Investment markets and key developments over the past week
Global share markets fell over the last week, mainly on the back of hawkish central banks and ever rising bond yields. US and Eurozone shares both fell 1.3%, Japanese shares fell 2.5% and Chinese shares fell 1.1%. Australian shares fell 0.2%, with strength in utilities and energy stocks offset by weakness in retailers, information technology and materials. Bond yields rose sharply, and oil, metal and iron ore prices fell. While the $A briefly made it above $US0.76 it ended the week lower, with a further rise in the $US.
While shares have had a great rebound from their March lows, they appear to be faltering again. We remain of the view that share markets will be higher on a 12-month horizon, but it’s still too early to be confident we have seen the bottom and volatility is likely to remain high. Key central banks are continuing to sound more hawkish, bond yields are continuing to rise, uncertainty remains high around the war in Ukraine (even if the Russia is refocusing on the more limited objective of controlling the Donbas), political risk may re-emerge in Europe with the French election and the return of possible tax hikes in the US to fund a slimmed down Build Back Better program may add to uncertainty ahead of the US mid-terms. The rebound in shares since early March has lacked the breadth often seen coming out of major market bottoms, with defensive stocks leading the charge.
The US Federal Reserve (Fed) has further ramped up its hawkishness. Just when it seems share markets were thinking the worst from the Fed was factored in, the minutes from the Fed’s last meeting and comments by Fed vice-chair Brainard have caused another reset. The Fed now looks likely to start quantitative tightening (i.e., reducing its bond holdings) from its May meeting at the rate of $US95bn a month, with this being phased in over three months. This is far quicker than the $US50bn a month that took a year to reach back in 2017. What’s more there appears to be a greater preparedness to do 0.5% hikes. The US money market is now factoring in another 2.1% in rate hikes this year.
The problem central banks face is that while the surge in inflation is mainly due to supply side constraints, which they can’t do much about, the longer inflation stays high the more it will be built into inflation expectations and becoming self-perpetuating. Hence, the scramble to tighten is all about keeping inflation expectations down.
The Reserve Bank of Australia (RBA) now appears to be coming to the same view, with its April meeting showing a big hawkish pivot as it looks to be gearing up for a rate hike soon. Just as Fed Chair Powell quickly dumped his reference to being “patient” in assessing the inflation outlook earlier this year so too has the RBA. It also dropped references to “uncertainties” about how sustained the pickup in inflation will be. Although it didn’t say so in its post meeting statement, the RBA looks to be shifting to focus on what Governor Lowe described as doing “what is necessary to maintain low and stable inflation in Australia.” It’s now focussed on inflation data (due 27 April) and wages data (due 18 May), both of which are likely to come in well above the RBA’s expectations. So, while a May rate hike in the midst of the election campaign can’t be ruled out, if March quarter inflation data really blows out, the timing of the next wages data does give it an excuse to wait till the June meeting. So, at this stage we remain of the view that it will hike rates in June, taking the cash rate from 0.1% to 0.25%, which has now become consensus. However, with inflation risks skewing to the upside, there is now a strong chance that the first hike will be 0.4% (taking the cash rate to 0.5%) in order to have a decent impact and either way we now see the cash rate being progressively increased to 1% by year end, with the risk that it will be increased to 1.25%. Market expectations for a hike to 2% by year end still look a bit too hawkish though.
The RBA’s Financial Stability Review suggests the financial system overall is in good shape and should be able to cope with higher interest rates – banks are well capitalised, loan arrears are low and many households have built up buffers on their mortgages. The latter are estimated to be equivalent to a median 21 months of payments for variable rate borrowers, which is up from 10 months prior to the pandemic. As a result of excess payments, roughly 40% of variable rate borrowers would see no increase in monthly payments, even with a 2% rise in rates. Against this, around 25% of variable rate borrowers would see their payments rise by more than 30%. And the RBA also notes that a large share of new housing loans have high debt to income ratios and that high levels of household debt have increased the sensitivity to higher interest rates, which will make it difficult for some households. All of which means interest rates won’t need to go up as much as in the past to slow spending and control inflation.
Later this year some of the pressure may start to ease on central banks. Global oil prices may have already seen their peak (Russia/Ukraine war dependent though), shipping freight rates have improved a bit and US used car prices have started to fall again – but of course there is a long way to go and we have seen a few signs of improvement in the last six months, only to see another round of supply pressures.
More on inverting yield curves - rising US recession risk but it’s complicated. The recent flattening and brief inversion of the US yield curve as measured by the gap between 10-year bond yields and 2-year bond yields has led to more talk of recession in the US. This is clearly a rising risk. However, there are several points to note. First, the more traditional measure of the yield curve which looks at 10-year yields less the Fed Funds rate (or the 3-month yield) is actually steepening and this indicator has been seen as a more reliable guide to recessions. So far, it says there is no problem. Second, the 10-year/2-year comparison may be distorted because while the 2-year yield has been pushed up by expectations of an increasing Fed Funds rate the 10-year yield is being suppressed by the Fed’s massive holding of Government bonds. This may soon reverse, with the Fed likely to start running down its bond holdings next month. Fourth, investors have been happy to have more bonds in their portfolios in recent times because bonds were seen as negatively correlated to shares which has in turn suppressed long-term bond yields. But if bonds now sell off with shares due to a more dominant influence from inflation, then this bond demand may fade and long-term bond yields will rise. Fifth, inverted yield curves have sometimes given false signals. And finally, the gap from an inverted yield curve to recession has averaged around 18 months. So a US recession is a risk, but I see it as more of a risk for 2024 or late 2023.
In Australia, the yield curve has given numerous false recession signals – but it’s nowhere near signalling a recession, albeit the 10yr-2yr gap has been flattening.
The French presidential election race is the latest thing to worry about. Polling has tightened in the last few weeks, with Marine Le-Pen of the far-right National Rally (which has been softened from National Front) gaining on centrist President Emmanuel Macron. Macron still looks to be ahead, but it has become a closer call. Recent polling shows Macron leading with around 26.5% in the first-round vote (on 10 April) where there are 12 candidates and Le Pen around 21.5%. An average of major polls then points to Macron beating Le Pen in the second-round run-off (on 24 April) by around 52% to 48%. However the gap has been narrowing, with Le Pen softening her far right image from five years ago. Euro-scepticism has declined in France over the last decade, with around 73% of French in favour of the Euro, so the election poses little risk of a Frexit (French exit from the Euro). A Macron victory would likely see him continue to take on the role of leading Europe (after Merkel’s departure) and a continuation of his economic reform program. By contrast, a Le Pen win would come as a shock to investment markets and while its unlikely to lead to a Frexit, her policies would threaten European unity in terms of economic policy and against Russia and would be bad for the Euro and French shares.
Australian petrol prices have fallen sharply over the last three weeks, reflecting lower oil prices, the higher Australian dollar and the 22.1 cents/litre fuel excise cut. Even ignoring the tax cut, petrol prices should be back to around or below February levels. So far, the fall can mostly be explained by the fall back in oil prices though. Whether it sticks depends largely on what happens to global oil prices.
Expect an increasing focus on the Australian Federal election in May – but substantive policy differences between the Government and the Opposition are minimal, suggesting little impact on investment markets. Current polling has the Australian Labor Party (ALP) ahead by around 54%/46%, but this was not a good guide to the 2019 election result. If the election were solely being determined by the state of the economy, then it would point to a victory by the Coalition, but it’s as much about how people feel and right now confidence is subdued as a result of a range of factors including the rising cost of living and increasing warnings of higher interest rates. There is some evidence that Australian shares go through a period of range trading through election campaign periods, reflecting political uncertainty. An ALP Government is likely to be more interventionist in the economy, focus more on public services including childcare and the aged and tighten decarbonisation commitments – but so far, it’s not offering a significantly different policy approach. Unlike in the 2019 election though, the ALP is not proposing a radical tax agenda this time around. Like the Government, it is seeking to repair the budget through economic growth rather than austerity and its priority areas of energy, skills, the digital economy, childcare and manufacturing have a significant overlap with the Government. Neither side is proposing a significant reform agenda in key areas like tax, education, industrial relations and housing affordability. So it’s hard to see a big impact on markets.
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New global Covid cases fell again over the last week with falls in Europe and Asia (excluding China).
China is continuing to have problems managing the Omicron wave threatening Chinese growth and further supply disruptions. Although the numbers are low compared to other countries, they are still rising and when combined with China’s zero COVID policy, are resulting in lockdowns. While much of the world has decided to live with COVID, particularly once higher vaccination rates were achieved, China’s problem is that its vaccines are reportedly not as effective against Omicron and it lacks much natural immunity. So Omicron poses a greater threat than seen in many other countries, with the result being more disruptions to Chinese economic activity. China is continuing to indicate that it will use stimulative policy measures to boost growth, but even with that, it’s looking harder to achieve its 5.5% GDP growth target for this year.
The rise in new cases in Australia has slowed a bit in the last week or so. Hospitalisations and deaths have edged up from recent lows, but remain relatively subdued compared to new cases (compared to the waves prior to Omicron).
So far, hospitalisation and death rates remain low across various major countries, with vaccines and prior exposure providing protection against serious illness, better treatments and the Omicron variants being less harmful (albeit more transmissible) than prior COVID variants.
58% of the global population is now vaccinated with two doses and 22% have had a booster. In developed countries it’s 74% and 46%, with Australia at 83% and 51%. The main risk remains the mutation of a more contagious and more harmful variant in lowly vaccinated poor countries.
Economic activity trackers
Our Australian Economic Activity Tracker rose over the last week, with gains in mobility and restaurant & hotel bookings, suggesting the economy is growing at a solid pace. Our European Tracker rose again, suggesting surprisingly little impact from the war, despite a hit to confidence.
Major global economic events and implications
In the US, jobless claims fell to a new low since 1969, while the services conditions ISM for March rose more than expected and remains very strong. Unfortunately, prices paid also remain very high.
Eurozone producer price inflation accelerated further to 31.4% year-on-year (yoy), mainly driven by higher energy prices.
China’s Caixin services index fell sharply in March, reflecting COVID lockdowns and global disruptions.
Australian economic events and implications
Australian economic releases were light on, but mixed. ANZ job ads rose another 0.4% in March following an upwardly revised surge of 10.9% in February. The weekly ANZ/Roy Morgan consumer confidence index rose slightly, suggesting some lift from the Budget, but remains subdued. The trade surplus fell sharply, reflecting flat exports but a strong rise in imports on the back of economic recovery and more Australian’s travelling overseas pushing the services balance back into deficit. Meanwhile, the Melbourne Institute’s Inflation Gauge for March showed a 0.6% rise in trimmed mean inflation. It rose 1.1% in the March quarter, pointing to another rise in underlying inflation well above the RBA’s implied forecast for a 0.7% to 0.8% quarterly rise.
What to watch over the next week?
In the US, inflation data on Tuesday will be the main focus. March CPI data is likely to show a further lift in inflation to 8.4%yoy (up from 7.9%) reflecting the further spike in energy prices after the start of the invasion of Ukraine, with core inflation also rising to 6.6%yoy (from 6.4%) as supply constraints continued. This is likely to add to impetus for the Fed to step up the pace of rate hikes and then start quantitative tightening in the months ahead, However, with oil and gasoline prices down from their high and shipping and trucking freight rates also rolling over, we may be getting at or close to the peak in inflation, which may take some pressure off the Fed later this year. Producer price inflation (Wednesday) is expected to rise further to 10.5%yoy, but continues to show signs that it may have peaked. In other US data, small business optimism (Tuesday) is likely to fall slightly, but retail sales (Thursday) and industrial production (Friday) are expected to show modest increases and the New York region manufacturing index (also Friday) is expected to rise. The US March quarter earnings reporting season will also start to ramp up.
The Bank of Canada (Wednesday) is expected to hike its policy rate by 0.5%, taking it to 1%.
The European Central Bank (ECB) (Thursday) is expected to leave monetary policy on hold, but is likely to be a bit more hawkish amid the further rise in inflation, despite increasing threats to growth. As noted earlier, the first round of the French presidential election is on 10 April.
Chinese CPI inflation (Monday) for March is expected to rise, but to a still-low 1.4%yoy and producer price inflation is expected to slow further, to 8.1%. Trade data (Wednesday) is expected to show a further slowing in export & import growth. Credit data will also be released and will be watched for signs of more lending, consistent with the People's Bank of China (PBOC) easing.
The Royal Bank of New Zealand (RBNZ) (Wednesday) is expected to raise its cash rate by 0.25%, taking it to 1.25%.
In Australia, the NAB business conditions survey for March (Tuesday) is likely to show conditions and confidence remaining reasonably solid, consumer confidence (Wednesday) is likely to see a bit of a lift from the Budget and jobs data (Thursday data is likely to show a 20,000 gain in employment, with unemployment falling to 3.9%).
Outlook for investment markets
Shares are likely to see continued volatility as the Ukraine crisis continues to unfold and inflation, monetary tightening, the US mid-term elections and geopolitical tensions with China (and maybe) Iran impact. However, we see shares providing upper single digit returns on a 6-12 month horizon as global recovery continues, profit growth slows but remains solid and interest rates rise, but not to onerous levels, at least for the next year.
Still very low yields and a capital loss from a rise in yields are likely to result in negative returns from bonds.
Unlisted commercial property may see some weakness in retail and office returns, but industrial property is likely to be strong. Unlisted infrastructure is expected to see solid returns.
Australian home price gains are likely to slow further, with average prices falling from mid-year as poor affordability, rising mortgage rates, reduced home buyer incentives and rising listings impact. Expect a 10 to 15% top to bottom fall in prices from later this year into 2024, but with large variation between regions. Sydney and Melbourne prices may have already peaked.
Cash and bank deposits are likely to provide poor returns, given the ultra-low cash rate of just 0.1% at present, but rising through the second half of the year.
Although the $A could fall back a bit in the near-term in response to the uncertain outlook, a rising trend is likely over the next 12 months helped by strong commodity prices, probably taking it 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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