Dr Shane Oliver
Head of Investment Strategy and Economics and Chief Economist
Investment markets and key developments over the past week
Share markets had a volatile ride over the last week on the back of worries that a resurgence of new coronavirus cases will derail the global economic recovery. US shares managed a 0.4% gain for the week as “dip buying” possibly helped by news of monetary easing in China drove a strong gain on Friday. However, Eurozone shares fell -0.2%, Japanese shares lost -2.9% and Chinese shares fell -0.2%. The poor global lead along with the worsening coronavirus outbreak in Sydney necessitating an extension and tightening of its lockdown pushed the Australian share market down -0.5% for the week with sharp falls in retailers, health, IT and financial shares. Consistent with the risk off tone, bond yields fell. Commodities were mixed with metals and iron ore up but oil down partly due to an output dispute amongst OPEC members. The Australian dollar fell despite a slight fall in the US dollar.
Why the rally in bonds? From their highs early this year, US 10-year bond yields have fallen 0.4% from 1.74% to 1.36% and Australian 10-year bond yields have declined by 0.5% from 1.9% to 1.33%. Of course, they are still way above last year’s lows of 0.5% and 0.6% respectively, but this seems a huge turnaround from the inflation and taper tantrum fears of earlier this year. The rally appears to reflect several factors:
- Increased confidence that the spike in inflation is due to pandemic distortions and transitory factors.
- The increase in new coronavirus cases globally and worries it might derail the economic recovery.
- Concern we have seen the best in terms of growth.
- Less US bond issuance with it all being bought by the Fed.
- Central banks not rushing to taper or hike rates.
- A short covering rally of extreme short bond positions.
While we believe the inflation spike is mainly transitory, with economic recovery likely to continue (albeit at a more sedate pace than seen so far) we see the bond rally as more of a correction against a rising trend in yields that will resume rather than a warning of a new economic downturn.
Likewise, the pull back in many share markets seen over the last week on growth and coronavirus concerns is likely also part of a correction. As with the decline in bond yields, shares could see more weakness in the short term as coronavirus cases rise globally and in Australia and as we come into the seasonally weaker months for shares around August/September, but the rising trend in shares led by cyclical trades is likely to resume into year-end as rising vaccination allows the economic recovery to continue at the same time that interest rates and bond yields remain low. In fact, falling bond yields are seeing share valuations improve again.
In terms of central banks, several developments over the last week indicate they are not rushing to the exits from easy money and are far from hawkish. Some are even going the other way.
- First, the RBA by shortening the period of its 0.1% bond yield target and reducing its bond buying by $1bn a week from November is clearly prepared to respond to the stronger than expected recovery seen so far, but on rates it remains dovish. Governor Lowe and the RBA are: prepared to look through labour market distortions caused by the closed international border; see full employment and the 3% plus wages growth necessary to sustain 2-3% inflation as being achieved when unemployment is in the low 4s; and see as its central scenario the conditions for inflation to be sustained within 2-3% not being in place until 2024. Further tapering is likely from November if the Fed moves to taper and recovery continues but that is still monetary easing but just at a slower rate. Overall, it’s hardly a big hawkish lurch by the RBA.
- Second, the ECB lifted its inflation goal to 2% to be interpreted symmetrically but will allow for an overshoot to avoid low inflation becoming entrenched during times when policy easing is constrained. This is up from the previous target of inflation “below, but close to 2%. This is actually a dovish move in the direction of the Fed’s move to average inflation targeting. With core inflation of less than 1% (despite producer price inflation of 9.6%) the ECB is a long way from any tightening.
- Third, while the minutes from the last Fed meeting showed agreement to begin planning for tapering bond buying they were not hawkish – eg the inflation spike was still seen as transitory – and are consistent with tapering beginning around the start of next year.
- Finally, China’s PBOC cut bank reserve requirements by 0.5% (allowing them to lend more) as foreshadowed earlier in the week by the State Council to offset downward pressure on growth from higher raw material costs. This confirms a more dovish tone from Chinese policy makers following the recent moderation in growth.
The past week saw a further rise in new coronavirus cases globally with a big proportion due to the more contagious Delta variant. Investors are right to be concerned about another coronavirus scare and this could be the trigger for further share market falls – but the key is what happens to hospitalisations and deaths in countries that are well down the vaccination path. So far so good which means that the vaccines are most likely providing a path to a sustained reopening in which coronavirus may still circulate but it does not cause serious illness and overwhelm healthcare systems.
The latest upswing is mainly in relatively lowly vaccinated regions and countries like South East Asia, South Korea, Bangladesh, South Africa, Russia and Mexico and so if hospitalisations and deaths are to be minimised such countries have little choice but to impose lockdowns (like Australia).
But it’s also continuing to become more evident in countries that are more advanced in terms of vaccination – notably the UK, Europe, Israel, and in the US (with around 33 states now seeing rising trends). This could be a problem as these countries are still yet to reach herd immunity (say 80% of people fully vaccinated). And this may be a particular risk for unvaccinated people (the proportion of which is still high in some US states especially with the vaccination rate having slowed in the US). What’s more, while its mainly younger unvaccinated people that are being infected (running the risk of a surge in “long covid” cases), some vaccinated people are too.
However, the risk of a return to lockdowns and a derailing of the recovery in more vaccinated countries is low compared to previous waves. First, while the vaccines are generally less effective against infection from the new variants, various studies show that they are highly effective (ie 90% plus) against serious illness necessitating hospitalisation. Second, most older and more at risk people have been already been vaccinated. So far so good with deaths and hospitalisations remaining low in the UK and Israel despite the rise in new cases and this remains the key to watch going forward. This explains why England feels confident to proceed with the removal of all distancing restrictions on July 19. It would be nice if it, the US and Europe were closer to herd immunity. But put simply its relatively high level of vaccination particularly amongst older people is enabling it to bet than it can live with coronavirus circulating in the community without causing major problems for its health care system and excess deaths as seen last year. The UK will be a key test case for Australia to watch.
So far 25% of people globally and 52% in developed countries have had at least one dose of vaccine. Canada is now at 70%, the UK at 69%, the US at 56%, Europe at 53% and Australia is at 26%.
Australia’s daily vaccination rate remains low at 0.5% of the population. But it has picked up a bit and with global vaccine production ramping up and more Pfizer and then Moderna vaccines scheduled to arrive in Australia (eg, Pfizer doses are expected to ramp up from 350,000 a week to 1 million), it will accelerate in the months ahead.
Of course, Australia is still a relatively lowly vaccinated country, which has meant that lockdowns are necessary to control the spread of coronavirus to limit pressure on the hospital system and prevent deaths following the latest outbreaks. The good news is that the snap lockdowns in Darwin, Perth and Queensland all ended very quickly because they started early when the number of local new daily cases was low (at 1-5) and so they were quickly able to bring new cases down enabling the lockdowns to be ended pretty quickly.
Unfortunately, the Sydney lockdown started later in terms of new daily cases (averaging around 20 a day over the 3 days up to the start of the lockdown) and so far, has been relatively light as far as lockdowns go (with much retailing still open) and so is taking longer to work having already been extended to three weeks. So, it makes sense that the Government has toughened it. It should still be relatively short compared to those seen overseas and the Victorian lockdown that started in July last year (when there were over 60 new cases a day) but – with new daily cases, the positive testing rate and new cases not isolating while contagious all yet to peak – it’s looking increasingly likely to be extended beyond Friday 16th July. Some modelling suggests it may need to be tightened further and may have to run for another four weeks or so. Victoria of course learned the lesson of July last year by starting its May lockdown when daily new cases were running at a relatively low 10 and was rewarded with coronavirus coming under control relatively quickly and so its lockdown was limited to two weeks. Unfortunately, NSW failed to learn that lesson.
The economic impact is now clearly evident in our Australian Economic Activity Tracker which fell again over the last week reflecting further declines in restaurant and hotel bookings, mobility and retail foot traffic mainly in NSW. Our rough estimate is that the Sydney lockdown is costing $1bn a week meaning that if it runs for the three weeks as currently scheduled then it will cost $3bn. Added together with the Victorian lockdown in May-June costing around $1.5bn and another $0.5bn from the recent lockdowns in Perth, Queensland and Darwin it means a hit of around $5bn spread across the June and September quarters. If the NSW lockdown ends soon and things bounce back reasonably quickly as they have after past lockdowns (see the next chart) then the economic impact will be pretty small for the September quarter and the Australian economic recovery won’t be significantly disrupted, with growth being a bit weaker than our forecasts for 0.9% and 1% respectively in the June and September quarters but rebounding in the December quarter to still be near our forecast of 4.75% through the year.
However, if as appears increasingly likely the Sydney lockdown is extended much beyond the current three weeks it will progressively cause more damage. For example, another 4 weeks will see the economic cost blow out to $7bn and take longer to recover from. This could flatten September quarter GDP and even allowing for a strong December quarter NSW driven reopening rebound could see through the year GDP growth pushed down to around 4% (which in turn would slow progress in reducing unemployment). A further extension and tightening of the lockdown would require more government lockdown assistance in order to minimise the economic impact. Fortunately, banks are already offering debt repayment deferrals for affected small business and home loan customers which will, as we saw last year, limit defaults and any negative impact on the property market.
Our US Economic Activity Tracker ticked down in the past week with lower confidence and reduced hotel and restaurant bookings, but our European Tracker recovered further and is now stronger than our Australian and US trackers!
So what’s going on with OPEC and the oil price? Basically, OPEC and Russia had agreed to increase production in August. The UAE vetoed it unless it gets a bigger output quota to the tune of 0.6 million barrels per day of oil. They couldn’t agree so the production hike is off for now. Initially oil prices rose to a $US0.77 on the thought of less production from August but they then fell back to as low as $US0.71 on the prospect of a breakdown in OPEC supply discipline. The likelihood is that close allies Saudi Arabia and the UAE will find a solution allowing the UAE to boost its output which when combined with the likely return of Iranian oil exports later this year will see prices settle back below $US0.70.
A few years ago, I rediscovered Carly Simon who penned excellent songs such as Anticipation. Maybe she provided inspiration for some Taylor Swift songs and here they are together with You’re So Vain. Like many I used to wonder who it was about but Carly has revealed that “the second verse is Warren (Beatty)” but that the rest of the song refers to two other men. But they have not been revealed.
Major global economic events and implications
US data releases were a bit mixed with the ISM services conditions index down in June but still strong, the employment component down sharply and job openings up less than expected and initial jobless claims up slightly although continuing claims continued to fall.
Eurozone business conditions were revised up in June and May retail sales rose 4.6%mom helped by reopening, but German factory orders were soft.
Japanese household spending fell in May reflecting the state of emergency, but June economic sentiment rebounded as it was removed. Of course, the latest state of emergency in Tokyo may see indicators fall back again.
Chinese services conditions fell sharply in June suggesting smaller businesses may be seeing a tougher time explaining why the authorities are moving towards making it easier for banks to end. Meanwhile, consumer and producer price inflation both slowed in June to 1.1%yoy and 8.8%yoy respectively with core CPI inflation running at just 0.9%yoy. Inflation pressures may have peaked in China and there is not much flow through of higher producer prices. The combination of some slower readings on growth and still low consumer price inflation is motivating some policy easing with the PBOC cutting bank reserve requirements and money supply and credit coming in stronger than expected in June.
Australian economic events and implications
Australian economic data was mostly good. Home building approvals fell sharply again in May reflecting the end of HomeBuilder but they remain strong and their lagged rise points to a further increase in dwelling construction. Retail sales were revised up in May and even if they fall -1% in June on the back of the lockdowns are on track for a strong June quarter rise. Meanwhile, payrolls are up 3.4% on pre-coronavirus levels and ANZ job ads rose another 3% in June. Finally, the Melbourne Institute’s Inflation Gauge points to a pickup in inflation in the June quarter but nothing like has been seen in the US, which will keep the RBA relatively dovish for now on rates.
What to watch over the next week?
In the US, the focus is likely to be on June inflation data with largely transitory pandemic related bottlenecks continuing to impact but with some slowing in the rate of increase as pressure starts to abate a bit thanks to increasing production and slowing goods demand. Expect CPI inflation (Tuesday) to slow slightly to 0.5% month on month taking the annual inflation rate down to 4.9% year on year from 5% in May. Monthly core inflation is also likely to slow slightly but with the annual rate rising further to 4%yoy. Producer price inflation (Thursday) is also expected to show some slowing in the monthly rate of increase. Meanwhile, expect small business confidence (Tuesday) to remain solid, a further solid increase in June industrial production and solid readings for the July New York and Philadelphia regional manufacturing conditions indexes (all Thursday) and a slight pickup in underlying June retail sales (Friday).
June quarter company profit results will start to trickle in with the consensus looking for a 62% year on year rise boosted by base effects but the rebound in various macro variables suggesting this could end up being +90% or so.
The Bank of Canada and RBNZ (Wednesday) and the BoJ (Friday) are expected to leave monetary policy unchanged.
Chinese June quarter GDP growth (Thursday) is expected to show a rebound to 1.0%qoq after 0.6%qoq in the March qtr, but year ended growth is expected to slow to 8%yoy from 18.3% as the low base in March quarter last year drops out of annual calculations. June data is expected to show a further slowing but still strong imports and exports (Tuesday) and retail sales, industrial production and investment (Thursday) as favourable base effects a year ago continue to drop out.
In Australia, the NAB business conditions and confidence survey (Tuesday) and the Westpac/MI consumer confidence survey (Wednesday) are expected to show some softening reflecting recent lockdowns but to still solid levels. Jobs data for June (Thursday) is expected to see employment constrained a bit by the late May/early June Victorian lockdown but we still expect employment to rise by 20,000 jobs with unemployment unchanged at 5.1%.
Outlook for investment markets
Shares are vulnerable to a short-term correction with possible triggers being the latest upswing in global coronavirus cases, the inflation scare and US taper talk and geopolitical risks. But looking through the inevitable short-term noise, the combination of improving global growth and earnings helped by more fiscal stimulus, vaccines allowing reopening once herd immunity is reached and still low interest rates augurs well for shares over the next 12 months.
Still ultra-low bond yields and a capital loss from rising yields are likely to result in negative returns from bonds over the next 12 months.
Unlisted commercial property may still see some weakness in retail and office returns but industrial is likely to be strong. Unlisted infrastructure is expected to see solid returns.
Australian home prices now look likely to rise 20% this year before slowing to around 5% next year, being boosted by ultra-low mortgage rates, economic recovery and FOMO, but expect a progressive slowing in the pace of gains as poor affordability impacts, government home buyer incentives are cut back, fixed mortgage rates rise, macro prudential tightening kicks in and immigration remains down relative to normal.
Cash and bank deposits are likely to provide very poor returns, given the ultra-low cash rate of just 0.1%. We remain of the view that the RBA won’t start raising rates until 2023.
Although the A$ could pull back further in response to the latest coronavirus scare and the threat it poses to global and Australian growth, a rising trend is likely to remain over the next 12 months helped by strong commodity prices and a cyclical decline in the US dollar, probably taking the A$ up to around US$0.85 over the next 12 months.