Share markets were mixed over the past week with uncertainty over the war in Ukraine, a rebound in oil prices, increased Fed hawkishness and a continuing surge in bond yields being offset by mostly solid economic data, still rising earnings expectations and hopes by some that shares will be a hedge against high inflation. 

US and Japanese shares rose but Eurozone and Chinese shares fell. Australian shares saw another strong gain with utilities, resources and IT stocks leading the rise. Bond yields rose on inflation concerns and increased expectations for rate hikes. Oil prices rebounded but are still below the levels seen soon after the start of the war. Metal prices were mixed, and iron ore prices fell slightly. The rising trend in commodity prices saw the AUD rise above $US0.75 despite a rise in the $US.

Share rebound continues – have we seen the low in shares? 

After a 13% top to bottom plunge US and global shares have rebounded cutting the fall to just 6% from their bull market high. Reflecting the boost from the resources sector, Australian shares have cut their losses from last year’s bull market high (with the market down 10% to its low in January) to just 3%. In fact, the Australian share market is now close to flat for the year to date and its likely to remain a relative outperformer thanks to the boost to commodity prices. It remains possible we may have seen the lows in share markets, but uncertainty remains high around the war and inflation is still likely to get worse before it gets better keeping uncertainty high around the extent of monetary tightening. And the rebound in US shares has still lacked the breadth and strength often seen coming out of market bottoms. So, while we remain of the view that share markets will be higher on a 6–12-month horizon it’s still too early to say we have seen the bottom.

Ukraine risks remain high

The war in Ukraine does not appear to be going well for Russia with reports that up to four times as many Russian soldiers may have died so far as the US lost in Afghanistan over 20 years. This along with the intense economic pressure from the sanctions along with the devastation in Ukraine may force both sides to accept a peace deal which would see a strong bounce in markets (before they go back to worrying about inflation). But it may also push President Putin into a more aggressive prosecution of the invasion resulting in a further escalation (including via sanctions) and disruption to energy and other commodity supplies. Reflecting the risk of this, oil and gas prices are on the rise again. So, Ukraine related risks for investment markets remain high in the short term.

The Fed getting even more hawkish pushing bond yields higher 

Fed Chair Powell has further dialled up the hawkish rhetoric indicating it will take the “necessary steps” to control inflation and will hike rates by 0.5% in May if appropriate. As a result, the US money market now expects the Fed Funds rate to rise from 0.38% at present to 2.28% by year-end. The ratcheting up in interest rates expectations has further pushed up bond yields. The UK also saw another stronger than expected acceleration in inflation for February to 6.2%. The challenge for central banks is that they cannot simply look through the current supply shock to prices which has been made worse by the war in Ukraine, because it risks boosting longer-term inflation expectations which means a risk of a wage-price spiral where price and wage increases beget more price and wage increases. With this comes the risk that central banks, ultimately including the RBA albeit under less pressure given lower price and wage inflation in Australia, will have to raise rates more aggressively to control inflation. It's early days yet though and so far, rising earnings expectations are helping to offset the negative impact on share markets from rising bond yields.

US recession risks on the rise, or are they? 

The shape of the yield curve (ie the gap between long term and short term borrowing rates) has long been used by economists as a guide to whether recession is imminent or not. When long rates are high relative to short rates it’s seen as a sign that it’s a good time to borrow short and invest in the economy but when long rates are below short rates it’s seen as a bad time to borrow and invest. Many are now pointing to a flattening in the US yield curve as measured by a narrowing gap between 10-year bond yields and 2-year bond yields as a sign that the risk of recession is rising in the US. However, the more traditional measure of the yield curve which looks at 10-year yields less the Fed Funds rate (or the 3-month yield) is actually steepening and this indicator has been seen as a more reliable guide to recessions. So far, it says there is no problem. Moreover, the 10-year/2-year comparison may be distorted at present because while the 2-year yield has been pushed up by expectations of an increasing Fed Funds rate the 10-year yield is being suppressed by the Fed’s massive holding of Government bonds. This is soon set to start falling with quantitative tightening which may push 10-year bond yields higher. I remain of the view that a US recession is more of a risk for 2024 than over the next year as the Fed is still a long way from tight monetary policy.

The yield curve has given numerous false recession signals in Australia – but in any case, it’s nowhere near signalling a recession, however defined.

For those wondering when all the rain down east coast Australia will go away, the Southern Oscillation Index is still in La Nina, ie cool and wet, territory.

What to watch over the next week?

In the US, March jobs data (Friday) will be the focus with payrolls expected to show another solid rise of 450,000 and unemployment falling to 3.7%. In other data releases expect continued strength in home prices and job openings but a fall in consumer confidence (all due Tuesday), continuing strength in the ISM manufacturing conditions index for March (Friday) and another rise in core private final consumption deflator inflation to 5.5%yoy (Thursday).

Eurozone economic confidence data for March (Wednesday) are likely to fall reflecting the impact of the war in Ukraine and inflation data (Friday) is expected to show a further rise.

Japan’s March quarter Tankan survey (Friday) is expected to soften and February jobs data will be released Tuesday.

China’s business conditions PMIs for March (Thursday and Friday) are likely to fall reflecting the impact of covid related restrictions.

The Australian Budget to see a “magic pudding” of more spending and lower deficits. The Federal 2022-23 Budget (Tuesday) is primarily expected to be about five things: the upcoming election; help for households dealing with “cost of living” pressures; increased defence spending; a shift in focus to “fiscal repair”- ie, stabilising and then reducing debt marked by spending restraint; and a budget windfall from faster growth and higher commodity prices allowing much lower budget deficit projections. Key elements are likely to include:

• An upgrade in GDP growth forecasts to 4.75% for the next financial year with unemployment expected to fall to 3.5% by June next year.
• Financial relief to help households deal with “cost of living” pressures with a one-off payment to low and middle income households, a 6 month or so cut or freezing in fuel excise (which is bad economic policy, but it is an election budget!) and a possible extension of the Low and Middle Income Tax Offset.
• Extra spending on infrastructure, an NBN upgrade for regions, digital transformation, skills training, manufacturing vaccines, childcare subsidies, defence and gas projects;
• More assistance for first home buyers – possibly with an extension of the first home loan deposit schemes.
• Much lower budget deficits of about $80bn this financial year and next (down from deficits of about $99bn for both years in MYEFO) falling to about $40bn by 2024-25 (down from $57.5bn in MYEFO). This reflects the budget windfall from a faster than expected economic recovery and higher commodity prices driving higher tax receipts and lower welfare payments only partly offset by increased spending this financial year and next.
• The budget windfall coupled with $16bn allocated last December as “decisions taken but not yet announced” means there is plenty of scope for the Government to announce extra short-term spending and yet still report a faster pace of deficit reduction than back in December.
• The Government’s shift towards fiscal repair over the medium term will take the form of medium-term spending restraint and a reliance on stronger growth rather than austerity. With tax receipts rising faster than expected there is a chance that more tax cuts will be necessary if the Government is to stick to its commitment to capping the tax to GDP ratio at 23.9%. Of course, this is just the return of bracket creep!

A key risk for the RBA is that significant fiscal stimulus this financial year and next in the Budget will only add to its challenges in controlling inflation, resulting in the cash rate needing to increase faster than we are currently forecasting for later this year and into next year. (We currently forecast the cash rate rising to 0.75% by year end, rising to 1.5% next year.)

On the data front in Australia, expect February retail sales (Tuesday) to show a 0.8% gain, building approvals to bounce 10% after a 28% fall in January, credit data to show a further rise in housing credit growth and ABS job vacancy data to remain very strong (all Thursday), housing finance data to fall 1% and CoreLogic data to show a 0.3% gain in March home prices but with prices falling in Sydney and Melbourne (all due Friday).