Weekly market update - 14th of February 2022
Written and accurate as at: Feb 14, 2022 Current Stats & Facts
The challenge for central banks — particularly in the US — is that the economy is growing well above trend, with little slack in labour markets. This implies the need to engineer a tightening of financial conditions to resolve this and at least slow the economy back to trend growth rates. This is yet to be achieved, inferring markets may need to adjust further. Australian equities may fare better than the US, reflecting its sector mix and less need to tighten. The S&P/ASX 300 is down 3.2% year-to-date versus -7.2% for the S&P 500 and -11.8% for the NASDAQ.
US inflation data came in higher than expected last week. In combination with further evidence of wage pressure, this saw an increase in the number of expected US rate hikes this year. Concerns over the Russia-Ukraine crisis also drove oil prices higher, adding to future inflationary pressure as well as geopolitical risk. The S&P 500 fell 1.8% and the NASDAQ lost 2.2% last week while the local S&P/ASX 300 rose 1.3%. This was partly a catch-up on the overseas rally in the previous week, but also reflected reasonable results in the local financial sector.
Economics and policy
US inflation data came in worse than expected last week. Headline CPI was at 7.5% and the underlying core measure at 6% annual growth. The current consensus is a peak of 7.9% headline and 6.4% core inflation in February. The latter would be the highest reading since 1984. It is then expected to ease as a result of base effects and easing supply chain pressure.
Prices of goods have been rising at 11% annualised, which has been the key driver of inflation. For example, of the 6% growth in core CPI, a disproportionately large 2.7% is coming from used cars and new vehicles. The unwinding of components such as these is underpinning expectations of a deceleration in inflation after February. However, we are also seeing services inflation start to rise, reaching its highest levels since 2007. The pathway here will be something to watch.
There is also a broadening of inflationary factors. The median three-month CPI component is running at an annualised rate of 5.9% — its highest level since data was first recorded in 1983. Key components such as rents (17% of the core PCE index) are yet to rise since measured rent is below signals of what spot rents are doing. For example, the Zillow measure of rents is up close to 14% versus the 4% in the PCE calculation. This is all adding to concern that inflation may prove harder to contain.
Concerns over the threat of a wage-price spiral were reinforced by the Atlanta wage tracker, which moved over 5% annualised growth, the highest level in 20 years. The issue here is one of the pathway and changing expectations. The market is still implying that annualised inflation drops below 3% by the end of 2022. There are reasons to be wary of this expectation:
- The US economy is growing well above trend (nominal GDP >10%)
- Commodity prices are still rising
- The housing market remains strong
- Labour market are very tight
- Real wages are declining, requiring labour to seek increases to catch up
- Money supply growth is still well over 10%
- Real rates still negative
- Companies are clearly stating a need to push prices higher to compensate for higher costs.
The key point is the size of the disconnection between policy conditions and the economic environment. We can see this in the Goldman Sachs Financial Conditions Index which captures contributing factors beyond just rates. This remains at a 39-year low.
This stance is grounded in the view that inflation will fall as supply chains improve; high levels of debt mean the economy will be sensitive to small adjustments in rates; and the belief that real rates can stay negative.
This means central banks need to do more to drive bond yields, the US dollar and credit spreads higher and/or equities lower – since these are all contributors to total financial conditions. This means either tightening faster than expected or going higher than expected – or seeing signs that the economy is rolling over quicker than expected.
None of these scenarios is benign for any asset class, though within equities there is scope for variance in outcomes. With real rates still needing to move higher, this remains a difficult environment for growth stocks. So shorter duration, cash-generating names will be more defensive which we have seen in the Australian market this week. Part of the reason equities can be a bit more defensive is that equity risk premiums have stayed at reasonable levels through this cycle.
A more positive data point was that Chinese loan growth was larger than expected. This reflected more issuance of local government bonds which are likely to underwrite greater infrastructure spending in China over the next few months. The Chinese economy remains fragile, particularly in the small-to-medium enterprise (SME) sector. However, this should lead to further easing of policy — with two key policy meetings towards the end of March — which can help underpin the resource sector.
Markets and results
Resources and financials helped the market last week. They are leading to an emerging theme of large-cap outperformance.
Good results
Suncorp (SUN, +6.8%) and Insurance Australia (IAG, +8.2%) reported. Both delivered stronger revenue growth, though SUN had better margins since its claims costs were lower. IAG’s result was messier and emphasised a shift in focus to gaining market share to offset recent volume declines.
Insurance has been an unloved sector, dealing with the twin headwinds of rising peril costs (more frequency and higher cost weather events) and falling investment returns (as rates have fallen). They have been raising prices to pass through this impact, but this has been with a lag, affecting margins and unit growth.
But the underlying environment is starting to improve. The rise in bond yields is set to improve investment returns. At the same time pricing is now beginning to compensate for claims inflation, helped by programs to contain costs.
There were also updates from Commonwealth Bank (CBA, +4.7%) and National Australia Bank (NAB, +6.9%).
There is nothing too positive about the banking sector’s immediate operation environment, but the worst of the margin pressure has been largely priced in.
Banks are likely to be relatively defensive in an environment where markets are adjusting to tightening conditions, due to the benefits of rate increases. The risk is if tightening leads to fears over housing or if competition continues to negate tailwind of rates
CBA delivered a good quality result with flat pre-provision profits, versus expectations of a decline. Loan growth remained strong, helped by annualised growth of 9% in mortgages – the strongest half in 12 years.
Margins continued to decline, but at a slower pace and costs were well contained. Management guided to renewed margin risk in the second half but presented an upbeat view on medium-term interest rate leverage.
This boosted the stock and sector, which have lagged global banks on the interest rate thematic.
NAB has delivered the best of the bank updates, with 6% pre-provision profit growth driven by best-in-class outcomes on volume (13% annualised growth in SME and mortgages) and margin (-2bp underlying vs CBA -4bp, ANZ -4bp, WBC -10bp). NAB continues to express confidence in cost control.
Macquarie Group’s (MQG, +0.5%) operational briefing included a trading update, with a record third-quarter underpinned by significant asset sales and gas price volatility. Consensus put through double-digit EPS upgrades but the share price struggled. MQG has been the safe haven growth play in the financial sector through the falling rate environment, trading on about 20x versus banks on 12-16x. But there seems to be some rotation back on renewed hope of rate leverage.
Computershare (CPU, +11.1%) was the strongest performer in the ASX 100. Its first half was in line with expectations, but management upgraded full-year guidance by 7% on the back of new revenues from the recent corporate trust acquisition. CPU is also one of the clearest plays on rising rates, with about +45% to EPS for every 100bps increase in cash rates. There were some quality issues with the result at the margin and the PE multiple is trading well above historic norms. But it is likely to hold while rate expectations are still rising.
AMP (AMP, +7.3%) beat expectations on the back of performance fees in AMP Capital. There is some complexity here at the moment with a lot of moving parts around the demerger, asset sales, divisional reallocations and restructuring programs.
There were some positive signs from Unibail-Rodamco-Westfield (URW, +5.1%) with US malls performing very well. This may help position URW to sell US assets and reduce gearing. It is up about 10% in 2022 and is a good example of the unloved value plays beginning to outperform.
Mixed results
Downer’s (DOW, -4.1%) result was messy as it is in the final year of a structural transition. Headline NPAT fell 18% versus market expectations at flat.
There seemed to be some confusion in the market around DOW’s asset disposals and the losses were driven by businesses that are being divested, such as hospitality. The core business itself saw 13% organic revenue growth, although EBITA was only up 3%.
Covid-driven disruption (such as employee absenteeism and shut-downs) and adverse weather weighed on margins. No guidance was provided given the uncertainty of the ongoing effects of Covid.
Much of the initial negative market reaction was subsequently retraced as management noted margin pressures should unwind. In particular, DOW noted that wage inflation would not be a negative since they can pass it on through contract pricing. They also emphasised substantial medium-term opportunities driven by the clean energy transition.
ASX’s (ASX, -2.7%) result was in-line with consensus. But the stock fell on an announcement that the CEO will leave in 2022 before the new CHESS platform is implemented in 2023.
Disappointing results
Mineral Resources (MIN, -8.4%) was the worst performer on the ASX100 as price realisations on iron ore — and to some extent lithium — were lower than expected. Costs were also higher due to the challenges of Covid, leading to materially lower profits than expected.
The company also announced an overhaul of its relationship with its lithium JV partner. While allowing better access to future investment opportunities, this will also lead to higher capex and potentially put a strain on the balance sheet. No dividend was paid.
Mirvac’s (MGR, -5.0%) NPAT came in below market expectations, with a result that saw development profits shifted forward to the first half. The skew of retail assets to CBD and tourist-driven areas has been a headwind to rent collections. Vacancies in the office portfolio are also starting to rise.
AGL’s (AGL, -7.3%) result was slightly better than very low expectations. But there is a material degree of complexity as the company continues to work through demerger options.