Investment markets and key developments over the past week
US shares fell sharply on Friday, dragging them down 1.9% for the week as a whole, as the US Federal Reserve’s (Fed) hawkish surprise earlier in the week weighed on cyclical reflation trades and inflation hedges. This also saw Eurozone shares fall 1.2% for the week. Chinese shares also fell 2.4% but Japanese shares rose 0.1% having missed Friday’s decline in the US share market. Australian shares also missed out on Friday’s US decline and so saw a strong week, with the ASX 200 rising to a new record high, although this was led by IT stocks while resource stocks were down. Bond yields fell slightly in the US but rose elsewhere, reversing some of their recent decline. Oil prices rose but metal, iron ore and gold prices fell, not helped by a rebound in the US dollar and the rotation out of cyclical stocks. The rebound in the US dollar also weighed on the Australian dollar.
The drumbeat of central banks looking to start slowing monetary stimulus continued over the last week, with the Fed surprisingly hawkish and the RBA heading in that direction, albeit slowly. However, while this could drive a correction in share markets, it’s way too early to get bearish in a cyclical sense. The move back from stimulus started amongst developed country central banks several months back, with the Bank of Canada, then the Bank of England followed by the Royal Bank of New Zealand and the Bank of Korea. The Fed has been gradually getting there, in relation to tapering its QE program, but it was more evident in the past week with the Fed more upbeat on the outlook and this showed up in the median expectation of Fed officials now showing two rate hikes in 2023 from zero after their March meeting. (See the next chart.) While Fed Chair Powell played down the importance of the so-called dots and noted that substantial further progress was “still a ways away” he did say that the Fed is now “talking about talking about tapering.” Our view is that formal taper talk is likely to start at next month’s Fed meeting, with actual tapering likely to start late this year or early next year and that 2023 for the first Fed hike is a reasonable expectation.
Meanwhile in Australia, the minutes from the last Reserve Bank of Australia (RBA) meeting and a speech by RBA Governor Lowe didn’t really offer anything new on the economic outlook, but it did provide some insight in terms of how they are approaching their July decisions regarding whether or not to extend their yield target and their bond buying program. In terms of the former, our view is that the RBA is unlikely to extend its yield target from the April 2024 bond to the November 2024 bond because there is a now a very high probability of a rate hike in the next three years, thanks to the continuing stronger than expected recovery as evident in the May jobs report. In fact, we continue to see the first-rate hike as being in 2023 and after the strong jobs numbers there is a risk it may come in late 2022. In terms of the bond buying program, the RBA has already ruled out ending it in September, but strong growth points to some sort of tapering. Our base case is that the RBA will reduce its bond buying program to $50bn over six months (under its option iii), but note that this could be combined with its option iv to adopt an open-ended approach with more frequent reviews. The latter has the benefit of being able to better calibrate to the needs of the economy and to what other central banks (namely the Fed) are doing in terms of quantitative easing. So the exit path for the RBA from ultra-easy monetary policy looks like this: ending the Term Funding Facility for banks this month; leaving the bond yield target focussed on the April 2024 bond; tapering the bond buying program from September; possibly ending the bond yield target next year - ahead of a first rate hike in 2023 (or maybe late 2022).
The shift to tapering and a pull-forward in first rate hikes may cause bouts of nervousness in markets, with shares vulnerable to a decent correction. Note however that tapering is not monetary tightening (it’s just slower easing) and rate hikes are still a fair way off in most developed countries. It’s also worth noting that through the last US taper, from December 2013 to September/October 2014, shares rose. Further, in recent cycles the first Fed rate hike has caused a dip in US shares, but the bull market then resumed and continues until rates become onerously tight, which in this cycle may be several years away. The recent shift in tone from central banks is unlikely to signal that they are backing away from their commitments to getting inflation sustainably back in their inflation targets. Rather, it reflects the reality that as recovery has been stronger than expected, they may meet their objectives earlier than previously thought. Hence, the post Fed meeting market reaction that has seen investors reversing some cyclical bets and inflation hedges is likely an overreaction, even though it could continue for a while yet. Finally, its noteworthy that the European Central Bank (ECB) and Bank of Japan (BoJ) are lagging well behind, as their recoveries have lagged and their inflation rates are much lower.
The G7 meeting represented another step down the path to a cold war between liberal democracies and autocracies, underpinned by the US returning to working more closely with its allies. While it was relatively mild, it may have been a contributor to China’s reported decision to send military aircraft into Taiwan’s air defence identification zone. Three points regarding this and investment markets: First, it highlights the increased importance of geopolitics for investment markets; second it’s worth remembering that adverse geopolitical events are often very hard to predict in terms of their happening and their impact on markets; and third, the US/Soviet cold war had its testing moments, but wasn’t negative for investment markets in a secular sense in the post WW2 period.
The Australia-UK free trade deal is good news for Australian farmers, consumers of British made cars and backpackers, but don’t expect a big macroeconomic boost. It will take at least a year to start up and some of the tariff cuts on red meat exports to the UK may take 10-15 years to be eliminated. At most, it may add around 0.2% to GDP spread over a decade, but on an annual basis it will be barely noticeable. More free trade is always better than less though.
The global downtrend in new coronavirus cases continued over the last week, driven by developed countries and a continuing fall in India. The spike in deaths in the charts was due to delayed reporting in India, but it’s expected to follow new cases down. However, various countries continue to see a rising trend in new cases, including South Africa, South Korea and some South American countries.
A rising trend in new cases in the UK, driven by the Delta variant, particularly among younger unvaccinated people, saw England delay the removal of final COVID restrictions by four weeks and highlights the danger of reopening too rapidly, before herd immunity has been reached. While 63% of the UK population has had at least one vaccine dose, that still leaves a big part of the population that has not been vaccinated or has not had a second dose. With the Delta variant being around 60% more transmissible than regular COVID and resulting in double the probability of unvaccinated people requiring hospitalisation, it may require 80% or so of the population to be fully vaccinated to reach herd immunity rather than the 70% or so we have been working on. Fortunately, the big progress the UK has already made in vaccinating should help head off anything like the COVID waves seen in the UK over the last year. Key to watch will be hospitalisations and deaths, where the UK will be a bit of a test case for other vaccinated countries.
Australia continues to see a low number of cases – but some cases of local transmission are still popping up in Melbourne and there has been several in Sydney due to the Delta variant (again linked to the hotel quarantine system) which has seen the return of the mask requirement on public transport.
So far 22% of people globally and 46% in developed countries have had at least one dose of vaccine. Canada is now at 67%, the UK at 63%, the US at 54%, Europe at 45% and Australia is at 24%. The success of the vaccines continues to be evident in low new cases, hospitalisations and deaths in countries with high levels of vaccination, although as noted earlier the UK has had some problems.
Australia’s daily vaccination rate remains relatively low at 0.4% of the population (see the thick line in the next chart).
Our Australian Economic Activity Tracker recovered part of its recent loss over the last week as Victoria’s economy reopened. Our US Tracker remains just below its pre-coronavirus level, and our European Tracker is continuing to rise rapidly as Europe reopens.
Arguably the Beatles promotion of love (beyond the boy/girl) She Loves You was cemented with John’s All You Need Is Love which was released bang in the middle of the “summer of love” via a live performance transmitted by satellite. But often ignored in relation to the Beatles were their 1995 singles by Ringo, George and Paul from tapes of incomplete songs left by John. Free As A Bird was the first single but Real Love was my favourite. By then George Martin
had retired so Jeff Lynne (of ELO) was the producer having worked with George Harrison. It has a kind of unfinished feel but that’s what makes it special in my view along with the piano in the video.
Major global economic events and implications
US data was mostly strong over the past week, although momentum may have slowed a bit after the stimulus driven surge of earlier this year. Retail sales were softer than expected in May, but the prior month was revised up and they are likely being impacted by a rotation back to services spending. Housing starts rose by less than expected but are still strong, as are home builder conditions. The New York and Philadelphia regions saw manufacturing conditions slow in June, but to still strong levels. Producer price inflation accelerated further, and the regional business surveys show price pressures remain high, but strengthening industrial production, which rose more than expected in May, should ultimately help tame goods price inflation as supply catches up with demand.
Japanese CPI “inflation” rose in May, but only to -0.1% year-on-year (yoy) and core inflation remained weak at -0.2%yoy, highlighting that there is not much bleed through from high producer price inflation, which is running at +4.9%yoy. As expected, the BoJ left monetary policy on hold and ultra-easy, but it extended its special COVID program to support financing and launched a new program to finance climate change mitigation.
Chinese May economic activity data was softer than expected, but remains consistent with reasonable growth. Port disruptions in China’s Pearl River Delta due to coronavirus cases may impact exports and imports.
New Zealand joined Australia in being one of the few developed countries to have GDP above its pre COVID level in the March quarter.
Australian economic events and implications
Australia saw another surge in jobs in May, resulting in an unemployment fall back to is pre coronavirus level and underemployment fall to its lowest level since 2014. Meanwhile, our Jobs Leading Indicator suggests that employment growth is likely to remain solid in the months ahead. The main risk is that the continuing COVID scares impact the jobs market – but provided any snap lockdowns are short, then the impact should be minimal. More fundamentally, it is reasonable to expect some slowing in jobs growth over the next six months given that the labour market has now recovered to pre coronavirus levels (and beyond, on some measures). However, It’s now likely that unemployment will be around 4.8% by year end. We think full employment is around 4%, but it’s likely that this will be reached in 2023, driving 3% plus wages growth and enabling the RBA to then start raising rates. That of course is still two years away.
Although it’s no surprise given the hit to immigration, Australian population growth slowed to just 0.5% through last year, which is the slowest rate since 1917 and compares to growth of around 1.6% pa in the years up to 2019. It’s likely to slow even further this financial year to just 0.1%. With immigrants unlikely to return till sometime next year at the earliest and then only gradually, the population will be around 1 million lower than previously expected by 2025. This means a big hit to underlying housing demand, particularly in Victoria and NSW, which are seeing the slowest population growth - and is one reason we expect house price gains to slow.
This is unlikely to happen quickly enough though to head off a tightening in lending standards by the Australian Prudential Regulation Authority (APRA), with the Council of Financial Regulators discussing policy responses if household debt growth substantially outpaces income growth. With home prices continuing to rise rapidly so far in June, it would make sense to do this sooner rather than later. The first thing to do would be to increase interest rate assessment buffers, though looking at limits on high loan to valuation ratio and high debt to income ratio lending would make sense too. Meanwhile, the upwards adjustment to the price caps under the Federal Government’s various home loan deposit schemes reflects the reality of rising home prices, but will do nothing to improve long term housing affordability.
The rate of increase in the minimum wage will pick up in the year ahead, but it’s not going to have much impact on overall wages growth. The Fair Work Commission decision to grant a 2.5% increase in the minimum wage is more than last year’s 1.8% rise, but won’t be effective until later this year (and compares to increases in the pre-pandemic years of around 3% to 3.5%). Assuming around 20% of the workforce is impacted directly, or via awards, then it will boost average wages growth by just 0.14% compared to last year.
What to watch over the next week?
In the US, expect a slight fall in existing home sales (Tuesday), but a slight rise in new home sales (Wednesday), a slight fall but still strong business conditions PMIs (also Wednesday) with possibly some decline in price pressure, continuing strength in durable goods orders (Thursday) and a reasonable rise in personal spending (Friday), reflecting services sector reopening. Core private final consumption spending inflation data (also Friday) is likely to show a further acceleration to 3.5%yoy, consistent with the May CPI.
Eurozone business conditions PMIs (Wednesday) are expected to show a further recovery.
The Bank of England is expected to leave monetary policy on hold when it meets on Thursday.
Japanese business conditions PMIs for June (Wednesday) are expected to show a slight improvement.
In Australia, expect a 0.3% gain in May retail sales (Monday) and business conditions PMIs (Wednesday) for June to show a slight pull back, owing to the Victorian lockdown, but to still strong levels.
Outlook for investment markets
Shares remain vulnerable to a short-term correction, with possible triggers being the inflation scare and rising bond yields, US taper talk and the wider pull back from monetary stimulus, coronavirus related setbacks and geopolitical risks. However, looking through the inevitable short-term noise, the combination of improving global growth and earnings, helped by more stimulus, vaccines and still-low interest rates, augurs well for shares over the next 12 months.
Our only-recently upwardly revised year-end target for the Australian ASX 200 of 7,400 is already looking way too conservative. With the economy continuing to recover faster than expected and this driving stronger than expected earnings growth while interest rates are still low, it’s likely the trend in the Australian share market will remain up for at least the next 6-12 months, notwithstanding the risk of a short-term correction. More broadly the surge in the Australian share market and in Eurozone shares are consistent with our view that non-US shares will outperform US shares this year.
Australian earnings per share – more upgrades
Still ultra-low yields and a capital loss from rising bond yields are likely to result in negative returns from bonds over the next 12 months.
Unlisted commercial property and infrastructure are ultimately likely to benefit from a resumption of the search for yield, but the hit to space-demand (and hence rents) from the virus will continue to weigh on near-term returns.
Australian home prices are on track to rise around 18% this year, before slowing to around 5% next year, being boosted by ultra-low mortgage rates, economic recovery and fear of missing out (“FOMO”), but expect a progressive slowing in the pace of gains as government home buyer incentives are cut back, fixed mortgage rates rise, macro prudential tightening kicks in and immigration remains down relative to normal.
Cash and bank deposits are likely to provide very poor returns, given the ultra-low cash rate of just 0.1%. We remain of the view that the RBA won’t start raising rates until 2023, although it could now come in late 2022.
Although the A$ is vulnerable to bouts of uncertainty, RBA bond-buying and China tensions will keep it lower than otherwise. A rising trend is likely to remain over the next 12 months, helped by strong commodity prices and a cyclical decline in the US$, probably taking the A$ up to around $US0.85 over the next 12 months.
Subscribe below to Oliver's Insights to receive my latest articlesShane Oliver, Head of Investment Strategy & Chief Economist
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