Investment markets and key developments over the past week
The past week saw a further escalation in sanctions over the war in Ukraine with now energy being targeted resulting in another surge in oil prices and leg down in global share prices before a relief rally kicked in on hopes for a peace deal and increased OPEC production only to see share markets fall again. The gyrations left US, Japanese and Chinese shares down for the week but European shares rose after a 10% plunge the previous week. Australian shares were also dragged down with strength in financials not being enough to offset weakness in materials, IT and telco stocks. Bond yields rose sharply on the back of inflation and monetary tightening concerns, particularly after the ECB surprised on the hawkish side. Oil prices initially surged into the decision by the US and others to ban Russian oil imports with West Texas Intermediate rising to just below $US130/barrel but then fell back on hopes for increased OPEC production leaving it down slightly for the week. Iron ore and gold prices rose but metal prices fell. The $A fell slightly and the $US was little changed.
From their bull market highs last year or early this year US shares and global shares are down 11%, European shares are down 17% and Japanese shares are down 18%. Reflecting the strength in commodity prices, strong dividend payments and maybe a less hawkish central bank Australian shares have held up better and are down by around 7.5%. The strength in commodity prices also explains why the $A has risen since the war started whereas normally it falls in crises.
The ongoing threat to global growth and inflation from the war in Ukraine and uncertainty as to how far the conflict will escalate will likely continue to drive huge volatility in investment markets with a high risk of more downside for a while yet.
The bulk of the threat to global inflation and growth is coming through the energy shock with various countries led by the US now banning Russian energy imports. So far it’s not as severe as the 1970s oil shocks: the rise in oil prices due to the war so far is nowhere near the four fold and three fold increases seen around 1973 and 1979; the amount of oil supply at risk in relation to supply is less than it was back then; there are more diverse sources of oil supply available today (eg shale oil in the US); and the oil intensity of GDP is less than half what it was in the 1970s. Offsetting the negative impact on consumers in the US and Australia is the huge boost to national income that will flow from higher energy and other commodity prices. However, Europe is far more at risk given its dependence on Russian energy imports (it may not be able to meet its objective to reduce Russian gas imports by two thirds by year end, but Russia may cut of its oil and gas anyway) as are other net energy and commodity importer countries in Asia. And oil prices can still go a lot higher if the conflict continues to escalate as can other commodity prices where Russia is a significant producer (like food and metals). So short of a peace deal being reached the risk of an ongoing threat to growth and inflation and hence share markets remains high in the short term.
As we have been noting though in the last few weeks, no one knows for sure how this will unfold. But the history of crisis events and associated share market falls tells us that after an initial hit there should be a decent rebound over 6 to 12 months. And while it feels bleak at present there are some things that may help drive the rebound:
- Just as in the Cold War, Russia & the West will likely find a way to co-exist without engaging in direct conflict. So far, they seem to be doing that.
- Surging oil and gas prices will incentivise increased production from key OPEC producers and US shale oil producers.
- Additional defence spending will provide a boost to growth and various countries including Europe are likely to see fiscal easing.
- While European growth will take a hit, global growth this year is still likely to be strong.
- As a result, company profit growth is likely to remain solid this year, albeit down from last year.
- Of course, a surprise peace deal would really help. This cannot be ruled out given the pressure Russia is putting on Ukraine and the rest of the world is putting on Russia, with Ukraine’s President indicating he is open to discussing Russia’s demand for neutrality in return for security guarantees and no loss of territory.
Given the stagflationary implications of the war and the financial stability risks posed by a likely Russian default on its debt and investors offloading Russian financial assets all at once, central banks continue to face a very challenging environment. So far they seem to be seeing it as more of a threat to inflation than growth. This was evident with the ECB surprisingly hawkish in the past week seeing still robust growth but much higher inflation and so accelerating the tapering of its bond buying, flagging an end to QE in the September quarter and signalling an openness to rate hikes this year. Central banks in energy producing countries will give even more weight to the impact on inflation – as we saw the Bank of Canada proceeded with a rate hike a week ago and the Fed is likely to raise rates in the week ahead, after US inflation rose to a new 40 year high in February with a further lift in median inflation indicating that the rise in inflation is broad based.
Even the RBA seems to be getting closer to a rate hike. RBA Governor Lowe reiterated that it can and will be “patient” in assessing whether inflation will be sustained in the target range (partly because inflation pressure is lower in Australia – see the last chart). But his comments in the past week were progressively more hawkish than they have been - noting now that its “plausible” the cash rate will be increased later this year and that its “prudent to plan” for a hike, alluding to the risk of sustained supply shocks boosting inflation expectations and stressing that the RBA will respond as needed to maintain low and stable inflation. While the RBA is aware of the negative impact of higher petrol prices on household budgets given the boost to national income from higher commodity prices it looks to be more concerned about the impact of the war on inflation than growth.
We continue to see the first RBA rate hike coming in June as March quarter inflation is likely to again come in well above RBA expectations and March quarter wages growth is likely to show a pickup. May is possible but unlikely given it will be in an election campaign and March quarter wages growth won’t have been released by then. While the departure of RBA Deputy Governor Guy Debelle for the private sector is a big loss for the RBA, its unlikely to change the direction of the RBA’s monetary policy. Assistant Governors Luci Ellis, Chris Kent and Michelle Bullock are well placed to replace Dr Debelle but are unlikely to bring a significantly different approach to monetary policy.
While the flooding disaster along Australia’s east coast intensified over the last week with more heavy rain our assessment remains that beyond a short-term disruption to growth it won’t change Australia’s outlook for strong growth of around 4.5% for this year as a whole. The 2011 floods drove a -0.3% fall in GDP in the March quarter of 2011 due to disruption particularly to resource exports from flooded mines but rebounded strongly in subsequent quarters helped by rebuilding. This time around we expect economic growth to slow a bit in the near term but to remain positive thanks to ongoing reopening from the pandemic and the floods being less broad based than in 2011, followed by a boost to growth from rebuilding in the second half of the year. However, the March and June quarters are likely to see around 0.2% added to inflation due to higher fruit and vegetable prices. Combined with the impact of higher petrol and grain prices flowing from the Ukraine war this will likely push Australian inflation to around 5%yoy by mid-year (which compares to the RBA’s forecast of 3.75%yoy) and push underlying inflation to around 3.8%yoy (compared to the RBA’s forecast of 3.25%yoy).
Through the last few weeks of gloomy weather here in Sydney I occasionally dreamt of summer beach days, which often leads me to Beach Boys songs. A friend recently reminded me of the song Beach Baby by The First Class. Listening to it one could be forgiven for thinking that it’s The Beach Boy’s but it’s actually a British group that was just put together for the song a very long way away from LA and Chevrolets. But it has a real epic summer beach feel to it.
New global covid cases edged up a bit over the last week after a sharp fall since January, with Asia continuing to see a rise reflecting the later start to the Omicron wave in some countries and Europe hooking up a bit too.
Hospitalisation and death rates remain well down compared to previous waves reflecting protection against serious illness provided by prior covid exposure and vaccines, better treatments and the Omicron variants being less harmful.
New cases are also rising again in Australia, with WA up sharply on reopening, NSW seeing a doubling in cases versus two weeks ago and SA, Tasmania and the ACT also seeing a rising trend. Hospitalisation and deaths are still falling but they lag. The rebound in NSW and other states looks to be due to the rise of the more transmissible Omicron sub variant BA.2 along with the ending of mask mandates, return to school, still low booster rates resulting in waning immunity and people dropping their guard. A further increase is highly likely. But if serious illness rates stay subdued relative to Delta and prior waves as appears likely (as vaccines provide protection and Omicron BA.2 appears to be no more harmful than the original Omicron BA.1 based on European experience with it earlier this year, and both are less harmful than Delta) then a return to economically debilitating restrictions is unlikely. Th return to softer measures like indoor mask mandates and a “work from home” advisory are possible though.
56% of the global population is now vaccinated with two doses and 18% have had a booster. In developed countries its 74% and 43%, with Australia at 80% and 47%. Interestingly NSW has now fallen below the national average with booster shots at 45% of the population.
Economic activity trackers
Our Australian Economic Activity Tracker fell slightly again over the past week reflecting falls in confidence, mobility and restaurant bookings on the back of flooding in NSW and Queensland. It remains strong though. Our US Economic Activity Tracker pushed a bit lower, but our European Tracker was little changed despite the war. A further impact from the war is likely as high energy prices impact.
Major global economic events and implications
US inflation up to a new 40 year high. CPI inflation rose again to 7.9%yoy in February with inflation excluding food and energy rising to 6.4%yoy. This was broadly as expected reflecting ongoing supply side pressures and is consistent with the Fed starting to raise interest rates in the week ahead. Meanwhile job openings and people quitting their jobs fell slightly but remain very high as does the ratio of job openings to unemployment indicating a very tight labour market.
Japanese economic sentiment fell slightly in February according to the Economy Watchers survey, with this likely reflecting a surge in covid cases at the time. Producer price inflation accelerated again to 9.3%yoy after slowing in January and wages growth picked up but only to 0.9%yoy.
China to boost growth. China saw stronger than expected growth in exports and imports in January and February, flat consumer price inflation at just 0.9%yoy and a slowing in producer price inflation to 8.8%yoy. Unlike many other countries China does not face an inflation constraint to stimulating growth and with the Government setting an above consensus 2022 growth target of 5.5% more proactive policy stimulus looks to be on the way.
Australian economic events and implications
Australian economic data was mixed. The NAB business survey reported a rise in business conditions and confidence but this relates to February as the Omicron disruption receded. Against this, consumer confidence fell in March according to the Westpac/Melbourne Institute survey reflecting the more recent bad news on interest rates, floods, the war in Ukraine and petrol prices.
More jobs. ABS payroll jobs continued to rise into February as part of a normal seasonal rebound along with recovery from the Omicron disruption in January, but wages data rose a lot faster reflecting a rebound in hours worked and compositional shifts along with possibly higher wage rates.
But higher prices. Ongoing inflation pressures were highlighted by the NAB survey which showed ongoing elevated readings for labour costs, purchase costs and selling prices, consistent with March quarter inflation likely to again surprise the RBA on the upside.
What to watch over the next week?
In the US, the focus will be on the Fed (Wednesday) which is set to start the long-flagged process of raising interest rates with a 0.25% hike in the Fed Funds rate taking it to a range of 0.25-0.5%. This is widely expected with Fed Chair Powell indicating he is likely to propose a 0.25% hike and not the 0.5% some had talked about prior to the war with Ukraine. It will be couched in terms of the need to start normalising rates to control inflation now that the economy has recovered. Outlook commentary is likely to be hawkish given the ongoing higher than expected outlook for inflation with the Fed’s dot plot shifting up to 5 hikes this year from 3 back in December, but uncertainty around Ukraine tempering the hawkishness. The Fed is also likely to announce more details around how it will proceed with Quantitative Tightening (ie, reducing its bond holdings).
On the data front in the US, expect a pickup in the New York regional manufacturing conditions index for March (Tuesday), a 0.4% gain in February retail sales after the huge gain in January and continued strength in the NAHB home builders index (both Wednesday), gains in industrial production and housing starts and continued strength in the Philadelphia region manufacturing index (all Thursday) and a fall in existing home sales (Friday).
The Bank of England (Thursday) is expected to raise its cash rate by another 0.25% taking it to 0.75%, express concern about the uncertainty posed by the war in Ukraine but remain hawkish given the upwards pressure on inflation.
The Bank of Japan (Friday) is expected to leave monetary policy very stimulatory and on hold, given the ongoing weakness in inflation in Japan. Core inflation (also Friday) is likely to have remained negative in February.
In Australia, the RBA minutes are expected to reiterate the Bank’s patience in assessing whether inflation will be sustainably in the target range. More detail around how it sees the impact of the war in Ukraine will be watched for, with the RBA seeming to so far be paying more attention to the upwards pressure it will put on inflation as opposed to the negative impact on growth from higher petrol prices which will be offset by the boost from higher commodity prices to national income.
On the data front in Australia, ABS data (Tuesday) is expected to show a 4% rise in December quarter home prices consistent with private sector surveys that were released earlier this year and jobs data (Thursday) is expected to show a 40,000 gain in employment, a big rebound in hours worked after the Omicron disruption and a fall in unemployment to 4.1%.
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 maybe Iran impact. However, we still see shares 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 this year.
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 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 in response to the uncertain global 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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