Investment markets and key developments over the past week

Share markets fell over the past week as US inflation data for April came in far stronger than expected raising fears of an earlier Fed tightening, before a rebound later in the week – partly helped by softer US retail sales which took some pressure off bond yields – pared losses. So, despite the sharp fall earlier in the week, US shares only fell -1.4%. Eurozone shares lost -0.5% and Japanese shares fell -4.3%. Chinese shares bucked the global trend and rose 2.3%. The poor global lead also weighed on the Australian share market after it hit a record high early in the week, although it fell back by far less given that the threat of higher inflation is a bit less in Australia than in the US and given the higher exposure in the local share market to cyclical and value stocks that may benefit from higher inflation and interest rates. For the week Australian shares fell -0.9%, and of course they missed out on a sharp rally in US shares on Friday. Bond and interest rate sensitive IT, utility, property and telco shares along with energy stocks led the declines in the ASX 200. Bond yields rose although not dramatically, and in the US and Australia they remain down from their highs earlier this year highlighting that the inflation scare had already been at least partly priced in. German bond yields look to be rapidly heading towards being above zero though on the back of the improving outlook in Europe. Oil prices rose but metal prices fell. Iron ore price rose to a new record high before declining later in the week. The A$ fell as the US$ rose.

After having run hard with investor sentiment becoming pretty elevated shares are vulnerable to a correction as we enter a seasonally weaker period that normally runs from around May out to September/October. The still intensifying inflation scare and the risk of a further bond market tantrum along with geopolitical risks – notably China tensions but also in relation to Israel and Iran – and possibly still more coronavirus setbacks could all be triggers. However, as we have seen over the last 12 months corrections are hard to time and beyond the short-term correction risks our broad view remains that share markets will head even higher by year end supported by strong earnings growth and central banks remaining ultra-easy. Our ASX 200 forecast for year-end remains 7,200 but having almost reached there early in the past week the risk is likely on the upside. (Note in relation to the fighting between Israel and Gaza: in the past Israeli/Palestinian related conflicts, while terrible, have rarely had a significant impact on global share markets unless oil prices are impacted.)

US inflation surged in April by a lot more than expected, but our assessment remains that its likely to be a confusing picture on the inflation front over the next few years, all against the likely bottoming of the long-term decline in inflation seen over the last forty years. US headline CPI inflation surged to 4.2% year on year and core inflation rose to 3%yoy compared to expectations for 3.6% and 2.3% respectively. The key drivers were 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. However, reflecting the reopening and bottlenecks the surge in inflation was not broad based. Just four groups with a weight of about 12% in the core CPI accounted for around 70% of the 0.9% increase in core inflation – including used car and truck prices which rose 10%, airfares up 10% and hotels up 7.6%. The median CPI which provides a better guide to underlying inflation rose just 0.2% in April or 2.1%yoy and indicates the rise in inflation was not broad based. In the months ahead annual inflation in the US (and elsewhere) will likely push even higher as base effects have further to go, bottlenecks persist and reopening continues. And this in turn will likely drive an ongoing inflation scare pushing bond yields higher and threatening share markets (particularly growth stocks like the tech sector which has long duration earnings and so is very vulnerable to higher interest rates).

However, while the risks have increased we remain of the view that the inflation spike will prove temporary as: the base effects will drop out and then reverse; 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, 9 US states have already announced that will now end the enhanced unemployment benefits that are seen as dissuading some workers from returning to the jobs market. So, inflation is likely to fall back again later this year as bottlenecks and the reopening boost fade. While the Fed was likely also surprised by the April CPI, its likely to hold the line and avoid rushing into an earlier tightening and the same will likely apply at the ECB, BoJ and RBA. The likely fall back in inflation later this 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 to be short lived. Key to watch will be inflation expectations and wages growth.

Viewed in a very long-term context though we are likely now going through the bottoming of the long-term decline in inflation that has been in place since the early 1980s as bigger government and slower to tighten central banks focussed on pushing unemployment as low as it can go to get inflation up, a reversal in globalisation and a decline in workers relative to consumers results in higher inflation on a more sustained basis. This is ultimately what central banks are aiming for. In this context the spike in inflation now occurring is likely part of a long term or secular bottoming process for inflation and bond yields. This will take several years to play out and the question is whether it results in inflation ultimately averaging around target or something higher. Our base case is the former, although the risks are possibly swinging to the latter.

Spend, spend, spend for jobs, jobs, jobs (and to get re-elected). Five points on the 2021-22 Australian Budget.

• First the additional spending of $96bn over five years was about double what I was expecting. It gave away almost all of the $104bn windfall to the budget from stronger growth.
• Second, it was consistent with a trend towards fiscal policy and government more broadly playing a bigger role in the economy – this is evident in the delay in fiscal repair in order to focus on pushing unemployment below 5% and also with many of new measures resulting in baked in spending in contrast to support measures last year that were mostly temporary. As a result, government spending is projected to settle at a relatively high 26% of GDP.
• Third, there is no medium-term plan for fiscal repair – but it may not be quite as bad as it looks. While the deficit is projected to decline a surplus is not expected for more than a decade. A saving grace is that the revenue forecasts may be too cautious due to conservative growth and iron ore assumptions. For example, if the iron ore price averages US$150bn per year from 2022-23 rather than US$55 it will cut nearly $25bn off the budget deficit (easily paying for the $17bn pa stage 3 tax cuts). But this would then bang up against the commitment not to let the ratio of tax revenue to GDP rise above 23.9% of GDP. So, at some stage spending cuts will likely be needed.
• Fourthly, the spendathon with the only losers being non-voters (future taxpayers and foreign aid recipients) highlights that this is a pre-election budget potentially bringing forward the next election to later this year.
• Finally, the key risks to the Budget are that: the extra stimulus brings forward the first RBA rate hike; rising global growth and inflation pushes bond yields back above nominal GDP growth making the new higher level of public debt less sustainable; and Australia loses its AAA rating – although this would mainly impact the national psyche with little real economic impact.

Is Australia’s recovery really dependent on reopening the international border? Angst around this got a new lease of life after the Budget assumed the border would not reopen until next year with jokes about Australia becoming a new “hermit kingdom” or “the lost kingdom of the South Pacific”. Everyone wants the freedom to travel out of and back into Australia and an open border is key to having a dynamic economy over the long term, but its short-term importance to the economic recovery should not be exaggerated. First, the economy has likely already recovered back to pre-coronavirus levels. Second, Australia normally runs a trade deficit in tourism equal to 1% of GDP as we lose more from Australians travelling overseas than we gain from foreign tourists coming here. And now, that spending by Australians is trapped here benefitting the Australian economy. Third, we normally run a trade surplus in education equal to 2% of GDP but with the pandemic we have lost maybe just half of that as many foreign students just went online. Fifth, while the loss of immigration means lower growth potential it doesn’t necessarily impact per capita GDP (and hence living standards) in the short term or recovery prospects (except for some sectors). Finally, a premature reopening before herd immunity is reached and we are confident vaccines will protect travellers from new variants, will risk reversing the recovery we have seen so far.

New coronavirus cases and deaths slowed further over the last week. Developed countries remain in a downtrend helped by vaccines (although Japan is a notable exception and still seeing a rising trend) and India continues to see signs of slowing momentum helped by reduced mobility.

Despite ongoing scares in relation to outbreaks from the hotel quarantine system for returned travellers, new cases remain very low in Australia.

Meanwhile the vaccine rollout continues. 9% of the global population has now received one dose of vaccine, with 6% in emerging countries. Within developed countries the UK is at 54%, the US is at 47%, Europe is at 30% and Australia is at 11%. 85% of those in aged or disability care in Australia have had at least one dose and a deal for Moderna to supply its mRNA vaccine starting at 10 million doses this year adds to confidence that the rollout will speed up. (It must be as I just got an invite from my doctor’s medical surgery to book for one!) The collapse in new cases, deaths and hospitalisations in Israel, the UK and the US indicate that the vaccines work. A key risk remains in some countries of further coronavirus breakouts (eg, of the Indian variant) if reopening proceeds too quickly before herd immunity is reached. That said herd immunity may be closer in some countries than the chart below suggests if those that have already been exposed and just adults only are allowed for.

Our Australian Economic Activity Tracker was little changed over the last week and so remains very strong indicating that recovery remains on track, despite periodic coronavirus scares. Our US Economic Activity Tracker edged slightly higher and our European tracker rose again but remains very weak.

Elon Musk backflips on accepting Bitcoin. Back in February Tesla’s announcement that it had bought Bitcoin and planned to accept it as payment was a big factor adding to enthusiasm in it and propelling it higher. Now its decision to suspend accepting it on the grounds of its increasing fossil fuel use has contributed to a sharp fall in its value. Bitcoin’s massive electricity consumption, which is around that of Sweden and Argentina, and arises from the computing power necessary to mine new Bitcoins is well known – and was back in February too. But it’s not just Bitcoin – Dogecoin which was created as a joke has lost close to half its value since Musk failed to say something positive about it while hosting Saturday Night Live. Bitcoin’s vulnerability to comments by influential individuals highlights its highly speculative nature (as its unlikely to ever be digital currency and its not a capital asset providing earnings on which it can be fundamentally valued).

In the past couple of weeks some colleagues have sent me some amazing music related clips. The first sees this music genius drummer Larnell Lewis listen to Metallica’s Enter Sandman for the first time and then replicate the drums perfectly. I am not really into metal (more pop for me) but I appreciate it (and love ACDC) and Larnell is just amazing. The second clip takes up back to pop with an episode of What Makes This Song Great? and breaks down Boston’s More Than A Feeling. I have never really been into Boston but this song always got my attention whenever I heard it and watching this you realise why and how it works so well and that its much more than just having a great tune and lyrics. And that’s episode number 71 so I have a lot of other episodes to get through to catch up!

Major global economic events and implications

Along with the stronger than expected surge in US CPI inflation seen in April, producer price inflation also rose more than expected. US economic activity data was mixed though. On the one hand, job openings rose to a record high, jobless claims fell further and small business optimism rose. But retail sales and industrial production for April were softer than expected. However, both retail sales and industrial production for March were revised up and retail sales held on to their stimulus driven 10.7% surge seen in March, remain around 15% above their long-term trend and are starting to be affected by reopening which is seeing a rotation away from goods back towards spending on services (which apart from restaurant sales which was very strong, are not really captured in the retail sales data).

The UK looks like staying together (for now) after the Scottish parliamentary election did not produce a clear win for the independence movement. The Scottish National Party did well but is one seat short of a majority and their performance was down from their 2016 and 2011 performances.

Chinese money supply growth and credit growth slowed further in April, likely as a result of the PBOC normalising monetary policy after easing last year. Producer price inflation rose to a stronger than expected 6.8% year on year, but CPI inflation was a bit less than expected at +0.9%yoy, with the rise from +0.4%yoy in March due to base effects as prices fell in April. Core CPI inflation rose to just +0.7%yoy from +0.3%.

Australian economic events and implications

Australian data remains strong. The NAB business survey’s measure of business conditions rose to a record high in April and business confidence rose to its highest since 1994 with strong readings for most components including for forward orders, employment and investment. Payroll jobs also rose adding to evidence that the ending of JobKeeper has had a minimal impact on employment. Real retail sales fell -0.5% in real terms in the March quarter which likely reflects a combination of lockdowns as well as the commencement of a rotation in consumer spending back towards services.

New home sales fell -54% in April as HomeBuilder ended. HomeBuilder likely pulled demand forward but the boost to construction it provided will continue for a long while yet and Budget deposit-based assistance schemes will provide an ongoing boost to new home demand.

What to watch over the next week?

In the US, expect home builder conditions (Monday) to remain strong, housing starts (Tuesday) to fall -2% but after a 19% gain in March, the minutes from the Fed’s last meeting (Wednesday) to remain dovish and May business conditions PMIs (Friday) to remain very strong. Manufacturing conditions indexes for the New York and Philadelphia regions will also be released and will likely remain strong.

Eurozone business conditions for May (Friday) will be watched for further improvement.

Japanese March quarter GDP (Tuesday) is likely to show a contraction of -1.1%qoq reflecting the covid related state of emergency. May business conditions PMIs and April’s CPI will be released on Friday.

Chinese April data for industrial production, retail sales and investment (Monday) are likely to show some further loss of annual momentum as the favourable base effects from the pandemic lockdown drops out of annual data, but underlying conditions are likely to have remained solid.

In Australia, April jobs data (Thursday) will give an initial look at the impact of the ending of JobKeeper. Given that the number of workers on zero or reduced hours in March were around normal levels, job vacancies are very strong and the number of people on welfare payments in April actually fell we see little impact other than a slowing in the pace of job gains to 15,000 leaving the unemployment rate at 5.6%. Meanwhile expect March wages growth (Wednesday) to have remained softish at 0.5%qoq or 1.4%yoy and a long way from RBA conditions for a rate hike, consumer confidence (also Wednesday) to have remained strong helped by the upbeat Budget, April retail sales (Friday) to show a 0.5% gain (with snap lockdowns continuing to have some impact and business conditions PMIs (also Friday) to have remained strong. The minutes from the last RBA meeting (Tuesday) are likely to remain dovish.

Outlook for investment markets

Shares remain are at risk of a correction with possible triggers being the inflation scare and rising bond yields, coronavirus related setbacks, US tax hikes 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.

Australian shares are likely to be relative outperformers helped by: better virus control enabling a stronger recovery in the near term; stronger stimulus; sectors like resources, industrials and financials benefitting from the rebound in growth; and as investors continue to drive a search for yield benefitting the share market as dividends are increased resulting in a 5% grossed up dividend yield. Expect the ASX 200 to end 2021 at a record high of around 7200 although 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 likely to rise another 15% or so over the next 18 months being boosted by record low mortgage rates, economic recovery and FOMO, but expect a 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%.

Although the A$ is vulnerable to bouts of uncertainty and RBA bond buying 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 US$0.85 by year end.