Investment markets and key developments over the past week

Uncertainty over the war in Ukraine resulted in another volatile week in investment markets as investors worried about the worsening conflict and disruptions to energy supply following the intensification of western sanctions on Russia. Reports of a fire at a Ukrainian nuclear power plant as a result of Russian shelling and the associated risk of a nuclear catastrophe added to the uncertainty. This saw US, European, Japanese and Chinese shares fall for the week. Despite falling on Friday Australian shares managed to rise through the week helped by surging commodity prices with gains in resources stocks offsetting weakness in most other sectors. Bond yields fell on safe haven buying offsetting concerns about higher inflation. Oil prices surged with West Texas Intermediate briefly rising above $US116/barrel on supply concerns before falling back helped by reports Iran and the US may soon reach a new deal but to still be 20% higher over the week. Metal, gold and iron ore prices also rose, and this helped push the $A up despite safe haven buying boosting the $US.

From their bull market highs last year or early this year US shares are down 9% and European and Japanese shares are down 15%. Thanks to the surge in commodity prices and upcoming strong dividend payouts flowing from the most recent earnings reporting season Australian shares have held up a bit better and so are only down by about 7%. The strength in commodity prices also explains why the $A has risen since the war started whereas normally it falls in times of global crisis.

The war in Ukraine remains the key factor driving markets at present and much uncertainty remains about how it will unfold and what its economic impact will be. If the conflict is limited to Ukraine with Russian gas and oil still flowing to Europe and NATO not getting directly involved (Scenario 1), then the economic fallout will be limited, and further share market falls may be minor or we may have seen the low. But if Russian energy supply is cut off and NATO military forces get directly involved (Scenario 2) then share markets could have a lot more downside (like another 15% or so). Scenario 1 seems more likely as Russia does not want to get into a fight with NATO, sanctions have been targeted to exclude the energy sector and Russia needs the revenue. But the risk of Scenario 2 and in particular a disruption to gas supply is high if Putin feels he has nothing to lose as the war drags on and as the now tough sanctions plunge the Russian economy into deep recession. And given the uncertainty, investors may fear the latter scenario even if its ultimately avoided. So markets are likely to remain volatile with oil prices remaining under upwards pressure until there is greater clarity around all this.

However, no one knows for sure how this will unfold. But the history of crisis events and share markets tells us that after an initial hit there should be a decent rebound over 6 to 12 months. There are some things that will help drive this:

• Just as in the Cold War, Russia & the West will likely find a way to co-exist, with mutually assured destruction or MAD providing an incentive.
• The crisis is more inflationary than deflationary, but for the next few months its likely to be a constraint on more rapid central bank rate hikes.
• Surging oil and gas prices will ultimately incentivise increased production from key OPEC producers and US shale oil producers.
• Additional defence spending will provide a boost to growth.
• While European growth will take a bit of a dent, global growth this year is still likely to be strong at around 4%.
• As a result, company profit growth is likely to remain solid this year, albeit down from last year.

Given the uncertainties around the Ukraine war including the potential for financial instability posed by exposure to collapsing Russian assets and cyber-attacks, central banks don’t want to be an added source of uncertainty but will still proceed with tightening – just a bit more cautiously for now.

• Fed Chair Powell’s comments in the past week were hawkish but careful and signalled that the Fed is focussed on controlling inflation, sees the US economy as strong enough to withstand rate hikes but will proceed cautiously given the uncertainty posed by Ukraine – hence while faster rate hikes may be possible at future meetings it looks on track for a 0.25% hike this month, not 0.5%.
• The Bank of Canada raised rates as widely expected by 0.25%, seeing Ukraine as adding to uncertainty but also adding to inflation.
• The RBA sees the Ukraine war as a “major new source of uncertainty” but appears to lean to the view that it poses more of a threat to inflation than to growth but is nevertheless prepared to remain “patient” in assessing the sustainability of the rise in inflation – meaning that rate hikes are at least still several months off anyway.

Our assessment remains that the Ukraine war is more of a threat to inflation via higher commodity prices than it is to growth. Beyond the threat posed by higher energy prices to spending power (which is the main risk) Europe, the US and Australia only have a small exposure to the Russian economy (with exports to Russia being less than 0.7% of EU GDP, less than 0.2% of US GDP and less than 0.1% of Australian GDP). But the rise in energy and food prices (with the oil price up 20% since the invasion started, thermal coal prices up 60% and wheat prices up 25%) will add to inflation. In Australia, the rise in world oil prices will likely add another 15-20 cents a litre to already record petrol prices. And higher wheat prices will push up bread prices.

Flooding in Queensland and NSW is a new source of uncertainty too. But again the floods are more likely to add to inflation than detract from growth. The 2011 floods contributed to a -0.3% fall in GDP in the March quarter of 2011 due to disruption but growth rebounded strongly in subsequent quarters thanks to rebuilding. But the impact on fruit and vegetable prices provided a boost to inflation. This time around we expect economic growth to remain positive thanks to ongoing reopening from the pandemic and the floods being less broad based than in 2011, but the March and June quarters are likely to see around 0.2% added to inflation.

Combined with the impact of higher petrol and grain prices flowing from the Ukraine war this will likely push Australian inflation to around 5%yoy by mid-year (which compares to the RBA’s forecast of 3.75%yoy) and push underlying inflation to around 3.8%yoy (compared to the RBA’s forecast of 3.25%yoy). This means inflation will be well above implied RBA forecasts of around 0.8%qoq for headline and underlying inflation in the March quarter.

As a result, we have brought forward our expectation for the first RBA rate hike to June. Our base case for the first rate hike had been for August with a high risk of June, but with March quarter inflation now likely to come in well above RBA expectations and the ongoing piling on of price rises only adding to upwards pressure on wages growth – which we expect to accelerate to a 0.8-0.9%qoq rise in the March quarter – we now see the RBA concluding that the conditions for rate hikes will be met in June. Following a 0.15% increase in the cash rate taking it to 0.25% in June, we now expect two more rate hikes by year end taking the cash rate to 0.75% by year end (up from our previous forecast of 0.5%).

Out of interest the Russian economy at $US1.6 trillion year is only a tad bigger than the Australian economy at $US1.5 trillion.

In Sydney it seems like it’s been raining forever. Actually I like La Nina’s – rain is far preferable to bush fires and its easier to get warm than to get cool. But you can have too much of a good thing. Here are my three favourite rainy-day songs. The Carpenters did an excellent job with Paul Williams’ Rainy Days And Mondays – Karen Carpenter’s voice lifts even a rainy day song. The Fortunes’ Here Comes That Rainy Day Feeling Again is actually kind of upbeat. And its hard to ignore BJ Thomas’ Raindrops Keep Falling On My Head. This was a Burt Bacharach and Hal David song that helped make Butch Cassidy and the Sundance Kid. I love the line “it won’t be long till happiness steps up to greet me.”

Coronavirus update
New global covid cases continued to fall over the past week. The decline is broad based across regions, but parts of East Asia are still seeing increases with the Omicron wave building a little later there. The same applies in NZ.

Deaths and hospitalisations in major countries are also rolling over in lagged response to the decline in new cases, having peaked at lower levels relative to new cases compared to previous waves. The lower rates of hospitalisation and deaths through the latest wave reflect a combination of protection against serious illness provided by prior covid exposure and vaccines, better treatments and the Omicron variant being less harmful.

This is also evident in Australia, although new cases may be starting to trend up again. This is partly due to a rise in WA as it moves to “living with covid” but signs of a rising trend are now evident in most states including NSW.

56% of the world is now vaccinated with two doses and 18% have had a booster. Nearly 80% of the Australian population have had two doses and 46% have had a booster.

Economic activity trackers

After a huge rebound from the Omicron disruption our Australian Economic Activity Tracker fell slightly over the past week reflecting slight falls in confidence, mobility and transactions. It remains strong though. Our US and European Economic Activity Trackers pushed a bit higher although improvement in Europe slowed – possibly as the war in Ukraine starts to impact. Further impact from the war is likely but it should be modest if gas and oil supplies from Russia are not cut.

Major global economic events and implications

US data was mostly strong. While the ISM services conditions index fell in February it remained strong at 56.5, the manufacturing conditions ISM rose, construction rose solidly and jobs data remaining strong. Of course, the sting in the tail remains high inflation pressures with the Fed’s Beige Book referring to prices rising at a “robust pace” and ISM price readings remaining elevated, although some are off their highs and supplier deliveries have improved.

Eurozone inflation rose more than expected again in February to 5.8%yoy, with core inflation rising to 2.7%yoy. This adds to the challenges facing the ECB but with uncertainty around the impact of Ukraine on growth and financial stability its likely to delay moves to wind up quantitative easing.

Japanese data was soft with industrial production, retail sales and consumer confidence down and unemployment up slightly, but the ratio of job openings to applicants rose.

Chinese business conditions PMIs for February were little changed at around 50/51 suggesting growth may have stabilised but its yet to pick up much.

Australian economic events and implications

The past week saw an avalanche of economic data releases in Australia – most of which were on the strong side with the highlight being a 3.4% rebound in December quarter GDP. This was in line with expectations and mainly reflected a rebound in consumer spending after the east coast Delta lockdowns, but it meant that GDP was up 4.2% through 2021. A further plunge in home building approvals in January points to slowing dwelling investment ahead but growth in consumer spending should remain robust supported by $250bn in excess savings, a still high household saving rate of 13.6% and spending on services still remaining below its pre-covid trend. A strong rise in January retail sales of 1.8%mom is consistent with this. While the east floods and a possible short term hit to confidence from Ukraine may depress near term growth, we continue to expect GDP growth this year of 4.5%yoy.

A rebound in the trade surplus in January to a near record $12.9bn highlights that the ongoing commodity boom is continuing to benefit Australia. This will receive another boost as global energy and food prices have surged following the start of the war in Ukraine.

An outworking of the strong rebound in the economy and the surge in export prices is that the Federal budget deficit for the financial year to date to January is running $13bn below the level implied by the Government’s mid-year review. That would translate to just over $22bn on an annualised basis. The upshot is that there is plenty of scope for the Government to announce more fiscal stimulus in the May Budget or ahead of the election and still announce a lower budget deficit than what it projected just back in December.

Housing finance up to record levels but home price growth slowing. Conflicting indicators are often the case at turning points and that’s the case right now in relation to housing with housing finance rising to a record in January and pointing to a further acceleration in housing credit growth and auction clearance rates remaining strong but CoreLogic data showing a further slowing in home price growth, with Sydney prices falling and Melbourne prices flat. Our assessment remains that national home price growth will continue to slow this year with prices likely to peak around mid-year and fall -10-15% into 2023-24 as poor affordability and rising mortgage rates impact. Sydney and Melbourne are likely to peak earlier if they haven’t already.

The Melbourne Institute’s Inflation Gauge for February rose again and points to a further acceleration in inflation with its measure of trimmed mean inflation accelerating to 3.2%yoy and pointing to a faster pickup in inflation this quarter than the RBA is expecting.

Another big dividend payout on the way. Thanks to another strong earnings reporting season the next two months will see $36bn in dividends paid out to shareholders (according to calculations by The Coppo Report) which is down from the record $38bn paid out six months ago but way up on the $26bn from a year ago.

What to watch over the next week?

In the US, CPI inflation data (Thursday) is likely to show a further rise in inflation to 7.9%yoy and in core inflation to 6.4%yoy. Small business optimism for February will be released Monday and January data on job openings will be released Wednesday.

The ECB (Thursday) is expected to retain a hawkish bias but delay any slowing in bond buying given the uncertainty posed by the war in Ukraine.

Chinese trade data for January and February will be released Monday and February inflation data (Wednesday) is expected to show CPI inflation remaining low at 0.8%yoy and producer price inflation slowing further to 8.6%yoy. Credit data for February will be watched for a further acceleration in credit growth following recent policy easing measures.

In Australia, the NAB business survey for February (Tuesday) is likely to show a rebound in conditions and confidence following the decline in Omicron cases but consumer confidence for March (Wednesday) may slow slightly reflecting the bad news of the war in Ukraine. RBA Governor Lowe in a speech on Wednesday will likely reiterate the RBA’s preparedness to be patient in assessing the rebound in inflation but his assessment regarding the impact of the Ukraine war and the recent floods will be watched closely given the additional upside risks both pose to the inflation outlook.

Outlook for investment markets

Shares are likely to see continued volatility this year as the Ukraine crisis continues to unfold and inflation, monetary tightening the US mid-term elections and geopolitical tensions with China and maybe Iran impact. However, we still see shares providing upper single digit returns this year as global recovery continues, profit growth slows but remains solid and interest rates rise but not to onerous levels.

Still very low yields & a capital loss from a rise in yields are likely to again result in negative returns from bonds this year.

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 further with prices falling later in the year as poor affordability, rising mortgage rates, reduced home buyer incentives and rising listings impact. Expect a 10 to 15% top to bottom fall in prices from later this year into 2023-24 but large variation between regions. Sydney and Melbourne prices may have already peaked.

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 the Ukraine crisis and Fed tightening, a rising trend is likely over the next 12 months helped by rising commodity prices, probably taking it to around $US0.80.