Generational shift drives ESG opportunity, which fixed interest funds are well placed for rising yields, what’s next for China and beware the ‘brownium’
Here are the main factors driving the ASX this week according to our head of equities Crispin Murray. Reported by portfolio specialist Chris Adams.
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The recent recovery in equity markets looks to be ending as the S&P 500 fell -1.2% and the NASDAQ -3.9% last week.
Australia remains more defensive in this environment, falling just 0.3% for the week. More hawkish comments from the Fed prompted the fall.
It signalled a 50bps hike in rates for May, absent any major new shock. It also reinforced the message that quantitative tightening is on its way. While this was known, it triggered a further sell off in long-dated bonds.
US 10-year Treasury yields rose 32bps for the week. It also took the yield curve back into positive territory.
This reinforces the key message that the Fed needs overall financial conditions to tighten sufficiently to cool wage inflation.
Surging equity markets loosen overall conditions, and the Fed is likely to try and prevent this.
China is also weighing on market sentiment. The situation in Shanghai appears to be deteriorating, with lockdowns potentially remaining in place into May.
This puts growth at risk but, unlike the US, Beijing’s desire to achieve its growth target is likely to see policy stimulus to mitigate the effect of lockdowns. This would be supportive of commodities.
Fed policy
The Fed remains focused on tightening financial conditions, as it tries to slow the economy enough to choke off wage inflation. The trick will be to do this without triggering a recession.
To this end, both Fed minutes and comments from Board member, Lael Brainard, last week suggested that quantitative tightening may proceed at a faster pace than expected. As well as implying greater risk to the upside for inflation.
Federal Open Market Committee (FOMC) minutes flagged a plan to shrink the balance sheet at a run rate of ~US$95bn per month, from May. This would comprise US$60bn in Treasuries and US$35bn in mortgage-backed securities.
This would enable them to reduce the balance sheet from US$9tr to US$6tr over 3 years. The technical aspect of how they would accomplish this was slightly more hawkish than the market expected.
The Fed also reiterated talk of moving ‘expeditiously’ towards neutral. This raised expectations of back-to-back 50bp hikes in rates.
These factors triggered the sell-off in bonds and led to slight steepening in the yield curve.
US 10-year Treasury yields are very close to a multi-decade trend line. This is being seen by some as the potential catalyst for a rally on bonds, as we saw for equities in May. Others see the potential for bonds to break the trend line, which could trigger a sell-off in equities and underperformance from growth stocks.
Any sustained rally in bonds would be contrary to the Fed’s goal of tighter monetary conditions.
We have also seen credit spreads tighten as fears around the US economy have eased. Hence the Fed remains hawkish on inflation and the need to tighten.
Former Fed official, Bill Dudley, noted in a Washington Post article that the Fed will only be able to achieve its inflation goals without increasing rates past 2.5% if;
- supply chains ease sufficiently
- the shift from goods to services ease inflationary pressures, and
- more people return to the labour market as wages move higher.
His key point is that the Fed needs tighter financial conditions if their plan is to work. This requires bond yields to move higher or equities to be flat to lower.
US economy
We are at an interesting juncture. Lagging indicators such as labour remains very strong, and wages are also continuing to slowly climb, with the latest Atlanta Fed wage tracker data coming in at 6.0 vs 5.8% quarterly wage growth.
Q1 GDP growth will slow down dramatically, with estimates down 1%.
Much of this reflects a reversal in the inventory build that drove Q4 growth, however some lead indicators of growth are signalling slowing momentum.
Consumer spending remains critical to the growth outlook. Anecdotally, consumption remains resilient, despite the increase in mortgage rates and inflation.
The US consumer is helped by having record net worth and a strong balance sheet, with US$3.9tr in savings and wages growing strongly in nominal terms.
In addition, the rotation from goods to services is becoming more evident.
Trucking appears to be showing signs of slowing, which is typically a good lead on consumption, however airline sales are strong.
There are some signs of easing inflationary pressures. For example, the backlog of container ships is falling rapidly. So too are the pricing rates for freight.
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China
Shanghai’s streets are deserted, while attendance at the Melbourne Grand Prix was 420,000 over the four days.
This demonstrates how quickly things can change in the space of just a few months in the Covid era.
Official statistics suggest that the number of districts classed at “high risk” of Covid started declining last week. The share of nationwide GDP at risk also dropped from over 30% to under 20%.
However, there is more anecdotal evidence that the trends are not improving.
The situation in Shanghai has deteriorated. There are reports of food shortages as lockdowns and a reluctance to deliver to Shanghai is constraining supplies and leading to unrest.
This situation has the potential to affect supply chains. It is also relevant for specific industries. For example, Shanghai and Jilin, another city affected by Covid, provide 20% of China’s auto production.
The State Council noted the ‘especially difficult’ conditions facing a number of service industries and the desire to underpin growth this year. This is likely to lead to more stimulus which, given the limits on consumer spending, may have to come in the form of infrastructure spending. This would be supportive of commodities.
Australian Federal election and rates
From a market perspective there appears to be little at stake in this election. Given Labor’s ‘small target’ approach and the likely focus on issues such national security.
However, once the election is over it is likely that the RBA will be looking to move rates. The April meeting release removed the reference to ‘patience’ in terms of the RBA’s stance.
Recent comments have noted wages rising outside of fixed agreements and building wage pressure.
The effect of floods on construction costs, further supply chain disruption from China and the stimulatory effect of the budget have also been flagged.
All this signals the need to raise rates.
June is set to be the ‘live’ meeting, with a debate as to whether they move 15 or 40bp.
The market is implying a cash rate of 3% by June 2023, which at this point we think is a bit high.
The financial stability review released last week showed that the loan-to-value distribution in mortgages has improved significantly in the last two years due to lower rates and higher house prices.
While that signals a more resilient housing market, it should be noted that the proportion of people with more than 6x debt to income levels has risen significantly, which raises the sensitivity to rate increase.
Part of this sensitivity to rates is initially mitigated by a high proportion of people maintaining higher than required repayments in recent years.
Data suggests that 40% of households would not be affected by a 200bp rise in mortgage rates as their current repayments are already high enough.
That said, by the same measure 20% will see their repayments rise by more than 40%.
The added complexity this cycle is the higher proportion of fixed rate mortgages. This will defer the initial impact of rate increases but may cause issues 18-24 months down the line.
Overall, a 150bp move in mortgage rates would reduce capacity to pay by around 10%. It would also render consumer discretionary exposure, particularly in goods, vulnerable to a slow down.
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Renewed concerns over Fed tightening and uncertainty in China saw bond yields rise while equity and commodity markets fell.
Heading into US earnings season, headline revisions still look good. However, once the energy sector is stripped out, the effect of input costs, labour, supply disruptions and a slowing consumer is beginning to tell, with the rest of the market seeing revisions back to flat for the calendar year to date.
The other thing to watch is the US dollar, which continues to grind higher and close to testing its highest levels in five years.
The Australian market saw more defensive sectors such as utilities, energy, and staples outperforming, while tech and discretionaries lagged.
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.
How the federal budget will affect rates and bonds, why ASX stocks and Australian bonds look good, how to find competitive advantage among international shares
Where will interest rates be at the end of 2022 and 2023? Here’s a view from Pendal’s head of government bond strategies TIM HEXT
THE Reserve Bank is keen to make its recent dramatic about-turn on rates look like an evolution — and not the revolution it is.
This week’s statement edged us a little closer to a June hike. The RBA dropped its usual reference to being “patient” — and its commitment to highly accommodative monetary policy.
The statement finished with:
“Over coming months, important additional evidence will be available to the Board on both inflation and the evolution of labour costs.
“The Board will assess this and other incoming information as its sets policy to support full employment in Australia and inflation outcomes consistent with the target.”
We get Q1 CPI on April 27, which will likely be around 1.7% and 1.2% underlying.
We also get Q1 Wages Price Index on May 18. This will be less spectacular but will not stop a June tightening.
Meanwhile there is a good chance one of the next few unemployment numbers will be sub 4%.
The RBA will therefore be able to say in May that inflation is sustainably within its band in the medium term and can tighten in June.
A May hike is not impossible. But with a federal election and the desire to evolve the narrative June is odds on.
News to some
Many (including us) expected all this. But judging by yet another sell-off of around 0.15% it was news to some.
Three-year physical bonds (as measured by the April 2025 Commonwealth Bond) are now nudging 2.5%.
Ten-years are nearly at 3% and with a large new syndication of a 2033 Commonwealth Bond next week will likely break 3%.
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The short end is now predicting cash rates to peak around 3.5% in early 2024.
If mortgage holders were aware of this impending doom house prices would be off 10% tomorrow.
Mortgage brokers I’ve spoken with are telling clients rates shouldn’t go up by more than 1% to 1.5%.
The average size of a new mortgage is now well over $600,000 – so an extra $20,000 a year in interest is coming borrowers’ way if markets are correct.
We still think a 2.5% cash rate is neutral.
Inflation is currently peaking. Although it will remain elevated into 2023 we think by late next year the RBA won’t likely need to push cash rates higher than 2.5%.
Rates should finish 2022 around 1.25% and 2023 around 2.5%.
Therefore markets are now cheap in the medium term.
However with the US Federal Reserve determined to keep pushing its rates higher – and ramping up the hawkish rhetoric – all markets globally will likely remain under pressure.
For those of us concerned with the short term as well as the medium term, the challenge will be to balance these two in the months ahead.
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
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.
What’s next for rates now the Reserve Bank has lost its patience? Assistant portfolio manager ANNA HONG explains
THE Reserve Bank this week took a small step towards a June rate hike.
In February and March, Governor Phil Lowe’s monthly statements referred to the board’s willingness to be “patient” as it “monitors how the various factors affecting inflation in Australia evolve”.
This month the word “patient” was conspicuously absent — though the omission was anticipated by the market.
“Over coming months, important additional evidence will be available to the board on both inflation and the evolution of labour costs,” Dr Lowe said.
“The board will assess this and other incoming information as its sets policy to support full employment in Australia and inflation outcomes consistent with the target.”
Some are expecting a hike in May. But the reference in this month’s statement to upcoming inflation data on April 27 and wages data on May 18 suggests a pre-election rate rise in May is unlikely.
It’s more likely next month’s statement will feature a further change of language that paves the way for a rate hike in June.
Only twice in Australian history has the RBA changed interest rates during an election — the first was a rate hike, the second a rate cut.
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Both times there was a change in government.
Dr Lowe declined to cut rates in May 2019 — just 11 days before the last federal election — even though unemployment was drifting higher.
We expect this time will be no different.
The first election rate change occurred in November 2007.
Back then RBA Governor Glenn Stevens decided to raise interest rates 17 days out from the election to manage rising inflation.
This action — and two more rate hikes in early 2008 — helped Australian inflation peak in September 2008. Though the global financial crisis may have played a bigger role.
There are similarities between our current state and November 2007.
But inflation is now more supply-side led. And the RBA has this time chosen to remain dovish for longer, continuing to leave cash rates at 0.1%.
Despite that, the banks are already repricing for the future.
Advertised fixed rates have risen more than 60% from an average of 2.14% to 3.48%, according to APRA and RBA data.
In addition, the serviceability buffer was raised from 2.5% to 3% in the new home loan assessments.
This has led to Sydney and Melbourne house prices cooling off, signalling that a phase of high capital gains may be behind us.
With a surge in fixed-rate borrowing well and truly behind us, variable rate rises are not far away.
The market is predicting more than 3% of rate hikes in the next few years. If that’s correct it will be interesting to see how mortgage holders cope.
Household deposits continue to rise — up $255 billion since the pandemic — indicating Australian households have a war chest to cushion the blow.
But that’s not necessarily good news.
Delayed action in tackling inflation may result in a long, drawn-out battle to curb price rises fuelled by supply chain issues.
Will the supply chain issues ease sufficiently to prevent a protracted rate hike cycle?
The RBA will be cautiously watching this dynamic.
Looking ahead, we have the RBA Financial Stability Review coming up, in addition to the NAB Business Conditions and CBA Household Spending Intentions.
We are keen to understand the RBA’s assessment of the impending mortgage stress and its concerns around the ability of the wider economy to withstand rate rises.
NAB Business Conditions and CBA Household Spending Intentions will provide a good gauge on forward-looking business and consumer confidence.
If those indicators remain elevated we may see costs of living get another leg up.
Portfolio implications
For many investors, the current dilemma in portfolio decisions relates to the relative importance of the geopolitical instability in Europe versus the inflation trajectory.
With Australian Government 10-year bonds appearing to have found support in the 2.8% to 3% range, a balanced portfolio can increase its defensiveness knowing that most of the inflation concerns are already priced in.
Furthermore, 10-year real yields are now positive (more than 0.3%).
That carry can provide good protection for investors.
About Anna Hong and Pendal’s Income and Fixed Interest team
Anna Hong is an assistant portfolio manager with Pendal’s Income and Fixed Interest team.
Pendal’s Income and Fixed Interest boutique is one of the most experienced and well-regarded fixed income teams in Australia. In 2020 the team won the Australian Fixed Interest category in the Zenith awards.
With the goal of building the most defensive line of funds in Australia, the team oversees A$22 billion invested across income, composite, pure alpha, global and Australian government strategies.
Find out more about Pendal’s fixed interest strategies here
About Pendal Group
Pendal is an independent, global investment management business focused on delivering superior investment returns for our clients through active management.
Here are the main factors driving the ASX this week according to portfolio manager Jim Taylor. Reported by portfolio specialist Chris Adams.
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THERE’S been increased chatter about yield curve inversion and potential recession, on top of speculation around inflation, commodity prices and the conflict in Ukraine.
Fed Chair Powell is showing signs of frustration with the view linking curve inversion to an inevitable recession — particularly since recent data indicates the US economy remains very strong.
The minutes from March’s Federal Open Market Committee meeting — due this week — are expected to contain details on the Fed’s thoughts about quantitative tightening.
Australian data also suggests ongoing economic strength, but the signs are more worrying in Europe. German data in particular shows an increased risk of recession.
Policy decision and timing in Europe are complicated by a strong inflationary pulse. This is underpinned by continued capacity constraints, second-order effects of the Ukraine war and China’s Covid response.
Despite all this US equity markets remained largely unchanged. The S&P 500 gained 0.1% last week.
The Australian market continued its bounce. The S&P/ASX 300 lifted 1.2% last week on the back of a 3.62% increase in resources.
Australian economy
A strong economic recovery has prompted a $150 billion expected improvement in public finances for 2025-26. This is underpinned by lower unemployment benefits and higher income from commodities.
Last week’s Federal budget set aside about 75% for fiscal repair and deployed 25% into new spending initiatives. This comes on top of an already strong economy.
Measures addressing the cost of living were probably the most significant feature, totalling around $10 billion.
This equates to 1% of household income for the next six months and includes:
- Expanded tax offsets worth $420 for about 10 million low or middle income taxpayers, payable in the second half of 2022.
- One-off $250 payment for about 6 million welfare recipients to be paid in April
- 50% reduction in fuel excise for the next six months
Australian retail sales increased 1.8% month-on-month in February — better than expectations of 0.9%.
Sales now are only 0.7% below the pre-Omicron peak in November. NSW did best with 3.6% growth and WA was the laggard at -2.9%. Fashion and eating out dominated with about 15% growth.
Statistics released during the week indicate housing credit growth continues to accelerate to a post-GFC high, while residential approvals have rebounded strongly from a Covid-induced delay.
It is also worth noting that the Budget expanded the First Home Loan scheme. Property prices have rolled over modestly.
Business credit growth is also strong, running at 10% year-on-year. This is also a post-GFC high.
Other data showed household wealth was growing as quickly as ever.
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On the jobs front, vacancies are up 47% year-on-year to a record high of 424,000.
The ratio of job vacancies to unemployed persons has also spiked to a record high 75%.
Normally for every job vacancy there are three-to-four unemployed people available. Now there are only about 1.25.
The transmission of this feature of the current cycle into wage growth continues to be very muted. But we are keeping an eye on negotiations surrounding minimum wages.
Australian businesses are still reporting that the tight labour market is a key constraining factor in their operations.
US economy
In the US 431,000 new jobs were added in March based on payroll data.
This was below expectations, though the January and February figures were revised up 95,000.
This marks the 11th consecutive month of job gains above 400k — the longest stretch since data was first recorded.
The participation rate also climbed 0.2% to 62.4% — compared to a pandemic trough of 60.2% in April 2020. There is evidence that women and retirees continue to return to the workforce.
The unemployment rate fell to 3.6%, one of the lowest on record.
Average hourly earnings rose 0.4%, after rising only 0.1% in February. The annual growth rate remains high at 5.6%, but all eyes will be on April to see if the trend of moderation continues.
Core PCE inflation rose 0.35% month-on-month in February and is running at 5.4% year-on-year versus 5.2% year-on-year in January. This was in line with consensus and is the lowest monthly gain since September 2021.
The breadth measures moderated substantially in contrast to the CPI data, due to different index constructs. Specifically the PCE has a higher weighting to healthcare and a lower weighting to petrol and housing which results in lower overall readings of PCE versus the CPI.
Indicators of manufacturer and retailer pricing power remain at extremely high levels. It is unlikely that inflation can be slowed materially until this recedes. At this point there is little evidence of demand destruction caused by rising prices.
The Dallas Fed’s Exuberance indicator is providing a different perspective on the state of the US housing market.
While materially lower than pre-GFC levels, it still shows just how strong the environment has been compared to any other era going back to 1981.
The move in the mortgage rate is rapidly impacting equity values in the space, though current activity levels remain very robust.
Europe and China economies
Surveys of economic activity in the Eurozone and China point to significantly slower activity.
The Ukraine war and higher commodity prices are dragging on Europe, while Beijing’s zero-Covid policy is seeing further shutdowns in China.
We expect the economies of the EU and the US to begin to diverge materially from here, given the much lower exposure of the US economy to these headwinds.
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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.
How the federal budget will affect rates and bonds, why ASX stocks and Australian bonds look good, how to find competitive advantage among international shares
Not surprisingly in an election year, the federal government is already spending its recent windfall in the Budget. TIM HEXT explains what that means for rates and bonds
WHETHER you like the federal government or not it’s a fact their time in power has not been a happy one.
Natural disasters and pandemics have defined the past three years.
But some good fortune has finally come their way in the past year as Australia’s terms of trade have boomed.
Even the Ukraine conflict, which of course is a terrible disaster, has seen prices take off for many of our exports.
This has delivered the government a huge windfall via company taxes and some royalties. Added to this is the massive fiscal spending delivering a stronger economy domestically.
Over the course of four months or so, the federal Budget has improved by about $115 billion over the next four years.
Not surprisingly with an election imminent Treasurer Josh Frydenberg (pictured above) has spent $30 billion of it — on top of a previously announced $16 billion in pre-election handouts.
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What it means for rates and bonds
From a bond market perspective this adds further fuel to an already strong economy.
Dealing with supply shocks by subsidising demand only helps keep prices elevated.
But politics trumps economics.
The 22c fuel excise reduction plays to this although I doubt Australia’s reduced demand will impact global prices much.
The RBA is already on the precipice of finally admitting they need higher rates — and this budget will only encourage them more.
But with markets forecasting 2% rates in Australia by early next year — and 3% by the end of next year — there is quite simply too much priced in.
We think the US will get to those levels, but investors assuming Australia must follow are missing a couple of factors.
Firstly, our inflation is significantly lower.
Secondly, our floating rate mortgage market means any rate hikes have more impact sooner.
It may seem strange but when the RBA actually starts to moderately tighten rates, bond markets will likely rally.
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
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.
Here are the main factors driving the ASX this week according to our head of equities Crispin Murray. Reported by portfolio specialist Chris Adams.
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Find out about Crispin’s sustainable Pendal Horizon Fund
EQUITY markets continue to bounce despite increasingly hawkish rhetoric from the Fed.
The S&P/ASX 300 gained 1.6% last week and is now up 0.8% for the 2022. The S&P 500 gained another 1.8% to be down 4.3% for the year. The NASDAQ is still down 9.3% in 2022 after gaining 2% last week.
It’s remarkable that this takes place against a sharp increase in two-year US bond yields, a surging oil price and a US dollar grinding higher.
These factors are usually headwinds for equity markets, as seen in late 2018.
There are several potential reasons for the ongoing recovery in equities. These include:
- Sentiment and positioning being too negative, leading to a technical bounce
- A poor outlook for bonds, driving rotation to equities
- Equity inflows remaining positive despite softer investor sentiment indicators
- Economic growth supporting earnings, underpinning a view that the market can de-rate without a bigger correction
- A belief that the pre-requisites for economic slowdown are being put in place and rates will not need to rise as far as the Fed is saying
We remain wary in the near term. The Fed needs financial conditions to tighten – and rising equities works against this objective.
Potential scenarios
We see three potential scenarios that are more likely than a continued strong equity market rebound:
- The market consolidates and treads water for a few months as we gauge central bank ability to contain inflation. This would be consistent with the history of US bull markets, which shows that the third year is often lacklustre — particularly if the first two are very strong. As an aside, if we are near the end of the post-March 2020 rebound it would be by far the shortest bull market in US history.
- The market falls back to set new lows reflecting falling liquidity, concerns over slower growth dragging on earnings and a lack of certainty. Slower economic growth eases inflationary pressure, allowing interest rates to peak at levels the market or Fed are currently expecting, without triggering a recession. This enables a market recovery. Fed chair Jerome Powell notes there have been similar “soft landings” in US monetary history in 1967, 1984, 1994 and 1998. Each involved the yield curve going flat, with the Fed funds rate subsequently getting cut.
- Similar to scenario two — except we end up in recession due to policy error or as the only way inflation can be contained. History indicates that when you see oil rise more than 100% year-on-year it triggers a recession. So too does persistent inflation at current levels.
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US monetary policy
Powell last week noted the need to move “expeditiously” back to a neutral rate setting.
This kind of language is usually a signal. It’s widely interpreted as an increased chance of a 50bps move in rates in May and possibly in June.
Powell also reiterated that the Fed would need to go above the neutral rate, which is currently estimated at 2.5%.
This is all about getting to the neutral rate as quickly as possible, since anything below that is still stimulatory. The challenge is doing so without prompting a financial shock.
As discussed last week, this rally in equities and credit is loosening the overall Financial Conditions Index. By some measures, it has unwound a third of the recent tightening. The Fed will need to engineer more tightening to achieve its goals.
The market is moving to a view that the Fed is worried real rates run the risk of being too low through 2022 — and therefore the best way to avoid a recession is faster near-term rate increases plus early quantitative tightening.
Inflation outlook
There are small positive signs that freight rates may be easing at the margin. A slowing economy will help this process.
This is countered by continued pressure in commodity markets.
The focus is shifting to food inflation, where we see:
- A sharp rise in fertiliser prices, which are tied to gas prices. The Tampa contract (a measure of ammonia prices) is up 43% in April compared to February/March.
- Glyphosate prices are already high, affecting weed control
- The price of diesel — necessary to run equipment — has more than doubled in the past 12 months
- Labour shortages
- Propane storage levels are at their lowest levels in seven years. Propane is used in about 80% of grain dryers to reduce moisture and allow storage.
The UN Food and Agriculture Organisation’s Food Price index has hit all-time highs, eclipsing the previous highs which played a role in the Arab Spring. This is before many of the effects of the Ukraine conflict have flowed through.
Europe
The European economy continues to weaken based on sharp falls in a number of sentiment indicators.
For example, the German IFO Business survey of future business conditions reported its biggest ever single-month decline.
Sentiment indicators are not far off what was seen at the onset of the Covid pandemic.
We are now seeing some fiscal policy response, predominantly in the form of fuel subsidies. The latter may be more effective politically than economically, given they underpin demand in a supply constrained environment.
Despite fiscal moves the chance of recession in Europe is still priced at greater than 50%.
Australia
There is speculation the federal budget will include a temporary reduction in the fuel excise (currently 44.2c per litre). A 5c cut for six months would cost about $1 billion.
Infrastructure spending of up to $18 billion is expected. But it’s hard to see this flowing through quickly due to difficulties in executing projects and the tight labour market.
More broadly we reiterate our view that Australia is better placed than many other countries.
There is less need to raise rates, allowing them to remain lower for longer.
The economy is benefiting from pent-up demand as restrictions roll back. Australia is largely self-sufficient in key commodities and is a beneficiary of rising prices here.
This underpins our relatively positive view of the domestic equity market.
This is reinforced by the degree to which the Australian market has underperformed the S&P 500 since the GFC.
While recent outperformance has been material, it is a blip on a longer-term view. This gives us confidence in the potential for further outperformance.
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A continued rise in 10-year US government bond yields (up 33bps last week to 2.48%) has taken them back to the top end of a 30-year downward trend.
The consensus is bearish — with a view that yields rise to 3%.
Sharp moves such as last week’s are often followed by a period of retracement, so we wouldn’t be surprised if there was some relief in the near term.
The rise in 10-year yields signals that the US market is still not of the view that we are entering a downturn. This may explain why equities have been able to rally through this increase.
It is worth highlighting how rate-sensitive sectors have been affected in the US.
Homebuilders continue to fall on expectations of a housing downturn, as have consumer discretionary companies seen as tied to housing, such as Home Depot. We have not really seen the equivalent of this in the Australian market.
Australian equities continued to grind higher last week.
Resources (+6.3%) and Energy (+5.3%) recovered from the prior week’s fall. Technology (+3%) began to bounce, but remains the weakest sector over 2022 to-date, down 15.5%.
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.