Investment markets and key developments

Share markets were mixed over the last week helped by some pull back in oil prices as the US held back from escalting further with Iran, a rebound in tech stocks and specifically chipmakers from oversold levels and the US Fed leaving rates on hold. However, it was a bit messy with only modest gains in US shares despite strong earnings results, a reasonable gain in Eurozone shares, but falls in Japanese and Chinese shares. The heavily AI exposed Korean share market rose strongly later in the week along with chipmakers helped by optimism that the unwinding of leveraged AI trades (including by a hedge fund called Situational Awareness) may be over or nearing an end. It’s the nature of bull markets to see relatively steady gains but then occasional sharp sell offs as investors who are predominantly long unwind their often leveraged positions. Of course the rebound in chip makers and Korean shares could just be a bear market rally so its best approached with some caution. Despite the global volatility Australian shares rose around 2.5% for the week helped by lower than expected inflation adding to expectations that the RBA will leave rates on hold at its August meeting. Gains were led by IT, health, telco, retail and property shares.

Bond yields mostly fell slightly, but as can be seen in the next chart remain in a rising trend. Copper and gold prices rose slightly but iron ore prices fell slightly. Bitcoin was little changed although it remains shaky and yet to confirm that its latest crypto winter is over. It was helped by a slightly softer $US which also saw the $A rise slightly.

Oil prices intially fell sharply early in the past week following Trump’s latest TACO (with the US holding off on further escalation and Trump talking again about a “good chance” of a peace deal) and easing in hostilities but then reversed some of its falls as hostilities resumed, but it still fell over the week.

The combination of high and rising oil prices, ongoing pressure on central banks to raise rates, a rising trend in bond yields and worries about an AI bubble amidst stretched valuations leaves shares at high risk of another correction as we come into the seasonally weak months of August and September. Of course, just as Australian shares didn’t get much benefit on the way up in the AI boom they may not fall as much if and when it does really start to unwind. That said, we remain a bit sceptical that we are at the peak of the AI story just yet as related capex has a way to go and growth in demand for AI is real.

The latest de-escalation and re-escalation in the Iran War seen in the last week just highlights the mess Trump has got himself into with Iran. While he clearly wants to TACO – with key munitions running low, uncertainty about whether more strikes on Iran are achieving anything along with sensitivity about rising gasoline prices and bond yields  - Iran is not so willing to play ball. And so the War continues with more attacks on energy infrastucture and Saudi Arabia joining strikes on Iran, the Strait of Hormuz remaining largely closed and uncertainty about the reliability of Saudi shipping through the Red Sea.

Another peace deal remains our base case with oil perhaps in a $US70-100 range with Iran preventing it going lower and the US moving to try and calm things down whenever it gets above $US100 as happened a week ago. On the latter Trump remains under immense pressure politically as Americans care most about inflation and affordability and not so much the Iran War which is just adding to inflation concerns – see the next chart. However, the risk remains that there will be no sustainable peace deal, the flow of oil out of the Middle East remains down 10-15% on normal levels and that we will have to face ever higher oil prices as reserves run down. This poses ongoing upside risks to inflation and downside risks to economic growth.

This brings us to inflation and rates where the messages over the last week were mixed, but with more of a bias to modestly higher rates:

• The Fed left rates on hold, but poor communication is seeing it lose inflation fighting credibility. While relatively benign inflation readings for June gave the Fed cover to leave rates on hold at 3.5-3.75%, which it did, the lack of clear guidance on how the Fed will react, three dissents in favour of a rate hike and the ongoing threat to inflation from higher oil prices is starting to see the bond market fret more about inflation and what the Fed might do with rates. While new Fed Chair Warsh reiterated the Fed’s commitment to the 2% inflation target, this was undermined by a failure to clearly articulate how the Fed would get inflation back to target and what the target actually is along with a misrepresentation as to why bond yields had been trending up. In terms of the latter, he seems to think the bond market is doing some of the Fed’s job for it, which may be partly true but more importantly the rise in yields appears to reflect increased uncertainty about the Fed and an assessment that the Fed will need to raise rates. This is consistent with pipeline inflation pressures from energy and other costs remaining elevated.

• Absent better inflation data in the next seven weeks the Fed will probably have to hike in September with the money market now seeing a 64% chance.

• In the UK, the Bank of England left rates on hold at 3.75% and sounded a bit dovish noting labour market weakness and limited second round effects from oil so far. However, the vote was 6 to 3 in favour of holding verses hiking.  

• The Bank of Japan also held at 1%, but revised up its economic growth forecasts, flagged the risk of underlying inflation exceeding its target and indicated that it will continue to raise rates. Another hike is likely by October. 

• Money market expectations still lean towards higher interest rates from major central banks although not dramatically so. 

• In Australia, lower than expected inflation for June provided relief with the RBA likely to hold in August - but it might just be a false dawn. June inflation fell to 3.8%yoy helped by a 10.9% fall in fuel prices and underlying or trimmed mean inflation remaining at 3.6%yoy. June quarter trimmed mean rose to 3.6%yoy too from 3.5%yoy in the March quarter but was materially lower than the RBA’s expectation for a 3.8% rise providing hope that inflation may have peaked.

• The combination of lower-than-expected inflation along with weaker than expected jobs and housing markets provide scope for the RBA to remain in wait and see mode and so we now expect the RBA will leave rates on hold at its August meeting. We are not as confident as the money market though which sees a less than 1% chance of a hike – we would put it at 30%! However, the RBA is likely to retain a hawkish bias and we continue to expect one further hike by year end because: trimmed mean inflation at 3.6%yoy is still too high with no clear evidence of a downtrend in monthly data; second round impacts of the oil price rise are still in the pipeline with oil and petrol prices up again; housing related costs are still trending up; there are still more items with inflation greater than 3% than less than 2%; and the RBA needs to be more cautious than it was in the last rate cycle because after five years out of six with inflation above target there is now a greater risk of the inflation target losing credibility.

• Out of interest while demand side factors likely drove the bulk of the rise in underlying inflation through 2025-26, supply side cost pressures are now elevated as indicated in our Pipeline Inflation Pressure Indicator for Australia threatening to keep inflation elevated.

On the cost front – petrol prices in Australia look headed to around $2.10 a litre if the Government follows through with its plan to end fuel tax relief on 2^nd August. They have already rebounded to $1.95 a litre from the 30 June low of around $1.53 a litre reflecting the 16 cents a litre from the halving of the 32 cents a litre fuel tax cut from 1 July and the flow through of the rebound in global oil prices. If fuel tax relief ends as scheduled, then petrol prices will rise around another 17 cents a litre (which is the remaining 16 cents a litre along with a 1 cent CPI adjustment). This will push up headline inflation again as well as the cost of the average households’ weekly fuel bill by around $20, although its still well below the levels reached in March.

Vale Bill Evans, former Chief Economist of Westpac. I first met Bill in 1991 soon after he was appointed to the Chief Economist role at Westpac and got to know him on the ABE committee. I quickly learned to highly value his well-reasoned and invariably entertaining insights, particularly in terms of where the RBA was headed. Back in 2011 I was thinking of changing our view on interest rates to be that the next move would be down rather than up which was the consensus at the time – but Bill beat me too it and was completely right! Being with Bill on a panel of economists always led to excellent debate and great fun. I miss him.

Major global economic events and implications

US June quarter GDP growth slowed to just 1.5% annualised but this was due to detractions from trade - as data centre capex sucks in tech imports, a bit like in Australia - and inventories with strong growth in investment and consumption.