Eley Griffiths on bonds, the ASX and Firmus, and the outlook ahead

It's been such a tumultuous few months for markets that there's likely more than a few investors pining for the halcyon days of June when the SpaceX IPO was its biggest preoccupation. 

Since then, we've had a still-unfolding bond market meltdown, a South Korean-led AI correction, rate hikes here and abroad, as well as a short-lived reprieve in oil prices. Despite all that, equities markets are still performing. 

If nothing else, it gives analysts plenty to talk about. As Eley Griffiths put it succinctly in its recent quarterly market review The Encylical:

"Unusually, equity markets traded to or near historic highs despite rising bond yields, elevated oil prices and extending inflation break-even indices."

Here are the key insights it's taken from the quarter and how it's seeing things going forward. 

ASX activity

A busy quarter for the ASX saw it hit record highs in August off the back of a solid reporting season. But as has become a recurring theme in markets everywhere, there was a clear divide between the have and the have-nots. 

"The local results season handed down in August slightly bettered expectations," Eley Griffiths wrote. "A clear dichotomy emerged among ASX reporters - those exposed to the investment economy (AI capex, infrastructure and mining contractors) performed strongly and those with consumer exposures largely struggled and foresaw challenges ahead."

Bond bedlam

Complicating the picture for equities is the ongoing bond market saga that has forced its way to the front of the stage for most of the big market developments. 

"Undoubtedly the big story of the quarter was the back-up in global bond yields between June end and the close of the September quarter. Investors began to discount the inflationary impulse from higher energy prices, an increasingly hawkish tilt from central banks, elevated sovereign debt/budget deficits and the prospect of private sector crowding-out from hyperscaler bond issuance."

So dramatic have the movements in bonds been that decades-long trends have been regularly broken, and drastic action taken by governments across the developed world. 

"For the first time in 28 years the US Treasury, via its Exchange Stabilisation Fund, bought Japanese yen in concert with the Bank of Japan (BOJ) in the final days of July," wrote Eley Griffiths. "Its purpose being to arrest the yen’s depreciation and reduce the exposure of US long bonds to BOJ liquidation (removing bond selling-pressure and therefore the upwards pressure on interest rates)."

Oil outlook

Oil has been a similarly disruptive force across markets, and Eley Griffiths' view is that the oil rally will continue. 

"Momentum is squarely on side with crude and similarly with global oil equities that are making historic highs every other night. Futures speculators are modestly net long, as they were at prior quarter end, and this is a satisfactory setting for a continuing rally. The line of least resistance appears to be to the upside for crude right now, a certain pointer to firmer prices."

Will AI change investing?

There are plenty of industries already grappling with the existential threat of AI, mathematics being chief among them recently. According to Eley Griffiths, the investing industry is grappling with that same question, and the outcome will be dictated by a simple test. 

"So, will AI make finance theory a practical reality? Like an econometrician who doesn’t require sleep, it will probably get ideas that work in theory to work in practice better than they ever have before."

"When it comes to empirical horsepower, AI is the ultimate. Questions that used to take a quant hours can now be answered by AI in minutes with the right prompting."

"But the major issue will be whether AI agents will become better than humans at predicting the future."

Ironically, the chaos that has characterised the September quarter has shown that human investors aren't quite obsolete yet.

"The recent geopolitically driven volatility has been a hard test for models calibrated on historical data, while some investors have navigated the turning points well using their expertise. A reminder that human judgment still matters."

Firmus failure

The cancelled IPO of Australian data centre operator Firmus made international news and has been held up as the latest crack in the sustainability of the AI equities boom.

"In the June quarter issue of The Encyclical we suggested the company’s pending float would be a ‘good test of market vitality’," wrote Eley Griffiths. 

"It has now become apparent that retail investors failed to engage and both local and international long-only’s/hedge funds stood back for a laundry list of reasons. The response couldn’t be more different from that which greeted the IPO of SpaceX back in early June."

What to watch ahead

According to Eley Griffiths, the differing receptions enjoyed by the SpaceX and Firmus IPOs arguably tells us a lot about market sentiment and the outlook going forward. It quoted John Armitage from UK-based Egerton Capital, who recently said “in euphoria, any company can raise capital”.

"Simply put, we may have just witnessed a sentiment shift from investors," it wrote. "It is interesting to observe several important structural changes presently under way." 

There are three key developments that Eley Griffiths has flagged that mean the outlook for equities isn't as rosy as it was back in June. 

"First, the US 10-year bond is now higher than the earnings yield of the S&P500, for the first time since 2001. This indicates the evaporation of the equity risk premium (depending upon how one calculates it) and is an important marker for tactical asset allocators. Essentially the inducement to buy stocks over bonds has disappeared."

"Second, The Encyclical has long decreed the importance of benign US credit spreads as a critical precondition of stock market health. Spreads (versus US 10-year bonds) on non-investment grade US debt (Caa/CCC or below) have been widening at pace since March this year. This level of investor angst is not yet observable in the BBB/Baa investment grade spreads, but this should be closely monitored."

The third factor is the pricing of corporate credit default swaps, which have trended upwards in recent weeks for key tech companies like Oracle, CoreWeave and SpaceX. 

Altogether it means equities are now back in uneasy territory. 

"Markets are entering an important phase, having largely traversed the seasonal weak trading period of August-October with no shortage of variables for investors to ponder," wrote Eley Griffiths. 

"US companies are forecast to report an ox-strong Q3 reporting season, which is widely expected among the investing class. It would be fair to suggest that higher bond yields leave less room for earnings disappointment."

But one interesting area of the market to watch could be ASX small caps.

"Finally, small company investors should note the S&P/Small ordinaries Index PE discount to the S&P/ASX100 of 11% is the deepest since the global financial crisis with a comfortably higher dividend yield (ex-franking) on offer."

To read the Eley Griffiths September Encyclical in full, click here