Markets were down last week and, as we all have come to expect, speculation around inflation was the lightning rod that fed into interest rate expectations and then onto US tech stocks especially. Over the last 8 weeks a benign US reporting season and then very tentative signs of a peak in US inflation pressures gave the markets hope that the US Federal Reserve might still be able to engineer a soft landing into a merely moderate, inflation dampening recession.  This has been despite a worsening inflation outlook in Europe and a sharply weakening Chinese economy. That’s the fundamental story anyway but it’s one that many analysts have struggled to reconcile with the dismal sentiment of the first half of the year and not much change since then. Another explanation is that this market rally, or at least the extent of it, can be explained by more technical factors and so-called short covering in particular. The short trade was obviously working well a few months ago but when investors short a market they first have to borrow the stocks so they can the non-sell them. A profit is made when the stocks go down in price, and short-sellers then buy them back at a lower price, returning them to their original owner and pocketing the difference between the high sell price and the low buy price. However, problems arise when the stocks start rising instead of falling, because the borrowed stocks will need to get bought back and returned regardless of price. Every day that stocks rise, short sellers see their losses accumulate, until they eventually capitulate and buy back the stocks, thereby fueling the rally, and putting additional pressure on their fellow short-sellers in a vicious (or virtuous depending on your perspective) cycle.. Another related factor is the recent success of trend following strategies which as the name suggests look for trends in market, long or short, and follow them - effectively amplifying that trend up to a certain point. That certain point might be a change in fundamentals that markets can’t ignore and/or what chartists call a resistance point. Market pundits have been talking about just such one resistance point, the 200-day moving average as it was coming into view in recent weeks. When a market breaks through such a point it is evidence that the recent price action is still strong and should continue and when it fails to break through the moving average, as happened last week, it is thought that the recent move has run out of steam. Many think this is like reading tea leaves or horoscopes and that chartists see what they want to see in the myriad of signals that they concoct but it is undeniable that if enough people read the same thing into the same signal, then technical trading can create its own market reality. It just so happens that this auspicious market marker was coming into view just as the latest Fed minutes were released and a few Fed speakers tried to pour cold water on the notion that the Fed might soon slowdown its interest rate driven assault on inflation. This was seemingly corroborated by persistently high inflation numbers in Europe and interest rates immediately started to rise again. This was enough to send the S&P500 and Nasdaq into reverse with each falling back sharply in the last three days of the week, ending them down almost 2% and 3% respectively.

European and Chinese markets were also down around 1% while Japan, the UK and Australia danced to a very different tune and made modest gains.  It’s early days but the Australian reporting season has started reasonably well with some strong results from quite a few consumer discretionary stocks being offset by weaker results from the ASX, AGL, Bendigo Bank, Magellan and some of the energy stocks. However, these largely offset each other, and  were trumped by enormous cash flows being generated by BHP which was up 7% after its results and the announcement of an enormous dividend. One might quibble about the sustainability of that dividend and the potential outlook in such a cyclical industry, but the sheer quantum of cash was enough to allay concerns for now and BHP’s rise accounted for most of the market’s advance despite actual iron ore prices reflecting the ongoing weakness of the Chinese economy. Most other metals and soft commodities were weaker while energy prices bounced back.

Bond prices also reflected a (once more) stagflationary tone as government bond prices fell (as expected interest rates rose) while credit spreads on corporate debt rose. Hopefully this was only a temporary set-back, but it was certainly the weakest sentiment across asset classes that we have seen in 2 months. One thing that could cheer markets up again this week would be a weaker Personal Consumption Expenditure inflation reading as this is a measure that everyone knows the Fed pays considerable attention to.  

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