Investment markets

Global shares fell over the past week amidst a long worry list including the US debt ceiling, the impact of power shortages on global inflation and growth and rising bond yields. This saw Australian shares fall too with health, IT and property stocks leading the decline. As a result September lived up to its name of being a bad month for shares with the month seeing US shares down -4.8%, global shares down -3.8% and Australian shares down -2.7%. Bond yields continued to rise not helped by rising inflation fears. Oil prices rose, iron ore prices were mixed and metal prices fell. The $A fell as the $US rose.

A long worry list for shares that may take a little while to resolve. Looking at the main worries in turn:

• While a US Government shutdown has been avoided, the US debt ceiling needs to be lifted by around 18th October (to avoid the US Government defaulting on its spending commitments) – this may be a white knuckle ride up until the deadline but neither side wants to be seen as responsible for a US Government default and the Democrats can ultimately raise it as part of the budget reconciliation process (requiring only their 50 Senators plus VP Harris). But a share market riot (which would impact Australian shares) may be needed to get this resolved.
• The US Government’s $550 billion infrastructure spending and $3.5 trillion Build Back Better spending packages – to get the debt ceiling resolved via reconciliation it will require a cut back in the size of President Biden’s spending plans in order to get moderate Democrat support. Democrat progressives seem to have become the Democrat’s version of the Tea Party but ultimately a compromise between progressives & moderates is likely in order to see all of the plans avoid total defeat.
• US tax hikes – the share market is not currently focussed on these, but will as they come into view. It’s likely that to get the reconciliation bill passed they will be scaled back.
• Fed Chair Powell’s renomination – worries around this rose with the trading controversy involving some Fed Presidents and as US Senator Warren criticised Powell. But Powell commands broad support in Congress and will likely be seen by Biden as a less risky option. Failing that its likely to be Lael Brainard who is more dovish than Powell.
• The energy crisis in Europe & China – is adding to supply bottlenecks and stagflationary pressures. In Europe it’s about Russia restricting its gas exports (for political reasons and to rebuild stocks) and in China it’s about power outages (mainly reflecting carbon emission controls and a shortage of coal). Both will raise prices and cut growth. However, both can be resolved politically as pressure builds.
• China Evergrande is yet to be resolved – but Evergrande is not big enough to threaten a Lehman’s moment (it may account for 5% of China’s $US bonds but it’s only 0.1% of Chinese bank debt) and as we noted last week a restructure is most likely. Evergrande shareholders and management are unlikely to be bailed out but suppliers and homebuyers are likely to be protected to limit the damage to the economy.
• Rising bond yields – providing they reflect stronger growth and not a permanent inflation surge they should be okay for shares. But too rapid a rise can create indigestion & ongoing supply constraints risk keeping inflation up for longer.

In short, the risk of a more severe correction reflecting these worries remains high – particularly with seasonal weakness for share markets running into mid-October in the US and into November in Australia. So far from their recent highs US and global shares are down about -5% and Australian shares are down about -6%. Being highly sensitive to the global growth cycle the Australian share market is more vulnerable to some of these worries than US shares are. However, ultimately we see the issues being resolved in a way that does not severely threaten global growth and so with global monetary policy likely to remain relatively easy for some time we continue to see the broader trend in shares remaining up. Reopening in the months ahead will also help local shares.

German election – more of the same or easier fiscal policy. The German election saw the Social Democrats win more votes (25.7%) than the governing CDU/CSU (24.1%). Coalition talks are now underway and may take a while with the most likely outcome being an SDP/Green/FDP coalition or failing that a coalition between the Social Democrats and Christian Democrats. The former means easier than otherwise fiscal policy but with the FDP constraining less business-friendly Green policies and both mean ongoing support for the Eurozone. So its likely either a positive for shares or neutral. While the decline of the centrist establishment parties continued it has not been to the benefit of populists with the far right AFD and the far left seeing a decline in support at this election.

Japan’s new PM Fumio Kishida is likely to see more fiscal stimulus. Additional fiscal stimulus was a key part of Kishida’s policy proposals going into the LDP election and is likely to be announced ahead of the lower house election later this year.

Coronavirus update

New global coronavirus cases are continuing to trend down with most regions seeing a flat or falling trend. This includes the US where new cases in the South and West are continuing to fall. The decline in new cases in South America and Africa suggests Delta may not have been as contagious as first estimated.

Meanwhile vaccines are continuing help prevent serious illness. Hospitalisations and deaths remain relatively subdued compared to previous waves in Europe and the UK. Deaths in the UK (red line in the next chart) are running less than 20% below what might have been expected on the basis of the last wave (dashed line). And Israel is seeing a slowing in new cases, hospitalisations and deaths, helped by booster shots.

47% of people globally and 72% in developed countries have now had at least one dose of vaccine.

The key risks to watch out for are:

• a renewed spike in cases in developed countries into the northern winter as recently seen in Israel and Singapore which highlights the need for very high vaccination rates, booster shots and possibly some ongoing restrictions to prevent too many getting coronavirus at once;
• the low coverage in poor countries; and
• the risk of more deadly/more transmissible mutations.

While new cases are falling in NSW, they have surged in Victoria risking a delay in reopening and new cases are threatening a snap lockdown in Queensland.

The good news is that 63% of Australia’s whole population has now had at least one vaccine dose and in NSW its now 70%. The next chart shows a projection of when NSW, Victoria and Australia will meet adult vaccination targets for one dose based on an extrapolation of vaccination rates seen in the last 7 days. For first doses, NSW is through 80% and will reach 90% around 7th October, Victoria is now through 80% and Australia is through 70% & will reach 80% on 5th October.

On the basis of this projection the following table shows roughly when double dose vaccination target dates will be met based on the current lag between 1st and 2nd doses. NSW will hit the 70% of adults target around 5th October, Victoria around 29th October and Australia on average around 24th October. At the current rate Australia could hit 80% of the whole population fully vaccinated by 17th December – which is nearer to what we should ideally be aiming for, given the risks.

NSW is on track to “start” reopening on 11th October, Victoria in late October/early November (cases permitting) and the ACT (not shown) by mid-October. However, as the experience in Singapore (that has seen new cases surge to around 2000 a day) and Israel has shown, the key is that the reopening is gradual until even higher vaccination rates are met and so new cases can be spread over time so as to avoid a sudden surge which overwhelms the hospital system necessitating a return to tougher restrictions which would result in a setback for the economy.

Vaccination is continuing to help keep serious illness down. Coronavirus case data for NSW shows that the fully vaccinated make up a low proportion of hospitalisations. While 11% of covid deaths occurring amongst fully vaccinated people may seem concerning just bear in mind that about 80% of those most vulnerable to die from coronavirus are fully vaccinated.

The level of deaths (the red line in the next chart) is running at around 20% of the level predicted on the basis of the previous wave (dashed line). That means the vaccines are helping save roughly 50 lives a day at present.

Economic activity trackers

Our Australian Economic Activity Tracker remains well down from its June high, but its continuing to edge higher partly reflecting regional lockdowns being eased, suggesting that Australian economic activity has probably bottomed. Assuming of course that there are no further major state lockdowns. Expect the recovery to gather some pace as the economy is gradually reopened through this quarter. However, given the likelihood of high coronavirus numbers through the reopening and only the vaccinated being able to initially participate in reopening in currently locked down states, this recovery will likely be far more gradual than was the case following last year’s lockdowns. Our US and European Economic Activity Trackers have held at reasonable levels.

Major global economic events and implications

US economic data was mixed. Consumer confidence fell and initial jobless claims rose but durable goods orders remain in a solid rising trend, pending home sales surged and home prices rose 1.6%mom to be up 20%yoy.

Eurozone economic confidence surprisingly rose in September and remains around record levels and unemployment fell in August to 7.5%.

Japanese industrial production and retail sales fell in August not helped by the state of emergency, but the unemployment rate was unchanged at 2.8% and the September quarter Tankan business conditions indexes improved slightly.

China’s official composite business conditions PMI rose with services up as coronavirus restrictions were relaxed but manufacturing was mixed with the official manufacturing PMI down slightly and the Caixin version up slightly.

Australian economic events and implications

Australian economic data was mostly solid. Retail sales fell another 1.7% in August and are on track for a 5% fall in the September quarter or slightly more in real terms which when combined with a bigger fall in services consumption is consistent with our expectation for a 4% lockdown driven fall in September quarter GDP. However, other data was reasonably solid. Job vacancies fell nearly 10% over the three months to August but are 46% up on pre-pandemic levels, are high relative to the labour force and have been far more resilient than in last year’s lockdowns which is positive for the post lockdown labour market. Home building approvals rose in August and while well down from their HomeBuilder subsidy high point they remain historically high and point to solid home building for the remainder of this year. Credit growth was stronger than expected with annualised growth in housing credit remaining above 7%. While housing finance fell -4.3% in August with owner occupier finance down but investor finance up this is consistent with the slowdown in sales in lockdown impacted Victoria and to a lesser extent NSW and its likely to rebound once lockdowns end. What’s more housing finance remains near record highs pointing to continued solid credit growth. Meanwhile first home buyers are continuing to lose out again relative to investors. Finally, national average dwelling prices rose another 1.5% in September leaving them up 20.3% on a year ago which is their fastest annual pace since 1989.

Macro prudential controls to slow housing are on the way. Housing credit growth is now running well above underlying household income growth and more than 20% of new loans are going to borrowers with debt-to-income ratios in excess of 6 times. With financial regulators now expressing concern about rising household leverage and set to release a paper outlining various options on lending restrictions in the next two months – we expect macro prudential controls to be introduced by year end. These are likely to focus on limitations on high debt to income and high loan to valuation ratio loans and on interest rate serviceability buffers. We expect that this along with worsening affordability and a return to more normal listings will contribute to a slowing in home price growth to 7% next year from 21% this year.

Lower Budget deficit for 2020-21, higher for 2021-22? Thanks to a strong jobs market and higher iron ore price the final Federal budget deficit for 2020-21 came in at $134bn, which is good news because its $27bn lower than forecast in the May Budget. Unfortunately, it’s history now as Covid Disaster Payments will cost more than $20bn and the jobs market has taken a hit due to lockdowns and we may see some pre-election spending. So the deficit this financial year could come in at $120bn or more, which would be above the $107bn deficit projected in the May Budget.

What to watch over the next week?

In the US, the focus will likely remain on the politics around increasing the debt ceiling. On the data front September jobs data (Friday) will be a key input into when the Fed starts tapering in November – market expectations are for a 500,000 gain in payrolls after August’s slower than expected rise and unemployment is likely to fall further to 5.1%. Meanwhile, the ISM services conditions index (Tuesday) is expected to fall back slightly but to a still strong level of around 60.

In New Zealand, its likely the RBNZ will follow through with its hawkish bias to raise interest rates on Wednesday after having delayed hiking last month due to the lockdown.

In Australia, the RBA’s board meeting (Tuesday) is likely to be pretty boring – with bond buying locked in at the rate of $4billion a week out to February at the Bank’s last meeting and the RBA likely to reiterate yet again that it does not expect the conditions for a rate hike – namely actual inflation sustainably in the 2 to 3% target range which will likely require wages growth of 3% at least – to be met before 2024. There has been no significant changes to the economic outlook since the last meeting to suggest any changes from the RBA. On the data front expect a fall in the August trade balance (Tuesday) and weekly payroll employment data will be released Thursday).

Outlook for investment markets

Shares remain vulnerable to short-term volatility with possible triggers being coronavirus, global supply constraints & the inflation scare, less dovish central banks, likely US tax hikes and the debt ceiling standoff and the slowing Chinese economy. But looking through the short-term noise, the combination of improving global growth and earnings, vaccines ultimately allowing a more sustained reopening and still low interest rates augurs well for shares over the next 12 months.

Expect the rising trend in bond yields to continue as it becomes clear the global recovery is continuing resulting in capital losses and poor returns from bonds over the next 12 months.

Unlisted commercial property may still see some weakness in retail and office returns but industrial is likely to be strong. Unlisted infrastructure is expected to see solid returns.

Australian home prices look likely to rise by around 21% this year before slowing to around 7% next year, being boosted by ultra-low mortgage rates, economic recovery and FOMO, but expect a progressive slowing in the pace of gains as poor affordability impacts, government home buyer incentives are cut back, listing return to more normal levels, fixed mortgage rates rise, macro prudential tightening kicks in and immigration remains down relative to normal.

Cash and bank deposits are likely to provide poor returns, given the ultra-low cash rate of 0.1%. The setback from coronavirus lockdowns could push the first rate hike back into 2024.
Although the $A could pull back further in response to the latest threats to global and Australian growth and falling iron ore prices, a rising trend is likely 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 $US0.80.