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Economics & Markets

Market Update 25 March 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 and key developments over the past week

Share markets were mixed over the past week with uncertainty over the war in Ukraine, a rebound in oil prices, increased Fed hawkishness and a continuing surge in bond yields being offset by mostly solid economic data, still rising earnings expectations and hopes by some that shares will be a hedge against high inflation. US and Japanese shares rose but Eurozone and Chinese shares fell. Australian shares saw another strong gain with utilities, resources and IT stocks leading the rise. Bond yields rose on inflation concerns and increased expectations for rate hikes. Oil prices rebounded but are still below the levels seen soon after the start of the war. Metal prices were mixed, and iron ore prices fell slightly. The rising trend in commodity prices saw the $A rise above $US0.75 despite a rise in the $US.

Share rebound continues – have we seen the low in shares? After a 13% top to bottom plunge US and global shares have rebounded cutting the fall to just 6% from their bull market high. Reflecting the boost from the resources sector, Australian shares have cut their losses from last year’s bull market high (with the market down 10% to its low in January) to just 3%. In fact, the Australian share market is now close to flat for the year to date and its likely to remain a relative outperformer thanks to the boost to commodity prices. It remains possible we may have seen the lows in share markets, but uncertainty remains high around the war and inflation is still likely to get worse before it gets better keeping uncertainty high around the extent of monetary tightening. And the rebound in US shares has still lacked the breadth and strength often seen coming out of market bottoms. So, while we remain of the view that share markets will be higher on a 6–12-month horizon it’s still too early to say we have seen the bottom.

Ukraine risks remain high. The war in Ukraine does not appear to be going well for Russia with reports that up to four times as many Russian soldiers may have died so far as the US lost in Afghanistan over 20 years. This along with the intense economic pressure from the sanctions along with the devastation in Ukraine may force both sides to accept a peace deal which would see a strong bounce in markets (before they go back to worrying about inflation). But it may also push President Putin into a more aggressive prosecution of the invasion resulting in a further escalation (including via sanctions) and disruption to energy and other commodity supplies. Reflecting the risk of this, oil and gas prices are on the rise again. So, Ukraine related risks for investment markets remain high in the short term.

The Fed getting even more hawkish pushing bond yields higher. Fed Chair Powell has further dialled up the hawkish rhetoric indicating it will take the “necessary steps” to control inflation and will hike rates by 0.5% in May if appropriate. As a result, the US money market now expects the Fed Funds rate to rise from 0.38% at present to 2.28% by year end. The ratcheting up in interest rates expectations has further pushed up bond yields. The UK also saw another stronger than expected acceleration in inflation for February to 6.2%. The challenge for central banks is that they cannot simply look through the current supply shock to prices which has been made worse by the war in Ukraine, because it risks boosting longer term inflation expectations which means a risk of a wage-price spiral where price and wage increases beget more price and wage increases. With this comes the risk that central banks, ultimately including the RBA albeit its under less pressure given lower price and wage inflation in Australia, will have to raise rates more aggressively to control inflation. Its early days yet though and so far, rising earnings expectations are helping to offset the negative impact on share markets from rising bond yields.

US recession risks on the rise, or are they? The shape of the yield curve (ie the gap between long term and short term borrowing rates) has long been used by economists as a guide to whether recession is imminent or not. When long rates are high relative to short rates it’s seen as a sign that it’s a good time to borrow short and invest in the economy but when long rates are below short rates it’s seen as a bad time to borrow and invest. Many are now pointing to a flattening in the US yield curve as measured by a narrowing gap between 10-year bond yields and 2-year bond yields as a sign that the risk of recession is rising in the US. However, 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. Moreover the 10-year/2-year comparison may be distorted at present 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 is soon set to start falling with quantitative tightening which may push 10-year bond yields higher. I remain of the view that a US recession is more of a risk for 2024 than over the next year as the Fed is still a long way from tight monetary policy.

Source: Bloomberg, AMP
Source: Bloomberg, AMP

The yield curve has given numerous false recession signals in Australia – but in any case, it’s nowhere near signalling a recession, however defined.

Source: Bloomberg; AMP
Source: Bloomberg; AMP

For those wondering when all the rain down east coast Australia will go away, the Southern Oscillation Index is still in La Nina, ie cool and wet, territory.

Source: Bureau of Meteorology, AMP
Source: Bureau of Meteorology, AMP

Elvis’s mid-70s songs are often overlooked, being seen as middle of the road and sometimes a bit maudlin. But many stand out of which here are three. Moody Blue recorded in the Jungle Room at Graceland in February 1976 and a hit in 1977 is up there with his best songs from the 1970s. My Boy recorded at Stax in Memphis is a classic 1970s song telling the story of family separation. And Elvis cover of Don McLean’s And I Love You So recorded at RCA’s Hollywood studio in March 1975 is a classic which Elvis sang in most of his concerts until his death, shown here in June 1977. All of these highlight the power of Elvis’s voice.

Coronavirus update
New global covid cases fell slightly over the last week, with slight falls in Europe and Asia (including China). However, various European countries remain in a new rising trend including the UK and France, its too early to tell whether China is back under control and the increasing dominance of Omicron sub-variant BA.2 and a rising trend in New York points a likely rise in US cases.

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

New cases are continuing to rise gain in Australia due to the rise of the more transmissible Omicron subvariant 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 likely but fortunately so far the rate of increases is slower than with the first Omicron wave. Hospitalisations are starting to edge up again and deaths have stopped falling.

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

Coronavirus shifting from being a pandemic to endemic does not mean that new cases will be stable and low. They could be high and unstable as we have been seeing with Omicron. But if hospitalisation and death rates remain low its manageable without causing significant economic disruption in contrast to the pandemic phase. So far so good, with vaccines and prior exposure providing protection against serious illness, better treatments and the Omicron variants (BA.1 and BA.2) being less harmful albeit more transmissible than prior covid variants. So, hospitalisation and death rates remain well down compared to previous waves. While a return to hard lockdowns is unlikely a return to softer measures like indoor mask mandates, a work from home advisory and other distancing requirements are still possible in order to slow the spread and keep hospitalisations manageable.

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

57% of the global population is now vaccinated with two doses and 20% have had a booster. In developed countries its 74% and 45%, with Australia at 82% and 49%. Fourth shots will be rolled out for at risk Australians from April and consideration is being given to an annual whole of population covid vaccine.

The main risk remains the mutation of a more contagious and more harmful variant in lowly vaccinated poor countries. Another unfortunate consequence of the Ukraine war is that it may have distracted from global efforts to boost vaccination rates in poor countries.

Economic activity trackers
Our Australian Economic Activity Tracker bounced back from its brief flood related dip and is now at a new high suggesting the economy continues to grow at a solid pace. Our US Economic Activity Tracker rose as did our European Tracker suggesting surprisingly little impact from the war despite a hit to consumer confidence from higher energy prices.

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
Consistent with our Economic Activity Trackers, business conditions PMIs for March were resilient. They fell slightly in Europe and the UK but remain strong and they rose in the US, Australia and Japan. While the war in Ukraine is a threat, so far economic conditions remain strong.

Source: Bloomberg, AMP
Source: Bloomberg, AMP

Unfortunately, while order backlogs for manufacturers are continuing to fall, input and output price pressures remain very high.

Source: Bloomberg, AMP
Source: Bloomberg, AMP

Apart from the continuing strength in US business conditions PMIs, jobless claims fell to a new post 1969 low and underlying capital goods orders fell slightly but along with shipments remain in a solidly rising trend in February. Against this new home sales fell. The US housing market like that in Australia remains vulnerable to deteriorating affordability and rising mortgage rates although low levels of listings remain a source of support.

Eurozone consumer confidence fell sharply in March reflecting the impact of the war particularly via higher energy prices.

UK inflation again rose more than expected in February to 6.2%yoy, with core inflation at 5.2%yoy, maintaining pressure on the Bank of England.

Australian economic events and implications
There wasn’t a lot of Australian economic data released in the past week, but it was mixed with business conditions PMIs up suggesting that businesses are happy but the weekly ANZ/Roy Morgan consumer confidence index fell to its lowest level since 2020 suggesting consumers are not so happy with the rise in petrol prices and talk of rate hikes. The PMI input and output price measures showed an ongoing acceleration pointing to ongoing inflationary pressures.

What to watch over the next week?
In the US, March jobs data (Friday) will be the focus with payrolls expected to show another solid rise of 450,000 and unemployment falling to 3.7%. In other data releases expect continued strength in home prices and job openings but a fall in consumer confidence (all due Tuesday), continuing strength in the ISM manufacturing conditions index for March (Friday) and another rise in core private final consumption deflator inflation to 5.5%yoy (Thursday).

Eurozone economic confidence data for March (Wednesday) are likely to fall reflecting the impact of the war in Ukraine and inflation data (Friday) is expected to show a further rise.

Japan’s March quarter Tankan survey (Friday) is expected to soften and February jobs data will be released Tuesday.

China’s business conditions PMIs for March (Thursday and Friday) are likely to fall reflecting the impact of covid related restrictions.

The Australian Budget to see a “magic pudding” of more spending and lower deficits. The Federal 2022-23 Budget (Tuesday) is primarily expected to be about five things: the upcoming election; help for households dealing with “cost of living” pressures; increased defence spending; a shift in focus to “fiscal repair”- ie, stabilising and then reducing debt marked by spending restraint; and a budget windfall from faster growth and higher commodity prices allowing much lower budget deficit projections. Key elements are likely to include:

  • An upgrade in GDP growth forecasts to 4.75% for the next financial year with unemployment expected to fall to 3.5% by June next year.
  • Financial relief to help households deal with “cost of living” pressures with a one-off payment to low and middle income households, a 6 month or so cut or freezing in fuel excise (which is bad economic policy, but it is an election budget!) and a possible extension of the Low and Middle Income Tax Offset.
  • Extra spending on infrastructure, an NBN upgrade for regions, digital transformation, skills training, manufacturing vaccines, childcare subsidies, defence and gas projects;
  • More assistance for first home buyers – possibly with an extension of the first home loan deposit schemes.
  • Much lower budget deficits of around $80bn this financial year and next (down from deficits of around $99bn for both years in MYEFO) falling to around $40bn by 2024-25 (down from $57.5bn in MYEFO). This reflects the budget windfall from a faster than expected economic recovery and higher commodity prices driving higher tax receipts and lower welfare payments only partly offset by increased spending this financial year and next.
  • The budget windfall coupled with $16bn allocated last December as “decisions taken but not yet announced” means there is plenty of scope for the Government to announce extra short-term spending and yet still report a faster pace of deficit reduction than back in December.
  • The Government’s shift towards fiscal repair over the medium term will take the form of medium-term spending restraint and a reliance on stronger growth rather than austerity. With tax receipts rising faster than expected there is a chance that more tax cuts will be necessary if the Government is to stick to its commitment to capping the tax to GDP ratio at 23.9%. Of course, this is just the return of bracket creep!

A key risk for the RBA is that significant fiscal stimulus this financial year and next in the Budget will only add to its challenges in controlling inflation, resulting in the cash rate needing to increase faster than we are currently forecasting for later this year and into next year. (We currently forecast the cash rate rising to 0.75% by year end, rising to 1.5% next year.)

On the data front in Australia, expect February retail sales (Tuesday) to show a 0.8% gain, building approvals to bounce 10% after a 28% fall in January, credit data to show a further rise in housing credit growth and ABS job vacancy data to remain very strong (all Thursday), housing finance data to fall 1% and CoreLogic data to show a 0.3% gain in March home prices but with prices falling in Sydney and Melbourne (all due Friday).

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.

Still very low yields & 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 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 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.

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Shane Oliver, Head of Investment Strategy & Chief Economist
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