Investment markets and key developments over the past week
Share markets have seen another volatile week being buffeted by waxing and waning fears of Russia invading Ukraine and fears of inflation and interest rate hikes. This left US, European and Japanese share markets down. Solid profit results helped protect the Australian share market, which was up slightly for the week, with gains in health, property and consumer staple shares offsetting falls in IT, telco and material stocks. US and global shares are at high risk of a re-rest of their January lows and this would likely drag Australian shares back down there too. Long term bond yields had a mixed week with safe haven demand partly offsetting rising inflation and rate hike expectations with yields up in the US, Japan and Australia but down in Europe. Oil prices briefly rose to their highest since 2014 on Ukraine tensions before falling back. Metal prices were flat, but the iron ore price fell. The $A rose slightly as the $US fell.
Pressure for monetary tightening continued over the last week. Both the UK and Canada saw higher than expected increases in inflation in January of 5.5%yoy and 5.1%yoy respectively, pointing to further rate hikes. The minutes from the last Fed meeting highlighted upside risks to inflation and that a faster pace of rate increases was likely compared to the post 2015 period but it was no more hawkish than previously flagged and there was little to point to a 0.5% initial hike.
What could drive a June rate hike from the RBA? Our base case remains that the first hike will come in August but the risk of an earlier move in June is high, and this has been reinforced by another strong jobs report for January. The RBA is clearly focussed on achieving full employment, seeing wages growth of 3% or more and the trimmed mean measure of inflation being sustained in the target range. Looking at each of these:
• Unemployment is currently at 4.2% and likely to slip below 4% by mid-year, which will leave it consistent with the RBA’s full employment objective given Assistant Governor Ellis’ indication that NAIRU (the non-accelerating inflation rate of unemployment) is between the high 3s and low 4s.
• December quarter wages data will be released in the week ahead and March quarter wages data will be released in the second half of May. RBA forecasts imply 0.6%qoq increases for both quarters, but various business surveys and anecdotal evidence point to an acceleration. For example, the ABS’s weekly payroll jobs data show a significant acceleration in total payroll wages growth relative to total payroll jobs growth since mid-last year. This is not a pure guide to wages growth as it will be affected by things like compositional change in the workforce and hours worked but it does suggest an acceleration in wages growth. We expect 0.8%qoq increases in wages in each quarter which would translate to above 3% at an annualised rate.
• March quarter CPI inflation data will be published at the end of April. RBA forecasts imply around a 0.7%qoq increase in the trimmed mean inflation rate but given indications from businesses regarding cost pressures and price increases it could easily come in at 1%qoq again, which yet again would be well above RBA forecasts.
In our view a combination of a further decline in unemployment, an acceleration in wages growth to 0.8% quarter on quarter for the December and March quarters and another upside surprise on inflation this quarter together would likely clear the way for a June rate hike. A rate hike in May is conceivable but the RBA won’t have the March quarter wage report by then and May will likely be in the midst of an election campaign. So while our base case is for the first hike to be in August, a June rate hike is a high risk. First thing to watch will be this coming Wednesday’s wages data.
There was some good news on inflation in China in January with both producer price and consumer price inflation slowing. And Japanese inflation also slowed. The slowdown in Chinese inflation partly reflects it being well ahead in terms of policy tightening which started early last year, whereas western central banks are only just starting to tighten.
But it’s also consistent with the message from our Pipeline Inflation Indicator, which tracks supply chain pressures, that global inflationary pressures may be starting to roll over. This is a bit tentative, and it won’t prevent rate hikes over the next 6 months but it points to some relief on the global inflation front in the next 6 months or so which should help take some pressure of global central banks in the second half of the year.
Tensions remain high regarding Russia and Ukraine, but talks still have a chance. While indications from Russia that it would continue with talks and the announcement of a partial troop pullback saw share markets bounce early in the last week, uncertainty quickly returned as western officials said the military build-up was continuing and President Biden warned of invasion in the “next several days” only to then see some relief as the US and Russia agreed to new talks in the week ahead. Trying to work out which way this goes is not easy but there are basically four scenarios:
1. Russia stands down – this would provide a very brief boost for share markets, including Australian shares, (eg +1%) and maybe knock 5% or so off the oil price.
2. Russia moves in to occupy the Donbas (which is already controlled by Russian separatists) with sanctions from the west but not so onerous that Russia cuts of gas to Europe – this could see a brief hit to markets (say -2-4%) like in the 2014 Ukraine crisis but it would soon be forgotten about.
3. Russian invasion of all of Ukraine with significant sanctions and Russia stopping gas to Europe (causing a stagflationary shock to Europe & possibly globally as oil prices rise further) but no NATO military involvement – this could see a bigger hit to markets (say -10%) but then recovery over six months.
4. Invasion of all of Ukraine with significant sanctions, gas supplies cut & NATO military involvement – this could be a large negative for markets (say -15-20%) as war in Europe, albeit on its edge, fully reverses the “peace dividend” of the 1990s. Markets may then take 6-12 months to recover.
Scenario 1 is still possible if there is a breakthrough in talks with Russian Foreign Minister Lavrov describing some western proposals as “constructive.” And it’s hard to see Russia undertaking a full invasion of Ukraine given the huge cost it would incur, let alone NATO troops being involved. But some combination of scenarios 2 and 3 is possible. Who knows for sure but there is a long history of various crisis events impacting share markets (major events in wars, terrorist attacks, financial crisis, etc) and the pattern is the same – an initial sharp fall followed by a rebound. Based on multiple crisis since 1907 Ned Davis Research found an average decline of 7% in US shares from such events, but 6 months later the market is up 10% on average and 1 year later its up around 15%.
I came to The Beach Boys long after their 1960’s peak but their combination of lush harmonies, falsettos and evocative lyrics never fail in taking me to the nearest faraway place. Your Summer Dream is a classic in this regard but they never let up with Shelter from their 50th anniversary album being equally as impressive.
New global covid cases fell again over the last week with broad based declines across most regions.
Deaths and hospitalisations remain subdued relative to new cases compared to prior waves. This is evident in the chart for global deaths versus new cases above and is evident in most developed countries (including in the relatively less vaccinated US – see the next chart) and likely reflects a combination of protection against serious illness provided by prior covid exposure and vaccines, better treatments and the Omicron variant(s) being less harmful. The evolution of coronavirus in a more transmissible but potentially less harmful direction along with protection from vaccines provides reason for optimism covid is transitioning to being endemic.
Australia has seen a further decline in new cases, but the decline may be stabilising with the even more transmissible but likely less harmful Omicron sub-variant BA.2 impacting along with back to school and related testing. Hospitalisations and deaths have also rolled over and remain low relative to new cases compared to earlier waves reflecting the protection provided by vaccines and Omicron being less harmful. Reflecting this NSW & Victoria are significantly reducing restrictions.
Studies continue to highlight that vaccines are providing significant protection against serious illness including from the Omicron variant(s). For example, Victorian data up to February showed unvaccinated people were 6 times more likely to be hospitalised than those with three doses.
54% of the world’s population is now vaccinated with two doses and 16% have had a booster. The main risk remains the evolution of a more harmful variant – which is why vaccination needs ramping up in poor countries.
41% of the Australian population have now had a booster and the proportion of the population with one dose has risen to 85%.
Economic activity trackers
Our Australian Economic Activity Tracker recovered further over the last week and is now at a pandemic era high reflecting improvement in mobility, restaurant bookings and job ads. With further reopening in NSW and Victoria a further recovery is likely. 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, more so in Europe reflecting reopening.
Major global economic events and implications
US economic data was a bit mixed, but overall still solid. New York region manufacturing conditions only improved slightly in February and they fell in Philadelphia albeit to a still solid level. Housing starts fell in January, but it looks weather related and a rise in building permits and strength in home builder conditions points to continuing strong housing activity. Meanwhile, retail sales surged in January despite the Omicron wave and industrial production also rose solidly. On the downside though producer price inflation rose more than expected and business survey inflation gauges remain high. Its worth noting that US retail sales remain above their long term trend and will fall back to trend as services demand continues to recover which should help take pressure of goods inflation.
84% of US S&P 500 companies have reported December quarter earnings with 77% beating expectations which is just above average & consensus earnings growth estimates for the quarter are now running at around 26%yoy and are likely to end up at around 27%yoy, which is well up on +21%yoy at the start of the reporting season.
Canadian and UK inflation both surprised on the upside in January rising to 5.1%yoy and 5.5% respectively and pointing to further rate hikes ahead in both countries.
Japanese December quarter GDP recovered by a less than expected 1.3%qoq, after covid restrictions were eased driven largely by a rebound in consumer spending. Some slowing is likely this quarter though reflecting its Omicron wave. Core inflation fell further to -1.1%yoy in January.
Chinese CPI inflation fell to 0.9%yoy in January with core inflation flat at 1.2%yoy. Producer price inflation also slowed to 9.1%yoy. Inflation is no barrier to policy stimulus in China.
Australian economic events and implications
Despite the Omicron surge the Australian jobs market remained very tight in January with unemployment staying at a 14 year low. Labour market underutilisation is also at levels last seen in 2008 when wages growth was 4.3%yoy. Hours worked took a hit as more workers than normal took sick leave or annual leave but participation actually rose and remains around record levels. With covid cases falling and mobility on the rise a rebound in hours worked is likely in February and unemployment is likely to have fallen below 4% by mid-year which will have taken it into full employment territory. The continuing strength in the jobs market adds to confidence that wages growth will reach 3%yoy by mid-year, which is well ahead of RBA forecasts that see it hitting 3% only in mid-2023.
The Australian December half earnings reporting season is now nearly 60% complete and the indications are that companies have weathered the Delta wave and are now weathering the Omicron wave reasonably well. However, supply shortages both in terms of goods and labour are causing significant issues in terms of pricing and/or margin pressure (as evident from a range of companies including Boral, Aurizon, JB HiFi, Ansell, GWA and Wesfarmers) albeit they are a benefit to some (like Seek) and JB HiFi expressed some optimism that the higher prices will be short lived. So far beats are outnumbering misses by a wide margin at 47% of results to 29%, but there has been a slowing in momentum with only 59% reporting profits up on a year ago which is down from 75% in the last reporting season and 54% have raised dividends which is less than the average of 59%. However, reflecting the bias towards upside surprises 51% have seen their share price outperform the market on reporting day. Consensus earnings growth expectations for the current financial year have edged up from 13.1% to 13.3% helped by energy and financials.
What to watch over the next week?
February business conditions PMIs for Europe, UK, Japan, and Australia (Monday) and for the US (Tuesday) may show some improvement after the Omicron hit to services in January.
US data is likely to show a further decline in consumer confidence but an ongoing rise in home prices (both due Tuesday), rising home sales (Thursday and Friday), a continuing rising trend in durable goods orders (Friday) and another lift in core private final consumption inflation (also Friday) to 5.2%yoy.
Eurozone economic confidence data (Friday) will be watched for a lift in the services sector following the easing of restrictions.
The Reserve Bank of New Zealand (Wednesday) is expected to lift its cash rate again by 0.5% taking it to 1.25% and announce plans to start quantitative tightening.
In Australia, the focus is likely to be on December quarter wages data (due Wednesday) as it will be a key check point on the path to higher interest rates in Australia. RBA forecasts imply another increase of 0.6%qoq taking annual wages growth to 2.25%yoy. However, various business surveys and anecdotes point to a pickup in wages growth and so we expect a 0.8%qoq increase which would be its fastest increase since 2014 and would see annual wages growth rate accelerate to 2.4%yoy. As noted earlier an acceleration in wages growth as we expect, followed by another upside surprise in inflation for the March quarter (due for release at the end of April) and then another solid increase in wages for the March quarter (to be released in the second half of May) would significantly boost the likelihood of a June rate hike. Our base case remains for an August hike, but the risk is heavily skewed towards a start to rate hikes in June. In other data expect a 2% rise in December quarter construction (Wednesday) and a 4% rise in business investment (Thursday) both after Delta related falls in the September quarter.
Australian December half earnings results will continue to flow with around 63 major companies reporting including BlueScope, Lendlease and Sonic (Monday), Cochlear, Coles and Monadelphous (Tuesday), Rio, Stockland and Woolworths (Wednesday), Flight Centre, Nine and Southern Cross Media (Thursday) and Brambles and Medibank (Friday).
Outlook for investment markets
Global shares are expected to return around 8% this year as global recovery continues, profit growth slows but remains solid and interest rates rise but not to onerous levels. However, we are now starting to see the long-awaited rotation away from growth & tech heavy 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, 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.
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.
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Shane Oliver, Head of Investment Strategy & Chief Economist