Investment markets & key developments
Share markets were mixed over the past week. US shares rose 1.3% helped by solid earnings results, Eurozone shares rose 0.9% and Japanese shares rose 0.3%, but Chinese shares fell 1%. The Australian share market fell 1.2% on the back of interest rate fears after a stronger than expected underlying inflation result and as the Reserve Bank of Australia (RBA) failed to defend its 0.1% yield target. Bond yields fell in the US, but rose in Europe and Australia, with the 10-year yield above 2% for the first time since March 2019 on rate hike expectations. Oil, metal and iron ore prices fell, but expectations for earlier and more aggressive RBA tightening pushed the A$ up.
Central banks diverging. Reflecting increasing concern about inflation, the Bank of Canada surprised some by ending its quantitative easing program and brought forward the expected lift-off for rates, from second half 2022 to the middle quarters of 2022. By contrast, both the European Central Bank (ECB) and Bank of Japan (BOJ) remained dovish - reflecting their lower starting points for inflation and subpar experience over the last decade. Given the Eurozone and Japan’s chronic underperformance on inflation pre pandemic, it’s hard to see either raising rates before 2023.
Pressure building on the RBA – we now expect the first rate-hike in a year’s time and the RBA to soften its rates guidance and weaken or abandon the 0.1% yield target, most likely on Tuesday. Underlying inflation at 2.1% year-on-year (yoy) in the September quarter came in well ahead of the RBA’s implied forecast of around 1.75%yoy. Of course, it’s well below the inflation rates being seen in some other comparable countries and the rise in inflation is narrowly based. However, it can’t be ignored and it has come at a time when the reopening in NSW and Victoria is occurring faster than expected and confidence and labour markets are stronger than expected. This is all evident in a rapid rebound in our Australian Economic Activity Tracker (see below). The RBA won’t rush into a rate hike, because it wants to see that “inflation is sustainably within the target range”. For this to occur, it will want to see more evidence that the inflation pick-up is moving beyond transitory distortions due to the pandemic, that the economic recovery is sustained, full employment is reached and wages growth is around 3% or more before hiking rates. However, with the economy recovering, the conditions for the start of rate hikes will likely now be in place by late 2022, so we expect the first hike to be in November 2022 taking the cash rate to 0.25%, followed by a 0.25% hike in December 2022 taking the cash rate to 0.5% by the end of next year.
In the interim, we expect the RBA to: bring forward its guidance for the first rate-hike to 2023; remove or weaken the 0.1% yield target; and further taper its bond buying in February next year to $2bn a week. With the RBA failing to defend the yield target in the last week, it’s looking likely that it will be abandoned or weakened on Tuesday along with a softening in forward guidance on rates. Interest rates will still be very low and monetary policy very easy into 2023 – just less easy than it has been. Allowing the yield target to die before the Board has taken a decision on it does strike me as surprising though and may have the effect of denting the RBA’s credibility a bit – if indeed that is what has happened!
However, money market expectations are for the RBA to start hiking by mid next year and for around four rate-hikes out to the end of next year, taking the cash rate to 1 to 1.25%, look way over the top. This is more aggressive than market expectations for the Fed, despite Australia having way lower inflation. I am also conscious of the market’s tendency to be way too hawkish for most of the last decade. So expect the RBA to push back against current market expectations for rate hikes, in terms of their timing and size.
Australian home price gains to slow further ahead of falls from late 2022 and through 2023. Further tapering and an end to the yield target will likely mean higher bond yields and higher fixed mortgage rates, which combined with the deterioration in affordability and higher interest rate serviceability buffers, points to a further slowing in home price gains over the year ahead and when combined with higher variable rates from late next year, points to likely price falls into 2023.
US Democrats getting closer to a deal on Build Back Better. The deal looks likely to involve around $US1.8 trillion in new spending (over several years), financed by various revenue measures possibly including a minimum 15% corporate tax, a levy on multimillionaires and tax enforcement measures (often a favourite). This would probably mean a smaller hit to corporate earnings than expected and if agreed, it should clear the way for passage of the infrastructure package and for moderate Democrats to support an increase in the debt ceiling.
Climate action. The Australian Government issued a plan to achieve zero net carbon emissions by 2050 ahead of the COP26 climate change meeting in Glasgow. Its reliance on investment and technology trends (some of which are unproven or yet to happen) suggest a far more modest impact on the economy from the plan compared to what would occur under a cap and trade carbon pricing system and a less certain outcome. A key risk is that investors will baulk at the lack of strong objectives for 2030, thereby slowing the necessary investment to facilitate the adjustment to a low carbon economy. The shift to a low carbon world will, if managed appropriately, including protecting those workers and communities adversely affected - result in more opportunities than it destroys, ultimately resulting in a benefit to the economy. But the faster we move, the easier the adjustment and the better the outcome for the environment. In the meantime, the impact of climate change on the economy and the shift in global demand away from greenhouse gas emitting activities will continue to have a huge impact in the decades ahead and affect the availability of capital for countries not playing their part.
More Epic songs. It was pointed out that I missed perhaps the most epic song of all – American Pie by Don McLean. It ran for 8.42 minutes. It relates to the 1959 plane crash which killed Buddy Holly, Ritchie Valens and The Big Bopper but also relates to the Baby Boomer generations’ disillusionment and loss of innocence by the early 1970s. Paul McCartney and Wings’ Band on the Run is another epic. At 5.09 its one of McCartney’s longest songs, has three different sections and was recorded in Lagos but not before the demos were stolen.
The decline in new global coronavirus cases appears to have bottomed as rising cases in Europe offset flat to declining trends in other regions (including the US).
A rise in new cases after reopening looks inevitable. The rise in new cases in the UK and Europe appears to reflect reopening and the rapid relaxation of distancing rules (notably in the UK), the start of cooler weather, vaccination rates stalling below 70% of the whole population, fading efficacy against new infection, a slow start to boosters and maybe a new Delta variant (AY.4.2). The US faces a similar risk with only 58% fully vaccinated. However, even gold standard Singapore with 83% fully vaccinated has seen a surge in new cases to over 3500 a day which saw the return of some restrictions to keep pressure of hospitals. There appears to be little political support for a return to lockdowns, but this can’t be ruled out if hospitals are overwhelmed. The key to avoiding problems appears to be to get vaccination rates to very high levels, reopen and remove distancing restrictions gradually and quickly roll out booster shots to those whose last shot was 5 months or so ago.
Key to watch will be whether vaccines remain successful in keeping hospitalisations manageable and deaths down. So far so good in Europe and the UK. Deaths in the UK are continuing to run at less than 20% of the level suggested by the December/January wave and hospitalisations remain subdued.
51% of people globally have now had one dose of vaccine and 39% have had two doses.
A risk remains that poor countries are lowly vaccinated which increases the risk of mutations.
Australia’s daily vaccination rate has slowed but remains high at around 0.9% of the population and the proportion of the total population that has had one dose (76%) has now surpassed many other developed countries and will soon do so for two doses. NSW has seen a slowing in first doses but has done well to get above 93% of adults with one dose and the ACT is at 99%. First doses will likely continue to drift up if vaccination is approved for 5 to 12 year old’s though. Allowing for current trends and the average gap between 1st and 2nd doses the following table shows approximately when key vaccine targets will be met. The ACT, NSW, Victoria and Tasmania are leading the charge. Other states should hit the 70% of adults double vax target around mid-November. On current trends Australia will average 90% of the adult population fully vaccinated by the end of November. And booster shots are on track to be rolled out from the next week or so.
The faster than expected uptake of vaccines is seeing a faster than expected reopening including earlier than expected moves to reopen some state borders and to allow Australians to travel overseas.
Vaccination is continuing to keep serious illness down. Coronavirus case data for NSW shows that the fully vaccinated continue to make up a low proportion of cases, hospitalisations and deaths and the level of deaths is running around 20% of the level predicted on the basis of the previous wave.
The main risk in Australia is a resurgence in new cases after reopening - like several other countries have seen - which threatens to overwhelm the hospital system necessitating some reversal in reopening. Key to watch will be hospitalisations and deaths – in terms of whether the hospital system is coping. So far so good – with hospitalisations and deaths remaining subdued relative to new cases compared to past waves - but its only early days in the reopening process.
Economic activity trackers
Our Australian Economic Activity Tracker surged higher again over the last week as Victoria joined reopening, with broad based improvement, but particularly in restaurant and hotel bookings, card transactions and mobility. It’s now back above 2019 levels and has almost caught up to the US. It’s also likely to move higher in the months ahead as reopening continues, although risks around reopening driving increased cases and possible setbacks could constrain it at times. Our European & US Economic Activity Trackers are little changed.
Major global economic events and implications
US GDP slowed sharply, but other US data was mostly strong. US September quarter GDP slowed to a 2% annualised pace, reflecting the Delta outbreak and supply constraints, but September data points to a rebound. Personal spending, consumer confidence, underlying durable goods orders, new home sales rose and house prices all rose and jobless claims fell. While the personal savings rate is now back to pre-pandemic levels, there is still more than $US2 trillion in excess savings built up through the pandemic that will help support spending. Core personal consumption deflator inflation slowed in September, but remains high at 3.6%yoy, with rising employment costs adding to price pressures for now.
US earnings reports continue to surprise on the upside. 56% of S&P 500 companies have now reported September quarter earnings and 82% have exceeded expectations, with an average beat of 10%. This is skewed towards financials, with an average beat of 20% as loan loss reserves are released, but the rest of the market is still beating by a still strong average of 9%. Earnings growth expectations for the quarter have now risen to 32%yoy and are likely to end up around 38%yoy.
Eurozone September quarter GDP rose a slightly stronger than expected 2.2% quarter-on-quarter (qoq), or 3.7%yoy, as reopening continued and core inflation rose a stronger than expected 2.1%yoy in October. Neither are likely to make the ECB more hawkish.
Japan saw a sharp fall in industrial production but a stronger than expected rise in retail sales rose and okay jobs data.
Australian economic events and implications
Australian inflation on the up. September quarter CPI inflation was in line with market expectations for a 0.8%qoq/3%yoy rise on the back of high petrol prices, but the surprise was that the underlying measures rose more than expected and are now back in the target range for the first time since 2015. While it’s pretty benign compared to the US, UK, NZ and Canada, it shows that supply constraints and other pandemic distortions are also impacting Australia. Producer price inflation and import price inflation also accelerated in the September quarter as global supply constraints impacted.
Retail sales bounced in September. Further recovery is likely this quarter as a result of reopening. For the September quarter though, real retail sales likely fell around 5%, implying a big hit to consumer spending from the lockdowns.
Housing credit growth remained solid in September at 0.6%, rising to 6.5%yoy. Owner occupiers continue to drive the strength, albeit it’s a slowed a bit and investor credit growth has picked up.
What to watch over the next week?
In the US, the Fed is expected to announce that its long flagged taper to its bond buying program will commence. This is expected to entail a reduction in asset purchases of $15bn a month ($10bn for Treasuries and $5bn in mortgage-backed securities) such that by mid next year the $120bn a month bond buying program will have come to an end. This is widely expected, so should not have much impact on markets. The Fed is likely to signal more concern about inflation, but indicate that it still sees it as transitory and the conditions for a rate a hike are still not met. We expect the first rate-hike to come in the second half of 2022.
Expect a strong US payrolls report. On the data front in the US, jobs data for October (Friday) is expected to show a 400,000 gain in payrolls and unemployment falling to 4.7% and the manufacturing and services ISMs for October (due Monday and Wednesday) are expected to remain strong at around 60, with still-high price indicators. Earnings reports will continue.
Eurozone unemployment (Wednesday) is likely to fall to 7.4%.
China’s Caixin business conditions PMIs for September will be released on Monday and Wednesday.
In Australia, the RBA on Tuesday is expected to weaken its dovishness in response to the faster than expected reopening of the economy and the greater than expected rise seen in underlying inflation. This is likely to see it bring forward its guidance for the first cash rate hike to 2023 and likely ditch or weaken its 0.1% yield target. On the one hand, it is likely to point out that the rise in the trimmed mean inflation rate was narrowly based and impacted by various pandemic related distortions (and that uncertainties remain about the pandemic) but on the other hand, it’s likely to be more upbeat on the growth outlook following reopening and is likely to revise up its inflation forecasts and revise down its unemployment forecasts in its quarterly Statement on Monetary Policy, on Friday. This is likely to be consistent with an adjustment to its forward rates guidance and an end or weakening of its 0.1% yield target on Tuesday, followed by a further tapering in February next year. It is however hard to see the RBA reducing its dovishness on rates too much just yet. More likely, it will prefer to wait and see how the recovery unfolds and whether the bounce in underlying inflation is sustained. The RBA is also likely to push back against current market expectations for rate hikes next year in terms of their timing and size.On the data front in Australia, daily data points to a solid 1.4% gain in CoreLogic’s home price index for October (Monday), led by Brisbane. Expect small gains in housing finance (also Monday) and building approvals (Wednesday) and a pullback in the trade balance (Thursday) to $12bn.
Outlook for investment markets
Shares remain vulnerable to short-term volatility, with possible triggers being coronavirus, global supply constraints & the inflation scare, less dovish central banks, the US debt ceiling and fiscal plans and the slowing Chinese economy. We are now however coming into a stronger period seasonally for shares and the combination of improving global growth and earnings, vaccines allowing a more sustained reopening and still-low interest rates augurs well for shares over the next 12 months.
Expect the rising trend in bond yields to continue as it becomes clear the global recovery is carrying on, resulting in capital losses and poor returns from bonds over the next 12 months.
Unlisted commercial property may still see some weakness in retail and office returns, but industrial is likely to be strong. Unlisted infrastructure is expected to see solid returns.
Australian home prices look likely to rise by around 21% this year, before slowing to around 7% next year, being boosted by ultra-low mortgage rates, economic recovery and fear of missing out ‘FOMO’, but expect a further slowing in the pace of gains as poor affordability impacts, home buyer incentives are cut back, listings return to more normal levels, fixed mortgage rates rise further, and macro prudential tightening slows lending.
Cash and bank deposits are likely to provide poor returns, given the ultra-low cash rate of 0.1%.
Although the A$ could pull back further in response to the latest threats to the outlook and weak iron ore prices, a rising trend is likely over the next 12 months, helped by strong commodity prices and a cyclical decline in the US dollar, probably taking the A$ up to around $US0.80.
Subscribe below to Oliver's Insights to receive my latest articlesShane Oliver, Head of Investment Strategy & Chief Economist
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