Investment markets & key developments

Global share markets saw another rough week as concerns about inflation and monetary tightening intensified against the backdrop of ongoing Russian tensions over Ukraine and Omicron disruptions. However, there was a decent bounce in Australian and Japanese shares at the end of the week from oversold conditions helped by an Apple earnings beat. From their highs to their lows US and Australian shares have now had 10% falls, Eurozone shares have had an 8% fall and global shares have had a 9% fall. Speculative and interest sensitive areas have generally been hit the hardest with Nasdaq down 17%, Australian IT shares down 31%, Bitcoin down nearly 50% and SPAC IPOs getting pulled. (Don’t ask me what SPAC stands for – they never did make much sense!). Long term bond yields mostly rose, although the rise has been capped by safe haven demand. Oil prices rose but metal and iron ore prices fell slightly but with metal prices continuing to be relatively resilient. The $US rose further as expected Fed rate hikes increased and this saw the $A fall.

Monetary tightening fears are continuing to intensify – led now by the Fed. The Fed left rates on hold but indicated that it will end bond buying in March, likely start raising rates in March and will then commence quantitative tightening (or QT) by letting its bond holdings run down. Fed Chair Powell’s comments pointing to a possibly faster tightening cycle than in 2015-2019 (due to higher inflation and lower unemployment) and not ruling out a rate hike at every meeting added to market nervousness though how high interest rates will rise. We expect the first Fed rate hike in March, four or five rate hikes this year (in line with market expectations) and QT to commence in the June quarter. QT could add to upwards pressure on bond yields – but this could be positive to the extent that it helps maintain a positive yield curve making it easier to avoid a recession.

Other central banks also moving to tighten. The Bank of Canada left rates unchanged but is on track to hike in March. And a rise in inflation to 5.9%yoy in New Zealand suggests its central bank could raise rates by 0.5% in February.

In Australia, inflation surprised on the upside yet again in the December quarter at 3.5%yoy with sharp rises in petrol prices and new dwelling costs but broad-based gains on the back of supply disruptions and strong demand driving a rise in underlying inflation to 2.6%yoy.

Reflecting the plunge in December unemployment and higher than expected underlying inflation for the second quarter in a row the RBA will likely stop bond buying at its meeting in the week ahead and like other central banks pivot hawkish on rates. RBA forward guidance that a rate hike is unlikely until 2024, possible in 2023 but not in 2022 was based on “data and forecasts” that the conditions for a rate hike – namely inflation sustainably in the target range, full employment and wage growth of 3% or more – would not be met this year. As it turns out key data for jobs and inflation have been far stronger than expected and its forecasts for both will likely have to be revised up so its guidance on the start of rate hikes will have to be brought forward. Wages growth is not yet at the 3 point something that the RBA would like to see, but unemployment is on track to fall below 4% in the second half which will push wages growth up to the desired pace in the second half and underlying inflation is now comfortably in the target range and likely to run above it. Our base case remains for the first hike to come in August followed by another in September taking the cash rate to 0.5%. But if December quarter wages data due in three weeks shows an acceleration in wages growth or the RBA decides to ditch its focus on wages then the first rate hike could come in May or June (probably June given the RBA would prefer to avoid getting politicised in the midst of a likely Federal election campaign in May).

Don’t be too critical of the RBA. Forecasting is always hard and those in glass houses shouldn’t throw stones. Particularly in a pandemic which has blown economic data and forecasts every which way and caused massive dislocation to supply and demand. And don’t forget that the RBA’s shift to focussing on actual inflation, as opposed to forecast inflation, and to dovish guidance was designed to break Australia out of the very low inflation and low wages growth trap it has been in for the last six or seven years and for which many criticised it for being too hawkish. And its not as if inflation is now out of control in Australia. Underlying inflation is in the middle of the target range and headline inflation is half what it is in the US. And at 3.5%yoy, inflation in Australia is well below that in many comparable countries, viz 7% in the US, 6% in Europe, 5.4% in the UK, 4.8% in Canada and 5.9% in NZ.

How far will interest rates rise in Australia? Given the cross currents this will be hard to pick. But I do know that the RBA will not be on autopilot mindlessly raising rates to some level based on where rates were in the past when inflation was this high and crashing the economy and property market in the process. Very high household debt to income ratios compared to when rates last went up (in 2009-10) and particularly when inflation was last a big problem mean much smaller rate hikes will be necessary than in the past as they will now be more potent in slowing spending. For example. the threefold increase in the debt to income rate since the late 1980s means a 0.25% rate hike today is equivalent to a 0.75% rate hike back then. An increase in the use of fixed rate mortgages arguably works the other way in initially protecting borrowers who are locked in but as best we can tell they are still only around 30% of total mortgage debt outstanding so the high level of household debt is likely to dominate in constraining how much the RBA will need to raise rates. So the RBA will move in small increments – probably two steps at a time and pause to see what happens before doing more but rates will not rise to nosebleed levels. That said rising rates will be another factor along with poor affordability slowing the housing market this year and driving a peak in dwelling prices sometime in the second half.

Monetary tightening and the uncertainty about how far rates will rise could push shares even lower in the short term and will likely drive continuing volatility. However, we still don’t see monetary tightening this year being enough to end the economic recovery and cyclical bull market:

• First, monetary policy will still be relatively easy for much of this year at least.
• Second, some relief on inflation should be seen this year as covid disruptions ease allowing goods supply to rise and goods demand to slow in favour of services. Interestingly input and output price components of the global PMIs and work backlogs are continuing to show signs of topping out which may be consistent with some easing in inflation pressures. See the next chart.
• Third, despite the falls in share markets, credit spreads have remained low, metal prices have held up and value stocks have been outperforming growth stocks (like tech shares) all of which are positive signs for economic growth.
• Fourth, investor sentiment has rapidly become negative which is positive from a contrarian perspective and along with stocks being very oversold points to the potential for at least a short-term bounce.
• Finally, in relation to Australia, market expectations for the RBA to tighten as much if not more than the Fed over the next few years (with the market expecting the Fed Funds rate to rise to 1.75% over the next three years and the RBA cash rate to rise to 2.3%) look out of whack given inflation and wages growth in Australia is half what it is in the US.
  

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Times like this call for happy songs. Here are three: Katrina and the Waves’ Walking on Sunshine; The Edwin Hawkins Singers’ Oh Happy Day; and Paul McCartney’s Dance Tonight.

Coronavirus update

The Omicron wave has seen new global cases surge again over the past week.

While the UK, US, Canada and Australia have seen new cases slow consistent with South Africa’s Omicron experience, Europe has seen a new leg higher which appears to be due to a new Omicron subvariant (BA.2) which may be more transmissible than the original Omicron (BA.1) but does not appear to be more harmful.

Fortunately, while deaths and hospitalisations have increased reflecting the surge in coronavirus cases they remain subdued relative to new cases compared to prior waves. This is evident in most developed countries – even the US as shown in the next chart where the lower vaccination rates are providing less protection than in other developed countries. It likely reflects a combination of protection against serious illness provided by prior covid exposure and vaccines, better treatments and Omicron being less harmful.

Australia is continuing to see a declining trend in new cases and the proportion of cases suffering serious illness remains low versus prior waves. Hospitalisations and deaths are showing signs of peaking.

Vaccines are continuing to provide protection against serious illness. Data from NSW shows that the unvaccinated are nearly 9 times more likely to end up in hospital, 15 times more likely to end up in ICU and nearly 20 times more likely to die with covid than a fully vaccinated person.

The combination of prior exposure to covid globally and vaccines providing some immunity, new covid treatments and covid morphing lately in a way which is more transmissible but less harmful all provide reason for optimism the pandemic may be heading down a path where the world can live with covid and disruptions caused by it will continue to ease. The main risk remains the possible emergence of more harmful variants – particularly in poorer countries where only 21% are fully vaccinated.

52% of the world’s population is now vaccinated with two doses and only 12% have had a booster.

27% of the Australian population have now had a booster and its rising rapidly and the proportion of the population with one dose has with the vaccination of 5-11 year olds.

Economic activity trackers

Our Australian Economic Activity Tracker rose slightly over the last week reflecting improvement in mobility, restaurant and hotel bookings, shopper traffic and confidence. This is consistent with the downtrend in new Omicron cases and lessening workplace disruptions. The worst may now be over with further improvement likely. Our US activity tracker fell a bit but our European tracker showed a further slight improvement.

Major global economic events and implications

Business conditions PMIs fell in January in the US, Europe, UK, Japan and Australia as Omicron disruptions impacted. With new cases declining in some regions and restrictions being eased the pull back may be short lived.

Other US data was mostly solid. Consumer confidence fell but by less than expected. Meanwhile, December quarter GDP rose by 6.9% annualised although that was mainly driven by inventories, capital goods orders are continuing to trend up, new home sales and house price gains are strong and jobless claims fell suggesting some lessening in Omicron disruptions. The fact that inventories are starting to rebuild is positive in indicating that supply bottlenecks may be starting to fade. Of course inventories are still very low relative to GDP.

So far 32% of US S&P 500 companies have reported December quarter earnings with 78% now beating expectations (compared to a norm of 76%) and consensus earnings growth expectations have been revised up to 23%yoy.

The German IFO business climate index saw a surprise rise in January driven by improved expectations.

Australian economic events and implications

In Australia a fall in business confidence in the December NAB survey confirmed the Omicron driven weakness evident in Australia’s PMI. Fortunately, we may have seen the peak in disruption with Omicron with new cases down and Woolworths noting the number of missing warehouse staff has halved. Apart from the stronger than expected CPI inflation for the December quarter, producer price inflation also accelerated in the December quarter to 3.7%yoy.

What to watch over the next week?

Jobs data in the US (Friday) for January is expected to be impacted by Omicron with payrolls up a relatively subdued 200,000 but unemployment remaining very low at 3.9%. In other data, Omicron disruptions are likely to see the January ISM manufacturing conditions index (Tuesday) and the services ISM (Thursday) pull back but job opening data for December (Tuesday) is likely to have remained strong. The flow of December quarter earnings will start to speed up.

Eurozone December quarter GDP (Monday) is expected to show a slowdown in growth to 0.4%qoq from 2.2% in the September quarter as a result of the surge in Delta cases from October. December unemployment (Tuesday) is expected to be unchanged at 7.2% and January inflation (Wednesday) is expected to fall back to 4%yoy. The ECB on Thursday is expected to leave rates on hold but continue with a slowing in its overall bond buying program and signal somewhat greater concern about inflation.

By contrast reflecting the continuing surge in inflation in December the Bank of England (Thursday) is expected to raise its policy interest rate to 0.5%.

In Australia, the RBA (Tuesday) is expected to leave rates on hold but following recent stronger than expected jobs and inflation data will likely revise down its unemployment forecasts and revise up its inflation and wages forecasts and as a result adopt a far more hawkish stance signalling that rate hikes are likely to start earlier than its previous guidance for around 2024. In the meantime, it will announce an end to its bond buying program. This more hawkish message is likely to be elaborated on in a speech by Governor Lowe (Wednesday) and in the RBA’s quarterly Statement on Monetary Policy (Friday). As noted earlier in this report our base case is for the first hike in August of 0.15%, followed a 0.25% hike in September with the cash rate end the year at 0.5% but the risk is that rate hikes will start in June with the cash rate ending the year at 0.75%.

On the data front expect a further acceleration in December credit growth (Monday) driven by housing credit, CoreLogic home price data for January to show a 0.9% rise, December retail sales to fall by 3% but leaving December quarter retail volumes up 7.3% and housing finance for December to fall by 1% (all Tuesday) and dwelling approvals to show 1% rise with the trade surplus falling to around $9bn (both Thursday). December quarter earnings results will start to flow but only with a handful of companies reporting including Amcor (Wednesday), Newscorp and REA (Friday). Consensus earnings expectations for this financial year are for a 4% rise with a 3% fall in mining profits but gains elsewhere.

Outlook for investment markets

Global shares are expected to return around 8% this year but we may now be starting to see the long-awaited rotation away from growth & tech heavy US shares to more cyclical markets. Inflation, the start of Fed rate hikes, the US mid-term elections & China/Russia/Iran tensions are likely to result in a far more volatile ride than 2021, and we are already seeing this. Mid-term election years normally see below average returns in US shares and since 1950, have seen an average top-to-bottom drawdown of 17%, usually followed by a stronger rebound.

Despite their rough start to the year Australian shares are likely to outperform helped by stronger economic growth than in other developed countries and leverage to the global cyclical recovery.
Still very low yields & a capital loss from a rise in yields are likely to again result in negative returns from bonds.

Unlisted commercial property may see some weakness in retail and office returns, but industrial property is likely to be strong. Unlisted infrastructure is expected to see solid returns.
Australian home price gains are likely to slow with prices falling later in the year as poor affordability, rising mortgage rates, higher interest rate serviceability buffers, reduced home buyer incentives and rising listings impact.

Cash and bank deposits are likely to provide very poor returns, given the ultra-low cash rate of just 0.1%.

Although the $A could fall further in response to coronavirus and Fed tightening, a rising trend is likely over the next 12 months helped by still strong commodity prices and a decline in the $US, probably taking it to around $US0.80.