Investment markets and key developments over the past week
The past week saw share markets rebound helped by optimism about a peace deal in Ukraine, a fall back in oil prices, relief that the Fed’s first rate hike was broadly as expected with the Fed seeing the US economy as strong and indications that China will provide more policy stimulus partly to combat covid related lockdowns. This saw strong gains in US, European and Japanese shares. The strong global lead saw Australian shares rise led by strength in IT, financial, telco and health care stocks more than offsetting weakness in resources shares. Bond yields rose on inflation concerns and increased expectations for rate hikes. Oil prices fell on optimism regarding a peace deal and metal and iron ore prices also fell, but all remain above pre-war levels. The $A rose as the $US fell.
Have we seen the low in shares? After a 13% top to bottom plunge US and global shares have rebounded cutting the decline to around 8% from their bull market high. Similarly Australian shares have cut their losses from last year’s bull market high (with the market down 10% to its low in January) to around 5%. Its possible we may have seen the lows, 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 so far the rebound in shares has 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 its still too early to say we have seen the bottom.
Ukraine and Russian peace talks seem to be making some progress, but reports on this are conflicting and they have a way to go yet. With Russia now under immense pressure economically due to sanctions and with no hope of an easy victory in Ukraine and Ukraine under immense pressure from Russia a peace deal is possible based on a neutral Ukraine and Ukraine getting security guarantees. If one is reached markets would see a strong bounce, but if not, things could get a lot worse before they get better. So, Ukraine related risks for investment markets remain high in the short term.
Oil and commodity prices seeing wild swings. After energy and commodity prices initially surged, they have since fallen on demand destruction concerns and hopes for a peace deal. When the dust settles, they are still likely to end up at levels above where they were pre-war, unless the sanctions are quickly removed. But maybe the worst-case scenarios like oil at $US200/barrel plus might be avoided. Out of interest the fall back in world oil prices means Australian petrol prices (E10) should be back around $1.9/litre.
The drumbeat of central bank tightening got louder with the Fed joining in. Its 0.25% hike was well flagged and the Fed was upbeat on the US economy which enabled shares to rally on the hike. However, the Fed was more hawkish than expected signalling another 6 hikes this year and 3-4 next year with the start of quantitative tightening as soon as May, all to bring inflation back under control.
Historically Fed tightening cycles usually end in some sort of crisis (not all of which are the Fed’s making), but it’s very early days yet as monetary policy takes a while to become tight enough to bring on a recession which ends the cyclical bull market in shares (which is probably more of a risk for 2024 than 2022). The progression of rate hikes at every Fed meeting this year along with high inflation and the war in Ukraine add to the risks though which will ensure a continuing volatile and constrained ride.
The Bank of England also raised interest rates for the second time, but its commentary shifted dovish signalling that a further tightening “might be appropriate” which was softened from “likely” in February given the risks to the economy posed by the war. Taiwan’s central bank also raised rates for the first time in this cycle. And another rise in Canadian inflation points to another Bank of Canada rate hike next month.
The RBA does not simply follow the Fed on rates and has diverged several times over the last 15 years, but with our economy now moving in the same direction as the US, albeit with lower inflation, we expect it to start raising rates in June. The fall in unemployment to 4% in February, strong labour market indicators pointing to a further fall to 3.8% by June and probably 3.5% by year end – levels not seen since 1974 – and a plunge in underemployment all point to significant upwards pressure on wages growth. The very tight labour market combined with a steady stream of anecdotes of rising consumer prices all point to RBA rate hikes sooner rather than later. Even the RBA’s minutes now show the RBA seeing the risks for wages growth as skewed to the upside. We are now already at full employment and the RBA will likely have to revise up its inflation and wages forecasts. A May rate hike is possible after a likely blow out inflation report is released for the March quarter but given it will be in the midst of the election campaign the RBA will probably prefer to wait to June. So, June remains our base case.
Covid versus more stimulus in China. Although the numbers are comparatively low (eg, South Korea is seeing around 350,000 case a day) the surge in coronavirus cases in China and associated lockdowns in various cities including Shenzen and parts of Shanghai will put more downwards pressure on Chinese growth and add to global supply concerns. China’s problem is that its vaccines are reportedly not as effective against Omicron and its zero covid policy means it does not have a lot of immunity against Covid. Against this, with Chinese sharemarkets plunging earlier in the week Chinese policy makers responded with a stronger commitment to boost growth and financial markets and address property developers’ risks. The 2020 experience where Chinese growth briefly slumped then rebounded indicates investors should not ignore this.
What would a Russian default mean? Short of a quick removal of sanctions which looks unlikely a default event almost looks inevitable sometime soon. However, short of a key player being heavily geared into Russian debt (like LTCM in 1998) its hard to see a default causing major problems. Investment funds globally are already divesting/writing down the value of their Russian debt (as in many cases it can only be sold at fire sale prices). The risk of financial instability flowing from a default though will be watched closely by central banks which are likely to inject short term liquidity into markets if needed. Argentina has regularly defaulted without major systemic financial problems globally. Of course it will mean that Russia will be frozen out of global debt markets – but then it is anyway.
With Australia’s unemployment rate on the verge of falling to levels not seen since 1974 its worth having a look at the top 3 singles in Australia that year. Alvin Stardust came in at No 1 with My Coo Ca Choo with a 1970s Elvis look. Paper Lace at No 2 really caught my attention though with the anti-war Billy Don’t Be A Hero. By 1974 Australians had seen through the deception and paranoia and had voted for a new Government that quickly pulled out of Vietnam (thankfully for the Vietnamese and those just a bit older than me) but in 1974 the US was still involved. Stevie Wright’s Evie at No 3 is one of my favourites though. Written by Stevie’s former Easy Beat’s bandmembers Harry Vanda and George Young it saw Stevie return to fame. Its one of the best rock songs and comes in three parts.
New global covid cases rose again over the last week, with Asia continuing to see a rise reflecting the later start to the Omicron wave and Europe, including the UK, rising further too. US cases are likely to start rising soon 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 Omicron being less harmful. This is likely to remain the case through the current upswing in new cases as its still reflecting Omicron subvariant BA.2 which is even more transmissible again than the initial Omicron but does not appear to be more harmful. The next chart relates to the UK.
New cases are also rising again in Australia, with all states except the NT in a rising trend. Hospitalisation and deaths are still falling but they lag. The surge in WA reflects its reopening but elsewhere it looks to be 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 if serious illness rates stay subdued relative to Delta as appears likely (as vaccines provide protection and Omicron BA.2 appears to be no more harmful) then a return to economically debilitating restrictions is unlikely. A return to softer measures like indoor mask mandates and a “work from home” advisory is looking more likely though.
57% of the global population is now vaccinated with two doses and 18% have had a booster. In developed countries its 74% and 44%, with Australia at 81% and 48%.
Economic activity trackers
Our Australian Economic Activity Tracker bounced back a bit over the last week as the disruption from flooding receded. Overall, it points to a continuation of economic growth this quarter albeit at a much slower pace than in the December quarter. Our US Economic Activity Tracker pushed a bit lower, but our European Tracker was again surprisingly little changed despite the war.
Major global economic events and implications
US economic data was mostly strong. Manufacturing conditions fell in the New York region but rose strongly in the Philadelphia region. Retail sales rose by less than expected in February, but this was offset by big upwards revision to the previous month. Industrial production growth was solid. Home builder conditions were a bit weaker than expected but were still strong and housing starts saw a strong rise. And jobless claims fell. Price pressures remained high in business surveys and producer price inflation still running at 10%yoy.
A speech by ECB President Lagarde was balanced on the risk to the Eurozone economic outlook from the war and indicated the ECB could develop new instruments to deal with any blow to the transmission of monetary policy from the war.
The Bank of Japan left monetary policy on hold, albeit it sees the war in Ukraine adding to inflation. Japan’s core inflation rate in February was -1%yoy and even adjusting for travel subsidies and lower mobile phone charges is 0.6%yoy.
Chinese data for retail sales, industrial production and investment surprised on the upside in January/February but its now a bit dated given Covid lockdowns. As noted earlier though further policy stimulus is likely to ensure China comes close to its 5.5% growth objective for this year.
Australian economic events and implications
Australian economic data was dominated by the news that employment rose twice as much as expected and that unemployment has already fallen to 4%. Our Jobs Leading Indicator points to more strong jobs growth ahead with a further fall in unemployment.
ABS data confirmed the strong growth in home prices last year, long ago reported by private data providers, with average prices up 23.7%. More timely data points to a sharp slowing with prices falling again in Sydney in March (albeit this may be flood related) and down slightly in Melbourne.
December data showed a further rise in the proportion of high debt to income ratio home loans. This may normally have kicked off more macro prudential tightening but rising interest rates & slowing home prices have likely headed that off.
The 2022-23 Federal Budget on 29 March looks to be about five things: the upcoming election; help for households dealing with cost of living pressures; increased defence spending; the start of spending restraint but not austerity or cuts; and a budget windfall from faster growth which has resulted in increased tax receipts and lower than expected welfare payments. The latter is reflected in the budget deficit running around $13bn lower than expected for the seven months to January which on an annualised basis may mean that 2021-22 deficit may come in around $80bn compared to $99bn in the December MYEFO and the starting point for the 2022-23 deficit is also likely around $20bn below the MYEFO projection of $99bn. Coupled with billions allocated last December as “decisions taken but not yet announced” there is likely to be plenty of scope for extra short term spending and yet still report a faster pace of deficit reduction than back in December. A key focus will be providing relief for welfare recipients and low and middle income households given cost of living pressures and this looks like it will take the form of one-off payments but could come via another extension of the Low and Middle Income Tax Offset and maybe a temporary cut to fuel excise. The latter makes little economic sense whereas a one-off payment will impact fastest without resulting in a permanent boost to spending. The Government’s shift towards stabilising and then reducing debt levels 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%
What to watch over the next week?
In the US, a speech by Fed Chair Powell (Monday) will be watched for more commentary on the tightening cycle, new and pending home sales data (Wednesday and Friday) are likely to rise, underlying durable goods orders (Thursday) are likely to remain in an uptrend and business conditions PMIs for March (also due Thursday) are likely to pull back from strong levels as the war in Ukraine further impacts supply chains.
Eurozone business conditions PMIs (Thursday) are likely to decline from strong levels as the war impacts confidence.
Japanese PMIs (Thursday) are likely to rise from depressed levels reflecting the latest decline in covid cases.
Australian business conditions PMIs (Thursday) are likely to pull back from strong levels reflecting supply constraints not helped by the war. An “appearance” by RBA Gov Lowe at the Walkley Awards (Tuesday) will be watched for clues on interest rates but its hard to see how he can say anything new.
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 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.
Shane Oliver, Head of Investment Strategy & Chief Economist