Weekly market update - 15th of March 2022
Written and accurate as at: Mar 15, 2022 Current Stats & Facts
We continue to face the combined challenges of geopolitical risk, Covid, inflation and rising rates. This is creating an intractable policy dilemma — the need to raise rates at a time when risk premiums are elevated, coupled with the risk that a commodity shock will lead to an economic downturn. The conflict in Ukraine intensified, US inflation data was no softer than expected, the Fed’s tightening bias persisted, the ECB was more hawkish than expected and China was facing another Covid outbreak, potentially causing disruptions to growth and supply chains. As a result equity markets were mixed. The S&P500 fell 1.6% and the S&P/ASX 300 was down 0.4%. European equities bounced 3.7% (Eurostoxx 50) after previous sharp falls.
The market is struggling to build on any bounce despite the S&P 500 is off 12.4% from its early-January peak.
Our key observations are:
- The near-term market is likely to remain weak
- Australia may be a relatively safe haven given the economy is in good shape and skews to commodity and financial stocks
- The environment we are in today is different to the post GFC era — what worked in the last six years won’t work going forward. We see corporate cash flow and consistency is critical.
- We do not expect high growth, speculative and profitless tech to resume market leadership
- Current drawdowns tend to be indiscriminate, thereby creating significant stock opportunities.
Commodity markets
Oil and wheat prices peaked early last week and then fell back, despite growing signs of self-sanctioning. One key debate is whether Russian oil will be locked out of global markets or find its way in via alternative channels. At this point there is an expectation that some of that oil will find a home. But this will extend trade routes and it’s unlikely all will be placed. There is about 2.5 million fewer barrels per day (bpd) in global markets, compared to before the invasion.
There are a number of potential sources of new supply to replace this:
- Saudi, the UAE and Kuwait: These countries have about 2.1 million bpd spare capacity, which would probably require a couple of months to come on line. Doing so would signal the end of the OPEC+ arrangement with Russia. Saudi is unlikely to make any moves until it sees the outcome of potentials deals with Iran and Venezuela.
- Iran: There is chatter the US and Iran may be nearing an agreement. But there is uncertainty over how many incremental new bpd would eventuate – and how long it will take.
- Venezuela: Easing sanctions on Caracas may provide scope for an additional 0.5 million bpd over time.
- US Strategic Petroleum Reserve releases: There is uncertainty in outcome here since this mechanism remains untested.
- US production: This will be a lot harder to ramp up due to shortages of equipment and people. For example, there is a lack of truckers due to the demand driven by online retail fulfilment. There are also capacity constraints in fracking as the Permian Basin, the most productive region, has already recovered to peak production.
There is also a persistent risk that Russia may itself disrupt supply, given its importance as a bargaining tool. The US is working with the likes of Saudi, Venezuela and Iran to bring other barrels back into the market to alleviate inflations. Any success there will mitigate some of the pricing pressure. But we suspect we will be looking at US$100+ oil for at least a few months.
Economics
The market is starting to factor in the risk to economic growth. For example, Goldman Sachs cut its expected US GDP growth in Q2 2022 from 2% to 1.75% compared to Q4 2021. This is driven by the impact on income and spending as a result of higher food and fuel prices. Financial conditions continue to tighten as the US dollar and bond yields rise and equities fall. This adds to the headwind to growth in Q2 onwards by 0.3-0.4% of US GDP
We do not believe this will translate into a recession due to:
- The strength of the labour market
- Pent-up demand where supply constraints have been limiting growth, eg autos
- Strong housing, which means consumer net worth continues to rise
- Strong loan growth and still negative real rates
- Good household balance sheets
In combination this should enable growth to continue, providing earnings support for the market in time.
US inflation
The good news is that the US CPI data was in line with expectations for the first time in eight months, rising 0.8% month-on-month and 7.9% year-on-year in February. The not-so-good news is it’s the highest rate in 40 years. Digging into the numbers we see food, energy and auto are driving almost two-thirds of the year-on-year figure. These should unwind over time. But there is also a broadening of the number of components where prices are rising. For example, the proportion of CPI components with deflation has fallen from more than 25% at the start of 2021, to about 5% today. This breadth issue is a concern for policy makers. Rent is one component seeing a strong rise. This is likely to continue, slowing the normalisation of overall inflation.
We had been seeing shipping freight rates start to fall as supply chain issues improved. However this has stalled as shipping needs to be re-routed as a result of the sanctions on Russia and growing Covid issues in China.
On wages, the Atlanta wage tracker rose from 5.1% to 5.8% annual wages growth, countering the more positive signal that came with last week’s household employment survey. So the challenge for the Fed is that a number of key drivers of future inflation are signalling that the problem is not resolving itself. This explains its hawkish stance, despite the wider geopolitical concerns.
Policy
The European Central Bank signalled that rate rises could come sooner than the market is currently pricing – potentially as early as July, though September is looking more likely. The key point is they are signalling a greater preparedness to tolerate weaker growth to fight inflation. If there is a risk of stagflation it is centred on Europe, given its greater sensitivity to energy prices and higher exposure to Ukraine and Russia. There is talk now of a fiscal policy response to this threat, which could allow monetary policy to focus on inflation.
Covid
We are watching two issues here.
First, an emerging new variant looks to blend some characteristics of Delta and Omicron. At this point it’s not expected to be any more transmissible that Omicron, so may not supersede the latter’s dominance. Second, we are watching rising cases in China – particularly in north-east provinces – and a potential headwind for economy activity.
Markets
We saw a snap-back in European equities — the German index made its seventh-biggest single-day jump. But history indicates such volatility is more often than not seen in a downward trend. From a technical perspective we still haven’t seen enough breadth of selling to indicate a low has been reached.
Bonds sold off despite concerns over growth — a very different reaction to what we have been used to in recent years. The number of rate increases priced in by the market have marginally increased for the US, so the need to fight inflation is seen to take precedence over growth concerns. Bonds remains a good signal on what’s happening in the economy. History indicates 10-year yields peak towards the middle or end of a rate cycle — rather than near the start. This suggests further to go on bond yields. If this is not the case it would indicate more economic risk in US. The other signal to watch is 2-year yields, which have not yet peaked. A peak in 2-year yields is a reasonable proxy for potential recession risk.
There is also a debate around whether commodities are peaking in terms of relative performance. While they have run hard, the relative move has been minor compared to past commodity cycles in the early 2000s or 1970s. These moves can be sustained over longer periods than we have seen so far.
The final signal worth noting is a continued decline in the Chinese tech index. This was the first part of the growth universe to roll over in February 2021 and is now down 75% from its high. Recent pressure relates to the risk of forced de-listings from the US.
It suggests the more speculative end of the growth cohort is still yet to find a bottom.
Australia
In Australia it was a pretty quiet week overall. Resources corrected from their recent run, while rising bond yields saw a rally in banks. Elsewhere the defensive rotation continued, with technology down and consumer staples up.
Incitec Pivot (IPL, +12.8%) was the best performer on the ASX 100 as the invasion of Ukraine put a squeeze on the fertiliser market.
BlueScope Steel (BSL, -9.5%) was the weakest, as a surge in coal prices crimped steel margins.