Global equity markets rebounded again this week with the US up 3.5%, Australia 2.9%, Europe 3.4%, Japan 3.8% while Chinese stocks are down 0.3%. Positive gains in most equity markets recently after weeks of declines raises the question of whether we have seen the bottom of the markets. Our view has not changed – we believe the risk is more downside for equities until there are clearer signs that inflation has peaked (meaning central banks may pause in rate hikes) and until economic data bottoms out (but hopefully avoids a recession). Looking ahead to 6-12 months, we are more bullish on equities as inflation recedes, central banks stop raising interest rates (and maybe even cut them) and a deep recession is avoided.
The US 2/10yr bond spread remained inverted this week, European bond yields were a bit higher due to the Italian political chaos (Italian 10yr yields are up 3.5% vs. 3.2% in beginning of the week), US rates The dollar is slightly down from recent highs, but it is still high and the $A is at 0.69 USD.
After three key parties in the Italian parliament voted “no confidence” against the government, Italian Prime Minister Mario Draghi resigned, meaning an election will be held on September 25. Italy is no stranger to political instability (due to a very fractured parliament with many small parties) over the past 161 years, with 132 governments – that means an average term of 15 months (the government by Draghi lasted 18 months – longer than normal!). There is no doubt that people will now worry about whether this instability has implications for Italy’s membership of the euro zone. The pandemic and the war in Ukraine have strengthened the euro and support for the euro remains very strong in Italy, with the latest Eurobarometer survey showing that 72% of respondents in Italy supported the euro (above the 69% reported for EU 27). Nevertheless, new elections and populist parties increase the risk of calls for independence from Italy. The spread between Italian bonds and Germany widened again this week due to political uncertainty, but is well below previous highs such as during the Eurozone debt crisis or 2019/ 20, which also experienced political uncertainty.
Gas flows to Europe will restart from the Nord Stream 1 gas pipeline which has been shut down since July 11 for scheduled maintenance. Reports are mixed, but it appears that initial gas flows will be at 40% of capacity (as before maintenance), but could drop to 20% if disputes over sanctioned pipeline parties are not resolved. This supply uncertainty will keep gas prices high for now. While most metal and agricultural commodity prices have fallen in recent weeks, gas and coal prices remain elevated (see chart below).
A decline in commodity prices will be needed to see a slowdown in inflation. Our Pipeline Inflation Indicator (see chart below) continues to track and indicates falling inflation over a 6-12 month horizon.
Monitoring of economic activity
Our weekly economic activity indicators are flattening in Australia, the US and Europe (see chart below), which is expected with rising interest rates. Indicators did not fall drastically despite economic fears and stock market declines.
Australian economic events and implications
There have been a lot of “RBA speeches” this week. The only major update in the RBA Board Minutes for July was the inclusion of the Board’s discussion of the neutral cash rate which the RBA assumes to be at least 2, 5% (but note that there is a wide margin of error around this estimate), meaning plenty more rate hikes from here. Governor Lowe’s speech on “Inflation, Productivity and the Future of Money” offered no new insights but reiterated the importance of defending the 2-3% inflation target, which which means that inflation expectations cannot increase too much. Deputy Governor Michelle Bullock spoke on “How Are Households Positioned for Interest Rate Increases?” and minimized the potential impacts on indebted households of higher interest rates. Bullock pointed to the usual positive sentiments towards households, including high accumulated savings worth $260 billion that can be drawn down and the large stock of mortgage prepayments, household credit-to-income ratio being about the same level as in 2007 once you take into account the compensation accounts (see the table below).
The general message from the RBA is that the average household with mortgage debt will be able to withstand at least 300 basis points of rate hikes. We believe this underestimates the risks to the economy for borrowers who are heavily impacted by rate hikes. By the RBA’s own estimates, around 38% of households with mortgages will see their monthly repayments increase by 40% or more, or around 1.3 million households. Excluding interest, for borrowers on fixed-rate mortgages maturing next year, the median increase is expected to be around $650/month. This is a huge increase and too big to be offset by an increase in wage growth. Along with higher inflation (especially on essential goods), these households will experience a significant drop in spending, especially if the unemployment rate rises.
Treasurer Jim Chalmers this week officially announced the terms of reference for the RBA review which will be overseen by three exports, with a recommendation to the government by March 2023.
The NAB Business Survey for the June quarter was also released and showed confidence falling in the quarter to June (to 5 from 14 in the last quarter), following a drop in the March quarter. July’s composite PMI fell to 50.6 from 52.6 last month, with a larger decline in services while manufacturing fell only slightly.