Investment markets & key developments

Share markets tumbled again over the last week as markets moved to anticipate even more aggressive rate hikes from central banks after the release of higher than expected US inflation data. For the week (so far) global shares are down around 6% and Australian shares are down by around 7%. The fall in the Australian share market was led by IT stocks which have been under pressures all year but also resources, retailers and financials as worries increased about the economic outlook. The rising risk of global recession also led to falls in oil, metal and iron ore prices. Bond yields generally rose to new highs with the Australian 10-year bond yield rising above 4% for the first time since 2014. While the $A initially plunged below $US0.69 it clawed back above $US0.70 as the $US fell.

From their all-time highs last year or early this year US shares have now fallen 24%, global shares have fallen 21% and Australian shares have fallen 15.5%. As has been the case all year the key drivers of the fall in shares remain: high and still rising inflation flowing from pandemic distortions to supply and demand made worse by the war in Ukraine and Chinese lockdowns; central banks stepping up the pace of interest rate hikes; and the rising risk that this will trigger a recession.

As always the most speculative “assets” are getting hit the hardest including the pandemic winners of tech stocks (with Nasdaq down 34%) and crypto currencies (with Bitcoin down 70% from its high last year). Crypto currencies surged with semi religious fervour around the marvels of blockchain, decentralised finance, NFTs, freedom from government, promises that its an inflation hedge, etc, only to become a bandwagon fuelled by speculative extrapolation on the back of easy money and low interest rates. Trying to disentangle its true fundamental value from the speculative mania become next to impossible. And now the easy money and low rates are reversing, pulling the rug out from under the mania.

We remain of the view that a global recession can be avoided but with central banks now hiking rates aggressively the risks have increased to the point that its now close to 50/50. Either way it’s still too early to say that shares have bottomed. First the bad news.

• Despite widespread expectations to the contrary US inflation has gone to a new high and other countries including Australia (with its partly home-grown electricity crisis) are still likely to see higher inflation ahead too. Energy prices – particularly for oil – are yet to put in a decisive top and its hard to be confident that the worst is over for inflation until they decisively stop rising.
• The Fed has now stepped up rate hikes to 0.75%. While Fed Chair Powell said he doesn’t expect 0.75% hikes to be “common” and that the Fed will be “flexible”, the Fed is now signalling (via its so-called dot plot of Fed officials’ rate hike expectations) more than 1% higher rates this year and next than it was just 3 months ago and still needs to see “clear and convincing” evidence of falling inflation.
  

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• Ever more Fed tightening is boosting the risk of a US recession with parts of its yield curve flirting with inverting (ie short term rates above 10 year bond yields) again.
  

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• While the ECB has announced measures to combat “fragmentation” (or a blow out in bond yields in countries like Italy relative to Germany as we saw in the Eurozone debt crisis) – with the flexible reinvestment of funds from maturing bonds and the development of a mechanism to combat spread blowout – this really just clears the way for more aggressive ECB rate hikes.
• The Bank of England raised its policy rate by another 0.25% to 1.25%, now expects inflation to peak slightly above 11% this year and remained hawkish indicating its prepared to act more forcefully if necessary, despite expecting the economy to contract this quarter.
• The Swiss National Bank hiked rates by an unexpected 0.5% taking them to -0.25%. Taiwan’s central bank also raised its policy rate albeit by less than expected.
• RBA Governor Lowe in a TV interview indicated that the Bank now sees inflation rising to 7%, that it “will do what is necessary” to bring it back to 2-3% and reiterated that “its reasonable…the cash rate gets to 2.5%”. Taken together with another strong jobs report for May it leaves the RBA on track to hike again at its July meeting by another 0.5%. While the move by the Fed to hike by 0.75% at its June meeting suggests a risk that the RBA may do the same as it faces similar pressures to the US, we lean to the view that it will stick to 0.5% moves given that the RBA meets monthly whereas the Fed meets 6 weekly and so the RBA does not need to hike as much as the Fed at each meeting to achieve the same over a 3 month period and inflation and wages pressures are a bit less in Australia than they are in the US. We continue to see the peak in the cash rate being around 2.5%, but it could come earlier given the RBA’s shift towards a more aggressive approach. Market expectations for the cash rate to rise to nearly 4% by year end and above 4% next year still look too hawkish though. A rise to 4% for the cash rate would see average discounted variable mortgage rates rise to around 7.5% (from around 3.5% in April). When combined with the surge in fixed mortgage rates (which have already gone from around 2% to around 5%) it would likely cause real problems for consumer spending, a big spike in mortgage stress (as debt interest payments will more than double from earlier this year) and push property prices down by 20 to 30%…which indicates its unlikely to happen as it would crash the economy and ultimately push inflation back well below the RBA’s target.

On the positive side though:

• Major central banks are serious about controlling inflation and while this comes with short term risks, given the 1970s experience its arguably positive for the longer term both from an economic perspective (as high inflation is ultimately bad for productivity and unemployment) and for investment markets.
• There are more indications that the US jobs market may be starting to cool a bit – with jobless claims drifting up and indications wages growth may have peaked. This may take pressure off services inflation which has been picking up.
• Our Pipeline Inflation Indicator continues to point to a peaking in US inflation. Of course, the process of peaking can always be messy and drawn out.
  

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• Reliable indicators of recession have yet to signal one is on the way – eg the gap between the 10 year bond yield and Fed Funds rate (which has always preceded recessions since 1970) is yet to come close to inverting. See the second chart in this report above. And the Fed Funds rate is still less than nominal GDP growth. It’s the same in Australia.
  

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• Some leading economic indicators like consumer confidence including in Australia are now weak suggesting that central banks shouldn’t have to raise rates too far to get a desired slowing in demand and hence inflation. (Of course, this also brings with it the risk that they miscalculate and overtighten).
• Forward price to earnings multiples have fallen sharply since the start of the year – down from 22 times to 16 times now in the US and down from 19 times to 14 times in global and Australian shares – making shares cheaper. This has been due to falling share prices and still rising earnings.
• Signs of capitulation are becoming more evident, with eg more indiscriminate selling of shares, and this is positive from a contrarian perspective.

The bottom line remains though that while shares are likely to be higher on a 6-12 month horizon, it remains too early to be confident that we have seen the highs for bond yields and the lows for shares in the near term.

Australian minimum wages to rise 5.2%, with minimum award wages to rise 4.6% from 1 July. Given this will directly impact about 22% of the workforce it will add about 0.5% to wages growth compared to the last financial year. The risk is that this will add to broader wage claims in the economy, hence to inflation expectations and the risk of a wage price spiral putting even more pressure on the RBA to raise rates further. However, there is a danger in exaggerating the impact as the tight labour market – with labour market underutilisation (unemployment plus underemployment) now back to levels last seen in 1982 – suggests that wages will go up anyway including for many of those on minimum rates.

1968 was something of a seminal year. Paris riots. The assassination of Martin Luther King and Bobby Kennedy. The election of Nixon. The intensification of the Vietnam War. Inflation. Barrenjoey High School opened. And it was for Elvis Presley’s career too signalling the shift away from movies and back to cool. But one movie stuck out with two great songs that year – one of which is The Edge of Reality and it (apparently as I haven’t yet seen it) gets a run in the latest Elvis biopic. I would rate it as one his best songs.

Coronavirus update

New global Covid cases remain low but rose slightly over the last week with slight increases in Europe and South America. New cases in the US are relatively low and stable, but up from April. In Australia new cases continue to trend down – although some states like NSW look to be on the rise again. New cases in China are low – but even small numbers can lead to restrictions (as we have seen again in Shanghai) given the zero covid policy.

Economic activity trackers

Our Australian Economic Activity Tracker rose slightly over the last week and remains strong but looks like it may have peaked. Our US and European Trackers both fell slightly.

Major global economic events and implications

US economic data was soft. May retail sales unexpectedly fell, manufacturing conditions indices were weak in the New York and Philadelphia regions, home builder conditions fell slightly, housing starts fell and jobless claims fell less than expected with a rising trend remaining in place. Slowing growth (with the Atlanta Fed’s GDP Now pointing to zero GDP growth this quarter) suggest that US monetary tightening is starting to get traction. And business surveys again showed some easing in pricing pressure (albeit from a high level) and better delivery times. Producer price inflation was also a bit more consistent with annual inflation having peaked although it remains very high.

The Bank of Japan made no changes to its ultra easy monetary policy, despite pressure from the Yen falling to its lowest in 24 years. However, its reference to the movement in the Yen and rising inflation suggest that its only a matter of time before it eases its yield curve control (or bond yield targeting).

Chinese economic activity data improved more than expected in May as covid restrictions eased – with industrial production up and unemployment down – but retail sales remain weak and home prices are still falling. Despite the return of some restrictions in Shanghai, China’s effective lockdown index has continued to ease.

Australian economic events and implications

Strong jobs data but falling confidence. May saw another strong jobs report in Australia with employment rising far more than expected, unemployment remaining at its lowest since 1974 as labour force participation rose to a record and a sharp fall in underemployment pushing total labour market underutilisation to its lowest since 1982. Job vacancy data is still strong and so we continue to see the unemployment rate falling to around 3.5% over the next 3-6 months. The plunge in labour underutilisation points to stronger wages growth ahead. This is all consistent with the RBA hiking by 0.5% again in July.

Of course, the labour market is a lagging economic indicator. Confidence is more of a leading indicator and while its slowing but still high for businesses (as measured by the NAB survey) its weak and falling for consumers with consumer confidence down 4.5% in June to levels normally associated with recession or very weak growth. Never before has consumer confidence been this week at the start of a tightening cycle. This points to weaker economic growth ahead and points to a rising unemployment rate through next year. All of which will put a lid on how much the RBA will be able to (and will need to) raise rates by.

While home prices are still well up from 2020 lows, falls now appear to be accelerating as a result of faster rate hikes and this will act as a drag on consumer spending ahead along with falling real incomes.

What to watch over the next week?

Monetary policy in the US and Australia is likely to dominate in the week ahead. In the US Fed Chair Powell’s Congressional testimony (Wednesday and Thursday) is likely to be hawkish reiterating the Fed’s commitment to continue tightening until there is “clear and convincing” evidence that inflation is falling. This is unlikely to reduce market expectations for a rise in the Fed Funds rate to 3.5% by year end and to well above 4% by mid next year.

Similarly in Australia, the minutes from the RBA’s last meeting (Tuesday), a speech by RBA Governor Lowe (also Tuesday) and his participation on a panel discussion (Friday) are all likely to be hawkish reiterating the RBA’s desire to keep inflation expectations down and commitment to bring inflation back to target. The focus is likely to be on any indications as to how high the RBA thinks it may need to raise interest rates.

Business conditions PMIs (Thursday) for the US, Europe, Japan and Australia will provide a guide as to how much global monetary tightening and supply constraints are impacting the growth outlook and price and cost components will be watched for further evidence of peaking.

US existing home sales data (Tuesday) are likely to fall but new home sales (Friday) are likely to rebound

Japanese core inflation for May (Friday) is likely to edge slightly higher to 0.9%yoy.

The NSW State budget (Tuesday) may contain measures on housing affordability and stamp duty reform.

Outlook for investment 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 high. However, we see shares providing reasonable returns on a 6-12 month horizon as valuations have improved, global growth ultimately picks up again and inflationary pressures ease through next year allowing central banks to ease up on the monetary policy brakes.

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). 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 and more aggressive up front RBA rate hikes risk pushing price falls to 20%.

Cash and bank deposit returns remain low but are improving as RBA cash rate increases flow through.

The $A is likely to 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 still strong commodity prices.