Investment markets & key developments

Share markets saw another volatile week. Shares initially rose from oversold conditions helped by good US earnings results, but rate hike expectations particularly in Europe and in the US after very strong US payrolls and divergent tech sector earnings news added to volatility.

Despite a hit from an earnings miss by Facebook, US shares rose 1.6% for the week and Japanese shares gained 2.7%, but Eurozone shares lost 0.5% as the ECB turned more hawkish. Australian shares rose 1.9% benefitting from the positive US lead and indications from the RBA that it would be patient in raising interest rates.

Long term bond yields rose sharply with German 10-year yields rising above zero for the first time since 2019 and Japanese 10-year yields rising to a 5-year high. Oil prices rose to their highest since 2014 on expectations for strong demand and geopolitical tensions and look like they are on their way to $US100 a barrel. Metal and iron ore prices also rose. The AUD rose as the USD fell.

The trend to monetary tightening continues:

• The Bank of England raised rates by another 0.25% citing higher inflation, making it the first back-to-back rate hike since 2004, commenced quantitative tightening and sounded hawkish with 4 of the 9 MPC members voting for a 0.5% hike and seeing “some further [albeit] modest tightening”.
• The ECB left monetary policy on hold but shifted more hawkish with President Lagarde indicating “the situation has indeed changed” with more “concern” about inflation and declining to reiterate that rates are unlikely to rise this year. With inflation rising to 5.1%yoy, the ECB looks likely to start tapering its bond buying from March, ending it about mid-year and starting rate hikes in the second half.
• A fall in unemployment to 3.2% and rising wages growth is maintaining pressure on the RBNZ for further tightening.
• Fears of aggressive Fed tightening declined a bit earlier in the week as various Fed speakers pushed back against expectations for a 0.5% March rate hike, but returned later in the week as January payrolls came in much stronger than expected and wages growth surged more than expected.

Even the RBA has become more hawkish, despite doing its best to sound as dovish as possible in the process. Through much of the last decade, it was thought that the RBA had to be dragged kicking and screaming into rate cuts. Now it seems to be a bit of the opposite. The RBA has stressed - through its post-meeting statement, a speech by Governor Lowe and the Statement on Monetary Policy - a preparedness to be “patient” in waiting for more confidence that inflation will be sustained in the target range and that wages are rising.

However, it has clearly become more hawkish: its unemployment forecasts have been revised down to levels not seen since the 1970s and its wages and inflation forecasts have been revised up to the point where they would normally be consistent with imminent rate hikes; its central case for a rate hike looks to have moved forward to 2023 from previously being “not before 2024”; and Governor Lowe has conceded that a rate hike in 2022 is now “plausible” after just a few months ago arguing against it and saying it was “extremely unlikely”.

The RBA’s preparedness to be “patient” may be justified for a few months and is not inconsistent with our own base case that they won’t start raising rates till August. But it does remind me of Fed Chair Powell’s comment in November that “it’s appropriate to be patient” in terms of when rates would go up... and of course now the Fed is on track for rate hikes starting next month!

And with unemployment now expected to push below 4% and underlying inflation likely to push above the top of the target range, the RBA is running the risk of waiting too long to start monetary tightening which in turn will then risk allowing much higher inflation to become entrenched as inflation expectations increase, making it harder to get back under control again. This is the risk that central banks like the Fed may now be facing. Wages are usually a lagging indicator so waiting for them to rise significantly before hiking runs the risk that the first hike comes too late to head off a blowout in inflation expectations.

But with the RBA moving progressively more hawkish our view is that its “patience” will only last six months or so. With numerous indicators pointing to rising wages growth, amidst ongoing reports of staff shortages, it's likely to surprise to the upside sooner than the RBA is allowing. As such, we maintain our view that the first-rate hike will come in August taking the cash rate to 0.25%, followed by a second hike in September to 0.5%. If wages data due 23 February and in May show a significant acceleration, then the first rate hike could come in June.

At a broader level the era of extraordinary monetary policy stimulus is now over in Australia… well for now anyway. Cheap financing for banks ended in June, the 0.1% yield target ended in November and now QE will end in the week ahead. The big question is now whether the RBA will decide at its May meeting to roll over its bond holdings as they mature and so maintain their balance sheet or let them rundown – which would amount to quantitative tightening. I expect a bit of the latter to allow “patience” on rates to run a few months more.

We remain of the view that monetary tightening will not be enough to end the global and Australian economic recoveries this year and that shares will remain in a rising (albeit more constrained) trend, but this does not necessarily mean the correction in shares is over. The bounce from the January low has been strong and welcome but a bounce from very oversold levels is not that unusual. Markets will still have to grapple with uncertainty about how high interest rates will rise particularly as inflationary pressures continue for a while yet, the unwinding of excessive valuations for some tech stocks, uncertainty regarding Russia and Ukraine and the threat posed to European gas prices and US mid term election years are known for volatility.

On the US political front, things are now a bit more uncertain with a Democrat Senator to be absent from the Senate for a while following a stroke. This robs the Democrats of their narrow majority. It could have the positive impact though of pushing President Biden down a more bi-partisan path on his agenda which may be a good thing.

As goes January for shares so goes the year, or does it?

The so-called January barometer posits that the performance of shares in January is a good guide to how they go for the year. On this basis, it's pointing to a bad year as US shares fell 5.3% in January and Australian shares fell 6.4%. But historically the January barometer has not been so reliable when it comes to falls in January. Since 1980 a positive January in US shares has gone on to a positive year 84% of the time, but a negative January has only seen a negative year 35% of the time. It’s similar for Australia where a positive January has gone on to a positive year 75% of the time but a negative January has only seen a negative year 33% of the time.

What to watch over the next week?

In the US, CPI data for January (Thursday) is expected to show another rise taking inflation to 7.3% year on year with core inflation rising to 5.9%yoy (from 5.5%). Small business confidence data will also be released Tuesday. December quarter earnings results will continue to flow in the US.

In Australia, expect a 7.5% gain in December quarter real retail sales (Monday), the NAB business survey for January (Tuesday) is likely to show confidence remaining down reflecting the Omicron disruption but Westpac/MI consumer confidence for February (Wednesday) may improve a bit.

December half earnings results will start to ramp up with about 30 major companies reporting including James Hardie (Monday), Suncorp and Computershare (Tuesday), CBA and Mineral Resources (Wednesday), AGL, AMP and ASX (Thursday) and IAG (Friday). Consensus earnings expectations for this financial year are for a 13% rise in earnings led by energy, industrials, and financials. Given Delta and Omicron disruptions a key focus will be on outlook statements.

Outlook for investment markets

Global shares are expected to return about 8% this year but we may now be starting to see the long-awaited rotation away from growth and tech-heavy US 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 and 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, higher interest rate serviceability buffers, reduced home buyer incentives and rising listings impact.

Cash and bank deposits are likely to provide very poor returns, given the ultra-low cash rate of just 0.1%.

Although the AUD 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 USD, probably taking it to around $US0.80.