Here are the main factors driving the ASX this week according to portfolio manager Brenton Saunders. Reported by portfolio specialist Chris Adams

MARKETS continue to rally hard, helped by dovish Fed commentary following last week’s 25bps rate rise in the US.

We’ve also seen notable US economic data.

The Nasdaq lifted 3.3% last week while the S&P500 was up 1.6%. The S&P/ASX 300 gained 1.1%.

The NYSE FANG+ index – which tracks tech companies such as Amazon, Google and Facebook-owner Meta – is up about 30 per cent this year. Meta jumped 23% last week.

US bond yields and the US dollar rose moderately by the week’s end. Most of the moves came on Friday in response to very strong non-farm payrolls data, which raises expectations for further rate increases.

A stronger US dollar weighed on most commodities, though iron ore continued to make good gains.

Elsewhere, the European Central Bank raised rates by 50 basis points. Another 50 points is likely in March.

Commentary suggested the ECB was heartened by falling inflation, helped by a mild winter and a fall in natural gas prices.

US economy and the Fed

The US economy is so strong that some are wondering if it’s less about a hard or soft landing – and more about whether there is a landing at all.

Inflation continues to cool in many areas. But strong labour markets are confounding the more bearish economic forecasts.

The Federal Open Market Committee – which is responsible for setting US monetary policy – raised rates 25 basis points to 4.75%, in line with expectations.

Fed chair Jay Powell noted greater optimism around inflation and the start of a disinflationary process.

However, he also said the FOMC “anticipates ongoing increases in the target range would be appropriate” and there was “more work to do” on raising rates.

If the US economy performed as the Fed expected, it would not be appropriate to cut rates in 2023, Powell noted. This is in keeping with recent signals.

But if inflation slowed faster than expected, this would be incorporated into their thinking, he said.

On balance, markets took this nod to data-dependency as dovish – particularly since Powell down-played improvement in total “financial conditions” in response to a question.

Financial conditions tries to capture the cost and availability of funding, which impacts spending, saving and investing for businesses and households. Indicators include corporate borrowing rates, US equities and even the US dollar.

While the language was softer, there is a risk that the market’s interpretation is overly dovish in the face of continued strength in the US economy and labour market.

The latter was emphasised by Friday’s non-farm payroll data.

By Friday the short end of the US yield curve had more than retraced a bond rally that came after the Fed’s press release.

Some analysts are raising the possibility that the Fed may be raising rates by 50 points in March or May, rather than the currently expected 25 points.

The market continues to price Fed rate cuts in late 2023. This expectation may have to shift if labour markets remain strong.

The market is also implying rate cuts in Australia by the end of the year, but from a high point of about 3.6%, versus about 5% in the US.

The US dollar is down about 10% from its late September high (as measured by the DXY).

Some degree of consolidation – or even reversal – is now likely, which may be a headwind to commodities and markets in the near term.

We are likely to see a partial reversal of the 70-point decline in US 10-year bond yields since October 2022, as the market digests the impact of strong jobs data on the interest rate trajectory. 

The yield curve remains inverted on most measures.

Bears still point to this as the most reliable recession predictor.

US employment data

The cost of employment – measured by the Employment Cost index (ECI) and Average Hourly Earnings – is trending in the right direction. But other employment data has been surprisingly strong in direction and magnitude.

The market was looking for 188,000 new jobs in the non-farm payrolls last week – and got 517,000 instead.

Unemployment fell to 3.4%, down from 3.5% and below a consensus expectation of 3.6%.

The return of 36,000 workers from strike – and seasonal effects such as relatively warm weather – played a role.

Nevertheless this was a strong print which may result in some re-thinking of the rates trajectory.

This strength was also reflected the latest Job Openings and Labor Turnover Survey and initial claims for unemployment insurance.

US quarterly earnings

Just over half the S&P 500 by number (and roughly two-thirds by weight) have now reported December-quarter earnings.

The proportion of companies beating eps estimates remains at 69% – below the long-term average.

Aggregate consensus earnings estimates for FY23 have bounced from their lows on February 1, but are still down 2.3% since the start of major earnings releases this season.

Markets

The S&P 500 next-12-months (NTM) PE is 18.3x, up from lows of 15.5x. The market is forecasting 9% EPS growth for the NTM.

The ASX200 NTM PE is 14.9x, up from lows of 12.6x. The market is forecasting 1.8% EPS growth for the NTM. Technical indicators suggest the ASX 200 is fairly over-bought, with resistance at the 7600-7650 level.

Fed chair Jerome Powell today gave the green light to the market’s move to risk-on investing. But it may not last, writes Pendal’s TIM HEXT

JANUARY was a great month for risk. Equities and bonds had strong rallies. Credit spreads contracted.

As we entered February all eyes were on Jerome Powell and the US Fed to see if they would push back on the easing of “financial conditions”.

Here we’re talking about overall financial conditions for the real economy – not just where the Fed Funds rate is.

Financial conditions tries to capture the cost and availability of funding, which impacts spending, saving and investing for businesses and households. Indicators include corporate borrowing rates, US equities and even the US dollar.

Below you can see the Goldman Sachs US Financial Conditions Index, which suggests it’s becoming cheaper to access money or credit.

The Fed’s response?

This morning the US central bank announced a rate rise of 25 percentage points after a year of bigger hikes.

As always, we look to changes in phrasing in the official Fed statement. Today we saw the phrase “extent of future increases” replace “pace of future increases”.

This is interpreted as the debate shifting from last year’s theme of “25bp, 50bp or even 75bp” to “25bp or nothing”.

The Fed is keeping a few more hikes in its “dot plot”, but it’s now distinctly less hawkish.

All this was not unexpected.

Markets really did not react immediately after the statement.

Rather it was Powell’s press conference that saw equities and bonds get a boost.

The first question asked about the recent easing of financial conditions.

Many would have expected Powell to call this out as unwelcome in the fight against inflation.

He did not.

The Fed, like many central banks caught flat-footed a year ago, is now happy to react to data rather than predict it.

Of course, inflation is a lagging indicator meaning central banks, including the RBA, are happy to sit back and observe these long and variable lags.

Two of the three planks of high US inflation are now in a downtrend. Goods and rents price should ease further in the months ahead and disinflation will be the trend.

However, the third area of services prices remains high. Easing of wages and employment will be need to return to 2 per cent.

Overall though Powell has given the green light to January’s moves to risk-on investing.

February should see that trend continue although at a more modest rate given current levels.

By the middle of the year though, weakness in the economy and falling business margins may see pressures go the other way.

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

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

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

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

The team won Lonsec’s Active Fixed Income Fund of the Year award in 2021 and Zenith’s Australian Fixed Interest award in 2020.

Find out more about Pendal’s fixed interest strategies here

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About Pendal

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

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

Contact a Pendal key account manager

Here are the main factors driving the ASX this week according to portfolio manager Jim Taylor. Reported by portfolio specialist Chris Adams

THE market is still waiting for a clear indication of how much the global economy will slow this year.

Last week’s economic data didn’t provide a strong signal one way or the other.

European data continued to be better than many feared. US data told the story of moderating inflation and slowing consumer activity as higher rates began to bite.

US reporting season has been mixed from an earnings perspective.

About 100 S&P 500 companies report this week – including Apple, Amazon, Meta, Alphabet, McDonalds, Caterpillar, Merck and Exxon Mobil – which could provide a clearer picture.

Job cuts, which started in tech, have now spread to a broader cross-section of sectors.

The US Federal Reserve meets this week and is expected to hike 25bps, perhaps with some jawboning around “we are not done yet” to keep the bulls at bay.

The S&P 500 gained 2.48% last week. The NASDAQ was up 4.32% and the S&P/ASX 300 rose 0.56%.

North America macro and policy

The Bank of Canada became the first G10 nation to pause its hiking cycle after a 25bp increase to 4.5%.

The Canadians cited “growing evidence that restrictive monetary policy is slowing activity – especially household spending”.

Though they also noted economic growth was “stronger than expected and the economy remains in excess demand”. 

This bolstered a growing view that the risk of central banks dogmatically driving the economy into deep recession may have fallen. Instead, a growing chorus of voices suggest the US can achieve a soft landing – in stark contrast to consensus views just a couple of months ago.

In addition to Fed hawk Christopher Waller’s recent “case for cautious optimism”, prominent economist Larry Summers has said economic figures are looking better than he expected three months ago.

Summers had previously been bearish on the Fed’s ability to avoid a hard landing.

International Monetary Fund managing director Kristalina Georgieva also noted the global economic situation was “less bad than we feared a couple of months ago”.

Elsewhere, there was a slew of data released last week, none of which was individually significant or market moving.

December’s Core Personal Consumption Expenditures (PCE) index (a measure of inflation that excludes more volatile categories such as food and energy) increased by4.4% annually.

This is down from November’s annual rate of 4.7%.

On a monthly basis it was up 0.3%, in line with consensus. It is now at its lowest level since October 2021.

The deflator rose at 3.1% (annualised) in Q4, slowing from 4.5% in Q3 and 5.4% in Q2. Most of the downshift is in the goods component, with rents expected to begin slowing.

Data shows consumers pulled back in December, with spending falling by 0.2% from the month before. Personal income rose 0.2% last month, the smallest increase since April.

Personal saving rate as a percentage of disposable income increased to 3.4% from 2.9% in November.

The savings rate is now up one percentage point from its September low. This is all possible evidence of belts tightening.

Headline US GDP growth of 2.9% looks positive, but strength was driven by inventories.

Domestic demand was relatively modest and likely further weakens in the March quarter.

December new home sales rose 2.3% to 616K, marginally below the consensus of 617K. It’s likely a lack of existing homes for sale is pushing people to buy new homes.

Initial jobless claims are extremely low at 186k, well below the four-week average of 198k.

Employment agencies continue to indicate that wage pressures are subsiding.

Australia

Australia bucked the trend of moderating inflation, with the December quarter’s CPI print coming in hotter than expected.

Inflation rose 7.8% year-on-year, its highest rate since 1990 and ahead of 7.6% expected. It was up 1.9% over the quarter versus 1.8% expected.

The RBA’s preferred measure – the trimmed mean CPI – lifted 1.7% in the quarter to 6.9% year-on-year, versus consensus expectations of +1.5% and +6.5% respectively.

This is well above the central bank’s 2-3% target and ahead of its 6.5% end-of-2022 forecast.

A 25bp hike in February is now baked in.

Consensus still expects rates to peak at about 3.75% somewhere in the middle of the year.

Digging into the numbers, 87% of categories in the inflation basket are now exceeding 2.5% annualised growth.

Services inflation is now at the highest level since 2008, at 5.5% annualised. This was driven by travel-related categories including domestic airfares and accommodation (+19.8%).

Rents continued to rise in the quarter with the annual pace of increase now at 4%.

Given the current rental crisis across Australia it is hard to see any abatement in this area soon. Food and grocery inflation remains high and broad-based.

One bright spot is that the rate of growth in business input costs, including labour, have been falling across all industries since the mid 2022 peaks

Europe

The outlook for economic activity in the European Union continues to look less dire.

The Euro area composite flash PMI – a measure of economic activity – increased 0.9pts to 50.2.

The gain was broad-based across sectors as the services sector surpassed 50 for the first time since July 22. New orders, employment and backlogs all showed improvement.

US Reporting Season

About 30% of S&P 500 companies have so far reported actual results for the December quarter.

Of these, 69% have reported actual EPS above estimates. This is an improvement on 67% at the end of last week. But the five-year and ten-year averages are 77% and 73% respectively.

At an index level, aggregate Q4 earnings are 5% lower than the previous quarter. If this figure holds, it will be the first time the S&P 500 has seen a decline in annual earnings since Q3 2020, when earnings fell 5.7%. 

Four of the GICS 11 sectors are reporting year-over-year earnings growth, led by the energy and industrials sectors.

On the other hand, seven sectors are reporting a year-over-year decline in earnings, led by materials, consumer discretionary, communication services and financials.

Financials have been the biggest contributor to the decline in earnings estimates since December 31.

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About Jim Taylor and Pendal Focus Australian Share Fund

Drawing on more than 25 years of experience investing in top-performing Australian companies and a background in accounting, Jim manages our Long/Short Fund and co-manages our Imputation Fund. He is a Chartered Accountant with membership of the Australian Institute of Chartered Accountants.

Pendal Focus Australian Share Fund is managed by Crispin Murray. The fund has beaten its benchmark in 14 years of its 18-year history (after fees), across a range of market conditions. Find out more about Pendal Focus Australian Share 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

THE market seems increasingly convinced that inflation is last year’s problem and is falling faster than expected.

The focus has now shifted to the size of the economic downturn and the impact on earnings.

In that context, bad economic news now becomes bad for the market as it indicates a worse downturn. Good news, conversely, indicates less earnings risk. 

Last week manufacturing sentiment indicators and retail sales flagged a weaker US economy, driving the market lower. However supportive comments from Fed officials boosted markets late in the week.

The S&P/ASX 300 ended up 1.7% for the week. The S&P 500 fell 0.7%, while US 10-year government bond yields dropped 19bps.

The market looks bound in a tight technical range for now.

Investor positioning has shifted away from a more defensive stance and is now more of a headwind. However the market’s breadth and resilience provide confidence that support levels will hold.

US quarterly earnings season have just kicked off. So far we do not have a strong signal either way.

Until we get more clarity on the economy, the S&P 500 is likely to stay range-bound between 3800 to 4000 with the flip-flop of sentiment set to continue.

In this environment stock specifics are set to become a greater focus locally and offshore.

US economics and policy

Indicators such as the EVRISI employment costs and pricing power surveys continue to highlight that inflation is decelerating rapidly.

The question is whether inflation plateaus in the high 3% range and holds or continues to fall into the 2% range.

Friday’s market bounce came in response to a speech from US Federal Open Market Committee member Christopher Waller.

While considered a hawk on monetary policy, Waller said recent data was breaking more positively and the Fed might be less rigid regarding rate increases than the market feared.

This echoed comments from the more dovish Fed vice chair Lael Brainard.

Neither Waller nor Brainard tried to adjust market expectations for rates to stay below 5%.

This potentially means two more 25bp hikes, with rates peaking in March at 4.75 to 5%.

Waller said the Fed might stay higher for longer than market would like – to manage risk and avoid inflation picking up later in the year.

On the economic front a survey of economists reported an average 65% expectation of recession in the US in the next 12 months.

Manufacturing surveys, weak housing, softer retail sales, low savings rates and inverted yield curves all support the recession call.

The holdouts expecting no recession or a shallow downturn are quoting some combination of these reasons:

1. Job momentum remains supportive. This is evident in lagging indicators such as solid payrolls and coincident indicators such as jobless claims which have not deteriorated. Forward-looking measures such as layoffs are not yet back to pre-pandemic levels, let alone those consistent with a recession. It is likely companies are more cautious on firing in certain sectors, given recent shortages of labour.
2. Consumer real incomes are set to rise – potentially up to 3.5% – as inflation falls and wages catch up. This can support consumption.
3. There are no major structural imbalances in terms of excess credit growth, overcapacity in industries or too much leverage in households. All these exacerbated the downturn in the GFC.
4. Financial conditions have been stable for six months, so the effect of tighter monetary policy is fading.
5. Lower bond yields are supportive for housing, possibly alleviating the risk of larger downturn.
6. Economic momentum is still quite good. Q4 GDP is likely to come in at 2%. While moving below trend, we have not yet seen a tipping point in the economy.

The bull-case scenario from here is that earnings-per-share (eps) for the S&P 500 holds at about US$220 and the market valuation multiple rises to 20x P/E as bond yields fall. This would equate to the S&P 500 index around 4400, or up roughly 10% from here.

The bear-case scenario is a drop in earnings of about 11% to around US$200 eps and a de-rating on uncertainty to 16x P/E. This could see the S&P 500 fall some 20% to 3200.

The US market multiple remains above its long-term average, in the 75^th percentile. A weaker US dollar, a better outlook for Europe and Chinese re-opening should all be supportive for earnings.

We remain of the view that the market’s upside remains capped by earnings risk and Fed actions to contain financial easing.

However, the downside scenarios are looking more benign for now.

US debt limit

The US Treasury has technically hit a debt ceiling approved by Congress. But Treasury officials say they won’t run out of money until June at the earliest. There are lots of moving parts to this equation.

There will be no impact on bond issuance through to the end of February. From March, Treasury will start running down cash holdings, reducing bond issuance and the Fed’s liquidity.

This will reverse in April as tax receipts come in, then resume until all the cash is spent. The market is seeing late July/early August as the crunch time.

Some sort of last-minute compromise in Congress is the best-case scenario.

Some scheduled payments could be missed. This is likely to be social security obligations rather than bond coupons. 

The risk here is that the market assumes a last-minute deal will be done – and doesn’t send a strong signal to Washington to solve the problem.

This could see a 2012-13-style scenario come July. However, it is not a major near-term market driver.

US earnings

Some 10 per cent of the US market reported last week, with a skew to financials. Earnings continue to be revised down, with S&P 500 eps growth for the year now at -1% versus flat two weeks ago.

 

US banks had a good 2022, with return on tangible equity (ROTE) at 15% versus 11.5% the previous year.

This is the highest since the GFC and was driven by a roughly 20% increase in net income as margins rose and loans grew 10%.

So far credit losses are still only half 2019 levels.

The picture gets tougher as deposits fall and competition increases. This is reflected in the sector’s 16% fall last year.

Australian equities

The S&P/ASX 300 has returned almost 6% year-to-date, with good returns across most sectors.

Commodity prices remain supportive on the back of improved sentiment around China. Lower bond yields are helping REITS and growth sectors – notably healthcare. 

A number of positive corporate updates last week reflect resilient earnings.

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About Crispin Murray and Pendal Focus Australian Share Fund

Crispin Murray is Pendal’s Head of Equities. He has more than 27 years of investment experience and leads one of the largest equities teams in Australia. Crispin’s Pendal Focus Australian Share Fund has beaten the benchmark in 12 years of its 16-year history (after fees), across a range of market conditions.

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

Find out more about Pendal Focus Australian Share Fund  

Contact a Pendal key account manager

IN LINE with our previous communications, today marks the official union of two of Australia’s leading asset managers, Pendal and Perpetual.

Last August we announced plans to create Australia’s pre-eminent global asset manager — with approximately $200 billion of FUM and clients benefitting from greater scale in customer service, distribution, technology, infrastructure and ESG leadership.

The process over the past few months was to seek approval from shareholders and regulators around the world. This has now been achieved.

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

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Pendal and Perpetual have been built on the concept of investment autonomy, so clearly there are no changes to the way our investment teams look after your assets.

However, we now gain access to deeper, more diverse coverage from a global network of investment and ESG experts across the United States, UK, Europe, Singapore and Australia.

There will be no change to your relationship with Pendal and we will continue to manage your investments to the best of our ability, as we have always done.

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

In the meantime, I encourage you to watch the video below from Perpetual CEO & Managing Director Rob Adams.

Yours sincerely,

Richard Brandweiner
Pendal

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A message from Perpetual CEO & Managing Director Rob Adams

Here’s a quick review of Emerging Markets in 2022 from James Syme, Paul Wimborne and Ada Chan, co-managers of Pendal Global Emerging Markets Opportunities fund

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

IT was a difficult year for emerging equity markets in 2022, but the December quarter was more positive despite ongoing growth and inflation pressures in key economies.

Last year Russia’s invasion of Ukraine drove prices of key commodities sharply higher in an environment where inflation was already high and the outlook for interest rates was difficult.

This was combined with ongoing economic weakness in China.

The MSCI EM Index returned -20.1% in USD terms.

Here is a recap of the main EM themes in 2022 and what we learned in the closing months of the year.

Russia

In Russia, the equity market in Moscow closed in February 2022 and did not re-open in a meaningful sense.

With foreigners banned from selling, capital controls imposed and tight financial sanctions on the country, it became impossible for foreign investors to recover money from Russian equities.

The impact of wide economic and trade sanctions mean the fundamental value of Russian equities is highly uncertain.

GDRs and ADRs of Russian stocks have been suspended. MSCI deleted the Russia index from MSCI EM in March with a zero valuation.

Growth countries

Despite rising global interest rates and bond yields, growth surprised to the upside in several traditionally high-beta, current account economies.

Brazil, Indonesia, India and Mexico were among the better-performing major emerging markets in 2022.

MSCI country index returns were +14.2% in Brazil, + 3.6% in Indonesia, -2% in Mexico and
-8% in India (in USD terms).

Brazil and Mexico benefited from strong exports, while central bank currency support allowed domestic demand growth in India and Indonesia.

Meanwhile, higher energy prices, a sharp slowdown in global technology spending and a worse outlook for global growth meant that Korea and Taiwan both underperformed. MSCI country indices returned -29.4% and -29.8% respectively (in USD terms).

China

Despite improving credit and monetary aggregates data, the Chinese economy remained weak in 2022 as policymakers prepared to stimulate.

The key causes of the weakness were the ongoing policy-driven slowdown in the real estate sector and the impact of Covid lockdowns.

In the final quarter of the year — facing street protests and mounting evidence of the negative economic effect of lockdowns — Chinese authorities began a controlled re-opening of the economy.

MSCI China returned -21.9% in USD terms in 2022, but Chinese markets finished the year with a rising index and a sense of optimism.

Weightings

During the year we maintained our overweight exposure to markets with strong fundamentals in trade balances and growth — including Brazil and Mexico — and moved from significantly underweight China to a neutral position.

We allocated to Indonesia, seeking exposure to the financial and consumer sectors.

Allocations to Indonesia and China were made by moving underweight Korea in response to slowing growth there.

We remain overweight India, encouraged by strong corporate and economic results but we are keeping an eye on macro-economic fundamentals.

We continue to have a broad preference for the equity markets of economies that have strong terms of trade and robust trade balances compared to history.

We continue to see upside to domestic demand and credit growth and believe that weaker global growth will have a limited impact.

Our preferred markets remain Mexico, Brazil, India, Indonesia and the UAE.

In China we recognise the improved outlook but are waiting to see follow-through from growth and earnings expectations.

Positive signs in December quarter

The fourth quarter of 2022 was more positive for emerging and global equity markets, despite ongoing growth and inflation pressures in key economies.

October was difficult, but a shift to a more growth-friendly set of policies in China — and a sense that the outlook for US monetary policy is more positive — led to a stronger finish to the year.

In the quarter MSCI EM Index returned +9.7% in USD terms.

China’s economy remained weak despite increasingly aggressive credit and monetary stimulus.

But markets focused on the more positive change in policymaker intentions. MSCI China returned +13.5%  in the quarter (USD terms).

The outlook for US monetary policy also improved in the quarter.

Although we saw interest rate hikes by the Federal Reserve, US CPI continued to trend lower in October and November.

In early November the US ten-year bond yield moved below policy interest rates.

This proved supportive for some emerging markets that had previously been held back by capital outflows.

Which countries are well placed

In the December quarter we saw strong MSCI index USD returns in Colombia (+19.7%), South Africa (+18.3%) and Peru (+17.4%).

Previous winners, especially those with high commodity exposure, generally underperformed in the quarter with softer commodity prices through the middle of the period and reallocation of investment flows towards China.

MSCI Brazil returned + 2.4% and MSCI Indonesia -3.6% (both USD terms).

The weaker oil price hit the Arab Gulf markets harder with MSCI Saudi Arabia returning -7.6%. UAE and Qatar also had negative returns.

In the quarter we maintained our overweight exposure to markets with strong fundamentals in trade balances and growth and moved from significantly underweight China to a neutral position.

The allocation to China was made by moving underweight Korea and by trimming the overweight positions in Mexico and Brazil.

We further increased our weighting in Indonesia, adding another consumer stock.

We remain overweight India, encouraged by strong corporate and economic results but keep an eye on macro-economic fundamentals.

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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

In this article Pendal portfolio managers James Syme, Paul Wimborne and Ada Chan explain how the US dollar affects emerging markets equities – and what a weaker dollar means for 2023

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

AT THE start of 2023 — after a rough 2021 and 2022 for emerging market equities — we wanted to revisit what we consider to be a key (possibly the key) driver for the asset class: the direction of the US dollar and the capital flows that result from that.

In general, EM economies and the EM equity asset class are dependent on external capital flows.

Economies driven more by domestic demand require capital inflows to finance current account deficits.

Economies with stronger export bases tend to have significant exposure to demand from emerging markets (eg Korean car companies sales in India) and a dependency on foreign financing of corporate investment.

When we talk about capital flows, we mean US dollar capital flows.

Fromer Bank of England governor Mark Carney summarised this well in 2019 (PDF).

Carney noted the dollar was the currency of choice for at least half of international trade invoices. That’s about five times greater than the US share of world goods imports and three times its share of world exports.

“Given the widespread dominance of the dollar in cross-border claims, it is not surprising that developments in the US economy, by affecting the dollar exchange rate, can have large spill-over effects to the rest of the world via asset markets,” Carney said.

“The global financial cycle is a dollar cycle.” 

When dollars are sold to realise outbound capital flows, the dollar tends to weaken.

When dollars are repatriated, the dollar tends to strengthen.

So an easy proxy for global dollar liquidity is the dollar exchange rate (or rather all the dollar exchange rates, which can be measured by the broad, trade-weighted US dollar real effective exchange rate).

US dollar cycles

The US dollar has, since the rise of emerging markets as an asset class, moved in large, multi-year cycles.

As you can see in the graph below, the dollar weakened from 1989 to 1995.

By that point 18 months of US interest rate hikes had started to drive a stronger dollar (as well as a series of devastating economic crises in the emerging world).

This up-cycle lasted until early-2002. By that point interest rate cuts after the dot-com bust started to weaken the dollar.

Despite some volatility around the Great Financial Crisis, the dollar remained in its broad downtrend until mid-2011, when the prospect of an end to the post-GFC quantitative easing started an upward move in the dollar which we may still be in (more on this later).

In 2019 we wrote about the importance of understanding the outsize impact of the US dollar environment on emerging market equity returns.

We wanted, post-Covid and the recent inflation spike, to provide an update to this work.

Starting in 1989 (which is about as far back as we can go, with the caveat that we have had to estimate the dividend component of total return indices for the period 1989-1999), we can see US Fed Funds (which is the global risk-free rate), have averaged 2.9%.

As the graph shows below, equity investors buying developed market equities have enjoyed a return pick-up to an annualised return of 6.7%, to compensate for a volatility in monthly returns of 4.4% (as measured by MSCI World Index).

EM equities investors have enjoyed a further return pick-up to an annualised return of 8.3%, to compensate for a higher volatility in monthly returns of 6.5% (as measured by MSCI EM Index).

This is good Modern Portfolio Theory stuff, in line with Harry Markowitz’s original model.

What this long period doesn’t capture, is the way that these returns change during strong and weak dollar environments.

Splitting those out shows the long-term average contains two very different groups of returns.

When the dollar is strong, the risk-and-return metrics of developed markets don’t change very much (the weight of the US in the asset class causes the slightest improvement) and there is a corresponding slight worsening in a weak dollar world.

Emerging markets are different.

As the graph below shows, in a weak-dollar environment (measured over 185 months), the average USD annualised return of EM equity is 20.4% with only a small increase in volatility to 6.9%.

Meanwhile, in strong-dollar environments the average annualised USD return is -1.5%.

Essentially, over the last 33 years, all the long-term gains in EM have been made in weak dollar environments.

What this means at a country level

Looking beyond the data, it’s interesting to consider which types of emerging market do best.

Investors can think of emerging markets on a spectrum from high-savings rate/current account surplus/net saver export economies (Korea, Taiwan, the Gulf States) to low-savings rate/current account deficit/net borrower economies with more dependence on domestic demand (South Africa, India, Turkey, Brazil, Egypt).

As this is a spectrum, some countries have characteristics of both ends, such as Indonesia, Malaysia and Chile.

There are also country-specific conditions that change a country’s characteristics. (For example, Mexico’s large remittances from overseas citizens offsets a tendency to run a current account deficit).

In the above analysis, Latin American markets have tended to perform especially well in weak USD environments.

But it is important to focus more on characteristics than individual markets.

The key characteristics of Latin America in this period have been weak domestic savings and current account deficits, which create an outsized sensitivity to capital flows.

Historically, markets with these features have tended to be weak-dollar winners and strong-dollar losers.

But these are not fixed identities.

Thailand and South Korea ran current-account deficits in the 1990s when they collapsed into crisis with a strong dollar — but both now run large surpluses and are net savers.

What this means for 2023

The US dollar has been significantly weaker in recent months, suggesting a peak was reached in October 2022.

To be clear, there have been previous short-term peaks and troughs in the dollar during broad upswings and downswings. (For example in March 2020 during the initial onset of COVID-19, after which the dollar weakened but remained in its uptrend).

But if the dollar has topped out (at a level similar to the top in 2002) — and 2023 and beyond are to be weak-dollar years — investors should bear in mind the highly positive implications for EM equity and for the more capital-sensitive markets within that asset class.

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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 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%.

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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

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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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.

 

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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 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