Here are the main factors driving the ASX this week according to Pendal investment analyst ELISE MCKAY. Reported by research analyst Jonathan Choong

Find out about Pendal Focus Australian Share Fund
Find out about Pendal Horizon Sustainable Australian Share Fund

MARKET expectations solidified around a 25bps February hike after the latest US CPI data suggested inflation had peaked and was showing a clear downwards trajectory — even as labour markets remained strong. 

But more evidence is needed to support the narrative that inflation has well and truly peaked and a downward trend is sustainable.

It’s looking increasingly like the US will hit its debt ceiling limit in mid-January and exhaust extraordinary measures by June.

Unlike recent debt ceiling negotiations, this is shaping up like the 2011 fiscal showdown which resulted in a downgrade of the US credit rating.

That downgrade was materially disruptive for financial markets, so this could develop into a major story in 2023.

It will be important to monitor this closely in coming months.

Key macro issues for 2023

It’s looking more likely that the UK and Europe recessions will be shallower than initially thought — or even avoided.

This is due to several things: a sharp decline in energy prices, a lower CPI print and industry benefitting from a faster-than-expected China reopening.

A scenario of more-resilient global economies, a potentially weaker USD and tight labour markets could lead to rates staying higher for longer.

If that turns out to be true, returns would likely be capped, particularly for sectors that have been most leveraged to lower rates.

Australian retail spending remained strong over the holiday period. Inflation at 7.4% has locked in a 25bps increase at the RBA’s February meeting.

We’ll get more clarity with further data in the coming week including Empire State manufacturing data on Tuesday; retail sales, industrial production and homebuilder sentiment on Wednesday; claims & housing starts on Thursday; and existing home sales on Friday.  

Economics and policy

In the US, headline CPI was in line with expectations at -0.08% for December. Core CPI rose 0.3% on the month.

Year-on-year headline inflation declined from 7.1% to 6.5% in December — the lowest reading in the US since October 2021.

The driving force behind this was the sharp monthly drop (-4.5%) in energy, with gasoline prices down 9.4%.

Gas prices were down 1.5% in December (YoY). On the current trajectory that rate will fall below -20% by March.

We also saw a material slow-down in food inflation after recovery from droughts which affected fruit and vegetable prices. Food inflation has now reached its lowest level since early last year.

On a last-quarter basis, core CPI has grown at an annualised rate of 3.1%.

The key contributor is deflation in core goods (about 20% of CPI). In contrast, monthly services inflation (about 60% CPI) has decelerated to 0.5% vs an average of 0.6% in the third quarter.

Declining used car prices have continued as the biggest driver of goods inflation.

Deflation has now moved into new cars where we saw the first price decline since January 2021. It’s expected this will continue based on anecdotal evidence of auto players cutting prices. (For example Tesla has cut prices globally by up to 20%.)

Services inflation is so far proving to be harder to break. Core services were up 0.5% in December (a 3-month annualised rate of 6.1%).

Shelter inflation has accelerated to its fastest growth in 12 months (+0.8%). But this is expected to moderate significantly through the second half, given deceleration in asking rent growth.

Core services (excluding housing) rose by +0.3% for the month. Hospital services was the biggest surprise, up +1.5% — the biggest jump since October 2018.

This increase is well above the trend of +0.2% per month due to seasonal issues and is expected to return to trend this month.

Overall, adjusted core inflation excluding rents and other Covid-distorted components (eg vehicles, airline fares, lodging, and health insurance) rose 0.3% in December.

This was slightly up from Oct-Nov 2022 but well below the spikes seen in Jun-Sep last year.

Labour market data shows hourly wage growth is slowing in temporary and permanent employment.

If this continues downward it should provide the Fed some comfort that the inflation trend has clearly moved lower.

Jobless claims remain low at 205,000 despite pain felt in the technology industry which continued to see further job losses this month.

However, low jobless claims and anecdotal feedback suggest recently-unemployed tech workers are quickly finding jobs in other parts of the economy.

Supply-chain bottlenecks continue to reduce as Covid pressures ease and demand softens.

Global container trade volumes declined 9.5% in the year to November (and -3.7% YoY so far in 2023). This is expected to continue into December and the first half of 2023 before recovering later in the year.

US Politics

US treasury secretary Janet Yellen called on Congress to raise the debt ceiling after forecasting the $US31.4 trillion borrowing limit would be reached on January 19 — and extraordinary measures would likely be exhausted by June.

A 2011-like US credit downgrade is looking more likely after it took 15 votes for Kevin McCarthy to be appointed Speaker of the House.

A package of concessions to win over conservative holdouts included a tougher stance on spending. 

This has the potential to be a major story for markets over the next six months and should be closely followed.

There is a wide range of potential outcomes from a bipartisan deal to government shutdown or even debt default.

Though it’s most likely there will be an 11^th-hour bipartisan deal, even if the path to get there is long, painful and volatile for markets. 

Eurozone and UK

Increasingly, it’s looking like Europe’s recession will be shallower than initially thought.

A better-than-expected outlook is due partly to a mild winter and widespread efforts to conserve energy.

This led to a 20 per cent yearly drop in European gas demand during the fourth quarter. There has been a sharp decline in energy prices as retail and industry seek greater energy efficiency.

On the supply side, actions to diversify gas sources via the importation of liquefied natural gas has contributed to European gas storage levels reaching 82 per cent.

This is well above the usual level of about 65 per cent at this point in the winter.

This should provide comfort that sufficient supply is available to maintain lower prices into — and potentially through — the summer.

The improving economic outlook is further supported by better-than-expected data for UK and Germany. 

The UK economy grew in November for the second month in a row after contracting in the third quarter. In Germany early estimates suggest fourth-quarter output was flat versus the previous quarter, compared to expectations of a contraction. 

European industrials are also well positioned to benefit from reopening in China economy throughout 2023.

These positive signs have been well received by the market. European stocks have outperformed so far this year (+9.5% vs +4.2% for S&P500 and +4% for ASX100).

Markets

Last week was strong across the board. 

NASDAQ was the strongest performer for the week while Europe continued to outperform with a solid 9.5% for the year so far. 

Looking back to 2022, since 1900 the US 60/40 “worlds and voting retirement” portfolio was down 17% in 2022 — the fifth worst year on record.

Following the ten worst years for the 60/40 portfolio, the median return for the next year is +17% with a 90% hit rate (only the great depression was negative).

The 2023 numbers further support this trend with the stock and bond portfolio off to its best start since 1987 after a return of +4% YTD.

As mentioned in last week’s note, Commodity Trading Advisor positioning is near five-year lows and Mutual Fund Exposure is running the biggest absolute cash levels on record ($235 billion). This should continue to be supportive for upside moves.

Australia

In Australia, November CPI was up 7.4% year-on-year (versus consensus of 7.2%). This was an acceleration from 6.9% in October.

Retail trade also surprised with a 1.4% increase in November, reflecting a strong start to the holiday shopping season.

This strong data supports the RBA continuing to hike by 25bps in February — and likely another 25bps in March.

It is still too early for the RBA to consider pausing — and if that’s the case, the housing correction is likely to continue until at least mid-year.

In markets, performance was largely driven by the macro themes with all sectors except utilities ending up for the week. The S&P/ASX 300 was up 3.11% and Small Ordinaries 2.86%.

---

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

Effective on or around 23 January 2023, Perpetual Limited (Perpetual) will acquire Pendal Group Limited (Pendal) by way of a scheme of arrangement. As part of this arrangement, Pendal Fund Services Limited, Pendal Institutional Limited and J O Hambro Capital Management Limited (JOHCM) will become wholly owned subsidiaries of Perpetual Limited but will continue to operate in the same way they have always done in the management of your money.

Who is Perpetual?
Perpetual is an ASX-listed, diversified financial services company which has been serving clients since 1886. Perpetual is one of Australia’s largest wealth managers, an expert adviser to high net-worth individuals, families and businesses, and a leading provider of corporate trustee services, with offices across Australia, Asia, Europe and the US.

What does this change mean?
There are no changes in relation to your investment. Pendal’s investment team independence and its Pendal, J O Hambro and Regnan brands will be retained. There will also be no change to the reporting you receive on your investment or the way you access information.

What do you need to do?
You will not have to do anything as a result of the change in ownership.
If you have any questions or wish to find out more, contact our Investor services team on 1300 346 821.

Pendal Dynamic Income Fund – Class R (APIR: BTA8657AU, ARSN: 622 750 734)

Effective on and from 11 January 2023, the existing units of the Pendal Dynamic Income Fund (the Fund) will be known as the Class R, class of units in the Pendal Dynamic Income Fund.

This is simply a change of name for your existing class of units. Importantly, there will be no changes to the terms of your investment or your rights and entitlements as an investor in the Fund.

What does this change mean?

As there are no changes to the terms of your investment, you will be able to continue to invest or withdraw from the Fund as you have always done.

A new Product Disclosure Statement (PDS) for the Pendal Dynamic Income Fund – Class R is available at www.pendalgroup.com. 

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 Pendal Focus Australian Share fund

US payroll data last week indicated that wage pressure is perhaps easing faster than expected.

If this comes without the need for a substantial rise in unemployment, it potentially allows the Fed to pause sooner than expected.

While it is dangerous to extrapolate one month’s data, it did drive bond yields lower while equities and gold moved higher.

The S&P 500 rose 1.5% and the S&P/ASX 300 gained 1.1%.

China’s shift away from their covid-zero policy continues to accelerate faster than almost all expectations. There are signs that Beijing has seen the worst of its wave, with a number of other cities close behind.

This suggests there will be more travel in Chinese New Year and a faster recovery once we get through February.

Iron ore rose a further 16.5% in response. Industrial metals also began to show some life.

Oil bucked the trend of commodity strength. Warm weather in the US and Europe – with forecasts of more to come over the next two weeks – drove gas prices lower, which flowed through to oil.

This helps with the narrative of easing inflation and less pressure on growth, although it is a short-term factor.

The key issues for 2023

There are six key questions leading into 2023.

1. The persistence of inflation, which will determine how tight financial conditions need to be.
2. The scale of economic slowdown in the US and other developed markets.
3. The leverage of earnings to that downturn.
4. Whether markets have already priced in the downturn.
5. How China’s economy performs as it exits covid-zero
6. Can the RBA engineer a soft landing in Australia.

Initial signs on the first three issues are positive. The first datapoints of the year suggest that inflation is lower than consensus expectations, which in turns requires less tightening, a milder downturn and a small hit to earnings.

This supports markets in the near term. So too does the current outlook for China.

The consensus view has been for markets to re-test equity low points in the first quarter as earnings revisions turn negative.

As a result investor positioning has been cautious, with the market braced for a poor reporting season. Ironically, this may lead to the market holding up better than expected.

Near term liquidity may also be supportive. The US Treasury has been running down its cash position as it nears its debt ceiling.

In the near term, this offsets some of the effect of quantitative tightening. That said, it is hard to see a sustained market move materially higher.

The Fed is likely to rein in any substantially easing of total financial conditions – which includes equity markets. The economic downturn is still also likely, with earnings set to fall. A market multiple of 17x in the US does not provide much of a buffer to this.

Economics & policy

US December payroll data showed a clear slowdown in Average Hourly Earnings. December’s print of 0.3% month-on-month growth was below the 0.4% consensus expectation.

November’s 0.55% figure was also revised down to 0.4%. This was an unusually large revision – a 3.5 standard deviation event and the largest since 2011.

Three month annualised wage growth now stands at 4.2% and annual growth at 4.6%.

The longer-term deceleration is now evident. The Fed will still want to see these figures below 4%, but it is likely to lock in a 25bp rate hike in February unless we see a dramatic deterioration in CPI numbers this week.

It is worth noting that other wage measures such as the NFIB survey are not as positive yet. Given the scale of swings in revisions, some caution should be applied to the Average Hourly Earnings data.  

The other key message from the payroll data is that while employment growth is slowing, it remains resilient. December payrolls rose 223k in December, above consensus expectations of 203k. This is still too high for the Fed to feel comfortable about inflation.

We note that the annual benchmark process takes place in February. This can lead to significant revisions.

Last’s month’s discrepancy between payroll data and the household survey unwound this month. The latter rose 717k, with unemployment falling back to cycle lows of 3.5%. The argument that this signalled overstated job growth is now dispelled. 

There was a second consecutive monthly fall in hours worked, which is a signal that the economy is slowing.

There is a reasonable argument that companies may “hoard” labour this cycle and reduce hours worked rather than lay off employees, given the recent challenges in hiring and high turnover rates.

Labour force participation rose this month and the additional supply may also help constrain wage growth.

Overall, the data suggests reduced risk of recession as we have seen wage growth decelerate without a rise yet in unemployment. Hence the market’s positive response.

All eyes will be on the CPI print on the 12th. Forward indicators are suggesting inflation easing off further.

China

Beijing’s policy U-turn is remarkable.

The Golden Week holiday runs from 21st to 27th of January this year. By that stage it appears that many people in major cities will already have had Covid. The travel during this period is likely to exacerbate the wave in other regions.

The true reasoning behind the change in policy is opaque. But it does appear as though Beijing has made a calculated gamble to wear the disruption this causes at what is traditionally a very quiet time of the year for the productive side of the economy.

While official Covid stats don’t provide much insight, other source such as commuting data (eg subway use) suggests that the slump in activity may already have bottomed, particularly in the major cities.

Japan

The shift in the target for bond yields has led to a sharp move higher in Japanese government bonds and is putting pressure on the Bank of Japan to intervene in the market.

One potential knock-on effect is possible repatriation from other bond markets as a result of the higher yields and stronger Yen.

Japanese holdings of US bonds have moved negative year on year. Other bond markets such as Australia are potentially more vulnerable to such selling, which may lead to bond yields holding at higher levels.

Energy

Over the next two weeks the US is forecasting temperatures 2.4 stand deviations above normal and Europe 2.1 standard deviations.

Austria’s ski slopes in January don’t normally resemble Thredbo in October. It goes some way to explain the recent weakness in oil prices.

The unseasonably warm weather helps Europe avoid the near-term energy crisis many feared. It has meant gas prices down -16% for the week, which has fed through to lower oil and electricity prices.

It is also raining hard in California, which will help with hydro generation.

All up it is estimated the weather effects are causing oil demand to be 1.4m barrels per day lower than normal. With China still in the midst of a covid wave, demand there has not yet started to pick up. That said, these are temporary factors and a reversion back to normal temperatures and China re-opening should help oil demand recover within a month.

 

---

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 a 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

• Crispin Murray: Why bringing together Pendal and Perpetual makes sense

IN AUGUST 2022 we announced plans to bring together Australia’s two leading asset management businesses, Pendal and Perpetual.

We continue to believe this proposal would create Australia’s pre-eminent global asset manager, with clients benefitting from greater scale across customer service, distribution, technology, infrastructure and ESG leadership.

Since then Pendal and Perpetual have been working together constructively to finalise the details of this proposal.

On November 17, Pendal and Perpetual both publicly confirmed in separate ASX statements that the proposed merger is proceeding.

You can read Pendal’s statement here and Perpetual’s statement here.

The proposal remains strongly supported by our fund managers, given Perpetual’s commitment to preserving our culture of investment independence and the autonomy of our investment management teams.

The NSW Supreme Court provided further clarity to enable the two businesses to come together. You can read more here.

On December 23, Pendal shareholders overwhelmingly voted in favour of the proposed acquisition by way of a scheme of arrangement. You can read about the details on our shareholder website.

The scheme remains subject to court approval on January 11.

In the meantime, I want to reiterate that Pendal will continue to manage your investments to the best of our ability, as we have always done.

We look forward to doing so for many years to come.

I warmly thank you for your support and trust. Please do not hesitate to call or contact your Pendal account manager.

Please do not hesitate to call or contact your Pendal account manager.

– Richard Brandweiner
CEO, Pendal Australia

Some investors might be surprised to find countries such as South Korea and Taiwan classed as emerging markets. There’s usually a good reason explains Pendal’s JAMES SYME

• Read more: Why some EM investors may benefit more than others as the tide turns
• Find out about Pendal Global Emerging Markets Opportunities fund

SOUTH Korea is one of the few countries in the world to develop its own supersonic jet fighter.

It’s a stable and mature democracy — and home to some world-leading technology companies.

So some investors might be surprised to find it’s classed as an emerging market, along with Taiwan and  wealthy Gulf countries such as Saudi Arabia and the United Arab Emirates.

What is an emerging market? Who decides the definition of emerging equity markets?

It’s an enduring controversy. Some countries at the more advanced end of the emerging markets (EM) spectrum could arguably be classified as developed markets.

It’s useful for investors to understand how countries are classified as emerging markets as opposed to frontier (or pre-emerging markets) and developed markets.

The origin of emerging markets

The term “emerging markets” dates back 40 years.

The International Finance Corporation (an arm of the World Bank) first began tracking stockmarket returns in 10 developing countries such as Argentina, Brazil and India in 1980.

The IFC came up with “emerging markets” as a way of describing these countries after rejecting dated terms such as “third world”.

The IFC based its definition on economic development, as measured by Gross National Product per capita (the annual value of a country’s goods and services divided by its population).

These days the definition used by the largest index provider, MSCI [PDF], is based around economic development, market size, liquidity and accessibility.

Under MSCI’s methodology four wealthy Gulf economies — Saudi Arabia, the United Arab Emirates, Kuwait and Qatar — are emerging markets, as are the highly successful economies of South Korea and Taiwan.

The case for South Korea

The question is often asked: is South Korea really an emerging market?

Events in the Korean domestic bond market since the end of September show why it probably still is.

The full series of events are too long to go into here.

But in short, a newly-elected provincial governor decided — for political rather than economic reasons — to push the local developer of a Legoland Korea theme park into bankruptcy and to renege on a government guarantee of the development company’s bonds.

The effect on domestic bonds was rapid and serious.

New issuance by local government development and housing companies proved impossible through October. Some major borrowers with investment grade credit ratings were unable to place bonds.

The bonds that the development and housing companies issue are called Project Finance Asset-Backed Commercial Paper (PF-ABCP).

They are the main funding source for Korea’s private-sector property developers, who saw their bond yields spike and began scaling back finance for new projects. In what very much looks like contagion, a mid-size life insurer delayed exercising a call option on some of its perpetual bonds.

This was the first time this had happened since the financial crisis in 2009.

Despite the specific cause, this has come at a time of rising global interest rates and bond yields, a stronger US dollar, and a slowing Korean economy.

The conditions were in place for financial stress, but the combination of volatile politics and weak institutions acted as a trigger.

Dramatic move

The overall effect has been a dramatic move in the whole Korean commercial paper market.

Three-month Korean commercial paper typically has yields 0.25-0.5% higher than policy interest rates, but the gap at the end of November had reached 2.3% and still looked to be increasing.

So, despite generally tightening monetary policy through higher interest rates this year, Korean authorities have had to engineer a repurchase program to stabilise the market.

At the time of writing, this was KRW 2.8trn (USD 2.1bn) — but its size and scope have been steadily increased and more may well be required.

Ultimately, the creditworthiness of these instruments has not changed.

This is a shock to confidence — a market panic in the style of the nineteenth century.

The Bank of Korea and the Ministry of Finance are responding in the right way and they have the monetary firepower to settle the market at some point.

But there must be some resulting drag on Korean GDP growth and corporate earnings.

And this is why South Korea remains an emerging market.

Long-term excess returns

The long-term excess returns of emerging market equities over developed market equities compensates investors for the extra risk and volatility of emerging markets.

That risk can come in many forms. But it definitely includes a single provincial politician pushing the local Legoland into default and blowing up the entire domestic commercial paper market.

---

About Pendal Global Emerging Markets Opportunities Fund

James Syme, Paul Wimborne and Ada Chan are 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 Pendal Focus Australian Share fund

A LOW point in the VIX volatility index last week proved to be the signal for a correction in the recent rally.

There was no specific macro news to prompt this. The weight of buying faded and the market shifted to a cautious position ahead of this week’s Fed meeting.

US ten-year government bond yields rose 9bps and the S&P 500 fell 3.4%.

Brent crude oil fell 11.1% and is now down for the year to date, as the market worries about a downturn in demand.

China’s re-opening appears to be happening faster than expected.

The iron ore price rose 9.6% as a result, and is helping underpin the Australian equity market. The S&P/ASX 300 was down 1% for the week. It has outperformed the S&P 500 by about 17% in 2022.

The RBA hiked rates 25bps, as expected, and struck a more cautious tone on inflation.

We also saw the federal government launch a new energy policy which at first glance looks under-prepared. The policy introduces price controls that would likely make the power problem worse in the future.

There are six big macro issues going into next year:

1. The persistence of inflation — and how tight financial conditions will need to be in response
2. The scale of economic slowdown in the US and developed markets. (Real-time signals are benign, but the yield curve is a very negative signal)
3. The earnings leverage to that downturn — and whether nominal growth buffers earnings
4. Whether markets have already priced in economic downturn. The bear view is that markets bottom during recession, not before. Bulls point to a falling oil price, a weaker US dollar and lower bond yields as evidence of lessening headwinds for equities  
5. What China’s economy does as it exits zero covid
6. Whether the RBA can engineer a soft landing in Australia

US inflation outlook

Inflation signals were marginally negative last week.

After average hourly earnings surprised on upside — which market founds reasons to dismiss — the Atlanta Fed wage tracker indicated wage growth was staying elevated at 6.5%. (Though the series is believed to overstate by around 1%, relating to career progression effects.)

When measured against the Employment Cost Index, this suggests limited relief on the wage front.

The Producer Purchasing Index was also higher than expected, rising 0.3% month-on-month and 7.4% year-on-year, versus 8.1% in October. Core PPI was +0.3% and 4.9% year-on-year. The trend is still lower.

There is a view that if you hold good inflation flat and factor in the real-time rent inflation number (which is now close to zero), you can make a case for inflation tracking to 3.2%.

The question is whether this is sufficient for the Fed.

Since this number may still drag inflation expectations up, it may be seen as still too high, requiring a weaker economy and tighter monetary policy to bring it below 3%.

The Fed and the economy

The Fed meets this week, with the market clearly primed for a 50bp hike in rates.

There will be a few key issues to watch:

• Whether the Fed signals any further slowing in the trajectory for rates at the next meeting. (This is unlikely given it’s not until the end of January)
• Where the dot plots have moved to in terms of peak rates and duration
• Any messaging on the long-term real rate assumption. (Again, we think this unlikely)
• The tone of the Fed press conference, given Powell’s recent shift from a hawkish to a more benign stance.

The market is now expecting the Fed rate to reduce relatively soon after hitting its peak.

Total financial conditions — a measure of changes in key indicators such as mortgage rates, credit spreads, equity markets and currency moves — have eased considerably since October.

This has reduced the risk of the Fed over-tightening. But it may also result in the Fed thinking they need to do more.

One thing to note is that real US money supply (M2) has plunged from more than 20% a year ago to -7.2% in December. This is its lowest point in more than 50 years.

This is prompting a view in some quarters that policy is already more than tight enough.

The US yield curve is more inverted than at any point in 40 years, providing further fuel for the bears

Job openings are coming down — indicating a cooling labour market — but there remains a fair way to go.

Elsewhere, developed-market ISM manufacturing indices are deteriorating and moving into contractionary territory. This indicates a slowing global economy.

China

Beijing continues to move faster than expected on re-opening, with zero covid effectively dead as a policy from December 7.

The retreat from PCR testing means we won’t see a headline surge in case numbers. The issue will be hidden until it is potentially evident through pressure on the hospital system.

This suggests we are tending towards the “quicker re-opening” or “chaotic re-opening” scenarios.

This may not be good for the economy in the near term if it leads to absenteeism and possible supply disruptions,

Oil

The oil market continues to weaken despite crude inventories continuing to fall.

Inventories of diesel and petrol products built meaningfully last week. Some saw this as a sign that end demand is falling in the US. But it may just reflect a seasonally stronger production period for refineries.

One concern for the oil market is that the time spreads for oil futures in the front months have moved into “contango” (an upward sloping curve, indicating futures contracts are trading at a premium to the spot price). This means trading oil becomes harder and less profitable, which reduces demand.

 

It may also signal weakness in the physical market, indicating softer demand.

We suspect oil will continue to be under pressure in the near term.

But the fundamentals relating to supply should underpin the medium-term outlook — as will demand recovery from China and when the market begins to look through any downturn in developed markets. 

Australia’s power intervention

There appears to be two elements to the Albanese government’s new energy policy.

The first is a near-term, stop-gap solution to try to get electricity prices lower. The second is draft legislation providing new powers for regulators and governments in the electricity and gas industry.

The near-term measures involve the government putting in a $12/GJ cap on uncontracted gas. It is unclear whether this is well-head or end-market including transport. There is also a A$125/ T cap on thermal coal, both contracted and uncontracted.

This means coal-fired power generation would break even at $60-65/MWH and gas power at $70/MWH.

The government is also committing to no coal or gas in the “capacity mechanism” — the structure that pays providers to have plants available to produce power when required.

The resulting lack of “firming capacity” — flexible supply to be called on when renewables are not functioning — would almost certainly lead to power cuts in the future.

In an effort to push it through before Christmas, the draft legislation is subject to only three days of consultation.

It involves a long-term price regime where gas is treated as a regulated utility.

Providers would be allowed an undefined “reasonable” price, based off an assessment of a fair return on the investment made.

The major flaw in this approach is that developing gas has a very different risk profile than traditional utility investment. The cost of developing gas projects can be a lot higher than planned. There are substantial operating risks and long-term pay-backs.

This means uncertainty around the pricing environment is likely to deter further investment in gas production and LNG import terminals, leaving Australia strategically short in gas.

The government is indicating it will introduce powers compelling companies to develop gas — effectively forcing private capital to invest against its will.

Unless changed, this demanding proposition could evolve into a battle like that over the mining tax under the Rudd government a decade ago.

From a stock point of view this may jeopardise the takeover offer for Origin (ORG).

It will also put pressure on AGL’s earnings, hampering its investment in the clean-energy transition. 

Markets

Resource stocks continued to outperform on the China re-opening theme. Fortescue Metals (FMG, +8.7%) was the best performer in the ASX 100 last week.

All other sectors lost ground and there was a clear defensive tilt. Tech and energy were the worst-performers sectors.

---

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

Emerging markets should benefit as sentiment turns on interest rates and the US dollar.
But some investors are better placed than others. Here’s why

• Economic outlook improving for Emerging Markets investors
• Country-level analysis an important factor in identifying opportunities
• Find out about Pendal Global Emerging Markets Opportunities fund

HIGHER US rates and a US dollar have recently curbed Emerging Markets returns, since they tend to depreciate other currencies, weaken US demand and draw capital out of EM economies.

As inflation comes under control, it’s expected that rate rises will decelerate and the US dollar will eventually weaken.

That’s good news for EM investors.

But there is another change that may benefit some emerging markets investors more than others: country-level factors are again becoming a powerful indicator of potential returns.

Investment managers that focus on top-down, country-level analysis should be able to take greater advantage of the changing conditions.

Why?

Country factors typically dominate style and industry factors in driving emerging markets returns.

This contrasts with developed markets which tend to have more features in common.

Emerging markets feature a wider range of political systems, demographic trends, industrial composition, resource endowments and economic development.

That’s where Pendal’s Emerging Markets team starts its analysis.

As you can see from these charts, most of the time it pays off:

But these charts also show that during the Covid period extraordinary monetary policy settings and falling bond yields drove the importance of style and industry factors.

This is reversing now and we are seeing country factors reassert traditional dominance.

This has coincided with a strong relative performance with the Pendal Global Emerging Markets Opportunities fund (GEMO), as you can see below:

%	3 Months	1 Year (pa)	3 Years (pa)	5 Years (pa)	Since inception (pa) 01/04/2005
Total return (after fees)	9.71	31.55	11.37	12.41	9.80
Benchmark: S&P/ASX 300 Accumulation Index	8.53	28.72	10.10	10.22	7.96
Performance over / (under) benchmark	1.18	2.83	1.27	2.19	1.84

Source: Pendal, Pendal Global Emerging Market Opportunities Fund – Wholesale, after fees and before taxes. Past performance is not a reliable indicator of future performance. Inception date Nov 7, 2012.

Performance drivers and positioning

This performance has been driven the fund’s strategy of holding countries that are well suited for a given investment environment — and avoiding those that are not.

The fund currently holds only nine of the 24 countries in the index.

These include countries such as Brazil, Mexico and Indonesia which have bucked the trend of broader emerging market weakness.

All three made positive returns in 2023.

Fund managers James Syme, Paul Wimborne and Ada Chan (pictured below) each draw on more 20 years of experience in emerging market investing,

They see clear signals that these markets are shifting into a virtuous circle of upswings in domestic demand which typically drive multi-year periods of outperformance.

A similar environment drove the last surge in investor demand for Latin America (prior to the GFC).

These economies have taken more than a decade to rebalance and repair.

Now another opportunity emerges.

The fund’s performance has also been helped by the team’s decisions on China.

The fund has been underweight in China as multiple headwinds — including Covid-zero and regulatory pressure on the property sector — weighed on markets.

James, Paul and Ada are keeping a close eye on Beijing, however.

There are signals of a shift in policies that have weighed on the economy and market.

It is too soon to overweight this market. Economic growth, the liquidity and credit environments and the currency outlook all remains negative.

But if policy becomes more supportive this could — in combination with historically cheap valuations — drive an opportunity.

Pendal Global Emerging Markets Opportunities fund’s emphasis on liquidity — and the agility to shift quickly between markets — will be a key factor in taking this opportunity when the time is right.

Emerging Markets outlook

High US rates and a strong US dollar are traditional headwinds to emerging markets as a whole — though as noted above there are countries bucking this trend.

It will take a shift in expectations around the US Fed’s hiking cycle to remove this headwind.

So far Pendal Global Emerging Markets Opportunities fund has been able to preserve capital relative to the benchmark. The fund has returned 0.73% annualised over the last two years, while the market is down 5.88% annualised.

This puts the fund in a relatively good place when the rebound in the asset class comes through.

We expect that, as always, owning the right countries will be important for performance in that period.

This is reinforced by the reestablishment of country factor dominance.

It is also aligned with our country-driven strategy, which has driven long-term outperformance.

---

About Pendal Global Emerging Markets Opportunities Fund

James Syme, Paul Wimborne and Ada Chan are 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 Pendal Focus Australian Share fund

JEROME Powell struck a more nuanced tone in a speech about US inflation and jobs last week.

The chair of the US Federal Reserve told a Washington DC thinktank that the central bank was mindful of overtightening as well as potential distortions in the CPI calculation.

The market interpreted this as a less prescriptive — and less hawkish — stance on rates than previously feared.

As a result, the S&P 500 gained 1.2% and US 10-year government bond yields fell 19bps. The S&P/ASX 300 was up 0.2%.

This outweighed the negative news of another firm payroll and average hourly earnings print.

There were reminders that the Fed may have to hold rates higher for longer than the market is expecting.

Optimism around China continues to support mining stocks and help underpin a rise in commodity prices.

It would not surprise us to see the market pause in the short term, given a) the equity market is approaching technical resistance levels, b) volatility has fallen to the low point of its range this year and c) key inflation data points are yet to come.

The depth of any economic downturn — and its effect on earnings — is the key swing factor for the medium-term outlook.

An important signal

Powell’s speech to the Brookings thinktank was an important signal.

There was not anything specifically new. He is still flagging a deceleration to 50bp in December and notes that the ultimate peak in rates may be higher than they expected in September.

The importance lay in the speech’s tone — which was far more balanced than his previous hawkish statements.

There were fears he would reprise the Jackson Hole speech, talking down markets after a strong rally.

Instead, his speech implied he did not feel the need to drive Total Financial Conditions higher in the near term.

(Total Financial Conditions indices try to pull together changes in key indicators — such as mortgage rates, credit spreads, equity markets and currency moves — as an early indicator of the market impact of stimulus or tightening).

Powell introduced a sense of both upside and downside risks. He noted several key points:

1. The view that peak rates may need to go higher than September expectations was his own opinion, and wasn’t necessarily shared by members of the Federal Open Market Committee (the Fed’s chief monetary policy body)
2. The probability of an economic soft landing was “very plausible”
3. The Fed could slow the pace of rate hikes as a “risk management” technique, to reduce risk of over-tightening
4. Taking rates beyond the expected peak would not be his “first choice”. He would prefer to hold rates at high levels for longer
5. Goods inflation is coming down
6. Housing inflation is mechanically higher due to low turnover; rents on some new leases are now dropping and will flow through with a lag
7. Services inflation was driven by wages, which have been affected by lower immigration and the great resignation

Without overstating its significance, this suggests the Fed is not looking to micromanage near-term financial conditions.

This more nuanced assessment of inflation — and the policy response — suggests the market does not need to react so violently to each individual data print.

The caveat, of course, is that Powell’s stance may change depending on the data.

US economic data insights

Jobs

Non-farm payroll data, while decelerating, continues to be stronger than expected with 263,000 jobs added.

Headline layoffs are still not countering broader employment gains across the service sector.

But the reaction was not as negative as might be expected.

There were seasonal elements at play, which may be subsequently revised down. The household survey showed a 138,000 fall in jobs and unemployment stable at 3.7%.

It was interesting to note that job leavers as a percentage of unemployed fell for the second consecutive month. This suggests people are more reluctant to leave jobs, which may be an indicator of a softening labour market.

Wages data remains incompatible with inflation falling below 3%. Private workers saw a 0.6% gain in hourly earnings. The three-month moving average stepped up as a result.

Powell highlighted a key challenge for the labour market: the section of the workforce that has not returned to work.

While the participation rate for 25-to-54-year-olds has rebounded, the same rate for over-55s has not recovered.

New job openings and labour turnover data was more positive for labour market softness as job openings continue to roll over.

However there is still a reasonable way to go here before the labour market has loosened up enough to lead to a step down in wage inflation.

Consumption

Earlier in the week we had the Personal Consumption Expenditures data — the Fed’s preferred inflation gauge.

It came in lower than expected, at 0.22% month-on-month versus a consensus expectation of 0.3%. The year-on-year figure is 4.98% versus 5% expected. 

The issue here is while underlying inflation has decelerated, it remains too high.

Manufacturing

The Institute for Supply Management manufacturing index fell from 50.2 to 49, versus 49.8 expected.

This confirms slowing manufacturing.

There were constructive signs. The employment component continued to fall, indicating softer labour markets. Pricing was lower and the supply component indicated backlogs reducing, which will help on the inflation front.

When you pull all this together, we conclude that the economy remains relatively resilient. There are clear pockets of weakness — notably in housing and some manufacturing.

 

But four factors indicate we still have a long path to sustainably lower inflation:

1. Catch-up in service sector spending
2. Real incomes holding up as a result of wage and employment growth and falling inflation
3. Excess savings remain in place (roughly US$1 trillion of the peak US$2.2 trillion still in place)
4. Lower participation rates

What’s changed is that earnings in the next couple of quarters may hold up better than feared — and the Fed is now more likely to hold rates higher for longer, rather than go for a higher, short-term spike.

This reduces some of near-term risk to markets. But it does not open the door to a more sustained rally.

We are likely to remain in something of a holding pattern.

China

Protests appear to have prompted a conciliatory policy response from Beijing.

Chinese vice premier Sun Chunlan avoided references to “dynamic clearing” (ie zero Covid) in a speech and said the virus was in a less dangerous phase.

Some lockdown measures were lifted in Guangzhou and Chongqing.

China is now aiming for vaccination of over-80s by the end of January.

However re-opening will be staggered and slow due to constraints such ICU capacity and desire to keep deaths low.

We may see more signals from the politburo and central economic work conference later this month.

Australia

Headline CPI data headline fell 40bp to 6.9% versus 7.6% expected. The trimmed mean fell 10bp to 5.3% (versus 5.7% expected).

Food prices fell more than 6% as the impact of floods receded. Holiday and travel prices fell 6.4%.

This is a short-term reprieve for the RBA which will help make the case for slowing rate increases.

However the firmness of the economy suggests inflation is unlikely to have been beaten yet.

Markets

Volatility — as measured by the VIX index of market expectations for near-term price changes — has fallen back to its lowest levels for 2022.

Historically, this has been a signal that markets are near a local high point.

This prompts caution. (Though it may also signal lower expectations of a significant policy mistake from the Fed and the market is getting more comfortable with the 2023 outlook.)

Overall, markets remain hostage to the inflation data and the degree the economy will slow.

Bears note that markets historically bottom three-to-six months after a recession has begun — and after rates peak, not before.

The Australian market was broadly flat last week, led by miners. A recovery in growth stocks and small caps indicates risk appetite has picked as bond yields have fallen.

---

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

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 Pendal Focus Australian Share fund

A CONTINUED drop in bond yields, a weaker US dollar and lower oil prices helped markets squeeze higher last week in a relatively quiet period on the macro front.

The S&P 500 rose 1.6% and the S&P/ASX 300 lifted 1.5% last week.

The key question is whether we are seeing the US economy slow enough to relieve inflationary pressure via labour markets and commodity prices.

This would allow the market to conclude the forward pricing of rate increases had peaked, regardless of Fed rhetoric. 

The other related issue is how weak the economy gets and what this means for earnings.

There are several possible scenarios:

1. A softer economy leads to falling bond yields and commodity prices. Earnings weakness is limited, allowing equities to continue rallying — potentially back to August highs (about 7% above current levels) 
2. A softer economy is followed by a significant earnings downturn, which after a near-term rally sees the market reverse to prior lows
3. Inflation remains stubbornly high, meaning the rate path needs to stay higher for longer despite a softening economy. This creates greater risk for economic and earnings downside and sees the market fall to new lows. All scenarios are plausible at this stage.

Equity markets are tied to the US dollar, the oil price and bonds yields.

It will be important to watch how oil performs following the OPEC meeting on December 4 and any potential Moscow reaction to price caps.

Bond yields are hostage to the outlook for inflation. The US dollar would likely weaken on signs of a softer economy and the rate outlook easing off — but would bounce back on signs of persistent inflation.

US Economics and policy

Minutes from the Fed’s last meeting suggest it is likely to pause rate hikes, reflecting the need to weigh up the lagged and cumulative effects of rate increases so far.

There was a reference to some members seeing the ultimate peak as higher than previously thought. This was the point Powell used in his press conference to try to contain any easing in total financial conditions.

Fed speakers continue to emphasise a lack of consistent evidence that inflation is coming down.

They continue to see embedded inflation as the key risk — and as a result prefer to err on the side of over-tightening. 

A variety of lead indicators such as shipping prices, import prices, crude oil prices and surveys of expectations are moving in the right direction.

Two issues continue to underpin inflation:

1. Supply chain shortages in certain areas. Several companies have recently flagged difficulties in obtaining certain parts. Part of the problem is that some industries re-tooled to different functions during the pandemic, prompting a structural decline in the number of suppliers of some industries.
2. Labour. Wages remain stubbornly high, underpinning service inflation which is not yet showing signs of falling.

There are some anecdotal signs of softening in labour demand.

The US National Retail Federation — the world’s biggest retail trade association — expect seasonal hires of 525,000 versus 670,000 last year. This week’s US employment data will be an important test of this.

Initial reports for Black Friday weekend indicate strong retail sales (partly due to inflation.

Mastercard data suggest in-store purchases increased 12%, e-commerce sales rose 14%, apparel sales climbed 19%, restaurants jumped 21% and electronics lifted 4%.

China

There are widespread reports of protests about Covid lockdowns. Whether this leads to more loosening or harsher clampdowns is unclear.

It is hard to get a near-term read on China.

Covid cases are rising as the country goes into winter with limited hospital ICU capacity and no new vaccines yet approved.

The resources sector has remained largely resilient. The market is choosing to look through near-term weakness to focus on the re-opening trade.

As expected, the People’s Bank of China further reduced its bank reserve ratio requirements by 25bp to 11%.

This is part of an effort to bolster the economy in the face of rising cases and lockdowns. 

Markets

The ASX has now recovered back above its August highs.

Financials, energy and resources have led the way. Staples, property and small caps have lagged.

Stocks expected to benefit from lower bond yields led the market higher last week. REITs, industrials and banks were the strongest sectors.

Miners lagged, driven mainly by weaker lithium stocks.

Chinese spot lithium prices have been falling. Monthly sales of electric vehicles (EVs) fell 21% in October, though there was some seasonality and impact from lockdowns.

EVs made up 19.4% of new registrations in October, versus 21.8% in September. There is some concern of excess lithium inventory in the channel. This is a volatile sector with a lot of momentum and is prone to sizeable drawdowns. Unlike other commodities the outlook for demand remains very strong and supply is likely to be constrained. Any inventory issue is likely to be short lived.

 

---

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