Weekly market update - 22nd of November 2021
Written and accurate as at: Nov 22, 2021 Current Stats & Facts
The market is focused on two issues right now.
First, there is increasing scrutiny on signals from the US Federal Reserve. Expectations are building that that rates will need to rise sooner rather than later. The idea that the Fed could be comfortable with higher inflation as a “catch-up” from the previous period of low inflation is under question. The second issue is the new wave of Covid in Europe, the extent to which this will be replicated in the US and its potential economic impact.
Both issues have the potential to depress bond yields. Confidence that the Fed will take action to control inflation can support the bond market. So too can another Covid wave if it suppresses economic growth.
This is reflected in the equity market with a rotation from cyclicals to growth and defensives.
Equity market returns were muted last week. The S&P/ASX 300 fell 0.47% and the S&P 500 gained 0.36%.
The sentiment on these two issues presents a risk to markets, some think more in the way of driving material rotation rather than a sustained sell-down. The markets suggest abundant liquidity, decent economic growth and stimulatory policy all remain supportive of the overall market.
Covid and vaccines
Unfortunately, the pandemic has escalated again. A surge in central European cases has culminated in a nationwide lockdown in Austria and the potential for other countries to follow suit.
About two-thirds of Austrians are fully vaccinated. But even in The Netherlands, where about 74% of people are fully vaccinated, there is a surge in new cases.
The acceleration highlights the seasonal element of Covid (as the northern hemisphere heads into winter) as well as the importance of increasing vaccine penetration.
In the US, both new cases and hospitalisations have increased.
The market is concerned a new wave will result in a repeat of the economic hit in June and July.
The key will be whether countries such as Germany and the US follows a UK-like path, where cases are at moderately high levels, but hospital numbers are manageable.
Economics and policy
Japan’s US$500 billion stimulus package and the passage of the Biden US$1.2 trillion infrastructure bill emphasise that fiscal policy will remain supportive.
We’ve also seen agreement at US agricultural equipment maker John Deere and Co, which experienced its first strike for wage growth in 30 years.
Workers agreed to a six-year deal including a 10% rise in the first year, sign-on bonuses and a return of cost-of-living adjustments. Yet another sign of the wage pressure coming through.
Inflation
There is a view building that the Fed is likely to signal a more hawkish shift on rates in its next meeting on December 14-15.
Previously, the Fed’s line has been that it was comfortable with higher inflation because there had been a period of lower-than-target inflation previously. This could act as a buffer for inflationary pressure.
No matter how transitory you believe current inflation to be, this buffer has now gone.
The Fed can continue to argue it is tolerating higher inflation to support employment goals. But the notion that inflation can run hotter to offset previous muted inflation no longer holds.
The market is also increasingly aware that some of the more structural drivers of inflation are flowing through and will be difficult to hold back. For example, leading indicators of housing rents suggest this will pick up materially over the next 12 months.
At the same time, the outlook for growth remains reasonably strong, despite the potential for another Covid wave, as discussed earlier.
To put some context around the combination of growth and inflation on nominal GDP, we are set to see levels in Q4 not seen since the early 1980s.
Nominal GDP is a reasonable proxy for corporate revenue and should underpin corporate earnings growth into CY22.
The risk comes if it also forces central banks to apply the brakes more aggressively.
This combination of higher growth and the flow-through of property-related inflation saw three members of the Fed signalling last week that the topic of faster tapering will be discussed at the December meeting.
There are two broad schools of thought on inflation at the moment:
- Current inflation is a function of temporary factors relating to the mismatch of supply and demand. Supply chains were unprepared for the rebound in demand as consumers came out of lockdown. There have been episodes of this before, such as in the early 1950s at the start of the Korean War. The lesson then was that inflation quickly fades as it begins to eat into the spending power of consumers and leads to demand destruction.
- The alternative view is that while the initial rise of inflation was induced by these temporary factors, it now becomes entrenched due to issues around labour supply, shortening supply chains, the impact of de-carbonisation (greenflation) and a lack of adequate response from central banks.
In this regard, the two key issues to monitor in upcoming months are US labour market participation and how prepared central banks are to anchor inflation expectations.
On the latter point, a decision to replace Fed Chair Powell or appoint him for a second term with being important. Lael Brainard is seen as an alternative. Powell remains the favourite, but his odds have fallen in recent weeks.
China
There have been signs in recent weeks that Beijing is looking to ease policy in response to slowing growth.
This is not straightforward. The same cocktail of factors dragging on growth also makes an effective response difficult. These include:
- Beijing’s zero-Covid approach
- Power constraints
- High raw-material prices
- Weak housing sentiment
- High debt, leading to constraints on local government financing
- A strong currency
Recent statements from Premier Li Keqiang and the People's Bank of China suggested an emphasis on constraining credit was diminishing and there was a need to safeguard exports.
A shift in policy direction will help limit the slowdown. Concerns around the Evergrande issue have also receded.
Beijing faces headwinds in its effort to combat slowing growth. Covid remains a challenge. So, too, do poor consumer sentiment towards property, rising inflation, weakening exports and constraints on local government funding for infrastructure due to falling land sales.
Meanwhile, China has imposed environmental-based constraints on growth ahead of the Winter Olympics in March.
While we are likely to see cuts in reserve ratio requirements for the banks, increased credit growth and some fiscal measures, these will probably be incremental in nature.
They will also take time to flow through.
We can reasonably expect concerns over China’s growth to remain in place for the first quarter of 2022.
Markets
Rising Covid, combined with a stronger US dollar, has led to a rotation away from cyclicals and back towards growth.
It’s worth noting that within tech, large-cap is performing better than small-cap in the US. This reflects rising volatility in the macro-environment, which favours the more stable names with stronger earnings.
Oil prices were weaker as the US released some strategic energy reserves. There was talk that Washington was lobbying China to do likewise to help ease energy prices, though this is unlikely to work in the medium term.
In Australia, the banks have given up their market leadership for 2021 (year-to-date) on the back of an update from Commonwealth Bank (CBA, -9.54%). Financials have returned 26.09% YTD, versus 33.33% for Communication services and 27.91% for Consumer Discretionary.
Growth names did best last week. Technology (+3.08%) and Health care (+2.82%) led. Financials fell 3.22%, Energy was down 1.57% and Materials lost 1.48%.
Banks
The usually innocuous CBA update surprised the market with weakness in margins.
This emphasises that margin pressure was seen in the recent Westpac (WBC, -2.42%) result goes beyond company-specific issues and reflects a sector-wide trend.
On an underlying basis, CBA and WBC saw margins fall 7bp. ANZ’s (ANZ, -3.40%) margins fell 4bp, while National Australia Bank (NAB, -2.17%) managed to hold it flat.
Focusing on each bank’s Australian retail division and adjusting for mix effects sees an underlying margin drop of 11bps for CBA, 8bps for WBC and 4bps for both NAB and ANZ.
The biggest cause is the shift from variable-rate mortgages to fixed-rate, the flow-through effect of low-interest rates and the diminishing benefit of wider margins on deposits.
Fixed-rate mortgages have had a 75bp lower margin than variable and their share of new mortgages has gone from 20% in H1 20 to 52% in H2 21. This mixing effect is the main driver of lower margins.
NAB has been better insulated due to a higher portion of mortgages coming from its business bank, where there is less competition.
In ANZ’s case, their loan book shrunk 1% while the others were up 6-8%. This meant less front-book dilution, although it also means it is ceding market share.
The challenge for the banks is that the “seasoning” of the book will continue to affect margins. Pricing has risen about 45bp for two-year fixed, but funding costs are up about 65bps.
This may be reflected in the WBC valuation multiple of 13.4x. But CBA’s 10.3x P/E multiple is harder to justify given it is not impervious to the industry pressures.
Other stocks
Outside of the banks, Aristocrat Leisure (ALL, -4.75%) was among the ASX 100’s weakest last week. It delivered a largely unsurprising result, given it had been largely pre-announced. The outlook for CY22 was constructive, although there was some focus on higher R&D expenses which led to a marginal downgrade of consensus expectations. They are also seeing good growth in digital. The stock fell on concerns that they may get caught up in a bidding war for Playtech, the UK business they bid for last month.
ALS (ALQ, -7.74%) reported a decent H1 22 result with NPAT just above guidance as to the industry benefits from more geological sample testing from junior miners, driven in turn by higher commodity prices. However, the market was hoping for a bit more. There are concerns the expected operating leverage to the cycle may not come through as strongly as hoped due to capacity constraints and higher costs.
Crown Resorts (CWN, +18.00%) was the best performer in the ASX 100 on the back of Blackstone making another take-over offer. Given this overture comes in the knowledge of the recommendations of the Victorian Royal Commission, it is a more tangible offer than the previous one. That said, the new management and board are likely to hold out in the near term, with the potential for other suitors to emerge.
Next DC (NXT, +8.47%) rose on the back of M&A in the US data centre sector — American Tower (AMT) buying CoreSite Realty (COR) for $10 billion and a private equity consortium buying Cyrus One (CONE) for $15 billion. NXT also reiterated its guidance at its AGM. NXT is a long-term growth story benefiting from data demand as companies, governments and other organisations move their business and systems to the cloud. This is complemented by demand for mobile gaming driven by 5G.
QBE (QBE, +5.54%) rose on a combination of rising bond yields (which are ultimately supportive for insurance companies) and rotation away from banks in the financial sector.
Gold miner Evolution (EVN, +5.49%) rose on the announced acquisition of the part of the Ernest Henry mine which they did not own from Glencore. It is a complex deal, but ultimately gives the company more exposure to copper in the near term. This provides additional cash flow to help fund investment to extend mine life at two of its gold assets. The combination of more upfront cash flow, Ernest Henry’s low-cost operation with reasonable life, and with its existing development profile restored some confidence in the stock’s outlook. It is also helped by signs that the gold price may be turning the corner.
Treasury Wine (TWE, +5.44%) announced it had acquired Frank Family Vineyards, a Californian wine business. The deal was well-received, at what looks to be a reasonable price. Frank is a high-quality brand focused on premium Chardonnay, which is growing at about 9% pa and where TWE has traditionally not been strong. There is potential to increase this growth via TWE’s distribution in other states. Frank comes with a strong distribution network in California and a good direct-to-consumer business.