Weekly market update - 15th of August 2022
Written and accurate as at: Aug 15, 2022 Current Stats & Facts
The reluctant rally continues with the S&P 500 up 3.3% last week and the S&P/ASX 300 gaining 1.4%. They are now down 9.3% and 3.7% respectively for 2022. The US market is now up more than 15% from its low and the rally has lasted 32 days.
Key drivers include:
- Positioning: Systematic and institutional investors have been sitting on their biggest equity underweights in years.
- Lower volatility: This leads to increased participation by systematic investors
- Better sentiment: Job data has helped quell the view that the economy is facing imminent recession.
- Stronger US earnings season: Hasn’t validated the pre-season market de-rating
- Lower commodity prices: Particularly in US gas which is helping dampened inflation expectations
- Early signs of goods inflation slowing as supply chains free up
A small shift in fundamental view — that things are not as bad as feared — has prompted a material shift into equities by various systematic approaches. This caught institutional investors off-guard. This is the nature of bear market rallies — sharp and often short. We now find ourselves at a key point. In the short term we’re likely to have a quiet couple of weeks ahead of the Jackson Hole central banking conference on August 25-27.
We suspect the market will be range-bound given it is high summer in the north, there are limited new data releases, we are near a large technical resistance level for the S&P 500 and it appears the sharp move in systematic investors has played out.
Beyond that there remains a wide distribution of outcomes:
- Inflation rolls over, the economy has a mild recession at worse, earnings declines are limited and the easing cycle starts at the back-end of 2023. In this scenario the market may consolidate, but ultimately moves higher.
- Inflation proves more persistent, driven by tight labour market and higher energy prices as the economy runs too hot and China re-opens. Central banks need to continue to tighten into the downturn and earnings decline more significantly, taking equities lower.
There is probably enough evidence to indicate the latter scenario does not take us to new lows. The key to the call remains the main drivers of inflation: the job market (particularly job ads and wage pressures), corporate pricing power and commodity markets.
Economics and policy
US year-on-year CPI (8.5%) and PPI (9.8%) were lower than expected. But one month does not create a trend — and there was enough in the data for both inflation bulls and bears to validate their outlooks. Core CPI (5.9%) was 0.3% month-on-month, a lot lower than recent months. But it is at 0.5% excluding the more idiosyncratic categories such as used cars and airline tickets. Core goods inflation is falling away reasonably quickly. Energy represents 34% of current inflation and is heading down as petrol prices drop.
Forward indicators of inflation — including the Crude Non-farm Materials ex Energy PPI which is a directional indicator for the Finished Goods (ex-energy and food) PPI — are moving in the right direction. Freight rates also continue to decline. All this underpinned more positive sentiment in market last week.
But in the medium term, categories such as direct rent and owner’s equivalent rent become more important. While these have begun to decelerate, it is marginal at this point and is still running above 8%. Unit labour costs also remain too high, while there is no sign of a turn in the Atlanta wage tracker. This means the Fed has had to re-iterate its vigilance on inflation.
China
There is some hope that cumulative stimulus measures will begin to drive economic recovery, particularly as we head into Autumn when construction activity should pick up.
We are cautious on calling this too soon. Some key lead indicators remain negative, notably property stock performance. Credit data continues to be weaker than expected, reflecting low demand given the zero-Covid policy.
Australia
The market continues to grind higher, helped last week by BHP’s (BHP) bid for OzMinerals (OZL) which fired up the resource sector. Small caps also continue their recovery, outperforming the S&P/ASX 300 by 8% QTD. This is helped by a combination of short covering and a position squeeze.
There is an emerging view that the government and RBA are looking to deliver a soft landing by allowing inflation to run a bit hotter than normal — on the premise that commodity prices should stop rising, and immigration can ultimately resolve labour shortages. In this context banks don’t face downside risk on bad debts and some of the consumer-exposed stocks may now be pricing in too much downside. As in the US, this is contingent on commodity prices staying subdued and labour markets loosening.
Markets
It was interesting that US bond yields couldn’t break the 2.51% low of August 8 in response to the lower CPI number. June’s hot CPI number coincided with the peak in bond yields (3.5% on June 14). Since then we’ve seen a 100bp move down, before a 33bp rise, closing the week at 2.83%.
Bonds could trade back towards 3% for several reasons:
- Economic data is surprising on the upside. The Fed is likely to be uncomfortable without further slowing, given inflation remains too high.
- The Total Financial Conditions index has begun to loosen, reflecting more confidence in the economy. This works against the Fed’s goals, which may lead them to signal rates stay higher for longer.
- QT beginning to kick in, which will potentially act as a headwind to lower yields.
- Yield curve inversion is implying too quick a reversal in US rates, particularly given economy and FCI trends
Given this, we do not expect to see bond yield moves lower — and they may move higher within a trading band. This does not necessarily spell bad news for equities, but it makes further moves higher harder. Given the moves seen so far we expect a period of consolidation coming soon.
Stocks
BHP (BHP, +0.1%) made an indicative all-cash takeover offer for copper miner Oz Minerals (OZL, +35.8%) at a 32% premium. OZL’s Board rejected the offer but left the door open to a negotiated deal. The rationale for BHP is that it adds to “future-facing metal” exposure and helps offset the declining grades they will face at Escondida in Chile in coming years. It may also mean lower capex is required for the Olympic Dam asset, given it’s adjacent to an OZL project.
Commonwealth Bank’s (CBA, -1.1%) result was in-line with expectations, with 2H revenue and pre-provision profit broadly flat sequentially. 2H margins are not yet showing benefits of rate rises, but this should turn sharply in FY23. The key message management wanted to convey was confidence in credit quality. Provided rates don’t go beyond 3%, CBA believes customers will be supported by repayment buffers, surplus deposits, home equity and low levels of unemployment.
QBE Insurance (QBE, +1.9%) delivered a strong, clean result. There were clear signs of conservatism in the assumptions made for the crop insurance business and inflation. The new CEO expressed confidence in turning around the US. Over time QBE’s discount multiple should recover if the CEO delivers on his message of consistency.
Suncorp’s (SUN, -1.5%) result was good with revenues, operating margins and investment yields all improving. The key focus was whether the recovery can continue despite sharp increases in reinsurance and the perils budget, following catastrophe claims in FY22. Guidance suggests everything remains on track. But to get there SUN needs to pass through price rises of 15-20% in home insurance, which won’t be easy. It continues to trade at a material discount to IAG.
IAG (IAG, +1.5%) delivered weaker operating trends than SUN, but with less headwind on reinsurance and perils. It still looks like IAG needs to be pushing through large price rises in home insurance. But it’s chosen to be not as aggressive as SUN, instead focusing on affordability and volume growth. While lower risk than SUN’s strategy, this also suggests lower margin momentum into FY24.
Telstra (TLS, -1.0%) had a solid result in line with expectations. The mobile segment continues to grow revenue through price increases and some growth in subscribers. The NBN headwind has largely receded. The only blemish is ongoing erosion of the data business reflecting pricing declines of 8% in FY22. Mobile and Infraco represent 82% of the group’s EBITDA and is growing 5% pa. The residual should be able to hold flat. This leaves the company on 17x adjusted PE, growing 5-7%. This outlook was reflected in the first dividend rise (albeit small) for seven years. The stock’s muted reaction reflected a narrowing of F23 guidance where the midpoint was lower than previously. This likely reflects the uncertain economic outlook plus new CEO taking charge next year.
REA Group (REA, +7.5%) produced a strong FY22 result with >20% top-line and bottom-line growth. The core domestic business finished the year strongly, beating market and internal expectations. FY23 has started strongly with listings +7% year-on-year in July, helped by a partial lockdown in the prior comparable period. FY23 will be a mixed year for listings, but is likely to finish marginally negative. Incremental commentary from the company reiterated that yield growth is set to exceed expectations, more than offsetting any listing downside.
Lithium stocks rose following the US Inflation Reduction Act, which incorporates substantial new subsidies to support the renewable sector.