‘Bizarre’ reason for ASX skyrocketing

You can never say never when it comes to stock markets. They are the craziest of all asset markets. Sentiment-driven, full of forced buying and selling robots, and without peer when it comes to responding to macro-stimuli.

All three of these factors are on display in the current ASX rally. The sentiment is being driven by global factors.

Europe’s energy war is all but over. Huge US liquid natural gas (LNG) flows have combined with a very warm winter to rob Vladimir Putin of his revenge.

China has simultaneously pivoted to living with Covid. The initial shock is brief and the rebound will be strong. Australia is still thought of as a China proxy.

The resulting relief rally has triggered all kinds of bizarrely named automated trading strategies. These range from buy programs that ramp when volatility falls, to momentum-chasing robots, to CTA automation that trades off futures and options via a dizzying array of “Delta” and “Gamma” strategies.

Thirdly, macro stimuli have turned favourable. Inflation is tumbling worldwide, central banks are slowing their hikes and unemployment rates are still low. Hopes of a soft landing are riding high.

Bear markets do not move in straight lines

So, have reached the all clear? After a nasty 2022 bear market (prolonged drop in investment prices), is it safe to rid the reflation in 2023?

Not so fast.

Sentiment is fickle and so are the robots that chase it. It will not take much in the way of bad economic reports for markets to swing back to growth worries.

Automated strategies do not make trends, they exacerbate them, so what is currently all-good can very swiftly turn all bad.

The biggest problem for the equity rally is the macro set-up has not pivoted as strongly as currently hoped.

A lot of the monetary policy tightening of last year is yet to impact the economy. The cycle has been so fast that only a portion of the rate hikes have been passed on to floating-rate mortgages.

Worse, the unprecedented number of fixed-rate mortgages in this cycle has held the RBA tightening at zero for around 30 per cent of indebted households. This is about to change and by year-end, all of them will have been shocked by rate rises from around 2 per cent to 5 per cent plus. The result is that most of the income impact of RBA tightening for households is still ahead not behind.

Adding to this pressure, property prices are falling sharply. One does not need to be Albert Einstein to know that will weigh on consumption in due course.

Price of commodities

So far, markets have also been happy to upwardly reprice Australia’s key commodities. But that still faces the test of what kind of recovery is coming to China and it is not likely to be commodity-intensive. Property construction remains deeply depressed and infrastructure investment is falling after a huge 2022 boom.

It is the Chinese consumer that will bounce hardest not its fixed asset investment which drives demand for Australian resources. After an early year period of restocking, beware of price falls in iron ore and coking coal later in 2023.

As well, Europe’s energy crisis may be over but that’s not good news for Australian gas and thermal coal exports, both of which are in the process of falling a long way.

The net result is Australia will earn less not more commodity income in 2023 and that will crimp national income.

For all of these headwinds, one could still be positive on stocks for the year ahead. The RBA is likely to ease as inflation comes off and bring relief to all.

However, that, too, comes with a very serious downside for the stock market. Over the Covid inflation boom, firms have enjoyed the best pricing power in 20 years. This has led to record-high margins for corporations.

But easing demand and falling inflation reverse this dynamic. Pricing power will likely fall and margins contract sharply.

This would translate into falling profits in due course. It will take not take a recession to deliver it. Two thirds of cyclical earnings recessions’ downside comes from margins being squeezed. That is more than enough to trigger a stock market rerating as pricing power is lost, even if we avoid outright recession.

The following chart is an example of earnings history from the US. The example of 2001 is instructive given its similarity to today. The US had a very mild recession after an inflation burst but a very large earnings shock and monster bear market. The same principles apply to the ASX.

Valuation of the cycle

The ASX has run hard towards the hope of a renewed economic cycle and spring in corporate earnings growth. It has benefitted particularly from Australia’s proximity to the Chinese reopening.

But, all is not what it seems. Much of the central bank tightening of last year is yet to land. Inflation widens corporate margins, and both will end together. This will weaken investment and employment in due course.

The ASX appears reasonably valued at 15 times forward earnings but we need to extract miners and financials to get a better read on what is discounted for domestic demand. On that basis, the bourse is rich at 21 times.

In short, none of the forthcoming pressures on earnings have been discounted.

David Llewellyn-Smith is Chief Strategist at the MB Fund and MB Super. David is the founding publisher and editor of MacroBusiness and was the founding publisher and global economy editor of The Diplomat, the Asia Pacific’s leading geopolitics and economics portal. He is the co-author of The Great Crash of 2008 with Ross Garnaut and was the editor of the second Garnaut Climate Change Review.