Weekly market update - 26th of May 2022
Written and accurate as at: May 26, 2022 Current Stats & Facts
THE market is at an interesting near-term juncture. The S&P 500 has lost ground for seven weeks and is now off about 20% from its peak. It has been re-tested and held recent lows. The market is yet to work through the effect of a slowing economy on corporate earnings.
The S&P 500 fell 3% last week as the market continued to worry about the potential for recession. Some poor earnings results compounded this out of US retailers. The issue here was not weaker consumption, but the mix shift from goods to services and a rising cost impost. This emphasises the market's vulnerability should a slowdown occur and affect earnings.
US 10-year government bond yields fell 14bp. The positive correlation between bonds and equities appears to have broken down as the focus moves to risk aversion and a flight to safety. We also saw a fall in the US dollar. This was probably a consolidation after a big run. It helped commodities and resource stocks, as did more signs of Chinese easing.
Australia again remains the market for these times. The S&P/ASX 300 was up 1.2% for the week. It's down only 2.5% for the calendar year, versus -17.7% for the S&P 500 and -27.2% for the NASDAQ.
Two key issues driving the market
We see two primary issues driving the outlook for markets.
- The first issue is whether the US economy slows down or slips into recession.
- A recession has led to more significant drawdowns in recent bear markets, such as in 2000-2002 and 2007-2009.
Current investor surveys indicate a 50-55% probability of recession.
This comes down to views on what the Fed sees as acceptable inflation and what they will need to do to achieve it. There are two scenarios here:
The positive scenario
Financial conditions have tightened enough, the economy is already slowing, inflation pressures are beginning to ease, and bonds have peaked. Aggressive monetary tightening (and hence recession) will not occur. A variant of this view is that the Fed will live with inflation in the mid to high 2s — rather than go for 2% — to avoid pushing the economy into recession.
The negative scenario
The economy will prove more resilient to rising rates, with consumers bolstered by excess savings and a tight labour market. This will force the Fed to do more tightening and ultimately "break" the economy to control inflation. Proponents point out that unemployment of 3.5% needs to rise to around 4.25% to create sufficient slack to ensure wages don't reinforce inflationary pressures. The US has never been able to engineer such a rise in unemployment without it being associated with a recession.
The second major issue is whether the Chinese economy deteriorates or sees a policy-driven rebound.
Again, there are two scenarios:
The positive view
China is close to peak Covid lockdown, and the combination of re-opening and additional infrastructure stimulus will trigger a recovery, generate good commodity demand, and underpin resource stocks.
The negative scenario
The economy is in far worse shape than the market realises. Lower rates reflect the financial vulnerability of property developers; stimulus will be ineffective due to low confidence, high input costs and inability to execute due to Covid restrictions.
Markets
We may be seeing a near-term low in the US equity market. Historically, bear market bounces average a 15% gain over 30-40 days.
This does not signal the market has hit its lows for the cycle. Most technical signals have not indicated a degree of panic or capitulation. For example, put/call ratio data has not yet moved into the 99th percentile level – a usual indicator of capitulation. Nor have we seen high volumes in stocks being sold down. Retail investors are yet to give up on the bull market.
The triple-leveraged NASDAQ ETF is still seeing large net inflows – despite being down over 60% year-to-date. Interestingly energy-related ETFs – among the best performing year to date – are seeing negligible inflows by comparison.
The high proportion of "buy" ratings on the market leaders of the past few years is another sign that we are yet to see capitulation.
Last week, the Australian market saw a good bounce in the resource sector (+3.8%) on China's optimism. The Technology (+5%) sector bounced as Xero's management clarified a post-result message and emphasised confidence in improved margins and cash flow over time. Consumer staples (-3.3%) lagged, following the US lead.