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Investment markets and key developments: Several reasons for optimism despite high short-term risks

Shane Oliver
20 September 2022

Share markets fell sharply over the last week, reversing their rally from the previous week’s lows as US inflation surprised on the upside adding again to Fed rate hike expectations.

The poor global lead saw Australian shares fall back to their lows of the previous week with falls led by property, health, consumer staple and industrial shares.

Bond yields rose as higher short-term interest rates for longer were factored in. Oil, metal and iron ore prices fell not helped by recession fears. The AUD fell as the USD rose.

Shares remain at high risk of further falls in the short term on the back of inflation, interest rate, recession and geopolitical risks. And as we have seen in the last week if US shares head down, Australian shares will follow even if the RBA takes a less hawkish path.

There is a danger in exaggerating the mid-week plunge in share markets because it just took shares back to where they were a week ago. Nevertheless, the speed of the fall highlights the vulnerability of share markets in the short term as inflation remains high, global central banks are still hawkish, recession risks are high, geopolitical tensions remain high and the period out to mid-October is known for share market weakness.

In particular, on the inflation front US core inflation came in far higher than expected at 6.3%yoy as the breadth of high inflation continued to increase, and it was a similar story in the UK with core inflation there also rising further to 6.3%.

This along with hawkish Fed comments and a still strong US jobs market likely keeps the Fed on track for another 0.75% hike in the week ahead and keeps the BoE on track for another 0.5% hike in the week ahead too.

The danger is that the Fed and other central banks have become locked into supersized rate hikes based on backward-looking data and a loss of confidence in their ability to forecast inflation at a time when they should really be giving more attention to monetary policy lags and slowing the pace of hikes. This increases the risk of recession/deep recession as it may make it hard to slow down rate hikes when they should be.

And technically, the rebound in shares from their June lows has lacked the cyclical leadership normally seen in new bull markets and earnings revisions remain negative.

However, while short-term risks remain high there are several reasons for optimism:

  • Producer price inflation is slowing and looks to have peaked in the US, UK, China and Japan. This is consistent with our Pipeline Inflation Indicator which is continuing to trend down given falling price and cost components in business surveys, falling freight rates and lower commodity prices (outside of gas and coal).
  • Consumer inflation expectations have fallen in the US and Australia helped by aggressive central bank moves and falling petrol prices. This should make it easier for central banks to get inflation back down without having to take interest rates to exorbitant levels.
  • Finally, money supply growth has slowed from its 2020 surge, and this is likely to contribute to lower inflation ahead.

In Australia, the RBA has flagged that it will consider scaling back to a 0.25% hike in October – this makes good sense. Reserve Bank Governor Lowe in his appearance before the House of Representatives Economics Committee reiterated his recent messages that: high inflation damages the economy; the RBA will do what is necessary to return inflation to target; more rate hikes are likely, but the RBA is aware monetary policy operates with a lag; and there is a case to consider slowing the pace of tightening.

The still-tight jobs market and still-high price and cost pressures evident in the latest NAB business survey point to the RBA hiking again next month. Governor Lowe has indicated that the RBA will consider a 0.25% or 0.5% hike at that meeting dependent on incoming data and we expect the RBA to scale back to a 0.25% hike with the peak at 2.85%.

However, given the strength in lagged data and RBA worries about inflation the risk is on the upside to our interest rate forecasts. And Governor Lowe’s reference to slowing the pace of hikes “at some point” suggests it’s not necessarily imminent.

But just because the Fed is likely to hike by another 0.75% in the next week does not mean that the RBA will have to keep going with 0.5% or greater hikes. The RBA sets interest rates for Australia, not the US; it would only need to match the US if it's worried about a crash in the AUD boosting Australian inflation but so far there is no sign of that (the Fed hiked from 2015 to 2018 while the RBA cut without the AUD crashing).

What's more, wages growth in Australia is running well below where it is in the US, giving the RBA a bit more flexibility to allow for monetary policy lags.

Economic activity trackers

Our Australian and European Economic Activity Trackers dipped in the last week whereas in the US it was little changed. Overall, they suggest that while some momentum has been lost after the recovery from the pandemic, economic activity is holding up reasonably well so far.

Based on weekly data for eg job ads, restaurant bookings, confidence, mobility, credit & debit card transactions, retail foot traffic, hotel bookings. Source: AMP
Based on weekly data for eg job ads, restaurant bookings, confidence, mobility, credit & debit card transactions, retail foot traffic, hotel bookings. Source: AMP
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