Weekly market update - 6th of June 2022
Written and accurate as at: Jun 06, 2022 Current Stats & Facts
BETTER-than-expected economic data and signs of Beijing rewinding Covid restrictions are fuelling concerns that inflation may not fall as quickly as some hoped. This has prompted a rebound in commodity prices. It’s also seen US 10-year bond yields rise 20bps to 2.94%, down from a peak of 3.19%.
The move-in bonds triggered a sell-off in US equities late last week. The S&P 500 finished down 1.2%. The S&P/ASX 300 was up 0.8%. The cautious sentiment was reinforced by JP Morgan CEO Jamie Dimon’s reference to the “hurricane… right out there down the road coming our way” due to higher rates and quantitative tightening. Elon Musk’s “superbad feeling about the economy” and need to cut 10% of Tesla’s workforce did not help.
The S&P 500 has rallied 7% off its lows, and many sentiment indicators have shifted from “oversold” to more neutral. The near-term market direction is likely to be driven by this week’s inflation data and the potential for earnings surprises. Rate expectations have shifted materially. The economy will still determine whether they will moderate or go higher over the next three months. It’s just too early to call.
Soft landing or recession
Going back to 1929, the average US soft-landing bear market has been -26% — and for a recession -41%.
Here are the current scenarios for each of these “book-end” soft-landing and recession paths:
- The path to a soft landing
- Building inventories mean consumer price rises ease off
- Chinese reopening eases product supply, also helping inflation
- Wages ease as a lack of stimulus means companies no longer need to pay up to induce workers to return. Companies begin to stop hiring and even lay off workers. Tesla and Amazon’s recent comments are pertinent in this regard.
- Commodity prices stop rising.
- As a result, the Fed doesn’t need to go harder than what’s already priced in the forward curve.
- The path to recession
- Inflation remains resilient as the economy doesn’t slow sufficiently
- Companies continue to catch up to the cost impost they are wearing
- Housing costs keep rising
- The labour market stays tight as service jobs continue to recover, and workers seek compensation for higher prices so wage growth doesn’t slow.
- Supply shortages combined with the return of China continue to underpin higher commodity prices.
- This leads to the Fed remaining hawkish, triggering a recession
The path should become more apparent in the coming months. The risk-reward at this point favours caution. The Fed still cannot afford financial conditions to loosen — which would be the case if equities rallied too far. The critical caveat is that Australian equities remain well placed in this environment and continue to hold up reasonably well.
Economics and policy
Monthly US payroll data was solid — 390k new jobs versus 318k expected. The rate of new jobs has eased from the 600k level, but it’s generally considered too high to be consistent with reducing inflationary pressure. The three-month moving average remains at 408k. The market believes a level of 100k-150k new monthly jobs is needed.
Participation picked up 0.1%, but this is not enough. This gap helps explain tightness in the labour market with unemployment at 3.6%. There is material deviation by age cohort, with participation rates in the 55-and-over range remaining stubbornly low.
The average hourly earnings growth of 0.3% month-on-month was lower than expected. The annual rate of 5.2% remains too high, though the three-month moving average has fallen into the 4-5% range. We need to see it drop into the 3-4% range.
The latest ISM manufacturing data was too strong for the market, rising to 56.1 versus a consensus of 54.5. Services ISM was marginally softer at 55.9 versus the consensus of 56.5, but this remains the vital part of the economy. The orders backlog component fell back to pre-pandemic levels, indicating supply chains are improving. This reflects the building retail inventory we have heard about from companies.
Overall there is nothing to reduce the likelihood of back-to-back 50bp moves from the Fed in June and July. It also reduces the possibility of a pause in rate hikes in September.
Oil
Oil markets saw a lot of action last week. OPEC+ announced it would bring forward an increase in oil supply. Initially, this was seen positively as a thawing of Saudi and the US relations. But the more you dug into it, the more it looked like another hollow effort to make it appear like something was being done about high US fuel prices.
OPEC is bringing forward a slated September supply increase to July and August. This equates to an extra 200k or so barrels per day (BPD) for two months — allocated across OPEC+, including Russia. Many of these nations cannot produce the additional barrels, so not all of that will come onto the market.
It is also apparent that Libya and Venezuelan production has been weaker than expected. Any agreement with Iran to potentially unlock another 500k BPD is still forthcoming. The Russian supply is estimated to be 1m BPD less than pre-invasion. The prospect of China reopening could add 1m BPD of demand.
The risk of fuel prices to the economy is high. US inventories are low. Strategic petroleum reserve releases are propping them up, but this is not sustainable. An extremely tight refining market caps all this off. The NYMEX 3-2-1 spread — the gap between a price of three barrels of oil and the two barrels of petrol and one of diesel which can be refined from it — is multiples of its historical average. This implies fuel prices at the pump are equivalent to US$175 oil. This is a challenge for the consumer and does not help the inflation outlook.
Australian Energy markets
There is an increasing focus on Australian power prices. A combination of outages and supply issues at coal-fired plants — plus cold weather and a limited solar supply at this time of year — have left the domestic market relying on gas to fill the void.
This comes at a time of limited gas supply and a high global price. Wholesale prices have surged in response. The NSW average price is $200 — almost double the previously highest prices over the past 15 years.
This affects only a few commercial buyers in the near term since most are on contract. Consumers are protected for now. The main effect is on power providers reliant on purchasing power from the National Electricity Market. Smaller players are looking to shed customers and load as a result.
However, the medium-term effects could be material. Some analysis suggests it could translate to power price rises of 9% in Sydney in FY23 and 30% in FY24. The situation would be worse in Queensland and marginally better in Victoria. This is politically unpalatable and raises the risk of intervention in the industry. Understanding the flow-on effects on the economy and corporate earnings is critical here.
Markets
The consensus view that peak inflation meant peak bond yields was challenged last week. History suggests that in most cycles, rates end up rising above inflation. If the latter isn’t below 3% in a reasonable time frame, we still may see rate and bond yields head higher. The issue for markets remains that central bankers will want to be seen to be hawkish until it is evident inflation is beaten — which will not help sentiment.
Commodities maintain their defensiveness. This partly reflects the oil issue flagged above and the belief that China appears to be reopening. Copper remains the best proxy for this sentiment and rose 6% last week.
The Australian market continues its resilient performance with energy and resources leading the way. Financials and utilities fell last week, mainly relating to stock-specific issues.
Woodside Energy (WDS, +5.5%) has performed better than many predicted post-merger with the BHP oil and gas assets. The market has easily absorbed the overhang of forced sellers.
Origin (ORG, -9.9%) delivered a significant profit downgrade due to issues with coal supply. Outages from its usual supplier mean ORG has to tap the spot market for coal, where prices are running at about US$250 a tonne. This issue persists into FY23 and results in 20% downgrades despite a sweet spot for the company’s LNG business.
Lithium stocks were hit on the back of some sell-side downgrades. The rationale is that supply growth – especially from China – will see the market return to surplus. There are a lot of moving parts here, which are all unpredictable. Supply out of China is typically low grade, while there are uncertainties around the level of demand growth. It remains a complex market to call.