Macro Monday: The prospect of higher rates rattles equities

James Gerrish

Market Matters

The ASX200 pushed ever higher last week taking its advance to ~12% year to date but following sharp losses in the US on Friday this week’s going to start off on a very different footing, the SPI futures are calling the local market to open down -1.5% this morning, wiping out over half of the month's gains in one fell swoop. The combination of central bank comments and strong economic data both locally and overseas has investors bringing forward their forecasts for when interest rate hikes will commence which appeared to be the catalyst to send the Dow plunging over 500-points on Friday:

  • Following Australia’s sharp decline in unemployment influential Westpac economist Bill Evans has now brought forward his forecast for when the RBA will commence raising rates to Q1 of 2023
  • Similarly, the US Fed is now flagging 2 rate hikes by the end of 2023 as their post-COVID economic recovery gathers momentum.
  • Last week felt like a fascinating workshop of looking through the obvious to understand what’s driving share prices on all levels. Today we will expand on the below 3-points and most importantly bore down into how MM anticipates reshaping our respective portfolios through the current and future macro market moves.

As mentioned earlier investors & economists have brought forward their estimates of when central banks would start hiking rates.

However, the closely followed US 10-year bonds fell to their lowest levels in 3-months leading to a significant outperformance by the IT and Healthcare Sectors i.e. the growth stocks.

The prospect of higher US interest rates next year finally sent overseas shares tumbling on Friday following comments from influential FOMC member James Bullard who predicted rates would actually rise in 2022, sooner than the Fed implied.

As we’ve stated a number of times this year MM believes it’s a matter of “when not if” interest rates would rise both here and overseas, at the moment as the week to week vagaries of economic statistics cross our screens the only question come Friday afternoon is which month are most pundits now guessing rates will indeed rise – I deliberately used the word “guess” because it feels the most accurate word and realistically a quarter here or there shouldn’t make a major difference to how investors structure their portfolios.

The losses on Friday night were concentrated in the Financials and Resources Sectors which doesn’t bode well for the ASX this morning and the -1.5% gap down early on today feels about right with BHP Group (BHP) dropping exactly -1.5% in the US.

MM remains a happy buyer of weakness over the coming weeks

ASX 200

Global Indices

Friday's aggressive drop by the Dow took it to fresh 12-week lows which might surprise some readers who focus mainly on the local market. We are targeting a technical pullback to the 32,000 area, similar in nature to that back in Q3 of 2020. Conversely, the strength in the US tech stocks saw the NASDAQ reach fresh all-time highs last week supporting the broader S&P500 in the process, at this stage I would expect the Dow to find a bottom first just like it topped out first back in mid-May.

MM’s ideal downside Dow is around the 32,000 area, or just ~4% lower 

US S&P500 Index

The US S&P500 has basically gone nowhere since April and on balance, it feels like its due a pullback to simply washout any weak longs – at this stage a decent dip under 4000 will see MM start buying especially for our cashed-up International Equities Portfolio.

MM is a keen buyer of the S&P500 ~7% lower 

ASX200 IT & Resources Sectors

The last few months have seen some significant outperformance by the IT Stocks when compared in particular to the resources, a move which has coincided with the fall away in longer-dated bond yields e.g. over last month:

Winners : Afterpay (APT) +23%, Megaport Ltd (MP1) +28%, Altium (ALU) +36%, Xero (XRO) +16% and Wistech (WTC) +25%.

Losers : South32 (S32) -2%, OZ Minerals (OZL) -11%, BHP Group (BHP) -4%, Fortescue Group (FMG) -2% and Newcrest Mining (NCM) -8%.

We’ve increased our exposure to the tech sector which has paid dividends so far, the plan is to migrate back to the resources sector in-line with recent reports e.g. we like South32 (S32) ~4% lower. The $US will be an important influence on when we pull this respective trigger but remember stocks often lead and our expectation is the resources sector correction will end when markets start believing the $US has bottomed, as opposed to when its recovery actually tops out.

MM feels the IT stocks will continue to outperform the resources for a few more weeks/months 

Interest Rates /bond yields

We believe the US yield curve holds the key and is very useful in clarifying what & why things are unfolding as they are in equities, first let’s look at 3 of the prominent durations:

  • US 2-years: The short-end of the curve had been edging higher all year but last week they doubled as the Fed signalled rates would rise sooner rather than later.
  • US 10-years: The 10-years advanced strongly into early April but they’ve been drifting since as the gap between the 2 respective durations went too far, too fast. We are looking to buy the 10-year yield ~1.35% which is approaching fast
  • US 30-years: Similarly the 30-years surged into a mid-March high before drifting for 3-months, we are keen buyers of this part of the curve under 2% which feels likely in the next fortnight i.e. they topped out first and will probably bottom first.

NB Bond prices trade inverted to yield hence when you buy yields you sell / short the underlying bonds

MM is looking for a buying opportunity in yields/sell in bonds over the next 1-2 months 

US 30-year Bond Yields

The picture is clearly different across the spectrum of yield duration but keeping it simple in our opinion the markets current view is interest rates are going up in the US sooner than most people predicted but they won’t ultimately go as hard and fast as people were anticipating in Q1, in other words, bond yields will slowly but surely converge in the months ahead. There are 2 very important read-throughs in our opinion:

  • The reflation trade will come back to life after this crowded trade has seen weak investors shaken out of their positions i.e. look for areas to buy banks and resources. However we feel investors positioning in these sectors will see deep pullbacks e.g. our target for BHP is ~5% lower which equates to a total correction of around 15~%.

If our call for longer-dated yields to bottom out sooner rather than later proves on point the tailwind for growth sectors will soon disappear and the recent strong outperformance by tech is likely to follow suit i.e. we are buyers of US 30-years under 2%.

MM will migrate back towards the resources stocks from tech over the coming weeks/months 

The stocks/sector rotation that has dominated 2021 looks set for yet another chapter which might this time include a pullback in the indices themselves.

Australian 3 & 10-year Bond Yields

The picture from Australia is fairly similar as would be expected even as the RBA sits on the 3-years, we feel they’re both going higher it’s a case of when and how through the tail end of major RBA intervention.

MM is ultimately looking for both yields to rise and the 3 & 10-years to converge 

Commodities

The Baltic Dry Index (shipping costs) hit fresh 2021 highs last week in-line with our previous thoughts, we now anticipate rotation in the 2500-3500 area implying global expansion is set for a period of consolidation after strong gains which suggests some similar consolidation for commodity prices – they couldn’t keep going up forever!

MM feels economic activity is looking for a new level equilibrium level 

Copper ($US/lb)

Copper has led base metals lower as the $US has rallied, the leading indicator of economic activity has already fallen ~15% from its mid-May high, interestingly topping almost in sync with the Dow Jones Index. As outlined earlier we are looking for areas/catalysts to start increasing our exposure to the resources sector into current weakness, a couple of pointers on our radar:

  • Copper more than doubled from It’s COVID low, an initial technical pullback target is another ~5% lower.
  • If / when we see copper break under the psychological $US400/lb and buying enters the copper stocks we may well follow suit.

Cash is finally king at the moment when we consider the resources sector but patience shouldn’t translate to complacency into further falls.

MM is looking for areas to buy the industrial metals 

Currencies

MM continues to believe that the $US is the dominant factor dictating moves in financial markets, last week’s strong advance as US rates look set to rise sooner rather than later saw an aggressive migration towards tech stocks, just as we’ve been forecasting. Importantly MM now believes the journey has travelled more than halfway and reversion is looming on the horizon. Our ideal scenario is the greenback advances towards the 94 area before resuming its downside trend implying the time to rotate back towards the resources is approaching just as people are discussing their demise.

MM is a seller of the $US in the 93 and 94 area 

Bitcoin

While we have no interest in this new financial instrument if we were trading the crypto we would be selling above 40,000 looking to buy under 30,000, a strategy that’s worked out perfectly over recent weeks.

MM is neutral/bearish Bitcoin

Sentiment indicators

The “Fear Index” woke up from its slumber on Friday as the Dow fell away finally closing up 17% on the day, albeit from very low levels. We are only looking for a ~7% downside from the S&P500 hence another test of the 30 area is likely to cap any rally in the VIX, unless of course it happens in a panic 24-48 hour style move.

MM remains bullish volatility from current levels 

Chart of the Week

The local tech sector has recovered solidly over the last 5-weeks and we remain bullish targeting at least another 10% upside hence any buying of the Resources Sector into weakness might initially be funded by cash as opposed to selling some of our tech holdings.

MM is targeting another 10% upside for the ATEC 

The Bottom Line

We feel the “rising inflation” trade has finally started to unwind with some gusto as expected:

  • The $US feels like it’s found a low for now and strength over the coming weeks will continue to pressure the value end of town i.e. banks and resources.
  • MM remains far more comfortable buyer of dips in equities as opposed to selling strength i.e. We still believe investors should be looking to accumulate stocks into market corrections as opposing to focusing on selling i.e. the more than a decade old bull market has further to unfold.

We see our next move as buyers of the Resources / Banking Sectors but whether we fund all / part of these purchases with tech stocks will depend on prices at the time, we may simply use cash.

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James Gerrish
Portfolio Manager
Market Matters

James is Portfolio Manager & Primary Author at Market Matters, a daily investment report with over 2500 subscribers that offers real market insight. He is also Senior Portfolio Manager within Shaw and Partners heading up a team that manages...

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