The rebound in share markets continued over the last week helped by good earnings data and relief that increased China/US tensions resulting from US House Speaker Nancy Pelosi’s visit to Taiwan did not spill over into a more serious conflict (at least not yet).

The positive global lead along with signs of slightly diminished hawkishness from the RBA pushed the Australian share market higher with gains in IT, telco and health shares more than offsetting falls in energy stocks. For the week bond, yields were little changed after their recent falls. Oil and metal prices fell, but iron ore rose. The AUD was little changed as was the USD.

We remain of the view that shares are vulnerable to a pullback over the next few months as central banks are still a way off from peaking and actually cutting rates, recession risk is still rising and this runs the risk of significant earnings downgrades.

What's more, geopolitical risk is still on the rise as highlighted by China/US tensions in the last week and the upcoming November US mid-terms. However, the continuing strength of the rebound (with the direction-setting US share market now up 13% from its low) raises the possibility that we may have seen the bear market low and any pullback may just be a partial retracement of the rally since mid-June. Either way, on a 12-month horizon we remain optimistic on shares as inflation recedes, central banks become less hawkish and a deep recession is likely to be avoided.

First the bad news – which drives the risk of another pullback:

• Central banks are still hawkish. Various Fed officials indicated the Fed is still a long way from pivoting to an easier stance. The Bank of England hiked rates by another 0.5% and started active bond selling, now expects inflation to peak at 13% and indicated a readiness to do more “forceful” hikes despite expecting a severe recession to start this year. The RBA hiked rates another 0.5% and indicated that more rate hikes are likely. Reflecting the low starting point and the severity of the inflation breakout this is the most aggressive RBA rate hiking cycle seen in the last 30 years, except for the rate hikes that occurred from August to December 1994 with which this cycle is comparable. See chart below:

• The risk of a “real” recession in the US is continuing to build according to the US yield curve with the US 10-year less 2-year yield curve inverting further and the 10-year less Fed Funds rate gap getting very close to inverting too. A “real” recession, i.e. beyond the technical recession in the first half of this year, would mean a significant downgrade cycle for US, global and Australian share market earnings.

• Surging gas and electricity prices in Europe are still adding to the risk of recession there – particularly in Germany.
• After July, the seasonal pattern for shares historically has turned down from August through to October.

• US shares usually have a rough year prior to the mid-term elections on the back of political uncertainty, but then rally once they are out of the way.
• China/US tensions flared up with House Speaker Pelosi’s visit to Taiwan.

But there is also good news – supporting the view that shares will be up on a 12-month view.

• Global inflation pressures may be at or close to peaking (excepting Europe with its specific energy issues). Our US Pipeline Inflation Indicator is continuing to trend down reflecting a combination of a falling trend in work backlogs, freight rates, metal prices, grain prices and even oil prices. This was also evident in the ISM business survey showing falling delivery times, order backlogs and price pressures.
• US earnings reports have surprised on the upside again with consensus earnings expectations for the year to the June quarter rising from 5%yoy three weeks ago to now nearly 9% with outlook statements being mixed as opposed to mostly negative as feared might have been the case. And earnings growth outside the US has been even stronger.
• Bond yields are well down from their June highs – with US 10-year yields down from 3.5% to 2.7% and Australian 10-year yields down from 4.2% to 3.1%. Falling bond yields reduce the valuation pressure on shares and can help economic growth as they reduce longer-term funding costs. Falling bond yields have already driven some Australian banks to lower their fixed mortgage rates (although this won’t be enough to avert the fixed rate cliff that fixed borrowers on roughly 2% rates will face when they roll over to fixed or variable rates two and a half times or higher).
• Share markets anticipated the inversion of the US yield curve and its recession signal this time whereas on previous occasions they only fell sharply well after the inversion. In other words, recession may have already been discounted.
• Central banks may still be hawkish but they are softening a bit at the edges – suggesting they may be getting closer to the top and that they are also conscious of the worsening growth outlook. This was evident in the Fed Chair Powel referring to eventually slowing the pace of rate hikes, the BoE noting that it's not on a “pre-set” path and in the RBA’s commentary this week.

Turning specifically to the RBA, which raised rates again by another 0.5%, the message from its post-meeting Statement and its quarterly Statement on Monetary Policy is that it remains hawkish, but it is starting to leave a bit of wiggle room.

Given its upwards revision to its inflation forecast for this year to 7.75%yoy and the very tight labour market it rightly remains focussed on slowing demand and keeping inflation expectations down and so is still flagging more rate hikes ahead. But its reference to wanting to keep the economy on an “even keel”, its downwards revisions to growth (to a very pedestrian 1.75% for the next of years), its forecast of a rise in unemployment from 2024, its acknowledgement of falling consumer confidence, its recognition of negative wealth effects from falling home prices, its stronger recognition that some households are not well placed to withstand rate hikes and its reiteration that its “not on a pre-set path” all suggest that its open to an easing in the pace of rate hikes in the months ahead as its tightening starts to get traction.

This is broadly consistent with our assessment that cash rate hikes will slow in the months ahead with some months seeing no moves ahead of a peak in the cash rate at 2.6% either later this year or early next, and that rates will start to fall in the second half of next year.

Economic activity trackers

Our Australian Economic Activity Tracker fell slightly in the last week continuing the loss of momentum seen since April consistent with a slowdown in growth. Our US Tracker rose slightly and our European Tracker fell slightly.

Australian economic events and implications

Australian economic data was mixed. On the positive side real retail sales rose strongly in the June quarter, car sales bounced back strongly in July and the trade surplus rose to a new record high of $17.7bn. Net exports are expected to contribute about 1 percentage point to June quarter GDP growth and the strong rise in real retail sales augurs well for June quarter consumption growth. Of course, monthly retail sales data is now slowing and rising interest rates and poor consumer confidence points to a slowdown ahead.

Against this, though ANZ job ads remained high but fell in July and may be starting to slow and housing-related data was soft.

Housing finance fell by more than expected – and now looks to be clearly rolling over. More falls are likely ahead as mortgage rate hikes and falling property prices impact. And CoreLogic data for July confirmed that the decline in home prices is accelerating, led by Sydney.

So far, the decline in national average home prices is just 2% which is just a flick off the top, but the pace of decline is comparable to what was seen going into the GFC, the run-up to the early 1990s recession and in the early 1980s recession. But all of those slumps followed long periods or rate hikes with interest rates at their peaks and about to start falling whereas this time around we are only four months into interest rate hikes with more rate hikes still to come.

The rapidity of the decline in home prices this time around so early in an RBA tightening cycle reflects the de facto tightening that started with rising fixed mortgage rates a year ago but more importantly the heightened sensitivity to rising interest rates flowing from much higher debt levels now and very poor consumer confidence.