Investment markets and key developments over the past week

Share markets mostly rose over the last week helped by good earnings and dovish central banks. US, European and Japanese shares rose but Chinese shares fell. Helped by the positive global lead and a dovish RBA the Australian share market also rose making a new recovery high with very strong gains in materials, energy and financial stocks. While the ASX200 has worked off technically overbought conditions after its early April surge, it’s now just 1% or so below its all-time high from February last year with a good chance of bursting through to a new record high soon. Bond yields fell, but oil, metal and iron ore prices rose with the latter reaching a new record high. The $A rose as the $US fell.

Inflation is on the up globally but its likely to be a confusing picture over the next few years, against the backdrop of a likely bottoming of the long-term decline in inflation seen over the last forty years. The pick-up in inflation pressures is most evident in the US with consumer price inflation on the rise, various business surveys pointing to sharply higher input and output prices and wages growth moving up. The key drivers are: base effects as last year’s deflation drops out of annual calculations (eg, US consumer prices fell -1.1% over the three months to May last year and Australian consumer prices fell -1.9% in the June quarter last year); higher commodity prices as stimulus measures have focussed on construction activity – notably in China; and goods supply bottlenecks as a result of a cut to production in the pandemic and then consumers switching spending to goods from services due to distancing restrictions at a time when industrial production is still depressed and so inventories are depleted. Wages growth is also being pushed up in the US as extended unemployment benefits out to September are discouraging workforce participation. Combined this will see headline inflation measures spike higher in the months ahead – probably towards 4% or more in the US (and in Australia too albeit less so in Europe and Japan). With this will come the risk of a renewed bond market tantrum as investors worry that central banks will not be able to control inflation.

Later in the year though annual inflation is likely to subside again as: the base effects will reverse (with, eg, a +1.4% rise in US consumer prices over the three months to August last year and a +1.6% rise in the CPI in Australia in the September quarter last year dropping out); industrial production will pick up in response to the surge in prices thereby boost supply and depressing prices; consumer spending will gradually rotate back to services and away from goods; some sectors like traditional retailing, corporate travel and CBD services will see a longer lasting hit to jobs from the pandemic; and in the US the ending of enhanced unemployment benefits will push more workers back into the workforce. So, inflation is likely to fall back again. This partly explains why central banks are reluctant to rush into rate hikes at present. The likely fall back in inflation later this year combined with central banks remaining dovish will mean that any near-term bond market panic and hit to share markets are likely to be short lived.

Longer term though its likely we are now going through the bottoming of the long-term decline in inflation that has been in place since the early 1980s as bigger government and ultra easy central banks focussed on pushing unemployment as low as it can go to get inflation up, a reversal in globalisation and a decline in workers relative to consumers results in higher inflation on a more sustained basis. This is ultimately what central banks are aiming for and they naturally worry that if they raise rates prematurely in response to what will likely be a short-term inflation spike in the next few months will just risk a downturn in 2022 which will just set back their longer-term desire to get inflation up and further damage their credibility. Albeit this will take several years to play out and the question is whether it results in inflation ultimately averaging around target or something higher. Our base case is the former, although the risks are possibly swinging to the latter.

While the Bank of England has followed the Bank of Canada in slowing bond purchases in response to stronger growth forecasts, rate hikes remain a fair way off and while other central banks will follow, it’s at least six months or so away in the US with various Fed officials making dovish comments over the last week.

While the RBA in its quarterly Statement on Monetary Policy upgraded its growth forecasts to 4.75% for this year and now sees unemployment at 4.5% by the end of next year it continues to see only a modest and gradual pick up in underlying inflation and wages growth to just 2.25% and 2% for mid-2023 respectively and therefore still doesn’t see the conditions for rate hikes being in place until 2024 at the earliest. The combination of its own forecasts and ongoing dovishness indicate that the RBA is determined to find out how low it can push unemployment before inflation rises sustainably to within the target range and that it (rightly in my view) suspects the NAIRU may have a 3 in front of it rather than a 4 (as Governor Lowe has admitted is possible).

Our view remains that share markets will head even higher this year as recovery continues, this boost earnings and monetary policy remains easy, albeit with some tapering in bond buying along the way. However, investor sentiment is very bullish which is negative from a contrarian perspective and we are coming into a seasonally softer period of the year for shares. A resumption of the bond tantrum as US inflation rises further in the months ahead, US tax hike concerns if Congress does not pare back some of Biden’s tax hikes, coronavirus setbacks and geopolitical risks (around US/China tensions, Russia and Iran) could all provide a trigger for a correction. It would likely be just another correction though. Our ASX 200 forecast for year-end remains 7200.

The news on coronavirus remained mixed over the last week. Singapore tightened restrictions in response to new local cases, as did NSW also after new local cases with the NZ-NSW travel bubble paused and concerns about the safety of vaccines appears to be impacting take up. However, there are some signs the latest wave in new global coronavirus cases may be rolling over again helped by a continuing downtrend in developed countries, notably the US and Europe and some signs that the rate of growth may be slowing in India (and hence Asia).

Despite the new local cases in NSW, new cases remain low in Australia and mainly amongst returned travellers, but the four-week moving average of new cases is up nearly three-fold over the two months – highlighting the increased risk of breakouts from the returned traveller quarantine system.

Meanwhile the vaccine rollout continues, and they continue to work. 8% of the global population has now received one dose of vaccine, with 6% in emerging countries. Within developed countries the UK is at 53%, the US is at 45%, Europe is at 26% and Australia is at 10%. Fortunately, at risk groups are getting rapidly vaccinated now in Australia, eg, nearly 80% of those in aged or disability care have had at least one dose.

The decline in new cases, deaths and hospitalisations in Israel, the UK and the US indicate that the vaccines work. So far young people have not been getting vaccinated (so perhaps the herd immunity line should be lower in the previous chart), but this may be starting to change with countries starting to approve vaccines for younger people. Moderna has also released trial results showing its booster shots bolster antibodies against mutant strains. And while it needs to be managed carefully to avoid resulting in reduced incentives (perhaps via compensation for drug companies) government plans (including by the US) to waive vaccine patents will help speed the rollout of vaccines globally.

Our Australian Economic Activity Tracker rose over the last week and remains very strong suggesting recovery remains on track, despite periodic lockdowns. Our US Economic Activity Tracker fell slightly but is running only just below pre coronavirus levels and our European tracker rose again but remains very weak.

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Major global economic events and implications

US data remains strong. ISM business conditions indexes fell back in April, but they remain very strong as does jobs data. Strong demand at the same time as higher raw material costs and supply chain bottlenecks are continuing to boost inflation pressures though with the ISM prices paid indexes at their highest since 2008. While Treasury Secretary Yellen stated the obvious in saying interest rates may have to rise to prevent overheating, she subsequently clarified that this was not a forecast and numerous Fed officials downplayed the risk of overheating and indicated that there is a long way to go to meet the Fed’s goals.

The US March quarter earnings reporting season has remained very strong and is now nearly 90% complete. 87% of companies to have reported so far have beaten earnings expectations by an average +24% and 71% have beaten revenue expectations. Consensus earnings expectations for the quarter have now risen to +44% year on year, from +23% two weeks ago.

Japanese annual wages growth turned positive in March for the first time in 18 months – but only to +0.2%yoy.

China’s Caixin business conditions PMIs rose in April with the composite at a solid 54.7, suggesting growth is strong and the better performance relative to the official PMIs suggesting that small companies may be doing better than large.

Australian economic events and implications

Australian data remained strong with booming home prices, housing finance and building approvals along with very strong business conditions PMIs, surging job ads, a sharp jump in vehicle sales and the MI Inflation Gauge showing a pick-up in inflation pressure.

While home price growth slowed a bit in April it remains very strong with record high housing finance commitments and still very strong auction clearance rates on the back of ultra-low mortgage rates, government incentives and economic recovery pointing to further gains ahead.

However, the pace of home price gains is likely to slow from 15% this year to 5% next year and then to a likely modest fall in prices in 2023 as incentives are wound back, fixed mortgage rates head higher, the RBA and APRA move to tighten lending standards sometime in the next six months and the surge in building approvals at a time of collapsed population growth leads over the next couple of years to an oversupply of property relative to underlying demand.

What to watch over the next week?

In the US, the focus is likely to be on CPI data for April (Wednesday) which is expected to show a sharp rise to 3.6% year on year for headline inflation and a rise to 2.3%yoy for core inflation as year ago deflation drops out and higher commodity prices along with goods supply bottlenecks impact. Producer price inflation (Thursday) is also likely to show a further acceleration. Job openings and small business optimism (Tuesday) are expected to show a further improvement, retail sales (Friday) is expected to show a 1% gain after March’s stimulus driven surge and industrial production (also Friday) is expected to rise 1.3%.

Chinese CPI inflation for April (Tuesday) is expected to show a further rise to 1% year on year and producer price inflation is expected to lift to 6.5%yoy. Money supply and credit data will also be released.

In Australia, the main focus will be on the Federal Budget (Tuesday) which is expected to provide further stimulus to help boost the economy with the aim of pushing unemployment below 5%, with fiscal austerity pushed off into the future. Key elements (some of which have already been announced) are likely to include:

• an upgrade to GDP growth forecasts to 4.75% for the next financial year with unemployment expected to fall to 4.75% by June next year;
• extra spending on aged care, childcare, disability and mental health, targeted industry support, climate, infrastructure and skills;
• measures to help boost women’s’ economic security including changes to help women bolster their superannuation balances;
• an extension of the Low and Middle Income Tax Offset (LMITO) to cover the next financial year;
• spending and tax breaks to support the digital economy;
• some possible tax reforms and deregulation;
• a possible lifting of the home price caps for the First Home Loan Deposit Scheme; and
• much lower budget deficits of $155bn this financial year and $65bn next financial year. The faster than expected economic recovery which means lower than expected welfare spending and increased revenue along with the higher iron ore price means that the starting point for the budget deficit is now much lower. However, we are assuming that more conservative Government forecasts, around $15bn in extra stimulus for the next financial year and a desire to leave some scope for surprise in the bag will see deficits of $155bn and $65bn reported on Budget night for this financial year and next.

On the data front in Australia, expect ABS retail sales data (Monday) to confirm the preliminary estimate of a 1.4% gain in March, with real retail sales down -0.4% in the quarter. Weekly payrolls data will also be released on Tuesday.

Outlook for investment markets

Shares remain at risk of further volatility with possible triggers being a resumption of rising bond yields, coronavirus related setbacks, US tax hikes and geopolitical risks. But looking through the inevitable short-term noise, the combination of improving global growth and earnings helped by more stimulus, vaccines and still low interest rates augurs well for shares over the next 12 months.

Australian shares are likely to be relative outperformers helped by: better virus control enabling a stronger recovery in the near term; stronger stimulus; sectors like resources, industrials and financials benefitting from the rebound in growth; and as investors continue to drive a search for yield benefitting the share market as dividends are increased resulting in a 5% grossed up dividend yield. Expect the ASX 200 to end 2021 at a record high of around 7200 although the risk is on the upside.

Still ultra-low yields and a capital loss from rising bond yields are likely to result in negative returns from bonds over the next 12 months.

Unlisted commercial property and infrastructure are ultimately likely to benefit from a resumption of the search for yield but the hit to space demand and hence rents from the virus will continue to weigh on near term returns.

Australian home prices are likely to rise another 15% or so over the next 18 months being boosted by record low mortgage rates, economic recovery and FOMO, but expect a slowing in the pace of gains as government home buyer incentives are cut back, fixed mortgage rates rise, macro prudential tightening kicks in and immigration remains down relative to normal.

Cash and bank deposits are likely to provide very poor returns, given the ultra-low cash rate of just 0.1%.

Although the $A is vulnerable to bouts of uncertainty and RBA bond buying will keep it lower than otherwise, a rising trend is likely to remain over the next 12 months helped by strong commodity prices and a cyclical decline in the US dollar, probably taking the $A up to around $US0.85 by year end.