The week that was

In recent years professional investors have got increasingly used to the fact that good news (strong economic numbers) is bad news for markets (because higher interest rates are likely to be necessary) and of course vice-versa. Ultra-low interest rates have driven asset prices ever higher and current price levels are now more dependent on interest rates than earnings. We might have expected this theme to wear off given the fall in the price of US stocks (almost 20% this year and more than that for especially interest rate sensitive US tech stocks). However, last week the effect was stronger than ever and stocks rallied mid-week amidst reports of widespread lay-offs (notably at Tesla) and expectations of a weak US jobs report. The report came in on Friday but it’s much stronger than expected and stocks swooned again, leaving the US market down almost 1% for the week and by a similar amount of for the month of May. The Nasdaq was down almost another 4% having been 10% down mid-month. “Bad news equals good news” to the extent that the markets seem to actually want a mild recession and the demand destruction that will entail. At a stock level Microsoft downgraded its guidance and the stock rose, go figure. European and Japanese stocks on the other hand were steadier and both actually ended up a few percent in May. The European Union actually agreed on what will be an economically painful Russian oil embargo early in the week but the market didn’t flinch perhaps indicating that a lot of bad news is already ‘in the price’.  As the earnings season drew to a close there was some good news with Salesforce producing a strong result but other tech names got a lift for less substantial reasons with Amazon and Alphabet (Google) up on news of imminent stock splits. This shouldn’t affect stock prices (a lower price simply means a smaller slice of the pie) but maybe it underscores the continued influence of retail investors. Chinese tech stocks also continued to rise as the Shanghai lock-down was eased and international investors seem to be starting to look at the sector seriously again (having vacated the scene last year).

The Australian market was fairly flat last week but May had already seen some of the lustre come off the local market (which had been a relatively stellar performer so far this year). Iron ore stocks held their ground but there was perhaps a late cycle feeling in the market where investors questioned Australia’s prospects with a slowing or even recessionary global economy. The biggest contributors were banks (down a few percent) and Real Estate Investment Trusts (down almost 10%) and there were also signs that the residential property market is starting to fall, especially in the capital cities that have been the ‘hottest’ since COVID.

While the markets’ sensitivity to rates and inflation is ever present it is also worth noting that bond volatility has calmed quite considerably, especially if you peer through the fog at ‘real’ interest rates. During the month, long term US Treasury rates drifted up slightly but so did long-term expected inflation meaning that real (after inflation) rates have actually plateaued. They are still at historically low levels (a positive margin of 1-2% is considered normal in an economically healthy environment) but for now at least bond volatility seems to have subsided somewhat.

The Australian version of this chart shows that real yields in Australia are already higher with inflation not quite as high as in the US and nominal yields a bit higher. This may be a sign of a healthier economic backdrop, but it is also because the market traditionally demands a premium for our bonds relative to those of the US, as the Dollar remains the world’s reserve currency and Australia is a cyclical resource dependent economy. It also means that in some ways monetary conditions are already tighter here than in the US, even if the RBA might look like is dragging its heels compared to the US Federal Reserve.    

After a strong run so far this year the US Dollar weakened somewhat in the last few weeks in what is probably a good sign that the world financial system is managing to digest tighter monetary conditions and the early stages of US liquidity withdrawal reasonably well so far.  A strong US Dollar can be a sign of fear in the market, and it can also put pressure on emerging market economies leading to a self-fulfilling feedback loop. Strong demand for commodities has also meant that the Aussie Dollar has been stronger than one would usually expect in a downturn but last month we saw the local Dollar fall 5% before recovering later in the month.  Hopefully, this isn’t an early sign of the increased currency volatility that many seasoned commentators have feared and, for now at least, the powers that be in the US will be happy enough with how this is all playing out even if investors are less sanguine. The next test will be later this week when the CPI data for the US is announced.