Investment markets & key developments
Share markets had another rough week with ongoing worries about monetary tightening to combat high inflation driving a possible recession, before a bounce from oversold levels at the end of the week. This left US shares down 2.4% for the week, Eurozone shares up 1.4%, Japanese shares down 2.1%, Chinese shares up 2.0% and Australian shares down 1.8%. Bond yields pulled back from their highs and metal and iron ore prices fell, but oil prices rose. Worries about global growth also dragged the $A down as the $US rose.
From their bull market highs, US shares are down 16%, Eurozone shares are down 15%, Japanese shares are down 14%, global shares are down 15% and Australian shares are down 7%. While European and Japanese shares initially fell harder after the invasion of Ukraine, the concern recently has swung back to higher inflation and higher interest rates, which has really weighed on the US share market given its higher tech exposure, with the Nasdaq now down 27%. The fall back in commodity prices has harmed Australian shares lately, but their low exposure to tech stocks is helping them in a relative sense.
Shares could have a further near-term bounce from oversold levels. But risks around inflation, monetary tightening, the war in Ukraine and Chinese growth remain high and still point to more downside in share markets before they bottom. The risks around inflation and rising bond yields are the main threat at present – but Chinese COVID lockdowns and the war in Ukraine are adding to supply disruptions.
• US inflation came in stronger than expected again for April. While annual inflation fell slightly (from 8.5%yoy to 8.3% for the CPI and from 6.5%yoy to 6.2% for core inflation) as higher monthly inflation readings a year ago dropped out it was still higher than expected. Goods inflation (green bars in the next chart) looks to be slowing but services inflation (blue bars) is continuing to pick up – particularly for airfares, health and rents – partly reflecting the surge in wages growth seen recently in the US. So while inflation may have peaked, it looks like it may be staying too high for comfort for the US Federal Reserve (Fed) (and other central banks), keeping it on track for 0.5% rate hikes at the next three meetings.
- European Central Bank (ECB) President Lagarde strongly hinted that the ECB will start raising rates in July. The ECB expects to stop its bond buying early in the third quarter, with the start of rate hikes “some time” after that.
- Rising pressure for wage growth to compensate for higher inflation risks resulting in a wage/price spiral and a rise in inflation expectations that simply locks inflation in at high levels. Talk of 5% wage claims in Australia suggests that this is also rapidly becoming a risk locally. The only sustainable way to get decent wages growth above inflation is to boost productivity growth and that requires significant economic reform.
- The danger is central banks won’t be able to get inflation under control without engineering a recession, particularly the longer supply constraints remain. Fed Chair Powell indicated that getting inflation to 2% will “include some pain”.
- While shares are getting oversold and investor pessimism is becoming extreme, we are not yet at levels for indicators like Vix or the Put/Call ratio seen at major market bottoms.However, there is some light at the end of the tunnel.
- While US inflation is still too high for comfort and may remain so for some months, signs of peaking remain evident in our Pipeline Inflation Indicator, reflecting lower freight costs and a slowing in commodity prices including oil and gas. This could enable central banks to slow the pace of tightening later this year – in time to avoid recession.
- While services inflation could continue to rise for a while yet, there are signs monthly US wages growth may have peaked, with e.g., monthly growth in average hourly earnings looking like it may have peaked late last year.
- Share market earnings are continuing to come in stronger than expected. The US March quarter earnings reports are continuing to surprise on the upside and earnings look on track to rise around 12%yoy, which is up from initial expectations for a 4.3%yoy gain. And earnings growth in Europe and Asia is averaging slightly faster.
- Maybe, just maybe, some of the risks around a widening in the Ukraine conflict to include NATO countries may be declining. Contrary to the fears of many, President Putin did not declare war on Ukraine and announce a general mobilisation signalling an escalation at his 9 May victory over Nazi Germany commemoration speech. It could become another frozen conflict which is horrible for Ukraine and those in the conflict zone, but not a further disruptor to global growth. The risks still remain high though, with new tensions around Finland wanting to join NATO.
- Covid cases in China appear to be slowing, which could enable an easing in restrictions and clear the way for policy stimulus to boost growth.
- Yield curves have yet to decisively invert and even if they do now, the average lead to recession is 18 months – which takes us to late next year, which would be too early for share markets to discount as they generally only look 6 months ahead.
- Just focussing on rate hikes ignores the tightening already underway from the ending of quantitative easing (QE) and the shift to quantitative tightening (QT), meaning that the Fed may have already tightened a lot and market expectations for a cash rate up to 3% in the US (and Australia) next year may be too hawkish.
So, while shares could still see more falls in the short-term, we remain of the view that a deep (or grizzly) bear market will be avoided as US and Australian recession should be avoided over the next 18 months, which should enable share markets to be up on a 12 month horizon.
Is a terra-fying cryptogeddon unfolding and what would it mean for global economies and markets? Crypto currencies have been behaving like a high beta version of shares. Like tech stocks, they benefitted immensely from easy money and ultra-low interest rates and bond yields. So now that easy money is being reversed they are suffering along with tech stocks, albeit more so, as there was far more hot air involved in cryptos. The risks were highlighted in the past week, with the collapse of TerraUSD, an algorithmic stablecoin meant to stay at $US1 through an arrangement with another crypto currency called Luna (which could be swapped for TerraUSD and vice versa in order to reduce or raise the supply of the latter to keep it stable). Stablecoins are popular in the crypto world because they allow crypto traders to trade without having to leave the crypto world – a bit like a money market fund in traditional investment markets. But TerraUSD depended on faith in Luna, which was weakened after a series of large withdrawals. It all broke down with TerraUSD falling to $US0.40, with a flow on to demand for other cryptos including Bitcoin, which the Luna Foundation Guard sold to raise funds to support Terra at a time when cryptos were under pressure anyway. Bitcoin is now down more than 50% from last year’s high. Notwithstanding short-term bounces, as with shares, further downside is a risk if falls feed on themselves and the speculative mania unwinds leading to yet another 80% top-to-bottom fall. Or buy and ‘hold on for dear life’ (HODL) may kick in again. With little in the way of fundamental value, it’s hard to know which way it goes. And to the extent that crypto currencies depend on bringing in more investors to keep moving forward, a collapse now could have a more lasting impact on interest in it than in the past when it was less “mainstream.” Particularly given that Bitcoin has so far offered little hedge against the surge in inflation over the last year. For the broader financial system and economy, a crypto crash poses a risk (particularly if the cash and other $US assets supposedly backing stablecoins like Tether have to be sold), but it’s unlikely to be another sub-prime crisis. Banking system exposure to crypto is limited and the exposure of the wider investing public is still small (contrary to various surveys claiming the contrary – but which seem more aimed at marketing interest in cryptos). Demand for Lamborghinis may suffer a setback though.
The Australian election is now rapidly approaching with polls pointing to an ALP victory. Two party preferred polling has the ALP ahead by around 55% to 45% and unlike in the run up to the 2019 election we have not seen the narrowing in ALP poll support that ultimately culminated in the Coalition retaining power. A high proportion of “soft voters” in polling suggests it is still unclear. But the key point for markets remains that unlike in 2019, apart from climate change policies the economic policy platforms of the major parties are not that different, so its hard to see a significant impact on markets from a decisive change in government to Labor. The main risk would come if neither of the main parties get enough seats to govern on their own forcing reliance on independents which could force a new government down a less business friendly path, such as the Greens demanding an ALP led minority government implement their proposed super profits taxes.
On rewatching Dark Shadows, the early sequence of the train moving along to The Moody Blues “Nights in White Satin” provided me with a reminder of just how good they are at fusing classical music with rock. “Tuesday Afternoon” also from Days of Future Passed is also one of their best.
New global COVID cases and deaths have continued to trend down. However, there are signs they may be bottoming and the US is still ticking up.
South Africa has seen a sharp upswing in new cases, reflecting Omicron sub-variants BA.4 and BA.5 which appear more transmissible again than the original Omicron was and with prior Omicron exposure offering less protection against infection. Fortunately, they do not appear to be more harmful, with hospitalisation and death rates remaining subdued compared to pre Omicron waves. Of course, this can still place pressure on hospitals and cause economic disruption due to absences from work if many get it at once.
China has seen a significant slowing in new COVID cases, which may allow for some easing in lockdowns which would be good news for an easing in global supply concerns. If followed up with more stimulus measures, which appears likely, it would also be positive for commodity prices, Australian shares and the $A. That said, China may face a far rougher ride if it continues with its zero COVID policy, as Omicron is far harder to suppress than the original COVID virus.
New cases in Australia are on the rise again, not helped by new Omicron sub-variants. Hospitalisation and death rates should remain low compared to pre-Omicron waves, helped by high rates of vaccination protecting against serious illness and the subvariants remaining mild. A surge in cases however could still cause workforce disruption as we saw in January.
Economic activity trackers
Our Australian Economic Activity Tracker fell over the last week, but remains strong. Our European Tracker was little changed, but the US improved.
Major global economic events and implications
US inflation dominated over the last week, with both consumer and producer price inflation slowing a bit on an annual basis but remaining too high. Meanwhile jobless claims remain very low, but small business optimism remained subdued, with a low proportion of firms keen on expansion and continuing high price pressures.
More than 90% of US S&P 500 companies have now reported March quarter earnings, with 76% beating expectations – which is in line with the norm. However, consensus earnings expectations for the quarter have now moved up to 11.7%yoy from 4.3% at the start of the reporting season. With the average beat running around 7.3%, it’s likely to end up at around 12%yoy. Energy, materials and industrials are seeing the strongest earnings growth. Earnings growth in Europe and Asia has been stronger though, averaging 13.9%yoy.
Japanese household spending improved in March as COVID restrictions were lifted. This also contributed to a further recover in the April Economy Watchers sentiment indicators.
Chinese export, import and credit growth all slowed in April, reflecting coronavirus lockdowns. CPI inflation rose to 2.1%yoy, but this was due to higher food prices, with core inflation slowing to 0.9%yoy and producer price inflation slowing further to 8%yoy. Meanwhile, the People’s Bank of China (PBOC) reiterated that monetary policy would “increase support to the real economy.”
Australian economic events and implications
Real retail sales growth remained strong in the March quarter. While part of the recent strength in retail sales was due to inflation, real retail sales were up a solid 1.2%qoq, which when combined with likely strength in services spending, suggests that consumer spending will make a strong contribution to March quarter GDP growth.
But consumer confidence is now down sharply and there is a big divergence with business confidence. Consumer confidence fell again in May according to the Westpac/MI survey and is now at its lowest since August 2020, thanks to rising prices and rising interest rates. However, while consumers are depressed, timely credit and debit card data suggests they are continuing to spend and this is helping keep business conditions and confidence strong, albeit the latter did fall a bit in May. The main concern for businesses is rising costs, with labour and purchase costs rising to new highs in April of 3%qoq and 4.6%qoq respectively, pointing to further inflationary pressure ahead and adding to pressure for the Reserve Bank of Australia (RBA) to increase rates further. We expect the RBA to increase the cash rate by 0.4% at its June meeting and raise it to 1.5-2.0% by year end, but the massive hit to confidence, the negative wealth effect from falling home prices and the rollover of fixed rate borrowers seeing a doubling in their rates suggests that the peak will be limited to 2.5% next year.
Consumers getting more pessimistic on housing. The Westpac/MI consumer survey showed another deterioration in sentiment towards buying homes, with the “time to buy a dwelling’ index falling again in May and down 25% on a year ago, consistent with a further softening in the housing market. So far this month CoreLogic data shows property prices continuing to slow, with more falls in Sydney and Melbourne.
What to watch over the next week?
In the US, expect to see solid gains in April retail sales and industrial production but with home builder conditions falling back slightly again (all due Tuesday), housing starts (Wednesday) also likely to fall and manufacturing conditions indexes for the New York and Philadelphia regions likely to pull back slightly in May (due Monday and Thursday).
Japanese March quarter GDP (Monday) is expected to have contracted by -0.5%qoq, reflecting the impact of COVID restrictions, while inflation data (Friday) for April is expected to jump, reflecting the dropping out of the reduction in mobile phone charges a year ago, with core inflation rising to 0.3%yoy from -0.7%.
Chinese economic activity data for April due for release on Monday is expected to be hit by COVID lockdowns, with industrial production likely to slow to just 0.5%yoy, retail sales likely to contract by -6.2%, investment growth to slow and unemployment likely to rise.
In Australia, the minutes from the RBA’s last board meeting (Tuesday) are expected to be hawkish, reinforcing expectations for more rate hikes to control inflation. Thanks to the tight labour market, March quarter wages data is expected to show an acceleration to 0.8%qoq, its fastest increase since 2014, taking annual wages growth to 2.5%. April jobs data is expected to show a 20,000 gain in employment, with unemployment dipping slightly to 3.9%, the lowest since 1974.
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 Chinese COVID lockdowns impact. However, we see shares providing reasonable returns on a 12-month horizon as global recovery ultimately continues, profit growth slows but remains solid and interest rates rise – but not to onerous levels, at least not for the next year.
Still-low yields and a capital loss from a further rise in yields are likely to result in ongoing negative 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), 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 average prices falling from mid-year as poor affordability, rising mortgage rates and rising listings impact. Expect a 10 to 15% top-to-bottom fall in prices from mid-year into 2024, but with large variation between regions. Sydney and Melbourne prices have likely already peaked.
Cash and bank deposits are likely to provide poor returns, given the ultra-low cash rate of just 0.1% at present, but it should rise as the RBA raises interest rates.
The $A could fall further in the short term if Chinese COVID lockdowns persists. However, a rising trend in the $A is likely over the next 12 months helped by strong commodity prices, probably taking it to around $US0.80.
Dr Shane Oliver
Head of Investment Strategy and Economics and Chief Economist, AMP