Investment markets and key developments over the past week

It was a mixed week for markets in terms of the economic data and news flow. US equities started the week strong, but are still down by 0.3% over the week (and ~6% below January highs), European shares had a good rebound up by 0.9% (but are still 11% below January levels), Japanese shares were 1.8% lower, Chinese shares continued to recover up by 2.1% and Australian shares continue to outperform (mainly because of the commodities exposure), up by 1.3% this week and just ~1% below January peaks.

US 10-year yields fell to 2.3% (after getting above 2.5% last week) and 2-year yields lifted to over 2.3% this week. This means that on the 2-10 year yield measure, the US yield curve finally went negative (or inverted) although it was only brief and the 2–10-year spread is now around neutral. As we have written previously, other measures of the yield curve (like the 10-year less fed funds rate) are still upward sloping and rising (see chart below).

While many commentators and central banks are dismissing the yield curve inversion, I think there is still some relevance in its signal such as the risk of an economic downturn (or recession) in the next 12-24 months, a future bear market or a policy mistake by the central banks which means future interest rate cuts. These are all valid concerns to keep in mind for 2023.

Oil price movements have been erratic, but prices fell back down to ~$100/barrel (from ~$113/barrel last week) after US President Biden said the US would release 1 million barrels of oil a day from US reserves for 6 months, which would be the largest release (accounting for 30% of US reserves) taking US oil stockpiles back down to 1984 levels.

Other government measures to force US oil companies to increase output should help to ramp up oil production in the coming months. Other commodity prices like gas, aluminium, nickel, wheat and soybeans have all been moving lower over the past week which is good news for inflation.

The Japanese Yen depreciated to a 7-year low this week (currently at $121USD/JPY) as the Bank of Japan defended its 10-year bond-yield target (which has a cap of 0.25%) as Japanese bond yields have been rising from global inflation pressures. The $A remains a strong performer and was up over $0.74US dollars this week, from $0.71 at the beginning of March.

The US Federal Reserve appears to be coming around to the aggressive market pricing for interest rate hikes this year. US Fed member Harker said that that 50 basis points hikes are not off the table in May/June. The market is pricing in a Fed funds rate over 2% by the end of the year (currently at 0.38%), which means a rate rise at every meeting this year, with at least one of those being a 50-basis point increase.

Coronavirus update

New coronavirus cases are still trending down and new deaths are moving sideways, but are well below deaths in recent waves which shows the lower mortality rate of the Omicron.

New cases in America have been falling a lot since the January peak but are now trending sideways. Europe cases are starting to creep back up again, especially in Italy, France, Portugal, Germany and UK. And China is still having problems in managing the latest Omicron outbreak.

In Australia, cases continue to tick up in Vic, SA, WA and Tas. On a per capita basis, Australian cases are again higher than in Europe, the UK and US (see the chart below).

While for most developed economies, the share of the population who has been vaccinated for Covid-19 has peaked (with 74.2% of developed economies populations fully vaccinated), we need to remember that poorer countries still have a way to go with only 25.9% of emerging countries fully vaccinated. So there is still the risk of more Covid-19 mutations and variants.

Economic activity trackers

This week, our economic activity trackers in the US and Europe improved slightly. In the US, there was a lift in mobility (also reflecting warmer weather), railway freight volumes and higher oil production. In Europe, mobility increased and truck mileage was also higher. The Australian tracker dropped slightly due to lower restaurant bookings, retail traffic and mobility. Our trackers continue to show positive economic activity in the March quarter and less severe disruption to economic activity as Omicron cases rise and fall.

Major global economic events and implications

US President Joe Biden proposed a $5.8trillion budget for 2022/23. The Budget process in the US runs a little differently to Australia. The President requests a budget to Congress, which is then voted on. The slim majority the Democrats hold in Congress means that the initial proposed budget is unlikely to pass as it initially stands (similar to what has been happening with the back and forth on the Build Back Better deal). Nevertheless, the Budget is still important because it sets out the goals and direction of the government. The key priorities for this budget included: a wealth tax on the ultra rich, more funds for the climate and increased defence spending. There was nothing specific about the Build Back Better bill because the Democrats want it to be passed via the reconciliation process, which is separate to the budget.

The US Dallas Fed manufacturing index was down by 5.3 points to an index level of 8.7 in March but other regional manufacturing indices have been stronger. Home price growth remains strong and had a decent lift in January (up by 1.8%) according to the S&P CoreLogic series. Conference Board consumer confidence was up in March to an index level of 107.2.

February job openings were down in February, but are still elevated with the job opening rate (the level of job openings to employment plus job openings) at 7%, a record high and well above the unemployment rate (at 3.8%). The labour market remains very tight which means further upward pressure on wages and a lower unemployment rate.

The February US PCE deflator (one measure of inflation) rose by 0.6%, as expected and annual growth was 6.4%. In core terms, annual growth was at 5.4%, a touch lower than consensus estimates of 5.5% but still very high.

In China, the official manufacturing PMI dropped below 50 in March to 49.5 (a PMI index level below 50 means a contraction in activity), from 50.2 in February. The non-manufacturing PMI fell even more in March to 48.4 from 51.6. The fall in activity relates to the Covid-zero policy in China which results in lockdowns and a stop to activity, adding pressures to shipping delays, port congestions and logistics problems. The non-official Caixin (which reflects small business activity) manufacturing PMI also missed expectations and was down to 48.1 (consensus at 49.9). Further downside in the PMI’s is likely in April.

In Japan, the unemployment rate fell to 2.7% in February (from 2.8% in the prior month). February retail sales were down by 0.8%, missing market expectations of a smaller 0.3% decline. Industrial production rose by a small 0.1% in February. But the Tankan large manufacturing business survey was stronger than expected in the March quarter, up to an index reading of 14 (down from 17 in the prior month).

In Germany, consumer confidence fell more than expected in April with the GfK consumer confidence index down to -15.5, close to its early pandemic low. This is not surprising given the very high rise in German inflation, especially on household gas and fuels. Germany March consumer price data was even stronger than expected, up by 2.5% in March (market was looking for +1.6%). Year-ended inflation is now at 7.3%, the highest level since the early 1980’s. February retail sales rose by a small 0.3%, lower than consensus estimates of a 0.5% lift which reflects the downside pressure on consumer spending power from higher inflation.

Australian economic events and implications

The Federal Government released its 2022/23 Federal Budget which we fully detail in this note. The main takeaways are: a pre-election cash splash worth around 1% of GDP in terms of new stimulus in 2022 which will add further to inflation pressures, a much stronger economic outlook than forecast thanks to higher GDP growth, a lower unemployment rate, higher inflation and wages growth and higher commodity prices, projections for lower budget deficits in coming years. The cost of living measures (including the tax offset to low and middle income earners, the $250 cash payment to pensioners and welfare recipients and the halving of the fuel excise for 6 months) will lift near-term retail sales growth. The small business tax incentives should also be positive for business investment. The oppositions reply to the budget included a focus on lifting wages growth and spending on aged care.

The NAB quarterly business survey showed a fall in confidence in the March quarter (-5 to an index level of 14) and conditions (-5 to an index level of 9) but both are still above average. The war in Ukraine did not have a material impact on the survey (the first half of the survey sample was taken before the invasion and the second half was taken after). Indicators of capacity utilisation, employment and capex all look high. Indicators around price pressures all look elevated (input prices, prices paid, prices received). Firms are still reporting some difficulty around the availability of materials.

Australian retail sales were strong in February, rising by 1.8% because of a big rise in eating out (as Omicron cases were lower in February versus January) but there was also higher spending in other categories like clothing, department stores and household goods which shows that there is still appetite for retail spending despite very strong growth over the past two years. Building approvals surged by 43.5% in February but have been volatile lately because of one-off approvals for large apartment buildings. Job vacancies were up strongly over the quarter to February (+6.9%) indicating further strength in the jobs market. Private sector credit was 0.6% higher in February but housing finance (ex-refinancing) fell by 3.7% in Australia, while consensus was looking for a rise of 1.5%.

Home prices in the capital cities, according to CoreLogic rose by 0.3% in March, with annual growth slowing to 16.3%. Home price growth in the regions was much stronger, up by 1.7% in March or 24.5% on a year ago.

The RBA announced Michele Bullock as the newly appointed deputy RBA Governor (taking over from Guy Debelle). Bullock has been the assistant governor of financial system at the RBA with a focus on financial stability risks. We don’t expect any major shifts in RBA policy from this appointment.

What to watch over the next week?

In Australia, March ANZ job advertisements are likely to show further strength, the Melbourne Institute March inflation gauge will give a guide to March quarter inflation. The April RBA Board meeting could see some more hawkish language adopted from the central bank as it starts to become more comfortable with the idea of hiking interest rates this year. The RBA will detail the key financial risks to households and businesses in Friday’s semi-annual Financial Stability Review. The details around risks to borrowers in housing market will be most interesting. And we think that the February trade balance will decline on January numbers, to around $11bn (from $12.9bn in the prior month) from lower export growth.

In the US, the March jobs data is released tonight. Payrolls are expected to rise by a solid 490K which would push the unemployment rate down to 3.7% (from 3.8%). Employment growth in the US is still not back to its pre-Covid levels. Other US data next week includes the March manufacturing ISM (expected to remain strong at an index level of 59), February factory orders (likely to fall by 0.6%), the February trade balance (consensus looking for a small decline in the trade deficit to $88.6bn) and the FOMC meeting minutes for the March meeting when the Fed raised interest rates for the first time this cycle.

In the Euro area, consumer price data for March is released tonight and is expected to show strong monthly growth of 1.8% or 9.7% higher than a year ago. Core inflation should be much lower at 3.1% over the year. The February producer price index is released later this week and along with February retail sales.

In China, the non-official Caixin services PMI is likely to fall below 50 in March because of the Covid-related lockdowns.

Outlook for 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 result in negative returns from bonds.

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 poor returns, given the ultra-low cash rate of just 0.1% at present but rising through the second half of the year.

Although the $A could fall back a bit in the near term in response to the uncertain outlook, a rising trend is likely over the next 12 months helped by strong commodity prices, probably taking it to around $US0.80.