Investment markets and key developments over the past week

Sharemarkets came under renewed downward pressure this week (after a few weeks of rallying). Themes of stagflation risks, heightened recession odds, hawkish central banks and questions as to whether inflation has peaked or not continue to be the main drivers of markets. US shares were down by 2.2% with the tech-heavy Nasdaq down by a similar am. Australian shares are 4% lower (with energy, utilities and healthcare up but financials, real estate and tech declining), Euro shares fell by 1.6%, Japanese shares managed a 0.3% lift and Chinese shares rebounded by 1.8% after the reopening of major cities from lockdown (although parts of Shanghai are now back in lockdown). US 10-year bond yields are back up over 3% and the US dollar was higher again, pushing the $A down to 0.70 USD.

Oil prices bounced around this week but still remain high at over $120 US/barrel which explains why Australian petrol prices are approaching $2/litre despite the halving of the fuel excise in late March. This keeps the weekly petrol bill for a typical Australian household around $70/week, well above its usual levels (see chart below). Gas prices remain high (especially in Australia) and other commodities were mixed this week, with further gains for copper, iron ore and coal but declines in nickel and silver. Grains and wheat prices continued to rise.

Central banks continue to set a hawkish tone that they will do what it takes to bring inflation down which is lifting short-dated bond yields globally. Besides the well publicised 50 basis point hike by the Australian Reserve Bank, a hawkish set of communications from the ECB and an announcement of the end of the asset purchase program, other global central banks are also lifting rates – the Polish central bank lifted interest rates by 75 basis points, the Reserve Bank of India hiked by 50 basis points and the Bank of Thailand indicated future rate hikes.

The market is still grappling with the question as to whether inflation has peaked (in annual terms) or not. Some signs are improving: container freight costs are down 27% from late 2021 levels, fertiliser prices are 30% below March higher, lumber prices are 61% below March levels and metals prices have fallen generally. This is in line with the continued moderation in our inflation pipeline indicator (see chart below).

But, oil prices remain high and agricultural commodities like corn and wheat are at multi year highs. The problem with high commodity price growth is that it impacts all goods because commodities are inputs into everything that is manufactured, produced or extracted. This is reflected in the global food price surge which started late last year (see chart below). High food prices are a big risk for food security in poor countries and increases the chance of social unrest and riots (which has been happening recently, e.g. Sri Lanka and has occurred in the past during times of high food prices e.g. Arab Spring Revolution).

On a lighter note, this week’s “cabbage-gate” situation in Australia saw the price of iceberg lettuce shooting up to $12, with KFC removing lettuce from its burgers in place of cabbage (much better choice in my opinion). This is another reflection of supply disruptions to food (due to flooding) which will take some time to abate. Although I seem to recall that Jamie Oliver said never to use iceberg lettuce (because it offers no flavour) so maybe its not such a bad thing.

In Australia, there was an emergency meeting of ministers to address Australia’s energy crisis where “11 points of action” were agreed. Most of the measures are long-term measures to secure energy supply through the form of a “capacity mechanism” which means the retailers procure energy from various sources (question as to whether coal and gas are included in the mix) and keep it in storage to be used in times of energy shortages. We discuss the major impacts of higher energy prices in this note with the main takeaway that inflation is now likely to reach a higher peak of 7% per annum and will take longer to bring down, because interest rate hikes will have little (if any) impact on energy prices or many other supply disruptions occurring. The next few months will be difficult for consumers with many cost of living issues hitting households at once. Retail spending is expected to soften over coming months.

We have revised down our 2022/early 2023 GDP growth forecasts based on more aggressive near-term RBA interest rate hikes. We now expect GDP growth of 2.7% over the year to December (from 3.5% and well below initial expectations earlier this year of 4.5%) and a further slowing in GDP growth into 2023, with Dec-2023 year on year growth of just 2.4%. We still see home prices falling by 10-15% peak to trough (reaching a bottom in late 2023). The risk is that the RBA decides it is behind the curve and hikes rates more than we expect (and closer to market pricing of a 3.8% cash rate in a years time) which would likely cause a recession.

Coronavirus update

China’s covid situation remains problematic. While new cases have fallen right down (see chart below), pursuing a zero-covid policy means that lockdowns will still be needed from time to time. Parts of Shanghai will now re-enter a lockdown while residents wait get tested, after the city only re-opened in early June. Until mRNA vaccines are utilised more in China (especially in the vulnerable older age group) and increase protection against the many variants of Omicron, lockdowns will continue to hit economic activity.

Economic activity trackers

Our Economic Activity Trackers fell slightly in the US and Australia this week because of lower mobility (in retail and recreation) and a drop in restaurant bookings. Australia’s weekly consumer confidence index also fell, along with consumer credit card spending – a sign that cost of living issues are hurting consumers. Job openings remain high. The Europe Activity Tracker was unchanged, with Spanish activity down due to a fall in retail traffic, Germany activity unchanged and an improvement in France and Italy.

Major global economic events and implications

The European Central Bank meeting didn’t offer too many surprises but the tone for the interest rate outlook was hawkish. The ECB will end its Asset Purchase Programme from 1 July and expects to raise interest rates by 25 basis points in July (this will take the deposit rate to -0.25% but there are three main interest rate policies used in the EU so all three would need to be adjusted higher). The ECB also plans to raise rates again in the September meeting which is now expected to be a 50 basis points hike, which was taken as a hawkish signal that initially sent the Euro higher (but this was later reversed). Another issue for the ECB is the blow-out in peripheral credit spreads which will cause higher borrowing costs for already very indebted countries. The ECB could use the purchase program to bring down credit spreads through purchases of peripheral bonds.

Other Euro data this week included the EU Sentix investor confidence which rose in June but was still negative and well below 2021 levels. Germany activity data remains weak as economic activity continues to be negatively impacted by high inflation. Factory orders fell by 2.7% in April (below estimates of a small rise). Industrial production rose by a moderate 0.7% but is negative on a year ago.

In the US, the April trade balance narrowed in April to a deficit of $87.1bn, mortgage applications fell over the week to 3 June and initial jobless claims over the week to 4 June were slightly higher than expected at 229K. Economic activity is slowing at the margin. US second quarter GDP is expected to be positive after the fall in the March quarter, but the latest forecast from the Atlanta Fed is low at ~0.9% annualised (and this follows a negative first quarter).

The Chinese Caixin May services PMI rose to 41.4, from 36.2 in April (reflecting the lockdown) but this was below expectations. The trade surplus expanded in May as import growth slowed due to less demand related to the lockdown. Producer price growth was 6.4% over the year to May, in line with expectations and consumer price growth was 2.1% over the year to May, much lower compared to developed countries.

In Canada, the Ivey Purchasing Managers Index rose to 72 in May, from 66.3 last month.

Australian economic events and implications

The RBA surprised markets again by lifting the cash rate by 50 basis points to 0.85%. Consensus economists were looking for a 25 basis point increase (we were +40 basis points) and the market was pricing in a 30 basis point rise. The RBA has clearly shifted its thinking and wants to front-load interest rate hikes and keep inflation psychology from becoming entrenched at a permanently elevated rate of inflation. Now, the market is pricing in even more interest rate hikes than before with a 3.8% cash rate expected in a years time.

There is a big risk that the RBA’s new found hawkishness proves too extreme for an economy that will buckle under higher interest rates given the sensitivity of the Australian housing to higher interest rates (because the household debt to income ratio remains at a record high at 186% while in many other countries, households have been deleveraging in recent years (the US household debt to income ratio has fallen to 102% from a peak of 137% in 2007).

The Melbourne Institute monthly inflation gauge showed that the trimmed mean gauge was running at 4.4% over the year to June (see chart below). ANZ May job advertisements rose by a small 0.4% in May and are 17.3% higher compared to a year ago, which signals strong demand for labour. Although, job advertisements do look to be peaking.

What to watch over the next week?

The US May consumer price data (released later tonight) is key to watch for signs of inflation peaking. Consensus expects a 0.7% lift in the monthly index, above the 0.3% recorded last month but below the monthly peak of 1.2% in March. Annual growth is expected to decline moderately to 8.2%. Core prices are expected to lift by 0.5% with annual growth slowing to 5.9%. More signs of inflation peaking will be a positive tailwind for equities. The University of Michigan Consumer sentiment index (also released tonight) is expected to show some further moderation in current conditions but future expectations to be flat, with both components of the index falling to their lowest levels in more than 10 years. The NFIB small business optimism index should be fairly unchanged in May and has also been trending down, although not as bad as the consumer indices. May producer prices are expected to rise by a solid 0.7% over the month or 10.8% over the year, driven by continued rises in commodity prices. May retail sales are expected to increase by a small 0.2% (well below recent monthly increases) with consumer spending slowing from rising inflation and interest rate hikes. The Federal Reserve is meeting next week (on Wednesday) and is tipped to lift the fed funds rate by 50 basis points from a 0.75%-1% range to 1.25%-1.5%. The market is expecting the fed funds rate to be just under 3% by the end of the year which would imply another few rate hikes of 50 basis points. May housing data is also released, including building permits and housing starts which are both expected to decline in May. The housing market is cooling amidst interest rate rises, some softening in economic activity and high prices of construction materials. However, signs of market undersupply from previous underbuilding suggests residential construction is unlikely to fall too far.

In Australia, the shortened week (thanks to the Queen’s birthday long weekend) the release of the June NAB business survey (on Tuesday) which will include any impact from the Federal election. Labor securing a majority in the election (versus concerns about a minority government) should be positive for confidence and Labor’s policies are unlikely to have major negative impacts on businesses although the uncertain macro environment with rising interest rates and high inflation could weigh on confidence this month. The ABS home price index (released on Tuesday) is expected to show a 2% rise in Australian residential property prices, based on the monthly outcomes of the CoreLogic home price data. The June Westpac/Melbourne Institute index is released on Wednesday and is at its weakest level since 2011 (not withstanding the initial Covid-related falls at the time of lockdowns) reflecting the big fall in real wages and multiple cost of living concerns. The May labour force data is expected to show a rebound in employment (up by 40K), with the participation rate expected to lift to 66.4% and the unemployment rate to decline to 3.8%, from 3.9% last month.

Economic data releases in Europe include April industrial production which could show further weakness given the tough environment of high inflation and commodity prices, the June ZEW survey of expectations, trade data for April and construction output for April.

The UK Bank of England meet next week and are expected to lift the bank rate, most likely by 50 basis points which would take interest rates to 1.50% (after an interest rate hike in May). May retail sales data is also released and is likely to remain weak (it is currently running at -4.9% on a year ago) due to high inflation and interest rate increases.

The Bank of Japan meeting should see the central bank maintain current interest rate settings. The BoJ has been defending its yield target and indicating that no changes to interest rates are likely for now, given the deflation problems Japan has been facing in recent years.

In China, credit data is due which will be a sign of the impulse from fiscal stimulus, the People’s Bank of China could cut the 1-year lending facility rate by 10 basis points to 2.75% to help economic activity, industrial production is likely to be negative over the year to May, retail sales are expected to be down by 7% over the year go May and property investment is also likely to be negative on a year ago given the recent lockdowns. Fixed asset investment data is also due and May along with home sales figures.

In Canada, May employment data is expected to show another decent lift in jobs (+28K) and an unchanged unemployment rate at 5.2%.May housing data is also released including starts and existing home sales.

Outlook for markets

Shares are likely to see continued short term volatility as central banks continue to tighten to combat high inflation, the war in Ukraine continues and fears of recession remain. However, we see shares providing reasonable returns on a 6-12 month horizon as global recovery ultimately continues, profit growth slows but remains solid and interest rates rise but not to onerous levels.

Still relatively low yields & the risk of a further rise in bond yields points to constrained 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 prices are expected to fall further as poor affordability and rising mortgage rates impact. Expect a 10 to 15% top to bottom fall in prices over the next 18 months but with a large variation between regions. Sydney and Melbourne prices are already falling.

Cash and bank deposits are likely to provide poor returns, given the still low cash rate of just 0.35% at present but they should improve as the RBA raises interest rates further.

The $A could remain volatile in the short term as global uncertainties persist. However, 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.