Equity markets managed to stabilize and, in most major markets, rebound from oversold levels last week as there were no further hawkish surprises from central banks and the Weak economic data saw bond yields fall, weighing on equity market valuations despite growing recession concerns.
For the week (to date), US stocks are up just over 3% and Australian stocks are up just over 1%, led by stocks in IT, real estate and health. Fears of slowing growth pushed bond yields lower (with 10-year yields down 0.4% and 0.5% from their recent highs in the US and Australia respectively) and also lowered the prices of oil, metals and iron ore. The AUD remained around $0.69 while the USD fell slightly.
After falling more than 10% in the previous two weeks, stocks needed to rebound, as we saw last week. More and more signs of a sell-off over the past few weeks – blind selling in stocks is a positive sign in terms of sell-out – and the rally could go even further. But it’s still hard to be sure from a technical perspective that we’ve seen the bottom – the put/call option ratios and the VIX have yet to reach the extremes seen in the last major hollow.
And the macro story remains the same with even higher inflation readings last week (in the UK where it rose to 9.1% YoY and in Canada where it rose to 7.7%) , more hawkish comments from central banks (Fed, ECB and RBA and a 0.5% rate hike in Norway) and lingering fears of recession. We remain of the view that a global recession can be avoided, but with central banks aggressively raising rates, the risks have increased to the point that this is now a close call. This is reflected in the distribution of the growth-sensitive copper price and the Korean stock market (often referred to as Dr. Copper and Dr. Kospi). And if a recession does occur, equities are likely to have more of a downside, as so far market declines mostly reflect valuation adjustment (i.e. lower PEs) in response to bond yields. higher. However, given the uncertainties, it is still too early to say that stocks have bottomed out.
The Fed remains hawkish – but perhaps a little less than markets had expected. While Fed Chairman Powell’s testimony to Congress reiterated the Fed’s commitment to bringing inflation down, it did not signal a new step forward in hawkish policy than markets were already expecting. That said, he noted that achieving a soft landing will be “very difficult” and that a recession is “definitely a possibility.” This, combined with falling business conditions in the US, saw market expectations for the year-end federal funds rate fall from around 0.25% to 3.45%.
The RBA is also hawkish – but like the Fed, it was a little less so than many expected. Governor Lowe’s key messages were:
- The RBA will do what is necessary to bring inflation back to its target but does not seek to do so immediately;
- He is very focused on maintaining inflation expectations (and therefore wants to see wage growth with a 3 in front of him, but not a 5);
- More rate hikes are on the way;
- He doesn’t see a recession; and
- Is not on a predefined path but will be guided by data.
Governor Lowe’s dismissal of recession risk should be taken with a grain of salt – he would say that and it’s hard to deny that falling real incomes and rate hikes haven’t significantly increased the risk of recession – and the money market has given a better lead on rate hikes than the RBA has. However, our assessment remains that the next hike will be 0.5%, the cash rate will “only” rise to 2.1% by the end of the year and will peak at around 2.6% in the first semester next year.
While money market expectations for the RBA cash rate have fallen sharply over the past week (from 3.86% for the end of the year to 3.22%) over the past week in response to Lowe’s comments and recession fears, at 3.9% a year from now, they still look too high. Raising cash rates to around 3.9% will mean variable mortgage rates of around 7.5% and more than double household interest payments, which will lower house prices by 20-30% and would plunge the economy into recession given the cost of living pressures hitting at the same time. Very low consumer confidence and slowing credit and debit card transactions, as reported by various banks so far this month, suggest that consumer spending is already starting to slow significantly. All of this means that the magnitude of the interest rate hikes expected by the money market is unlikely to occur.
It may sound perverse, but the best outcome for the stock markets would be if the economic data starts to slow down sharply now. This would reduce pressure on inflation and allow central banks to ease their tightening before triggering a recession. And on that front, the evident cooling in the PMIs of global trading conditions over the past week (see below) is a positive sign.
So has the continued decline in our pipeline inflation indicator. The components of the business tendency surveys relating to prices, arrears and delivery times continue to show signs of improvement. Shipping and freight costs seem to have peaked. And the recent pullback in oil prices – which are now down 10% from their peak earlier this month, helps support the idea that inflation may have peaked. Of course, it’s still too early to be overconfident on this front given the lingering risks around Ukraine – with Russian gas increasingly cut off to Europe and Russia threatening Lithuania over its imposition of a blockade of EU goods in Kaliningrad.
The RBA’s revision of its failed yield target (which initially targeted 0.25% and then 0.1% for the 3-year bond yield) held few surprises. Yes, it has reduced financing costs and avoided the worst downside risks during the height of pandemic shutdowns. But it contributed to the debacle of the RBA’s forward guidance (“no rate hike expected until 2024”) and thus damaged the reputation of money markets and the wider community. It’s hard to see the RBA going down this path again.
What to watch next week?
In the US, the focus should be on the Fed’s preferred inflation measure, the core private final consumption deflator for May (Thursday), which is expected to fall to a still very high 4.8 % YoY versus 4.9%. On the economic data front, expect continued modest growth in durable goods orders (Monday), lower consumer confidence (Tuesday) but continued strength in house prices (also Tuesday) and a slowdown in the June manufacturing conditions PMI (Friday).
Eurozone CPI inflation for June (Friday) is expected to show a further rise to 8.3% year-on-year. Meanwhile, economic confidence for June (Wednesday) is expected to fall further and unemployment (Thursday) is expected to fall to 6.7%.
Chinese trading conditions PMIs for June (expected Thursday and Friday) may show further improvement reflecting the recovery from the covid shutdowns around March.
Australian retail sales growth for May is expected to slow to 0.3%, reflecting the impact of cost of living pressures and the impact on confidence from rising interest rates. Further weakness is likely. Vacancies data for May likely remained strong and credit growth is expected to remain strong, reflecting past strength in housing finance (both due Thursday). House price data from CoreLogic is expected to show the capital’s home price slump accelerating to -0.8% in June, led by Sydney and Melbourne.