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In this month’s update, we provide a snapshot of economic occurrences both nationally and from around the globe.

Key points:

– US Fed pivots its interest rate policy
– Current estimates are for between three and eight interest rate cuts in the US in 2024
– The RBA while most unlikely to raise rates again does not appear to be in a hurry to start cutting
– Share markets respond positively to the Fed pivot and finish 2023 well into positive territory

We hope you find this month’s Economic Update as informative as always. If you have any feedback or would like to discuss any aspect of this report, please contact your Financial Adviser.

The Big Picture
Given how markets finished up in 2023, there was a lot of pain endured in getting there.

The US 10-year Government Bond yield went from 3.8% to 3.8% via just above 5.0%

ASX 200 screamed up in January 2023 only to shed all those gains, and more, as the US regional bank crisis shook confidence. But the ASX 200 rallied back and gained 7.8% on the year (without dividends and franking credits)!

The S&P 500 was dominated by the so-called ‘Magnificent 7’ – 7 mega cap tech stocks like Apple, Amazon and Nvidia. The ‘other 493’ did not fare so well but they did finish the year with a little bit of a flourish. The index gained 24.2% on the year.

The Dow Jones reached an all-time high in the last week of 2023. The S&P 500 and the ASX 200 each came very close to all-time highs in the final week of the year.

There were plenty of obstacles along the way in 2023 that prevented markets moving in a straight line. US Regional banks’ crises, Israel-Gaza conflict, Red Sea drone attacks and the rest. But the big one was trying to second-guess central banks as they bobbed and weaved in their battle with inflation. The US Federal Reserve (Fed) stuck to its guns of reiterating higher for longer until mid-December. It even stated on December 2nd that it was ‘premature’ to talk about interest rates cuts. Then a slew of favourable data on US inflation convinced it to ‘pivot’ (change its mind) at its last meeting and press conference for the year – just two weeks after the ‘premature’ statement! The Fed dot plot forecasts for cash rates at various intervals for the coming few years (from 19 Fed members) suggested there might be three 0.25% interest rate cuts in 2024.

While the above is the view of the Fed board members, the US Government bond market is taking a different view with current interest rates implying a 96% chance that the Fed will cut interest rates between five and eight times in 2024. Needless to say, the Fed ‘pivot’ in December has seen the US bond prices rally strongly (interest rates falling).

Surprisingly, the RBA minutes revealed that Australia’s central bank was still considering a rate increase at its December 5th board meeting, this approach puts it at odds will all other developed world central banks. Despite this, in Australia, for four of the last five quarters, per capita GDP went backwards, the household savings ratio nearly fell to zero and retail sales showed lots of weakness.

While the RBA clearly has some concerns regarding the stubbornness of inflation there is growing evidence that the economy is slowing and interest rate policy has done enough to contain inflation. The concern now is that unless the RBA joins in with its developed world peers and begins easing monetary policy (reducing interest rates) then it risks sending the economy into a more sever slowdown than is otherwise anticipated.

The RBA interest rate tracker app on the ASX website assigns an 8% chance of a rate hike at its next meeting in February. The predominant outcome currently predicted is ‘no change’ to the RBA cash interest rate.

Media reports have possibly led many astray as they portrayed the Fed increasing interest rates from 0% to 5.5% in less than two years as being aggressive and strongly contractionary and will ultimately result in an economic recession, which hasn’t happened yet.  This narrative is ignoring the whole point of monetary policy.

There is an economic concept of a ‘neutral’ central bank interest rate that neither causes the economy to slow down, nor is it accommodative. Most economists would agree that the neutral rate for the US and Australia – among others – is about 2.5% to 3.0%. That means the first set of Fed hikes shouldn’t have slowed down the economy until 3% was exceeded in September 2022! They’ve only had 2.5% points of tightening and not 5.5%! The first 3% of hikes were simply being less accommodative.

The other key insight is that at least from the late 1960s, it has been widely thought that the implementation of this sort of monetary policy acts with ‘long and variable lags’. Conventional wisdom is that this time frame is around 12 – 18 months. Even central bankers have agreed on occasion!

Putting these two concepts together and applying it to our current cycle, the first interest rate tightening that started in September 2022 shouldn’t have had any material impact until September 2023 to March 2024. So, the media tell us economists ‘got it wrong’ by stating that the anticipated recession never happened, when the more considered statement is ‘it hasn’t happened yet’. From an economic perspective it is just too early to say ‘it didn’t happen’, notwithstanding that it may not. Some reasons for this are that, US consumers were awash with Covid stimulus cheques and a student loan moratorium until October 2023. And fourth quarter US GDP data, even its preliminary form, is not available until late January 2024 so we don’t yet know how the US economy is travelling in late 2023.

There is likely to be plenty of pain in the pipeline for 2024 from rate hikes not yet felt. By reasonable definitions, Australia has been in recession for most of 2023 but massive immigration – running at about 2.6% of population – has distorted the headline data from revealing the hardship facing many.

The US economy is doing better than ours but there seems to be cracks appearing in the data picture. There has been solid job growth but increasingly this growth has not been in those sectors usually associated with a strong economy. Both the US and UK official statistics agencies have had to change their data collection methods to get normal response rates to survey methods. It is very difficult to measure what the unemployment rate really is!

It’s not obvious that recent labour force data can usefully be interpreted in the traditional manner. Moreover, with the growth in options to work in casual food and ride delivery, it is much easier for those who want to work to do so. The definition of work has changed.

With regard to market forecasts – particularly for the ASX 200 and S&P 500 – earnings forecasts are quite strong. LSEG (formerly Thomson Reuters) collects broker-forecasts of earnings for the relevant companies in the indices. Companies are required to report material changes in their expectations and they share their view of their futures with the brokers.

We have found over nearly two decades that these earnings expectations give useful guides to market direction. Of course, there is always the possibility of a ‘black swan’ event or some geopolitical upheaval.

Asset Classes

Australian Equities
The ASX 200 had a very strong December (+7.1%) to back up a strong November (+4.5%) to make a two-month total of near 12%.

The Materials sector did well at +8.8% in line with strong iron ore prices (+7.3%).

Total returns for the year were 12.4% making it a well-above average year. By our metrics we have the market overpriced by +3.3% making that a bit of a headwind for 2024. However, news of actual interest rate cuts might still spur on the market to new highs. Markets usually lead the real economy!

International Equities
The S&P 500 gained +4.4% for the month or 24.2% for the year. The London FTSE and the German DAX were similarly strong for the month but Japan’s Nikkei was flat. China’s Shanghai Composite fell by -1.8%.

We have the S&P 500 overpriced by +4.6% so, by our estimation, that index also faces a modest headwind starting the year.

Bonds and Interest Rates
It seems that almost every economist and commentator is expecting cuts by the Fed during 2024. 75 bps of cuts seems to be the smallest number being predicted. There is an 11% chance of eight cuts to a range of 3.00% to 3.25%.

We think the Fed might start at the March meeting and then go again in June taking the rate down to a range 4.75% to 5.0%. What happens thereafter would seem to be highly dependent on whether inflation and unemployment stay down and GDP growth remains solid.

US CPI inflation over the last six months was below target at 1.9% pa.

The 10-yr US Treasurys yield fell from just over 5% on October 23rd to 3.88% at the end of the year.

The RBA minutes stated that the board considered a hike at their last board meeting. The newly constructed committee to deal with rate movements is expected to meet on the first Tuesday in February.

The ECB and the Bank of England appear to be on hold. EU inflation fell to 2.4% from 2.9% when 2.7% was expected with the core rate falling to 3.6% from 4.2%. Both economies are flirting with recessions.

Other Assets 
The price of oil dropped sharply again in December with – West Texas Intermediate Crude (WTI) by -5.7% and Brent Crude by -7.0%. Brent ended the year at US$77 per barrel having traded in a range of $72 to $97 over 2023. OPEC+ appears to be losing its grip over controlling oil supply which they have historically used to influence the market price for oil.

The price of iron ore again rose very strongly – at 7.3% in December or +20.7% for the year. Copper and gold prices each rose in December by just under 2%.

The Australian dollar – against the US dollar – appreciated by 2.9% which will further help reduce import prices and, hence, domestic inflation in Australia.

Regional Review

Australia
Australian GDP growth for the September quarter disappointed at 0.2% being less than the expected +0.4%. The growth for the year was 2.1%.

But the really disappointing news was that per capita growth for the quarter was -0.5% and -0.3% for the year. The average resident went backwards in 2023.

The last three quarters of growth were all negative and four of the last five were negative. That should define a recession in anybody’s analysis.

GDP per hour also went backwards for the year at -2.1%. Importantly, the household savings ratio fell to 1.1% from 2.8% in the previous quarter and from 3.5% in the one prior.

These statistics do not mean that households are spending more than they earn – at least not yet – but they are saving less than they did before the pandemic – at around 5%. We interpret these data as meaning households are having trouble maintaining their lifestyle in the face of cost-of-living pressures. They are not saving enough for a ‘rainy day’ or retirement. At 1.1% as a savings ratio, there’s not much room left before households have to start going into debt.

While it is true that (the rate of) inflation has been falling – prices keep rising and wage increases have been insufficient to keep pace with price inflation.

The latest inflation print from the Australian Bureau of Statistics has been held over for a couple of weeks – as has the data for retail sales – owing to the Christmas and summer holidays.

The Labour Force Survey data looked good for November. There were 61,500 new jobs of which 57,000 were full-time positions. The unemployment rate rose to 3.9% from 3.8%. But, with immigration surging, how many jobs constitute a good number?

The Westpac and NAB consumer and business confidence indices were all weak and consistent with being in a recession.

Hopefully the RBA will see past the immigration flows distorting traditional economic statistics and not only not increase interest rates but give serious consideration to cutting them sooner rather than later.

China 
China’s inflation data showed that it is experiencing deflation. CPI inflation came in as expected at -0.5% and wholesale price inflation as measured by the Producer Price Index (PPI) was -3.0% against and expected -2.8%.

While there is much speculation that China’s economy is struggling, the strength in iron ore prices gives us some comfort that China will not be adding to our economic woes.

US
US CPI inflation came in at 0.0% for the month and 3.1% for the year. The core inflation variant that strips out volatile fuel and food prices was 0.3% for the month and 3.4% for the year. PPI inflation was 0.0% for the month.

Our method of calculating CPI inflation, based on sound statistical principles, produced estimates of 2.2% for the headline rate and 3.4% for the core variant.

It is worth pointing out that a major component of CPI inflation is derived from Shelter (housing) estimates. A survey is conducted among owner-occupied housing to ask what they think the rent might be if it were rented out. We see this as a difficult estimate to produce at the best of times but, in a post-pandemic falling market we wonder whether there is inertia in owner’s assessment about what their properties are worth in a rental market. This component is running at around an inflation rate of 6% which could upwardly bias CPI estimates if, indeed, we are correct.

The Fed’s preferred core PCE (Personal Consumption Expenditure) inflation read was 0.1% for the month or 3.2% for the year. Headline inflation was -0.1% for the month and 2.6% for the year. PCE inflation over the last six months was 1.9% which is below the Fed target of 2%.

The second revision to the September quarter GDP growth reverted to 4.9% from the first revision of 5.2%. It should be recalled that the data appeared to be distorted by government infrastructure spending and a possibly unintended build-up in inventories.

Europe 
The Bank of England (BoE) and European Central Bank (ECB) are claiming some success in fighting inflation. For both economies, inflation has fallen rapidly. For the European Union (EU), inflation is now only 2.4% and core inflation is 3.6%

We maintain that much of these and other economies success in inflation might be due to the winding back of supply conditions. The long and variable lags effect might bite in 2024.

Rest of the World 
There is much being said and written about the Israel-Gaza conflict. We acknowledge the human tragedy and hope for a speedy resolution.

The Ukraine war with Russia continues with no apparent end in sight. Escalation of either or both of these conflicts presents a level of risk to the global economy.

It is reported that some terrorists based in Yemen have been using drones to intimidate or damage ships passing through the Red Sea in their quest to pass through the Suez Canal. It is said that this behaviour is related to the situation in Israel.

A number of ship owners have said that they will divert ships via the Cape of Good Hope which might add 10 – 15 days in travel time.

In unrelated reports, the Panama Canal has been very affected by drought limiting the traffic in this waterway potentially up to 50% by February.

A reduction in freight volumes through these two iconic waterways are putting renewed supply pressures on freight costs which in turn will feedback into inflationary pressures.

Canada’s latest GDP growth came in at -1.1% and New Zealand’s at -0.6%. The start of the global recession might be underway.

In this month’s update, we provide a snapshot of economic occurrences both nationally and from around the globe.

Key points:

• Australian inflation back in the RBA target range
• The RBA seems to be going it alone for another hike
• US inflation all but back to target
• US jobs data almost signal a recession

We hope you find this month’s Economic Update as informative as always. If you have any feedback or would like to discuss any aspect of this report, please contact your Financial Adviser.

The Big Picture

Our quarterly inflation read published in late October signalled a slight uptick which we addressed last month in our Economic Update. However, that was enough for the RBA to hike its overnight cash rate on Melbourne Cup Day, even though most of the other major central banks seem to be done. The odds for a hike – as priced by the market – were only 50% prior to the meeting.

Michele Bullock, the new RBA governor, inflamed the situation in a recent speech when she all but said we should hike again. Indeed, she singled out dentists and hairdressers, among a handful of services, as significant causes in the little inflation spike in August and September. That call was in our view unwarranted in that such a relatively tiny amount is spent on those two services.

We singled out the crude oil price spike, which has since faded and the depreciation of our currency as major contributors to the recent increase in inflation. Our dollar was appreciating back up to around 66c from under 63c almost as RBA governor Bullock was speaking.

To make matters worse, Philip Lowe, the outgoing RBA governor, fuelled the need to hike more. So, what happened to the monthly inflation read that came out at the end of November?

We calculate inflation (annualised) on a rolling quarterly basis using the monthly data series. Miraculously, the headline CPI (Consumer Price Index) came in at 3.0%, at the top of the RBA’s target range – and not above it. It was also down from the recent peak the month before. The Core variant of inflation that excludes such things as food, fuel and certain vacation spending was higher at 4.4%.

Aussie retail sales in current value terms fell by ?0.2% in October so, after, allowing for inflation and population changes, the retail picture is grim. Sales were up +1.2% for the year or about ?3.7% in volume terms. Population grew at around 2.6% so that is about a ?6.3% decline in volume per capita terms. And the RBA now under Bullock is maintaining a tightening bias which we believe is difficult to support based on our assessment of the available data.

Fortunately, the RBA and governor Bullock appeared to take onboard the view of the market and decided to leave official interest rates on hold at its meeting on December 5^th, now all eyes are focused on the RBAs next interest rate policy setting meeting in February 2024.

In the US, the Federal Reserve Board (Fed) is backing away from hiking again and there is speculation that some Fed members are even talking of cuts soon. In support of this view the US CPI inflation came in at 0.0% for the month; the market loved it. Personal Consumption Expenditure (PCE) inflation which is weighted by what is actually being spent was also flat for the month!

In the space of about a month, the US 10-year Government Bond yield popped above 5% only to end November at around 4.3%. In terms of bond yields, that is a big move and it gave US equities a big boost.

The CME FedWatch tool, which uses bond yields/prices to predict future official interest rate movements, looks to be pricing in one or two interest rate cuts for the US by June next year and maybe four or five by the end of 2024. If the US Fed doesn’t cut interest rates and inflation continues to fall, the so-called real rate (being the difference between the headline yield and inflation) will be driven higher making monetary policy even more restrictive.

The US unemployment rate, released in early November, rose to 3.9% from a recent low of 3.4%. There is a ‘rule’ (the so-called SAHM rule after a former Fed staffer) that says if the (average over three months) rate climbs 0.5% or more above the recent low, that is a strong signal for a recession. The unemployment rate is a small move away triggering that rule.

Other aspects of the US labour report also showed weakness – as did retail sales and the outlook statements from some, but by no means all, US retailers.

Although we believe Australia is already in a ‘per capita’ recession and maybe heading for worse as past rate hikes work their way through the economy, companies’ earnings are not based on per capita consumption. Population growth can support the market through bad times and that is what our data is showing. So, markets can remain positive at times when the economy is weakening!

China even published some quite reasonable economic data during November and a strong China is always good for us. However, the end of November read of the China manufacturing activity index, the PMI, again came in below 50 at 49.4 from 49.5, a reading below 50 indicates contraction. A reading of 49.7 had been expected. However, The Materials sector of the ASX 200 and iron ore prices over November were both very strong countering the impact on the Australian share market of a China slow-down!

We are broadly positive about the share markets going forward into 2024. While bond yields might fall in line with expected changes in monetary policy, though we do not anticipate it is highly unlikely that the US Fed and RBA interest rates will fall to neutral levels (in the range of 2.5%p.a. to 3.0% p.a.). In this environment traditional approaches to portfolio construction which have been disrupted by the historically low interest rates following the Global Financial Crisis will make a return with defensive assets, such as bonds, potentially offsetting the volatility of equity markets and paying a more attractive yield.

Asset Classes

Australian Equities

The ASX 200 had a strong November with gains of 4.5% taking the year-to-date into positive territory at 0.7%.

The Healthcare and Property sectors produced double digit gains over the month. At the other end of the spectrum, gains in Telcos were flat and sharply negative for Utilities.

International Equities

The S&P 500 had an extremely strong month, gaining 8.9% and 19.0% for the year-to-date. The German DAX and the Japanese Nikkei moved roughly in line with the S&P 500 over November but the FTSE was a laggard at 1.8%.

If the Fed starts to cut rates from the first quarter of 2024 as some expect, because inflation is falling and not because the economy is going into recession, we expect a stronger 2024 than otherwise. If a recession becomes apparent, we still expect some positive, but more modest returns. Markets are largely still off their recent all-time highs.

It seems reasonable to attribute some of the strength on Wall Street to long bond yields having settled down at well below 5%.

Bonds and Interest Rates

When we look back on history we may see November 2023 as the beginning of the return to less aggressive monetary policy – except possibly for Australia.

As a result of recent changes in sentiment, the price of US Treasury’s rose sharply forcing yields down. 10-year yields were down by about 0.7% points in November – a massive change indeed. Market indicators are pointing to an end in Fed rate hikes having already been achieved and for a reasonable chance of a cut in the first quarter, followed possibly by another in the second quarter. By the end of 2024, the modal rate is expected to be about a full 1% below the current rate.

The Fed chair is not yet acknowledging this breakthrough in expectations but there are rumours that some Fed members are openly discussing it.

Other Assets

The price of oil dropped sharply in November – around ?6% for WTI and ?5% for Brent. Gold prices rose 2% and copper nearly 4%.

The price of iron ore rose very strongly – at 8% –which helped the Materials sector on the ASX 200 achieve a monthly gain of 5%.

The Australian dollar – against the US dollar – appreciated by 4.8% which will help reduce import prices and, hence, domestic inflation in Australia.

Regional Review

Australia

On the surface, Australian employment growth was strong at +55,000 new jobs in October with the full-time / part-time split being +17,000 / +38,000. However, the unemployment rate rose to 3.7% from 3.6%.

When the strong population growth arising from immigration is taken into account, some of the shine is taken off these numbers. However, +9 million hours extra were worked in the latest month. That number cancels out the ?9 million from the previous month but still leaves ?8 million hours lost over the last three months – or about 50,000 full-time-equivalent jobs. The mix is changing making it harder to interpret these data.

Retail sales were unequivocally bad. In volume terms they fell ?1.7% over the year or about ?4.3% on a per capita basis.

The wage price index rose 4.0% on the year or just about in line with inflation. CPI went up 4.9% on the year when 5.2% had been expected and down from 5.6% the month earlier. Core CPI rose 5.1% for the year down from 5.5% from the month earlier. Recent data point to sharply lower levels of inflation.

The so-called cost of living crisis is only really a problem if wages do not keep up with price inflation – which they are not. The crisis is real and workers deserve pay rises at least to maintain living standards including catch-up where appropriate. Wage rises are not the culprit. The old enemies of supply-chain, oil prices, currency depreciation and flood damage were the main causes our inflation problem.

China

China’s retail sales bounced back at 7.6% against an expected 7.0% and industrial output rose 4.6% against an expected 4.4%. Not a bad set of numbers but China must address some very real issues in the property sector.

At the end of November, it was reported that there was a surge respiratory cases in China. Hospitals are struggling to cope and masks are back in play but, so far, there are no travel restrictions in place.

It would be devastating if this was the start of another ‘pandemic scale’ crisis but it could just be a typical seasonal health problem on a larger scale.

US

US inflation data released in November beat expectations. CPI inflation was 0.0% for the month or 3.2% for the year against expectations of 0.1% and 3.7%. Core CPI inflation was 0.2% for the month and 4.0% for the year against expectations of 0.3% and 4.1%. While these numbers were not big beats, it appears the psychological 0.0% for the month caused a big sigh of relief. Bond and equity markets rallied strongly. PCE inflation was also flat for the latest month.

On the wholesale front, PPI inflation came in at ?0.5% for the month and 1.3% for the year (against an expected 1.9%). Wages only grew modestly at 0.2% for the month. If this were a political election, we think inflation would have declared defeat.

150,000 new jobs were created which was well down on last month and expectations. On top of that, the composition of jobs created was skewed towards sectors that are not part of the growth economy. The unemployment rate at 3.9% is now 0.5% points above the recent minimum.

Europe

The BoE was on hold and its inflation rate dropped to 4.6%, a two-year low, from 6.7% in the prior month. Inflation was only 0.1% for the month! However, retail sales volume was down ?0.3% for the month of October.

The UK government announced several stimulus initiatives in the November budget. These stimuli will fight against the inflation story but are most needed to redress the pain that many households have suffered in the last few years.

EU growth was negative in the latest quarter – as was that for Germany. EU inflation was down sharply from 4.3% to 2.9% for the headline rate. The core rate, at 4.2% was down from 4.5%.

Rest of the World

Thankfully a cease-fire in the Gaza-Israel conflict allowed a number of hostages and prisoners to be exchanged and essential supplies to be trucked in by the UN. The Ukraine-Russia conflict still seems nowhere near resolution. Neither conflict appears to be having a major negative influence on markets.

Turkey predicted 2023 inflation to be 65% falling to 36% in 2024. It puts our inflation problem into perspective!

Seasons Greetings

As this is our last economic update for calendar year 2023, we would take this opportunity to thank you for your many comments, feedback and discussion over the year. From all in the Research and Investment team, we hope you and your families have a very happy, healthy and safe Christmas and New Year.

We look forward to returning in 2024 to continue our observation and commentary on what is a very interesting period.

In this month’s update, we provide a snapshot of economic occurrences both nationally and from around the globe.

Key points:
– The new RBA Governor, Michelle Bullock, increases the RBA Cash rate to 4.35%
– US Fed chooses not to increase the US Cash rate as data indicates some economic softening
– European and UK central banks hold interest rates steady as inflation and growth both ease

We hope you find this month’s Economic Update as informative as always. If you have any feedback or would like to discuss any aspect of this report, please contact the team.

The Big Picture

We entered October with an air of positive expectancy about the outcome at the Melbourne Cup Day RBA Board meeting. Earlier in November, the market was flirting with a 14% chance of a possible rate cut in October. A cut did not eventuate and, by mid-October, the mood had shifted to being on hold with only a slight chance of a hike in November. On the back of the latest inflation read in late October, the odds turned the mood swiftly to a 50:50 split between the chance of a pause or a 0.25% interest rate rise according to the RBA Rate Tracker tool on the ASX website.

There is no doubt that the quarterly CPI read did jump from a modest 0.8% for the June quarter to 1.2% for the latest quarter resulting in a reading of 5.4% for the latest 12 months.

It is of extreme importance to recall that oil prices rose from just $72 / barrel earlier in the year to $97 largely based on supply changes orchestrated by OPEC+. That input-price-inflation ‘passed through’ to automotive fuel prices around the globe.

Oil prices swiftly fell to $84 in October before retracing to $87 by the end of the month. The fall was too late for the latest month or quarter’s inflation being measured. OPEC+ does not respond to RBA interest rates and it would be foolish to try to quell that component in the CPI with a rate hike in November.

The Australian Bureau of Statistics (ABS) also produces a monthly CPI series, albeit based on a slightly narrower coverage of goods and services. Our analysis of that data shows that the monthly CPI data peaked in August at 6.4% (following a succession of readings in the target range) before retreating to 5.8% for September – both months being within the September quarter.

It is most probably the case that several factors are at work in affecting our CPI inflation. Our $A depreciated from about $US0.70 to below $US0.63 over 2023. Such a depreciation causes import prices of many goods and services to rise. In response, CPI inflation is likely to have increased. Of course, oil prices, supply-chain disruptions and the rest are also in the mix.

It is difficult to point to the precise factors that caused the depreciation of our dollar but weakness in the China economy and rate movements in the US and here are likely to have been important. However, it is doubtful if a 0.25% increase in the RBA cash interest rate would redress a significant part of the depreciation.

Dr Luci Ellis, who only recently left the hierarchy of the RBA to become chief economist at Westpac, has been arguing that a rate hike is likely in November.

While Australia appears to be moving towards a renewed rate-hiking policy, the US has moved in the opposite direction. The November 1st Federal Open Markets Committee (FOMC) meeting had been thought to be leaning towards a pause but with a significant chance of a hike. However, by the time of the meeting markets were pricing in a 1.6% chance of a rate cut and a 0% chance of a hike hence the overwhelming expectation was for a pause, which is what was announced. At the time of writing, the fixed intertest market, as assessed through the CME Fedwatch tool, still has a 10% chance that the Fed could increase the cash interest rate again at its December 13th meeting. That said, what we have observed in past months is that the CME FedWatch tool varies in a wide range for the probabilities appended to the Feds next interest rate move and are very data dependent.

Across the Atlantic, the European Central Bank (ECB), Bank of England (BoE) and the Swiss National Bank (SNB) all kept their respective cash rates ‘on hold’ at their last meetings.

There is little doubt that the Australian economy is weaking: we have experienced two consecutive quarters of negative growth when expressed on a per capita basis; and the last three quarters of retail sales growth, when adjusted for inflation, have been negative. The last jobs report showed only 6,700 new jobs but there was an accompanying fall of 39,900 full-time jobs with the difference made up from new part-time jobs (replacing the full-time?). Eight million hours of work were reported as lost in the latest month (September) and nine million hours were lost in the month before. Those lost hours each equate to around 50,000 lost full-time jobs.

It is true that our unemployment rate is historically low at 3.6% – as is that of the US at 3.9%. In a revealing announcement at the end of October, Britain has abandoned its data collection survey method to compute unemployment because, reportedly, millennials and generation Z are reluctant to answer their phones, which impacts on the accuracy of the report!

Are US and Australian data also similarly affected? We do not know but serious questions about labour force data should be asked given how critical the assessment of the structure of the labour force is in the formation of both monetary (RBA) and fiscal (government) policy. There may well need to be changes in either the calculation of the rate or its interpretation following the social upheaval of the pandemic. When there are so many other signals of a weakening economy, it would be foolish to rely on a single part of the economy to guide the direction of monetary policy.

The US, however, reported an extremely strong labour market – at least at first glance. Two separate sources said the 336,000 new jobs reported in September – compared to an expected range of 90,000 to 250,000 – did not reflect that most of the new jobs were for lower paid, part-time positions. The sources proffered that it was more likely that these jobs were for second jobs to cope with the cost-of-living crisis rather than as an indicator of a strong market.

Some cite that there is ‘a strong US consumer’, particularly after the block-buster GDP growth of 4.9% for Q3. However, retail sales over the year – after adjusting for inflation – were flat. Recent data have been unduly affected by Covid related stimulus payments and people living off accumulated excess household savings.

The three-year US student debt forgiveness programme has just ended and excess savings are reportedly all but exhausted. So, from now on we will get to see how the economy fares when consumers now need to fund their lifestyles from their current earnings.

The savings ratio in the latest quarter fell from 5.2% to a low 3.8%. Households are saving less per quarter than their historical average which does not bode well for the future.

Because most US home mortgages have fixed interest rates for 30 years, many have not yet been affected by recent rate rises – unless they chose to, or needed to, move home. Many were smart enough to have locked in low rates for their fixed rate mortgages during the pandemic years.

The US 30-year fixed term mortgage rate just exceeded 8% – the highest since the year 2000 after climbing from a recent low of about 4% during the pandemic. That’s about double the interest repayments so it will obviously affect decisions of many to move. However, when rates do fall, people borrowing at 8% can typically refinance at the lower rate without penalty. The US is different from Australia in so many ways.

In mid-2023, many were calling no US recession – or, at most, a mild one. The majority now seem to be accepting of the notion that the US is heading towards a recession of some degree. But there is hope that any recession would be short-lived, providing that the Fed reacts quickly.

The third quarter US company earnings’ reporting season is now underway and many companies have posted strong earnings and have positive views of their earnings prospects in the quarters to come. With share markets having retreated substantially (of the order of 2% to 8% since the end of June) having bounced back from correction territory for some, markets could rally quickly if the central banks soon choose to make statements of likely cuts to interest rates to support their flagging economies.

Interest rate cuts are being priced into the US Fed funds rate in the first half of 2024 as assessed by the CME Fedwatch tool. Some central bankers, with the ‘higher for longer’ mantra, are still talking of no cuts in 2024 or even 2025. We find it difficult to see that happening.

While there has rightfully been much attention on equity markets, bond markets require some serious consideration. The yield of the US 10-year Government bond broke through 5% in the second half of October – the highest since 2007. When the price of a Bond falls the yield rises, and the longer the maturity of the bond, the larger the price impact. The mounting problem with the US is that the appetite to hold US debt was waned in recent times. Some bond auctions held by the US Treasury have not gone as well as expected which has caused some instability/volatility in the US bond market. In the long run, the US will have to address its significant level of Government debt.

As bond yields go up, they become more attractive – especially if they are held to maturity. Higher yields typically have a depressing impact on equity returns because the alternative to holding equities becomes more appealing as a result the relative attractiveness of equities declines

Of course, the Israel-Gaza conflict could adversely affect markets if the conflict escalates across the Middle East and beyond. From an economic perspective the risk to global oil supplies is particularly high.

Asset Classes

Australian Equities 

The ASX 200 had another bad month at -3.8% following the -3.2% it fell in September. Much of the action seemed to flow from volatile bond yields in the US and swirling news about interest rate increases or the changes in the likelihood of interest rate increases. Of course, the Israel-Gaza conflict cannot be ruled out as a source of angst in markets but news from the Ukraine seems now to be more muted.

If it were not for the materials and utilities sectors, the ASX 200 would have been in much worse shape in October.

While a rally into Christmas is still possible, it seems doubtful unless there is good news coming from the RBA or US Fed. So far this year, the ASX 200 index is down -3.7% but LSEG (formerly Refinitiv, which was formerly Thomson Reuters) forecasts for earnings growth are quite positive with an above-average year ahead. Indeed, our analysis of these data show that the prospects for the following 12 months has risen from 3.6% at the beginning of 2023, to 9.0% today.

International Equities 

The S&P 500 was down by slightly more than the ASX 200. However, its performance-to-date over 2023 is well up at +9.2%.

There have been some spectacular winners and losers in the Q3 reporting season – particularly among the so-called ‘magnificent 7’ mega-cap tech stocks.

There are many stocks – including some of the magnificent 7 – that may be largely unaffected by any recession in the US however, regulation is more of an issue with some of these companies.

Bonds and Interest Rates

We found it particularly interesting that the Fed suddenly came out ‘dovish’ (more likely to be supportive of the economy than inflation fighting hence more likely to be easier with monetary policy implementation) the day before the FOMC minutes (from a meeting two weeks prior) landed on the news wires with a distinctly ‘hawkish’ (opposite of dovish) tone.

Europe’s ECB, too, has suddenly taken a more dovish tone with their monetary policy settings being ‘on hold’ in October.

Australia is the odd-man-out in the change of direction of central bank policy settings. The new Governor, Michelle Bullock, at her first real test, has increased the RBA Cash rate to 4.35%. Despite the market being evenly divided between her pausing or raising the Cash rate, she has determined to increase the rate on the basis that, at its current trajectory, inflation would not return to the target level ‘within a reasonable timeframe’ hence the need for her to ‘use the whip’ on Melbourne Cup Day.

Other Assets 

The price of oil and copper were down in October, iron ore was flat but gold prices – owing to heightened degree of uncertainty – strengthened. Unsurprisingly, the VIX (a measure of US equity market volatility) rose. The $A against the greenback lost -1.7%.

Regional Review

Australia

We raised concerns last month about the state of the Australian labour market in part because most of the new jobs were for part-time positions. This month we find that trend is even more pronounced. 39,900 full-time jobs were lost and 46,500 part-time jobs were created leaving a positive balance of +6,700 total jobs. That is not really a positive swap! Eight million hours of work were lost – a similar amount to the previous month.

The Westpac consumer sentiment index remained well into the pessimistic zone (below 100) at 82. That level is like that found in previous recessions. The NAB business confidence and conditions indexes hovered just into the optimistic zone.

Retail sales – unadjusted for inflation – were up 0.9% for the latest month or 2.0% for the year which was well behind inflation for the year at 5.4%. Therefore, in CPI-adjusted terms, retail sales went backwards by -3.4% in the last 12 months. That the 0.9% reading was above the expected 0.3% is cold comfort for the state of the consumer.

The last four quarters of CPI inflation over the corresponding period in the previous year were 7.8%, 7.0%, 6.0% and now 5.4%. It is encouraging that inflation has been steadily falling but not at a fast-enough pace for many and new RBA Governor Michelle Bullock who increase the RBA cash rate to 4.35% on Melbourne Cup Day.

Our calculations based on the monthly CPI data series on rolling quarters (annualised) for the last three months have been 3.1%, 6.5% and 5.8% (for September). The spike can largely be attributed to auto fuel price inflation but other categories did stand out too. The core inflation data, that strips out auto fuel, fruit and vegetables, and holiday travel using the same methodology produced 4.8%, 5.2% and 5.5% for the last three months. The trend prior to that sequence seemed comfortably heading soon to the 2% to 3% target range.

Core inflation does not strip out auto fuel for that part of it which is used as inputs to other sectors. Electricity was up 18.0% on the year while gas and other household fuels were up 12.7%. Rents were up 7.6% possibly due to rate increases! The Cup Day rate rise will not help bring down inflation in these sectors.

With oil prices having pulled back from their peaks, and if the Gaza conflict does not escalate to result in major oil shortages, there is the prospect of a return to the previous trend of a fall in inflation rates.

China 

China’s PMI (Purchasing Managers’ Index) for manufacturing returned to above the ‘expansionary’ measure of 50 for the first time in four months.

China GDP surprised the market with a reading of 4.9% when only 4.5% had been expected.

Woes in the property market continue and some significant defaults on property developer bond repayments were reported.

US

US CPI inflation statistics came in a little above expectations at 0.4% for the month and 3.7% for the year. The core variant was 0.3% for the month.

The Fed’s preferred Personal Consumption Expenditure ‘PCE’ measure came in at 0.4% for the month and 3.4% for the year. The core variant was 0.3% for the month and 3.7% for the year.

Despite the stubbornness of inflation to return quickly to the target 2%, increasing fears of a recession are causing the market and the Fed to pull back a little from expecting interest rate hikes.

Retail sales came in at 3.8% for the year which is only just above the inflation rate of 3.7%. In ‘real terms’ sales have been static. Industrial output did beat expectations with a growth of 0.3% against an expected 0.1% in the latest month.

The non-farm payrolls (jobs) data massively beat expectations. There were 336,000 new jobs created against an expected range of 90,000 to 250,000. However, it has been reported that most of these jobs were part-time positions and of lower pay than average. Some observers believe that the apparent resilience in non-farm payrolls more likely indicates people needing to get a second job to supplement their earnings in the face of the cost-of-living crisis rather than the strength of the US economy.

The unemployment rate was marginally above expectations at 3.8% and wage increases were up 4.3%.

There are early signs that the US Auto Workers Union is coming to an agreement with two of the three auto manufacturers.
The House of Representatives finally appointed a Speaker of the House of Representatives – at the fourth attempt. The next deadline of the US debt ceiling vote might now be averted on November 17th.

US GDP growth came in very high – as expected – at 4.9% (annualised) for the September quarter but the household savings ratio fell to 3.8% from 5.2%. A portion of this economic activity was due to government infrastructure spending and a big build-up in inventories. It is not yet clear whether the build-up in inventories is in anticipation of future demand or failure to sell as much as expected in the September quarter. Based on the more dovish attitude of the Fed recently it may be the latter.

Europe 

The BoE, ECB and SNB paused their tightening cycles. House prices in Britain – adjusted for inflation – have fallen 13.4% from their peak.

Germany’s GDP growth came in at -0.1% for the September quarter. German inflation fell to 3.0% in October – the lowest since August 2021.

EU growth was also  0.1% and its inflation rate of 2.9% was well down on the previous estimate of 4.3% Core inflation in the eurozone was 4.2%, down from 4.5%.

Rest of the World 

Japan’s CPI inflation came in at 3.0% while its core variant was 2.7% against an expected 2.8%.

The anticipated Bank of Japan shake up on rates had little impact. The prime interest rate stays at -0.1% and the change to the Yield Curve Control (YCC) for longer dated Japanese government bonds was minor.

The Israel-Gaza conflict remains a human tragedy with the prospect of the conflict escalating to involve other forces remaining a real threat to the region and potentially to oil prices.

In this month’s update, we provide a snapshot of economic occurrences both nationally and from around the globe.

Key points:

• US Fed pauses interest rates in September but upsets markets with hawkishness commentary
• US economic data remains positive but further analysis indicates conditions are softening
• GDP data for Australia is showing mild growth but on a per capita basis we are in recession

We hope you find this month’s Economic Update as informative as always. If you have any feedback or would like to discuss any aspect of this report, please contact your Financial Adviser.

The Big Picture

So much data is released every month that it is nearly always possible to find a justification for a ‘good’ or ‘bad’ forecast/outlook, depending on one’s view or motivation. The responsibility of macroeconomic analysts is to deploy skill in their analysis and be able to step back and synthesise the information to present a cogent and balanced view.

We agree that both the US and Australian economies can currently be viewed through an optimistic lens. But we see some cracks beneath the surface getting bigger. The lion’s share of responsibility for managing the many stresses and forces operating in the global and national economies falls in no small part to governments and in particular, central banks.

At time of writing, this turns on how central banks increase their interest rate settings to hopefully return inflation to an acceptable range without causing economic growth to slow to the point where a deep economic recession is inevitable. In our view, the now restrictive interest rate policies have done the job and it is time for central banks to acknowledge the lagged effects of high interest rates, in order to ensure that economies do not unduly succumb.

A key economic measure/indicator is employment. At the start of September, US jobs data were seen by many as holding up while inflation data were showing some impressive gains i.e. falling. As a result, almost everyone expected the Fed to keep rates on hold at its 20 September 2023 meeting – and it did. Therefore, the immediate stock market reaction was positive – until the Fed chairman’s press conference which started half an hour later.

During that question time, the Fed chair, Jerome Powell, became increasingly hawkish – meaning that he was leaning towards more interest rate hikes, or, at least, the current hikes being held ‘higher for longer’. As a result, September proved to be a bad month for equity markets.

Our take on the US jobs data is that it went against the superficial media coverage. 170,000 jobs had been expected and 187,000 jobs were created. The unemployment rate was 3.8% and wages rose by 4.3% against an expected 4.4%. We can see why a cursory glance might lead one to view that the US labour market was strong.

What we also read was that the previous two months jobs’ data were revised down by 110,000 and that most of the jobs created in the latest month were in two non-growth sectors: health care & social assistance, and government. However, jobs in many of the important building blocks of growth went backwards by -28,300, which was a clear deterioration from prior months.

When viewed through that lens, interest rates may have been (and potentially should have been) cut in September! And 3.8% for an unemployment rate is a big kick up from the expectation of 3.5%. Some say a 0.5% increase in the unemployment rate is a sign of a slowdown.

US GDP data came in after the Fed meeting and showed that growth in the June quarter, at its customary second monthly revision each quarter, held steady at 2.1%. We can see how that could also be construed as good. The Fed thinks anything above 1.8% causes upward pressure on inflation and the like. But consumption, the big driver of the US economy (circa 67% of GDP growth), was revised downwards from an initial 1.7% to an unimpressive 0.8%, and that is an annual figure. That is unequivocally not good!

So how did GDP growth hold up then? It transpires that business investment was revised upwards and it compensated for the loss in consumption. That investment was fuelled by Biden’s push to onshore semiconductor production after the pandemic/ shutdown/China situation from 2020 to 2022. There is an old saying, ‘Never fight the Fed’. It seems the government is fighting the Fed and that in part explains why temporarily the economy is holding up a bit longer than some expected. Monetary and fiscal policy work better in unison.

And other headwinds are gathering in the US. It was reported that US consumers had accumulated $2.1 trillion in ‘excess savings’ from government Covid-related cheques and personal savings back in 2021. Those savings had dwindled to $190 billion by June and was thought now almost gone except the GDP report also suggests they found a little bit more savings in the revision. Consumers have been partly living off excess savings for two or three years and that well has almost run dry.

The market still thinks the Fed might not hike rates again this year – pricing in about a 35% chance of another hike – and cuts could start as early as the first half of 2024.

However, the Fed published its dot plots last meeting – a brilliant graphic to show what all the members (voting and non-voting) think the Fed rate will be at each of the end of this and the next few years. Since the dots are not attributed to each member, and not all members vote, it is not trivial to interpret the expectations of the voting Fed.

Since there are only two meetings to go this year (1 November and 13 December) there was reasonable cohesion among the Fed members (12 for a hike and 7 for on hold) for the end of 2023. For 2024 and beyond the dots are dispersed widely. Two members expect a higher rate in 2024 than now (1 or 3 hikes from here); 4 the same as now; and the rest for up to four cuts from here (or five if they hike again this year).

Given that there are accepted to be long and variable lags following interest rate changes before effect, knowing that they will need to cut quite a few times soon, it makes little sense to put in another hike to then try and cancel it quickly.

Here in Australia, the RBA looks more likely to be ‘done’ and interest rate cuts could start soon. Our CPI monthly inflation data were within the RBA’s target range for three consecutive months but petrol/fuel inflation burst the bubble in the latest month.

Our initial GDP data were released for the June quarter and, again at first sight, they looked fine. Growth was 0.4% for the quarter (not annualised) and 2.1% for the year. However, when our material immigration flow is accounted for, growth per capita was -0.3% for the June quarter following -0.3% for the previous quarter. We were in a per capita recession during the first half of 2023. On average, we were going backwards!

The September quarter has now finished but it will be nearly three months before we find out whether the ‘going backwards’ continued. The Organisation for Economic Cooperation and Development (OECD) is pulling no punches. It forecasts we (Australia) will be in a per capita recession for two years (2023 and 2024). So, the OECD assessment adds further weight to the argument for the RBA to not raise interest rates further and to be contemplating cutting rates sooner rather than later.

The Bank of England (BoE) has surprised in the opposite direction. It was widely expected to hike again this month but it didn’t. The BoE hinted that the inflation data released the day before turned its hand. For the record, the UK headline CPI came in at 6.7% down from 6.8% the month before and the core variant that strips out volatile items came in at 6.2% down from 6.9%. No matter which variant you use, US inflation is around 4% or better and they are talking about hiking. Clearly there is significant divergence between how various central banks choose to implement monetary policy and their strong reliance and dependency on data.

China is the real mystery in all of this. Of course, their economy is not hitting the higher growth rates of years gone by. That is the fate of all maturing economies. What is 5% growth now amounts to about the same extra output as 10% growth when China was half the size (not so long ago). The problem is to do with what is going on with property and property developers. There have been defaults and possibly more to come. But the third quinquennium (Chinese long-term economic plan) is just around the corner. Every five years China has a big conference and announces new policies and possibly stimulus. Perhaps during October, we will have a stronger picture to paint for our major trading partner!

Asset Classes

Australian Equities

The ASX 200 fell -3.5% in September in part due to the hawkish comments made by the US Fed and concerns over property in China. Energy (+1.3%) was the only one of the 11 sectors to make gains. Property (-8.7%) and IT (-8.0%) took by far the biggest tumbles.

For the nine months to the end of September, the ASX 200 is up by only +0.1%; the IT sector is up +22.5% and consumer discretionary by +12.2%.

When dividends are included (but not franking credits) the ASX 200 is up +3.7% for the nine months.

We still have consensus earnings forecasts, sourced from Refinitiv, pointing to a solid end to the year and the market is modestly under-priced by our assessment.

International Equities

The S&P 500 was also down by -4.9% over September. In contrast, the London FTSE was up +2.3% but all the other major indices we follow fell by a similar quantum to the ASX 200 and S&P 500 for the month.

Over the year-to-date, the Japanese Nikkei has rocketed ahead by +22.1%; the S&P 500 (+11.7%) and the DAX (+10.5%) have made creditable gains. The other major indices are more or less flat over 2023 to date but, at least, showing small positive gains.

Bonds and Interest Rates

The Fed did not raise interest rates at their 20 September 2023 meeting but the chair, Jerome Powell, made a hawkish statement in the press conference that followed. The Fed dot plots chart, showing participants forecasts for the US cash interest rate for the end of this year and several following, show a broad divergence in opinion.

More members than not saw another hike in rates this year with the CME Fedwatch tool which measures the Feds interest rate changes that are implied by movements in the bond market, show only modest support for that view.

The US Government bond market has experienced some volatility with the 10-year bond yield closing at 4.57% being markedly ahead of the 4.10% at the end of August.

The RBA now has a new governor, Michele Bullock, and she has not ushered in a rate hike at her first meeting, especially as the market had not pricing one in. Indeed, the market had priced in a small chance of a cut!

We consider Australian inflation largely under control with some doubts about the strength of the economy. We are in a per capita recession and chinks are appearing in the labour market which until recently has proven to be quite resilient.

The Bank of England kept its interest rates on hold in September despite a market prediction of an increase and inflation coming in at over 6%.

The European Central Bank (ECB), Norway, and Sweden all raised their official cash rate by 0.25% and hinted at the prospect of more to come. Switzerland’s central bank held rates steady instead of increasing them, the first pause since March 2022.

Japan is still maintaining its negative interest rate of -0.1% although there is growing commentary about the need for the Bank of Japan (BoJ) to change its stance. Japan’s latest GDP growth is 4.8% (after a revision from 6.0%) and inflation is running at just over 3%.

Other Assets

The price of oil was up by nearly 10% in September following OPEC+ (essentially Saudia Arabia plus Russia) supply cuts.

The price of iron ore rose 2.1%. The prices of copper (-2.8%) and gold (-4.4%) were both weaker. The Australian Dollar depreciated fractionally (-0.4%) against the US Dollar over September.

The VIX (US Share market) volatility index rose to 17.7 at the end of September after being in the normal range (at around 13) for some time.
Regional Review

Australia

CPI inflation came in at 5.2% (for the year) from 4.9% the month before. Core inflation was reported to be 5.5% and down from the previous month of 5.8%. We also compute a quarterly (annualised) inflation rate to follow new trends in a timely fashion.

Our headline quarterly inflation rate was in the RBA’s target range (2% to 3%) for three consecutive months but then a massive increase in petrol/fuel prices in August took that measure to 6.4%. The core equivalent quarterly rate was falling steadily into June and close to the RBA’s target but drifted a little higher in the latest two months possibly on the back of a depreciating Australian dollar which makes imports more expensive.

GDP growth came in at 0.4% for the June quarter and 2.1% for the year. However, when population growth is taken into account, per capita GDP shrank by -0.3% in the June quarter following on from a -0.3% fall in the March quarter.

Although the definition of a recession in this country is usually ascribed in terms of GDP, and not per capita GDP, we cannot ignore that, on average, the Australian economy in a viable metric (per capital GDP) has been going backwards and the OECD predicts that behaviour to continue into 2024.

The household savings ratio fell modestly from 3.6% to 3.2% in the June quarter but this ratio is well below ‘normal’ levels. It seems unlikely that saving will fall much more making it less likely for consumption to maintain current levels unless consumers increasingly use debt facilities.

The ‘mortgage cliff’ is almost on our doorstep when hundreds of thousands of mortgages previously fixed on low interest rates in the unusually low interest rate era will need to be rolled over to interest rates significantly higher. However, data from Domain.com suggest that stress in the form of ‘forced sales’ has been falling after a very recent peak. Hopefully the worst of that sort of stress has passed.

At first sight, the latest jobs report seemed promising with 64,900 jobs created – about three times what would normally be considered good. However, only 2,800 of these were for full-time work – the rest being for part-time work. The unemployment rate was unchanged at 3.7% but the number of hours worked fell by 9 million. That loss is equivalent to losing about 60,000 full-time jobs, which is further evidence that the labour market is weakening.

Unsurprisingly, therefore, the Westpac MI consumer sentiment index fell to 79.7 (with 100 being the breakeven point between optimism and pessimism). The index has been around 80 for several months; this level is usually associated with a recession or at least a serious downturn. Business sentiment indices from NAB, however, were more positive. Both the confidence and conditions measures were marginally up and in positive territory.

China

China holds a major government conference, the quinquennium, every five years to realign policies and, possibly announce new stimulus. It is due to start on 16 October 2023.

There have been many reported problems within China’s property sector including the massive Country Garden failing to pay coupon payments on some of its debt securities on time. Other data have been more encouraging.

Retail sales were up 4.6% against an expectation of 3.0% and industrial output was up 4.5% against an expected 3.5%.

China is reviewing some of the tariffs applied to imports from Australia imposed in 2020 and several of them have already been lowered or removed.

US

US inflation statistics continued to improve. Indeed, the monthly rate of the Fed’s preferred ‘core PCE variant’ came in at 0.1% which is below the Fed target of 2% pa. That measure rose 3.9% over the year. Headline PCE inflation rose 0.4% for the month and 3.5% for the year.

US CPI headline inflation rose 0.6% for the month and 3.7% for the year. The core variant rose 0.2% for the month and 4.3% for the year.

In our view US inflation is nearly there but, if the Fed holds interest rates higher for longer, there is a big danger of overshooting i.e. a recession ensues due to restrictive interest rate policy settings.

The headline jobs number was good but, as our preceding analysis shows, there are cracks appearing as the composition of the numbers shows employment growth is occurring in government and care sectors which are less positive for economic growth.

Europe

The Bank of England (BoE) paused its interest rate tightening cycle. CPI inflation fell to 6.7% from 6.8% (over the year). Core inflation fell to 6.2% from 6.9%.

On the other hand, the ECB hiked 25 bps to 4.0%.

Rest of the World

The New Zealand economy bounced back with 0.9% growth for the latest quarter and 1.8% for the year. Only 1.2% growth had been expected.

In this month’s update, we provide a snapshot of economic occurrences both nationally and from around the globe.

Key points:

– The impact of interest rate increases is starting to appear in economic data
– China is struggling to reinvigorate its economy
– Equities take a breather

We hope you find this month’s Economic Update as informative as always. If you have any feedback or would like to discuss any aspect of this report, please get in touch with your financial adviser.

The Big Picture

Backward looking inflation data, with most of the level being delivered in the early months of the data reporting window, has our current inflation rate at 4.9% annualised. However, if we take our guidance from more recent data (calculated on a rolling quarterly basis and then annualised) then we are seeing a level that is within the RBAs target band of 2%-3% p.a. The past three-monthly observations for this series being 2.4% p.a., 3.1% p.a. and 2.7% p.a. respectively.

On this basis the RBA should be encouraged that their monetary tightening policy is delivering the results intended and, save for a sudden inflation shock, be sufficient to tame inflation and not require further interest rate increases.

Further support for this position is evident through the latest retail sales data in Australia. The June quarterly result was -0.5% when measured in volume terms (i.e. removing inflation effects) and -1.4% for the year. The latest three quarterly results have all been negative.

Employment data was also softer as 15,000 jobs were lost in the latest month but that figure masks a worse outcome for full-time jobs which were down 24,000 because there was an offsetting gain in part-time positions. In July our unemployment rate went up from 3.5% to 3.7% indicating a deteriorating employment environment. The Westpac consumer confidence index also fell.

By taking a similar approach to observing US inflation data, its rate has also improved and looking contained, but there are so many alternative variants of that measure. Focusing on the measure that consumers actually face (CPI), and for the latest quarter and not the whole year, the latest read was 1.9% which is just under the Fed’s stated 2% target.

The US did record 185,000 new jobs in the latest month but three factors contribute to our view that this number was weak. First, it was 15,000 jobs less than expected. Second, 87,000 of those new jobs were in government and ‘health care & social assistance’ sectors which are typically not growth sectors. Third, the 209,000 new jobs for the prior month were revised downwards to 185,000.

During August, one of the big three ratings’ agencies, Fitch, downgraded US debt one notch to AA+ because of the debt default deliberations. Moody’s, another big ratings’ agency, down-graded 10 US banks and put six big banks on negative watch. Home affordability was reported to be the worst in 38 years, and the Fed just hiked its interest rate again in late July to the highest in 22 years.

The annual Fed-sponsored conference in Jackson Hole, Wyoming, was held at the end of August. Fed Chair, Jerome Powell, emphasised the need to keep policy restrictive and to be data dependent!

Is anybody winning? Well Japan hasn’t flinched yet still keeping its negative interest rate (-0.1%) on hold since 2016. Its latest inflation read was 3.1% and its economic growth rate for the June quarter was 6.0% (annualised). However, there was some disturbing signs in their growth when we dig deeper. Consumption went backwards and imports were well below expectations. Offsetting this, retail sales were up an impressive 6.8% against an expectation of 5.4%.

We have often been able to point to China to lead the way for our economy – but so far, not this time. All China’s major economic statistics were weak and it is experiencing deflation rather than inflation. Deflation incentivises not spending now! We anticipate China will continue to try and find ways to stimulate its economy but what this looks like is not yet clear.

While there were several negatives during August, we are of the opinion that stock markets have largely factored in the state of the economies. Markets work on expectations of the future and not so much on past data. Our analysis of Refinitiv expectations of future company earnings remains positive overall.

After a bit of whiplash, US 10-year bond yields have settled down at just below 4.1%. Bonds are again a viable investment vehicle. Market volatility, as measured by the VIX Index, is at normal levels.

Asset Classes

Australian Equities 

The ASX 200 fell 1.4% over August. A lot of the negativity appeared to arise from uncertainty about the Fed’s next move. Consumer Discretionary was the stand-out sector rising +4.6%. The year-to-date capital gain of +3.8% for the broader index is quite respectable given the long-term average of around 5%. August finished with a strong spell of daily gains. Moreover, our analysis of company earnings data, provided by Refinitiv, noted a modest increase in predicted gains over the next 12 months.

International Equities 

The S&P 500 was also weaker over August, falling 1.8%. All of the other major global share indexes that we follow were also negative. However, the year-to-date gain for the S&P 500 is an impressive +17.4%. Japan’s Nikkei is even more impressive having risen 25.0% so far this year.

Bonds and Interest Rates

The Fed did not meet in August but it raised its cash interest rate at the end of July by 25 bps to a range of 5.25% to 5.50% (the highest in 22 years) in a widely telegraphed move. The probability of a further rate hike at the Fed’s September 20th meeting has been priced at around 10% to 20% since the last hike. However, the odds only just favour no hike at the November 1st meeting.

We agree that the Fed will likely pause interest rate increases this month despite Powell’s sabre-rattling talk of the prospect of further interest rate increases at the Jackson Hole conference in Wyoming of the world’s central bankers. We think there might be enough additional evidence in inflation, jobs, and growth data over September to convince the Fed to pause again at its November meeting.

By the final Fed meeting of the year on December 13th, we think it likely that there is only a very minor chance the Fed would contemplate a further interest rate increase. We think the ‘interest rate cutting debate’ will start around that time as the earlier interest rate increases will have slowed the economy. We anticipate the conversation will turn to when stimulus measures (interest rate cuts) could begin in the first quarter and most likely before June 2024.

The RBA should be encouraged by the latest monthly Inflation data to hold off on increasing our interest rate further. The RBA interest rate tracker app on the ASX website prices in an interest rate increase at 0% in September and 14% for a rate cut. While we are certainly supportive of no further rate increases in the near term, we think October is also a bit too soon for a cut, only 18 days into the tenure of the new RBA governor Michele Bullock.

Without going through the details of what all of the other major central banks did and might do, it does seem that there is overwhelming support for global interest rates being at or near their peaks. Except for Japan and, to some extent, Switzerland whose economies have not followed the same path of rapid rises in inflation in recent years.

Other Assets 

The price of oil was slightly up over August.

The price of iron ore rose 5.6%. The price of copper fell 4.0%. The price of gold was down fractionally. The Australian dollar depreciated 2.9% against the US dollar over August.

Regional Review

Australia

Cracks are starting to appear in the Australian economy. Growth in inflation-adjusted retail sales data have been negative for three successive quarters. Westpac’s consumer sentiment indicator has been hovering around a score of 80 (compared to 100 for a neutral reading) for about nine months. This read is worse than during the GFC but not quite as bad as that in the depths of the 1990/91 recession.

Even the jobs report has started to show weakness but, given the sampling error range associated with using a very limited data set, one month of weakness is insufficient to call it problematic yet. It is reasonable for businesses to hold on to workers longer than seemingly necessary because of the cost of re-hiring when the economy bounces back. And on the supply side, workers losing jobs in times of downturns might accept inferior positions to keep their cash flow going. However, history shows us that labour markets can then sour quite quickly.

The RBA is predicting 1.75% p.a. economic growth in 2024 and 2% in the following year. We see that scenario as being an optimistic one. Because of lags in the system, the full force of the high interest rates will not be felt until 2024.

Meanwhile, wages growth has not yet been a problem. Wages grew by 0.8% in the June quarter or 3.6% over the year. Workers are still playing catch up to the pandemic induced high inflation period during 2020 – 2022. As yet, there is no wage-push inflation (i.e. wages increase at a rate faster than productivity).

With China saving our economic bacon in 2008/9, we avoided a recession when the rest of the world went into what some called ‘the Great Recession’. This time China is struggling to manage its own economy. It is hard to see from where a silver bullet might be fired to stave off the effects of higher interest rates and inflation on the Australian economy.

China 

Chinese data released in August were weak almost across the board. Retail sales, industrial output, and fixed asset investment were slow in absolute terms and all missed ‘weak’ expectations.

The purchasing managers index (PMI) for manufacturing was below the threshold ‘50’ level for the last five months but, at least, there were small improvements over the last three months. At 49.7 for August, the PMI easily beat the expectations of 49.4. We’re not talking about a collapse. It is just taking time for the economy to recover from the three-year shutdown. But there are signs of deep-seated debt problems arising in the property sector.

More disturbing is the deflation that appears to be underway in China. The broad inflation measure the Consumer Price Index (CPI) was -0.3% in the latest month when -0.4% had been expected. The Producer Price Index (PPI) was -4.4% against an expected -4.2%. Deflation is thought to be bad because it incentivises delaying purchases until those goods and services become cheaper.

US

US inflation statistics – and there were many variants published in August – were largely interpreted as showing that there was more work to be done before the fight against inflation can be considered won. Assessing US inflation with a measure that gives more weight to the most recent data, we concur with this assessment. Of course, we need to see this trend of softening inflation data confirmed in the coming months before we are comfortable enough to call a victory, but the trend has been for a steadily improving read over most of 2023.

The headline jobs number at 187,000 was big enough for many to conclude that the US economy is still strong however, what is concerning to us is that jobs in many of the growth sectors were small or negative and the data relies of government jobs for its overall level.

The June quarter GDP growth was revised downwards to 2.1% from 2.4%. The Fed considers 1.8% to be the neutral growth rate as far as inflation pressure is concerned, indicating an improving situation for inflation fighting – but still some work to do.

With credit ratings agency Moody’s downgrading credit worthiness for 16 US Banks (or putting issuers on negative watch) is disturbing. This change in ratings is no doubt the fall-out from the regional banking crisis that started in March. The combined credit tightening, the Fed interest rate well above its neutral rate, and the Quantitative Tightening programme (the Fed paying back on more maturing bonds than it is issuing new ones) appears to be building up to produce a downturn in the US economy. Whether this results in a recession and how deep that recession is, should it eventuate, remains to be seen.

Europe 

The Bank of England (BoE) is still on a tightening cycle. Its latest 25 bps increase to 5.25% takes its cash interest rate to the highest in 15 years. CPI inflation stands at 6.8% over the year.

Britain has a different problem to that of Australia or the US, it reportedly took up the green energy challenge with more gusto than most – and found itself caught out by the supply-side energy price inflation. It is not easy to mitigate the impact of such a major policy shift.

EU inflation came down to 5.3% from 5.5% and its economic growth jumped back to positive territory after two consecutive quarters of negative growth. The first recession might be over but the next might not be far behind.

Rest of the World 

Japan’s inflation declined further from its recent high to 3.1%. While Japan’s GDP growth came in at an impressive 6.0% (annualised) for the June quarter, the headline result masked the underlying compositional issues. Consumption growth was negative and capital expenditure was flat. However, retail sales jumped 6.8% (annualised) in July against an expected 5.4%.

In this month’s update, we provide a snapshot of economic occurrences both nationally and from around the globe.

Key points:
– Inflation has undeniably come down but is higher than Central Banks’ preferred range
– Is there something different about this inflation and interest rate hiking cycle?
– The road ahead for the economy, inflation, interest rates and markets

We hope you find this month’s Economic Update as informative as always. If you have any feedback or would like to discuss any aspect of this report, please contact your Financial Adviser.

The Big Picture

The latest inflation data in Australia, the US and indeed, many other economies is showing inflation has declined from their respective peaks. So the question is, how low does inflation need to be before the mindset of central banks transitions away from inflation fighting and a bias to lower interest rate settings? And, assuming this transition occurs, the obvious question then becomes; when are they likely to start cutting interest rates?

We have previously documented the source of this bout of inflation. To recap, prices rose post Covid as demand increased rapidly but, because of Covid lockdowns, the supply side e.g. shipments of manufactured goods from Asia, were unable to respond to the sudden rise in demand. Consequently, competition for the limited supply available resulted in price rises which fed into a corresponding jump in inflation.

Central bankers, economists and many others assessed that the drivers of this inflation were transitory. The rationale being that once the supply side responded to the Covid created demand imbalance, prices would recede to ‘normal’ levels and inflation would return to manageable levels in the 2% to 3% p.a. range. That being the case, the need for interest rate policy tightening at that time was not required as the period of elevated inflation would indeed be temporary.

As a consequence of this assessment central banks did not respond to the initial price surges. Dr Philip Lowe, Governor of the Reserve Bank of Australia (RBA), throughout much of 2021 said that rates would not rise until at least 2024. So why was there a change of heart?

There are a range of reasons, key among these were:

• The timing of the Russian invasion of the Ukraine exacerbated inflationary pressures through food and energy price inflation as instability in supply of these fundamental resources drove their prices higher.
• The general supply demand imbalance lasted longer and remained more severe than anticipated as much of the developing world continued to grapple with Covid, long after the developed world had contained the pandemic as mass vaccination programmes proved effective.
• Central banks saw inflation rising as they anticipated and, in keeping with their ‘transitory’ assessment, were unresponsive with interest rate policy. By the time inflation data confirmed that inflation was not as transitory as anticipated and that it had become more entrenched, they then had the well documented change of heart.

The RBA first raised interest rates in May 2022 while the US Federal Reserve (Fed) started increasing US interest rates in March 2022. Fed chair, Jerome Powell, has since said he regretted ever using the word ‘temporary’. With the exception of Switzerland and Japan, most developed world economies have seen their central bankers walk a similar path.

Part of the problem has also been data dependency i.e. Central Bankers waiting for the data to confirm what was already known before responding with policy changes. The risk of this delay now being an economic recession. Some developed economies are already there.

A major risk is that, as central bankers delayed interest rate tightening on the way in to this bout of inflation, they will be slow in cutting rates on the way out as they wait for longer timeframes of inflation data to confirm that it has indeed receded. Look back to the experience during the 1989 to 1991 period in Australia when there was the interest-rate-induced ‘recession we had to have’. The recession persisted even though the RBA were sharply cutting interest rates throughout that period!

But is this time different?

That phrase, or its affirmative variant, is used too often but there are some differences worth noting for the current cycle. Prior to this bout of inflation interest rates had been low and even negative in some countries for a very long period. That is extremely unusual!

In economics, there is a concept of a ‘neutral rate of interest’ – one which is neither expansionary nor contractionary. Economist consensus is that in Australia and the US, that neutral rate is about 2.5% to 3.0% p.a.

In the current cycle in Australia, the RBA cash interest rate did not get into ‘tightening’ mode until December 2022 i.e. RBA taking the cash interest rate above 3.0% – the first seven rate hikes from 0.1% to 3% merely reduced and then removed the existing ‘loose monetary policy’. One reason we haven’t seen economies falling into recession is that interest rate increases only became restrictive in the last 12 months. Using the same metric, the US monetary policy became restrictive i.e. higher than 3.0% p.a. in September 2022 after the Fed started hiking in March of that year. What is different this time is that tightening cycles do not usually start from such a low base.

There is also another important fact to consider. Fixed rate mortgages don’t ‘exert any pain’ on borrowers until the loans roll over or a new loan is initiated. The so-called ‘mortgage cliff’ is just starting in Australia as borrowers on fixed interest rate loans move to variable interest rate loans. In the US, where fixed rate loan terms are much longer (up to 30 years) the effect of such a short sharp rates’ upswing is diluted even more.

In the current environment the data is not all pointing to the same outcome. Some key data points indicate ongoing strength (upward inflationary pressure) which is adding to the complexity for Central Bankers trying to manage inflation back to preferred or neutral levels.

Key among these in both Australia and the US is the labour markets which are still holding strong but the same is not true for other inputs. The US has experienced several months of contraction in retail sales and Australia’s GDP, in the March quarter 2023 (reported in June), was barely above zero (and was negative when population growth is taken into account). The recent June quarter 2023 estimate of growth for the US was an impressive 2.4%, but that includes a lot of fiscal stimulus (government spending) from the Biden administration, which is actually stimulatory and is fighting against the Fed policy.

The economic outlook remains opaque as we transition from tightening monetary policies through to a plateau phase (it feels like we are entering the plateau phase now), before interest rates decline to support economic growth/recovery post inflation returning to its neutral range.

The outlook for share markets is somewhat brighter even though earnings’ forecasts for companies were revised down for the June quarter in the US and the half year ending June 30 in Australia. So, the current forecast for corporate earnings is not that high and, as a consequence, not that hard for companies to achieve.

Markets can look through the malaise and rise before a downturn in the economy is over, and, based on the historical experience, often do. Refinitiv, one of our data providers, surveys hundreds of stock broker forecasts of company earnings for to the three years ahead. The analysis of that data is, on average, supportive of current share market valuations and prices.

Asset Classes

Australian Equities

The Australian share market as measured by the ASX 200 Index was up +2.9% in July. The index of Energy shares led the way rising 8.8% whereas the Indices of Financial and IT companies rose 4.9% and 4.4% respectively. Good results all things considered. The indices for Staples and Healthcare went backwards in July.

It would appear that equity investors have gradually moved to be more accepting of a ‘soft-landing’ scenario for the economy and are allocating capital back into shares as markets are trending more positively. While a ‘hard landing’ remains a risk for markets, data, particularly in the US, continues to support a ‘soft-landing’ outcome.

International Equities

The US S&P 500 Index of the largest 500 companies listed on the US share market had a strong July rising +3.1%.

Much attention continues to be paid to the magnificent 7 large cap technology stocks listed in the US and, while they have performed well and largely carried the market to its loftier heights, the positive move in the market has been broader than these stocks alone. This broadening provides a degree of comfort in the general health of the share market.

Bonds and Interest Rates

In a widely telegraphed move the Fed raised its cash interest rate by 0.25% to a range 5.25% to 5.5% (the highest level in 22 years). The RBA, on the other hand, decided to leave our cash interest rate on hold at 4.1% p.a. at is meeting on August 1. The European Central Bank (ECB) took its base interest rate to a record high level of 3.75% p.a. The Bank of Japan (BoJ) unsurprisingly stayed at ?0.1% p.a. but it did adjust the allowed movement around its longer maturity bond rates (e.g. 10-year Government bond.

It appears that the mood across developed economies at least is that central banks are at or near their expected highs for interest rates. The US Fed has an estimated probability of 20% for one more interest rate increase to be announced at its next meeting on September 20^th. With inflation seemingly coming under control, there is a growing belief among many analysts that the Fed might already be ‘done’ raising rates.

The US 10-year Government bond rate has moved both up and down in recent months. The latest move was to briefly rise back above 4%. We note that after a period of volatility the US bond market is stabilising somewhat.

Other Assets

The price of oil moved sharply higher in July (+14%) fuelling gains in the energy sector of the ASX 200.

The price of iron ore was down a little (?1.9%). The price of copper was up +3.6%. The price of gold was up +2.7%. The Australian dollar appreciated 0.8% over July.

The VIX volatility index, a measure of share market volatility, closed July at 13.6, a level that is in the normal range.

Regional Review

Australia

Our jobs report for June was strong with 33,600 new jobs being created and the unemployment rate at 3.5%. Of course, immigration is strong perhaps helping the increases in the demand for labour.

Dr Philip Lowe was not reappointed for a second term as RBA Governor. He is to be replaced by the current Deputy Governor, Michele Bullock, on September 17^th. We do not think that change will make a material difference to the conduct of monetary policy, particularly as inflation is now receding.

We do not think the RBA will start cutting interest rates any time soon unless, or until, more of a material slowdown in economic growth is observed. Retail sales fell by ?0.8% over the last month but rose 2.3% on the year. In other words, the annual growth in retail sales at current prices is about the same as the general level of prices so inflation-adjusted retail sales have been flat.

China

China data are a little mixed. The latest GDP growth for the June quarter came in at 6.3%, 1% below the expected 7.3%. Both figures are well above the long run expectation of a little over 5% p.a. because of the ‘base effect’ of coming out of the three-year long lockdown. However, the quarterly growth was 0.8% against an expected 0.5%. That bodes well for the September quarter.

The usual monthly growth statistics of retail sales, industrial output and fixed asset investment were at or above expectations but weaker than pre-pandemic rates. Exports and Imports both contracted in the latest month and were worse than expected. Youth unemployment was reported to stand at 22.3%! No doubt a concern for Chinese authorities.

China manufacturing PMI came in at 49.3 making it the fourth successive reading below 50 (a reding below 50 indicates contraction). However, the index has risen slightly in the last two months from a low of 48.8 in May.

US

US employment growth (non-farm payrolls) increased by 209,000 in June slightly missing the expected 225,000, but the unemployment rate fell from 3.7% to 3.6%. Importantly, around 150,000 of the jobs created were in government positions and lower-level healthcare. This change in the mix could be a sign of weaker jobs growth to come and, hence, to a softer monetary policy stance from the Fed.

The US has two more Consumer Price Inces (CPI) reports and two more employment reports before the next interest rate setting meeting on September 20^th. The Fed will also be hosting the Jackson Hole global conference for Central Bankers in late August. Should we expect a joint statement that the bulk of the work on inflation is over?

US June quarter GDP growth surprised to the upside at 2.4% when 2% had been expected. We recall that March quarter growth was 1.1% for the preliminary estimate reported in April which was then revised upwards to 1.3% and then 2% in June, indicating some resilience in the US economy.

US retail sales were weak at 0.2% for the month and industrial output went backwards at ?0.5%. Despite this the mood continues to remain sanguine.

Europe

UK wage inflation grew the equal fastest on record in the three months to June 30 at 7.3%.

France’s GDP growth for the June quarter came in at 0.5% against a forecast of 0.1% and a previous reading of 0.1%. Inflation came in at 4.3% from a previous reading of 4.5%.

There is little in Europe data to give us much joy but they seem to be struggling through rather than collapsing. The latest European Union GDP growth data for the June quarter ended the run of two consecutive quarters of negative growth rates with a rate of 0.3% against an expected 0.2%.

Rest of the World

Japan’s inflation is off its recent high at 3.3% and core inflation was 4.2%. The Tokyo core inflation read was 3% which beat expectations. Japan retail sales came in at 5.9% above the expected 5.6%. However, industrial output at 2.0% was slightly below forecast.

Russia has reportedly ended the food corridor for ships carrying Ukrainian grain exports to pass freely though the Black Sea. There are many reports of the Ukraine fighting back by firing missiles at Russian targets. There seems to be no peace in sight. There is an elevated chance of a hike in food and fertilizer prices from these recent moves but we do not see it as having the same effect as at the start of the invasion in February 2022. Alternative sources of supply have, to some extent, been found.