Investment markets & key developments
Share markets had another volatile week with worries about central bank rate hikes and Chinese covid lockdowns depressing global growth but generally good earnings news. Despite a fall back to March lows US shares managed to find support there and rose slightly for the week but European, Japanese, Chinese and Australian shares fell. The fall in Australian shares was led by sharp falls in IT, resources and health stocks. Global bond yields pulled back a bit from recent highs but they rose further in Australia. Oil prices rose, but metal and iron ore prices fell albeit they remain very high. The $A also fell as the $US continued to rise.
Despite the pull back, the Australian share market remains a relative outperformer – thanks to its high exposure to resources shares and low exposure to tech stocks – being virtually flat year to date compared to falls of 10% in US shares, 12% in European shares and 7% in Japanese shares. While the pullback in commodity prices from overbought levels in the short term may weigh, Australian shares are likely to continue to outperform over the medium term as the commodity super cycle continues and as higher bond yields compared to the pre-covid era weigh on tech stocks.
Our base case for investment markets remains that US, global and Australian recession will be avoided over the next 18 months at least and this will enable share markets to have reasonable returns on a 12-month horizon. However, the past week provided a reminder that short term risks around inflation, rate hikes, the war in Ukraine and Chinese growth remain high which of course saw more volatility in share markets with US shares falling back to their March low and Nasdaq and Chinese shares making a new low.
While investment markets seem to have moved on from worrying too much about the war in Ukraine the risk of escalation remains significant with: Russia cutting Poland and Bulgaria off from its gas as part of a strategy to put more pressure on western Europe and enforce its insistence they pay for gas in roubles; Russia appearing to be trying to destabilise Moldova (via its allies in Transnistria); and Sweden and Finland seriously considering joining NATO which will add to Russian annoyance. Russia is still unlikely to cut gas off from Germany because it needs the revenue, but it may. And in the meantime, Europe appears to be moving towards a ban on Russian oil imports which could put more pressure on oil prices. A Russian war with NATO remains unlikely (given both have nuclear weapons) but signs of an escalation in the war and more restrictions on Russian energy exports could still unnerve investment markets.
Australian inflation blowout sets the scene for the RBA to start rate hikes at its May meeting. While we expected a bad inflation report for the March quarter it turned out far worse than expected:
- headline CPI inflation rose to 5.1%yoy which is the highest since the GST – and if the tax driven boost from the GST is excluded it’s the equal highest inflation rate since 1990;
- the RBA’s preferred measure of underlying inflation – the “trimmed mean” – rose to 3.7%yoy; and
- consistent with this the rise in inflation was broad based and more than just due to the 11%qoq rise in petrol prices with fruit and vegetables, meat and seafoods, soft drinks & juices, pets and pet products, new dwellings, tertiary education and non-durable household products like toilet paper seeing price rises of 5 to 7%qoq.
While Australian inflation is still below the 8.5% in the US and the circa 7% rates in Europe, the UK, Canada and NZ, petrol prices will likely fall back this quarter, in the near-term underlying inflation will likely push higher with eg Coles warning of further significant supermarket inflation ahead.
While much of the surge in inflation owes to pandemic distortions to global supply and goods demand made worse by the war in Ukraine and the recent floods, the RBA has to act for two reasons. First, having a near zero cash rate when unemployment is 4% and inflation is over 5% makes no sense. Second, the experience from the late 1960s and 1970s tells us the longer high inflation persists the more inflation expectations will rise making it even harder to get inflation back down again without engineering a recession. Waiting till after the release of wages data and till after election would have been nice but the stronger broad based surge inflation means the RBA no longer has time on its side and should move now and do so decisively. As a result we expect the RBA to hike rates on Tuesday and to do so by 0.4%. While it’s a close call as to whether the first hike is 0.15% (taking the cash rate to 0.25%) or 0.4% (taking it to 0.5%) as the RBA may prefer a cautious approach initially and to not upset the Government too much given the election we are concerned that a 0.15% hike won’t send a particularly strong signal in terms of its resolve to keep inflation expectations down and so we lean to a 0.4% move on Tuesday. We expect another 0.25% hike in June and now see the cash rate rising to 1.5% by year end.
Moving earlier and faster initially should allow the RBA to slow the pace of rate hikes next year. And through next year the combination of fixed rate borrowers seeing a doubling in their interest rate as their fixed terms come to an end and falling home prices exerting a negative wealth effect will start to do some of the RBA’s work for it.
The good news for central banks is that inflationary pressures may be peaking – as evident in our US Pipeline Inflation Indicator which is continuing to show signs of having peaked. Inflation rates will still be way too high which will keep the Fed and other central banks tightening in the short term. And annual inflation in Australia probably won’t peak until the September quarter. But a peaking in inflation pressures may allow some slowing in the pace of rate hikes from later this year and through next year.
Two things went well for investment markets in the last week. First, US March quarter earnings reports are continuing to surprise on the upside and earnings look on track to rise around 11%yoy which is up from initial expectation for a 4.3%yoy gain. And earnings growth in Europe and Asia is averaging slightly faster.
Second, centrist Emmanuel Macron was returned as French president with 58.5% of the vote which was around 2% ahead of the more recent polls in the second-round runoff with far-right Marine Le Pen. This is positive for continued European integration and European resolve against Russia and a continuation of President Macron’s French economic reform program, depending on June parliamentary elections. Which in turn means it’s a positive outcome for European assets – all things being equal which of course they weren’t in the last week.
In Australia in the 1980s it was pretty hard to avoid the pub rock scene – and even if you didn’t go to a pub the pub rock sound was everywhere. Of course, that sound which defined Australian music had a huge spectrum. At the politically and cosmically conscious end of the spectrum (and often just down the road from me at the Antler) were Midnight Oil. My first Oil’s LP (we didn’t really say vinyl back then) was 10, 9, 8, 7, 6, 5, 4, 3, 2, 1 which was their big break through album but Diesel and Dust was huge peaking at #1 in Australia for six weeks. Their formula of combining great music with thoughtful lyrics around issues such as injustices committed against first Australians with Beds are Burning and asbestos with Blue Sky Mining was a winner. And thankfully they are still going – Rising Seas was released last year.
New global Covid cases were relatively stable at a low level over the last week. Europe (notably Germany) and the US saw a bit of an uptick, but Asia continued to fall.
China has seen some slowing in new covid cases but is continuing to see restrictions, including in Beijing, threatening Chinese growth and commodity prices and adding to global supply chain disruptions. However, Chinese lockdowns are likely to be relatively short and more stimulus looks to be on the way. With the PBOC appearing somewhat reluctant to provide a significant easing – probably given concerns about the falling Reminbi and high debt levels – the focus appears to have shifted fiscal policy with President Xi signalling a step-up in infrastructure spending. Which in turn is likely to help drive a return to strength in commodity prices. So while Australian shares and the $A are a bit vulnerable to lower commodity prices in the near term, their relative outperformance is likely to resume on a 6 to 12 month horizon.
New cases in Australia have continued to trend down, although this may be distorted by recent public holidays and positive testing rates have not had the same fall.
Hospitalisation and death rates generally remain low compared to pre-Omicron waves, but the main risk remains the mutation of a more contagious and more harmful variant in lowly vaccinated poor countries where vaccination rates are only rising very slowly. Whereas 75% of people in developed countries and 84% of Australians have now had two vaccine doses (48% and 52% for boosters) only 27% of those in poor countries have (with just 9% having had a booster).
Economic activity trackers
Our Australian Economic Activity Tracker rebounded in the last week with broad based gains suggesting the economy is continuing to grow at a solid pace. Our European and US Trackers also rose with Europe remaining surprisingly strong.
Major global economic events and implications
While the US economy contracted by 1.4% annualised in the March quarter, underlying growth was strong, and this is not the start of a recession. The fall was driven by trade (which detracted 3.2 percentage points from growth) and inventories (which detracted 0.8 percentage points) but real final domestic demand grew at a solid 3% annualised rate with consumption up 2.7%, business investment up 9.2% and housing up 2.1%. So, a rebound in growth is likely this quarter – including from inventories where the ratio of inventory to sales is low. So, this is unlikely to be the start of a recession and partly also reflects payback from 6.9% annualised growth in the December quarter. Other US data was mixed with falling home sales, flattish consumer confidence but strong home price gains and durable goods orders and a further fall in jobless claims.
52% of US S&P 500 companies have now reported March quarter earnings with 81.5% beating expectations (versus a norm of 76%). Consensus earnings expectations for the quarter have moved up to 7.4%yoy from 4.3% at the start from start of the reporting season. With the average beat running around 7% its likely to end up at around 11%yoy. Energy, materials and industrials are seeing the strongest earnings growth. Key to watch going forward though will be the impact of rising costs.
The German IFO business conditions index surprisingly rose in April driven by stronger expectations. Inflation data for April was mixed – up sharply to 7.8%yoy in Germany but down slightly to 8.3%yoy in Spain. The Swedish central bank started raising rates, moving its cash rate from zero to 0.25%
The Bank of Japan maintained its ultra-easy monetary policy and doubled down on its defence of its yield curve control (YCC) by announcing a daily offer to buy 10-year bonds at 0.25%. It also revised up its core inflation forecasts but only to 0.9% for this year and 1.2% for next, which is still below target. While some seem to be pitching the sliding Yen as “the markets versus the BoJ” it likely now sees the weaker Yen as a path to getting sustainably higher inflation and so will continue with YCC until it gets that. March retail sales and industrial production rose, jobs data was solid with unemployment down slightly and the ratio of jobs to applicants rose slightly.
Australian economic events and implications
Australian inflation data dominated over the last week with the rise in March quarter CPI inflation to 5.1%yoy and producer price inflation accelerating further to 4.9%.
Another big terms of trade boost. Export and import prices surged in the March quarter with export prices up a whopping 18%qoq or 47%yoy on the back of the war in Ukraine and strong demand for iron ore and coal, swamping a 5%qoq rise in import prices. The surge in export prices will lead to another big rise in the terms of trade and a huge boost to national income.
Housing credit growth remains solid at 7.9%yoy, but the monthly pace has slowed a bit reflecting a slowing in lending to owner occupiers. However, credit growth to investors is continuing to pick up and is now at its strongest pace since 2015. Reflecting the earlier record level of housing finance commitments housing credit growth is likely to remain strong for a few months yet. With housing credit growth running well above income growth this would normally concern APRA but its unlikely to do further macro prudential tightening as rising interest rates are already starting to slow the property market down which in turn will lead to a slowing in housing credit.
What to watch over the next week?
In the US, the Fed at its meeting on Wednesday is expected to raise the Fed Funds rate by 0.5% taking it to a range of 0.75-1%. A 0.5% rate hike has been well flagged with Fed Chair Powell saying a 0.5% hike is on the table for May so it will come as no surprise. We also expect the Fed to acknowledge the various threats to the growth outlook but maintain an upbeat outlook with a hawkish bias and signal rate hikes will continue likely taking the Fed Funds rate to above neutral (which is seen by the Fed as being 2.4%) by year end. On the data front expect the ISM business conditions indexes for April (due Monday and Wednesday) and labour market openings data (Tuesday) to remain strong with April jobs data on Friday to show a 400,000 gain in payrolls and unemployment remaining at 3.6%. The March quarter earnings reporting season will also continue with another 164 S&P 500 companies due to report.
Eurozone economic confidence data for April will be released Monday and the unemployment rate for March (Tuesday) is expected to hold at 6.8%.
The Bank of England (Thursday) is expected to raise its key interest rate again by 0.25% taking it to 1%.
In Australia, the RBA is expected to raise the cash rate for the first time since November 2010 on Tuesday, probably by 0.4% although as we noted earlier it’s a close call as to whether it will be just by 0.15%. The latest surge in inflation means that its too high for comfort and while its primarily being driven by supply constraints (due to the pandemic, war and floods) not responding quickly risks seeing inflation expectations rise which will make it harder to get inflation back down again. Acting with resolve to keep inflation down trumps the desire to wait for wages data due on 18th May or till after the election. The RBA is also expected to revise down its unemployment rate forecasts (to 3.75% by June) and revise up its inflation and wages forecasts, and its post meeting statement and quarterly Statement on Monetary Policy (Friday) are expected to be hawkish consistent with further rate hikes ahead. It may also announce the start of quantitative tightening by letting its bond holding run down as bonds mature, albeit that’s not going to have much impact in the near term as only 5% or so of its bond portfolio will mature out to end next year.
On the data front in Australia, CoreLogic data for April (Monday) is expected to show another 0.3% gain in home prices but with prices falling again in Sydney and Melbourne, housing finance for March is expected to fall by 1% but retail sales are expected to rise by 0.8% with March quarter real retail sales up by 1.5% (all Wednesday) and building approvals are likely to fall 15% after rising 43.5% in February with the trade surplus rising to around $8.5bn (both due Thursday).
Outlook for investment markets
Shares are likely to see continued short term 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 12-month horizon as global recovery continues, profit growth slows but remains solid and interest rates rise but not to onerous levels at least for the next year.
Still low yields & a capital loss from a further rise in yields are likely to result in negative returns from bonds.
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 pre-covid levels), 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 average prices falling from mid-year as poor affordability, rising mortgage rates and rising listings impact. Expect a 10 to 15% top to bottom fall in prices from mid-year into 2024 but with a large variation between regions. Sydney and Melbourne prices have likely 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 it should rise as the RBA raises interest rates.
A rising trend in the $A 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