Easing inflation pressures, yield curve inversion, cash rate expectations, floods, Covid

Dr Shane Oliver, Head of Investment Strategy & Chief Economist at AMP, discusses developments in investment markets over the past week, the coronavirus, economic activity trackers, major global economic events and Australia economic events.

Investment markets and key developments over the past week

Share markets mostly rose over the last week on hopes that central banks will be able to tame inflation without causing a recession. However, it was messy with Eurozone shares – where the risk of recession is greatest – first making a new bear market low earlier in the week. Australian shares followed the global lead higher with very strong gains in IT, consumer discretionary, health and property stocks. Bond yields generally rose except in Australia. Oil and metal prices fell but the iron ore price rose. The $A rose slightly despite a further rise in the $US.

The beat goes on with rising interest rates but there was nothing really new over the last week.

The minutes from the last Fed meeting were hawkish – referring to a “significant risk…[that] elevated inflation could become entrenched”, that the “outlook warranted moving to a restrictive stance” and that it saw a 50 or 75bps hike as being appropriate in July – but there was nothing new in this. And since the last Fed meeting economic data and inflation indicators have been softer.

The RBA hiked by 0.5% as expected citing high inflation, the resilient economy, the tight jobs market, likely faster wages growth and the importance of keeping inflation expectations down and it repeated its commitment to “doing what is necessary to ensure inflation returns to target”. But again, there was nothing new here. We remain of the view that higher debt levels today & falling real incomes will see the economy slow faster in response to rising interest rates than seen in the past which will see the cash rate peak around 2.5% early next year, well below market expectations for a rise to 3.5% or more next year.

Market expectations for rate hikes have generally fallen over the last three weeks as inflation fears have receded a bit and economic data has slowed. For example, the market’s expectation of the Fed Funds rate at year end has fallen from 3.7% three weeks ago to 3.36% now and the market’s expectation for the RBA’s cash rate at year end has fallen from 3.86% three weeks ago to 3.18%. The hawkish pivot a month or so ago by central banks including the RBA has seen market expectations for longer term inflation fall. What’s more various indicators suggest that inflation pressures in the US may have peaked and if so this is positive sign for other countries including Australia as the US is leading other countries by about six months on inflation.

This is indicated by our Pipeline Inflation Indicator which is continuing to trend down reflecting a combination of falling work backlogs, freight rates, metal prices and grain prices.                                                                                                                                          

Source: Bloomberg, AMP

Global economic data has also softened as seen recently in business conditions PMIs. The risk of recession is greatest in Europe, but there is now a high risk that the US will have a technical recession – ie two quarters in a row of falling GDP – in the first half of this year. What’s more the US yield curve has continued to flatten with the gap between 10 year and 2 year bond yields inverting again. And if a recession eventuates shares likely have more downside as earnings start to fall, because the falls in markets so far mainly reflect a valuation adjustment (ie lower PE’s) in response to higher bond yields.

Source: Bloomberg, AMP

The bottom line remains that with central banks still tightening and recession risk high shares remain at high risk of further falls in the short term. This could well run out to September or October with October having a reputation as a “bear market killer”.

On a 12 month view we remain optimistic that shares can rise on the grounds that cooling inflation pressures – as suggested by our Pipeline Inflation Indicator – should enable central banks to ease up on the interest rate brake in time to avoid a recession (or at least avoid a deep recession). With US inflation pressures slowing it’s unlikely that the Fed needs to cause a recession to get inflation under control. While the US could have experienced a technical recession already in the last six months its doubtful that the NBER will define it as such given personal income, employment and other indicators have remained strong. Also while the 10 year yield less 2 year yield US yield curve has inverted the 10 year less Fed Funds rate yield curve which has inverted prior to all US recessions since 1970 is yet to invert. In Australia the various yield curves are still far from inverting (not that they have been a great guide).

Source: Bloomberg, AMP

The latest NSW floods are devastating for those directly impacted but are more inflationary than deflationary and so are unlikely to see the RBA change course. Analysing the economic impact of the latest floods is complicated because for some areas its now the fourth major flood this year. But while they will cause a short-term disruption to economic activity the net effect as with most natural disasters is likely to be stimulatory as rebuilding kicks in (yet again). So on a six month horizon they are more likely to add to economic growth rather than detract from it. They will though add to inflationary pressure because of a further disruption to fruit and vegetable supplies and increased demand for household furnishings and other equipment, building materials and workers who are in short supply. They are yet another supply shock threatening to boost inflation expectations. So, the latest floods are unlikely see the RBA delay rate hikes or change course.

The US may be edging towards cutting some of its Trump era China tariffs and passing a shrunken Build Back Better budget reconciliation package – but both may have little macro impact. The Trump tariffs imposed on $360bn of China imports disrupted US economic activity but didn’t add much to measured inflation so the removal of tariffs on a proposed $10bn of goods won’t have much impact in cutting inflation either. If a reconciliation package is passed it will be a fraction of the size proposed last year which is why its often called Build Back Smaller. If tax increases proceed on high income earners, capital gains and dividends then it may have more impact on investment markets but this looks to have been replaced with a surtax on very high income earners (amounting to just 17,000 tax payers) and even this looks to have been dropped. So Build Back Smaller is now looking mainly like a 15% minimum corporate tax rate plus international corporate tax reform being used to pay for renewable energy and health care tax credits.

Burt Bacharach/Hal David songs are classics and when put together with Andy Williams interpretation of them they are an absolute gem. This Andy Williams-Burt Bacharach medley with Andy singing and Burt conducting aired in April 1968 on The Andy Williams Show. When I saw this sort of stuff as a kid I thought it was dorky and boring. Now I think its amazing.

Coronavirus update

New global Covid cases continued to rise over the last week as the more transmissible (but no more harmful) Omicron BA4 and BA5 subvariants come to dominate. The rise is being led by Europe, but with South America, the US, Japan, Australia and New Zealand also on the rise. Omicron variant BA2.75 which is even more transmissible again risks driving another wave beyond the BA5 wave.

Source: ourworldindata.org, AMP

Deaths and hospitalisations are also on the rise in Australia with hospitalisations in NSW now back to February levels. The key is that not too many people get infected at once (causing problems in hospitals) and that hospitalisation and death rates remain subdued (indicating a low level of serious illness), although these are now distorted a bit due to the increasing under-reporting of new cases as it becomes endemic and incidental covid cases in hospital.

Source: ourworldindata.org, AMP

While eligibility for a 4th vaccine dose has now been widened in Australia to those aged over 30, a concern is that 3rd shots (ie the first booster) – which are important in protecting against serious illness from Omicron – appear to have stalled out at around 54% of the population.

Source: covidlive.com, AMP

Fortunately, South Africa’s experience with Omicron BA4 and BA5 in April/May augurs well in that it saw a brief spike in new cases but hospitalisations and deaths remaining subdued. So, while the latest wave combined with the flu and winter risks increased worker absence another significant economic disruption in Australia from Covid is hopefully unlikely. Some restrictions – like mask mandates – are likely to return though.

Source: ourworldindata.org, AMP

New Covid cases remain low in China, but various breakouts highlight the high risk of a return to lockdowns.

Economic activity trackers

Our Australian Economic Activity Tracker was little changed in the past week and our US and European Trackers softened slightly. All have lost momentum.

Based on weekly data for eg job ads, restaurant bookings, confidence, mobility, credit & debit card transactions, retail foot traffic, hotel bookings. Source: AMP

Major global economic events and implications

US economic data released over the last week was still solid but appears to be slowing. The services ISM fell in June but remains strong at 55.3. Job openings and quits fell in June but both remain high, and layoffs remain low. Jobless claims continued to trend up, although they remain low. At least these indicators are starting to cool down – which will eventually take pressure off the Fed (which hopes to be able to slow job vacancies without pushing unemployment up much).

China’s Caixin services PMI for June surged 13.1 points to a strong 54.5 consistent with other June PMIs in showing a rebound after the removal of Covid lockdowns.

Australian economic events and implications

Australian economic data was generally stronger than expected although its yet to reflect the full impact of rate hikes and cost of living pressures. Housing finance unexpectedly rose 1.7% in May but still appears to be in a gradual topping process with higher mortgage rates and the slump in the property market likely to drive a sharp downturn in home loans. Building approvals also rose 9.9% in May but this was driven by a bounce in volatile unit approvals and the trend still points down. Home building activity is likely to hold up better than suggested by the fall in approvals from their high because there is still a large pipeline of work yet to be completed (due to bad weather and supply bottlenecks).

Source: ABS, AMP

ANZ job ads rose another 1.4% in June and are up 18%yoy indicating that the jobs market remains tight for now. However, annual growth has slowed from 40%yoy in December and a further slowing is likely as demand cools in response to rising interest rates and as immigration continues to recover.

Australia’s trade surplus rose to a new record high in May as exports surged driven by coal and gas reflecting global energy problems made worse by Russia’s invasion of Ukraine. Coal has now taken over from iron ore as Australia’s biggest export – maybe not a good look from an environmental perspective but it’s mainly been driven by the surge in coal prices evident in the commodity chart earlier in this report and increased coal demand in response to the surge in gas prices. The flow through to real GDP growth from the record trade surplus may be limited though given that much of the rise in export values is due to higher energy prices. 

Source: ABS, AMP

The news on the Federal budget deficit remains positive. While high inflation and rising interest rates are putting pressure on the new Government to cut spending to reduce the budget deficit (and this is likely to be evident in the October Budget), a surge in corporate tax revenue (associated with high commodity prices), rising personal tax collections (due to strong jobs growth) and reduced unemployment benefit payments continue to put downwards pressure on the budget deficit. For the financial year to date to May the deficit is $27bn less than projected in the March Budget. This implies that the budget deficit for 2021-22 will come in at around $45-50bn well below the $80bn projected in March.

What to watch over the next week?

In the US, the focus is likely to be CPI inflation for June (Wednesday) which is expected to rise to a new high of 8.8%yoy due to higher energy prices (since partly reversed) and higher food prices, but June could be the peak and core CPI inflation is expected to slow to 5.7%yoy, its third decline in a row from a high of 6.5%yoy. This may add to market confidence that inflation is peaking. Meanwhile, the NFIB small business optimism index will be released on Tuesday and data on Friday is expected to show a modest rise in retail sales in June, flat industrial production and continued softness in the New York manufacturing conditions index. US June quarter earnings reports will start to flow with the consensus expecting at 5%yoy rise.

Chinese June quarter GDP (Friday) is expected to have contracted by -2%qoq reflecting Covid lockdowns dragging annual growth down to 1.2%yoy, from 4.8%yoy. However, June activity data should benefit from the subsequent reopening with a rebound in industrial production, retail sales and investment and a fall in unemployment. Trade data (Wednesday) is expected to show a slowing in export growth and stable import growth. Credit data is likely to show a further pick up.

The Reserve Bank of New Zealand (Wednesday) is expected to raise its cash rate by 0.5% taking it to 2.5%.

In Australia, the NAB business survey for June (Tuesday) is expected to show a further softening in conditions and confidence, the Westpac/MI consumer confidence index for July (also Tuesday) is expected to show a further fall to very weak levels after the latest rate hike and floods and June jobs data (Thursday) is expected to show a slowing in employment growth +15,000 with unemployment falling to 3.8%. 

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 fears of recession remain high. However, we see shares providing reasonable returns on a 12-month horizon as valuations have improved, global growth ultimately picks up again and inflationary pressures ease through next year allowing central banks to ease up on the monetary policy brakes.

With bond yields looking like they may have peaked for now short-term bond returns should improve.

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 pre-covid levels). Unlisted infrastructure is expected to see solid returns.

Australian home prices are expected to fall by 15 to 20% into the second half of next year as poor affordability and rising mortgage rates impact, but with a large variation between regions. Sydney and Melbourne prices are already falling aggressively, and most other cities and regions are seeing price gains slow ahead of likely falls.

Cash and bank deposit returns remain low but are improving as RBA cash rate increases flow through.

The $A is likely to remain volatile in the short term as global uncertainties persist. However, a rising trend in the $A is likely over the next 12 months as commodity prices ultimately remain in a super cycle bull market.   

Ends

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