

Unemployment claims

Initial claims rose from 223k to 243k, well ahead of 229k consensus expectations.

The step-up is largely attributed to the combination of auto plant shutdowns being more concentrated than normal, as well as the disruption caused by Hurricane Beryl.

Despite this, claims are gradually trending up and is a leading indicator of the unemployment rate which should rise over the following twelve months. This is supportive for Fed cutting.

Europe and the UK

UK CPI inflation came in a touch ahead of expectations at 2% headline (0.1% beat) and 3.5% core for June 2024.

While headline inflation is in line with the Bank of England’s (BoE) target of 2%, services inflation is proving sticky at 5.7% – that’s well ahead of the latest BoE projections, which expect 5.1% in June 24.

The Taylor Swift effect does appear to have weighed, with restaurant and hotels accelerating from 1.7% in June 2023 to 8.8% in June 2024 – a pace that seems unlikely to be sustained through the remainder of 2024.

UK employment data was also released, with three-month average private sector regular pay growth decelerating from 5.8% in April to 5.6% in May.

However, there was a significant step down in monthly data from 5.9% in April to 4.9% in May, which was weaker than expected.

The unemployment rate was unchanged at 4.4%, in line with expectations.

The two offsetting data releases should mean that the BoE’s August meeting remains in play for its first cut, but it is a close call.

As expected, the European Central Bank (ECB) kept rates unchanged at 3.75%.

While not making a commitment on whether it will cut for the second time in September, the statement was more dovish than feared following recent sticky services inflation.

The ECB downgraded its view of the Eurozone’s economic prospects, with risks to growth now “tilted to the downside”.

Australia

Employment rose by 50k month-on-month in June, well ahead of expectations for 20k.

However, despite this increase the unemployment rate also rose from 4.0% to 4.1% (in line with expectations), with the participation rate increasing from 66.8% to 66.9%.

Only 12.5% of people took annual leave in June, versus the pre-Covid average of 14.5% – contributing to a 0.8% lift in hours worked, versus declines in May and in April.

This suggests that labour demand is not quite keeping up with labour supply.

Leading indicators of labour demand (e.g. job ads, employment intentions and vacancies) have continued to show signs of deterioration.

Conditions are slowly softening but remain fairly tight overall relative to full employment, which is consistent with the view presented by the RBA in June’s meeting minutes.

With the August meeting expected to be live, the Q2 CPI data out on 31 July is more likely to play a key role in the RBA’s decision on whether to raise or leave rates on hold.

The market is pricing in 22% chance of a hike in August.

Australia is an outlier compared with the rest of the world (excl. Japan) who have either started cutting rates or expect to do so soon.

While the Aussie dollar bounced earlier in July, reflecting this dynamic, the market is questioning if the RBA has the gumption to raise rates when expectations for a first cut in the US are being brought forward, which has reversed most of the currency’s move.

Should we see the Aussie dollar resume its march higher, this raises an issue for USD earners like Brambles (BXB), ResMed (RMD) and CSL (CSL).

China

The Chinese Communist Party held its third Plenum of the current Congress, concluding with a brief communique and press conference on Friday, and more complete briefings expected over the coming days.

While there were no surprises on the long-term targets, the Plenum discussed near-term issues – an unusual move that signals a sense of urgency on addressing economic weakness and suggests incremental stimulus is on its way.

Economic weakness was on display in the disappointing Q2 GDP growth reported at the start of the week, slowing from 5.3% to 4.7%.

The average is in line with 5.0% target for CY24, but the quarter-on-quarter pace of deceleration is concerning.

Weak domestic demand and no signs of property improving puts the 5% target for 2H24 at risk.

As a result, it is likely more policy easing could be announced at the Politburo meeting at the end of this month.

Combined with the fear that a Trump presidency could increase tariffs on China (noting prior comments from Trump floating a 60% tax on products from China), commodities did not have a great week.

While seemingly unlikely, an across-the-board 60% tariff from US could be a cumulative 2% GDP drag over several quarters, according to Goldman Sachs estimates.

Copper legged down 8% on the week and the miners followed.

Though the copper bulls argue that the set up for supply deficits is a sure thing post-2025, the market is currently in surplus, inventories are building at the London Metal Exchange, and China demand remains a headwind – suggesting there is further risk to the downside over the near term.

IT outages

Computers across the globe started displaying the “Blue Screen of Death” on Friday, with an update from Crowdstrike causing outages for millions of Microsoft Windows device users.

The outages touched almost every industry, from financial institutions through to airlines – with about 1,400 flights disrupted globally on Friday. Qantas (QAN) appeared to be back online relatively quickly.

The disruption was caused by a software update (not a hacking issue) pushed via Falcon, a cybersecurity monitoring service, to client computers.

While the change has now been undone, clients are required to perform a manual workaround to download a fix to affected computers.

We don’t expect this to have meaningful insurance implications.

Most cyber policies are designed to cover cyberattacks/security breaches and are therefore unlikely to cover this incident. On the Business Interruption side, most policies typically have a 45-day clause before they start paying out.

Markets

Last week saw substantial moves within the S&P 500, catalysed by a shift in Fed expectations, earnings hits and misses, overbought technicals, rotational pressures, and increased odds of a second Trump presidency and Republican sweep.

This completely upended the CY24 year-to-date patterns of very strong headline returns, very low realised volatility, and steady factor and thematic trends.

Small caps were, by far, the strongest performer – up 1.7% for the week and 7.6% month-to-date.

There is a strong fundamental case for strength in small caps continuing:

1. Decelerating inflation and expectations for a first Fed cut brought forward to September. Approximately 49% of Russell 2000 debt is floating, compared to ~9% for S&P500.

2. Steady/improving economic growth.

3. Increased likelihood of a Republican election sweep, though a lot can change between now and 5 November. Small caps are typically more domestic facing, less vulnerable to tariffs and very levered to US economic growth. They performed strongly following Trump’s 2016 election.

4. Compressing earnings growth premium for the largest tech companies versus the rest of the index. Collectively, Microsoft, Nvidia, Amazon, Aphabet and Meta are expected to grow 37% in CY24 versus 5% for the S&P 500 median – a 32% spread. But this is expected to compress to a 9% spread in CY25 and 5% spread in CY26, with the largest companies growing EPS at slowing rates while the rest of the index accelerates.

The rotation was exacerbated by extreme positioning versus history and the need to close out shorts related to a slowing economy.

This resulted in a period of de-grossing, with hedge funds aggressively unwinding risk across both the long and short sides of books and at the fastest pace since January 2021. Tech, Financials, Consumer Discretionary and Healthcare saw the most notional de-grossing activity.

The combination of strengthening fundamentals and extreme positioning led to some violent rotations within the market.

Small caps, homebuilders, financials and REITs rose quickly – as key beneficiaries of lower rates – funded by previous winners in AI, GLP and copper.

Market breadth increased, but not as much as might have been expected, which raises some questions as to the strength of this rally.

Market dispersion is picking up, albeit still below the 30-year average – suggesting a more selective, stock-pickers market heading into reporting season.

Factor rotation has been sudden and meaningful, with most of the year’s underperformers rallying hard. Therefore, we are being presented with an opportunity to take risk off the table for any names with near-term downgrade risk.

We are heading into a seasonally weak period, with August and September usually the softest two months of the year.

Systematic strategy positioning remains elevated, with commodity trading adviser (CTA) equity positioning remaining near highs. CTAs have moved from net short to now max long the Russell 2000, with the signal to trim at about 6% lower than current levels.

While the structural AI thesis remains intact, the likes of Microsoft (30 July) and Nvidia (28 August) can’t afford to miss earnings expectations.

Historically, a pull-back in momentum stocks (i.e. AI basket) is usually recovered within the following six-to-twelve months as the longer-term structural thesis plays out. But near-term historical returns could support the argument for taking some profits here.

Though it is still early days, US Q2 2024 results so far have been relatively good, with 14% of the market cap having reported and – on average ­– surprising on sales (up 1.8%) and earnings (up 5%).

There is a big week ahead, with 29% of the S&P market cap reporting, including Tesla and Alphabet kicking off the Magnificent 7. The bar for Q2 earnings is pretty high.

So, while much of the move over the past week has been technical (e.g. forced hedge fund de-grossing and CTA buying in the Russell 2000) and arguably overextended, the risk is elevated for a broader market wobble as we enter the seasonally weakest period of the year, as the Fed’s first cut is still two months away, and as the US election is not until 5November.

Earnings expectations are high and there is plenty more data to drop ,which could threaten the soft-landing thesis near term.

But – as discussed earlier – the longer-term bull market remains intact and a market wobble should present a buying opportunity. We continue to position the funds for a wide range of potential market scenarios.

---

About Elise McKay and Pendal Australian share funds

Elise is an investment analyst and portfolio manager with Pendal’s Australian equities team. Elise previously worked as an investment analyst for US fund manager Cartica where she covered a variety of emerging market companies.

She has also worked in investment banking and corporate finance at JP Morgan and Ernst & Young.

Pendal Horizon Sustainable Australian Share Fund is a concentrated portfolio aligned with the transition to a more sustainable, future economy.

Pendal Focus Australian Share Fund is a high-conviction equity fund with a 16-year track record of strong performance in a range of market conditions. The Fund is rated at the highest level by Lonsec, Morningstar and Zenith.

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

Contact a Pendal key account manager here