Share markets fell again over the last week with ongoing worries about monetary tightening to combat high inflation driving a possible recession. The plunge in global shares also dragged down the Australian share market which saw sharp falls in IT, material, property and industrial shares with only health stocks rising for the week. Global bond yields pulled back from their highs, oil, metal and iron ore prices fell and the risk-off tone dragged the AUD below $US0.69 as the USD rose.

From their bull market highs US shares are down 18%, Eurozone shares are down 18%, Japanese shares are down 14%, global shares are down 17%, and Australian shares are down 8%. While European and Japanese shares initially fell harder after the invasion of Ukraine the concern recently has swung back to higher inflation and higher interest rates which has really weighed on the US share market with its higher-tech exposure with the Nasdaq now down 29%. The fall back in commodity prices has harmed Australian shares lately but their low exposure to tech stocks is helping them in a relative sense.

US inflation came in stronger than expected again for April. While annual inflation fell slightly (from 8.5%yoy to 8.3% for the CPI and from 6.5%yoy to 6.2% for core inflation) as higher monthly inflation readings a year ago dropped out it was still higher than expected. Goods inflation (green bars in the next chart) looks to be slowing but services inflation (blue bars) is continuing to pick up – particularly for airfares, health and rents – partly reflecting the surge in wages growth seen recently in the US. So while inflation may have peaked it looks like staying too high for comfort for the Fed (and other central banks) for a while yet keeping it on track for 0.5% rate hikes at the next three meetings.

ECB President Lagarde strongly hinted that the ECB will start raising rates in July. The ECB expects to stop bond buying early in the third quarter with the start of rate hikes “some time” after that.

Rising pressure for wage growth to compensate for higher inflation risks resulting in a wage/price spiral and a rise in inflation expectations that simply locks inflation in at high levels. Talk of 5% wage claims in Australia suggests that this is also rapidly becoming a risk locally. The only sustainable way to get decent wage growth above inflation is to boost productivity growth and that requires significant economic reform.

The danger is central banks won’t be able to get inflation under control without engineering a recession, particularly the longer supply constraints remain. Fed Chair Powell indicated that getting inflation to 2% will “include some pain”.

While shares are getting oversold and investor pessimism is becoming extreme, we are not yet at levels for indicators like Vix or the Put/Call ratio seen at major market bottoms.

However, there is some light at the end of the tunnel

While US inflation is still too high for comfort and may remain so for some months signs of peaking remain evident in our Pipeline Inflation Indicator reflecting lower freight costs and a slowing in commodity prices including oil and gas. This could enable central banks to slow the pace of tightening later this year – in time to avoid recession. 

While services inflation could continue to rise for a while yet there are signs monthly US wages growth may have peaked e.g. monthly growth in average hourly earnings looking like it may have peaked late last year.

Share market earnings are continuing to come in stronger than expected. The US March quarter earnings reports are continuing to surprise on the upside and earnings look on track to rise about 12%yoy which is up from initial expectations for a 4.3%yoy gain. And earnings growth in Europe and Asia is averaging slightly faster.

Covid cases in China appear to be slowing which could enable an easing in restrictions and clear the way for policy stimulus to boost growth.

Yield curves have yet to decisively invert and even if they do now the average lead to recession is 18 months – which takes us to late next year which would be too early for share markets to discount as they only look 6 months ahead.

Just focussing on rate hikes ignores the tightening already underway from the ending of QE and the shift to QT, meaning that the Fed may have already tightened a lot and market expectations for a cash rate up to 3% in the US (and Australia) next year may be too hawkish.

So while shares could still see more falls in the short term we remain of the view that a deep (or grizzly) bear market will be avoided as US and Australian recession should be avoided over the next 18 months, which should enable share markets to be up on a 12-month horizon.

The Australian election is now rapidly approaching with polls pointing to an ALP victory 

Two-party preferred polling has the ALP ahead by about 55% to 45% and unlike in the run-up to the 2019 election, we have not seen the narrowing in ALP poll support that ultimately culminated in the Coalition retaining power. A high proportion of “soft voters” in polling suggests it is still unclear. But the key point for markets remains that unlike in 2019, apart from climate change policies the economic policy platforms of the major parties are not that different, so it's hard to see a significant impact on markets from a decisive change in government to Labor.

The main risk would come if neither of the main parties gets enough seats to govern on their own forcing reliance on independents which could force a new government down a less business-friendly path, such as the Greens demanding an ALP led minority government implement their proposed super profits taxes.  

What to watch over the next week in Australia?

The minutes from the RBA’s last board meeting (Tuesday) are expected to be hawkish reinforcing expectations for more rate hikes to control inflation. Thanks to the tight labour market, March quarter wages data is expected to show an acceleration to 0.8%qoq, its fastest increase since 2014 and taking annual wages growth to 2.5%. April jobs data is expected to show a 20,000 gain in employment with unemployment dipping slightly to 3.9%, the lowest since 1974.