Share markets had a bounce in the last week from very oversold levels and lots of negative investor sentiment after falling back to around their June lows. The bounce was helped along by the UK tax backflip, softer US manufacturing and jobs data which may take pressure off the Fed in a “bad news is good news” way and, for Australian shares, the dovish RBA hike. This saw Australian shares rise around 4.5% for the week with gains led by energy, IT, material and financial stocks. Bond yields rose again in the UK, were little changed in the US and fell in Australia. Oil prices rose as OPEC announced it would cut oil production to stop prices falling and metal prices rose slightly, but iron ore prices fell. The $A rose slightly despite a slight rise in the $US.

Are we there yet? After falling back to around the June lows, shares were due for a bounce and having effectively made a double bottom its possible that we have seen the low. However, the tech wreck and GFC bear markets saw several similar big 5% plus rallies that proved short-lived only to see the bear market resume. And from a macro perspective the risks are most likely still on the downside in the short term as central banks remain hawkish, recession risks are high and still rising, the conflict in Ukraine looks likely to escalate, oil prices could move higher on OPEC’s move to cut oil production and earnings expectations are still being revised down. Looking at key developments in the last week:

Global central banks remain hawkish with ongoing hawkish comments from various US Fed officials, the Bank of Canada and ECB President Lagarde (all to the effect that they remain “resolute” and there is “more to be done” in controlling inflation) and the Reserve Bank of New Zealand hiking by another 0.5% to 3.5% for its 8th hike in a row and signalling more hikes ahead.

OPEC’s decision to cut oil production by 2 million barrels a day risks reversing the downtrend in oil prices. The cutback relative to actual production levels is really about 1 million barrels. But coming at a time when there is a high risk that Russia will cut production further to retaliate against EU/US price caps it risks reversing the recent downtrend in prices and exacerbating the risk of global recession. A more benign interpretation though is that OPEC is simply seeking to keep the oil price around $US90/barrel (as stated by the Nigerian oil minister) and so if Russia cuts production by more than agreed with OPEC, it will offset it with increased production to try and stop the oil price going up too far in order to avoid making any economic downturn worse (which could result in a worse outcome for OPEC).

The UK Government’s decision to abandon its plan to cut the top income tax rate from 45% to 40% provided a bit of relief. The reality is that it only saved about 2bn pounds of the total 45bn pounds in fiscal stimulus so still leaves pressure on the Bank of England which is still expected to raise rates by 1-1.25% in November.

The good news remains that our Pipeline Inflation Indicator continues to slow reflecting improving global supply conditions and reducing corporate pricing power. We remain of the view that this along with slowing economic conditions will see inflation falling faster than central banks expect through next year. This should enable them to start slowing the pace of hiking from later this year.

The RBA has sensibly broken from the ultra-hawkish global central bank consensus and opted to slow the pace of rate hikes from the 0.5% to a more normal 0.25%. This made good sense given: the rapidity of the rate hikes so far; the need to better assess the impact of those rate hikes and in particular allow for those on fixed 2% rates rolling over to rates two to three times higher next year; the greater sensitivity of Australian households to interest rate changes due to high household debt levels and a very high reliance on variable or short dated fixed rates (compared to 30 year fixed rates in the US); a bit of breathing space provided by lower wages growth in Australia compared to other countries; and the rising risk of global recession and financial turmoil. 

Of course, the slowdown in rate hikes does not mean that the RBA has finished hiking – it stressed that it “remains resolute” in returning inflation to target, will do “what is necessary to achieve that” and expects to increase rates further. We expect that the RBA will hike by another 0.25% in November or December taking the cash rate to 2.85% which will be the peak as a clear slowing in consumer spending is expected to emerge in the next six months. The risk is on the upside but probably only to 3.1%. By end next year we expect that the RBA will have started to gradually cut rates as inflation should be falling rapidly by then as supply improvements continue and demand weakens.

The RBA’s latest Financial Stability Review is more sombre than six months ago and consistent with it’s decision to slow the pace of rate hikes. The key points are that: financial stability risks have increased globally with tightening financial conditions; Australian households, firms and banks are generally in a strong financial position; but household resilience is uneven with some households already feeling the strain and a small number with high debt and low saving are particularly vulnerable. Its clearly within the household sector that the greatest risk lies with RBA analysis showing that:

• 40% of variable rate borrowers won’t have to raise their payments after the 2.5% cash rate rise but about 20% will see their minimum payment go above 30% of their incomes;
• A household earning $150,000 with $800,000 debt will see their monthly free cash flow fall by around $1300 following the 2.5% rise in rates so far;
• If rates go up another 1% then just over half of variable rate owner occupiers will see their free flow fall by more than 20%, with 15% seeing negative cash flow;
  
• Two thirds of fixed rate loans (which are about 35% of total mortgages) will expire by the end of next year and will face a 3 to 4% increase in their interest rate.
• It notes that recent home borrowers and particularly first home buyers are most vulnerable.
  
• A 20% fall in home prices (we expect a 15 to 20% fall) would see around 3% of all mortgages and 20% of new first home buyer loans go into negative equity.

While the RBA notes that signs of financial stress are low right now, surveys, Google searches and liaison suggest that its picking up. The key is that the decline in free cash flows from higher rates and inflation will slow consumer demand. The RBA sees the direct impact on financial stability as being modest, but this could change if there is a large rise in unemployment and a large fall in home prices. Along with the rising risk of global recession it all supports the case for the RBA to be cautious in raising rates further from here.

In Australia, we are now getting a regular reminder that a Budget is near under a new Government with warnings about how bad the budgetary situation is – just as we were seeing 9 years ago with the new Coalition Government. There is nothing new with the blow out in spending (on aged, health, NDIS, defence & interest costs) as they were well known before the election (when neither side wanted to discuss how to pay for them). But it all seems to be gearing up to difficult decisions in the Budget (& beyond) including regarding the legislated final phase of the tax cuts. Regarding the latter - which are mainly about removing bracket creep from 2008-09 (under which taxpayers find themselves in tax brackets never intended for them) - there is a strong case to index tax brackets to wages growth to take it out of the hands of politicians (who use it for pretend tax cuts or to surreptitiously raise revenue).

Our Australian, US and European Economic Activity Trackers slowed a notch in the last week.