Stocks not out of the woods, warns Macquarie

Macquarie says the sharemarket outlook is ‘still challenged’ despite some positive signs for banks and renewed hope the Fed will shift to smaller rate rises before the year’s end.

Macquarie says the sharemarket outlook is “still challenged” despite some positive signs for banks and renewed hope that the Fed will shift to smaller interest rate rises before the year’s end.

Requirements for a “sustainable low” in sharemarkets have not been met, according to the broker’s Australian equities strategist, Matthew Brooks.

“Central banks need to ease to support confidence and valuations, but they are still hiking,” he said.

A smaller rate increase from the RBA last month “replaces growth risks with foreign exchange and inflation risks”, and earnings downgrades are “nowhere near” those often seen at bottoms.

While Australia’s sharemarket jumped 1.5 per cent on Monday, trading value was light.

It followed a 2.4 per cent jump on Wall Street as bond yields cooled from decade highs amid speculation that the Fed would deliver a smaller rate increase in December.

If the Fed wanted to deliver a smaller rate rise in December, it would want to signal that at next week’s meeting “without prompting another sustained rally” in markets, The Wall Street Journal’s Nick Timiraos said.

One possible solution would be for Fed officials to approve a half-point increase in December, while using the dot plot to show they might lift rates somewhat higher next year than projected last month.

In other words, the Fed may give with one hand and take with the other. The Fed may want to keep financial conditions reasonably tight but prevent overtightening, and a strong hint of smaller rate rises in the near term may be viewed positively by the sharemarket.

Even if the Fed were to slightly increase its interest rate projections for 2023 to stop the markets loosening financial conditions, a smaller rate rise may be viewed as a sign that the Fed is getting close to the point where it can stop lifting rates, fuelling the usual year-end rally.

But Macquarie’s Brooks notes that in recent weeks, real bond yields have continued to rise as markets price a higher terminal Fed Funds rate and delay in the timing of cuts.

“As a result, the price-to-earnings ratio for industrials is even higher now relative to real yields than it has been at any time in 2022,” Brooks says.

He also warns that falling liquidity from central banks is “also a headwind for equities”.

Macquarie expects the Fed to drain $US283bn ($447bn) of liquidity by the end of the year via quantitative tightening, or selling of US Treasuries.

Earnings forecasts have held up better than expected in Australia this month, but that’s mainly due to upgrades for banks, on a positive read through from Bank of Queensland’s net interest margins.

US quarterly results have beaten recently downgraded ­estimates, but downgrades of ­December quarter earnings forecasts have outnumbered upgrades by three to one.

“Based on AGM season (in Australia) and US results, current conditions continue to hold up, likely supported by savings buffers and low unemployment,” Brooks says. But cash flow is “again an area of disappointment” in the US, with inventories higher than expected for nearly half of reporting companies.

“While extra inventory may be needed to account for supply chain risks, investors seem sceptical of this rationale in the context of a slowing cycle,” he says.

The Australian market has clearly outperformed the US market this month, with the June low on the S&P/ASX 200 remaining intact despite a break below that point in the S&P 500.

That’s mainly due to a 12 per cent on-average rise in banks this month – 8 per cent of which came after Bank of Queensland’s results showed stronger-than-­expected net interest margins.

But Barrenjoey analyst Jon Mott remains underweight on the sector due to his concern about the economic damage from sharply rising interest rates.

“Following the sharp rally post BoQ, most of the near-term NIM upside is rapidly being priced in,” Mott says. “However, the impact of higher rates on over-leveraged consumers is not being reflected in prices.”

He says it will be “risky to extrapolate” the current reporting season for banks. In his view, banks’ net interest margins will be “shorter, but sharper than ­anticipated”.

The next two bank reporting seasons will see the lagged impact of policy stimulus and leverage to rate rises, but “the good news on NIM” will be followed by an increasing focus on the risks associated with sharp interest rate rises.

Outlook comments will be “challenging” as the big banks will be “particularly sensitive to the impact on all stakeholders from NIM expansion”.

Justifying record bank risk-adjusted net interest margins at a time many customers are coming under severe financial stress will be “difficult”, in his view.

“Reputational and political implications cannot be ignored post-royal commission,” Mott says. “The majors may not be as upbeat on NIM as BoQ.”

Wages pressure, investments in digital and risk/compliance/“fix” continue to rise, and the Optus data breach is a “reminder of these risks”.