7 May 2024
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The past week saw a further escalation in sanctions over the war in Ukraine with energy being targeted.
This resulted in another surge in oil prices and a leg down in global share prices before a relief rally kicked in on hopes for a peace deal and increased OPEC production only to see share markets fall again. The gyrations left US, Japanese and Chinese shares down for the week but European shares rose after a 10% plunge the previous week. Australian shares were also dragged down with strength in financials not being enough to offset weakness in materials, IT and telco stocks.
Bond yields rose sharply on the back of inflation and monetary tightening concerns, particularly after the ECB surprised on the hawkish side. Oil prices initially surged into the decision by the US and others to ban Russian oil imports with West Texas Intermediate rising to just below $US130/barrel but then fell back on hopes for increased OPEC production leaving it down slightly for the week. Iron ore and gold prices rose but metal prices fell. The AUD fell slightly and the USD was little changed.
From their bull market highs last year or early this year, US shares and global shares are down 11%, European shares are down 17% and Japanese shares are down 18%. Reflecting the strength in commodity prices, strong dividend payments and maybe a less hawkish central bank, Australian shares have held up better and are down by about 7.5%. The strength in commodity prices also explains why the AUD has risen since the war started whereas normally it falls in crises.
The ongoing threat to global growth and inflation from the war in Ukraine and uncertainty as to how far the conflict will escalate will likely continue to drive huge volatility in investment markets with a high risk of more downside for a while yet.
The bulk of the threat to global inflation and growth is coming through the energy shock with various countries led by the US now banning Russian energy imports. So far it’s not as severe as the 1970s oil shocks: the rise in oil prices due to the war so far is nowhere near the four-fold and three-fold increases seen around 1973 and 1979; the amount of oil supply at risk in relation to supply is less than it was back then; there are more diverse sources of oil supply available today (eg shale oil in the US); and the oil intensity of GDP is less than half what it was in the 1970s.
Offsetting the negative impact on consumers in the US and Australia is the huge boost to national income that will flow from higher energy and other commodity prices. However, Europe is far more at risk given its dependence on Russian energy imports (it may not be able to meet its objective to reduce Russian gas imports by two thirds by year-end, but Russia may cut off its oil and gas anyway) as are other net energy and commodity importer countries in Asia. And oil prices can still go a lot higher if the conflict continues to escalate as can other commodity prices where Russia is a significant producer (like food and metals). So short of a peace deal being reached the risk of an ongoing threat to growth and inflation and hence share markets remains high in the short term.
Though as we have been noting, in the last few weeks, no one knows for sure how this will unfold. But the history of crisis events and associated share market falls tells us that after an initial hit there should be a decent rebound over 6 to 12 months. And while it feels bleak at present there are some things that may help drive the rebound:
Given the stagflationary implications of the war and the financial stability risks posed by a likely Russian default on its debt and investors offloading Russian financial assets all at once, central banks continue to face a very challenging environment. So far they seem to be seeing it as more of a threat to inflation than growth. This was evident with the ECB surprisingly hawkish in the past week seeing still robust growth but much higher inflation and so accelerating the tapering of its bond-buying, flagging an end to QE in the September quarter and signalling an openness to rate hikes this year.
Central banks in energy-producing countries will give even more weight to the impact on inflation – as we saw the Bank of Canada proceeded with a rate hike a week ago and the Fed is likely to raise rates in the week ahead, after US inflation rose to a new 40-year high in February with a further lift in median inflation indicating that the rise in inflation is broad-based.
Even the RBA seems to be getting closer to a rate hike. RBA Governor Lowe reiterated that it can and will be “patient” in assessing whether inflation will be sustained in the target range (partly because inflation pressure is lower in Australia – see the last chart). But his comments in the past week were progressively more hawkish than they have been - noting now that it's “plausible” the cash rate will be increased later this year and that it's “prudent to plan” for a hike, alluding to the risk of sustained supply shocks boosting inflation expectations and stressing that the RBA will respond as needed to maintain low and stable inflation.
While the RBA is aware of the negative impact of higher petrol prices on household budgets given the boost to national income from higher commodity prices it looks to be more concerned about the impact of the war on inflation than growth.
We continue to see the first RBA rate hike coming in June as March quarter inflation is likely to again come in well above RBA expectations and March quarter wages growth is likely to show a pickup. May is possible but unlikely given it will be in an election campaign and March quarter wages growth won’t have been released by then. While the departure of RBA Deputy Governor Guy Debelle for the private sector is a big loss for the RBA, it's unlikely to change the direction of the RBA’s monetary policy. Assistant Governors Luci Ellis, Chris Kent and Michelle Bullock are well placed to replace Dr Debelle but are unlikely to bring a significantly different approach to monetary policy.
While the flooding disaster along Australia’s east coast intensified over the last week with more heavy rain our assessment remains that beyond a short-term disruption to growth it won’t change Australia’s outlook for strong growth of about 4.5% for this year as a whole. The 2011 floods drove a -0.3% fall in GDP in the March quarter of 2011 due to disruption particularly to resource exports from flooded mines but rebounded strongly in subsequent quarters helped by rebuilding.
This time around we expect economic growth to slow a bit in the near term but to remain positive thanks to ongoing reopening from the pandemic and the floods being less broad-based than in 2011, followed by a boost to growth from rebuilding in the second half of the year. However, the March and June quarters are likely to see about 0.2% added to inflation due to higher fruit and vegetable prices. Combined with the impact of higher petrol and grain prices flowing from the Ukraine war this will likely push Australian inflation to about 5%yoy by mid-year (which compares to the RBA’s forecast of 3.75%yoy) and push underlying inflation to about 3.8%yoy (compared to the RBA’s forecast of 3.25%yoy).
What to watch over the next week?
In the US, the focus will be on the Fed (Wednesday) which is set to start the long-flagged process of raising interest rates with a 0.25% hike in the Fed Funds rate taking it to a range of 0.25-0.5%. This is widely expected with Fed Chair Powell indicating he is likely to propose a 0.25% hike and not the 0.5% some had talked about prior to the war with Ukraine. It will be couched in terms of the need to start normalising rates to control inflation now that the economy has recovered. Outlook commentary is likely to be hawkish given the ongoing higher than expected outlook for inflation with the Fed’s dot plot shifting up to 5 hikes this year from 3 back in December, but with uncertainty around Ukraine tempering the hawkishness. The Fed is also likely to announce more details around how it will proceed with Quantitative Tightening (ie, reducing its bond holdings).
On the data front in the US, expect a pickup in the New York regional manufacturing conditions index for March (Tuesday), a 0.4% gain in February retail sales after the huge gain in January and continued strength in the NAHB home builders index (both Wednesday), gains in industrial production and housing starts and continued strength in the Philadelphia region manufacturing index (all Thursday) and a fall in existing home sales (Friday).
The Bank of England (Thursday) is expected to raise its cash rate by another 0.25% taking it to 0.75%, express concern about the uncertainty posed by the war in Ukraine but remain hawkish given the upwards pressure on inflation.
The Bank of Japan (Friday) is expected to leave monetary policy very stimulatory and on hold, given the ongoing weakness in inflation in Japan. Core inflation (also Friday) is likely to have remained negative in February.
In Australia, the RBA minutes are expected to reiterate the Bank’s patience in assessing whether inflation will be sustainably in the target range. More detail around how it sees the impact of the war in Ukraine will be watched for, with the RBA seeming to so far be paying more attention to the upwards pressure it will put on inflation as opposed to the negative impact on growth from higher petrol prices which will be offset by the boost from higher commodity prices to national income.
On the data front in Australia, ABS data (Tuesday) is expected to show a 4% rise in December quarter home prices consistent with private sector surveys that were released earlier this year and jobs data (Thursday) is expected to show a 40,000 gain in employment, a big rebound in hours worked after the Omicron disruption and a fall in unemployment to 4.1%.
