Weekly market update - 14th of June 2022
Written and accurate as at: Jun 14, 2022 Current Stats & Facts
Higher-than-expected US inflation data, combined with a hawkish tone from European and Australian central banks, have helped push equity markets down through the May lows. US bonds have sold off, with a “bear flattening” of the curve as 2-year yields rose 41bps and 10-year yields rose 22bps (at Friday’s close). Risk aversion saw the US dollar and gold hold up, while equities fell. The S&P 500 was off 5% last week, the NASDAQ lost 5.6% and the Euro STOXX 50 was down 4.9%. For the year-to-date, the S&P 500 is -17.6%, the NASDAQ -27.3% and the Euro STOXX 50 -18.5%.
A record low in the University of Michigan Consumer Sentiment index (which goes back to 1978) and evidence that consumer longer-term inflation expectations are on the rise adding to the sense of foreboding. The market increasingly fears high-interest rates and a recession.
The RBA’s 50bp rate hike triggered recession fears domestically. This prompted some shorting of domestic banks by international investors and saw the Australian market sell off even before Friday’s move. The banks sector fell 10.6% last week. The S&P/ASX fell 4.3% and is down 5.5% in so far in 2022.
The US Fed meets this week and the market is pricing an 80% chance of a 75bp hike. The rationale is they need to “get in front of the curve” and restore confidence that inflation will be subdued. There is a growing view the Fed has to choose between allowing inflation to stay high or triggering a recession. This translates to either rating or earnings risk for equities. The combination of rates up, oil up and US dollar up is not good for equity markets.
Economics and policy
The May CPI print was only 0.1% worse than expected. However, the underlying components were considered more negative.
Some key points to note:
- Headline inflation rose to 8.6% year-on-year — a new high for this cycle and up from 8.3% last month.
- Energy accounted for was 0.3% of the 1% month-on-month increase. Gas prices are up a further 10% this month.
- The Median CPI across all categories was +0.58% m-o-m. This was the highest-ever print, as was the y-o-y median. This reflects the breadth of pricing pressure.
- Core CPI rose 0.63% m-o-m versus 0.5% expected. It’s running at 6% y-o-y, down from 6.2% last month.
- Core goods inflation picked up m-o-m, goods CPI +0.7% m-o-m versus +0.2% last month. New and used auto prices picked up as car manufacturing remained constrained.
- Core services inflation rose 0.6% m-o-m. Airfares remained strong, up 12.6% m-o-m.
- Shelter (50% of services inflation) did not decelerate as expected, rising 0.6% m-o-m.
One key issue is that goods inflation is not coming off quickly enough to offset the rise of services inflation. The rent component was expected to decelerate, but did not. Some private measures of rent indicate this will continue to rise. This needs to be watched since it comprises 40% of core CPI. The problem for policy makers is that inflation expectations are beginning to step up.
This puts more pressure on the Fed to break the wage-price feedback loop by slowing the economy and creating slack in the labour market. The Atlanta wage tracker is staying flat at 6.5% and hasn’t yet shown signs of falling back.
The University of Michigan Consumer Sentiment index weighed on markets, falling to levels not seen since the early 1980s. The disconnect here is that people are still spending despite a low confidence level. There appears to be an emerging divergence between lower and higher income consumers. The former are hit harder by inflation and the removal of stimulus payments. This is evident in feedback from consumer stocks, where luxury and premium products are continuing to see good demand.
Europe
The European Central Bank met and sent a clear hawkish shift in their outlook. They noted CPI was now expected to be above the target range through 2024, despite lowering the outlook for economic growth. They also signalled the risk to CPI expectations was to the upside. The signal is for rates to increase 25bps in July. The market is now expecting 50bp in September and possibly another 50bp in October, with rates peaking at 1.75%.
This means the market is now seeing 125bps tightening this year, versus 50bps only four weeks ago. It is worth bearing in mind that inflation isn’t expected to peak before September, at around 9.3%. Using the old rule of thumb that rates need to reach the inflation level, there still seems risk to the upside.
The market’s other issue was the lack of any specific mechanism to avoid the “fragmentation risk” of widening spreads from Eurozone “periphery” economies. This is already occurring with Italian 10-year yields now at 3.98% versus Germany at 1.58% — a spread of 240bp. This is a 100bp widening from the start of the year when German bonds were -0.18% and Italian 1.19%. The ECB believes it has the tools to prevent this from becoming a problem. But lack of detail opens the door to the market testing the level at which the ECB will act.
Markets
The rally over the last fortnight lacked conviction, with low breadth compared to previous market returns. We are now breaking through the May lows in US equities. The near-term outlook remains uncertain, as;
- US bond yields have risen to cycle highs on the tail of a break-out in German bonds
- The most bombed-out tech names are rolling over again
- Mega-cap tech look to be rolling over; these have propped the overall index up
- The US dollar index is testing new highs
- Oil price – the source of a lot of problems – refuses to soften given supply issues
- The risk-off signal is also apparent in speculative tech and also in cryptocurrencies, where
- Bitcoin is falling on liquidity concerns.
Tightening cycles often trigger some form of financial shock, which can create a capitulation in the market. This often marks the low.
In this context, there are specific areas we are watching for signs of further strain:
- Peripheral bond spreads in Europe (indicates pressure on the Euro as ECB forced to raise rates into downturn)
- Credit spreads (indicates evidence of recession risk)
- US$/Yen and Japanese bond yields (indicates evidence market losing confidence in yield curve control)
- CNY/USD (reflecting pressure on Chinese economy from higher energy and food prices)
- Crypto, first real test of how liquid this is in a bear market
- Performance of banks versus market
Australia
The RBA rose 50bps rather than the expected 25-40bp. Like many other central banks the Reserve seems to realise the need to get back to neutral quickly. Rate expectations have now risen for the balance of the year. This has weighed on the ASX, with banks hit on economic concerns and REITs over the increase in funding costs.
After a multi-year cease fire, global long/short funds chose to put the short back on Australian banks, on the premise the economy is going to slow and that housing will follow.
We have been here before and it has historically been a losing trade.
The rationale, from an international perspective, is grounded in the fact that Australian house prices have more than doubled the growth rate of the US over the past 30 years.
There are explanations for this, including the impact of immigration and lack of supply.
But the simple narrative for now is that Australian mortgage rates are set to rise from around 2% to potentially over 5%. In the near term that means risk for housing and the banks.
This saw Westpac (WBC) -13.1% last week, Commonwealth Bank (CBA) -10.9%, National Australia Bank (NAB) -10.3% and ANZ (ANZ) -7.7%. Year-to-date the banking sector has now performed in line with the market.
Discretionary retail is the other sector particularly vulnerable to the rise in mortgage rates. This is translating through to underperformance in JB Hi-Fi (JBH, -10%), Wesfarmers (WES, -7.4%) and certain small caps.
Atlas Arteria (ALX, +13.0%) was the strongest performer after private equity secured 15% of the company, indicating they want to see certain information to determine whether to make a non-binding indicative bid. ALX responded by saying they do not intend to provide this information, but will meet with IFM.
Tabcorp (TAH, -8%) settling litigation with Racing Queensland, paying away $150m in return for a lower tax rate and release from certain requirements of spending. The tax on point of consumption rises to 20% from 15%, which is what the competing corporate bookmakers pay. This effectively levels up the playing field in the state and yields a $30m benefit to the company.