It has been a turbulent few weeks for markets after the US Federal Reserve raised interest rates by 0.5% at its May board meeting. This outcome was expected by the market and economists and the market actually rose from comments by Fed Chair Powell that 0.75% rate rises was “not something that the committee is actively considering” which alleviated fears of an extremely aggressive short-term rate hike profile from the Fed. The market pushed out US interest rate hikes further over the next 1-2 years, with US interest rates now expected to reach close to 4%.

 

The RBA delivered a 0.25% increase to the cash rate at its May board meeting, which was a “surprise” in the sense that the market and economists were looking for a 0.15% lift. This takes the cash rate to 0.35% from 0.1%. The RBA also announced that it will start quantitative tightening, by allowing the bonds on its balance sheet to run down as they mature, which will shrink the size of its balance sheet. Clearly the central bank wanted to quickly get on top of the breakout in inflation (perhaps after seeing the issues with high inflation in the US). The RBA’s commentary was also more hawkish than expected, citing a big lift in its inflation forecasts and committing to do “what is necessary to ensure inflation in Australia returns to target over time”. This signals an aggressive profile for interest rates over the next 12 months. We expect a follow-up rate hike of 0.4% in June and for the cash rate to end the year between 1.5-2% and 2-2.5% by mid-2023.

 

The latest employment data in the US was broadly neutral. Payrolls were a touch better than expected at 428,000 new jobs versus 380,000 expected. However the previous two months were revised down 39,000, offsetting the gap. Average hours worked were +0.3% vs expectations of 0.4%. All this signals the rate of expansion in jobs is slowing. The participation rate also declined, reversing positive signs of people returning to work in the last couple of months. All up, none of this shifts the dial for the Fed in terms of resolving the fundamental problem of too few people available for each vacancy.

 

There are signs that inflationary pressures are beginning to moderate. Average hourly earnings are plateauing, some commodity prices (including copper) have stalled, and money supply growth has decelerated. This is not enough to dampen fears around the level of required tightening.

 

The market is also mindful of: 

Higher oil prices

A stronger dollar

Higher nominal yields 

High mortgage rates

Tighter policy 

 

 

Shares are likely to see continued short term volatility as the Ukraine crisis continues to unfold and inflation, monetary tightening, the US mid-term elections and geopolitical tensions with China and maybe Iran impact on markets. However, we see shares providing upper single digit returns on a 12-month horizon as global recovery continues, profit growth slows but remains solid and interest rates rise but not too onerous levels at least for the next year.

 

Australian home price gains are likely to slow further with average prices falling from mid-year as poor affordability, rising mortgage rates and rising listings impact. Expect a 10 to 15% top to bottom fall in prices from mid-year into 2024 but with a large variation between regions. Sydney and Melbourne prices have likely already peaked.

 

Cash and bank deposits are likely to provide poor returns, given the ultra-low cash rate of just 0.35% at present but it should rise as the RBA raises interest rates.