Share markets mostly rose again in the past week as the rebound from oversold levels continued partly on hopes that some cooling in demand will take the pressure off inflation and central banks, and as China has started to reopen. 

European shares were little changed but US, Japanese, Chinese and Australian shares rose. The gains in Australian shares were led by resources, consumer staples and industrials offsetting falls in utilities where surging energy prices weighed. However, bond yields rose as did oil, copper and iron ore prices. The rise in the oil price came despite OPEC agreeing to increase oil production by 648,000 barrels a day for July and August and reflected scepticism that all members will be able to achieve it at the same time that US oil stockpiles fell and the EU announced a partial ban on Russian oil imports. The AUD rose as the USD fell.

On the negative side of the equation over the last week:

• Rising global energy prices pose a threat to the “peak inflation” scenario – the EU’s ban on the two-thirds of Russian oil that it imports by sea and China’s reopening is the latest source of upwards pressure on oil prices. The EU move raises the risk that Russia will cut off some more of its gas exports to Europe in retaliation.
• More generally risks remain around the war in Ukraine potentially widening and Russia’s response to Finland and Sweden seeking to join NATO.
• US economic activity data remains mostly strong – suggesting it's too early to be confident that the Fed will be able to be less hawkish from September. Consistent with this, Fed Vice Chair Brainard noted that a 0.25% or 0.5% hike in September is more likely than no change.
• The Bank of Canada (like the RBNZ the week before) hiked rates by 0.5% warning of more hikes before inflation peaks, highlighting again that central banks are getting more hawkish.
• Another stronger than expected rise in Eurozone inflation to US levels has increased expectations that the ECB’s first rate hike will be 0.5%.

On the positive side though:

• There are more indications that the US jobs market may be cooling a bit – with the Fed’s Beige Book referring to anecdotes of hiring freezes and wage increases levelling off.
• China’s reopening following a decline in its covid cases will start to take pressure off global supply chains. Goldman Sach’s Effective Lockdown Index for China had been falling into the end of May and is likely to fall further following the reopening in Shanghai from 1 June.

Our Pipeline Inflation Indicator continues to point to peaking in US inflation.

Reliable indicators of recession have yet to signal one is on the way – eg in the US the 10 year less Fed Funds rate yield curve is yet to invert and the Fed Funds rate is still less than nominal GDP growth. It’s the same in Australia.

Forward price to earnings multiples have fallen sharply since the start of the year – down from 22 times to 17 times now in the US and down from 19 times to 15 times in global and Australian shares – making shares cheaper. This has been due to falling share prices and rising earnings.

The bottom line is that while shares are likely to be higher on a 6-12 month horizon, it remains too early to be confident that we have seen the highs for bond yields and the lows for shares in the near term.

As Australia’s new Treasurer has pointed out Australia has lots of challenges – high inflation, falling real wages, surging energy prices, rising rents, skill shortages and a high budget deficit and public debt. And we urgently need to implement policies to boost productivity. Since this may require some pain it makes sense to openly acknowledge the challenges – as Hawke and Keating did in the 1980s. That said, Australia’s economic problems on these fronts are mostly minor compared to many comparable countries and there is also a danger that too much negative talk will only weaken confidence and make the situation worse. 

The last thing we want to do is “talk ourselves into a recession”.

On this front, Australian March quarter GDP data was far more good news than bad. Sure, it highlights some of the problems facing the economy. But to have the economy grow 0.8%qoq in the quarter after 3.6% growth in the December quarter and despite the hit from Omicron in January, supply constraints, floods and reopening driving a surge in imports (which knocked 1.5 percentage points off growth) is good news. It was better than we and many - including the RBA’s implied forecasts - were expecting.

Cost of living pressures and rising mortgage rates will constrain growth but ongoing reopening, still high household savings with a roughly $250bn excess saving buffer, strong business investment plans and a big pipeline of residential construction to be completed leave us continuing to expect 3.5-4% GDP growth through the course of this year.  

What’s driving the surge in energy costs in Australia? 

Put simply, coal drives about two-thirds of electricity generation in the Australian electricity grid. Coal prices are up something like fourfold on a year ago reflecting global recovery and more recently the war in Ukraine.

At the same time, numerous coal-fired power generators are out of action for maintenance. The combination has led to more demand for gas at a time when its international price has also skyrocketed because of the issues in Europe. So the wholesale cost of electricity has gone up fourfold or so since January. This drives about one-third of the retail price of electricity and the Australian Energy Regulator is allowing energy retailers to raise prices to their customers with 10% plus increases. And of course, the gas price has also skyrocketed. If sustained this could all add roughly 0.5-0.75% to inflation this year.

Getting the out of action coal generators back online will help but it’s likely the pressure will continue at least through winter. The longer-term solution is to get cheaper sustainables (with adequate “battery” storage into the mix) with the new Government targeting that to be 82% of electricity supply by 2030. Of course, we should have started much earlier!

What to watch over the next week?

In the US, CPI inflation data for May will be watched for further evidence of “peak inflation”. The CPI is expected to rise 0.7%mom thanks to higher energy prices, but this will still see yoy inflation fall slightly again to 8.2% from 8.3% in April. Core inflation is expected to slow further to 0.5%mom or 5.9%yoy from 0.6%mom and 6.2%yoy in April. Of course, this will still leave inflation too high and won’t stop the Fed from hiking by 0.5% at each of the next two meetings but it may not add to expectations for more aggressive Fed hikes. The renewed rise in oil prices is the main threat though.

The ECB is expected to confirm on Thursday that quantitative easing will stop at the end of the month consistent with President Lagarde’s recent blog. This will leave it on track to start raising interest rates at its July meeting. While it's likely to acknowledge risks to the growth outlook it's likely to be more focussed on the blowout in inflation and may intimate that a 0.5% hike could be on the table for July.

Chinese data for May is likely to show a pick-up in export and import growth (Thursday), a slight rise in CPI inflation to 2.2%yoy due to higher food and energy prices, but a fall in producer price inflation to 6.5%yoy.

In Australia, the Reserve Bank (Tuesday) is expected to raise its cash rate by 0.4% taking it to 0.75%. The clear messages from the RBA since its May meeting are that:

• It's concerned about a rise in inflation psychology (or expectations);
• bigger rate hikes are not off the table as it seriously considered a 0.4% hike in May but opted for a “business as usual” 0.25% hike; and
• more rate hikes are on the way.

Since the last meeting:

• March quarter wages data was on the soft side but was in line with RBA expectations;
• the fall in unemployment to 3.85% in April along with numerous business surveys and the RBA’s own business liaison point to an acceleration in wages growth;
• March quarter GDP growth was strong and was around or slightly stronger than the RBA’s own implied forecasts;
• news of inflationary pressure continues to mount notably with a rebound in petrol prices; and
• reports of surging power prices and rents.

As a result, RBA concerns about rising inflation psychology are likely to have increased arguing for a step up in the pace of tightening in June in order to get on top of inflation – just as we have been seeing in New Zealand, Canada and likely soon in the US – and so we expect a 0.4% hiking taking the cash rate to 0.75%. There is a risk it could even opt for a 0.5% hike. Either way, by year-end we continue to see the cash rate rising to between 1.5% and 2% with a peak of 2-2.5% next year.