Weekly market update - 18th of October 2021
Written and accurate as at: Oct 18, 2021 Current Stats & Facts
Concerns over inflation and China remain heightened and persistent. Inflation, in particular, is likely to remain a key issue for markets for some time. But there are indications of small improvements at the margin for the sentiment on these issues. Further indication that concerns on these issues have peaked — combined with continued economic recovery and a period of seasonal strength in markets — could set up equities well into the year’s end.
It is far too early to declare victory in this regard. But equities moving higher despite the ostensibly bad news, as we saw last week, can be a strong positive signal. The S&P/ASX 300 was up 0.65% and the S&P 500 1.84%.
Whether or not this continues in the coming weeks is likely to rely heavily on US earnings season and Chinese data and policy signals.
Economics, policy and markets
The market has 3 broad concerns at the moment;
- Inflation and its implications for policy tightening: The risk is that we start to see stagflation, where price rises choke off demand and economic growth, or that we see the Fed forced to tighten earlier, also weighing on growth.
- Chinese growth: People are concerned that a slowing property market and power constraints will drive a sharper-than-expected slowdown in growth.
- US debt ceiling: The fear is that political discord disrupts the government’s ability to function.
At this point, there are signs that each of these issues may have reached a near-term crescendo, which is helping markets rally. In the US, Congress and the Biden administration have been able to delay the debt ceiling issue to December. It hasn’t disappeared, but they’ve bought time.
Outlook on China
There are signs that China is addressing power shortages. Beijing is looking to source coal and gas from all available sources – including Australia, despite previous embargoes. This will not flow through immediately, but the signal is that China is looking to solve the problem and not stubbornly stick to old policies.
Property remains more complex in China. The Evergrande issue has seen credit spreads blow out in the property sector. So far this looks contained within that sector and has not spread to other parts of the market.
There are indications in the data that monetary policy is too tight in China. There are various committee meetings this week which may result in some indication of easing.
Outlook on inflation
Inflation is one of the greatest long-term threats to markets.
In the past few weeks, there has been a shift in expectations including a realisation that inflation is likely to be higher and more durable than previously thought.
At his Jackson Hole speech on 27 August, Fed Chair Powell was able to calm inflation concerns with the idea that it was transitory. His key reasons were:
- It is not broad-based
- The largest surges are already receding
- No threat yet from wages
- Inflation expectations are anchored
- Globally, pressure on inflation is downward
Since then inflationary pressures have strengthened, due to:
- Expanding supply chain bottlenecks: Lockdowns in some countries and Chinese power issues have constrained production.
- Labour availability: This continues to disappoint in the US, where it’s increasingly apparent there has been a reduction in supply, driving real wage increases and rising friction between employees and employers.
- Commodity prices: Key inputs such as gasoline and power prices have continued to rise.
- House prices: Continue to rise and are flowing through into rents.
- Strong demand: Bolstered by re-opening and reducing delta concerns.
- What was “transitory” is now being described as “transitory for longer”.
This is because the “transitory” argument is now falling foul of its own rationale outlined in the Jackson Hole speech:
- It is not broad-based: Inflation is showing up in a broader range of sectors as new supply chain problems occur and fuel prices rise. Last week’s CPI data shows prices in longer-duration areas are rising. Rents, for example, are increasing at their highest monthly rate since the housing bubble in 2006.
- The biggest surges are already receding: This is true in some categories. In others, such as timber and autos, there have been recent rebounds. New auto prices were up 1.3% in the month.
- No threat yet from wages: Average hourly earnings have not surged, but are steadily picking up.
- We are also seeing greater friction in labour markets. For example workers at machinery maker Deere and Co knocked back a front-loaded 11-12% wage increase over six years and called a strike for the first time in 35 years. This kind of action reflects the recognition that supply chains need to be shortened and the threat of off-shoring has diminished.
- There are further indications that early retirements and career changes are having a negative impact on the labour supply.
- Inflation expectations are anchored: This is still the case, but they are rising. The risk is this starts bringing forward consumption and drives higher wage demands.
- Globally, pressure on inflation is downward: It’s true that inflation is less of an issue outside the US. But rising fuel prices are having an impact. The move-in global bond yields indicate some concern about inflation.
The market realises the Fed is in something of a bind. It wants to promote growth while being mindful of the need to keep inflation expectations anchored. The balance in recent weeks has been a shift in expectations to the Fed having to move sooner on tapering and rate hikes.
As a result, we saw a “bear flattening” in bond markets, with 2-year yields rising while 10-year yields remain flat. Despite this, equities and commodities made gains.
One factor could be that supply chain fears have perhaps reached their nadir. Freight rates from China to the US east and west coasts have rolled over recently. Surveys suggest the proportion of US firms reporting inventories as “too low” has also rolled over.
The Biden administration has recognised the importance of this issue. It’s been working with stakeholders to keep the Port of Los Angeles open 24/7. This alone won’t solve the problem. But combined with factories re-opening in Asia and private companies adapting their sourcing, it can help calm fears on the issue.
We see inflation as a key issue for markets going forward. But signs of alleviation in supply chain pressure, coupled with marginally better news on China and the US debt ceiling — plus expectations of good US corporate earnings — may continue to support markets in the near term.
US economic outlook
While the big risk issues are marginally improving, the outlook for US growth is also encouraging.
US retail sales were better than expected at +0.7% m/m, with positive revisions for the previous month. This means it’s holding up despite a surge in the past year. There is strength in discretionary spending (clothing, sporting, e-commerce) which was up 13.9% year-on-year (and 15.6% ex-autos).
Fiscal stimulus has played an important role in this. It also goes some way to explaining some of the supply chain issues we are seeing.
Consumer spending is expected to shift from retail to the service sector as restrictions are rolled back. It remains supported by $US2 trillion in excess savings as a result of the stimulus. Income growth also remains greater than expenditure.
Markets
We are seeing some important and positive signs, such as:
- Commodity prices appear to be breaking higher, having consolidated for six months. This reinforces the notion that concerns over supply chain issues may be peaking.
The sectors most affected by supply chain issues are beginning to perform. This suggests the market is looking through near-term issues and expecting a strong catch-up in demand next year. - Chinese bond yields have begun to move higher. They had previously been falling since the start of the year and were a decent signal of the impending Chinese slowdown.
- The Australian dollar is rallying against the Yen — another positive cyclical indicator.
- There are signs the equity market is broadening, with the small-cap index stabilising versus the overall market.
In conclusion, the market signals are more positive than the media headlines. This is often a reliable signal to watch for.
Last week Resources (+3.02%) led the Australian bourse higher. Banks (-1.18%) sold off as Commonwealth Bank (CBA, -2.08%) unwound post its buy-back and Westpac (WBC, -2.20%) noted some write-downs ahead of its result.
Star Entertainment (SGR, -13.79%) was the week’s worst performer. Press stories highlighted a series of issues relating to the handling of junket operators and possible money laundering. Given the current regulatory review into Crown (CWN, +3.80%), this raised fears Star will follow a similar path.
Insurance Australia (IAG, -5.20%) weakened on the news that ASIC would launch court proceedings in relation to pricing procedures.
Commodity names were generally stronger.
South32 (S32, +6.70%) was among the best. It announced the acquisition of a 45% non-operational stake in a Chilean copper mine. It will cost $US1.55 billion upfront, with potential follow-on payments of $500 million.
This appears to be a reasonable price given where the copper market is. The market liked the fact this was aligned with more future-facing commodities and that the company did not need to issue equity to fund the deal.