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Market Drivers - April 2022

In March high inflation and what central banks might do to tackle it was the dominant theme in financial markets. Government bond markets suffered their worst month in 30 years with yields up sharply responding to fear of aggressive hikes in official interest rates by central banks. The US Federal Reserve (Fed) facing sustained high US inflation caused by strong growth stretching disrupted supply chains and showing signs of being sustained by rising wages, talked about the need for regular and bigger rate hikes. It delivered at its March policy meeting a minimal 25 basis point (bps) rate hike taking the Federal Funds up to 0.25% to 0.50% range to combat US inflation at 7.9% y-o-y in February and expected to be above 8% in March.

The US bond market took to heart the Fed’s tough rate guidance and started to factor in an aggressive hiking cycle, ignoring the reality of the modest start by the Fed in March. The US 10-year bond yield rose in March by 52bps to 2.34% while the 2-year bond yield rose much more, by 90bps to 2.33%. The US bond yield curve started to invert at times. In the past bond yield curve inversion has often heralded much weaker economic growth and bearish sentiment in share markets. In US financial markets in March the bond market yield inversion was met with an unusual rally in the share market.

The US S&P 500 rose by 3.6% in March helped by evidence of continuing strength in the US economy. While higher interest rates may slow the pace of US economic growth down the track there is near-term momentum for business and household spending from current rapid economic growth, a strong labour market, past build-up of wealth and savings and continuing lift in government spending. The strong US economy is providing most US businesses with growing sales volume and ability to price higher with higher inflation yet to be staunched by Fed policy action running much softer than its tough talk.

US economic readings released in March and early April still show current strong economic growth and prospects. The labour market is very strong with March nonfarm payrolls up 431,000 after lifting an upwardly revised 750,000 in February. The unemployment rate fell from 3.8% in February to 3.6% in March and is lower than where it stood at the start of the pandemic early in 2020. Annual growth in average hourly earnings accelerated to 5.6% y-o-y in March from 5.2% in February. Importantly, weekly initial jobless claims are hovering very low around the 200,000 level among the lowest readings in 50 years and mark continuing labour market tightness and likelihood of several more months of big increases in nonfarm payrolls, falling unemployment and higher wages.

It is possible that the Fed starts to walk its tough talk hiking interest rates but that would imply several 50bps rate hikes at and between policy meetings to drive the Funds rate up quickly to around 4%. It is possible but unlikely in our view. Instead, we see the Fed continuing to move slowly with 25bps rate hikes at every policy meeting the remainder of this year and through 2023. That implies a Fed funds rate around 3% by the beginning of 2024.

In Australia, the bond market sell-off in March was more pronounced than in the United States with the 10-year bond yield rising by 70bps to 2.83% although shorter-maturity bond yields rose a little less and the bond yield curve is still positively shaped as it should be in an economy exhibiting strong growth with growing inflation but a central bank still being patient before starting to hike the cash rate.

The most recent Australian economic growth reading for Q4 2021 was exceptionally strong, up in real terms by 3.4% q-o-q, 4.2% y-o-y (more than 10% y-o-y in current price terms). Australian households are spending up after being restrained periodically in lockdowns during 2021 and now with the promise that we are living with Covid, and lockdowns will not return. Retail spending growth was very strong in Q4 2021 and is still lifting rapidly early in 2022 with retail sales up 1.8% m-o-m in both January and February.

Post lockdowns employment has rebounded strongly taking the unemployment rate down to 4.0% in February. The Federal Budget last week is providing more money to households over the next few months with a $250 one-time higher cost-of-living compensation payment to government pensioners and a $420 additional tax rebate to low-to-middle income taxpayers. A halving of Government excise duty on petrol is already cutting the high cost of petrol that was starting to impact household budgets.

Apart from the more than $A8 billion near-term government largesse for households, the Ukraine War has added to high commodity prices boosting the incomes of Australian resource companies. Australia’s strong economic growth rate with a tightening labour market looks set to continue recognised in Treasury’s economic forecasts released with the Budget. Treasury forecasts 2021-22 real GDP growth at 4.25% but up 10.75% in nominal terms.

Strong economic growth and the near-certain prospect of more strong growth ahead is allowing the Australian share market to outperform. In March the ASX 200 rose by 6.4%. Its nearest rival was Japan’s Nikkei up 4.9% while European share markets were more challenged by the Ukraine War and impact on European energy supply. The Eurostoxx 50 was down by 0.6% and Germany’s Dax was down by 0.3%.

Australian share market outperformance has also carried to Australian credit. Spreads narrowed a little in March although yields were higher because of the marked rise in Australian government bond yields. The rise in Australian bond yields may soon be justified by RBA policy action. Even though the RBA continued to indicate in March that it is still prepared to be patient before hiking the cash rate there have been more signs that annual inflation is running consistently above 3% and annual wage growth will soon push up to nearer 4%.

The Q1 CPI in late April will see annual inflation push above 4% y-o-y from 3.5% in Q4 2021. Widespread public sector pay disputes in New South Wales all encompass first year pay increases of 4.5% or higher, well above the 2.5% on offer from the State Government. The next National Minimum Wage Case is centering around a 5% claim. Given the much higher pay claims in train in the areas of the workforce that have been the biggest brake on wage growth in the past, it is likely that quarterly wage growth will mark up sharply from 0.7% q-o-q recorded in Q4 2021.

We now expect the RBA to start hiking the cash rate in June and a cash rate no lower than 1.00% by the end of 2022 and no lower than 2.25% at the end of 2023.