The Overnight Report: Rates Moving Higher

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By Greg Peel

The Dow closed up 112 points or 0.6% while the S&P rose 0.4% to 2159 and the Nasdaq gained 0.5%.

All About Rates

As global central banks look to shift away from ultra-easy monetary policy, the scramble amongst global investors to reallocate portfolios is on in earnest. No more was this in evidence than on the Australian stock market yesterday.

Aside from the direct impact of rising US rates or tapering ECB QE on Australian stocks with offshore exposure, rising global rates also eases the need for the RBA to cut further. That “complication” of a too-strong Aussie will be dealt with.

Already the yield-paying sectors have borne the brunt of portfolio reallocation, as investors move away from safety and guaranteed return into growth and risk. Gold is a beneficiary of low global rates, and thus a loser on the flipside. While yesterday did indeed see carnage amongst Australian gold producing stocks, the materials sector was not the biggest loser on the day.

That privilege was reserved for utilities, which suffered another 2.0% drop. Telcos fell 1.1%. The diverse industrials sector contains many a dividend payer and it fell 1.5%. Despite eight of the top ten biggest down-movers on the ASX yesterday being gold stocks, the materials sector clocked up only a 1.4% fall, as other commodities provided some balance.

On the other side of the ledger, the Australian company most leveraged to US interest rates, QBE Insurance ((QBE)), won the day with a 3.4% gain. In a similar position is registry company Computershare ((CPU)), which rose 2.2% against the tide. These moves helped the financials sector to a 0.4% gain to provide some offset. The Big Four banks saw mixed moves.

This new global paradigm is a tough one for Australian banks. US banks rose on Wall Street last night because banks are beneficiaries of rising rates. A steeper yield curve means a bank can borrow cheap and lend dear. But why is the theory not the same for Australian banks?

Well, it should be. But the problem is the local banks pay high yields, so they are under pressure as yield stocks like any other. They also lend most of their money based on short term rates – mortgage rates are based off the RBA cash rate — and not off the long term government bond rate as they are, far more logically, in the US. RBA rate cuts have provided the opportunity for the local banks to reprice their mortgage books amidst otherwise tepid growth in general credit demand.

Rising global rates are therefore not great news for Australian banks, albeit not a disaster either.

On a more domestic front, yesterday’s August retail sales number showed a 0.4% jump after being flat in July, beating expectations of 0.2%. This provided some balance to the consumer discretionary sector yesterday, given higher rates, or no further RBA cuts, are a headwind for retailers.

The local service sector PMI was also released yesterday, which showed a jump back to 48.9 in September from 45.0 in August. A positive, no doubt, but as I have said often enough, Australian PMIs are so volatile they are pretty meaningless.

Rates and Oil

Not so meaningless is the US service sector PMI, given the US economy is 70% domestic consumption based. It shot up to 57.1 from 54.1 and thus provided further cause for Wall Street to believe a December Fed rate hike is locked in. Or maybe even a November hike, although that is seen as unlikely. Tomorrow night’s non-farm payrolls number could nevertheless be a determinant.

To that end, the ADP private sector jobs number for September came up short, showing a drop to 154,000 new jobs from 175,000 the month before. But as long as non-farm payrolls come in with something reasonable, Wall Street will still assume a December hike.

And that means banks are the stocks of preference. While fears over Deutsche Bank’s survival have not gone away, they have abated somewhat. This has allowed the US banks to regain some lost ground on the back of rate rise expectations. Last night financials were a primary driver of Wall Street strength.

The other primary driver was the energy sector. Financials and energy are the two biggest sectors in the S&P500. Weekly US oil inventory data showed a drawdown last night when a build was forecast. The WTI price shot up to US$50/bbl at one stage before settling just under that level.

Of course it could all come a cropper if two things don’t happen before year-end – a Fed rate hike and confirmation of an OPEC production freeze. And there’s the US election of course. But the question is: were the Fed to stay on hold, is that good or bad for stocks?

On the one hand there are those believing a rate hike would trigger a sell-off, and on the other those who believe a lack of action from the Fed would have markets turning tail on sheer frustration. The fact that Wall Street rallied last night on, in part, rate rise expectation, is evidence that investors are adjusting to the inevitable rather than running scared.

Hence we see the same ongoing portfolio reallocation pattern as is underway in Australia – sell yield, buy cyclicals. Were the Fed not to hike this would all swing back the other way, but it’s hard to see, given the TINA effect, what would actually send Wall Street crashing. Except maybe Deutsche Bank crashing.

Commodities

West Texas crude is up US$1.10 at US$49.73/bbl.

Base metals were steadier last night other than lead and zinc, which both suffered 1.5% falls.

With China absent, iron ore fell US50c to US$54.50/t.

Gold has managed to steady, dropping slightly to US$1267.10/oz.

The US dollar index is steady at 96.15 and the Aussie is steady at US$0.7621.

Today

The SPI Overnight closed up 25 points or 0.5%.

While gold stocks should stop falling today, the rate-related theme otherwise remains the same.

Australia’s August trade data are due out today.

Bank of Queensland ((BOQ)) will release its earnings result.

And it’s the turn of the Westpac and NAB CEOs to be hit over the head with a parliamentary wet newspaper.
 

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