Investment markets and key developments over the past week
Share markets were hit over the last week as Ukraine tensions escalated and then Russia invaded Ukraine. Although Russia has indicated it does not plan to occupy Ukraine it has indicated that its attack is aimed at its “demilitarization and denazification.” While US shares saw a small bounce on Wednesday on hopes that a worsening of the energy crisis would be averted, this still left US and global shares below the lows they saw in January. Australian shares were also dragged down with retailers, materials and financials hit the hardest more than offsetting gains in defensive sectors like consumer staples and utilities. Oil prices pushed higher as the conflict escalated with West Texas Intermediate rising above $US100/barrel briefly before pulling back a bit. Long term bond yields were mixed with fear of higher inflation being offset by safe haven buying. Metal prices rose but the $A was little changed despite safe haven buying pushing up the $US.
From their bull market highs late last year or early this year US shares have now fallen 12%, Nasdaq has fallen 19% and global shares have fallen 10%. To their lows in January Australian shares fell 10%, but they are currently about 2% above that low.
The market reaction to the Ukraine conflict reflects a fear of the unknown about how far the conflict will go, how severe sanctions will ultimately be and uncertainty about how severe the economic impact will be with the main threat being through higher energy prices. In terms of latter the key risk is that Russia (which accounts for around 30% of European gas imports) cuts off its supply of gas to Europe when prices are already very high, with a potential flow on to oil demand at a time when conflict may threaten oil supply. In short, investors are worried about a stagflationary shock to Europe and, to a lesser degree, the global economy generally.
With uncertainty over the conflict remaining high the risk is that shares face further weakness in the short term. As markets fall, defensive trades like utilities, health and consumer staples along with energy and hedges like gold (which has been a far better hedge through this crisis than Bitcoin which just seems to bounce around with shares) will likely outperform. If the conflict is limited to Ukraine with Russian gas still flowing to Europe and NATO not getting involved, then the economic fallout will be limited, and further share market falls may be no more than another 5% or so. Of course, if gas is cut off and NATO countries get involved then the plunge in share markets could be much deeper (like another 15% or so).
However, there are several points to make in relation to all of this:
- First, Russia is aiming to neutralise Ukraine to prevent it joining NATO and the conflict there could go on for a while until this achieved.
- Russia has no interest in war with NATO and President Biden has continued to stress that the US will not engage in military conflict with Russia just as it managed to avoid it right through the Cold War and ever since. The presence of nuclear weapons on both sides remains a huge deterrent here.
- While western sanctions on Russia targeting banks, financing, individuals and technology transfer will have a significant impact on Russia, the Russian energy sector has been excluded with both the US and Europe seeking to avoid a further sustained surge in energy prices (both oil and gas). Germany has halted approval of the Nord Stream 2 pipeline, but no gas is flowing through it anyway.
- European exports to Russia are just 0.7% of its GDP and US exports to Russia and Ukraine are less than 0.2% of its GDP so the direct impact on them from say a collapse in the Russian economy would be small. The main threat will come via a short term hit to confidence (which is likely to be brief if the conflict is contained to Ukraine) and higher energy prices.
- The US economy is less vulnerable on the energy front than Europe as it produces and exports more energy than it consumes and imports. There is a high risk Russia could cut off the flow of gas to Europe but with the sanctions carving out the Russian energy sector and Russia needing the revenue its unlikely to do so - about a third of Russian government revenue comes from the energy sector. But energy prices are likely to be higher than otherwise reflecting a risk premium as long as uncertainty remains high around the conflict and therefore the risk of supply disruption. The same will likely apply to other commodity prices including foodstuffs as Ukraine is a significant food producer.
- On balance, providing the conflict is limited to Ukraine, NATO troops stay out, and Russian gas is not cut off the conflict is unlikely to significantly damage global growth but is more of a threat to inflation.
- Australia’s trade links with Russia are trivial – with exports to Russia accounting for less than 0.1% of GDP and the sanctions on it will have little economic impact on us. However, the main impacts will be three-fold. First, a positive boost to national income via higher energy and commodity prices as export earnings will see a boost. Second, a higher cost of living mainly via the further boost to oil and hence petrol prices (which could easily spike another 10-20 cents a litre in the next two weeks). And third, a hit to economic activity if global growth slows hitting confidence and export demand. But as noted above the latter is likely to be relatively minor.
Of course, no one really knows for sure how this will all unfold. But there is a long history of various crisis events impacting share markets (major events in wars, terrorist attacks, financial crisis, etc) and the pattern is the same – an initial sharp fall (which we have been seeing) followed by a rebound. Based on multiple crisis since 1940 the average decline in US shares has been about 6% (albeit with a wide range) but six months latter the market has been up 9% on average and then up 15% on average one year later. The same is likely to apply this time as well but trying to time this will be very hard so the best approach is for investors to stick to an appropriate long term investment strategy.
The Ukraine crisis is unlikely to stop central bank monetary tightening, but it may prevent rapid tightening moves. The uncertainty and hit to confidence it provides in the short term will probably help head off a 0.5% rate hike next month in the US and may at the margin help delay RBA tightening. But as noted above, ultimately the hit to economic activity globally and in Australia is likely to be limited and the upwards pressure it adds to energy prices and wider commodity prices will reinforce the case for monetary tightening. So, we are not making any changes to our interest rate expectations.
In Australia, December quarter wages growth at 0.7%qoq and 2.3%yoy was not strong enough to advance the case for a June RBA rate hike, so we continue to see the first hike as coming in August. Of course, another significant upside surprise on inflation for the March quarter (due in late April) and a further acceleration in wages growth in the March quarter (due in late May) and a continuing fall in unemployment could tilt the scales to a June hike but we are not there yet.
I finally got to see the new James Bond film No Time To Die and found it up there with the best. Bond films have regularly paid homage to past Bond adventures and the connections make them even more interesting. While watching No Time To Die, it was impossible not to think of On Her Majesty’s Secret Service given the story line and with both OHMS themes making it into No Time To Die. When it was released in 1969 OHMSS did not do as well as prior Bond films at the box office or amongst critics. Like all older Bond films it has its obnoxious sexist and racist moments, but apart from that OHMS is actually one of the best Bond films – it followed the Ian Fleming book closely, has a great plot, George Lazenby made a great James Bond (and it’s a pity he refused to do more), Diana Rigg was excellent in the female lead (in fact she was already a star whereas Lazenby was little known), the film looks great with a fantastic skiing sequence and it has two brilliant John Barry songs being the OHMSS theme and the romantic interlude We Have All The Time In The World which is sung by Louis Armstrong with lyrics by Hal David. Like Daniel Craig, Lazenby in OHMSS showed a more emotional and vulnerable Bond.
New global covid cases continued to fall over the past week, with deaths also rolling over. The decline is broad based across regions, but parts of Asia are still seeing increases with the Omicron wave building a little later there – this includes South Korea, Singapore, Malaysia and New Zealand.
Deaths and hospitalisations remain subdued relative to new cases compared to prior waves. This is evident in the chart for global deaths versus new cases above and is evident in the next chart for hospitalisations relative to new cases. (Note that this data can be volatile and the hospitalisation rate for first half last year was exaggerated in Australia with cases being low but some states mandating the hospitalisation of all cases. The declining hospitalisation and death rates reflect a combination of protection against serious illness provided by prior covid exposure and vaccines, better treatments and the Omicron being less harmful.
As is the case globally, Australia is continuing to see a further decline in new cases, albeit the rate of decline may be slowing, and hospitalisations and deaths have continued to fall.
55% of the world is now vaccinated with two doses and 16% have had a booster. Nearly 80% of the Australian population have had two doses and 44% have had a booster.
Economic activity trackers
Our Australian Economic Activity Tracker recovered further over the last week pushing to a new pandemic era high as reopening continued. The strength of the rebound adds to confidence that GDP continued to grow this quarter despite the Omicron disruption. Our US and European Economic Activity Trackers also improved. Our Trackers may take a bit of a hit in the weeks ahead from the conflict in Ukraine – but this is more of a risk for Europe and even here the impact is likely to be modest providing gas supplies are not cut.
Major global economic events and implications
Business conditions PMIs rose in the US, Europe, the UK and Australia in February as Omicron cases fell and restrictions were eased but fell in Japan reflecting its more recent spike in Omicron cases.
Inflation pressure readings from the countries to have released manufacturing PMIs for February so far have been mixed, with output and input prices up, albeit down from recent highs, but the backlog of work to be done continuing to fall.
US economic data was mostly strong. Capital goods orders and consumer spending saw strong gains in January, consumer confidence fell in February but was stronger than expected, home prices continued to surge in December, jobless claims fell and as already noted business conditions PMIs rose in February. Core private final consumption deflator inflation rose further in January to an as expected 5.2% year-on-year (yoy).
95% of US S&P 500 companies have reported December quarter earnings, with 77% beating expectations (which is around average) and consensus earnings growth estimates for the quarter are up around 30%yoy (which is well up on +21%yoy at the start of the reporting season).
Along with a rebound in Eurozone business conditions PMIs in February, economic confidence also rose.
Chinese home prices stabilised in January after a few months of falls, possibly reflecting policy easing measures.
The Reserve Bank of New Zealand (RBNA) raised its cash rate for the third time in a row to 1% and will commence quantitative tightening by not replacing its holdings of maturing bonds and actively selling bonds. Its commentary was hawkish, with inflation forecasts revised up and more rate hikes foreshadowed.
Australian economic events and implications
Australian economic activity data was mixed. Construction spending fell slightly in the December quarter, reflecting a fall in dwelling investment and business investment rose a less than expected 1.1% quarter-on-quarter (qoq). However, while this points to a fall in dwelling investment and soft growth in business investment in December quarter GDP, new Australian Bureau of Statistics (ABS) data based on bank transactions points to very strong growth in consumer spending in the December quarter, of 6% or more. Furthermore, investment plans were relatively strong, with plans for this financial year revised up slightly and the first estimate for 2022-23 being nearly 11% higher than the first estimate a year ago for 2021-22. Further, as noted earlier, business conditions PMIs for February rebounded.
December quarter wage growth accelerated to 0.7%qoq or 2.3%yoy. This is still only modest and well below the RBA’s desired 3% annual pace. However, it is picking up, private wages growth including bonuses accelerated to 3%yoy, business surveys continue to point to faster wages growth and labour underutilisation has collapsed to levels seen last decade that saw wages growth above 3%. So, we continue to see wages growth picking up to a 3% annualised pace by mid-year.
The Australian December half earnings reporting season is now largely complete and while the strength of results tailed off a bit in the past week (as it often does), the overall impression has been positive. Companies have weathered the Delta and Omicron waves reasonably well. Supply shortages and rising inflation are causing significant issues, but most are managing costs and maintaining margins successfully. Outlook statements were more positive than negative. Beats have outnumbered misses, albeit by a narrower than normal margin. There has been some slowing in momentum, but only to around normal levels, with 64% of companies reporting profits up on a year ago. 54% have raised dividends, which is less than the average of 59%. 48% of companies have seen their share price outperform on the day they reported, but this is less than the norm of 54%. The greater number of beats though and the generally positive outlook has seen consensus earnings growth expectations for the current financial year revised up from 13.1% early in February to 14.9%, driven by energy, materials, financials and utilities.
What to watch over the next week?
In the US jobs data for February (Friday) is expected to remain strong with payrolls to rise another 400,000 and unemployment expected to fall to 3.9%, consistent with the Fed starting rate hikes at its March meeting. In other data expect increases in the ISM business condition indexes (due Tuesday and Thursday) consistent with gains in PMIs.
The Bank of Canada (Wednesday) is expected to raise its official cash rate to 0.5% and remain hawkish reflecting the pickup in growth and inflation.
Eurozone inflation data (Wednesday) is expected to show a further rise and unemployment (Thursday) is expected to be unchanged at 7%.
Japanese industrial production (Monday) is expected to rise and jobs data will be released Friday.
China’s business conditions PMIs for February are due Tuesday and Thursday and are likely to remain softish.
In Australia the RBA is expected to leave monetary policy on hold and reiterate that it will be patient in assessing whether inflation will be sustainably in the 2-3% target band. Since the RBA’s last meeting jobs data for January was stronger than expected adding to confidence that unemployment will soon move below 4% and be consistent with full employment, but while wages growth picked up in the December quarter its not yet at the 3% or more pace that the RBA would like to see. Our base case remains that the first hike will be in August with the risk that it will be in June albeit that risk fell a bit after December quarter wages growth came in a bit softer than we expected.
On the data front in Australia, December quarter GDP (Wednesday) is expected show a 3.5%qoq rebound after the Delta wave hit in the September quarter. This will take annual growth to 4.1% and be largely driven by a surge in consumer spending along with strength in public spending and a contribution from inventories with capex soft and dwelling investment and trade detracting from growth. In other data releases, expect to see a small rise in January retail sales as Omicron hit, continuing strength in housing credit growth and a further lift in the MI Inflation Gauge (all Monday). Housing finance on Tuesday is expected to fall 3% and CoreLogic is expected to report a further slowing in home price growth to just 0.3%mom in February with prices in Sydney and Melbourne falling slightly. Building approvals are likely to have fallen 5% after an 8% bounce in December and the trade surplus is likely to rise slightly to $9bn (both due Thursday).
Australian December half earnings results will wrap up with just a few companies left to report on Monday including Invocare and ZIP.
Outlook for investment markets
Shares are likely to see continued volatility this year as the Ukraine crisis continues to unfold and inflation, monetary tightening the US mid term elections and geopolitical tensions with China and Iran impact. However, we still see them providing upper single digit returns this year as global recovery continues, profit growth slows but remains solid and interest rates rise but not to onerous levels.
Still very low yields & a capital loss from a rise in yields are likely to again 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 with prices falling later in the 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 2023-24 but large variation between regions. Sydney and Melbourne prices may have already peaked.
Cash and bank deposits are likely to provide very poor returns, given the ultra-low cash rate of just 0.1%.
Although the $A could fall further in response to the Ukraine crisis and Fed tightening, a rising trend is likely over the next 12 months helped by still strong commodity prices and a decline in the $US, 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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