Investment markets & key developments

Share markets saw another volatile week. Shares initially rose from oversold conditions helped by good US earnings results, but rate hike expectations, particularly in Europe and in the US after very strong US payrolls and divergent tech sector earnings news, added to volatility. Despite a hit from an earnings-miss by Facebook, US shares rose around 1.6% for the week and Japanese shares gained 2.7%, but Eurozone shares lost 0.5% as the European Central Bank (ECB) turned more hawkish. Australian shares rose 1.9%, benefitting from the positive US lead and indications from the Reserve Banks of Australia (RBA) that it would be patient in raising interest rates. Long term bond yields rose sharply, with German 10-year yields rising above zero for the first time since 2019 and Japanese 10-year yields rising to a 5 year high. Oil prices rose to their highest since 2014 on expectations for strong demand and geopolitical tensions; and look like they are on their way to $US100 a barrel. Metal and iron ore prices also rose. The A$ rose as the US$ fell.

The trend to monetary tightening continues:

• The Bank of England (BoE) raised rates by another 0.25% citing higher inflation, making it the first back-to-back rate hike since 2004. I also commenced quantitative tightening & sounded hawkish, with 4 of the 9 MPC members voting for a 0.5% hike and seeing “some further [albeit] modest tightening”.
• The ECB left monetary policy on hold but shifted more hawkish, with President Lagarde indicating “the situation has indeed changed” with more concern present about inflation, though declining to reiterate that rates are unlikely to rise this year. With inflation rising to 5.1% year-on-year (yoy), the ECB looks likely to start tapering its bond buying from March, ending it around mid-year and starting rate hikes in the second half.
• A fall in unemployment to 3.2% and rising wages growth is maintaining pressure on the Royal Bank of New Zealand (RBNZ) for further tightening.
• Fears of aggressive US Federal Reserve (Fed) tightening declined a little, earlier in the week, as various Fed speakers pushed back against expectations for a 0.5% March rate hike. Fears however returned later in the week, as January payrolls came in much stronger than expected, while wages growth surged also more than expected.

Even the RBA has become more hawkish, despite doing its best to sound as dovish as possible in the process. Through much of the last decade it was thought that the RBA had to be dragged kicking and screaming into rate cuts. Now it seems to be a bit of the opposite. The RBA has stressed (through its post meeting statement, a speech by Governor Lowe and the Statement on Monetary Policy) a preparedness to be “patient” in waiting for more confidence that inflation will be sustained in the target range and that wages are rising. However, it has clearly become more hawkish: Its unemployment forecasts have been revised down to levels not seen since the 1970s and its wages and inflation forecasts have been revised up to the point where they would normally be consistent with imminent rate hikes; its central case for a rate hike looks to have moved forward to 2023 from previously being “not before 2024”; and Governor Lowe has conceded that a hike in 2022 is now “plausible”, after just a few months ago arguing against it and saying it was “extremely unlikely”.

The RBA’s preparedness to be “patient” may be justified for a few months and is not inconsistent with our own base case that they won’t start raising rates till August. It does however remind me of Fed Chair Powell’s comment in November that “it’s appropriate to be patient” in terms of when rates would go up…and of course now the Fed is on track for rate hikes starting next month! Further, with unemployment now expected to push below 4% and underlying inflation likely to push above the top of the target-range, the RBA is running the risk of waiting too long to start tightening, which in turn will then risk allowing much higher inflation to become entrenched as inflation expectations increase, making it harder to get back under control again. This is the risk that central banks, like the Fed, may now be facing. Wages are usually a lagging indicator, so waiting for them to rise significantly before hiking runs the risk that the first hike come too late to head of a blow-out in inflation expectations.

However, with the RBA moving progressively more hawkish, our view is that its “patience” will only last six months or so. With numerous indicators pointing to rising wages growth, amidst ongoing reports of staff shortages, it’s likely to surprise to the upside sooner than the RBA is allowing. As such, we maintain our view that the first-rate hike will come in August, taking the cash rate to 0.25%, followed by a second hike in September to 0.5%. If wages data (due 23rd February and in May) show a significant acceleration, then the first rate hike could come in June.

At a broader level, the era of extraordinary monetary policy stimulus is now over in Australia…well for now anyway. Cheap financing for banks ended in June, the 0.1% yield target ended in November and now quantitative easing (QE) will end in the week ahead. The big question is now whether the RBA will decide at its May meeting to roll over its bond holdings as they mature and so maintain their balance sheet or let them rundown – which would amount to quantitative tightening. I expect a bit of the latter, to allow “patience” on rates to run a few months more.

We remain of the view that monetary tightening will not be enough to end the global and Australian economic recoveries this year and that shares will remain in a rising (albeit more constrained) trend, but this does not necessarily mean the correction in shares is over. The bounce from the January low has been strong and welcome, but a bounce from very oversold levels is not that unusual. Markets will still have to grapple with uncertainty about how high interest rates will rise, particularly amidst ongoing inflationary pressures, the unwinding of excessive valuations for some tech stocks and uncertainty regarding Russia and Ukraine (and the associated threat posed to European gas prices). US mid-term election years are also known for volatility.

On the US political front, things are now a bit more uncertain, with a Democrat Senator to be absent from the Senate for a while following a stroke. This robs the Democrats of their narrow majority. It could have the positive impact though of pushing President Biden down a more bi-partisan path on his agenda, which may be a good thing.

As goes January for shares, so goes the year… or does it? The so-called January barometer posits that the performance of shares in January is a good guide to how they go for the year. On this basis, it’s pointing to a bad year, as US shares fell 5.3% in January and Australian shares fell 6.4%. Historically however, the January barometer has not been so reliable when it comes to falls during that month. Since 1980, a positive January in US shares has gone on to a positive year 84% of the time, but a negative January has only seen a negative year 35% of the time. It’s similar for Australia, where a positive January has gone on to a positive year 75% of the time, but a negative January has only seen a negative year 33% of the time.

Unfortunately, coronavirus is dragging on like ground hog day and touching all of us. Meatloaf and now Glenn Wheatley have recently died from coronavirus complications. Glenn is perhaps best known for managing John Farnham, including his famous 1980’s comeback with songs like You’re The Voice, as well as Delta Goodrem. In the late 1960s and early 1970s however he was a member of The Masters Apprentices, which had unbelievable songs like It’s Because I Love You (“do what you want to do, be what you want to be yeah”). Thanks for the music, Glenn.

Coronavirus update

New global covid cases slowed a bit over the last week.

New cases have continued to slow in the US and Canada, but Europe has seen a further rise driven by Germany and a renewed spike in the UK as Omicron sub-variant BA.2 impacts. Several countries in Europe are seeing a declining trend though and this includes France, Italy and Spain and several countries across Europe have been easing restrictions, including Denmark which also looks to have peaked.

A new but less severe Omicron wave on the way? The bad news is that the rise of Omicron sub-variant BA.2 – which appears to be more transmissible than the original Omicron (BA.1) – could extend the latest global covid wave as it has in several European countries. However, Omicron BA.2 appears to be no more severe than BA.1. In fact, based on Denmark’s experience – which was one of the first countries to be hit by BA.2 – it looks to be much less severe with far more ICU patients at the height of the Omicron BA.1 wave in early January than in the second BA.2 wave (which saw more than double the number of daily cases) in late January. Taken together with Denmark’s very high vaccination rate – with around 80% of the population double vaccinated and around 60% having had a booster – it has removed all covid restrictions because covid is no longer seen as a “critical threat”. The further evolution of coronavirus in a more transmissible but potentially less harmful direction along with protection from vaccines provides reason for optimism covid is transitioning from being a pandemic to being endemic.

Deaths and hospitalisations remain subdued relative to new cases compared to prior waves. This is evident in the chart for global deaths versus cases above and is evident in most developed countries (including Europe in the next chart) and likely reflects a combination of protection against serious illness provided by prior covid exposure and vaccines, better treatments and Omicron being less harmful. Europe’s experience is particularly noteworthy – so far its spike higher in new cases in the last few weeks which appears to have been largely driven by Omicron BA.2 has not been associated with much of a rise in hospitalisations at all which may be consistent with Omicron BA.2 being less harmful than Omicron BA.1, which was in turn less harmful than Delta.

Australia has seen a further decline in new cases. While the level of hospitalisations and deaths increased in the last two months, they remain low relative to new cases compared to earlier waves reflecting the protection provided by vaccines against serious illness and Omicron being less harmful. The decline in new cases points to a further fall in hospitalisations and then deaths as they follow with a lag. The high risk for the next few months is that Omicron sub-variant BA.2 along with the return to school leads to a resurgence in new cases. However, as noted above, Omicron BA.2 may be less harmful than the original Omicron and if its mainly more children getting covid, a new Omicron wave of cases may not necessarily put significantly more pressure on the hospital system.

Various studies continue to highlight that vaccines are providing significant protection against serious illness including from the Omicron variant(s). For example, during the week ending 8th January unvaccinated adults were 23 times more likely to be hospitalised in Los Angeles County than vaccinated adults.

53% of the world’s population is now vaccinated with two doses and 13% have had a booster. The trouble is that its rising slowly (at about 1% of the world’s population a week) and in poor countries only 22% have had two doses – which prolongs the risk of new more harmful mutations developing.

33% of the Australian population have now had a booster and it’s rising rapidly and the proportion of the population with one dose has risen to 85% with the vaccination of 5-11 year olds.

Economic activity trackers

Our Australian Economic Activity Tracker has recovered further reflecting improvement in mobility, restaurant and hotel bookings, shopper traffic and confidence as Omicron cases and workforce disruptions receded. The shallow and brief dip in the Tracker points to far less impact on March quarter GDP than seen with the Delta lockdowns in the September quarter. In fact, we just see a moderation in the rate of GDP growth rather than a contraction. Our US and European Economic Activity trackers also improved.

Major global economic events and implications

US data was mostly strong. Payroll employment growth at 467,000 in January was far stronger than expected with prior months revised up by 709,000, unemployment rose; but only to 4%, with underemployment falling again and wages growth accelerated to 5.7%yoy. This was despite the Omicron disruption. While participation rose, it’s still well below pre pandemic levels. Meanwhile, job openings and quits data also point to a continuing very tight labour market and jobless claims have been falling since mid-January, suggesting a fall in unemployment in February. The strong January jobs report keeps the Fed on track for a March rate hike which could yet turn out to be 0.5%, four or five rate hikes this year and the start of quantitative tightening. The ISM business conditions indexes fell back in January with Omicron impacting, but by less than expected, and remain strong.

56% of US S&P 500 companies have reported December quarter earnings with 76% beating expectations which is about average & consensus earnings growth expectations have jumped to around 28%yoy and are now likely to end up at around 30%yoy.

Eurozone December quarter GDP growth slowed to just 0.3%qoq as coronavirus outbreaks impacted with Germany down but France, Italy and Spain up. Eurozone unemployment fell to 7% in December, but inflation surprisingly rose further in January to 5.1%yoy.

Japanese economic data was mixed with industrial production and consumer confidence down but unemployment falling to 2.7% and the ratio of job openings to applicants rising.

China’s business conditions PMIs for January moderated, pointing to further policy stimulus measures.

A fall in NZ unemployment to just 3.2% in the December quarter and a rising trend in several wage growth measures (following the surge in inflation to 5.9%yoy) is adding to expectations that the RBNZ will raise rates by 0.5% this month.

Australian economic events and implications

While Australian retail sales fell in December, it looks like payback after two very strong months as Black Friday sales brought spending forward, but in any case December quarter retail sales look like were up 7.5% or so in real terms and they remain well above their pre-pandemic trend. Omicron is also likely to have impacted late in the month and this will likely also depress January retail sales ahead of a rebound this month.

The trade surplus fell again in December, but this was because of strong imports, rather than weak exports, which is consistent with rising demand in the economy.

Housing data was all strong: total credit growth rose to its fastest since 2008 and housing credit growth remained solid in December, with investor lending growth continuing to accelerate; housing finance rose to a new record high, pointing to a further acceleration in housing credit; building approvals unexpectedly rose in December and look to be settling at a pretty high level; and CoreLogic data showed another 1.1% gain in national home prices in January, led by very strong gains in Brisbane and Adelaide.

We remain of the view that home prices will peak later this year as poor affordability and rising rates impact, but in the meantime the continuing surge in investor lending keeps alive prospects for further Australian Prudential Regulation Authority (APRA) macro prudential tightening.
Meanwhile, the Melbourne Institute’s Inflation Gauge saw another acceleration in January, pointing to a further acceleration in underlying inflation this quarter.

What to watch over the next week?

In the US, CPI data for January (Thursday) is expected to show another rise taking inflation to 7.3% year on year with core inflation rising to 5.9%yoy (from 5.5%). Small business confidence data will also be released Tuesday. December quarter earnings results will continue to flow in the US.

In Australia, expect a 7.5% gain in December quarter real retail sales (Monday), the NAB business survey for January (Tuesday) is likely to show confidence remaining down reflecting the Omicron disruption but Westpac/MI consumer confidence for February (Wednesday) may improve a bit.

December half earnings results will start to ramp up with around 30 major companies reporting including James Hardie (Monday), Suncorp and Computershare (Tuesday), CBA and Mineral Resources (Wednesday), AGL, AMP and ASX (Thursday) and IAG (Friday). Consensus earnings expectations for this financial year are for a 13% rise in earnings led by energy, industrials, and financials. Given Delta and Omicron disruptions a key focus will be on outlook statements.

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, rate hikes, the US mid-term elections and China/Russia/Iran tensions are likely to result in a far more volatile ride than 2021, and we are already seeing this..

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.