Investment markets and key developments over the past week

Global share markets continued to rise over the last week with reopening and earnings optimism offsetting Delta concerns and propelling US and European shares to record highs. The Australian share market also rose to a new high on the back of good earnings news offsetting ongoing dismal news on lockdowns – notably in NSW – with banks, telcos, utilities and retail stocks leading the market higher. Bond yields were little changed – up slightly in the US and Australia but down slightly in Europe. Oil and metal prices rose but iron ore continued to slide. The $A fell slightly as the $US rose.

So how can Australian shares be at record highs given the hit to the economy from the lockdowns? While it may seem perplexing there are good reasons behind it: earnings news has been strong with investors cheering the return of capital via dividends and buybacks from several companies; last years’ experience showed that the economy will bounce back strongly helped by massive fiscal support; monetary policy may now be easier for longer; lower bond yields and the surge in earnings have made shares cheaper; some are expecting more M&A activity; and vaccines are providing optimism that we will see a more sustained recovery from later this year; and of course global shares have also been strong supported by some of the same things. While shares are at risk of a short-term correction, we ultimately see the rising trend continuing.

The wave of new coronavirus cases globally is continuing.

New cases are still on the rise in Asia – including Japan, Malaysia & China although the numbers are low in the latter – and the US is rising rapidly.

Lowly vaccinated countries continue to respond with restrictions. China is seeing the toughest restrictions in some provinces since early last year – and they seem to be working in Nanjing where the outbreak started. But we are also seeing the return of more mask mandates & vaccination requirements (to go to work, enter venues, etc) in Europe and the US.

The good news is that vaccines are continuing to work – less so in preventing infection and onward transmission but particularly so in preventing hospitalisation and death (although death can still happen as we unfortunately saw in NSW in the last week). This is evident in deaths in developed countries remaining far more subdued compared to new cases in this wave thanks to higher levels of vaccination.

While the US has seen a surge in hospitalisations putting a strain on its medical system this remains mainly in lowly vaccinated states. The lowest 25% of US states by vaccination are seeing 3 times the number of new cases per capita, 4 times the number of hospitalisations and 7 times the number of deaths compared to the top quartile of states by vaccination. The US also highlights the risk of easing restrictions too quickly if there is still a significant portion of the population who are unvaccinated (say 50%) who remain highly vulnerable to getting sick from coronavirus and needing to go to hospital – which is a risk NSW and Australia will need to consider. A positive sign in relation to the US is that the rate of positive test results may be showing signs of slowing and historically this has led to a decline in new cases.

The UK has continued to see hospitalisations and deaths remain low relative to new cases. And it’s the same in Europe. A caution is that new cases may be starting to hook up again in the UK and Europe. But with vaccines working there appears to be little support for new lockdowns in Europe, the UK and US unless it’s as a last resort. Rather the path ahead is focussed on increasing vaccination rates and with masks and distancing restrictions at most.

The main risk would be if a new variant evolved that could get around the defences provided by current vaccines in relation to serious illness. The WHO lists several variants of interest and the Lambda variant (which originated in Peru late last year) has attracted some concern. Its early days but so far it appears that current vaccines remain protective against it. But the risk is significant. The only option is to rapidly vaccinate the whole world to control the spread of coronavirus and prevent further mutations.

On the latest count 32% of people globally and 61% in developed countries have had at least one dose of vaccine. It’s the low levels in emerging and less developed countries that are a big concern given the risk of more mutations.

Australia’s vaccination rate is rising rapidly, reaching 1.46 million doses over the last week or 0.8% of the population each day reflecting increased vaccine supply and a sharp fall in hesitancy (with only 7% of Australians now saying they are not planning to get vaccinated according to a Commonwealth Government survey). And this is likely to speed up even more with vaccine supply set to ramp up further (including now 10 million Moderna doses by year end). At the current rate of vaccination, the national objective of 70% of adults being vaccinated (to be able to start transitioning away from lockdowns) should be met by late October with 80% of adults (which is the trigger for further reopening) by mid-November. 80% of the whole population being vaccinated – which is what ultimately may be needed to live safely with coronavirus and variants like Delta – could now be met by year end, although this may require a bit of carrot and stick. Restrictions on what the unvaccinated can do already appear to be on the way in Australia – in fact NSW has already applied it to the building industry.

Unfortunately, the lockdown news in Australia remains bleak – with new cases still on the rise in NSW, the ACT now in lockdown, an extension to Victoria’s lockdown and various regional lockdowns in NSW. At least the Queensland lockdown ended and other states remain “free”.

NSW is easily on track to reach the Premier’s target of a total of 6 million vaccinations by the end of August (from currently 4.8m) – but it’s doubtful that will be enough to safely allow much of an easing of restrictions unless new cases suddenly start falling rapidly. In fact, the trend in cases points to the lockdown being extended through September. There are basically three options facing NSW – ending the lockdown and letting it rip; continuing with the current lockdown and hoping cases fall or if not until vaccine targets are met in October and November; and tightening the lockdown (with eg a ring of steel around Sydney, a state wide lockdown and a curfew). The first would be unacceptable as it would overwhelm the medical system and threaten other states; the second could end up costing the NSW economy another $8bn or more; and the third may ultimately be the cheapest in that it should turn case numbers down earlier and so allow an earlier easing of the lockdown. It’s a tough one though!

The economic impact of the lockdowns is evident in a further fall in our Australian Economic Activity Tracker. After a brief bounce reflecting the ending of the Victorian and SA lockdowns it has since fallen again reflecting the return to lockdown in Victoria.

We now estimate that the lockdowns since late May are costing around $17bn – with NSW at around $9bn assuming it ends at the end of this month which is looking unlikely and Victoria’s three lockdowns at nearly $5bn. Last week we revised down our September quarter GDP growth forecast to -2.5% quarter on quarter and growth through this year down to 2.5% year on year, but this is already looking optimistic. This could see unemployment spike back up to 5.5% in the months ahead, mainly driven by NSW. However, we remain of the view that growth is likely to start recovering through the December quarter as lockdowns ultimately suppress cases but more sustainably as rapidly rising vaccination rates allow a transition away from using lockdowns and as pent up demand supported by government pandemic support payments is unleashed. We expect GDP growth through next year to be well above 4%.

Our US Economic Activity Tracker dipped over the last week with the Delta outbreak weighing on mobility, restaurant and hotel bookings. Our European Tracker edged up and remains strong but Delta concerns also seems to be constraining it.

More US Government spending looks likely but there is now an increasing risk of a debt ceiling showdown. President Biden’s agenda took a big step forward with the US Senate passing a $US550bn package of new infrastructure spending with a bi-partisan 69-30 vote and US Senate Democrats passing a new budget through the reconciliation process (ie with a simple majority) that allows for (but does not yet legislate) the remaining $US3.5trn of Biden’s American Families and Jobs plans. For shares this all looks good – more spending on long needed infrastructure is great for productivity and it all keeps the spending going. But there are now a lot of balls in the air and several qualifications. First, with the mid-terms next year this is likely the last big spending initiatives until maybe 2025. Second, both involve spending spread over 8 years or so which means the huge stimulus is behind us and next year will (in the absence of a new crisis) see a big step down in stimulus equal to around 9% of GDP. Second, the reconciliation bill is planned to see tax hikes (on high income earners, corporates, capital gains and dividends) which shares won’t worry about till they happen. Third, Senate Democrats did not include an increase in the debt ceiling which means they don’t have the votes on their own to raise it and pass $3.5trn of spending (and tax hikes) at the same time. Two Democrat senators (Joe Manchin and Kyrsten Sinema) have already said they will not support it and the Republicans won’t. Which means the $US3.5trn in spending and tax hikes will likely have to be watered down to get the votes for it and the debt ceiling increase. Either with just Democrats as a reconciliation bill or with some Republicans. In the meantime, it may make sense for Nancy Pelosi to allow a House vote on the bi-partisan infrastructure bill on the grounds that a bird in the hand is worth two in the bush. Finally, the experience last decade tells us that debt ceiling showdowns can go down to the wire (it was reached early this month but Treasury can hang on till maybe October) but at the end of the day neither side can afford to be blamed for the Government defaulting on its debt and payments so a deal will be reached. But markets may get nervous along the way at some point (as we saw in 2011 and 2013).

Pressure to do something about climate change gets another push. The latest UN IPCC Report on Climate Change was bleak reading – under the best-case scenario of rapid emission cuts global temperatures will rise 1.5C by 2040. Things seemed bleak back in 2006 when Al Core had his slideshow. But here we are 15 years later and not enough has been done globally or locally. Unfortunately the cost is now ramping up. For Australia there is a positive in increased climate action will mean increased demand for some commodities (like copper). But there will also be big costs as the Australian continent is highly vulnerable to global warming, it will most likely mean reduced coal demand and a perceived failure to pull its weight in terms of reducing carbon emissions could mean trade sanctions from some countries and increasing funding costs as global investors increasingly judge countries on their climate action or inaction.

Time for some really happy songs. Here are some of my favourites. Walking On Sunshine by Katrina and the Waves is hard to pass up (yeah yeah, I gave it a mention last year). And it may seem a ways off right now…but The Only Way Is Up by Yazz and The Plastic Population is another good one. Plus I always love a bit of bubble gum pop so here is Happy Together.

Major global economic events and implications

While US small business optimism fell in July it remains solid, jobless claims fell and US job openings surged to a record high, but a moderation in consumer price inflation has given the Fed a bit of breathing space. Core CPI inflation was actually weaker than expected in July slowing to 0.3%mom and 4.3%yoy as pandemic related price distortions eased with slowing or falling prices for used vehicles, new vehicles, vehicle rental, airlines and hotels after these items drove 3 months of core inflation around 0.8 to 0.9%mom. The remaining 88% of core inflation remained relatively subdued at around 0.2%mom. This supports the Fed’s assessment that the spike in inflation is mostly transitory. That said, once the Fed has a better handle on the impact of the Delta outbreak on the economy and has seen the impact of the end of enhanced unemployment benefits next month a tapering is likely to be announced in November with tapering starting soon thereafter – particularly given that jobs data is strong, producer price inflation didn’t slow in July and median inflation has edged up a bit.

Japan’s Economy Watchers sentiment survey improved in July but its hard to see it being sustained given a surge in coronavirus cases. Producer price inflation rose further to 5.6%yoy but as in Europe and China there is little flow through to consumer price inflation which looks stuck around flat.

Chinese data was on the soft side with a bigger than expected slowing in import and export growth and in money supply and credit growth for July. The latter may be partly seasonal but its all consistent with the authorities sticking to their new easing bias for monetary policy, particularly with the Delta variant outbreak and stringent restrictions across 17 provinces set to depress September quarter GDP growth. While producer price inflation rose to 9%yoy in July the flow through to consumer price inflation remains weak with core CPI inflation at 1.3%yoy. Some easing in inflation may flow from the lockdowns and an easing in carbon reduction efforts.

Australian economic events and implications

In Australia, new home sales as measured by the HIA fell sharply and business and consumer confidence fell reflecting the impact of the lockdowns. Fortunately, confidence has held up far better so far than was the case early last year and this likely reflects the fact that not all of Australia is in lockdown, there is more confidence this time around that government support will work and the economy will bounce back, people have found better ways to live and work with lockdowns and the vaccines are now providing hope.

The June half earnings reporting season has ramped up and while the lockdowns are weighing on the outlook so far this seems to have been swamped by reports of strong earnings growth and a huge return of capital to share holders via dividends and buybacks notably by Rio, CBA and Telstra. Its early days yet as only about 35 major companies have reported so far and there is a tendency for good news results to come out early in the reporting period, but so far 52% of results have surprised on the upside, 79% have seen earnings up on a year ago & 71% have increased dividends.

What to watch over the next week?

In the US, comments by Fed Chair Powell (Tuesday) and the minutes from the last Fed meeting (Wednesday) will be watched for clues regarding the taper decision. On the data front expect flattish retail sales for July after their strong rise in June, another solid rise in industrial production and continuing strength in home builder conditions (all due Tuesday), a slight fall back in housing starts (Wednesday) and continuing strong readings in the New York and Philadelphia manufacturing conditions indexes for August (due Monday and Thursday).

Japanese data is expected to show a 0.1% gain in June quarter GDP (Monday) & ongoing weak CPI inflation (Friday).

Chinese activity data for July on Monday is expected to show a further slowing but still solid growth in retail sales, industrial production and investment with unemployment remaining around 5%. Recent lockdowns and travel restrictions will impact August data.

The Reserve Bank of New Zealand is expected to raise interest rates on Wednesday.

In Australia, jobs data for July on Thursday will be the first big data release to show some impact of lockdowns in response to recent Delta outbreaks. However, it may not fully show up due to the timing of the ABS’ reference period for July so as a result we only expect a loss of 50,000 jobs mainly driven by NSW with unemployment rising to 5% (from 4.9%), but with a much bigger impact showing up in August. Ultimately employment is expected to fall by around 300,000. This is less than the -857,000 jobs lost in April and May last year as not all of Australia is in lockdown, businesses may be less inclined to lay off this time around given the rebound seen last year and only recent talk of labour shortages, and business confidence and job ads don’t seem to have fallen as rapidly as seen last year. However, there will likely be a bigger hit to hours worked. June quarter data is expected to show a 0.5% lift in wages (Wednesday) taking annual wages growth to 1.8%.

The Australian June half profit reporting season will start to ramp up with about 90 major companies comprising about one third of the share markets capitalisation reporting in the week ahead. This includes JB HiFi and Bluescope (Monday), BHP and Woodside (Tuesday), Amcor, Coles and CSL (Wednesday), ASX, South 32 and Treasury Wine Estates (Thursday) and Cochlear and Stockland (Friday). Consensus earnings growth expectations are for a 50% rise in earnings for 2020-21 and a 56% rise in dividends. The resources sector is expected to see a doubling in profits followed by 58% growth in bank earnings. Outlook statements are likely to be cautious though given the uncertainty posed by recent coronavirus outbreaks and lockdowns.

Outlook for investment markets

Shares remain vulnerable to a short-term correction with possible triggers being the upswing in global coronavirus cases, the inflation scare and US taper talk, likely US tax hikes and a debt ceiling standoff and geopolitical risks. But looking through the short-term noise, the combination of improving global growth and earnings helped by more fiscal stimulus, vaccines allowing reopening once herd immunity is reached and still low interest rates augurs well for shares over the next 12 months.

Expect the rising trend in bond yields to resume 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 20% 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 poor affordability impacts, government home buyer incentives are cut back, fixed mortgage rates rise, macro prudential tightening kicks in and immigration remains down relative to normal. The lockdowns have increased short term uncertainty though.

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 could pull back further in response to the latest coronavirus outbreaks and the threats posed to global and Australian growth, 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 over the next 12 months.