Here are the main factors driving the ASX this week according to our head of equities Crispin Murray. Reported by portfolio specialist Chris Adams.

Find out about Crispin’s Pendal Focus Australian Share Fund
Find out about Crispin’s sustainable Pendal Horizon Fund

TIGHTENING monetary policy prompted further market falls last week.

The issue is not so much the rate hikes — which have been well flagged — but widespread scepticism that central banks can tame inflation without causing recession.

Inflation is presented as a material issue. But in the same breath central banks are saying rates only need to get back to neutral levels to contain it.

The market is concerned that the goal of a “soft landing” is wishful thinking.

Negative sentiment was compounded by the Bank of England warning of recession as they increased rates, raising the risk of stagflation. China’s reiteration of Covid-zero adherence also weighed last week, as did weaker US productivity data and the need to rebuild oil reserves.

The positive correlation between equities and bonds continued.

US 10-year Treasury bond yields rose 19bps, breaking through 3%. Meanwhile the S&P 500 failed to maintain a mid-week bounce, finishing the week down 0.2%. It is now off about 11% since March 29 and down 13.1% for the calendar year to date.

Growth continues to do worse. The NASDAQ is given up 17% since Mar 29 and 22.2% year to date.

The S&P/ASX 300 could no longer maintain its previous disconnection, falling 3.2% for the week as REITs joined growth stocks in underperforming under the weight of higher bond yields.

Resource stocks also declined as commodity prices weakened on concerns over future demand.

Confidence in the RBA’s inflation credentials appears low — 10-year yields rose 35bps to 3.47%, versus 1.6% at the start of the year.

We continue to remain cautious on markets in the near term.

Economics and policy

The US Fed raised rates 50bp and indicated moves of the same size at the next two meetings, with 25bp per meeting likely thereafter.

Chair Powell said a 75bp move would not be necessary. This initially reassured markets. But it was later viewed as an unnecessary constraint on the Fed’s ability to react to inflation, and bond yields continued to sell off.

Powell continues to soothe market concerns, saying he can bring inflation back to target without causing a recession. He noted the risk of recession was below what the market was pricing. He was also non-committal on the need to raise rates above the neutral level, which he puts at 2-3%.  

However, the market is far more sceptical.  There is a view – reflected in comments from recently retired Fed member Richard Clarida – that rates need to go well above neutral to reduce inflation.

Clarida estimates at least 3.5%. Others are saying 4%.

The way to think about policy is that financial conditions need to tighten to a level which brings growth materially below the trend of 2%.

Based on historic relationships this requires equities to fall further, higher rates, wider credit spreads and a stronger US dollar.

This is all consistent with weaker markets. As long as it remains orderly we are unlikely to see the Fed intervene.  

Another way to think about this paradox is that unemployment is probably running 50bp below sustainable levels.

To dampen wage inflation unemployment needs to increase by at least that amount, which history indicates is consistent with a recession.

The latest employment data was broadly neutral.

Payrolls were a touch better than expected at 428,000 new jobs versus 380,000 expected. However the previous two months were revised down 39,000, offsetting the gap. Average hours worked were +0.3% vs expectations of 0.4%. All this signals the rate of expansion in jobs is slowing.

The household survey saw a significant drop in jobs (-353,000) — but this needed to be -559,000 to be considered statistically significant.

The participation rate also declined, reversing positive signs of people returning to work in the last couple of months.

All up, none of this shifts the dial for the Fed in terms of resolving the fundamental problem of too few people available for each vacancy.

There are signs that inflationary pressures are beginning to moderate. Average hourly earnings are plateauing, some commodity prices (including copper) have stalled and money supply growth has decelerated.

This is not enough to dampen fears around the level of required tightening.

The market is also mindful of:

• Higher oil prices
• A stronger dollar
• Higher nominal yields
• High mortgage rates
• Tighter policy

All this suggests markets will remain under pressure in the near term.

Market outlook

The positive correlation between bonds and equities remains, which encourages portfolio de-risking.

Looking at technical indicators, there is a lot of focus on sentiment being at levels consistent with a market low.

However we counsel caution on this view, since flows into the equity market have remained strong. This suggests we have not yet seen the capitulation on equities – particularly on the retail side – which could signal a true trough in sentiment. 

We may need to see the FAANGs roll over for this to occur – and there are signs that this may be in train.

Australia participated in the sell-off. This was partly due to concern over the impact of slowing growth on commodity prices. The big move in bond yields also weighed on REITs and the growth names. Energy is remaining defensive, with oil prices proving resilient.

There has been large sector divergence across the ASX300 in the calendar year to date.

From the best-performed to the worst:

• Energy: Positive fundamentals, making it the most defensive
• Consumer staples: Supported by predictability and lack of cyclicality
• Financials: Becoming less defensive in the past two weeks, probably as the market has started to focus on the prospect of a domestic economic slowdown
• Property: The break-out in Australian bond yields has turned this sector from defensive to under pressure in last two weeks.
• Healthcare: Has lagged due to growth characteristics, but becoming more defensive recently
• Discretionary: Has been under pressure due to cyclical concerns and the unwind of Covid benefits
• Tech: Remains the weakest

Last week we saw some bank half-yearly results and a number of company updates.

The bank results were reasonable, but cost pressures seem to be emerging as an offset to the benefit of higher rates. The issue going forward is that they are domestic cyclicals.

We do not expect a major bust in the housing market. A softer outlook is likely to weigh on sentiment but corporate updates were generally positive.

But the market is increasingly looking through the near term and focusing on the reality that the RBA — like the Fed — needs to engineer a material economic slowdown which will not be good for cyclical earnings.

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About Crispin Murray and 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 an independent, global investment management business focused on delivering superior investment returns for our clients through active management. 

Find out more about Pendal Focus Australian Share Fund  

Contact a Pendal key account manager

How to think about cash right now, China’s impact on fixed interest and global equities, a critical juncture for Aussie equities

The RBA’s credibility has taken a hit, but it can now get on with normalising policy like most other developed market central banks, says Pendal’s TIM HEXT

TODAY’S RBA announcement indicates rates are headed back to neutral (at least) and stagflation has arrived.

The RBA has finally capitulated on what was obvious to everyone else – inflation isn’t going to behave and the time for accommodative monetary policy has long passed.

Other central banks got the memo late last year but the RBA clung to the idea that inflation was temporary and would behave itself.

Now its forecasts are for headline inflation at 6% this year, underlying at 4.75% and only/maybe falling back to 3% by mid-2024.

That last forecast assumes they have tightened rates back to neutral.

The Reserve is now wary of giving too much guidance. But it’s trying to make up for lost ground, assuring everyone it will do “what is necessary to ensure that inflation in Australia returns to target over time”.

This is a little short of “whatever it takes”. But it opens the possibility of tight monetary policy (above 2.5%). The market certainly thinks so as cash rates in the market for 2024 nudge above 3.5%.  

This should concern not only bond holders, but holders of all financial assets as the RBA seems to be no longer separating supply-led and demand-led inflation.

Given its lack of ability to control supply-led inflation, it sounds like the RBA is prepared to hit demand harder than previously thought… Not that different to the US Federal Reserve after all.

The RBA also confirmed it will not be reinvesting maturing bonds — and not selling any of its holdings.

This glide path to a smaller balance sheet can be called Quantitative Tightening (QT) — but is largely what everyone expected and really is a sideshow.

The RBA will feel relieved that what must have been a constant stress of being so far behind the market is now over.

Their credibility has taken a big hit. But they can now get on with normalising policy, just like every other developed market central bank (okay, except the Bank of Japan).

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About Tim Hext and Pendal’s Income & Fixed Interest boutique

Tim Hext is a Pendal portfolio manager and head of government bond strategies in our Income and Fixed Interest team.

Tim has extensive experience in banking, financial markets and funding including senior positions with NSW Treasury Corporation (TCorp), Westpac Treasury, Commonwealth Bank of Australia, Deutsche Bank, Bain & Co and Swiss Bank Corporation.

Pendal’s Income and Fixed Interest boutique is one of the most experienced and well-regarded fixed income teams in Australia.

Find out more about Pendal’s fixed interest strategies here

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About Pendal

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

In 2023, Pendal became part of Perpetual Limited (ASX:PPT), bringing together two of Australia’s most respected active asset management brands to create a global leader in multi-boutique asset management with autonomous, world-class investment capabilities and a growing leadership position in ESG.

Contact a Pendal key account manager

Here are the main factors driving the ASX this week according to our head of equities Crispin Murray. Reported by portfolio specialist Chris Adams.

Find out about Crispin’s Pendal Focus Australian Share Fund
Find out about Crispin’s sustainable Pendal Horizon Fund

US equity markets continue to fall and have now erased the March rebound, breaking through to new lows.

The S&P 500 fell 3.3% last week and is now down 12.9% for the calendar year to date. The NASDAQ was off 3.9% and has lost 21% for the year.

The S&P/ASX 300 continues to display more resilience — down 0.8% for the week but still up 1.2% for the year. It has now reversed almost all its underperformance of the US market since the start of the pandemic.

The expected hit to resources occurred on Tuesday, but hope of Chinese stimulus led to much of that unwinding through the week.

Four issues are weighing on markets:

1. The pace and scale of central bank tightening, with the Fed due to meet this week
2. The impact of China’s lockdowns on supply chains and economic growth
3. The effect of the Ukraine war on growth and energy supply
4. The emerging headwind of cost inflation to corporate earnings

While some economic data released last week looks a bit soft, it is unlikely to change the Fed’s current course of back-to-back 50bp rate hikes.

There was some improvement in sentiment on China following comments from President Xi around supporting growth via stimulus.

We saw Russia turn off gas supply to Bulgaria and Poland, raising concerns over an escalation. There was some speculation over the weekend that the EU may start refusing Russian oil in May.

An ugly inflation print in Australia means this month’s RBA meeting is now “live” in terms of a rate hike.

A 2% drop in the Australian dollar as the US dollar continues to rise adds to the RBA’s conundrum regarding inflation.

Markets

There are signs of stress building in markets. But we are also seeing weak sentiment and some pockets that look to be oversold.

This is a critical juncture in terms of which way markets break. We remain cautious in the near term.

Key areas of concern include:

1. Dislocations in foreign exchange markets. The Japanese yen and Chinese yuan continue to fall, while the euro is now also testing downside support levels against the US dollar. The last time it traded at parity was 2002.
   The yen has already broken down to 20 years lows. Such US dollar strength can be a problem for markets since it complicates the ability to contain inflation outside the US. It also leads to potentially significant capital outflows and puts a lot of strain on emerging markets, particularly those with US dollar denominated debt. Markets tend to be more volatile when currencies are not stable.
2. Credit markets continue to deteriorate as the US high yield credit default swap index moves higher. It has more room to go as the economy slows.  
3. The correlation between bonds and equities appear to have reversed.  Correlation has been low post-GFC, where bonds offered protection against equity sell-offs. It is now high, making it harder for investors to hedge portfolios.
   This has an impact on the amount of money investors can deploy in equities – as does recent high levels of volatility. This means lower liquidity, exacerbating the likely effect of quantitative tightening. 

US earnings

At a headline level the season looks good so far (about 55% of the market has reported).

Aggregate earnings per share (eps) for the year are up 9% versus an expected 5%. There are more beats than usual.

However a lot of the momentum is driven by the energy sector. Stripping it out, eps growth falls to 3%, which is a material deceleration.

The market was hoping decent earnings from Meta, Apple and Microsoft would improve sentiment towards technology — but it was not enough to hold the sector up.

Amazon disappointed after logistic and fuel costs were US$2 billion higher than expected. It wore also US$4 billion of internal costs relating to sub-optimal staff issues and excess capacity in fulfilment.

While Amazon sees no signs of a slow-down in consumer demand, it could still come later in the year.

This result highlights the emphasis that will now be placed on cost. This may be the first warning sign of a weaker labour market.

The other issue to watch is that Amazon alone represents 10-11% of total US private non-residential construction activity, and that share has doubled since 2015. They also represent 25% of US warehouse construction. So clearly any signs of slower capex spending may also affect other sectors.

Buy-backs will start to kick again soon which should support the market.

China

Concerns over Chinese growth continue to mount. However last week we saw more confidence in the policy response from Beijing.

The Politburo’s April 29 meeting emphasised keeping the epidemic contained and the economy on track.

These twin goals are clearly contradictory — but the message is China will strive for its growth target.

This may indicate they would accept falling short, given the extenuating circumstances. But it also suggests they will take action to try to get close, which likely means substantial infrastructure stimulus.

Chinese stocks and resources stocks performed well in response.

Beijing is facing a myriad of issues: the effect of lockdowns on consumer demand, supply chain disruption, a weak housing market, high household debt, slowing global growth and a currency appreciating against competitors.

The question is whether policy measures will be effective in dealing with these issues.

Projects have lagged, there are constraints on labour and materials and cost inflation is high. There is a risk the infrastructure lever won’t work this time.

European gas

Russia turned off the gas to Bulgaria and Poland raising the risk of more broad-based disruption.

The move looks carefully considered as a signal. Both countries only import small amounts and have alternative sources of supply, so the economic impact is likely to be limited.  It does demonstrate that the risks to supply disruption are higher than the market is pricing.

There is speculation the Europeans may begin to restrict Russian oil imports, having found some alternative sources.

This would probably underpin oil prices if it occurs, which have been under pressure from Chinese lockdowns.

Macro data

Last week we saw:

1. Eurozone inflation came in higher than expected at 7.5% year-on-year. Core inflation was 3.5% — the highest level in 20 years. Expectations around EU rate hikes have been brought forward from September to as soon as July.
2. Headline quarterly US GDP growth was weak. Though this reflected the previous inventory build unwinding and high net exports, so it’s not yet a sign of consumer weakness.
3. US PCE indicators of inflation were a bit lower than expected, coming in at +0.3% month-on-month and 5.2% year-on-year. This is a result of some goods disinflation, softer health care inflation and a decline in financial services and insurance costs. Ultimately, the policy goal is 2% inflation, so this is not likely to shift the Fed’s current hawkish stance.
4. The US employment cost index rose to new cycle highs in Q1. Other, more temporal measures have already signalled this. But the need to contain the flow-on effects of wage inflation are driving the need to raise rates materially. Private sector wages and salaries were up 5% year-on-year.
5. Australian inflation was worse than expected, rising 2.1% quarter-on-quarter and 5.1% year-on-year. The trimmed mean (the RBA’s preferred measure) was up 1.4% quarter-on-quarter versus an expected 1.2% — and is at its highest level since 1990. It was up 3.7% year-on-year versus the 3% expected by the RBA and 3.4% consensus. This is the highest level since 2009. Housing construction was up 13.7% year-on-year and was a key driver. Food inflation is running at 4.3% year-on-year and rents are starting to rise.

This is expected to lead to faster and earlier rate moves in Australia.

Two-year rates are now expected to hit 3%, which is among the highest in developed nations. This is surprising given the degree of household debt and variable mortgages.

This highlights the challenge that the economy needs to be slowed quickly. If rates don’t get high it will only be because the economy is weak.

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About Crispin Murray and 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 an independent, global investment management business focused on delivering superior investment returns for our clients through active management. 

Find out more about Pendal Focus Australian Share Fund  

Contact a Pendal key account manager

Pendal Sustainable International Share Fund (APIR: BTA0568AU, ARSN 612 665 219)

Investment Manager, Strategy and Exclusionary Screens

We have decided to replace AQR Capital Management, LLC (AQR) as the investment manager of the Fund and bring management of the Fund in house, leveraging the expertise of Pendal Group’s global equities teams. The change will take place on or around 31 May 2022.

The Fund will continue to be an actively managed global equities portfolio. The portfolio will typically comprise around 90 stocks (though this will fluctuate over time), blending the Pendal Global Select and Pendal Sustainable Concentrated Global Shares strategies with a much stronger focus on fundamental stock analysis. There will also be enhanced scope for company engagement and the incorporation of ESG and sustainability considerations in the management of the Fund.

The exclusionary screens of the Fund will be enhanced consistent with broad market feedback around the screens required for a contemporary sustainable strategy, improving the Fund’s sustainability footprint by tightening the screens for fossil fuels and weapons.

The Fund will avoid investing in companies which directly:

• extract or explore for fossil fuels (specifically, coal, oil and natural gas); or
• produce tobacco (including e-cigarettes and inhalers); or
• manufacture controversial weapons (such as cluster munitions, landmines, biological or chemical weapons, nuclear weapons, blinding laser weapons, incendiary weapons, and/or non-detectable fragments).

The Fund will also avoid investing in companies which derive 10% or more of their total revenue directly from:

• fossil fuel-based power generation, or fossil fuel distribution or refinement (coal, oil and natural gas)*;
• the production of alcoholic beverages;
• manufacture, ownership or operation of gambling facilities, gaming services or other forms of wagering;
• manufacture of non-controversial weapons or armaments;
• manufacture or distribution of pornography; and
• uranium mining for the purpose of nuclear power generation.

* Companies with a climate transition plan may be exempted from this exclusion, provided that they have in place a Paris Agreement aligned transition plan and produce climate-related financial disclosures annually, which in both cases we consider credible. We define fossil fuels as coal, oil and natural gas.

Why are we making the change?

We have decided to implement these changes because we believe it is in the best interests of investors to bring the management of the Fund’s international strategy in-house, following a review of the Fund’s existing external investment manager, AQR. We expect the changes will deliver improved investment and sustainability outcomes for the Fund, providing investors with better risk-adjusted returns over the medium to long term.

What will stay the same?

The Fund’s investment objective, benchmark, management fee and buy-sell spread will remain unchanged.

What do you need to do?

No action is required. You will be able to continue to invest or withdraw from the Fund.

An updated Information Memorandum (IM) reflecting the change in investment manager, investment strategy and exclusionary screens is available on request. If you would like a hard copy of the IM, please contact us.

If you have any questions about your investment or would like further information regarding the changes, please contact our Investor Services Team on 1300 346 821 (for Australian investors) or +612 9220 2499 (for overseas investors) from Monday to Friday, 8.30am to 5:30pm (Sydney time). For any questions regarding how this change may impact your own financial situation we recommend that you speak to your financial advisor and/or tax accountant.

Pendal Active High Growth Fund (APIR: BTA0488AU, ARSN: 610 997 674)
Pendal Active Growth Fund (APIR: BTA0125AU, ARSN: 087 593 682)
Pendal Active Balanced Fund (APIR: RFA0815AU, ARSN: 088 251 496)
Pendal Active Moderate Fund (APIR: BTA0487AU, ARSN: 610 997 709)
Pendal Active Conservative Fund (APIR: BTA0805AU, ARSN: 087 593 100)
Pendal Balanced Returns Fund (APIR: BTA0806AU, ARSN: 087 593 011)

Investment Manager

We have decided to replace AQR Capital Management, LLC (AQR) as the investment manager of the international shares portion of the Funds and bring management in house, leveraging the expertise of Pendal Group’s global equities teams. The change will take place on or around 31 May 2022.

Why are we making the change?

We have decided to implement this change because we believe it is in the best interests of investors to bring the management of the Funds’ international strategy in-house, following a review of the Funds’ external investment manager, AQR. We expect the change will deliver improved investment outcomes for the Funds, providing investors with better risk-adjusted returns over the medium to long term.

What will stay the same?

The Funds’ investment objective, benchmark, management fee and buy-sell spread will remain unchanged.

What do you need to do?

No action is required. You will be able to continue to invest or withdraw from the Funds.

An updated Product Disclosure Statement (PDS) for each Fund reflecting the change in investment manager is available on www.pendalgroup.com. If you would like a hard copy of the PDS, please contact us.

If you have any questions about your investment or would like further information regarding the changes, please contact our Investor Services Team on 1300 346 821 (for Australian investors) or +612 9220 2499 (for overseas investors) from Monday to Friday, 8.30am to 5:30pm (Sydney time). For any questions regarding how this change may impact your own financial situation we recommend that you speak to your financial advisor and/or tax accountant.

Pendal Sustainable Balanced Fund – Class R (APIR: BTA0122AU, ARSN: 637 429 237)
Pendal Sustainable Balanced Fund – Class G (APIR: PDL4756AU, ARSN: 637 429 237)
Pendal Sustainable Balanced Fund – Class Z (APIR: PDL0478AU, ARSN: 637 429 237)
Pendal Sustainable Conservative Fund (APIR: RFA0811AU, ARSN: 090 651 924)

Investment Manager and Exclusionary Screens

We have decided to replace AQR Capital Management, LLC (AQR) as the investment manager of the international shares portion of the Funds and bring management in house, leveraging the expertise of Pendal Group’s global equities teams. The change will take place on or around 31 May 2022.

Also, the exclusionary screens of the Funds will be enhanced consistent with broad market feedback around the screens for a contemporary sustainable strategy, improving the portfolios’ sustainability footprint. Investment in certain companies and industries which are materially involved in activities we consider contrary to the ethical and ESG goals of the Funds will be excluded, including industries such as:

• Fossil fuels
• Uranium
• Logging
• Gambling
• Pornography
• Weapons
• Alcohol
• Tobacco
• Animal testing
• Predatory lending

These exclusions may be applied differently across the asset classes of the Funds.

Why are we making the change?

We have decided to implement these changes because we believe it is in the best interests of investors to bring the management of the international strategy in-house, following a review of the existing external investment manager, AQR. We expect the changes will deliver improved investment and sustainability outcomes for the Funds, providing investors with better risk-adjusted returns over the medium to long term.

What will stay the same?

The Funds’ investment objective, benchmark, management fee and buy-sell spread will remain unchanged.

What do you need to do?

No action is required. You will be able to continue to invest or withdraw from the Funds.

An updated Product Disclosure Statement (PDS) for each Fund reflecting the change in investment manager and exclusionary screens is available on www.pendalgroup.com. If you would like a hard copy of the PDS, please contact us.

If you have any questions about your investment or would like further information regarding the changes, please contact  our Investor Services Team on 1300 346 821 (for Australian investors) or +612 9220 2499 (for overseas investors) from Monday to Friday, 8.30am to 5:30pm (Sydney time). For any questions regarding how this change may impact your own financial situation we recommend that you speak to your financial advisor and/or tax accountant.

How the oil price is affecting sustainable investors, impact of falling Yen on equities, pre-election rate rise on the cards, what’s driving China sentiment

A monthly insight from James Syme and Paul Wimborne, managers of Pendal’s Global Emerging Markets Opportunities Fund

FOLLOWING the initial shock of the Russian invasion of Ukraine, it is becoming possible to focus on the secondary effects around the world.

These substantially result from the disruptions to the supply of many commodities.

Although highly volatile, prices of many basic commodities have moved very sharply since the start of the year.

Compared to the end of 2021, the Brent crude oil price is (at the time of writing) up 30%, wheat futures are up 38%, while and urea prices are up significantly (after doubling in the fourth quarter).

Other major Russian export commodities have also risen, but for the world’s poorest countries the trinity of fuel, food and fertilizer is absolutely key.

Many of these countries are significant importers of these products, subsidise them to their populations or have large weights of these in their inflation baskets.

This means sharp price rises stress the fiscal and current account balances. They also increase inflation and reduce the ability of consumers to purchase other goods and services.

Some of these effects are being seen in major frontier countries, whose equity markets are too small to be in the mainstream emerging market equity asset class.

Pakistan

For example, in Pakistan — which was recently demoted from the MSCI EM Index — a developing political crisis (where the opposition are seeking to bring down the government through a vote of no confidence) coincides with the need to renew a $6 billion debt with the IMF.

Without IMF funding Pakistan will almost certainly face a balance of payments crisis, as foreign exchange reserves have fallen recently to just two months of import cover.

The ramping price of imports has pushed inflation to 12.7% in the year to March, accompanied by a sharp fall in the Pakistani rupee.

Sri Lanka

Meanwhile, Sri Lanka’s poor agricultural policies — combined with the collapse of tourism after Covid — have created a weak starting point from which to deal with soaring prices.

Widespread street protests over severe shortages of food and power, and rampant price inflation led to the resignation of all the ministers in the government cabinet, and of the central bank governor.

In a sign of the depth of the crisis, the new finance minister then resigned after less than 24 hours in post.

Sri Lanka faces soaring inflation (18.7% in the year to March) and a probable sovereign debt default in July.

Mainstream EM markets

Three mainstream emerging markets are potentially exposed to these kinds of risks: Egypt, India and Indonesia.

Egypt is the most exposed of the three. Russia and Ukraine are major wheat exporters. Wheat is a particularly high component of Middle East and North African diets — and Egypt imports over 60% of its wheat.

Inflation has been pushing higher in recent months (to 8.8% in the year to February). Policymakers have begun to react, devaluing the Egyptian pound by 15%, hiking interest rates and imposing price controls on bread.

While these steps are likely to help — and Egypt is a net oil exporter — the non-oil component of the economy is already showing stress, with PMIs declining sharply.

The risk is a repeat of the political unrest that led to the overthrow of the Mubarak government during the Arab Spring in 2011.

There are, so far, no signs of unrest, but Egypt must be carefully monitored in the months ahead.

India

India has historically had vulnerabilities, both as a major importer, but also as a major subsidiser of these commodities.

India’s current account deficit will weaken with oil prices above $100/barrel — and inflationary pressures are showing. But India is in a much better position than in previous periods of commodity price inflation.

Firstly, the reforms to the subsidy regime have essentially removed the risk to the fiscal balance.

Diesel subsidies were removed in 2014, while direct LPG subsidies were replaced with cash transfers to poorer citizens, and fertilizer subsidies have been substantially reduced in recent years.

Secondly, India has in recent years become a major producer of wheat, even becoming a small exporter, while a series of rich harvests have allowed the government’s wheat reserves to reach 21 million tons against a targeted level of 7.5 million tons.

The economic reforms the government has driven have absolutely moved India onto a safer and more sustainable footing, and the country should feel the benefit of this in coming months.

Indonesia

The other major emerging market to have had historical problems with fuel subsidies is Indonesia. Indonesia also had problems in the mid-2000s from the fiscal effects of fuel price subsidies.

In 2004-5, newly elected president Yudhoyono faced a budget crisis, as spending on fossil fuel subsidies for gasoline, diesel and kerosene had reached $8bn.

The government was forced to trim fuel subsidies to alleviate the budget deficit, but this both lifted inflation and hit growth.

Subsequently, though, fuel subsidies have been first reformed and then, under current president Widodo, removed.

Additionally, inflation in Indonesia is very benign, reaching just 2.6% to March, so commodity price pressures are far more manageable.

Emerging markets are generally countries with macro-economic vulnerabilities, but the examples of India and Indonesia show that good planning and effective economic reform can limit these vulnerabilities.

While frontier equity markets and some of the major emerging market sovereign debt issuers may face a difficult 2022, emerging equity markets look to have lower secondary risks from the conflict in Ukraine.

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About Pendal Global Emerging Markets Opportunities Fund

James Syme and Paul Wimborne are senior portfolio managers and co-managers of Pendal’s Global Emerging Markets Opportunities Fund.

The fund aims to add value through a combination of country allocation and individual stock selection.

The country allocation process is based on analysis of a country’s economic growth, monetary policy, market liquidity, currency, governance/politics and equity market valuation.

The stock selection process focuses on buying quality growth stocks at attractive valuations.

Find out more about Pendal Global Emerging Markets Opportunities Fund here
 
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

Here are the main factors driving the ASX this week according to our head of equities Crispin Murray. Reported by portfolio specialist Chris Adams.

Find out about Crispin’s Pendal Focus Australian Share Fund
Find out about Crispin’s sustainable Pendal Horizon Fund

FIVE factors combined to drag down equity and bond markets last week, while commodity prices also fell:

1. Further signals of aggressive Fed tightening, which saw US two-year government bond yields rise 21bps
2. Concerns over Chinese economic growth with the Shanghai stock market and yuan both falling sharply
3. Fears that supply chain problems will re-emerge as a result of Chinese lockdowns
4. Some fear of a slowing US economy
5. Selective US earnings disappointments – primarily from Netflix and Alcoa.

The combination of factors meant technology and cyclical sectors were both affected.

The S&P 500 fell 2.7% last week and is now down 10% year to date. The NASDAQ lost 3.8% last week and is down 17.8% for the year.

The S&P/ASX 300 (-0.7%) held up better, but the futures market suggests that effect will be lagged into this week. It is up 1.8% for the year.

Market paradoxes

Several paradoxes are facing the market, complicating portfolio positioning:

• US growth is strong and earnings revisions positive — but the market is pricing in a slowdown as the mechanism for the Fed to reduce inflation
• Measures of investor sentiment are negative — but flows into equity markets remain strong
• There are signs inflation may be peaking — but bond yields continue to rise
• Lockdowns are seeing sentiment towards Chinese growth sour — but commodities and resources have been strong.

We remain wary of the near-term outlook in this environment.

As mentioned in previous weeks, the tighter financial conditions needed to tame inflation require equity markets to remain flat at best.

Meanwhile we are seeing the twin headwinds of uncertainty over Chinese growth and the market’s need to deal with what is likely to be back-to-back 50bp rate hikes in the US.

US inflation and rates

A number of signs suggest US inflation has peaked:

• Statistically we will see the biggest months of inflation growth in 2021 – April, May and June – rolling off the annual figures
• Commodity prices are rolling over off recent peaks
• The US dollar continues to rise
• There are signs of supply chain pressures easing in the US. Shipping rates for freight and containers have begun to fall. There is also evidence of less pressure in US trucking systems.
• Employment participation rates are creeping higher. There’s an argument the impact of inflation and running down of savings is slowly encouraging people back into the job market.
• Company wage surveys have begun to ease. This reflects less pressure to raise wages, which have already been materially re-based. 
• Company pricing power surveys are stalling, albeit at historically high levels

We can conclude that at this point inflation is unlikely to get worse. But before declaring victory on inflation it’s important to note three things:

1. The labour market remains very tight, so some wage pressure is likely to remain
2. Supply chain issues could be about to flare up as a result of lockdowns in China
3. The US economy remains strong, though there is a shift in demand to services. Coincident indicators are robust.  Continuing unemployment claims are at 50-year lows, bank lending is rising 7% year-on-year and house prices remain strong.

Key question

The key question is: if inflation rates have peaked, where do they fall back to? This comes down to two unpredictable factors:

1. At what point will the Fed tolerate inflation in order to avoid a recession?
2. The Fed’s ability to control the economy

The Fed maintains a hawkish message.

Federal Open Market Committee member James Bullard mentioned the potential need for a 75bp hike in some remarks last week. Again, there was talk of an “expeditious” need to get back to neutral.

At this point we think back-to-back 50bp hikes are more likely — with the potential for a third — as well as a start of quantitative tightening.

The market continues to price in further acceleration of rate hikes. The consensus is now 2.75% by the end of 2022, versus 2.5% previously.

It’s been a long time since markets have had to face such a rapid tightening cycle. There is still a question over the degree to which this is priced in. This underpins our near-term caution.

There is also a view that Fed tightening cycles will continue until something “breaks” — such as the 2016 collapse in oil prices, the 2012 Eurozone Crisis or the Russia/Long Term capital management crisis in 1998.

This is also making some in the market cautious.

China

There has been a rapid deterioration in sentiment towards the Chinese economic outlook due to a combination of:

• Lockdowns choking demand and supply chains
• Currency appreciation relative to competitors
• Global slowdown
• Weak consumer confidence
• Property market remaining fragile

It is estimated that 44 Chinese cities are under some form of lockdown. This equates to 25% of the population and 38% of GDP — of which around 16% is in strict lockdown.

Estimates indicate Chinese growth could slow from 4.8% in Q1 to less than 2% in Q2.

This risk is emphasised by a sharp fall in road freight volumes (a reasonable indicator of Chinese economic health) and a backlog of ships off Shanghai.

There were hopes that policy easing would see a moderate pick-up in the housing market. This is not yet showing any sign of coming through.

The rise of the US dollar — against which the Chinese yuan is managed — has left China in a difficult competitive position given the relative depreciation in the Japanese yen and Korean won.

This exacerbates the existing pressure on China’s export engine from slowing global growth and a shift in consumer demand from goods to services.

Under pressure

This pressure seems to have forced a crack last week, with the currency breaking down relative to historical ranges.

It moved about 3% against the US dollar. While that may not be large in absolute terms, it is a four-standard-deviation event in historical terms.

The equity market was also pummelled. The rebound after the government’s comments in support of the market following concerns earlier in the year has proved short-lived, with some signs of outflows in foreign capital.

The policy response so far is regarded as too limited. The People’s Bank of China announced a 25bp cut in the bank reserve requirement ratio from April 25.

The immediate impact is concern around commodity demand, which risks being crimped by slower growth and a weaker currency.

We think the structural story in commodities remains attractive. But there is a sense it is a very long position among investors at the moment.

Aggressive Fed tightening — plus slowing Chinese growth and a devalued yuan — may see a sharp near-term unwind in the sector.

This is also materialising in some recent Australian dollar weakness.

Markets

Most asset classes weakened in response to all this.

Some are pointing to negative sentiment measures as a possible support. We are not so convinced by this — we are still seeing positive inflows into equity markets.

This is the key week for US earnings.

Last week saw two high-profile disappointments which dragged on sentiment:

1. Netflix: The US$100bn cap stock fell 38% in a week. Several issues (such as switching off the Russian subscriber base) were specific to the company, but they exacerbated market concerns regarding consumer demand. Combined with other issues outlined above, this seemed to be a negative catalyst for mega cap growth names which have previously supported the market overall.
2. Alcoa: The alumina and aluminium producer fell 23% on concerns regarding costs – particularly around energy which is a large input into the refining and smelting process. This was compounded by the broader growth outlook.

Interestingly, despite a few major disappointments aggregate revisions to Q1 FY23 have been positive, reflecting what remains a strong economy.

For example, US airlines are seeing strong upgrades. At this point, earnings remain supportive of markets.

The ASX missed the big US fall on Friday, which is likely to emerge this week.

The local market was helped by the private equity bid for Ramsay Health Care (RHC, +30.6%). This supported the health care sector. Other than this, defensive sectors out-performed.

Mining was weak on a series of disappointing quarterly production report. Costs and production both disappointed, mainly due to the disruption associated with Omicron.

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About Crispin Murray and 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 an independent, global investment management business focused on delivering superior investment returns for our clients through active management. 

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