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Economics & Markets

Market Update 29 July 2022

By Dr Shane Oliver
Head of Investment Strategy and Economics and Chief Economist, AMP Sydney, Australia
Source: Bloomberg, FXStreet, AMP
Source: Bloomberg, FXStreet, AMP

Investment markets & key developments

The bounce back in shares continued over the last week, on hopes that slowing growth will see central banks ease up on the pace of monetary tightening helped along by mostly good earnings results, despite stronger than expected US and European inflation data. For the week, US shares rose 4.5% and Eurozone shares gained 3%, but Japanese shares fell 0.4% and Chinese shares lost 1.6%. The positive global lead, along with a better than feared CPI result, reduced the risk of a further step up in RBA rate hikes and pushed the Australian share market up 2.3%. Gains were led by resources despite a dividend cut from RIO, property stocks and financials. This capped off a strong month, after the slump in June, with US shares up 9.1% in July, global shares up 7.9% and Australian shares up 5.3%. For the week, bond yields fell on expectations for slower growth, but oil, metal and iron ore prices rose. The $A also rose as the $US pulled back slightly.

Shares have had a good rebound from their June lows, but we remain of the view that they are still at high risk of further falls: The rally since the June lows has been lacking in conviction; we need to see clearer signs that inflation has peaked such that central banks can slow and then stop raising rates; it’s still early days in the profit downgrade cycle; uncertainty remains high regarding how badly economic activity will be hit; and the period out to September/October is often weak for shares, particularly when their trend is already down. On a 6-12 month horizon we remain optimistic on shares as inflation recedes, central banks become less hawkish and a deep recession is likely to be avoided – but there is a way to go yet.

The US Federal Reserve (Fed) raised rates by another 0.75%, taking the Fed Funds rate to a range of 2.25 to 2.5%, and remains hawkish. While there were no new hawkish surprises and Chair Powell noted that at some point rate hikes will slow down (which markets took favourably), the key messages remained hawkish, with Powell noting that inflation is too high, the Fed is strongly committed to bringing it under control, another 0.75% hike is on the table for September, the Fed Funds rate could still be on its way to 3.8% and that while the Fed is not seeking to bring on a recession, the path to avoiding one has narrowed. Stronger than expected increases in June quarter employment costs and June core private consumption (or PCE) inflation will keep the Fed hawkish for now.

The International Monetary Fund (IMF) downgraded the global growth outlook again and increased its inflation forecasts. Citing monetary tightening, China lockdowns and spill-over from the war in Ukraine, the IMF cut its global growth forecasts again to 3.2% for 2022 and to 2.9% for 2023. While it’s not forecasting a recession, it notes that the risks are tilted to the downside. It also revised its rich country inflation forecast up to 6.6% for this year and to 3.3% for next year. There is nothing new in any of this for investment markets, where the deteriorating economic outlook has already been factored in, but the next chart comparing IMF global growth forecasts through time highlights the extreme volatility in economic forecasts since the pandemic began.

Source: IMF, AMP
Source: IMF, AMP

US in a “technical recession”. US June quarter GDP contracted by -0.9% annualised, which after the March quarter contraction, met the technical “two quarters in a row of GDP falls” concept of a recession, but with inventories playing a big role in the fall and payrolls still strong, it’s unlikely to be classified as a recession by the National Bureau of Economic Research (NBER), at least not yet…

…The risk of a real recession in the US is continuing to increase, with the US 10 year less 2 year yield curves remaining inverted and the 10 year less Fed Funds rate gap getting close to inverting too.

Source: Bloomberg, AMP
Source: Bloomberg, AMP

Russia’s announcement that it will cut gas flows to Europe through the Nord Stream 1 pipeline from 40% to 20%, supposedly due to maintenance issues (but more likely as part of a strategy to destabilise Europe and weaken its resolve in penalising Russia), have further increased the risk of recession in Germany and to a lesser degree, Europe.

The good news remains that global inflation pressures may be at or close to peaking. Our US Pipeline Inflation Indicator is continuing to trend down, reflecting a combination of a falling trend in work backlogs, freight rates, metal prices, grain prices and even oil prices. This is likely to flow through to cooler monthly inflation readings over the next six months in the US and then eventually elsewhere, which along with evidence of slowing demand, should start to take pressure off central banks and slow the pace of rate hikes in time to avoid a recession, or at least a deep recession. Of course, there is a long way to go.

The Inflation Pipeline Indicator is based on commodity prices, shipping rates and PMI price components. Source: Bloomberg, AMP
The Inflation Pipeline Indicator is based on commodity prices, shipping rates and PMI price components. Source: Bloomberg, AMP

Another rise in inflation in Australia to 6.1% for the June quarter keeps the RBA on track for another 0.5% rate hike in the week ahead, but it wasn’t high enough to justify another step up in the pace of tightening to 0.75%. The CPI increase was slightly below market expectations. Nevertheless, inflation is still going up, underlying price pressures are still rising (with the trimmed mean inflation rate rising to 4.9%yoy, which is its highest since 1990), the breadth of price-increases in the CPI basket greater than 3%yoy rose again to 65%, various government subsidies (for transport fares, tourism and childcare) helped keep inflation down a bit and a further increase to 7-7.5% by December is likely as higher power and gas prices impact along with the scheduled reversal of the cut to fuel excise. The reversal of the fuel excise cut alone will add 0.5% to December quarter inflation.

Our assessment is that inflation will peak around 7-7.5% this half year and that the peak in the cash rate will be around 2.6% either late this year (if the RBA continues to go fast) or early next year. Supply pressures appear to be globally easing a little, with declines in freight costs, input and output prices, metal and food prices and reduced delivery lags (as indicated by our Pipeline Inflation Indicator). Energy prices should stabilise next year and the plunge in consumer confidence and home prices is pointing to a slowing in Australian demand, all of which should lead to a fall back in inflation through next year.

Source: ABS, AMP
Source: ABS, AMP

Market expectations for the cash rate to rise to around 3.5% will likely crash the property market and the economy. The implication from the Reserve Bank of Australia’s (RBA) relatively relaxed view on the ability of the Australian household sector to withstand rising interest rates and argument that the cash rate remains well below its estimate of the so-called “neutral rate” have been interpreted by some as supporting expectations for the cash rate to rise above 3%. While we agree that the RBA has to sound tough to keep inflation expectations down, which is what it’s been doing lately, it’s unlikely that rates will need to rise that far; and if they do, it will cause a major problem for the economy. While it’s true that many households are well ahead on their mortgage payments, many are seeing a massive increase in their monthly debt servicing bill. On the RBA’s own analysis, around 1.3 million households are set to see a 40% or greater increase in their mortgage payments with a 3% rise in interest rates. This, at a time of falling real wages, will have a huge impact on spending in the economy and risk a significant rise in forced property sales. Coming at a time when home prices are already falling rapidly due the impact of rising rates on home buyer demand, it will only add to home price falls, which will weigh further on consumer spending. And the neutral rate of interest concept was also of little use in the pre-pandemic period when rates were below estimates of neutral and yet growth remained weak. As such, our assessment remains that the RBA won’t need to raise rates above 3% and we continue to see the peak in the cash rate as being around 2.6% either later this year or early next year.

After 37 years it’s sad to see Neighbours come to an end. It made a huge favourable contribution to perceptions of Australia and to the local entertainment industry. And I love the music many of its stars have gone on to produce. After hearing I Should Be So Lucky and reading the SMH disparaging her as “The Singing Budgie” I became a glued-on Kyle fan, buying every album she put out and seeing her every concert tour since 2000. Natalie Imbruglia’s Torn was up there with the best too. Kylie and Jason’s Especially For You was released shortly after the UK broadcast of the Neighbour’s episode in which their characters got married.

Coronavirus update

New global COVID cases edged down a bit over the last week, with Asia (notably Japan) up, but Europe down. Hospitalisations and deaths generally remain subdued in most countries, relative to cases, compared to pre-Omicron waves.

Source: ourworldindata.org, AMP
Source: ourworldindata.org, AMP

Australia has seen hospitalisations rise above their January high - although hospitalisation and death rates remain subdued compared to pre-Omicron waves. Fortunately, there has been some tentative signs of a slowing in the last few days. South Africa’s experience with Omicron BA4/5 is continuing to augur well, with cases, hospitalisations and deaths now low again after a spike in May. The proportion of the population to have had a 3rd dose is now at 55%, and 4th doses are now at 15%.

Source: covidlive.com.au, AMP
Source: covidlive.com.au, AMP

While Monkeypox is causing increasing concern, it is far harder to get than COVID, it can be treated and the Smallpox vaccine is around 85% effective against it.

Economic activity trackers

Our Australian Economic Activity Tracker was little changed again in the last week and is still showing a loss of momentum consistent with a slowdown in growth. Our US Tracker was also little changed, but our European Tracker rose slightly.

Based on weekly data for eg job ads, restaurant bookings, confidence, mobility, credit & debit card transactions, retail foot traffic, hotel bookings. Source: AMP
Based on weekly data for eg job ads, restaurant bookings, confidence, mobility, credit & debit card transactions, retail foot traffic, hotel bookings. Source: AMP

Major global economic events and implications

Apart from the fall in June quarter US GDP, other US data was mixed with falls in home sales and consumer confidence and just 0.1% growth in real personal spending in June, solid but slowing gains in home prices, strong durable goods orders and falls in unemployment claims (albeit the trend remains up). Both the June core private consumption deflator (+4.8%yoy) and June quarter Employment Cost Index (+5%yoy) rose more than expected, which will keep the Fed hawkish for now, even though longer-term consumer inflation expectations (according to the University of Michigan) remain benign, at 2.9%pa.

56% of US S&P 500 companies have now reported June quarter earnings, with so far 73% ahead of expectations and earnings growth expectations for the quarter moving up from 5%yoy to 6.7% (and on track for around 9% based on the current rate of earnings surprise.) Outlook comments have been mixed, reflecting the uncertainty regarding the growth outlook. Earnings growth outside the US has actually been stronger.

Source: Bloomberg, AMP
Source: Bloomberg, AMP

Looks like the Democrats may be getting a Build Back Better budget reconciliation – called the Inflation Reduction Act - back on track, but don’t get too excited as it’s a fraction of the size of the original $3.5trn plan. The main elements appear to be a 15% minimum corporate tax rate (which will make it easier for other counties to do the same), lower drug prices and clean energy subsidies. Over ten years it will raise more revenue than it costs, and it may help lower drug prices, but its downward impact on inflation will likely be minor.

Eurozone June quarter GDP rose a greater than expected 0.7%qoq/4%yoy – no “technical recession” here – and the relative strength of Europe versus the US is consistent with the relativities in our activity trackers above. But July inflation rose more than expected, to 8.9%yoy and 4%yoy for core. All of which will keep the European Central Bank (ECB) hawkish for now, even though weak confidence and the gas crisis threaten weaker growth ahead.

Japanese data was mixed, with a sharp rise in industrial production for June, but stable jobs data and a fall in retail sales.

Australian economic events and implications

The Federal Treasurer’s statement on the economic outlook provided few surprises, with economic growth revised down (but still a long way from recession) and inflation revised up to a peak of 7.75% in December and not expected to fall to target until 2024. This is similar to what markets have been assuming. The Treasurer is now acknowledging that the 2021-22 budget deficit will be far better than expected thanks to higher commodity prices and lower unemployment - recent data suggests it will be at least $30bn lower than forecast in March. But he also pointed to $30bn in extra spending pressure over the next 5 years. The statement appears aimed at resetting expectations lower and setting the scene for savings in the October Budget. Spending cuts would make the RBA’s job in controlling inflation easier.

Aust retail sales growth slowed to 0.2% in June, which would be negative after inflation. It looks like the pace of gains may be starting to slow, reflecting the drag from cost-of-living pressures and rising mortgage rates.

Source: ABS, AMP
Source: ABS, AMP

Credit growth remained solid, at 9.1%yoy in June. Business credit growth is still strong and housing credit growth remained solid, though it’s likely to fall as the housing downturn impacts.

Another terms of trade surge in the June quarter. Export prices rose another 10% due to surging coal prices (+271%yoy) and gas prices (+105%yoy) whereas import prices rose only 4%qoq (largely due to higher petrol prices). The continuing surge in the terms of trade is good for national income and tax revenue – but can’t be assumed to last. (Fortunately, Treasury is not assuming that it will in its budget projections.)

What to watch over the next week?

In the US, the main focus is likely to be on July jobs data to be released on Friday, which is expected to show a further slowing in payroll growth to around 250,000, unemployment to be flat at 3.6% and wages growth slowing slightly to 5.1%yoy. June data for job openings (Tuesday) is likely to remain high but show some moderation and the ISM business indicators (Monday and Wednesday) for July are likely to slow further. US June quarter earnings reports will continue.

China’s July Caixin business conditions PMIs (Monday and Wednesday) are likely to see a stalling in their improvement.

In Australia, the RBA on Tuesday is expected to raise the cash rate by another 0.5%, taking it to 1.85%, as part of an ongoing effort “to do what is necessary” to return inflation to target by slowing demand and ensuring that long-term inflation expectations don’t rise. Fortunately, the slightly slower than expected inflation rate for the June quarter of 6.1%yoy likely removed the need for a further step up in the size of rate hikes to 0.75%. However, with the RBA still seeing the economy as resilient, the labour market coming in stronger than expected, inflation on its way to over 7% and the RBA viewing the cash rate as still well below its assessment of the neutral rate, the RBA is expected to remain hawkish warning of further rate hikes ahead. The RBA’s Statement on Monetary Policy (Friday) is expected to lower its unemployment rate forecast for this year to 3.25% but revise down the growth outlook for the next year and revise up the inflation outlook to over 7%yoy for this year.

Another 0.5% increase in the cash rate, if passed on to mortgage holders as we expect, will add roughly another $150 to the monthly payment on a typical $500,000 mortgage, which will take the total increase in monthly payments since April to around $500 a month.

On the data front in Australia, expect CoreLogic home price data (Monday) for July to show a 1.5% fall with Sydney prices down by 2.3%, the Melbourne Institute’s Inflation Gauge for July (also Monday) to show a further pick up reflecting rises in energy prices, June building approvals and housing finance data (Tuesday) to show falls of -14% and -2% respectively, June quarter real retail sales (Wednesday) to rise 0.6% and the June trade surplus (Thursday) to fall back to $12.5bn.

The June half Australian earnings reporting season is now getting underway. Consensus expectations are for around 20% earnings growth for the 2021-22 financial, year but with this boosted by energy earnings (+275%) and industrials averaging around 9.5% growth. The focus will likely be on the outlook, particularly given cost pressures, labour shortages and slowing consumer demand. Only a handful of companies will report in the week ahead though, including Genworth and Woodside.

Outlook for investment markets

Shares remain at high risk of further falls in the months ahead as central banks continue to tighten to combat high inflation, the war in Ukraine continues and uncertainty about recession remains high. However, we see shares providing reasonable returns on a 12-month horizon as valuations have improved, global growth ultimately picks up again and inflationary pressures ease through next year allowing central banks to ease up on the monetary policy brakes.

With bond yields looking like they have peaked for now, short-term bond returns should improve.

Unlisted commercial property may see some weakness in retail and office returns (as online retail activity remains well above pre-COVID levels and office occupancy remains well below). Unlisted infrastructure is expected to see solid returns.

Australian home prices are expected to fall 15 to 20% into the second half of next year as poor affordability and rising mortgage rates impact. Sydney and Melbourne prices are already falling aggressively, and falls are spreading to other cities.

Cash and bank deposit returns remain low, but are improving as the RBA cash rate increases flow through.

The $A is likely to remain volatile in the short-term as global uncertainties persist.

However, a rising trend in the $A is likely over the medium-term as commodity prices ultimately remain in a super cycle bull market.

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Shane Oliver, Head of Investment Strategy & Chief Economist
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