The stock market rebound continued over the past week, helped by strong earnings data and the relief that heightened US-China tensions stemming from the visit of US House Speaker Nancy Pelosi in Taiwan has not escalated into a bigger conflict (at least not yet).
The positive global lead along with signs of a slightly diminished RBA hawkishness pushed the Australian equity market higher as gains in IT, telecoms and healthcare stocks more than offset losses. falls in energy stocks. For the weekly 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 equities are vulnerable to a pullback over the next few months as central banks are still a long way from peaking and actually cutting rates, recession risk continues to rise and this raises the risk of a significant downward earnings revisions.
Additionally, geopolitical risk is still on the rise, as highlighted by the US-China tensions of the past week and the upcoming US midterm elections in November. However, the continued strength of the rebound (with the US stock market now giving direction up 13% from its low) raises the possibility that we have seen the bear market bottom and any pullback is just a partial retracement of the rally since mid-June. Either way, on a 12-month horizon, we remain bullish on equities as inflation recedes, central banks become less hawkish and a deep recession is likely to be averted.
First the bad news – which runs the risk of a new pullback:
- Central banks are still hawkish. Various Fed officials have indicated that the Fed is still a long way from pivoting to an easier position. The Bank of England raised rates another 0.5% and began actively selling bonds, now expects inflation to peak at 13% and has signaled readiness for more “powerful” rises despite the expectation of a severe recession this year. The RBA raised rates a further 0.5% and indicated that further rate hikes are likely. Reflecting the low starting point and severity of the inflation spurt, this is the most aggressive RBA rate hike cycle seen in the last 30 years, except for the rate hikes that have occurred from August to December 1994 with which this cycle is comparable. See table below:
- The risk of a “true” recession in the US continues to build according to the US yield curve, with the US 10y minus 2y yield curve inverting further and the Fed Funds yield spread at 10 years less approaching the inversion too. A “true” recession, that is, beyond the technical recession of the first half of this year, would mean a major earnings downgrade cycle in the US, global and Australian stock markets.
- Soaring gas and electricity prices in Europe continue to increase the risk of recession there, especially in Germany.
- After July, the seasonal trend for equities historically reversed from August to October.
- US equities typically have a rough year before the midterm elections due to political uncertainty, but then recover once they are out of the way.
- Tensions between China and the United States erupted with House Speaker Pelosi’s visit to Taiwan.
But there is also good news – supporting the view that stocks will be up on a 12-month view.
- Global inflationary pressures could reach or approach a peak (with the exception of Europe with its specific energy problems). Our US pipeline inflation indicator continues its downward trend, reflecting a combination of a downward trend in labor backlogs, freight rates, metal prices, grain prices and even oil price. This was also evident in the ISM business survey showing falling delivery times, order books and pricing pressures.
- US earnings reports surprised on the upside again, with consensus earnings expectations for the year through the June quarter rising from 5% year-on-year three weeks ago to nearly 9 % now, with outlook statements being mixed rather than negative, as feared. . And earnings growth outside the US was even stronger.
- Bond yields are well down from their June highs – with US 10-year yields dropping from 3.5% to 2.7% and Australian 10-year yields dropping from 4.2% to 3.1% . Falling bond yields reduce pressure on equity valuations and can promote economic growth by reducing long-term funding costs. Falling bond yields have already prompted some Australian banks to lower their fixed mortgage rates (although this will not be enough to avoid the fixed rate cliff that borrowers at rates around 2% fixed will face when they move at fixed or variable rates two and one and a half times or more).
- The equity markets this time anticipated the inversion of the US yield curve and its signal of recession whereas previously they had fallen sharply only well after the inversion. In other words, the recession may have already been discounted.
- Central banks may still be hawkish, but they are softening a bit around the edges, suggesting they may be nearing the top and are also aware of the deteriorating growth outlook. This was evident when Fed Chairman Powel spoke of a possible slowing in the pace of rate hikes, with the BoE noting that he was not on a “pre-set” path and in the RBA’s commentary this week.
With specific regard to the RBA, which again hiked rates another 0.5%, the message from its post-meeting statement and quarterly monetary policy statement is that it remains hawkish, but begins to leave a little room for manoeuvre.
Given its upward revision of its inflation forecast for this year to 7.75% year-on-year and the very tight labor market, it rightly remains focused on slowing demand and holding up expectations. inflation at a low level and therefore continues to anticipate further rate hikes. But his reference to wanting to keep the economy “in balance”, his downward revisions to growth (to a very modest 1.75% for the next few years), his forecast of a rise in unemployment from 2024, his acknowledgment of declining consumer confidence, his acknowledgment of the negative wealth effects of falling house prices, his greater acknowledgment that some households are not well positioned to withstand rate hikes, and his reiteration that it is “not on a predefined path” all suggest it is open to easing the pace of rate hikes in the coming months as its tightening begins to gain traction.
This is broadly in line with our assessment that cash rate hikes will slow in the coming months, with some months seeing no movement until the cash rate peaks at 2.6% later this year or early in the year. next year, and that rates will start falling in the second half of next year.
Monitoring of economic activity
Our Australian economic activity tracker dipped slightly last week, continuing the loss of momentum seen since April, consistent with slowing growth. Our US tracker was up slightly and our European tracker was down slightly.
Australian economic events and implications
Australian economic data was mixed. On the positive side, real retail sales rose sharply in the June quarter, car sales rebounded strongly in July, and the trade surplus hit a new record high of $17.7 billion. Net exports are expected to contribute about 1 percentage point to GDP growth in the June quarter and the strong rise in real retail sales bodes well for consumption growth in the June quarter. Of course, monthly retail sales data is slowing and rising interest rates and poor consumer confidence point to a slowdown ahead.
On the other hand, although ANZ job vacancies remained high but fell in July and may start to slow and housing related data was soft.
Housing finance has fallen more than expected – and now appears to be clearly recovering. More falls are likely to come as rising mortgage rates and falling house prices will have an impact. And data from CoreLogic for July confirmed that the decline in house prices is accelerating, led by Sydney.
So far, the national average house price decline is only 2%, which is only a boost, but the pace of decline is comparable to what has been seen in the GFC , the period before the recession of the early 1990s and in the recession of the early 1980s. But all of these meltdowns followed long periods or rate hikes with interest rates at their peaks and about to begin down as this time around we are only four months away from interest rate hikes and more rate hikes are yet to come.
The speed of house price declines this time around so early in an RBA tightening cycle reflects the de facto tightening that began with the rise in fixed mortgage rates a year ago, but more importantly the heightened sensitivity to rising interest rates resulting from much higher debt levels now and very poor consumer confidence.