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Economics & Markets

Market Update 02 September 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

Global share markets remained under pressure over the last week on the back of continuing hawkish comments from the US Federal Reserve (Fed) and European Central Bank (ECB), and ongoing concerns about recession. For the week, US shares fell 3.3%, Eurozone shares fell 1.4%, Japanese shares lost 3.5% and Chinese shares lost 2%. Australian shares had remained a bit more resilient through August (relative to global shares) helped by mostly positive earnings reports, but are now coming under pressure too, with a 3.9% fall in the last week. Bond yields rose sharply as higher short-term interest rates for longer were factored in. Oil, metal and iron ore prices fell, with iron ore particularly hit by fears around new lockdowns in China. The $A fell as the $US pushed higher.

In our view, shares remain at high risk of further falls in the short-term. Share markets ran ahead of themselves in the rally from their June lows into their mid-August highs, recovering just over half of their earlier decline, helped by mostly good earnings reporting seasons in the US and Australia. As the US share market became overbought and hit resistance at its 200-day moving average, they became vulnerable to ongoing central bank hawkishness and recession risks and pulled back. Shares also remain at high risk of further falls in the short-term: central banks including the Reserve Bank of Australia (RBA) remain hawkish and a long way from a “dovish pivot”, as evident in comments by various Fed and ECB officials in the last week; recession risks remain high, running the risk of significant earnings downgrades; Historically, September has been the weakest month of the year for US and Australian shares, particularly when markets are already in a downtrend; and geopolitical risks remain high over Taiwan, Ukraine and the US mid-terms.

Source: Bloomberg, AMP
Source: Bloomberg, AMP

Fortunately, our Pipeline Inflation Indicator is continuing to decline so some pressure me reduce on central banks (the Fed initially) and allow a slowing in tightening in the next six months – hopefully in time to avoid deep recessions. South Korea has now joined the US in looking like its inflation rate has peaked.

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

Australia’s jobs & skills summit. While some fear it was just a talk fest, if it helps resolve the log jam in fixing key problems in the labour market by bringing people together to find common ground on a way forward, it’s a good thing. And it does appear some progress will be made, with key moves confirmed or likely in the following areas: an increase in the permanent immigration cap for this financial year to 195,000 (from 160,000) and increased training to help solve the labour and skills shortage; measures to reinvigorate the enterprise bargaining system to, in particular, soften the “better of overall test”, which should help boost productivity; and allowing pensioners to work extra hours without losing their pension. A foreshadowed return to multi-employer bargaining could be a big risk if not managed carefully, to the extent it could impose cost increases on enterprises not able to cope and lead to increased industrial action, as was common in the 1970s. The problems with industry bargaining were partly why enterprise bargaining was introduced in the first place. The boost to immigration also risks exacerbating the shortage of rental property.

A&M Records and Brazil 66. One of the things about flying around is that you come across amazing documentaries on the plane that I may not otherwise find. One I saw this week was Mr A and Mr M: The Story of A&M Records. Mr A was Herb Alpert, a musician, and Mr M was Jerry Moss, a businessman – the combination resulted in a musician focussed business (unlike some big record companies). Herb Alpert & The Tijuana Brass had a unique sound and even recorded the theme to the “unofficial” James Bond film Casino Royale (which Austin Powers channelled many years later). One of A&M’s coolest acts was Sergio Mendez & Brasil 66. Interestingly the lead singer Lani Hall ended up marrying Herb Alpert (and they still are) and also recorded the theme to the other “unofficial” James Bond film Never Say Never Again.

Coronavirus update

New global COVID cases are continuing to fall, with deaths rolling over too. Cases in China remain low, but a “temporary” lockdown in Chengdu (population 21m) highlights that a return to broad based lockdowns is a risk.

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

Australia is also seeing falling new cases, hospitalisations, deaths and positive testing rates.

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

Economic activity trackers

Our Australian and European Economic Activity Trackers dipped in the last week whereas it rose in the US. All suggest a loss of momentum since earlier this year suggestive of slowing growth. In Australia restaurant and hotel bookings are off their highs.
 

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

US data was mostly a bit stronger in the past week with consumer confidence up, payrolls up solidly, job openings up, jobless claims down again, the ISM manufacturing index remaining resilient but home price gains slowing and construction down. Note though that there is a big difference between the Conference Board’s consumer confidence index, which is impacted more by strong jobs data, and the University of Michigan measure, which is impacted more by financial conditions, and still sending a very weak signal.

Source: Macrobond, AMP
Source: Macrobond, AMP

US jobs data for August is unlikely to see the Fed become less hawkish. The good news for the Fed is that payroll growth slowed to 315,000, labour force participation rose (which drove a rise in unemployment to 3.7%) and wages growth moderated. Against this, jobs growth is still strong, wages growth is still high (at 5.2%yoy) and other data shows continuing strength in job openings and still-low jobless claims. All of which is likely to keep the Fed hawkish for now. A potential concern is that while the uptick in unemployment was driven by increased workers, it’s consistent with what is often seen prior to recessions.

Source: Macrobond, AMP
Source: Macrobond, AMP

Eurozone economic confidence fell further in August, not helped by the ongoing surge in electricity prices. Another new high in Eurozone inflation, at 9.1%yoy, will only keep the pressure on the ECB for rate hikes. While higher energy and food prices (with drought not helping) are a big part of it, core inflation also rose more than expected, to 4.3%yoy. Russia’s further delay in reopening NordStream 1 gas flows will only add to the energy crisis and recession risks in Europe.

Japanese data was good, with stronger than expected industrial production, a rise in the ratio of job openings to applicants and stronger retail sales and consumer confidence.

Chinese business conditions PMIs softened in August, suggesting the post lockdown rebound is faltering – not helped by extreme heat and COVID-zero policy uncertainty. Hence the scramble for more policy stimulus in China.

Source: Macrobond, AMP
Source: Macrobond, AMP

Australian economic events and implications

Australian data was mixed, with booming retail sales, strong capex plans & weak housing indicators. Retail sales are 17.5% above their pre-COVID trend. This is likely inflated by inflation, but so far consumers are still spending. Higher rates, falling confidence & falling real wages point to softness ahead.

Construction and investment data was mixed in the June quarter. Construction fell, with declines in home building, non-residential building and engineering, as shortages and bad weather impacted. Reflecting this, business investment also fell slightly in the June quarter, but with a rise in plant & equipment investment. Capex plans remained strong though, up 15% from a year ago, suggesting that despite the uncertainty, businesses are still planning to boost investment.

Source: ABS, AMP
Source: ABS, AMP

By contrast, housing indicators are pointing down, with building approvals down 17% in July and housing finance down sharply, which in turn is resulting in slowing housing credit. The falling trend in building approvals points to softer home building over time, but there is still a large pipeline of approved but not completed dwellings. The fall in housing finance reflects rising rates and falling home prices, with more weakness likely.

Source: ABS, AMP
Source: ABS, AMP

Finally, the slump in home prices accelerated in August and has now spread to 7 of the 8 capital cities, as well as regional prices. CoreLogic data shows that home prices fell 1.6% in August and are down 3.5% from their April high. Sydney prices are leading the way down and have fallen 7.4%. We continue to expect a top to bottom fall of 15 to 20% out to the second half next year, as ongoing rate hikes continue to impact. If the cash rate pushes much beyond 3%, as many expect, then price declines are likely to be deeper.

Source: CoreLogic, AMP
Source: CoreLogic, AMP

Five key points from the now completed June quarter earnings reporting season in Australia. First, earnings growth last financial year was solid, at around 21.5% - which is in line with expectations at the start of the reporting season. This is pretty good, given the lockdowns, disruptions, shortages and inflation problems of last year. Second, earnings growth was dominated by a 280% gain in energy earnings and a 21% gain for materials, with the rest of the market averaging 10% growth. Third, positive surprises dominated misses by around 3 to 2, but the upside surprise has been trending down over the last 18 months - see the first chart. Fourth, the best is likely behind us for now, with the proportion of companies reporting rising earnings (on a year ago) and increasing dividends falling and now running below average (see the second chart below). Fifth, earnings growth expectations for this financial year are being cut, reflecting the impact of rising labour cost pressures and expectations for slower demand growth. Consensus earnings expectations for this financial year have fallen from around 8% to 6.5% over the last month.

Source: AMP
Source: AMP
Source: AMP
Source: AMP

What to watch over the next week?

In the US, a speech by Fed Chair Powell (Thursday) will likely maintain the Fed’s hawkish stance, reiterating the importance of getting inflation under control and that there is more work to do. Tweaks at the margin – e.g., around slowing the pace of hikes and observations around peak inflation, will no doubt be watched carefully. The ISM services index for August (Tuesday) will likely show some further slowing.

The Bank of Canada (Wednesday) is expected to hike by 0.75%, taking its key rate to 3.25%, as underlying inflation has risen further. It may however signal some slowing in hikes ahead.

The ECB (Thursday) is likely to raise its key policy rates by 0.75%, taking its refinancing rate to 1.25% as part of an ongoing effort to combat still-rising inflation. It’s a close call with a 0.5% hike, but given the upside surprise in August inflation and increasingly hawkish ECB Council members, a 0.75% hike looks more likely to us. It’s also likely to foreshadow more rate hikes ahead.

Chinese trade data for August (Wednesday) is likely to show a slowing in export growth and still weak imports, and CPI inflation (Friday) is likely to show still soft underlying inflation.

In Australia, the RBA on Tuesday is expected to raise the cash rate by another 0.5%, taking it to 2.35%, 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. Given the significant monetary policy tightening already seen, the reality that this will only hit the economy with a lag, the big hit from falling real wages and the increasing weakness in leading indicators (notably for consumer confidence and housing) there is a strong case for the RBA to slow the pace of tightening to give more time to assess its impact so far and move by only 0.25%. However, with the RBA having revised up its inflation forecast to 7.75% for year-end and given its expectation at the time of its last meeting “to take further steps in the process of normalising monetary conditions” (jargon for more rate hikes!), the RBA is probably likely to give more weight to the strong data seen since its last meeting and hike by another 0.5%. The latter includes the unemployment rate falling further to 3.4%, retail sales rising strongly in July, the NAB business survey showing a further rise in price and cost pressures and a rise in capacity utilisation to record levels and ongoing indications from the ABS and various business indicators pointing to a further pick up in wages growth. Moving by 0.4% might be a good compromise (and return the cash rate to a more “normal” number) and this is what’s priced in by the futures market. It’s a close call, but our base case is for a 0.5% hike.

The RBA’s rate guidance will probably remain hawkish, signalling further tightening ahead. But given its recent comments that it is “not on a pre-set path” and that it is aiming to return inflation to target “while keeping the economy on an even keel”, Governor Lowe may signal in the post meeting statement (or in a speech on Thursday on the “Inflation and the Monetary Policy Framework”) a possible slowing in the pace of hikes ahead, given increasing downside risks for the economy. We still see the peak in the cash rate being 2.6% later this year or early next, but given the ongoing strength in jobs and spending data, there is an increasing risk that the RBA will tighten beyond this. Governor Lowe’s speech on Thursday will be watched closely for clues on the monetary policy outlook and how big a risk the RBA is prepared to take on the growth and employment fronts in pursuing its inflation objective.

Another 0.5% increase in the cash rate, if passed on to mortgage holders as we expect, will add roughly another $140 to the monthly payment on a typical $500,000 mortgage, which will take the total increase in monthly payments since April to nearly $650 a month. This may not have hit spending much yet, but it will in the months ahead. As Milton Friedman long ago observed, the lag from a change in monetary policy to its impact on the economy is “long and variable.”

On the economic data front, June quarter GDP (Wednesday) is likely to show that the economy grew by a solid 0.7%qoq or 3.3%yoy, driven by strong contributions from net exports and consumer spending but weakness in housing and inventories. June quarter business indicators (Monday) and trade data (Tuesday) will provide further guidance for June quarter GDP forecasts, with net exports expected to contribute 1 percentage point to growth. The trade surplus for July (Thursday) will likely show a fall back to $15bn. Melbourne Institute’s August Inflation Gauge (Monday) will likely show a further rise, although it’s been understating CPI inflation lately.

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, uncertainty about recession remains high and geopolitical risks continue. 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 a bit further.

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% top to bottom into the second half of next year, as poor affordability and rising mortgage rates impact.

Cash and bank deposit returns remain low, but are improving as 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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