Investment markets & key developments
Share markets fell sharply again over the last week in response to another round of hawkish rate hikes pushing up bond yields and adding to recession fears and with a threatened intensification of the war in Ukraine adding to worries. A large UK stimulus package which risks adding to inflation didn’t help. For the week, US shares fell 4.7%, Eurozone shares lost 4.6%, Japanese shares fell 1.5% and Chinese shares fell 2.0%. As a result, US and global shares are now back around their June lows. Reflecting the poor global lead, Australian shares fell 2.4%, with falls led by interest sensitive IT, property, utility and retail shares. Bond yields rose as ever higher short-term interest rates (for longer) were factored in. UK 10-year bond yields spiked 69 basis points higher, partly on the back of UK stimulus measures. Oil, metal and iron ore prices fell on the back of ongoing recession fears. The $A fell sharply as the $US rose.
Shares are likely to see more downside in the short-term as central banks remain hawkish, recession risks are high and rising, the conflict in Ukraine looks likely to escalate, we remain in a seasonally weak period of the year for shares out to mid-October and earnings expectations continue to be revised down. While investor confidence is very poor, we have yet to see the sort of spike in put/call ratios or Vix that can signal major market bottoms. Shares are now oversold and due a bounce, but a break below the June low for the US share market could open up another 10% leg down, with a similar flow through to Australian shares.
Hawkish central banks remain the key driver of the downside in shares. While inflation is showing signs of peaking in the US, it’s not enough for the US Federal Reserve (Fed), which hiked by another 0.75% and remains very hawkish. High inflation also drove rate hikes from numerous central banks over the last week – with another 0.5% hike from the Bank of England (BoE) which also remains hawkish, a 1% hike from the Swedish central bank and a 0.75% hike from the Swiss central bank (although these were both catchups). There were also rate hikes in South Africa, Norway, the Philippines, Indonesia and Taiwan.
While the Fed’s 0.75% hike to 3-3.25% was expected, its post meeting statement and comments were very hawkish. The so-called dot plot of Fed officials interest rate expectations was revised up by 1% for this year to 4.25-4.5%, its inflation forecasts were revised up, its growth forecasts were revised down and its unemployment forecasts were revised up to 4.4% next year. While the Fed is not yet forecasting a recession, its forecast rise in unemployment would normally be consistent with one and it appears willing to tolerate a recession as its “overarching focus” is to bring inflation down to 2%. Channelling Paul Volcker, Fed Chair Powell said “we will keep at it until the job is done.” Or maybe Tom Petty and The Heartbreakers (along with half the Beatles and Jeff Lynne in the video) with “I Won’t Back Down”. To slow the pace of tightening, Powell wants to see a slowing labour market and more evidence inflation is slowing. Another 0.75% hike looks likely in November.
The commitment of central banks to getting inflation down is good news, as a sustained return to a 1970s style high inflation would be very bad for economies, living standards, jobs and investment markets. The danger though is that the Fed and other central banks have become locked into supersized hikes based on backward looking inflation and jobs data, amid a loss of confidence in their ability to forecast inflation (at a time when they should be giving more attention to monetary policy lags). This increases the risk of overtightening driving a deep recession. (Just as in hindsight they were too slow to start hiking.) Fed tightening and hawkishness has seen the US 10-year vs 2-year yield curve further invert, strengthening its recession warning, with the more reliable 10 year-Fed Funds rate curve yet to invert but getting close.
However, while inflation is still too high for the Fed and other central banks, there remain snippets of good news and reason for optimism on a 12 month horizon. Our Pipeline Inflation Indicator continues to slow, suggesting that inflation will fall faster than the Fed is now expecting, inflation expectations outside of Europe have fallen and Canada has joined the US in showing signs of peak inflation.
The bottom line is that while short-term inflation remains high, these considerations are consistent with the US having reached peak inflation and point to sharply lower inflation ahead, which should enable central banks to slow down the pace of hiking by year-end, hopefully in time to avoid a severe recession (except perhaps in Europe). If this applies in the US, then Australia should follow, as it’s lagging the US by about six months with respect to inflation. For this reason, while shares are likely to fall further in the short-term, we remain optimistic on shares on a 12-month horizon.
Five reasons why the RBA should be less hawkish than the Fed. The increased hawkishness coming from the Fed has led many to conclude that the RBA will have to get more hawkish too and match extra Fed rate hikes. However, there are several reasons why the RBA should be less hawkish than the Fed and other central banks:
- Household debt to income ratios in Australia are almost double US levels – at 187% in Australia v 102% in the US.
- Household debt interest costs in Australia are far more responsive to rising interest rates – as most borrowers are on variable rates tied to the Reserve Banks of Australia’s (RBA) cash rate and the rest are on relatively short dated fixed terms many of which mature next year, in contrast to the US, where most mortgages are 30-year fixed, so only new borrowers are impacted by rising rates. Combined with the first point, this means that a given sized rate hike in Australia will be more potent in slowing consumer demand than in the US.
- Inflation is lower in Australia, at least for now.
- Wages growth – the biggest single driver of business costs - is running around half what it is in the US.
- The Fed risks overtightening and causing a serious recession in the US and there is no logical reason why the RBA should do the same. But taking the cash rate to 4.15% by mid next year, as the money market is assuming, may knock home prices down by 30% and put the economy into a recession we don’t have to have.
In short, the combination of Australian households being far more vulnerable and hence responsive to rising rates than US households, lower inflation pressures in Australia and a desire to avoid overtightening means that RBA should not raise rates as aggressively as the Fed.
The main argument for following the Fed is that if the RBA doesn’t, the $A might crash - but the whole point of floating the dollar was to get an independent monetary policy. And we have seen this in recent times with RBA hikes in 2009-10 (but no move by the Fed) and Fed hikes in 2015-18 (but the RBA still cutting rates). Of course, if the $A crashes to say $US0.50 and brings Australian inflation up to US levels then it may be harder for the RBA – but it’s also worth noting that strong commodity prices are providing a bit of an offset to the negative $A impact of the Fed hiking more than the RBA. If the $A does crash though, it will probably be in a period of immense global stress and plunging commodity prices, where it would make more sense for the RBA to let it go as it did in the GFC and early in the pandemic when it fell to $US0.60 or below.
Overall, we think the RBA should scale back its hike to 0.25% at its October meeting, but it’s starting to feel like another 0.5% is on the way. A 0.4% hike might be a nice compromise!
ABS Monthly CPI Indicator to show a further rise in Australian inflation. The ABS has decided to bring forward the release of its monthly CPI Indicator to 29 September, with data for July and August. As at June, it had already increased to 6.8%yoy. Based partly on the already released Melbourne Institute’s Inflation Gauge showing a sharp rise in July and some fall back in August, we expect it to show that monthly inflation rose to 7.8%yoy in July and fell back to around 7.1%yoy in August. Note that this volatility is partly due to the base effect of a strong rise in August last year. Caution should be applied in interpreting it, at least initially, as: it only updates around two thirds of CPI items and will be subject to revisions; it will be very volatile month to month; and there will be no trimmed mean or median initially making it hard to assess underlying pressures. The RBA has indicated that it could take time for reliable trends to be discerned and reflecting this, Deputy Governor Bullock has noted that it’s “unlikely” to have much impact on the October rates decision. But a big move either way may be hard to ignore and could impact market volatility.
Australian fuel excise cut to end Wednesday, adding 25 cents a litre to petrol prices. The fuel excise cut in March made political sense ahead of the election, but was of dubious merit economically – it would have been better to use the $3bn it cost to provide direct help to low and middle income earners and it doesn’t appear, until recently, to have led to fuel prices substantially lower than what otherwise would have been the case. See the next chart. In the interest of the budget and sending a long-term message to motorists to switch away from using petrol, it makes sense that it ends on schedule. The reversal of the cut will push average petrol prices up to around $1.90 a litre. Some service stations look to have already started to anticipate this and fortunately, global oil prices have been falling and so this may offset some of the impact.
Russia doubling down on Ukraine after Ukraine’s successes. We noted last week that Ukraine’s recent successes in retaking its territory could be a false dawn, as Putin could double down - and this looks to be the way he is going with a partial mobilisation which would see as many as 300,000 reservists called up, “referenda” in occupied territory aimed at annexing them as part of Russia and a reiteration of his nuclear threat. The former would amount to a major escalation and annexing could see Russia claim that any attempt by Ukraine to regain such territory is an attack on Russia. Of course, conscription comes with more risk of a backlash, but at this stage short of a change in the Russian leadership, this conflict unfortunately has a long way to go yet.
New global COVID cases and deaths are continuing to trend down. This includes in Australia. Cases in China are low and trending down, but the risk of more lockdowns remains high.
Economic activity trackers
Our Australian, US and European Economic Activity Trackers were little changed in the last week. Overall, they continue to suggest that while some momentum has been lost after the recovery from the pandemic, economic activity is holding up reasonably well so far – but this likely reflects the usual lags from monetary tightening.
Major global economic events and implications
September composite business conditions PMIs were mixed – down in Europe and the UK but up in the US.
Pricing indications from the PMI surveys were mixed with input and output prices up in Europe on their energy price surge but down further in US with delivery times improving further.
US data releases over the last week focussed on housing and it was weak. Housing starts rebounded by a greater than expected 12% in August but the trend is likely to remain down with permits to build new homes down 10% and home builders conditions and existing home sales continuing to fall. More broadly, the US leading index is sending a recession signal. Jobless claims still remain low, but jobs are a lagging indicator.
Canada saw some good news with a bigger than expected fall in inflation in August, but with the underlying measures still running at an average 5.2%yoy the BoC is likely to remain hawkish for a bit longer yet.
Eurozone consumer sentiment fell to a new low in September which doesn’t augur well for spending. Meanwhile German producer price inflation surged to 46%yoy reflecting energy pressures which will help keep the ECB hawkish.
A large UK package of tax cuts for mainly high-income earners and companies (amounting to 1% of GDP) and deregulation may have some supply side merit but that takes a long time to pay off and with the economy lacking spare capacity just risks adding to inflation and pressure on the BoE to hike by more. Hence UK bond yields spiked with a sense of panic about the UK fiscal outlook pushing the pound to a 37-year low.
The Bank of Japan left monetary policy ultra easy. While CPI inflation picked up to 3%yoy in August, core (ex food and energy) inflation is still just 0.7%yoy suggesting that once the food and energy price surge subsides inflation will likely still be left well below the 2% target.
Australian economic events and implications
In Australia, business PMIs rose slightly in September suggesting conditions remain okay for now. Meanwhile, work backlogs have fallen, delivery times have improved and price pressures have eased albeit they are still high.
Population growth rebounded to 0.9% over the year to the March quarter reflecting the return of net immigration. Net immigration rose to 96,000 people in the March after being negative through 2020-21. Monthly arrivals data points to a further pick up. Population growth was strongest in Queensland thanks to interstate migration but NSW and Victoria are picking up reflecting the return of immigrants.
Good news – the 2021-22 budget deficit is likely to be $50bn better than expected in March. But don’t assume a similar improvement across the forward estimates. It’s been known since before the election that based on monthly budget data the last financial year’s deficit would be far smaller than predicted in March thanks to a combination of soaring corporate tax (with high commodity prices) and personal tax (with the strong jobs market), lower welfare payments and delays in some spending. This means the 2021-22 deficit will be around $30bn (far below the $80bn projected in March or the $99bn projected in December). Normally this would flow through to subsequent years deficit projections but the flow through this time will likely be limited as: commodity prices will fall back at some point; unemployment will rise as the economy slows; some of the delayed 2021-22 spending will be pushed into this year; structural pressures from health, aged care, the NDIS, defence and debt interest costs will boost spending in future years; and a likely lower long term productivity growth assumption will lead to lower long term revenue assumptions.
REIA data for the June qtr shows a sharp fall in rental vacancy rates in Sydney and Melbourne & continuing low vacancy rates in other capitals. Melbourne is still high but monthly data points to a further fall. This in turn is contributing to rapid growth in rents.
What to watch over the next week?
In the US, expect a continued rise in underlying durable goods orders, a small rise in consumer confidence but a slowing in home price gains and a fall in new home sales (all due Tuesday) and sluggish August growth in personal spending (Friday). Core personal consumption deflator inflation for August (Friday) is expected to show a rise to 4.8%yoy but remain well down from its February high of 5.3%yoy.
Eurozone data is likely to show a further fall in economic confidence (Thursday) and flat unemployment at 6.6% but another rise in CPI inflation to 9.7%yoy with core inflation rising to 4.9%yoy (both Friday).
Italy’s election on 25th September is likely to see a right-wing victory with dominance by the populist Brothers of Italy. Its unlikely to threaten Italy’s membership of the Euro as Italian support for the Euro is running around 71% which is similar to that in the rest of Europe. It risks weakening Europe’s response to Russia over Ukraine though and could lead to future budget conflicts with the European Commission and upwards pressure on Italian bond yields although this may be limited by European fiscal and monetary incentives.
Japan’s unemployment rate is expected to have fallen to 2.5% in August with industrial production showing another small gain (both due Friday).
Chinese business conditions PMIs for September (Friday) are likely to have remained subdued.
In Australia, the main focus is likely to be on new monthly ABS CPI inflation data for July and August on Thursday, whereas noted earlier we expect a further acceleration to 7.8%yoy in July and 7.1%yoy in August, which cutting through the noise will be consistent with expectations for a further rise in inflation into year end. In other data, retail sales (Wednesday) are likely to rise just 0.1% in August after a 1.3% surge in July, August job vacancy data (Thursday) is likely to show that vacancies remain very strong but that their pace of growth is slowing and private credit data for August (Friday) is likely to show some further loss of momentum in housing credit.
Outlook for investment markets
Shares remain at high risk of further falls in the months ahead as central banks continue to tighten, 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 likely at or close to peaking 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% top to bottom into the second half of next year as poor affordability & rising mortgage rates impact. This assumes the cash rate tops out below 3% but if it rises above 4% as the money market is assuming then home prices will likely fall 30%.
Cash and bank deposit returns remain low but are improving as RBA cash rate increases flow through.
The $A is likely to remain at risk of further falls in the short term as global uncertainties persist and as the RBA remains a bit less hawkish than the Fed. However, a rising trend in the $A is likely over the medium term as commodity prices ultimately remain in a super cycle bull market.
Subscribe below to Oliver's Insights to receive my latest articlesShane Oliver, Head of Investment Strategy & Chief Economist
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