Investment markets and key developments over the past week

Global share markets mostly rallied over the last week. The big surprise perhaps was the US where shares rallied to a new record high and bond yields fell despite another surge in inflation, because investors (rightly in my view) interpreted the make-up of higher than expected inflation for May as consistent with the Fed’s assessment that the spike in inflation would be transitory. Eurozone and Japanese shares also rose but Chinese shares fell. Australian shares also rose to a new record high led by bond sensitive IT, utility, property and health stocks. Bond yields generally fell on expectations that the Fed will remain dovish and as the ECB committed to an increased rate of bond buying for another quarter. Oil prices continued to rise, and the iron ore price rose, but metal prices fell. The $A rose as the $US fell.

Global inflation readings continued to rise over the last week with producer price inflation accelerating in China and Japan and US inflation surging again in May to 5% year on year with core inflation rising to 3.8%yoy (its highest since 1992). However, our assessment remains that the current spike is likely to be transitory. The key drivers remain base effects as last year’s deflation drops out of annual calculations; higher commodity prices; goods supply bottlenecks as a result of cuts to production in the pandemic and then consumers switching spending to goods from services; and reopening leading to a rebound in some prices.

Looking at the US, just as we saw in April the surge in prices was not broad based. Just five groups with a weight of about 14% in the core CPI accounted for more than 0.4 percentage points of the 0.7% increase in core inflation – including used cars up another 7%, airfares also up another 7% and new cars up 1.6%. All of these groups have been impacted by reopening and/or bottlenecks. The median CPI which provides a better guide to underlying inflation rose just 0.26% in May or 2.1%yoy and indicates the rise in inflation is not broad based.

We remain of the view that the inflation spike will prove temporary as: high inflation numbers a year ago will drop out of annual calculations; industrial production will pick up in response to the surge in prices thereby boosting 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 in September will push more workers back into the workforce. In fact, half of US states are already ending enhanced unemployment benefits. So, inflation is likely to fall back again as bottlenecks and the reopening boost fade. In fact. US core inflation may be close to peaking in year on year terms as high monthly numbers a year ago will start to drop out. It’s also noteworthy that while producer price inflation has surged in China, Japan and Europe the flow on to the consumer price inflation is proving a lot weaker with all running core inflation below 1% year on year.

The continuing US economic recovery and a desire to keep inflation expectations under control will keep the Fed on track to start tapering its bond buying from later this year with the taper talk commencing either in the week ahead or at its July meeting. But with the make-up of the inflation spike consistent with the Fed’s assessment that it will be transitory, its likely to hold the line and avoid rushing into any early monetary tightening and the same will likely apply at the ECB, BoJ and RBA. The likely fall back in inflation into later this year and early next year combined with central banks remaining dovish will mean that any near-term inflation driven bond market panic and hit to share markets will likely be short lived. Key to watch will be inflation expectations and wages growth.

The past week saw a big move towards agreement on minimum global tax but there is a long way to go yet. The G7 endorsement of an excess profits tax on the biggest global companies and a 15% minimum tax rate on earnings outside a company’s home country still has been helped along by the US’ desire to raise its corporate tax but not at the same time severely harm US companies. There are several points to note. First, it still has to go through the G20, the OECD and individual countries parliaments. Second, the excess profits tax is heavily weighted against US companies and it’s difficult to see Congress agreeing to that. Third, the excess profits tax could just lead to wasteful activities by multinationals to reduce profit margins which could be bad for investment and jobs and it provides a benefit for companies that are not big enough to qualify for the tax. Finally, most Australian companies will actually receive a competitiveness boost given Australia’s already high corporate tax rate.

It was another interesting week on the Bitcoin/crypto currency rollercoaster. First the FBI confirmed it had “hacked” back $US2.3 million of the $US4.3 million in Bitcoin ransom paid by Colonial Pipeline last month to the DarkSide. While its unclear how they did this – its undeniably good news. But it also calls into question how secure Bitcoin actually is. Which of course contributed to another plunge in its price. But it then got a lift after El Salvador adopted it as legal tender adding to hopes other countries would do likewise. Some who rely on the US dollar as their currency like El Salvador may do so too. And countries like El Salvador may see an opportunity to profit from interest in it, eg, by offering Bitcoin miners access to clean energy. But it’s hard to see most countries adopting Bitcoin as legal tender and if anything we are likely to see more regulation of it: most governments won’t want to see the seigniorage revenue they get from their own currencies threatened; they will face increased pressure to protect their citizens from its volatility; its use for illegal activity particularly in ransomware will likely lead to more regulation; its high carbon emissions will work against it as governments focus on reducing emissions; its slow transaction speed and high cost per transaction work against it as a digital currency; and governments will likely provide their own digital currencies. Finally, a proposal by international banking regulators to classify Bitcoin as the riskiest of assets may be seen as positive for Bitcoin to the extent its getting recognised but then such a risk weighting would make it very hard for banks to even hold it.

The trend in new coronavirus cases and deaths remained down over the last week with developed countries falling sharply helped by vaccines (with Japan also in a steep decline) and new cases in India continuing to fall sharply. Several Asian countries that had been in a rising trend now appear to be rolling over but the trend remains up in South Africa, South Korea and in some South American countries.

The good news in Australia is that the lockdown in Melbourne has ended, albeit with various restrictions remaining, after the number of new cases trended down. Risks remain though so it could still flare up again but so far so good and it’s clear that snap lockdowns if implemented early when cases are low can help avert a longer more debilitating lockdown as well as save lives. The only way to avoid them going forward is to rapidly ramp up vaccination.

So far only 12% of the global population has had at least one dose of vaccine, with only 9% in emerging countries but 43% in developed countries. Canada has now shot up to 64% after a slow start, the UK is now at 61%, the US is at 53%, Europe is at 42% and Australia is at 21%. The success of the vaccines continues to be evident in low new cases, hospitalisations and deaths in Israel, the UK and the US. However, the UK has seen an edging up in new cases due to the highly contagious Delta variant, particularly amongst young unvaccinated people highlighting the risks of reopening before enough people have been vaccinated. But vaccines should help prevent anything like past waves and keep hospitalisations and deaths down in the UK.

While Australia’s vaccination rate has increased to 0.5% of the population a day (see thick line in next chart), its lagging much of Europe and Canada that has been running around 1% a day.

Our Australian Economic Activity Tracker fell sharply over the last week as Victoria’s lockdown continued to impact. However, with the lockdown now over we are likely to see the rising trend in economic activity quickly resume again as seen after the various other snap lockdowns ended.

Our US Economic Activity Tracker remained just below its pre-coronavirus level, and our European Tracker is continuing to rise rapidly as Europe reopens.

Continuing with the Beatles, George Harrison also continued with a focus on love post the Beatles. Give Me Love (Give Me Peace On Earth) from 1973 and This is Love are two of his classics. This is Love was written with Jeff Lynne and the video (which I only came across a few years ago on a DVD) was filmed in Hawaii and shows a very relaxed and late 1980s cool George. For a singer who reportedly shunned pop stardom he certainly looked the part for this video.

Major global economic events and implications

US small business confidence fell slightly in May but remained strong with businesses reporting ongoing price and wage pressures data consistent with record job openings in April and very high levels of quits. Jobless claims also continued to fall. Reflecting the ongoing inflation scare the May CPI saw a further surge. But as noted earlier this reflects a combination of base effects and bottlenecks associated with reopening with underlying measures of inflation remaining subdued.

The European Central Bank left monetary policy on hold as expected and remained very dovish committing to maintaining its bond buying at an increased pace through the next quarter.

Chinese producer price inflation surged to 9% year on year in May, a 13 year high, but consumer price inflation is far more subdued at 1.3%yoy or 0.9%yoy excluding food and energy. As in other countries the surge in producer price inflation reflects the low base a year ago and the sharp increase in commodity prices but the muted increase in consumer prices suggests that it’s not being passed onto consumers in a big way and so is unlikely to illicit a monetary policy tightening from the PBOC, particularly with consumer demand being relatively weak. Meanwhile, Chinese import growth boomed in May suggesting strong domestic demand, but export growth slowed a bit which is surprising given reported shortages of goods globally. Money supply and credit growth picked up in May easing fears of excessive monetary tightening.

Producer price inflation also accelerated in Japan in May to 4.9%yoy reflecting the same pressures as in China, and wages growth accelerated but only to 1.6%yoy. With CPI inflation around zero its very unlikely to concern the Bank of Japan.

Australian economic events and implications

Business and consumer confidence both fell back in May and June respectively with Victoria’s snap lockdown weighing on the latter and not just in Victoria. However, both remain strong, some rebound in confidence is likely with the Victorian lockdown being relaxed and business conditions remain at record levels. As is the case globally and in other Australian business surveys, the NAB business survey showed price pressures remain high.

Two points on the Australian housing market. First, there is a big divergence in rental property vacancy rates with Melbourne seeing a continuing rise, Sydney remaining high but falling but the other six capital cities all seeing very low vacancy rates. Melbourne’s high vacancy rate mainly reflects units due to the absence of foreign students, the pandemic driven desire to escape to houses in the suburbs and the relatively bigger impact coronavirus has had on Melbourne. It largely explains the relative weakness of Melbourne unit rents and prices relative to other cities.

Second, most of the metrics of higher risk home lending that APRA follows closely were little changed in the March quarter suggesting that macro prudential tightening is still several months away. The share of high debt to income loans rose to a record, but the share of very high loan to valuation loans ticked down and the share of new interest only loans was flat. While they are arguably all in rising trends, they are not at levels that would trigger APRA to tighten lending standards yet. That said housing debt growth is accelerating particularly for investors and property booms usually lead to a slackening in lending standards by lenders so we remain of the view that APRA will move sometime in the next six months.

What to watch over the next week?

In the US, the focus is likely to be on the Fed on Wednesday which we expect to leave monetary policy on hold, but either start to talk about tapering its bond buying or agree to start the taper talk at its July meeting. However, its likely to stress that it still has a long way to go to meet its full employment and inflation goals. On the data front expect: solid growth in retail sales ex autos and gas; a solid rise in industrial production; continuing strength in home builder conditions; and a further acceleration in producer price inflation (all Tuesday); and a solid rise in housing starts (Wednesday). June manufacturing conditions indexes for the New York and Philadelphia regions will also be watched closely.

The Bank of Japan (Friday) is expected to leave monetary policy on hold and remain dovish. Japanese core inflation for May is likely to stay weak at around -0.2%yoy (Friday).

Chinese May data for industrial production, retail sales and investment (Wednesday) is likely to show a further loss of momentum, as it settles back to pre-coronavirus growth rates.

In Australia, the minutes from the last RBA meeting on Tuesday will likely remain dovish but some clarification around the RBA’s removal of its preparedness “to undertake further bond purchases” from its post meeting statement will no doubt be looked for by some investors. A speech by RBA Governor Lowe on “From Recovery to Expansion” (Thursday) will provide a more up to date view on how the Bank is seeing things and may provide hints about an anticipated tapering in its bond buying to be considered at its July meeting. May employment data to be released Thursday will be watched carefully to see if there is any delayed impact from the end of JobKeeper – but we expect a 40,000 gain in employment and unemployment remaining at 5.5%. ABS house price data for the March quarter is likely to show a 6% gain in dwelling prices consistent with already released private sector data.

Outlook for investment markets

Shares remain vulnerable to a short-term correction with possible triggers being the inflation scare, US taper talk and rising bond yields, coronavirus related setbacks 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.

Our year-end target for the Australian ASX 200 is 7400 reflecting stronger than expected earnings growth, a faster than expected rebound in dividends and ongoing low interest rates keeping shares relatively attractive. 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 on track to rise around 18% this year before slowing to around 5% next year, being boosted by ultra-low mortgage rates, economic recovery and FOMO, but expect a progressive 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%. We remain of the view that the RBA won’t start raising rates until 2023.

Although the $A is vulnerable to bouts of uncertainty and RBA bond buying and China tensions 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.