ASX Update 25th October 2023

Global Market Commentary

Chart: S&P 500 as at 24/10/23

As much as the cogs of the market shift and change under the hood the overarching themes remain familiar and continue to drive markets. The steeping of the yield curve, that we were discussing this time last year, continues to be the main driver of market sentiment, but only this time it’s been concentrated in the long end of the yield curve instead of the short. The S&P500, pictured above has, seen a decent sell off since we last spoke and it now down 7% from August highs and 11% off all time highs set in January 2022. It’s been a rough time for equity bulls all round. Also don’t think the ASX200 has been spared as we have sunk 8% since our August highs as well, but we will cover that in more detail later.

Chart: US 10yr Treasury Yield as at 25/10/23

Those pesky yields I have spoken about above are the source of most of the market’s troubles. We have seen the 10yr yield steepen aggressively since the end of July as it touched 5.01% earlier in the week, its highest level since 2007, but has since paired back those gains. On the short end we have also seen some rises but by nowhere near as much as the 2yr Treasury yield holds at 5.06%. The inversion spread between 10yr & 2yr yields has narrowed significantly in the last few months. It got as low as 11bps earlier this week but now stands at 23bps. This was 110bps 6 months ago and generally when the 2/10yr become inverted, it signals a recession will occur within 24 months. So why has the long end of the yield curve steepened so much of late?

It’s mostly to do with the strength of the US economy and stickiness of some inflation. Around July we saw economic data for the US trough, and we have had an improvement since then, especially in consumer spending. Consumers have remained stubbornly resistant as retail spending, durable goods orders, sentiment, PMIs etc. have all come in better than expected. We have also seen the labor market remain strong with unemployment hovering at historic lows and hiring fortified. This has changed the narrative that a recession is imminent to the Fed have been able to thread the needle and we have that soft landing they so hoped for. This suggests that there is a slight chance of further rate rises in the future but at a minimum reinforces the notion of higher yields for longer. There is also still a large amount of fiscal spending in the system or to come with the Biden administration still trying to get its Green Inflation act finalized, wants another $100bill to fund Ukraine + there is talk now they will also fund Israel (we will get to that situation in a moment). Despite military spending being targeted and most of the tanks, jets, ammunition etc. being sent overseas a lot of that doesn’t come back and gets blown up and destroyed. This means more must be made which keeps people in jobs and so on. It’s the US war machine in all its glory. Finally, we also have liquidity issues with new bond issuances being rolled out at an alarming rate and without the likes of China or Japan buying its mostly being funded by private institutions which are demanding a higher term premium for their investments.

So why is this bearish for equities? Well, it all comes down to expected return and risk. The earnings risk premium between the S&P500 and 10yr treasuries is basically non-existent now. Remember US treasuries are considered a risk-free investment, so if you can go and park your money in a bond for 10 years and receive 5% annually risk free, why would you be overweight equties? So, funds allocate a higher proportion of their investments to longer-dated bonds and less to shares or will do so soon. Earnings have been going backwards too, so it’s not like 2005-07 when yields and equities could both rise in unison as earnings were running at a very healthy rate back then.

This is a lot to take in and I could really go deep into the plumbing of the financial system to explain this in more detail, but this is not something you really need to know. The Israel conflict has become a thing in the last two weeks and has grabbed many of the headlines and blame for the market’s performance. I am calling BS on that and believe the markets couldn’t care less about the conflict. Yes, it has a chance to spread to Lebanon and Iran but in the grand scheme of things economically it doesn’t impact us at all. Even Oil couldn’t really muster much of a rally on the back of this and it’s the most likely sector to be impacted. If the market couldn’t spend any time on the Russia/Ukraine situation, which had far greater implications, then why would it care about Israel? That may sound a bit cold, but I am referring strictly from a macro point of view.

My base case is still for the US to enter a recession in 1H 24, which won’t be confirmed until Q3 24 due to the lagging nature of macro data. This will see rates cut substantially, maybe as low as 2%, and a very healthy rebound to ensue. A lot of this comes back to consumer spending and housing construction. I have shown the above chart before but as you can see excess covid savings have now been exhausted and households are eating into regular savings, which are growing at a much slower rate. Student loans repayments restarted on the 1st of October again after a 2 year hiatus impacting 25million Americans. Also wage growth is at the slowest it’s been at since September 2021. So, we have depleted savings, still higher prices, new debt repayments and your wage is not growing as fast as it once was. This paints a bleak picture for the US consumer and one that will accelerate into the end of the year.

Chart: 30yr Fixed Mortgage rate courtesy of @Barchart on X

The second part to this is housing construction which is normally the first domino to fall leading into a recession. The chart above depicts the US 30yr mortgage rate which most households utilize when buying a home. This sits above 8%+ now, the highest since 2000, which begs the question, who would buy a home at these rates unless you are forced to? Not many is the answer. With 80% of all mortgages sitting at a rate of 5% or below, most homeowners will sit tight until rates come down again. This means a lot less homes are constructed, which means less builders are needed and so on. I have stated this before but once construction peaks around 600-800k jobs are lost in the sector and 2-3mill in other jobs as a roll-on effect. We are seeing housing construction and new home applications fall consistently since last year and it’s only a matter of time before it breaks.

Finally, the last piece to discuss is US government debt. Around 30% of national debt needs to be refinanced in the next 2 years. This means a whole lot of T-bills and Bonds will be issued and a heap of bonds will be rolling over to rates much higher than they are currently on. The US government needs yields to deflate, and deflate quickly, so a recession should be welcomed by the Biden administration as it will do that for them.

S&P/ASX 200

Chart: S&P/ASX 200 as at 25/10/23

As mentioned above the XJO has not been spared from the sell-off either seeing an 8% pull back itself. Our local 10yr yields have also surged to over 4.75%, a rise of over 40bps in just over a week. We also have a situation whereby earnings are expected to decline around 5% FY24 making our own earnings risk premium look unfavorable for equities. Unlike the US our forward PE ratio isn’t expensive at all, sitting around the 13x level with a 4.2% forecast yield. Our historical average is around the 15x mark. We do have those Chinese headwinds that are impacting commodity prices negatively and then resource company earnings. China’s economy is still sluggish, especially in the real estate sector and unfortunately that is where most of the demand for resources comes from. There has been talk of another round stimulus to come with $137bill of new debt issues being suggested. I would, however, expect more stimulus and a more favourable environment to ensue in 2024. This will obviously help the resources and energy sectors.

The Australian household is also under pressure. Mortgage rates are peaking, and this is eating into discretionary spending. Add in higher prices at stores and the pump and many households will be hurting. Thus far it’s not really showing up in mortgage arrears and defaults. We also still have a very large excess savings buffer from covid even though savings rates are falling.

Employment figures were sluggish in the second half of the year and wage growth is cooling. High net immigration is driving most of our growth as Albanese and co import demand and stoke inflation. CPI figures for Q3 dropped today and were a touch hotter than expected. This has forced most economic commentators to raise expectations of a rate rise in November. I am of the opinion it’s not needed, and the RBA would be jumping at shadows if it did. Of the quarterly 1.2% rise 0.7 was house prices & fuel. Fuel obviously influenced by global macro events and our house prices impacted by high net immigration plus low supply. A rate rise would not change much there and in fact would miss the target demographic which is influencing this the most. Inflation is slowing and the RBA by its own admission wants it at 3% by mid-2025. This gives it plenty of time and as Woolworths proved today when markets are allowed to act as they are supposed to things will come back to the mean, as it reported fresh food produce prices fell 12% in Q3. I do not expect Australia to enter a recession in 2024 but a significant slowdown is occurring and I expect two cuts in 1H 24.

Energy

Chart: Brent Crude Futures as at 25/10/23

We saw an initial spike in oil on the back of the Israel conflict, but it has since lost most of those gains. This would be due to the markets properly digesting the conflicts economic impacts plus excess oil/gas in the system. Whilst it may disrupt some supplies, we have EU gas storage at 98% capacity and falling into a recession and Chinese demand still soft. The US is at record production as well as exporting large amounts of LNG to the EU as well. We have seen gasoline demand dive and stockpiles aggressively rise in the US as well suggesting overall fossil fuel demand is soft and the prevailing headwind here.

There has been some major M&A action in the energy space, mainly in the US. Chevron just made a $65bill bid for Hess this week and that’s after ExxonMobil made a $60bill bid for Pioneer Natural Resources. Oil and gas giants still have massive FCF and cash stockpiles from recent energy price hikes, lower cost bases and overall more efficient business’. Stock prices remain cheap as most energy companies trade sub 10x forward earnings, allowing for M&A opportunities to occur and for the major companies to sure up additional production and high-quality assets.

One has to wonder how long before one of the majors makes a bid for Woodside Energy Group ($WDS)? A top 10 producer now with 180-190mboe pa vs Hess who will produce 133mboe this year. Also due to the lower AUD it would be a bit cheaper at only $43bill USD market cap making it steal in my opinion. Someone like Shell who is sitting on $US45bill cash and high FCF could easily make a $US55bill (approx. $45ps) bid for them and excite the market at the very least. The FIRB may be a large hurdle, but I can’t see a reason why they should block the deal. Shell already operates in our jurisdiction and would have to adhere to all our legislation etc. Are from a close ally in the UK, thus no security fears and our energy market are well diversified these days to not pose a threat there. Regardless supply contracts and laws would still have to be adhered to.

What Happens Next?

This is the million-dollar question and a very tough one to answer. I can’t remember a tougher time to invest and evaluate markets as what lies ahead is so uncertain. What we do know is the characteristics of the market a very late cycle and mature. This is evident from the very low unemployment rates, rising yields & high inflation. Thus, my base case is for a recession in the US with a correction in equity markets as a result, rate cuts and then stimulus both monetary and fiscal. This would play out over 2024/25. If this were not to play out then we would need to see earnings rebound in a meaningful way, macro data to continue to improve and credit conditions to ease. Given the mortgage rates in the US and pressure on household budgets I can’t see how this plays out, but just because this is late cycle doesn’t mean it couldn’t drag on for some time yet. Maybe even years. If we do get a correction in markets in 2024 I don’t expect a savage GFC/Covid style sell off rather a moderate 20%. It will present us with excellent entry positions in many stocks and especially high-quality tech stocks on the Nasdaq. I would be an aggressive buyer then if it were to play out.

That’s enough from me as I feel we have covered the most important points of the past few weeks. Markets tend to rally into the end of the year but if yields keep on behaving the way they are I can’t see that happening. It will be interesting if we see that ‘Santa Rally’ come December. On a personal note the kids have started term 4 and again I can’t believe another school year is almost over. We have been getting tremendous feedback from their teachers and are incredibly proud of them. Our little lady also turns one next week, again something else that has gone incredibly fast. I love watching her growth every day and building such a vibrant and happy personality. I hope you all have a wonderful end to the week and stay safe. Look forward to speaking with you all soon. Go Crows!

heath@hlminvestments.com.au

0413 799 315

Important Notice

Any advice in this article should be considered General Advice only and does not consider your personal needs and objectives or your financial circumstances. You should therefore consider these matters yourself before deciding whether the advice is appropriate to you and whether you should act upon it. I am happy to assist you in this process. To do so, I will need to collect personal and financial details from you before providing my recommendations. Please note the author may own shares in the companies mentioned in the above blog.