Here are the main factors driving the ASX this week according to our head of equities Crispin Murray. Reported by portfolio specialist Chris Adams.
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.
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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:
- 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.
- Consumer real incomes are set to rise – potentially up to 3.5% – as inflation falls and wages catch up. This can support consumption.
- 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.
- Financial conditions have been stable for six months, so the effect of tighter monetary policy is fading.
- Lower bond yields are supportive for housing, possibly alleviating the risk of larger downturn.
- 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 75th 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.
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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.
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.
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.
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
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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.
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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.
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.
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.
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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.
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.
Here are the main factors driving the ASX this week according to Pendal investment analyst ELISE MCKAY. Reported by research analyst Jonathan Choong
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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.
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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.
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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 11th-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.
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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.
Here are the main factors driving the ASX this week according to our head of equities CRISPIN MURRAY. Reported by portfolio specialist Chris Adams
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.
- The persistence of inflation, which will determine how tight financial conditions need to be.
- The scale of economic slowdown in the US and other developed markets.
- The leverage of earnings to that downturn.
- Whether markets have already priced in the downturn.
- How China’s economy performs as it exits covid-zero
- 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.
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.
Find out about
Pendal Global Emerging Markets Opportunities Fund
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.
Here are the main factors driving the ASX this week according to our head of equities Crispin Murray. Reported by portfolio specialist Chris Adams.
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:
- The persistence of inflation — and how tight financial conditions will need to be in response
- 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)
- The earnings leverage to that downturn — and whether nominal growth buffers earnings
- 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
- What China’s economy does as it exits zero covid
- Whether the RBA can engineer a soft landing in Australia
US inflation outlook
Inflation signals were marginally negative last week.
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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.
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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.
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.
Find out about
Pendal Global Emerging Markets Opportunities Fund
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.