Commodities help shore up risk asset resilience

Commodity producers have propped up the Australian sharemarket after the recent pullback but narrow gains aren’t a great sign of underlying strength.

Commodity producers have propped up the Australian sharemarket after the recent pullback but narrow gains aren’t a great sign of underlying strength.

Iron ore miners have surged, but banks were smashed as investors switched between sectors.

After falling 5 per cent from its early February peak, the S&P/ASX 200 index tentatively bounced off an uptrend line drawn from its October trough.

The S&P 500 broke an equivalent line, hitting a fresh six-week low on Wednesday, but remained above its 200-day average, which recently started rising.

In the absence of any clear ­fundamental insight on whether these trends should continue, these well-recognised chart points would normally be seen as good levels to “buy the dip”.

But much as changed in the past few weeks. The interest rate outlook has become more challenging, and earnings updates in the US and Australia underwhelmed. Business costs blew out amid high inflation, tight jobs markets, rising rates, bad weather and lingering supply chain issues.

To be sure, the potential for a strong “reopening” rebound in China was reinforced by strong manufacturing PMI data. Together with strong euro-area CPI inflation and US ISM manufacturing price data this week, China’s manufacturing data highlights the case for owning commodity producers as an inflation hedge as well as for the potential for earnings upgrades on a “mark-to-market” basis.

But apart from the commodity producers, the Australian market has remained weak.

With S&P 500 futures down 0.7 per cent in Asia-Pacific trading hours, it looks as though the US benchmark will break its 200-day moving average, and retail longs will panic to some extent.

Patient institutional investors may finally get a chance to reduce their underweight positions.

Many will have been frustrated at the lack of dips – widely predicted by strategists in recent months – and could buy shares around 3800 points. That would be near 10 per cent below the ­recent peak.

If the S&P 500 falls, as expected, Australia’s S&P/ASX 200 could test its 200-day average near 7005 points, marking a fall of a bit over 7 per cent from the February peak.

But Bell Potter’s Richard Coppleson notes that ASX-listed companies will pay $36.27bn in dividends to shareholders in March and April, almost as much as the record $36.32bn paid this time last year.

The last week of March is by far the biggest week of dividend payouts, as $19bn will be paid from heavyweights including BHP, CBA, Fortescue, Santos and Wesfarmers. As is often the case, dividend money can find its way back into the market. However, the resilience of risk assets such as equities to the upward repricing of the interest rate expectations has been “puzzling” for months, according to JP Morgan.

The S&P 500 is near the same level it was in May 2022, when the Fed funds rate was expected to peak at 3 per cent, while Europe’s Eurostoxx 50 index was near its level of January 2022, before the Ukraine invasion when rate markets were looking for end-2023 ECB policy rates of zero.

A 240 basis points increase in peak Fed pricing and a 100 basis points lift in the 10-year US Treasury yield since then had little overall impact on US equity prices, and a 380 basis point lift in end-2023 ECB pricing and a 270 basis point increase in the 10-year Bund yield has had little overall impact in EU equity prices.

A combination of stronger than expected growth and more persistent inflation indicators has prompted an abrupt change in the market narrative away from “soft landing” and towards a more extended tightening cycle.

Not only have rate markets raised the peak in Fed, ECB and RBA policy rate pricing to 5.4 per cent, 3.8 per cent and 4.3 per cent respectively, they have given up on expectations of cuts this year.

More strikingly, the end-2024 expected policy rates by the Fed and the ECB have increased by around 100 basis points from their lows at the beginning of February.

Risk assets suffered only to a modest extent from this big shift in rate markets.

“This has raised questions in our conversations over what explains this resilience in risk assets,” said Nikolaos Panigirt­zoglou, managing director of global risk assets at JP Morgan. His explanation is that the “equity risk premium” – the earnings yield premium of equities over bonds – has compressed, credit stress has been contained as borrowers on fixed rates before 2022 have been immune to interest rate increases, and there’s plenty of excess cash. In his model, the S&P 500’s equity risk premium has fallen from 400 basis points in early May 2022 to 200 basis points now, lowering it to “pre-Lehman crisis norms”.

“There are several reasons in our opinion behind the remarkable resilience of risk assets such as equities and credit to the severe interest rate increases of the past year,” Mr Panigirtzoglou said.

These may keep supporting risk assets in the short term, but the persistence of inflation pressures “point to increased risks of central banks having to raise rates materially from current levels”.