Global equities weakened further last week, although not due to another surge in bond yields. Rather, it was due to signs of a weakening in corporate earnings from two major US retailers, Target and Walmart. That said, most Fed speakers (including Powell) continued to talk tough, suggesting they are still intent on hiking rates by 0.5% next month. Another chunky 0.5% hike is still likely in July.
As for Wall Street weakness, to date, the Fed seems unfazed. Indeed, weaker stocks appear part of the transmission mechanism to lowering demand via a tightening in financial conditions and negative wealth effects.
Last week’s market performance is consistent with a potential transition in asset class performance. Bonds yields are no longer pushing higher, though equity markets remain under pressure. This is due to a growing focus on the implications of the initial increase in bond yields (which, in turn, reflected heightened expectations of aggressive monetary tightening) on economic growth and corporate earnings.
The surge in bond yields since late last year has so far had a negative impact on equity valuations, not corporate earnings. Broadly speaking, equity price-to-earnings valuations have returned to their pre-COVID average levels. The S&P 500 is already off almost 20%, which is usually the deepest sell-off we see in the absence of a recession. US economic growth remains good, though some indicators – such as housing demand and consumer confidence – are beginning to buckle.
Where to from here?
If the rate of increases in US inflation drops sharply in coming months, the Fed may at least pause its rate hike plans after June or July. This could avoid recession and might allow equities to at least grow in line with still-positive corporate earnings. If inflation remains stubbornly high, however, the Fed won’t stop, even if the economy edges closer to recession. Equities would likely drop at least another 20 to 30%. Earnings would fall while panic potentially causes PE ratios to move from current levels (average) to well-below average levels (i.e. cheap).
We are still some months away from a clearer picture on the speed of US disinflation. It’s also possible that equities drop further in coming weeks if we get further signs of economic weakness without the Fed being able to signal they’re backing down.
The first and last scenarios are consistent with a likely peak in long-term bond yields already being in place. And even in the second scenario of continued aggressive US rate hikes, much of this already seems priced into the bond market.
Data releases to watch
Expect Wall Street to be tested again this week with the release of more retail earnings updates from the likes of Costco and Best Buy.
We also get US personal income and consumer spending, which includes the Fed’s favourite inflation measure – the private consumption price deflator. The core price deflator (i.e. excluding food and energy) is expected to show a 0.3% monthly increase for April, which is the same as March. This would still suggest that inflation pressures, while easing, are not falling fast enough to stop the Fed raising rates further.
New home sales data are also out. In line with a range of other housing indicators, these data are likely to reveal further weakness in the face of a surge in mortgage rates and squeeze on real incomes.
Last but not least, the latest Fed meeting minutes will also be out. These are likely to show most members are still intent on hiking rates even in the face of an economic slowdown – if inflation remains stubbornly high.
The most that can be said about Labor’s weekend Federal election victory for markets is that a potential Monday sell-off were it a hung parliament has been avoided. I expect markets to quickly refocus on the darkening outlook for the US economy, along with the ongoing massive disruption to China’s economy caused by never-ending lockdowns. Concerns over the global growth outlook is evident with weakness in local bond yields, the $A and resources stocks in recent weeks.
Last week’s highlight was the softer than expected March quarter wage price index result. This revealed annual official wage growth inched only a little higher – to 2.4% from 2.3%. One day later we learnt that the unemployment rate dropped to 3.9% in April – the lowest rate since 1974 – while only 4k net new jobs were created, potentially reflecting growing labour shortages.
Although the RBA is talking up “business liaison” anecdotes of rising wage costs, so far at least it’s not evident in the official data. I’d also note that the RBA’s recent focus on the private sector WPI, including bonuses, disappointed last week. Annual growth dropped from 3% to 2.6%. All up, the wage data suggests the RBA need not risk unduly destabilising the economy with a 0.4% rate hike next month. My base case is a hike of only 0.25%.
In the week ahead, we get Q1 construction and business investment data, both of which are likely to show some rebound following lockdown-induced weakness in H2’21. The April retail sales report is also expected to show spending remained relatively firm. All this is consistent with continued growth in the economy and higher interest rates ahead.
Have a great week!