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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:

– Despite inflation peaking markets are pricing in more interest rate hikes in the US and Australia
– Share markets remain buoyant and to date showing little concern for the recession risk
– Artificial Intelligence (AI) popularised by ChatGPT has boosted the Tech sector, is it a bubble?

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.

The Big Picture

As we start a new financial year it’s good to reflect on the year just past. Despite rising interest rates and the ongoing Ukraine war, returns on many major share markets have been well above average. We all noticed interest rates and bond yields rose sharply.

The start of the last financial year witnessed the early days of the interest rate hiking cycles by many central banks. We didn’t then know how high rates would go in the ‘fight against inflation’ but most would have been surprised by the size of the hikes that eventuated – and there may well be more hikes to come. This uncertainty around interest rates contributed to the share market low last October but need we go back there?

Depending on how you measure inflation, one could be satisfied by how it has fallen in the US. Oil prices are down by more than a third over the year after the spike partly caused by the Russian invasion of the Ukraine. Supply chain issues caused by Covid have largely dissipated.

It is interesting to observe that two developed countries, Switzerland and Japan, have had only a modest inflation problem. Switzerland only just hiked its rate to 1.75% and Japan’s central bank has kept its interest rates on hold since 2016 at -0.1%! Switzerland has a massive dependence on hydro power for electricity and both countries have well-regulated energy prices, which are in part a reason why they have lower inflation.

Swiss inflation stands at 2.3% compared to a recent peak of 3.2%. Japan’s core inflation stands at 3.2% which is down from 3.4%.

What this points to is that the mantra pervading most central banks – that “we must keep rates higher for longer to control inflation” – misses the point that other policy tools could have been employed in the fight against inflation. There is no simple relationship between interest rates and inflation so we believe that central banks are employing their largest and primary instrument, interest rates, and in the process are running the real risk of taking their economies into recession as a result of their inflation fighting approach. Deutsche Bank has assigned a 100% probability to the US going into recession. While we don’t think anything is certain, it is becoming increasingly difficult to make the argument that the US economy is not heading that way.

The Reserve Bank of Australia (RBA) had promised us that rates would not go up at least until 2024. They did have a brief pause in April this year having started hiking in May 2022, but followed that with two more hikes in this May and June. Many are predicting that there might be two more interest rate hikes in the pipeline.

We thought, at the start of 2023, that the RBA would not have hiked interest rates as much as they have. Had the RBA not been so aggressive with interest rate increases and China’s economy started bouncing back from the three-year Covid lockdown instead of the anaemic recovery it has had so far, we may well be better positioned to avoid a recession than it appears we are now.

We still think the RBA should have stopped hiking months ago. Our latest estimate of Australian inflation is 3.1% – almost within the RBA target band of 2% to 3%. Why didn’t you know this? The media is lazy.

Australia’s latest economic growth estimates came in at the start of June. Our economy grew by 0.2% in the March quarter. Not great, but positive. Over the whole year, growth was 2.3% which is not far off the historical average.

The problem comes when we adjust growth for population changes. Immigration is going gang-busters so the per capita growth in the March quarter was -0.2%. On average we went backwards!

The household savings ratio fell to 3.7% from 4.4%. It was nearly 20% in the early part of our Covid lockdowns because there was less available to spend income on, and probably because households wanted to put some extra aside for a rainy day – given the uncertainty created by the onset of Covid-19.

The current savings ratio of 3.7% is below what it was before the lockdowns. The stream of falls in savings ratios helped bolster the measured economic growth. That party is now likely to stop.

This savings data does not imply that people are spending more than they earn. They mean that they are not putting away as much for the future as they did before.

It would be remiss of us not to mention AI (artificial intelligence) and its effect on stock markets in the 2023 financial year. The US technology heavy Nasdaq index just experienced the best first half (January to June 2023) in four decades!

AI has been around for years but it only seemed to tantalise investors after ChatGTP was brought to our mainstream attention at the start of the year. Ordinary folk can now easily ask it questions and ask it to write an essay or computer program for us. This is big stuff and it is not going away. But let us be clear what it is.

AI has two major strands – both enabled by the massive increase in computing power in recent times. It can help us search very quickly from what already exists on the internet. That does raise questions of privacy and some are calling for AI development to be regulated.

The other component is image or pattern recognition. By taking, say, a digital photograph and changing each pixel into a number – say on a pantone colour score – one photo’s array of numbers can be compared to a massive number of other arrays. Western Australia just released a machine that can recognise feral cats from native animals and poison them.

Neither of these strands ‘think like a human’ – they just do what humans tell them to do, but extremely quickly!

Image recognition can help (and invade privacy?) identify people walking through immigration or a shopping centre. It can also be used to interrogate, say, aerial photos to work out who has a swimming pool or solar panel. Over time, this form of image recognition can monitor the effects of climate change, population movements and changes in traffic congestion. It will also drive cars without us!

AI has already made significant contributions to society, and it will continue to improve the efficiency of many tasks, but it can’t replace everyone’s jobs. It just doesn’t do that! It will put people with repetitive jobs in jeopardy but even this will take time.

Take the banking industry in Australia as an example. There has been a massive increase in employment at some major banks over the last decade – even as branches were being closed – owing to the switch to AI and a sub-branch of AI called machine learning (or generally data science). Computer models need to be designed, implemented, and monitored. This is a process that will takes years. Research never ends. There will always be a demand for people who can push computing power to its limits.

Many developed countries, including Australia and the US, are currently puzzled by the strength in their jobs markets. But should we be comparing unemployment rates today with those from years ago without adjusting for the types of work? Some restaurants claim they can’t organise home deliveries because they can’t get the workers! So, anyone who loses a ‘good job’ through AI or whatever can become say, an Uber driver or delivery person in a trice. Obviously, compensation and job satisfaction may not be the same in the two segments of the workforce. But unemployment data are not adjusted for happiness.

No one can reasonably assess what the impact of monetary policy has already had since the start of 2022 with any accuracy. Everyone in the profession is aware that monetary policy impacts the real economy ‘with long and variable lags.’ Central banks admit it but most say that rates should remain high until we see inflation back to a reasonable level.

The consensus view is that the lag length is 12 to 18 months. That means we may not even yet have seen the full impact in Australia of the first rate-hike of 0.25% point in May 2022 – let alone the cumulative impact of the next dozen or so hikes! If they wait until inflation returns to its target range, whatever that may be, there will be a dozen or more rate hikes still waiting to have their impacts – presumably then sending many economies into recession. Stopping interest rates hikes, or even cutting rates, will not reverse the economic declines quickly enough.

If the chance of a recession is already priced into share prices, markets can continue to grow as the real economy works its way through the recessionary impacts. Our analysis of broker expectations of company earnings suggests we might expect more of the same over FY24 – average to above average capital gains. A correction or bear market is not an obvious expectation unless one is worried about any ‘AI bubble’ bursting.

Over twenty years ago, we had the dotcom bubble and bust. The current situation is very different. The dotcom boom was based on dreams of making new products that never, in fact, ever got made. People invested in companies with no actual products and no revenue streams. The big US tech companies involved in AI today are already making good money and AI already exists. Of course, there could be new regulation that slows things down a bit but there will also be improvements in AI over time as innovation and development continue unabated.

Investing in share markets is always risky. There is always a possibility that one buys at too high a price. There is also the possibility that one misses out on a great opportunity of not buying now. Prudent investors manage these risks and expected rewards. And over, say, five-year periods, the timing of buying and selling become much less important.

The founder of modern portfolio theory, Nobel Laureate Dr Harry Markowitz, passed away at the end of June, aged 95. By and large, the same theory is as relevant today as it was when it was first published 70 years ago – just the investment products on offer have changed! Harry was reportedly a good, humble man. His contributions were massive. R.I.P.

Asset Classes

Australian Equities

The ASX 200 was up +1.6% for June and +9.7% for the 2023 financial year. When dividends are included, those (total) returns increase to +1.8% and +14.8%, respectively. Of course, many investors also have franking credits available to them making for a very solid FY23. All eleven sectors produced total returns in excess of 5% and three (Materials, Information Technology (IT) and Utilities) produced total returns in excess of 20% for FY23.

We currently have the broader index approximately priced as ‘fair value’ and broker forecasts are pointing towards capital gains of above the historical average for the 2024 financial year.

International Equities 

The S&P 500 had capital gains of 6.5% for June and 17.6% for the 2023 financial year. The gains were certainly not even across the component sectors. It was the top 10 companies on Wall Street that led the charge in the S&P 500 this year. The other 490 companies’ share prices didn’t do that much. The top 10 companies are largely mega-tech companies with some focus on AI.

The Russell 2000 index is commonly used to track where US small cap stocks are going. This index started to underperform the top 50 stocks from March when the Silicon Valley Bank and others went under and credit conditions tightened.

Emerging markets were flat over the 2023 financial year but they had a good June rising +2.6%.

Our analysis of the US company earnings forecasts points to another strong financial year but a lot will depend on the depth to which any recession hits the country – and the extent to which any bubble, assuming there is one, in AI bursts.

Bonds and Interest Rates

The US Federal Reserve (“Fed”) paused its hiking cycle for the first time in June. In a confusing press conference, Fed Chairperson Jerome Powell emphasised that this was a “pause” and not a “skip” (presumably meaning we shouldn’t automatically expect a hike in July). However, the dot plot forecasts of the members of the Federal Open Markets Committee (FOMC) clearly showed that the Fed expects two more hikes this year – with only four meetings to go. And that is two more hikes than they expected at the prior meeting!

The market is pricing in an 85% chance of an interest rate hike by the Fed in late July. Gone are the market expectations of three or four interest rate cuts this year – the market expects more rate hikes. Any rate cuts are a little unlikely with a market probability of 1.1%.

The RBA paused again at its July meeting and left the official cash rate unchanged at 4.10%. In the lead up to the decision market economists and pundits had been divided as to the outcome as data can be found to support either case.

With money market account interest rates having risen substantially the ‘there is no alternative’ (“TINA”) to equities is no longer the case. Share markets continue to have better long-term prospects than bonds or cash but a blend of these assets may well be appropriate for prudent investors who want to manage the risk of their asset allocations.

Other Assets 

The price of oil has fallen by more than a third over FY23 but they were up over 2% during June.

The price of iron ore was much the same at the end of the financial year ($112 / tonne) as it was at the beginning ($121 / tonne) but the range over that period was enormous ($80 to $133). During June, the price was up about 13% as China comes back out of the lockdowns.

The price of copper was flat over the 2023 financial year but up about 1% during June.

The price of gold was up 6% over the 2023 financial year but down 3% in June.

The Australian dollar appreciated 2.1% over June but was down about 4% over the 2023 financial year.

Regional Review

Australia

We again got a bumper monthly labour report. Two of the last three were extraordinarily strong. Because of sampling error in the way that the data are collected, we are comfortable to accept the middle month’s weak result as an anomaly.

76,000 new jobs were created in the latest month. The unemployment rate fell from 3.7% to 3.6% which is historically very low indeed.

GDP growth was a different story. The March quarter was weak and we were possibly saved from going negative by the cut to household savings. Per capita growth was negative at -0.2%! We cannot reasonably expect further falls in the savings ratio to support our growth estimates. However, strong immigration might keep headline growth positive.

In contrast, retail sales, that are not adjusted for inflation, came in strongly at 0.7% for the month or 4.2% over the year. However, we note that inflation was running at about 7% p.a. (April) (or 5.6% p.a. from the May monthly series) so real (i.e. adjusted for inflation) sales were down around 3% (or 1.4%), over the last 12-months.

We have been experiencing higher inflation than even the US. The Fair Work Commission gave a 5.75% wage increase to those on minimum wages. Owing to a technicality, that translates to about 8.5% for some.

Will this wage increase be inflationary? It certainly puts costs up and some or all of this increase will be passed on. However, the increase does not help those workers keep up with the inflation that has already occurred. Not to give such a wage hike might have slowed down inflation but at what human cost?

There is some evidence being presented that companies have been increasing profitability in this inflation round so hopefully such companies will be able to absorb some of the wage increases.

The latest quarterly inflation read (for the March quarter published in April) was 1.4% for the quarter or 7.0% for the year. Many think it was this number that prompted the RBA to hike interest rates again after their April 4th pause. There is a new official monthly, as opposed to quarterly, series that aims to provide a more timely view of price movements.

The May monthly inflation rate came in below expectations at 5.6% for the 12-month period published at the end of June. It was the lowest in 13 months but the new monthly series does not correspond very closely to the established quarterly series.

Our in-house analysis, in which we calculate a rolling quarterly inflation series – rather than the official rolling annual series – shows that the latest quarter came in at an annualised 3.1% (only just above the RBA’s inflation target range of 2% to 3%) but core inflation (that strips out the more volatile food and fuel prices) is still stubbornly high at 5.2%. We expect that the next quarterly inflation reads will continue to trend lower but the monthly data are a little volatile.

China 

China is struggling to get its economy back on track. It cut a couple of key interest rates in June and seems likely to do more to stimulate the economy.

China’s Consumer Price Index (CPI) inflation came in at 0.2% and the producer price variant was -4.6%. The government is trying to be selective in how it stimulates the economy. While some agencies are downgrading their forecasts of growth for 2023, estimates generally are still comfortably above 5%.

However, the manufacturing Purchasing Manufacturer’s Index (PMI) was below 50 (indicating a contraction) for the third month in a row showing that the stimulus packages have not yet filtered through to expectations that will take the economy back into a more sustained growth path. The latest read of 49.0 was better than the previous month’s read of 48.8 but below the April read of 49.2. In that sense, the economy is more likely struggling with getting back to stronger growth rather than falling into worsening conditions.

US

US jobs again impressed at 339,000 new jobs and an unemployment rate of 3.5%. Only 190,000 new jobs had been expected. Wage growth was 0.3% for the month or 4.4% for the year.

US GDP growth for the March quarter was revised upwards from 1.1% to 1.3% to 2.0% in each of the last two months.

When we calculate CPI inflation on a quarterly basis – as we do in Australia – the read was 2.2% (annualised) compared to the target 2% but the Fed seems very likely to hike again. And this low read was not a one off. Rolling quarterly reads have been drifting lower from 4% for several months. The problem is that the US focuses on a rolling 12- month inflation figure. At 4.0% for the headline rate and 5.3% for the core reading, the high inflation period up to the middle of 2022 is still biasing the annual estimates upwards.

The Fed prefers the Personal Consumption Expenditure (PCE) to the CPI variant of inflation because the weights attached to each expenditure segment evolve over time. The latest monthly headline read was only 0.1% or 3.8% for the year. The core variant that strips out the more volatile energy and food prices was 4.6% compared to an expected 4.7%.

US President Biden’s student debt forgiveness plan was not supported by the Supreme Court. Biden plans changes which he hopes will get the plan through but, for the moment that is an extra impost on spending power for those struggling with student debt. Add to that the effect of credit tightening and the repaying government debt programme (called quantitative tightening) and the economy has a lot to deal with without having more interest rate hikes.

Europe 

UK inflation was stuck at 8.7% and the Bank of England surprisingly hiked interest rates by 0.5% points rather than the expected 0.25%. Britain, along with Germany and the EU have had two consecutive quarters of negative growth. The ECB hiked by 0.25% to 3.5% but its President, Christine Lagarde, stressed that she wants rates to stay high until inflation, currently 5.5%, falls to 2%. She did not acknowledge the policy lag in her statement.

Rest of the World

Japan’s growth in the March quarter was revised upwards to 2.7% from 1.6%. Its core inflation read was 3.2% from 3.4% and the Bank of Japan interest rate is  0.1%.

New Zealand growth came in at -0.1% giving it claim to being in a recession after this second quarterly negative read.

The Royal Bank of Canada had paused after its January interest rate hike but proceeded to start hiking again in June with a 0.25% increase to 4.75%.

Turkey raised its rate by 6.5% from 8.5% to 15% in order to try and save its currency, the lira. The rate was 19% in the early phase of the pandemic and it was progressively cut to the previous month’s 8.5%.

In a puzzling state-of-affairs, the Wagner private army comprised mainly of former Russian soldiers marched on Moscow and got to within 300km before turning back. The leader, Prigozhin, cut a deal with Putin to stand down in exchange for safe passage to exile in Belarus. All of this happened over the weekend when markets were closed!

Wagner played a major role in the Ukraine offensive. Putin did not look good in this and it is not clear what the aim of the ‘mutiny’ was. Charges against the mercenaries have reportedly been dropped. Reportedly residents in Poland, Latvia and Lithuania are extremely worried by having these ‘serial killers’ in neighbouring Belarus. The army is not expected to return to fight in the Ukraine. However, the Pentagon claims some of the army is in the Ukraine.

Markets did not seemingly respond to this chain of events.

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

Key points:
– US debt ceiling deliberations coming to an end
– Central banks are still hiking rates despite agreeing that inflation peak now behind us
– China economy not yet out of the woods as indicators remain mixed

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

It seems that every time there is a divided Congress in the US, like there is now, both sides engage in brinkmanship. They always come to a solution but is there a better way? It destabilises asset markets and causes consumers unnecessary angst.

President Biden announced that a deal had been reached with Republican leadership on the last weekend in May, and was finally ratified by the US Congress in the past week, ahead of the reported June 5th deadline after which the US government becomes at risk of defaulting on its debt. Despite the apparent risk the US Government does have some wiggle room before they would actually default e.g. public servants and the like get furloughed first, as has occurred previously in response to this issue.

As a result of this squabble, one of the big three ratings’ agencies, Fitch, put US Treasury Securities on ‘negative watch’ meaning that their AAA credit quality status was in jeopardy.

While we make light of the posturing for the TV cameras by the opposing political parties, a huge and very real problem is emerging. The total of US Government debt is now $31,000,000,000,000! (Trillion) As rates rise, the interest bill is becoming dangerously high unless some long-term deficit reduction solution is agreed upon. One day, US debt might become too risky for other nations to hold. What happens then when they’ve all but maxed out their credit card.

It is hard to unscramble all the influences on central banks and bond yields. It seems safe to ascribe a little of the recent uncertainty to the debt ceiling negotiations but a lot must also be due to central banks’ interpretation of the economic and inflation data that are landing on the news wires in rapid fire.

The Reserve Bank of Australia (RBA) surprised markets in May by increasing the official cash rate by 0.25% to 3.85% when the consensus was that they would leave rates on hold. At the June meeting the odds of a rate increase changed markedly during May from a minor chance of an increase in June to the point of ‘much more likely than not’ in the few days prior to the June meeting on Tuesday 6th of June. The RBA decided to go with the majority and increased the cash rate to 4.10%.

Our CPI inflation data did come in a bit high at 7% in the last week of April and that was backed up by 6.8% from a new monthly publication at the end of May. While that figure is well above the target rate of 2% to 3%, we have no real way of knowing what will be the delayed impact of all the previous interest rate hikes in the future.

Everyone agrees that the impact of rate hikes is felt with ‘a long and variable lag.’ So, if Central Banks wait for inflation to be reasonable before they pause or ‘pivot’ down, there is no doubt that some bad economic conditions will inevitably follow. Even swift rate cuts wouldn’t solve that problem as cuts also take time to work their way through the system.

In relation to the large swings in expectations of where Central Banks decide to take interest rate policy settings, when the probabilities change so much from day to day it makes little sense to take each number at face value. We prefer to interpret these probabilities and abrupt changes as evidence of confusion in the market. The next new number could be sufficient to flip expectations back to the RBA being on hold. We anticipate this volatility continuing for the near term at least.

The US Federal Reserve (Fed) also hiked rates by a quarter of a percent at the start of May to a target range of 5.0% to 5.25%. That means the current (average) Fed funds rate is about 5.1% or the figure the Fed forecast its rate would be at the end of 2023 – the so-called ‘terminal (peak) interest rate’. Therefore, any more hikes put them in a more aggressive stance than they were at the beginning of the year. But what has happened since? Most US news this year has been encouraging but the falls in inflation – and there have been some substantial falls – have not been as big as hoped for.

But on top of the Fed’s actions, the regional US banks bailouts have caused a credit tightening which has been acknowledged by the Fed and the market. Fed chair, Jerome Powell, said in a press conference that the credit tightening might be equivalent to one or maybe two hikes – or maybe even more. He claimed not to know.

Professor Jeremy Siegel, a particularly well-credentialed finance academic from the Wharton School (University of Pennsylvania) with both feet firmly on the ground thinks the credit tightening is worth about 0.75% to 1.0% in addition to the 5.1% Fed funds rate.

On top of that, Jamie Dimon, the high-profile CEO of JP Morgan, thinks the Fed rate will have to go to 6% or 7%. Putting all this analysis together, the US could easily be looking at an ‘effective’ Fed funds rate of 7% or maybe even 8% sometime this year. That might spell a big recession for the US. If that were to be the case then there is time to save the economy, but swift action could be necessary but it doesn’t look likely.

At the start of the year, the Fed was predicting a terminal or peak interest rate of 5.1% while the market’s prediction was a little under 5%. By March, the Fed hadn’t shifted its view but the market was then pricing in about 3.5% (due to the regional banking crisis). In the run-up to the June Fed meeting, the market was pricing in a terminal rate at around 5% – just like the Fed.

At one time, the market was pricing in three or four cuts this year. We didn’t see that happening and the chance of cuts is all but off the table. One cut is priced in unless they hike in June and then it will be two cuts!

The probability of a hike in June has gone from about 5% earlier last month to 71% near the end of May and then back down to 35% to close off the month. Again, these probabilities speak more to the difficulty to interpreting current data in this economic climate.

Our economic future in Australia looks a little brighter than that for the US but a lot is riding on how the China economy plays out. The last GDP reading for China was reasonable at 4.5% and the June quarter read could be very strong as opposed to the same quarter last year which was very weak. In recent data imports just came in at -7.9% for the month when 0% was expected; industrial profits were down -18% for April; but exports were on track at +8%.

Then, the Purchasing Manager’s Index (PMI) came in well below expectations for both manufacturing and services with the manufacturing variant indicating a contractionary sentiment at 48.8. However, this recent weakness could well cause a reaction from the Chinese government to stimulate the economy.

We are cautiously optimistic about China’s economy as it exits the pandemic lockdown but there could be some speed bumps along the way.

All-in-all, Financial Year (FY) 2023 looks like producing strong returns for the ASX 200 and the S&P 500. FY23-to-date capital gains are 8.0% and 10.4%, respectively. Dividends and franking credits in Australia put both returns well into double figures.
So far, surveys of company earnings’ expectations are looking moderately strong for FY24 but there are a lot of unknowns that could upset these expectations.

Asset Classes

Australian Equities

The ASX 200 had a bad end to the month on the back of the US debt ceiling deliberations, our inflation data and the patchy weakness in the Chinese economy. The broad index was down 3.0% in May making it all but flat for the calendar year to date. Except for the IT sector, there was little in May to celebrate on the ASX.

International Equities

US equities just managed to close May with a positive return which gives an 8.9% calendar year to date capital gain.

Japan’s Nikkei index had a spectacular month rising +7.0% but Emerging markets were flat. The German DAX, UK FTSE and China’s Shanghai Composite Indices were well down.

Bonds and Interest Rates

The market has now capitulated on its stance against the Fed’s ‘higher for longer’ position. Gone are the expectations of three or four cuts this year.

The market thinks it is more likely than not that the Fed will pause in June after having leant towards a hike for much of May.

The ECB is on a tear to keep hiking rates to fight inflation despite its largest economy, Germany, falling into recession in the March quarter on the back of a downward revision to growth.

The Bank of England (BoE) at last got some slightly good news as UK inflation fell from 10.1% to 8.7% in one month. Now at 4.5%, the latest quarter point increase took its interest rate well above the ECB’s 3.25%.

Perhaps the biggest danger in the Fixed Interest sector is the possibility of increased defaults in corporate credit.

Other Assets 

OPEC has just opened the door to allow Iran back into the club after sanctions are removed. The price of oil has been a little volatile of late but it is well down on the prices that caused much of the global inflation spike. Brent Crude oil was well over US$100 per barrel a year ago and is now just over US$70.

The price of iron ore has also retreated from around US$130 per tonne a year ago to close on US$100 today.

Over the month of May, the prices of copper, iron ore and oil were all well down but gold was only down by -1.0%.

The Australian dollar against the US dollar fell by -1.7% in May to US$0.65 cents.

Regional Review

Australia

On the face of it, our jobs report looked weak but it followed an extremely strong prior month. Taken together, the labour market seems to be holding up against higher rates.

Our unemployment rate jumped from 3.5% to 3.7%. Total jobs fell 4,300 but part-time jobs rose 22,800 reversing the big switch to full-time work in the prior month. Wages grew modestly at 0.8% for the quarter and 3.7% for the year.

Retail sales volumes again fell in the March quarter making for two consecutive quarters of negative growth: -0.3% and -0.6%.

While the Federal Budget made attempts to redress the cost-of-living crisis there wasn’t a lot for economists to agree or disagree with.

China

The China trade balance improved sharply as exports met strong targets but imports fell well short. The economy seems to be quite patchy with some areas of strength – mainly in services – but industrial profits falling by 18% in April did attract attention.

The manufacturing PMI came in at 48.8 at the end of May which was a big miss compared to the expected 49.2. However, the services PMI was well in expansionary territory at 54.5 – although that statistic did mark the second month of decline. It is quite possible that this weak manufacturing outcome will push the government into an expansionary policy phase.

China inflation came in light at 0.7% from 2.8%. The Producer Price Index (PPI) inflation was -3.6%, less than the -3.2% expectation.

US

The forecast for US new jobs to be reported at the start of May was 180,000 with a range of 95,000 to 265,000. The outcome, at 253,000, was at the top of the range. The anticipated weakness in the labour market is yet to appear. Wages growth was quite strong at 4.2%. The unemployment rate fell from 3.6% to 3.5%.

Nevertheless, the New York Fed calculator estimates that there is a 68% chance of a recession in the US.

Core inflation is above the headline variant as energy and food prices that are stripped from the headline measures are currently falling. Our calculation of quarterly CPI inflation at 3.2% (annualised) is not that far from the 2% target but the annual figure, as represented in official data, is stubbornly high because of the hangover effect of the high mid-2022 inflation spike. That should pass through the data measurement ‘window’ in a few months.

Europe 

The Bank of England is still intent on trying to suppress inflation with interest rate hikes. There is some slight evidence that it is winning.

Now that Germany is in recession it is not bringing any confidence to those who thought EU inflation could be supressed with interest rate hikes without causing a hard landing.

Rest of the World

Japan’s inflation was a little higher than expected at 3.4% and that is the highest inflation has been there since 1981. After the ‘lost decade’ and beyond characterised by deflation, Japan’s experience may have swung the other way. However, as Japan’s central bank has not meddled with interest rates – which are unchanged since 2016 at -0.1% – growth is doing moderately well.

Japan’s growth in the March quarter came in at 0.4% and 1.6% for the year when 0.2% and 0.7%, respectively, had been expected.

Japan’s industrial output fell by -0.5% while +1.5% had been expected. Retail sales grew strongly at +5.0% but missed the +7.0% expectation.
The Tokyo CPI inflation index pointed to inflation falling to 3.2% from 3.5% when 3.3% had been expected.

With a new governor at the Bank of Japan, we await a clear signal of a possible change in interest rate (monetary) policy.

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

Key points:
– Peak inflation now appears to be behind us
– US economic growth showing some resilience but is weakening
– Inflation is declining as higher interest rates start to bite on household spending
– Interest rates in Australia look close to peaking this cycle but appear to be data dependent

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

There are signs that the US economy is softening but, following the anticipated 0.25% rate increase early this month, will this be enough to cause the US Federal Reserve (Fed) to now pause its interest rate hiking cycle? At the time of writing, the market-based probability of a pause at the Fed’s June 14 meeting is 100%, notwithstanding, expectations of Central Bank interest rate movements are more volatile in the current environment of elevated uncertainty. Again, and at time of writing, markets are forecasting that the Fed will have cut interest rates at least once by the end of the year which is at odds with the Fed’s view that they won’t. This divergence of views, in part, makes it somewhat easier to reconcile the market reaction to the Fed’s decision to raise interest rates this month when confronted with a softening economy and knowledge of a potential recession. We note the European Central Bank (ECB) followed the Fed and increased their cash rate by 0.25%.

It can take quite a while – many say about 12 to 18 months – for interest rates to work their way through to the ‘real economy’ (like jobs and growth). Nobody has a good handle on what impact the interest rate hikes of the past year have already done to the economy. In the US, the market expected a modest 2% GDP growth (annualised) for the March quarter of 2023 and it came in at about half of that at 1.1%. The latest monthly US retail sales fell by -0.9% against an expected -0.5% for the month. The annual figure was -3.1%. Usually, when a recession hits, it generally occurs quite quickly.

Many economists expect a US recession to start this year. Any recession might be expected to get worse the more interest rates are hiked – or held at too high a level for too long.

A recession need not have a negative impact on the share market going forward. The US March quarter reporting season has already produced a few stellar results among the large tech companies. Of those companies that have reported so far (approximately 50%), 80% have delivered better than expected earnings for March quarter after earnings expectations had previously been marked down. We think a mild recession has been priced in and this seems reasonable unless the Fed blindly institutes further interest rate rises beyond what is already factored in for May.

Annual US inflation rates are still high owing to the double-digit supply (input price) induced inflation of nearly a year ago. Recent monthly data are now more promising. The Fed’s preferred inflation measures, the Consumer Price Index (CPI) and Private Consumption Expenditure (PCE) indices both came in at only 0.1% for the month of March.

The economic picture here is quite different from that in the US. The month of April ended with an estimated 100% chance of the Reserve Bank of Australia (RBA) being ‘on hold’ in May. The markets were taken by surprise on Tuesday 2nd of May when the RBA increased the cash rate by 0.25% to 3.85% citing concerns of residual strength in inflation as the reason. The RBA press release announced this change also opens the way for further rate increases should the RBA deem them as necessary to contain inflation and return it to the target band of 2% to 3% by mid-2025. Ahead of the rate increase a number of banks had already started cutting some of their mortgage rates!

Our labour force data published in April was particularly strong. The unemployment rate was steady at near a multi-decade low of 3.5%, 72,000 new full-time jobs were created and 19,000 part time jobs were lost. Retail sales were soft, up 0.2% for the month but 6.4% for the year, indicating a slowing in trend growth.

Australian inflation is still a little elevated at 1.4% for the March quarter but the RBA’s preferred variant came in at 1.2%. The annual rate was 7% which is down from the 7.8% recorded in the December quarter of 2022.

A review of the RBA by an independent panel was completed. They recommend a specialist committee be formed to consider interest rate changes and for it to meet only 8 times per year rather the current 11. The changes could actually improve monetary policy implementation and decision making.

The best economic news of the month came in the publishing of China’s economic growth data which came in at 4.5% p.a. when only 4.0% p.a. had been expected. The December 2022 quarter was 2.9% p.a. and the official forecast for 2023 is 5.0% p.a. China’s inflation is also well contained. We see the resurgence of the Chinese economy after the pandemic lockdowns as being a big positive factor in Australia being able to avoid a recession.

The European economy continues to languish with the latest estimate for March quarter growth at 0.1%, narrowly avoiding a technical recession marked by two successive quarters of negative growth. EU inflation was the lowest in a year at 6.9% but the UK is still struggling with inflation at 10.1%.

The ‘banking crisis’ that started in the US regional banks over a month ago does not appear to be spreading materially although there have been a couple of subsequent failures noting that depositors’ funds were protected. We do not think this is the beginning of a systemic issue in the banking system but do note that it is a clear indication that stress and vulnerabilities exist which could lead to isolated issues with other regional banks.

Sadly, the situation in the Ukraine does not seem to be improving. However, the economic consequences for the global economy anticipated at the outbreak of the conflict have not occurred to the extent expected. Food prices are still elevated but their rate of change has settled down and some falls have been recorded. Shipping costs of containers and the like are down over 82% from the pandemic peak and the Covid lockdown in China is largely behind us.

As our base case, we see modest capital gains in the US (S&P 500) and in Australia (ASX 200) to the end of the year and government bond markets have settled down. The worst of inflation is most likely behind us and the annual calculation of inflation rates will soon improve markedly as the previous higher monthly data points fall out of the calculation window.

Asset Classes

Australian Equities 

The ASX 200 bounced back +1.8% in April after a -1.1% decline in March. All industry sectors, except Materials, were firmly in positive territory. The index is up +3.8% for the year to date and +11.3% since July 1 of 2022 (financial year to date).

International Equities 

US equities (S&P 500) rose 1.5% in April and other major developed world indexes were up similarly.  In contrast, Emerging Markets were down  0.9%.

For the year-to-date there are some impressive performances from foreign equities: S&P 500 +8.6%; London FTSE +5.6%; German DAX +14.4%; Japan Nikkei +10.6%; Shanghai Composite +7.6%; Emerging Markets +2.4%; and the World +9.0%.

Bonds and Interest Rates

The US Fed is thought to be on pause now after the 0.25% interest rate increase early in May. However, the ‘CME Fedwatch tool’ which uses current data from the bond market to arrive at an estimate for the US cash interest rate, is reporting a forecast that the most likely interest rate is 4.25% at year-end (48% chance). We caution that these forecasts are very fluid and have fluctuated significantly recently. Our expectation is that this will continue and the Fed responds to subsequent economic data. This current market view is divergent from the view of the US Federal Reserve Board member median view, which forecasts a rate of 5.1% for the cash rate at year end.

Closer to home, following the RBA’s surprise interest rate increase in May, the prospect of further increases is low and will be data dependent. More broadly our expectation is that the RBA will likely pause again in June.

Other Assets 

The price of iron ore was well down over April (-16.9%) but the price is still above $100 per tonne. The prices of oil and gold were largely flat and copper also was down -4.7%.

The Australian dollar fell by -1.5% against the US dollar in April.

The VIX volatility index (a measure of US share market volatility) is now back to almost the ‘normal’ levels at 15.8. Investors seem to be getting more comfortable with the direction of the share markets and appear to be of the view that inflation is heading down and interest rates rises are at or nearing an end.

Regional Review

Australia

Our unemployment rate stayed at a very low 3.5% and net 53,000 new jobs were created (+72,200 full-time and  19,200 part-time) made up the total jobs figure. This composition of the job’s growth data (more full time than part time) is positive for economic growth and shows continuing strong demand for labour.

Retail sales were a bit soft at +0.2% for the month or 6.4% on the year.

The 1.4% quarterly CPI inflation figure was buoyed by a +5.3% education component.

The Federal Budget will be handed down on May 9th. It is widely expected that the government will make some improvements to healthcare.

China 

As the impact of China’s pandemic lockdown subsides, economic growth is bouncing back. March quarter growth came in at 4.5% (annualised) which is not far short of the 5% targeted by the government for 2023.

China CPI came in at  -0.3% for the month and 0.7% for the year. The market expected 1.0% for the annual figure. The producer price index (PPI) came in on expectations at -2.5% for the year.

US

The US recorded 236,000 new jobs which was only just below the 238,000 expected. However, news of big job cuts, particularly in big tech companies is concerning. The unemployment rate was still quite strong at 3.5% and slightly better than expected.

Wage growth at 4.4% p.a. was the lowest for the past year.  CPI headline inflation was 0.1% for the month or 5.0% for the year. The core CPI data were 0.4% for the month and 5.6% for the year as the energy and food prices that are stripped from the headline rate made negative contributions.

The Personal Consumption Expenditure (PCE) measure of inflation, which is preferred by the Fed, was 0.1% for the month and 4.2% for the year in the headline form and 0.3% for the month and 4.6% for the year in their ‘core’ state. The peak PCE rate was 7.0% in June 2021 and that was the highest since 1981.
There was some weakness in economic growth at only 1.1% for March quarter (annualised) against an expected 2.0%. Retail sales were a big disappointment at -0.9% against an expected -0.5% with the annual change now being -3.1%.

As the delayed impact of past interest rates hikes works its way through the economy, we expect growth and sales to remain soft. Jobs maybe resilient for somewhat longer.

Europe 

EU growth was negative in the December quarter of 2022 but backed that up with +0.1% in March quarter of 2023 thus avoiding a technical recession – for now!
Inflation for the region was 6.9% but 10.1% for the UK where 9.8% had been expected, the previous reading was 10.4%.

Rest of the World 

Japan’s core rate of inflation was unchanged at 3.1%. The last time Japanese inflation was higher was 41 years ago.

OPEC+ (+ includes Russia) cut supply by 1.2 million barrels per day and this had an immediate impact on oil prices – which rose 6% to 7% for that day.

The International Monetary Fund (IMF) shaved 0.2% points from its January global growth forecast for 2023 of 3.0% to 2.8%. The 2024 forecast is currently 3.0%

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

Key points:
– What impact has the banking crisis had on interest rates and markets?
– Who/what caused some of the failures in the US regional banks?
– Economy showing resilience – key employment data still strong in US and Australia
– Inflation still above objectives but growing evidence that the high point is in the past

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

There is a lot going on in the world of finance and to make some sense of it, we will do our best to walk you through it in a calm and rational manner.
Cutting to our conclusion, we do not think we are in a crisis – like in 2008 – or anything like it. Yes – some did/will get hurt but the problem is well-contained – at least until the next ‘crisis’ emerges.

Going back to our previous Economic Update of March 1st, no one was talking about banking crises. Indeed, the month started calmly with our growth data release and the RBA decision to increase the cash rate seemingly just as we all expected.

Indeed, the first nine days of March were largely ‘business as usual’. Then, unbeknown to us at the time, a moderately-sized bank in California, called Silicon Valley Bank (SVB) had a $42bn run on its deposits in only one day – a record of sorts. Still unbeknown to us at the time, the next morning, SVB contacted the regulator that it had about $100 bn more of requests to withdraw deposits and it couldn’t make them good. The bank was shut down and events escalated quickly.

Before we get into the details, it is important to refresh our understanding of how banks work. Around the 1960s, life was a lot simpler in terms of financial products and technology. Depending on the jurisdiction, a bank would accept deposits and establish customer accounts then allow customers to transact on them to facilitate their lives and businesses. The bank would only hold about 10% of those deposits in cash (when cash really was cash – i.e. notes and coins) and lend out, or invest, the other 90% often in the form of loans to businesses, home loans and personal loans.

Cash could usually be withdrawn at call (i.e. immediately, when the bank was open – no 24 hour internet banking!) but the loans usually had fixed, much longer investment terms. If depositors suddenly demanded their money back, the first 10% of assets could be offset against the cash holding. 10% then was thought to be a reasonable buffer to withstand the whims and needs of depositors. If more funds were to be withdrawn, there was a problem as the longer-term loans could not usually be reversed at will.

Banks exist for many important reasons. We couldn’t have an efficient society without them. They make their profits on the difference between the interest paid out on deposits and that received on longer term loans. Banks compete with one another on both deposit rates and loan rates to make the system work efficiently.

As we all know, depositors don’t get much interest on simple deposits but they pay quite a bit on home loans and the like. The bank pockets the difference and this is called the ‘net interest rate margin’ (NIM). What happens to fresh deposits that have not yet been lent out in the traditional way? They would usually be parked in safe assets such as long-term government bonds and the like until prudent loans could be made to clients.

Under normal conditions, long-term bonds have a higher yield than short-term bonds and deposits. All is then good for the banks. However, from time to time, particularly when a central bank is trying to slow down its economy, a central bank might force up short-term rates such that there is a so-called ‘inverted yield curve’. That is, short-term yields are higher than long term ones. When this happens, part of the traditional banking model doesn’t work. Such inversions are usually short-lived and there are complex financial products that allow banks to deal with the inverted situations.

Because a bank exists on this model that does not keep 100% of deposits on call, if a situation arises where depositors lose confidence in the bank and are concerned for the safety of their money, they collectively and actively withdraw their capital. This results in a ‘run on the bank’. In the ’old days’ this might have amounted to a queue at a cashier’s counter to take out bundles of notes and coins. Runs do not require logic or fact. Older readers might recall John Laws, the one-time famed Sydney radio announcer, started a run on a bank from some slack comments he made on his show and he got into trouble for it.

Dialling forward many decades and deposits can be removed electronically and moved directly to another financial institution – within seconds or less. No queues; no notes; and no coins!

Let’s return to the SVB case in particular. It has been reported in mainstream media that SVB was ultra successful in attracting new customers. Indeed, they specialised in ‘tech start-ups’ and the like, and some of the venture capitalists who funded these start-ups located around Silicon Valley, even insisted that they use SVB as their bank. As a result, the SVB client base was not diversified in any reasonable sense and the clients were largely very well educated and very well connected (including via social media and other rapid contact methods). Some have suggested SVB was more of a hedge fund than a bank in this regard.
That SVB was particularly successful in attracting deposits was arguably its downfall. It attracted deposits so rapidly that it couldn’t match those assets quickly enough with sound loans so they parked these large amounts of excess assets in seemingly safe long-term US Treasuries – often thought of as the safest assets on the planet.

Let’s now introduce the US Federal Reserve (The Fed). Whether rightly or wrongly, the Fed has been on a mission since March 2022 to raise the Fed Funds rate (short-term interest rate) to bring down price inflation which has undoubtedly been above its policy objective of 2% – 3%.
For many years before, the Fed rate was low and often close to zero. The rapid rise in its rate from just above zero to nearly 5% in less than a year caused the yield curve to ‘invert’. That is, the yield on short bonds became substantially higher than those of long-term bonds. That was a deliberate action to (hopefully) control inflation.

Let’s get back to SVB. It had a rapid run on its deposits for whatever reason. It was rapid because the depositors were sophisticated and well-connected. We saw analysis from reputable experts on CNBC saying that the deposits withdrawn did not go to cash or anything like it. The deposits largely went to the bigger well-known banks or the money market to earn higher returns on savings. This was not a run on ‘the banks’ as a whole, but simply reflected clients making a choice of which bank or institution to deal with.

We have noted evidence to suggest that SVB was not squeaky clean in a number of regards but it also got caught out on the presumption that US Treasuries are all but riskless. If a Treasury is held to maturity (like holding a 10-year bond for 10 years), the holder will reasonably expect to get all of their money back and all of the yield payments along the way. Corporate bonds might well have quite different probabilities of default. However, if a Treasury is not held to maturity, its (mark-to-market) price fluctuates on a daily basis responding intraday to changes in interest rate expectations.

SVB, when faced with a run on its deposits, would have needed to sell its long-term Treasuries at an unexpected loss (on a mark-to-market basis) because the price of a Treasury is inversely related to its yield and yields were being forced sharply upward. As the Fed forced up yields, they forced down the value of SVB’s (and others) Treasuries and the gap was enormous because of the aggression of the Fed policy. Selling a Treasury early can always result in a profit or a loss on capital.

To start a run, it wasn’t necessary for SVB to actually crystalise a loss through selling the long- dated bonds it owned at a loss. Any qualified financial analysts could view the SVB portfolio and realise the increased risk that SVB was facing.

Some have suggested that SVB should have been subjected to the same stress tests that bigger banks faced after the GFC – and that would have prevented the problem. Seemingly expert analysts on CNBC suggested that SVB would have passed such stress tests because the existing stress test was about how a bank could deal with falling rates. There was no stress test for rising rates. Whose fault is that?

So where does this leave us? Several smaller banks have been subjected to runs. That is no different in substance in Australia from people and businesses moving deposits from small banks to the big four or five. We may not like it, but that is business.

Contrast that to 2008 or so when there were complex financial products that no one seemingly fully understood and who owed how much to whom. In the panic most financial institutions then stopped lending to each other – called a credit freeze. Central banks freed up liquidity from the end of 2008 and commercial banks then got back on track. This time around, government agencies merely ‘insured’ the deposits over the traditional $250,000 limit. Problem solved!

This run on SVB and a few regional banks was not nice but it will not knock the global economy off track – or at least that is what we think.

Having hopefully dealt with the ‘banking crisis’ let us focus on analysing market behaviour and possible projections – including any ongoing implications from the ‘crisis’.

At the start of March, Australian GDP growth came in at a respectable, but not stellar, 0.5% for the quarter or 2.7% for the year. The RBA hiked its rate by 25 bps to 3.6% and foreshadowed more hikes to come. This action was largely anticipated.

China surprised a little with some strong economic data and policy objectives.

The US then reported its very strong labour market data which followed an even stronger prior month.

Even the UK dodged the recession bullet with positive growth in Q4, 2022 rather than the expected pull-back and the start of a recession.

Before the SVB collapse, Fed chair, Jerome Powell, was talking about maybe returning to a 50-bps hike at the March 22nd meeting following the smaller 25- bps hike in February. The market started pricing in an e o y 2023 Fed rate even higher than the Fed’s projection of 5.1%. Back in January, the market thought 4.4% was the level. Expectations were swirling; then the story about SVB broke!

Market expectations for the e-o-y Fed rate were rising to the point in time of the SVB collapse but then fell from a high of 5.84% to 3.44% in a week. Panic was permeating the markets. In normal times a small fraction of that change would have been considered big.

US regulators moved swiftly to insure (guarantee) all necessary bank deposits so that depositors were insulated from the collapses. Moves were initiated for bigger banks to absorb some of the stricken smaller peers. Credit Suisse also got into financial trouble but for different reasons. The European Central Bank (ECB) reportedly ‘leant on’ the other big international Swiss bank, UBS, to buy Credit Suisse out and absorb much of its losses. Another problem solved!

Of course, the inflation story had not gone away. New data in the US and Australia pointed to slightly better inflation data – so what would the Fed do on March 22nd? Many suggested the Fed would not hike because of the SVB problems. In the end, the Fed hiked interest rates by 0.25% (25 bps) rather than the 0.50% or 50 bps, touted before the SVB collapse. However, Powell stunned some, including us, in his press conference.

Powell pointed out that there would be a tightening of credit resulting from the problems in the regional banks. He went on to say [paraphrased] that such tightening would act in the same direction as a rate hike and might amount to the equivalent of a 25 bps or maybe 50 bps or more hike. We cannot say with any precision!

So, what Powell has admitted to is a much bigger than anticipated effective policy tightening. That sounds like a recession is on its way to us (if it wasn’t before). The Fed’s 25 bps hike, plus another 25 or 50 (or more) bps from credit tightening spells trouble when we’ve already witnessed problems from the Fed’s prior hiking policy.

We have been arguing for some time that the US couldn’t avoid a recession (either later this year or next) but we think that has already been priced in by the market. That does not mean that share markets can’t go higher from here – with a little bit of volatility thrown in. In due course, we think the Fed will review its policy and go easier on interest rates.

We are (and have been) somewhat sceptical about the tight US interest rate policy for two reasons. First, the supply side problems in inflation (from the Ukraine invasion and the pandemic etc) do not respond to rate hikes. Secondly, because we all agree that interest rates – if they work at all – act with a ‘long and variable lag’. In other words, it might be too soon to know whether the first hikes that occurred in March 2022 in the US and May in Australia, have yet had any impact let alone the subsequent hikes!

But there is a possible lesson from Japanese actions (or lack thereof). Japan just released its inflation print of 3.1% (as expected) which was down from 4.2% the month before (a recent record). You might ask how high did they force rates up to get that effect. The answer is that their official cash interest rate is still  0.1% and the Bank of Japan hasn’t hiked since 2016. Go figure!

The market expects (has priced in) that the Fed will have to cut rates this year as ominous signs of a slowdown in economic growth start to build. However, the Fed is still clinging on to a policy of no cuts to the Federal Funds (Cash) interest rate in 2023!

To summarise – markets have recovered well following the dip after SVB failed. There hasn’t been a material impact on broker forecasts of company earnings as published by Refinitiv. But that could be because brokers do not yet know how to react to recent changes in macro effects.

There is no longer ‘no alternative’ to equities as both bond and cash yields have recovered so a portfolio containing both shares and bonds may have greater merit than in recent years.

The RBA looks like it might be ‘on hold’ after these events. Either way, Australia could dodge the bullet owing to having a smarter central bank and China’s nascent resurgence.

Asset Classes

Australian Equities 

The ASX 200 didn’t have a good month – it was down  1.1% – but it has recovered from the mid-March low. Financials ( 5.1%) got hammered – probably because of the irrelevant knock-on fears from US regional bank woes. Property ( 6.9%) and Energy ( 4.8%) also saw losses.
We have the market as being slightly cheap and earnings forecasts are continuing to hold though we think the risk is, on balance, to the downside.

International Equities 

US equities were up on the month (S&P 500 rising 3.5%) after a big wobble in mid-March. Other international markets had a mixed month. It is too soon to see any new trend emerge but we are of the opinion that markets will work their way through a difficult March and beyond.

Bonds and Interest Rates

The US Fed did equities no favours in its about-face on interest rate hikes. There is a general consensus that the sharp rise in the Fed funds rate caused (at least in part) longer term Treasury yields to rise sharply. Those rises in yields directly caused big falls in the value of portfolios of supposedly safe bonds. Had investors been able to hold on to maturity, investors would have been rewarded but, in this mark-to-market world, assets of many financial institutions caused a mis-alignment between assets and liabilities.

The Fed and the RBA each hiked their base rate by 25 bps. The ECB, not to be outdone, went +50 bps. The Bank of Japan (BoJ) didn’t blink as it hasn’t for around seven years. Its rate is still  0.1% and its inflation rate fell from 4.2% to 3.1%.

The RBA is widely expected to be ‘on hold’ for a month but then go again.

The Bank of England (BoE) raised rates by 25 bps to 4.25% but their inflation rate rose to 10.4%.

Other Assets 

The price of gold was well up on the month (8.2%) but that of oil was well down ( 5.5% for Brent). The prices of copper and iron ore each grew modestly.

The Australian dollar against the US dollar fell by  0.3%.

The VIX, an index that measures US equity market volatility, returned to a level below 20, a more normal level after a period of higher volatility recently. This gives an indication that investors seem to be getting more comfortable with the direction of the market.

Regional Review

Australia

Our unemployment rate dropped back to 3.5% from 3.7% and a bumper 64,600 new jobs were created in February. The number of full-time jobs increased by 74,000 while part-time jobs fell by 10,300. These are incredibly strong labour force figures and indicate a reasonably robust economy during the period.

While the RBA might have wished for weakness in this data as a sign that inflation might soon ease, it has only been 10 months since the tightening cycle started. If the RBA maintains a tight monetary stance, we fully expect the unemployment rate to shift higher quite quickly but at some unspecified future point in time. After a bout of higher unemployment, the rate usually returns to levels consistent with full employment rather slowly.

Our 2022, December quarter GDP growth came in at 0.5% for the quarter or 2.7% for the year. The more important figure from that statistical report was that the household savings ratio, it fell to 4.5% from 7.1%. This fall demonstrates that households are not adding to their savings – whether for retirement or consumer durables – as they do in general.

China 

The Purchasing Managers Index (PMI) for manufacturing expectations came in at 52.6 at the start of March and 51.9 at the end, after having been as low as 47.0 at the beginning of the year. The re-opening of China’s economy after a three-year semi lock-down appears to be going well. The People’s Republic announced that it is targeting 5% or more growth in the coming period.

China seems to be committed to stimulus but with a focus oriented to a consumption led recovery as opposed to development as it has in the past. Evidence of its stimulatory approached was a cut to the Required Reserve Ratio (RRR) by 25 bps for banks, this enables them to lend a little easier.

Retail sales came in at 3.5% p.a. for January-February which was on expectations. Industrial output at 2.4% p.a. missed the expected 3.6% p.a. Fixed asset investment was 5.5% p.a.

US

The US recorded yet another bumper new jobs number of 311,000 – compared to a typical range of 200,000 to 250,000 in good times. The unemployment rate came in at 3.6% following the previous month’s 3.4%. Wage growth was moderate at 0.2% for the month.

CPI inflation came in at 0.4% for the month or 6.0% for the year. Core inflation – which strips out energy and food price inflation – came in at 0.5% for the month or 5.5% for the year.

Producer Price Index (PPI) inflation was actually negative at  0.1% for the month, 0.0% for the quarter and 4.6% for the year.

Personal Consumption Expenditure (PCE) inflation also showed nascent signs of recovery. The core version – which is the Fed-preferred measure of inflation – came in at 0.3% for the month against an expected 0.4% and 4.6% for the year. The headline rate was also 0.3% for the month but 5.0% for the year. While these data do not yet mark a victory for the Fed in its fight against inflation, it does seem to be getting close.

Since wages growth is now modest and PPI inflation shows input prices are not increasing, we expect consumer inflation (both CPI and PCE) to start falling to acceptable levels in the near future. Hence the Fed might soon pause and even consider cuts to its rate.

Both Powell and US Treasury Secretary Janet Yellen are reporting that banks have stabilised after the flurry of activity surrounding the SVB collapse. Fed data on its balance sheet reported at the end of March supported that view. There has been some outflow from banks of various sizes but they are largely offset by inflows to the money market. Some prefer to earn around 4% from the money market rather than close to zero in a bank deposit but the former is not insured as the latter is.

Europe 

UK growth came in at 0.3% for Q4, 2022 when a negative result was widely expected. Its inflation rate jumped back up to 10.4% from 10.1% despite continued increases in the Bank of England interest rate from 4.0% to 4.25%.

The ECB vigorously addressed the inflation issue with a 50-bps hike to its interest rate even though banking problems had just come to light in the US and Switzerland.

Rest of the World

Japan’s rate of inflation fell from 4.2% to 3.1% while the Bank of Japan has kept its rate at  0.1% since 2016.

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

Key points:

– The big fear of central bankers is a wage price spiral, this is not happening
– Recession fears are rising but China turning on again may help Australia dodge the bullet
– February sees some unwinding of the stellar equity market performance in January

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 our team.

The Big Picture

If January was a month of unbridled optimism in equity markets, February witnessed a big reality check.

Both the ASX 200 and the S&P 500 went up 6.2% in January which is slightly more than the historical average gain in a whole year on these indexes over a lengthy period.

The market was pricing in a ‘terminal’ Fed Funds rate of about 4.4% (for the end of December 2023) at the start of the year while the Fed had steadfastly reiterated its forecast of 5.1%. By late February, the Fed hadn’t budged but the market expectation was up to 5.3%! Capitulation.

Why did this happen? Of course, nobody knows what is really in the minds of the millions of investors but what seems likely is that the market had thought some of the inflation data would have improved more quickly than it did.

Central Banks around the world fear a ‘wage-price spiral’ gets out of control – as it did decades ago. US wages growth came in at 4.4% annualised in February while Australia’s statistic was just 3.3% for the year and less than the expected 3.5%.

In ‘normal’ times, we expect wage inflation to be about 1% above price inflation to give workers some of the benefits of productivity gains. If wage and price inflation remain equal to each other, people would not be getting better off over the decades! What would be the point of progress?

Our latest inflation read was 7.8% for the year while the US experienced 6.4% price inflation (CPI). In both countries, wages are not even keeping up with price inflation, let alone causing a wage-price spiral. Workers are going backwards in inflation adjusted (real) terms. There is no spiral.

Economists typically identify two types of inflation: demand-side and supply-side inflation. If costs were going up from wage claims (demand-side) then prices need to rise to at least maintain profit margins. Evidently, we do not have demand-side problems. But we do still have the supply-side problems that arose because of the Russian invasion, COVID pandemic, and climate change. Economically, interest rate changes have almost no impact on the supply side – one just has to sit it out and wait for equilibrium to be re-established. While the RBA and US Fed acknowledge this, they do not act on it.

So, what are Central Banks doing? They seem to be mostly concerned that if they pause the hiking cycle seemingly too soon and inflation stays where it is or jumps up, they will be blamed. The Fed has often stated that it would rather go too far with interest rates to be sure of containing inflation. The risk of this, that we are all becoming more aware of, is that the high interest rates dampen demand to the point where it contracts and ultimately results in an economic recession.

Everyone in the finance industry – assuming that they were properly trained – knows that the lags between tweaking rates and the real economy are ‘long and variable’. The Fed, the RBA and general economists keep stating that as a fact and we would agree. No one knows how long and how variable but the old adage from Nobel Laureates in the seventies was about 12 – 18 months. The lags might now be shorter – say 6 – 9 months – but there are lags. They could still be 12 – 18 months or even longer away. It is impossible for us to be precise on how long this lag will be.

Consider your own personal spending patterns. Many might feel committed to that weekly or monthly dinner out; the holiday you booked; the car you needed to replace; etc, etc. If the interest rate goes up even by a full 1% point you might still feel committed this time around but, by next year, you are maybe going for a nice pub lunch rather than a meal in a fine dining restaurant (or a take-out versus a café). When lots of people have these or similar feelings and act accordingly, the economy slows.

The Fed as late as the end of February re-stated that it was ‘data dependent’ and not ‘forecast dependent’. That means, with certainty, if one believes in any sort of lags, they will most likely not pause or cut before it is too late. Waiting for inflation to get back to 2% or unemployment to jump up means that any rate pause, or cut, will take months, if not years, to reverse recent economic behaviour. It took years to get the Australia unemployment rate back to full employment levels after the policy-induced 1990 recession.

China seems to be doing well after coming out of its prolonged COVID lock-down. Its PMI read, measuring manufacturing expectations, is ‘back in the black’ at 50.1 after a few dismal months. China can be a great help to us as it was in the so-called GFC period.

So where do we go from here?

1) The Fed seems intent on doing what it can to go too far in hiking rates. The plus side is that its labour force is still seemingly strong. The consumer was strong but it is now showing signs of capitulation. It doesn’t seem likely that the US can avoid a recession but it might not be too deep.

2) The RBA has been more moderate (so far) and China may help our economy to pull through. A recession is not a given but the risk of Australia experiencing one in the nearer term is clearly elevated.

3) China is coming back to the party, but not as quickly as anticipated and could be a key reason why the Australian economy may avoid a recession.

4) Europe is going round in circles just as water does before it goes down the gurgler. The UK just avoided a recession in Q4 but there are plenty of quarters to come. Europe got lucky with warmer winter weather. Next winter might not be so accommodating.

On the plus side, our analysis of Refinitiv broker-based forecasts of company earnings has shown a marked improvement in market prospects over the year-to-date. True, past earnings have been chalked down but equity prices depend on future earnings compared to today and not the past!

We expect to see continued market volatility over the next month or two as markets continue to react to central bank actions and inflation related data releases. Currently the markets appear pre-occupied with inflation and interest rates policy settings.

Asset Classes

Australian Equities 

The ASX 200 gave back some of its 6.2% gain made in January during February. The ASX lost 2.9% last month but it has still gained 3.1% on the year-to-date.
The resources and financials sectors bore the brunt of the losses. Five of the eleven industry sectors actually made gains in February.

International Equities 

Company reporting season in the US was a bit soft as expected and some big firms produced some very bad results. However, when we compare broker-based forecasts of future earnings forecasts with current (revised) expectations, future market prospects are holding up.

A possible US recession is not inconsistent with a positive market. The S&P 500 gave up a lot of ground last year ( 19%) so, to some extent, a recession might already have been priced in. Since market prices are based on expectations, rather than on past performance, the S&P can grow from here but heightened volatility can be expected in the near term as inflation data are updated and Fed reactions are assimilated into market prices.

The S&P 500 lost 2.4% in February making the year-to-date gain 3.6%. The German DAX, UK’s FTSE and the Japanese Nikkei indices all posted modest gains in February seeing them post gains of over 5% for the year-to-date.

Bonds and Interest Rates

As most expected, the Fed only hiked its Federal Funds (Cash) interest rate by 25 bps at the start of February to a range 4.5% p.a. to 4.75% p.a. It also stated that it would not be publishing its revised forecasts until its next FOMC meeting on March 22nd.

The US 10-yr Government Bond yield rose sharply over February to just under 4%. Along with this development, largely due to higher-than-expected inflation data, market expectations for the December 2023 Fed Funds rate have climbed. The CME Fedwatch tool publishes market expectations for the Fed Funds rate after future Fed meetings. The latest expected rate for end of December 2023 is 5.3% which is well above the 4.4% expectation made around the start of January. The market now expects a higher Fed Funds rate than the Fed itself for the first time in quite a while!

The RBA also hiked by 25 bps but to 3.35%. An accompanying statement leads us to believe that they at least have a couple more 0.25% increases planned for 2023.

In New Zealand the RBNZ hiked by 50 bps to 4.75% and it expects the rate to be 5.14% by mid-2023 and 5.5% by mid-2024.

After a significant portion of the market, following the February US Fed meeting, expected no change at the March meeting, the mood has shifted to around 23% expecting a 50bps hike. 99.2% expect the Fed rate to be higher than now by the year end.

Other Assets 

The prices of copper, gold, oil and iron ore each fell by around 2% to 5% during February.

The Australian dollar against the US dollar fell by around 4.4%. It started the year at 67.75 cents, peaked at 71.50 cents and it has now returned to just above 67 cents. Part of this move relates to a strengthening of the $US.

Regional Review

Australia

Our unemployment rate inched back up to 3.7% from 3.5% the month before. Total employment fell 13,700 but it had risen 17,600 in the prior month. The labour force has not yet shown any material signs of weakness from the interest rate hikes that started last May.
Our wage rate for Q4, 2022 was 0.8% for the quarter and 3.3% over the whole year. Wage inflation has been consistently below price inflation this past year.

China 

The Purchasing Managers Index (PMI) for manufacturing expectations came in at 50.1 after having been as low as 47.0 at the beginning of the year (a value above 50 indicates expansion and value below 50 indicates contraction). The re-opening of the China economy after a three-year semi lock-down appears to be in train.

An international banker that had just returned from a visit to mainland China at the end of February reported on CNBC that the bulk of the re-opening is seemingly well behind them and that China fiscal policy is sufficiently accommodative.

China CPI price inflation came in at 2.1% from 2.2% but only 1.8% had been expected. The Producer Price Index (PPI) was  0.8% compared to an expected  0.7%. Inflation in China appears to be well-contained.

We are cautiously optimistic that China’s economy will grow sufficiently in 2023 to provide some support the Australia economy. Some of the goods banned by China in the 2020 trade war have now been allowed to be imported again. A broader range of imported goods might soon be expected to follow suit.

US

The US recorded a bumper new jobs number of 517,000 in January – compared to a typical 200,000 to 250,000 monthly outcome. However, there were two big monthly spikes in the previous 12 months so the latest number might not be indicative of a new trend.

Since US President Biden’s infrastructure plan has already started, and is forecast to create 1.4 million jobs over the next while, the jobs market will be supported more than it might otherwise have been expected to do with higher interest rates.

The unemployment rate remained at 3.4% which is as low as it has been since the sixties. Wage growth is a little high at 4.4% if price inflation is to return to 2%.

The provisional December quarter GDP growth figure of 2.9% was revised downwards to 2.7%. September 2022 quarter growth was 3.2%. The Fed reported at its December meeting that it expected 2023 growth to be 0.5%. Updated forecasts are expected at its March 22nd meeting.

The latest US CPI monthly inflation read came in at 0.5% but when that is folded into our rolling quarterly analysis, US inflation has been between 2% and 4% since August 2022. The trailing 12-month annual calculation will not have the higher monthly inflation numbers reported in the first half of 2022 and will drop from August 2023 onward.

Europe 

The UK and European economies have done better than expected largely due to the unseasonal mild winter.
The ECB and the Bank of England both hiked their reference interest rates by 50 bps in February. UK inflation while still uncomfortably elevated is now at a six-month low of 10.1%.

It has been claimed that a deal has been brokered between the UK and the EU to deal with the vibrant and porous land border between Northern Ireland, part of the United Kingdom, and the Republic of Ireland which is part of the EU. This contentious issue has been a thorn in the side of the respective governments since Brexit started three years ago.