Stock markets rose again last week as the rebound from oversold levels continued partly on hopes that some cooling in demand will ease pressure on inflation and central banks, and that China has started to reopen.
European stocks were little changed, but US, Japanese, Chinese and Australian stocks rose. Gains in Australian equities were led by resources, consumer staples and industrials, offsetting falls in utilities where soaring energy prices weighed. However, bond yields rose, as did oil, copper and iron ore prices. The oil price hike came despite OPEC’s agreement to increase oil production by 648,000 barrels a day for July and August and reflected skepticism about all members’ ability to achieve this by at the same time as US oil stocks fell and the EU announced a partial ban on Russian oil imports. The AUD rose while the USD fell.
On the negative side of the equation over the past week:
- Rising global energy prices threaten ‘peak inflation’ scenario – EU ban on two-thirds of Russian oil it imports by sea and reopening of China latest source upward pressure on oil prices. The EU decision increases the risk that Russia will further cut its gas exports to Europe in retaliation.
- More generally, risks remain around the potential widening of the war in Ukraine and Russia’s response to Finland and Sweden seeking to join NATO.
- Data on economic activity in the United States remains generally strong, suggesting that it is too early to be convinced that the Fed will be able to be less hawkish from September. Consistent with that, Fed Vice Chairman Brainard noted that a 0.25% or 0.5% hike in September is more likely than no change.
- The Bank of Canada (like the RBNZ the previous week) raised rates by 0.5%, warning of further hikes ahead of inflation spikes, again emphasizing that central banks are becoming more hawkish.
- Another stronger-than-expected rise in eurozone inflation to US levels has boosted expectations that the ECB’s first rate hike will be 0.5%.
On the positive side though:
- There are more indications that the US jobs market could be cooling down a bit – with the Fed’s beige book referencing anecdotes of hiring freezes and wage increases stabilizing.
- China’s reopening after a drop in its covid cases will begin to reduce pressure on global supply chains. Goldman Sach’s effective lockdown index for China had fallen in late May and is expected to fall further after reopening in Shanghai from June 1.
Our Pipeline Inflation Indicator continues to point to a peak in US inflation.
Reliable recession indicators have not yet signaled that a recession is underway – for example, in the United States the 10-year lower Fed Funds yield curve has not yet inverted and the Fed Funds is still below nominal GDP growth. It’s the same in Australia.
Futures price/earnings multiples have fallen sharply since the start of the year – from 22 times to 17 times in the US and from 19 times to 15 times for global and Australian equities – making equities cheaper. This is due to falling stock prices and rising earnings.
Ultimately, while equities are likely to be higher over a 6-12 month horizon, it’s still too early to be convinced that we’ve seen the highs for bond yields and the lows for equities at short term.
As the new Australian Treasurer has pointed out, Australia faces many challenges: high inflation, falling real wages, soaring energy prices, rising rents, skills shortages and high budget deficits and public debt. . And we urgently need to implement policies to boost productivity. As this may require some pain, it makes sense to openly acknowledge the challenges – as Hawke and Keating did in the 1980s. That said, Australia’s economic problems on these fronts are mostly minor compared to many comparable countries and there is also a danger that too much negative rhetoric will only weaken trust and make the situation worse.
The last thing we want to do is “go into a recession”.
On that front, Australia’s March quarter GDP data was far more good news than bad. Of course, this highlights some of the problems facing the economy. But for the economy to grow 0.8% quarter-on-quarter in the quarter after growing 3.6% in the December quarter and despite Omicron’s blow in January, supply constraints, floods and the reopening leading to a surge in imports (which depressed growth by 1.5 percentage points) is good news. It was better than we and many – including the RBA’s implied forecasts – expected.
Cost of living pressures and rising mortgage rates will limit growth, but the ongoing reopening, household savings still high with an excess savings buffer of around $250 billion, strong plans to business investment and a major residential construction pipeline to be completed leave us continuing to expect 3.5-4% GDP growth this year.
What is driving Australia’s soaring energy costs?
Simply put, coal generates about two-thirds of the electricity generated by the Australian power grid. Coal prices have almost quadrupled from a year ago, reflecting the global recovery and, more recently, the war in Ukraine.
At the same time, many coal-fired generators are out of service for maintenance. The combination has led to a surge in gas demand at a time when its international price has also skyrocketed due to problems in Europe. Thus, the wholesale price of electricity has quadrupled since January. This is around a third of the retail electricity price and Australia’s energy regulator allows energy retailers to raise prices for their customers with increases of over 10%. And of course the price of gas also skyrocketed. If this continues, all this could add about 0.5 to 0.75% to inflation this year.
Bringing decommissioned coal generators back into service will help, but the pressure is likely to continue at least through the winter. The longer-term solution is to get cheaper sustainable energy (with proper ‘battery’ storage in the mix), with the new government aiming to reach 82% of electricity supply by 2030. Of course, we should have started much earlier!
What to watch next week?
In the US, CPI inflation data for May will be watched for further evidence of an “inflation spike”. The CPI is expected to rise by 0.7% m/m on the back of higher energy prices, but this will lead to a further slight drop in y-o-m inflation to 8.2% from 8.3% in April . Core inflation is expected to slow further to 0.5% yoy or 5.9% yoy, from 0.6% yoy and 6.2% yoy in April. Of course, that will still leave inflation too high and won’t prevent the Fed from hiking 0.5% at each of the next two meetings, but it may not add to expectations of more aggressive Fed hikes. Fed. The new rise in oil prices, however, is the main threat.
The ECB is expected to confirm on Thursday that quantitative easing will end at the end of the month, according to President Lagarde’s recent blog. That will leave him on track to start raising interest rates at his July meeting. While he is likely to acknowledge the risks to the growth outlook, he is likely to focus more on exploding inflation and could hint that a 0.5% hike could be on the cards for July.
Chinese data for May is expected to show a recovery in export and import growth (Thursday), a slight increase in CPI inflation to 2.2% YoY due to higher food and energy prices, but a decline in producer price inflation to 6 .5% YoY.
In Australia, the Reserve Bank (Tuesday) is expected to raise its key rate by 0.4% to 0.75%. The clear messages from the RBA since its May meeting are:
- He worries about a rise in the psychology of inflation (or expectations);
- bigger rate hikes are not out of the question as he seriously considered a 0.4% hike in May, but opted for a “business as usual” 0.25% hike; and
- further rate hikes are in the works.
Since the last meeting:
- March quarter earnings data was weak but in line with RBA expectations;
- the fall in unemployment to 3.85% in April together with numerous business surveys and the RBA’s own trade liaison point to accelerating wage growth;
- GDP growth in the March quarter was strong and was close to or slightly above the RBA’s implied forecast;
- news of inflationary pressures continue to mount, particularly with a rebound in gasoline prices; and
- reports of soaring electricity prices and rents.
As a result, RBA concerns about the psychology of rising inflation have likely increased, arguing for an acceleration in the pace of tightening in June to bring inflation under control – just as we saw in New Zealand, the Canada and probably soon in the United States – and so we expect a 0.4% increase bringing the cash rate to 0.75%. There is a risk that he could even go for a 0.5% hike. Either way, by the end of the year, we continue to see the cash rate increase between 1.5% and 2% with a peak of 2-2.5% next year.