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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:

– Will the much-anticipated recession eventuate? If so, how much does it matter?

– US and Australian economies still look strong based on growth and employment data

– US inflation appears to have peaked (for now)

– China abandons zero-Covid policy and is experiencing a significant rise in case numbers

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

At the start of a new year, it seems a good time to reflect on lessons learned from the one that just ended. Most forecasters got bond and equity market forecasts wrong – and many by a big margin.

Some events are impossible to predict but are there ways to mitigate some forecast errors? The obvious ‘rule’ in finance is to diversify but what about in economics?

It is easy to blame poor market performance on China and Russia, amongst others. But, to some extent, the actual problems were of our own making.

For decades the talk was all about globalisation and the push to outsource the production of output and services to China and the rest of South East Asia. As a result, when the pandemic hit China, globalisation became the problem. The supply chain – particularly for semiconductors – broke and with demand outstripping the constrained supply, became a significant catalyst for inflation in the last couple of years.

Now that the horse has bolted, the US and others are building semiconductor plants elsewhere so that future country-specific problems will be partially offset as manufacturers can then switch their supply sources.

Although the Russian invasion of the Ukraine caused tragic loss of life, injuries and devastation, the economic impact on global inflation was caused, in part, by the reliance many countries placed on the Russian supply of oil and food. Not much could have been done about the food supply from the Ukraine but Europe is now backing away from the energy crisis seeking as quickly as possible to significantly reduce its dependence on Russian oil and gas, particularly for heating through the winter – again, after the horse has bolted.

The energy problem was exacerbated by the hectic switch to renewable energy. While a laudable target, it (in hindsight) wasn’t a smart idea to decommission fossil fuel power plants until the renewables sector was sufficiently strong. The UK, Europe and California are now bringing fossil fuels back to fill the void caused by Russia controlling the supply of energy, particularly to Europe. New England in the North East of the USA switched from using almost zero oil in electricity generation in October 2022 to 30% on Boxing Day!

At the stock and sector level of share markets, many investors were unduly affected by the sell-off in the mega tech sector in the US and its impact on the S&P 500 index. Even the ‘market darling’, Apple, hit a 52-week low in the last week of 2022. The falls in Tesla, Amazon, Meta (formerly Facebook) and many others lost a massive amount from their valuations. This reversal of the 2021 upward trend in tech wiped out much of the big gains of 2021 in particular for those who didn’t take enough off the table before the fall.

There was a useful discussion at the year’s end on CNBC about Tesla. It was pointed out that the share price of Tesla was about 21 times its earnings (the so-called P/E ratio) while that for the car industry as a whole was more like five times. So, after a massive fall in value over 2022, it has a lot further to go if one believes it is mainly a car manufacturer. If, however, Tesla is viewed as an IT company, its P/E ratio is in closer harmony with other stocks in that sector.

It is almost as though a number of ‘cult heroes’ came undone in 2022. The Green movement went too far too quickly on fossil fuels, Elon Musk devotees got their fingers burnt and Musk, himself, also got burnt on his Twitter purchase.

Parts of the crypto world also came undone. Sam Bankman-Fried’s (“SBF”) FTX exchange went from a valuation of over $30 bn to close to bankruptcy in rapid order as a ‘scam’ was unveiled. Two of SBFs lieutenants have pleaded guilty and SBF is reportedly about to seek a plea deal.

Elizabeth Holmes’ blood testing scam got her an eleven-year prison sentence. The 2021 ‘rock star’ fund manager, Cathie Wood, lost more than two thirds of the value of her ‘disruptor’ ARK fund over 2022. It has been reported that most investors didn’t get on board in her fund until near the peak so most lost more than those who gained during the rock-star growth phase.

We are not suggesting that people should not have invested in any of these companies. There may have been some red flags but investing always comes with risk. The essential point is that it is important not to go overboard on any one risky company. A managed fund, or broad-based stock market index, invests in many companies thus limiting losses when only a few component companies suffer badly.

As we launch into the new year, most are focusing on whether or not there will be a recession in the US and elsewhere, and what impact this may have on our investments. In Australia, a recession is defined as 2 consecutive quarters of negative economic growth as measured by Gross Domestic Product (GDP). It is worth noting that different countries use different methodologies for defining a recession. With the US Federal Reserve (“Fed”) and the Reserve Bank of Australia (“RBA”) looking to back-off hiking rates sooner rather than later, either the damage has already been done or, there won’t be much damage i.e. a mild slowing but not a recession.

But, as a word of caution, only a year ago the RBA said they wouldn’t raise rates until 2024! The overnight rate was then 0.1% and now it is 3.1%. The Fed one year ago predicted three 0.25% hikes. It actually made one 0.25%, two 0.50% hikes and four 0.75% hikes. It is not surprising, therefore, that equity market forecasters and others ‘got it wrong’.

Economic growth and the jobs markets in Australia and the US are currently unquestionably good so what then is the problem? It is widely accepted that monetary policy takes a long time to filter through to the real economy – 12 to 18 months was a generally accepted lag from the nineteen seventies onwards, however some are now saying the lag is shorter but there is no evidence yet to support such a claim. Interest rate hikes didn’t start until March 2022 so there’s probably a long way to go before the full effect is felt.

Some are arguing that because short-term yields (i.e. two-year bonds) are higher than long-term yields (i.e. ten-year bonds) a recession will follow. Again, the data on this hypothesis does not support that a recession is a forgone conclusion. It is also important to take the impact of inflation into account.

With rising prices, perhaps a more useful way to measure the cost of borrowing is to use the so-called ‘real rate’ which is the difference between the actual interest rate and inflation. With inflation having run well above government bond yields until recently, there was not much impost on the borrower unless the borrower’s wages or earnings weren’t keeping pace with price inflation.

In December, the US quarter three (Q3) GDP growth was revised upwards to 3.2% (annual). The Q3 result for Australia was 0.6% (for the quarter) and 5.9% annualised – both good results. The unemployment rates in both countries are near 40-year lows.

The trouble with relying just on these data points is that they can mask the ‘true’ underlying rate. Companies might hold on to workers longer than maybe they should because it is hard to re-hire good workers if a downturn turns out to be short. Consumers can borrow (or save less) to smooth out consumption. As a result, when a recession gets underway, the labour market and consumption can turn quickly. This is not a time to be complacent but fear doesn’t help either.

There is much discussion and conjecture around whether inflation has peaked. Because many people – particularly in the US – rely on calculating inflation over a 12-month period, any return to ‘normal’ rates will be masked by the very high inflation experienced in 2021 and the first half of 2022. Until this data ‘rolls out’ of the annual reporting period, it artificially skews the current reported level of inflation higher than it actually is.

Our analysis of monthly US CPI data shows quite clearly that inflation in that country got back to around 2% p.a. from August. In that sense, it is not a case that inflation has peaked (using a poor statistical tool) but 2% is back! Some of that return is due to the fall in oil prices. If that fall ends or some other burst of inflation works itself into the economy, inflation can go back up. There are no guarantees in economic forecasting.

In China, the government has walked away from its zero-Covid policy. This relaxation of restrictions could go in one of two opposing ways. On the good side, the supply chain could start to get fixed and China residents can start to travel to other parts and spend. The down side is that the rate of infection might continue to snowball and get out of hand. That could cause a global recession on its own.

We have not seen any reputable forecasters predicting the world will look rosy in the first half of 2023 although inroads might well be made. Data are already out from 24 well-known forecasters for the end-of-year 2023 value of the US S&P 500 share index on Wall Street. The range goes from around  15% to about +30% with a median consensus of +6% not including dividends.

The range is big because the known uncertainties are many and varied – and there are some unknown ones that might come and spoil the party! A positive year on Wall Street is not inconsistent with there being a recession. Markets get priced on expectations and some probability of a recession has already been factored into the current price.

We still think Australia can avoid a recession but it could be a close call. The US seems likely to be heading at least for a mild recession. It will all depend largely on how the RBA and the Fed conduct monetary policy from here on in, and all else unfolding without significant unanticipated disruption.

One thing is close to certain. Sitting totally out of the market while waiting to pick the bottom will likely result in getting back in too late and missing out.

Our analysis of US and Australian company earnings’ forecasts from major stock brokers is positive. Our forecasts of the two markets (Australia and the US) including dividends, are comfortably above those of government bonds.

The biggest known downside risk (apart from a more serious escalation of the Russian invasion of the Ukraine) is the possible impact of quantitative tightening (“QT”) in the US. For many years the US pumped trillions of dollars into the bond market through quantitative easing (“QE”) or bond buying. QT is a reversal of the QE policy so it is hard to think it won’t have some impact – but we have no past experience of such a policy. The first six months or so of QT do not seem to have had much of a detrimental effect. Of course, the Fed could slow down QT if it sees a problem emerging.

Australian Equities 

The ASX 200 had a poor month in December ( 3.4%) and an even poorer year ( 5.5%). Nearly all sectors went backwards in December with just Telcos making a slight gain.

As we get closer to the next reporting season in February, we note that the broker-based earnings’ forecasts have improved a little when compared to the current estimate. We now expect 2023 to show capital gains just below their long-term average of 5%.

International Equities 

The S&P 500 also had a bad December ( 5.9%) and a bad year ( 19.4%). The mega tech sector of the S&P 500 brought the index down in the first part of the year as rising bond yields made growth stocks less attractive.

The FTSE was the only major index we cover to post a gain in 2022, albeit a modest one at 0.9%.

Bonds and Interest Rates

The Fed eased back to a 0.5% increase in its fund’s rate from 0.75% at the December meeting. With an expected terminal (or peak) rate of 5.1%, the Fed should now be close to pausing its current regime of tightening monetary policy. The RBA also made a more modest hike of 0.25% in December. The RBA does not meet in January and the Fed’s next meeting is scheduled for February 1st, 2023.

In sharp contrast, the Bank of Japan (“BoJ”) kept its rate on hold at  0.1% in December. It has not changed its rate since early in 2016! Inflation in Japan is currently around 3.7%. The BoJ did however change its target rate range on 10-year government bonds from 0 ± 0.25% to 0 ± 0.5%.

The European Central Bank (“ECB”) and the Bank of England (“BoE”) each hiked rates by 0.5% to 2% and 3.5%, respectively.

Many longer-term government bond rates have come down from their 2022 peaks as investors increasingly believe that the inflation problem is coming under control.

Other Assets 

The price of iron ore did quite well in December (+16%) but the price of oil was flat. The prices of copper and gold made modest gains. The Australian dollar against the US dollar made a slight gain (+1.1%).

Australia

The latest jobs report in Australia continued to show that the unemployment rate is near a 40-year low at 3.4%. 32,600 jobs were created.

The third quarter National Accounts showed that Australian GDP grew by 0.6% in the quarter and 5.9% over the year. Australian households continued to lower their savings ratio – this time from 8.3% to 6.9%. The cutting back on savings has undoubtedly helped buoy economic growth. Since 6.9% is close to recent pre-pandemic savings ratios, there may be less support for future growth from this source.

China 

President Xi lost face to some extent over the dropping of the zero-Covid policy following public unrest. China does not have access to the mRNA Covid vaccines that have worked so well in the US and Australia. China’s infection rate has been climbing and it is not clear how infections will play out over 2023.

Chinese residents are now largely free to travel again but the US and Europe, among others, are seeking negative tests or more evidence of travellers from China being Covid free before allowing them to enter their countries. China is not responding well to the introduction of these policies.

Retail sales fell by  5.9% for the 11 months to November when a fall of  3.5% had been expected. Industrial production also missed expectations at 2.2%.

US

As with Australia, the US jobs report was again very strong. 263,000 jobs were created and the unemployment rate was 3.7%. Wages rose by over 5% suggesting workers are starting to get some claw-back on the real wage losses experienced earlier in the year.

Retails sales were  0.6% for the latest month when  0.3% had been expected but the Q3 GDP growth estimate was revised upwards to 3.2% from 2.6%. The US household savings ratio has been in the range of 2% to 3% in recent quarters giving US consumers less wiggle room to smooth consumption into the years’ end for 2022 and then 2023. The average savings ratio between 1959 and 2022 was 8.9% and peaked at over 30% at the start of the pandemic.

The Fed is predicting US growth to be 0.5% in each of 2022 and 2023 from previous forecasts of 0.2% and 1.2%. We believe that the Fed is fundamentally committed to reducing inflation to its target of 2.0% p.a. more than it is concerned about preventing a recession should one result from policies settings designed to achieve its inflation objective.

The plethora of US inflation data released in December caused most to think that inflation has peaked. We think CPI inflation returned to the target of near 2% possibly as early as the September quarter but future blips are possible if global policies again adversely impact domestic prices.

Europe 

The UK inflation rate came in at 10.7%, down from 11.1%. There is clearly an energy crisis which is impacting on the cost of living in the UK. Europe is also facing a bleak winter as it struggles to replace Russian energy supplies.

Rest of the World

Japan’s CPI came in at 3.8% with the core value stripping out energy and food prices at 3.7%. Japan has been able to control prices better than most because it had in place long-term policies to control energy supply and prices. The BoJ’s reference interest rate is  0.1%!

This was Treasurer, Dr Jim Chalmer’s first budget and the first for the Labor government since winning the election in May this year. The government came to power against a backdrop of the economic disruption and commodity-driven inflationary pressures stemming largely from the Covid-19 pandemic and the war in Ukraine, with anemic wage growth, skills shortages, underemployment and energy costs rising out of control during the current transition from fossil fuels to renewable energy and natural disasters, to name a few.

If the market’s reaction to recently deposed UK Prime Minister Liz Truss’s economic plan for the UK based on spurring economic activity with further quantitative easing in a volatile and increasingly inflationary environment was any “how-not-to” guide for our newly minted government, they certainly heeded the message.

In his budget address, the Treasurer talked about some of the current global challenges and high inflation and laid out a plan built on “responsible, reasonable and targeted” economic management and “exercising fiscal restraint so as not to put more pressure on prices and make the Reserve Bank’s job even harder.”

So, we didn’t see any broad cash splash, which will leave a lot of people scratching their heads thinking, “how does this help me and my family with the cost-of-living pressures we’re all facing?”  Instead, the Budget sets out a targeted 5-point plan for cost-of-living relief in the areas of childcare, expanding paid parental leave, medicines, affordable housing and wage growth.

There were also announcements in areas such as preparing for the referendum to enshrine a First Nations Voice to Parliament in the Constitution, funding 480,000 fee-free TAFE and community based vocational education places, increasing the maximum co-payment under the Pharmaceutical Benefits Scheme (PBS), further funding for the transition to cleaner energy (including a commitment to a national rollout of hydrogen refuelling and charging stations for hydrogen and electric powered vehicles), a $15 bn reconstructions fund to help address the devastation cause by the recent multiple east-coast flood events, commitment to continue addressing violence against women and children, veteran suicide, repairing the NDIS and preserving our military strength, among many others.

However, was there anything for individuals and businesses for tax, superannuation, social security or anything that we can really hang our hats on when looking at wealth creation and retirement funding strategies? Not really. Let’s look at the economic numbers first and decide who the winners and losers might be out of this budget.

Some good news is that while higher prices are impacting all of us, the government has picked up a handy $150 bn windfall in extra revenue from higher commodity prices. The budget deficit is actually $100 bn better than the forecast from the previous budget and while inflation is expected to peak at around 7.75% by Christmas, it is projected to moderate to 3.5% through 2023-24 and return to the Reserve Bank’s target range of 2.0% to 3.0% in 2024-25.

On the downside, the economy is expected to grow by 3.25% in 2022-23 but is then predicted to slow to 1.5% for 2023-24, lower than the 2.5% that was forecast in March.

The Budget estimates an underlying cash deficit of $36.9 billion for 2022-23 (and $44bn for 2023-24). Net debt projected in the March budget of $714.9 billion for 2022-23 and peaking at $864.7 billion (33.1%) in 2025-26, is reasonably better at $766.8 bn (28.5% of GDP) but borrowing is more expensive in a higher interest rate environment, so it doesn’t seem there was much wriggle room on any cash splash … pity.

At a high level, this budget contained a range of very specific measures targeting taxation, superannuation, housing and social security but no wholesale tweaking or reforms that really enter conversations on wealth creation and retirement funding strategies. The following summary is not complete and focusses only on the specific taxation, superannuation and social security measures. Some of the following announcements are described in more detail further on in this report.

• Personal tax rates remain unchanged for 2022-23 and the already legislated Stage 3 tax cuts starting from 2024-25 unchanged.

• Cryptocurrency is not a foreign currency – as governments around the world tackle with how to assess gains and losses on crypto, the Government will introduce legislation to clarify that digital currencies (such as Bitcoin) continue to be excluded from the Australian income tax treatment of foreign currency.

Superannuation

• Super downsizer contributions – the government confirmed that it will reduce the eligibility age to 55 (60 currently).

• SMSF residency changes – the proposal to extend the central management and control (CM&C) test safe harbour from 2 to 5 years, and remove the active member test, will now start from the income year commencing on or after assent to the enabling legislation (previously 1 July 2022).

• SMSF audits every 3 years – the Government will not proceed with the former government’s proposal to allow a 3-yearly audit cycle for SMSFs with a good compliance history.

• Retirement income products – the Government will not proceed with the proposal to report standardised metrics in product disclosure statements (PDSs).

• Affordable housing measures – the Government will establish a Regional First Home Buyers Guarantee Scheme and a Housing Australia Future Fund.

• Housing Accord – targeting 1 million new homes over 5 years from 2024. The Government will commit $350m over 5 years to deliver 10,000 affordable dwellings. The Accord has been struck between State and Territory governments and investors and will include super funds.

• Paid Parental Leave (PPL) scheme – to be expanded from 1 July 2023 so that either parent can claim the payment. From 1 July 2024, the scheme will be expanded by 2 additional weeks a year until it reaches a full 26 weeks from 1 July 2026.

• Childcare subsidy – maximum CCS rate to be increased from 85% to 90% for families for the first child in care and increase the CCS rate for all families earning less than $350,000 in household income.

More detail on a few of the measures

There were no changes to personal tax rates announced in this budget. The Government’s legislated three-stage tax plan that was announced in 2018 and enhanced in 2019 is as follows.

• Stage 1 amended the 32.5% and 37% marginal tax brackets over 2018-19 to 2021-22 and introduced the Low- and Middle-Income Tax Offset (LMITO);

• Stage 2 was designed to further reduce bracket creep over 2022-23 & 2023-24 by amending the 19%, 32.5% and 37% marginal tax brackets: and

• Stage 3 was aimed at simplifying and flattening the progressive tax rates for 2024–25 and increasing the Low-Income Tax Offset (LITO). From 1 July 2024, there will only be 3 personal income tax rates – 19%, 30% and 45%. The Government estimated that around 94 per cent of taxpayers would be on a marginal tax rate of 30% or less (as shown in the tables below).

The LMITO increased by $420 for the 2021-22 income year so that eligible individuals (with taxable incomes below $126,000) received a maximum LMITO up to $1,500 for 2021-22 (instead of $1,080).

There was no announcement in this Budget of any extension of the LMITO to the 2022-23 income year meaning the LMITO has effectively ceased and been replaced by the low-income tax offset (LITO) (described below).

The low-income tax offset (LITO) will continue to apply for the 2021-22 and 2022-23 income years. The LITO was intended to replace the former low income and low- and middle-income tax offsets from 2022-23, but the new LITO was brought forward in the 2020 Budget to apply from the 2020-21 income year. The LITO will continue to apply for the 2022-23 income years and beyond.

Superannuation

The Government confirmed its election commitment that the minimum eligibility age for making superannuation downsizer contributions will be lowered to age 55 (from age 60). This measure will have effect from the start of the first quarter after assent to the enabling legislation – the Treasury Laws Amendment (2022 Measures No 2) Bill 2022 (introduced in the House of Reps on 3 August 2022).

The proposed reduction in the eligibility age will allow individuals aged 55 or over to make an additional non-concessional contribution of up to $300,000 from the proceeds of selling their main residence outside of the existing contribution caps. Either the individual or their spouse must have owned the home for 10 years.

As under the current rules, the maximum downsizer contribution is $300,000 per contributor (i.e., $600,000 for a couple), although the entire contribution must come from the capital proceeds of the sale price. A downsizer contribution must also be made within 90 days after the home changes ownership (generally the date of settlement).

Specific to the social security assessment of the proceeds from selling a principal place of residence, the Government also confirmed its election commitments that seek to assist pensioners looking to downsize their homes, by:

• extending the social security assets test exemption for sale proceeds from 12 months to 24 months; and

• changing the income test to apply only the lower deeming rate (0.25%) to principal home sale proceeds when calculating deemed income for 24 months after the sale of the principal home.

These measures are contained in the Social Services and Other Legislation Amendment (Incentivising Pensioners to Downsize) Bill 2022 (introduced in the House of Reps on 7 September 2022). The Bill will commence on 1 January 2023 (or 1 month after the day the Bill receives the assent).

The Government announced that it will expand the Paid Parental Leave (PPL) scheme from 1 July 2023 so that either parent is able to claim the payment and both birth parents and non-birth parents are allowed to receive the payment if they meet the eligibility criteria. The benefit can be paid concurrently so that both parents can take leave at the same time. From 1 July 2024, the Government will start expanding the scheme by 2 additional weeks a year until it reaches a full 26 weeks from 1 July 2026.

Sole parents will be able to access the full 26 weeks. The amount of PPL available for families will increase up to a total of 26 weeks from July 2026. An additional 2 weeks will be added each year from July 2024 to July 2026, increasing the overall length of PPL by 6 weeks. To further increase flexibility, from July 2023 parents will be able to take Government-paid leave in blocks as small as a day at a time, with periods of work in between, so parents can use their weeks in a way that works best for them. Further changes to legislation will also support more parents to access the PPL scheme. Eligibility will be expanded through the introduction of a $350,000 family income test, which families can be assessed under if they do not meet the individual income test. Single parents will be able to access the full entitlement each year. This will increase support to help single parents juggle care and work.

Business taxation

Businesses, particularly small businesses faced with ever-increasing energy and other costs will be disappointed with this budget. The government announced new integrity measures for off-market share buybacks, new anti-avoidance measures for significant global entities (SGEs), dropped a previously announced budget proposal from 2021-22 to allow taxpayers to self-assess the effective life of intangible depreciating assets and dumped a swathe of previously announced finance-related proposals and deferred a few more. But the government did announce new reporting requirements in the name of increasing tax transparency and also increased funding to the ATO (and the TPB) for tax compliance programs.

Probably the only measure of some relevance relates to businesses who benefitted from various State and Territory COVID-19 grant programs which the government announced would be eligible for non-assessable, non-exempt (NANE) treatment, which will exempt eligible businesses from paying tax on these grants.

Conclusion and where to from here?

Truth be told, this has been a very “unexciting” budget. There were no visionary reforms or even minor tweaks. The government had to face the hard task of what potentially irresponsible spending might do in a high-inflation environment and it has certainly chosen the more “responsible” and conservative route, which is the usual course for a government in its first term. It will be interesting however to see how the electorate responds in the face of crippling cost of living challenges, especially given the government came to power on a platform of “no one will be left behind”.

With inflation projected to moderate to 3.5% through 2023-24 and return to the Reserve Bank’s target range of 2.0% to 3.0% in 2024-25, and the net debt position on the improve, maybe we’ll see a bit more cheer as we get through the second and into the third term of government (some spending might go down well before the next election, if we can afford the electricity bill for our frozen dinners, TVs and Wi-Fi).

As with all budget announcements, the measures are proposals only and need to be enacted by Parliament.

I urge readers to contact your financial adviser with any specific questions you may have.

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

Key points:

– US Fed maintains hawkish stance increasing interest rates by 0.75% again

– Volatility persisted and, in some instances, increased for Equities, Bonds and Currency

– Economic data remained mixed but the prospect of a recession rose over the month

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 us.

The Big Picture

The fledgling bounces off the June lows into mid-August reversed to give all of the gains back. The ASX 200 and the S&P 500 both more or less touched the June lows in late September after an impressive mid-period rally.

The biggest relevant change for markets over the past couple of months has been the US Federal Reserve’s (Fed) stance on monetary policy.

In mid-September, the US core CPI inflation (that strips out volatile items like energy and food) actually rose from 5.9% the previous month to 6.3% for August. Wall Street fell 4% over the session following this data release.

There were a number of relatively good US inflation prints in September, but the media and investors focused on the worst. It is true that the monthly wholesale price inflation was  0.1% and monthly headline CPI inflation was only 0.1% but these two prints did not receive the attention that they deserved.

What is possibly happening is that energy and food prices are falling but the indirect effect of these items on inputs to other goods and services is following through with a lag.

Nevertheless, Fed chair, Jerome Powell, is beating his drum even louder about doing whatever it takes to rid the US of this “scourge” called inflation.

He openly admits there will be ‘pain’ – to the tune of the unemployment rate rising from a recent low of 3.5% to 4.4%. That rise translates to about one million people losing their jobs. A Yahoo Finance columnist pointed out that deliberately inflicting pain is called ‘cruelty’.

So, what should be the trade-off between jobs and inflation? The latest annual core PCE (Personal Consumption Expenditure) inflation figure – the Fed’s preferred measure – was only 4.5%. Does bringing that rate down from 4.5% to 2% – if, indeed, that can be achieved from the high interest rate policy – justify the loss of a significant number of jobs as the economy slows, and possibly enters recession?

Many analysts, including ourselves, are becoming increasing convinced that a US recession in 2023 or 2024 is almost inevitable. A recent Bloomberg survey put the odds for a US recession at 50% and those for the UK at 60% while Australia only attracted a 25% chance. Some big names in finance are now making stands about an imminent US recession.

Our official interest rate is still at a modest 2.35% following the 0.5% increase at the start of September. Retail sales grew by just 0.6% in the latest month (August) following 1.3% in the previous month. Our latest GDP figure (June quarter) was 3.6% for the year. These data are not at levels that indicate immanent recession.

While we do not seem to be at risk of recession in the near term, caveat being the Reserve Bank of Australia (RBA) does not implement a major policy mistake. So far, the RBA governor, Dr Philip Lowe, looks far more in tune with the realities of current policy than Jerome Powell, his Fed counterpart. In Australia, there is even a groundswell of opinion supporting the view that Lowe could pause the current rate hiking programme. Prior to the RBA policy announcement on Tuesday 4 October to increase the RBA Cash rate by 0.25% instead of the anticipated 0.50%, So it is clear Dr Lowe taking a softer line on interest rates which surprised the market somewhat. However, in his brief commentary that accompanied the decision he noted that further rises are likely if inflation is to be returned to the 2% to 3% band.

There are still significant supply-side issues affecting inflation courtesy of the Covid lockdowns. Besides the supply-chain problem, caused to a significant extent by China’s zero covid policy, the situation is further exacerbated by US dock unions who are into their fourth month of industrial unrest at major west coast ports.

Despite these impediments, supply side issues are dissipating slowly, food prices seem to be better contained than earlier in the year. But the Russian invasion of the Ukraine continues to impact on energy supply volatility and, hence, prices. Notwithstanding oil prices have retreated to levels below those prior to the start of the war, and OPEC is meeting to discuss production cuts.

Russia cut off much of its energy supply to Europe until, reportedly, sanctions on Russia are removed. At the end of September there were significant leaks from the gas pipelines under the Baltic Sea which some are claiming could be the result of sabotage. Perhaps the more significant invasion issue is Russian troops being forced out of parts of the Ukraine as the now better armed Ukraine army reclaims recently relinquished territory, China’s Premier Xi met with Putin in Uzbekistan and, apparently was less than sympathetic with Putin’s stance regarding Ukraine. Nevertheless, Putin has ordered a ‘partial mobilisation’ (read mini conscription) of 300,000 new troops to add to the original 150,000 sent at the start of the invasion. There are reportedly of the order of 70,000 – 80,000 Russian casualties so far from the initial 150,000 deployed.

Two new big problems have emerged for Putin. Many of the original soldiers that joined on short-term contracts have now been made ‘indefinite’ in the partial mobilisation bill. Many new conscripts are poorly trained and some are reportedly people who were arrested for opposing the invasion. These factors do not make for a cohesive fighting force. Putin might find it very difficult to maintain his offensive, particularly as winter approaches.

If it were not for the ability of Russia to affect a nuclear weapons response, it would seem that the invasion of the Ukraine may lose its potency. No one seems to know if Putin can, or really wants to, resort to the nuclear option, albeit a limited one.

At the end of September, Putin declared that four regions of the Ukraine had voted in referenda to be annexed to Russia. He signed a treaty confirming the new status.

There is widespread condemnation that these referenda were rigged. Regardless of this Putin might now claim he is defending Russian soil in these ‘previously’ Ukrainian regions. That could drastically alter the positions of the West on the one hand and Russia on the other. There is as yet no clear opinion about how this latest move will play out.

China economic data showed some resilience in September but Europe is not faring well. The Bank of England (BoE) had largely lost control of its monetary policy with the pound sterling in all but free-fall. The BoE has pushed its official rate up to 2.25% which is the highest since 2008 and inflation is running at 9.9%, albeit down from 10.1% the month before. UK retail sales came in at  1.6% for the month with  0.5% having been expected.

The UK government is trying to find many solutions for the economic malaise including unfunded tax cuts for higher income brackets though it appears these have been rescinded. There are caps and subsidies being applied to help make energy costs more palatable as heating bills start to mount. There is widespread condemnation of the new UK parliament’s policies.

Indeed, the BoE on September 29th was forced into averting a crisis by buying over one billion pounds of long dated (20 – 30 yr) bonds and promising to buy around five billion a day until the middle of October. It is being forced to do this because of the profligate government policies now being labelled as ‘Trussonomics’ after the newly sworn-in prime minister, Liz Truss.

Of course, the BoE, along with the Fed, RBA and most other central banks was trying to do the opposite of bond buying (or quantitative easing, QE). The upshot of the new BoE action is likely to be even higher inflation for even longer.

Wall Street and the ASX 200 did start an impressive 2% bounce back near the end of September but that was cancelled out, and more, over the following days. We do not think this is the start of a solid rally. It is more likely that inflation and central bank news over the next couple of months would have to be very positive for a sustained rally to get going at this juncture. Rather we see some choppy trading for a couple of months or more and then, if the Russian invasion impact dissipates and supply-side factors come back into line, a share market rally could well start before the end of this year or early into next However, the situation remains very fluid.

As always, we don’t advocate investors trying to time the market. We saw a big rally from mid-June until mid-August get reversed. That could happen again. Long-term asset allocations that evolve with conditions are preferred to possible trading solutions.

With Australian 10-yr government bonds yielding around 4% near the end of September, equities are less compelling. However, ASX 200 equity yields have been reasonably stable at over 4% in addition to franking credits for many investors. There is not yet any evidence from Refinitiv’s survey data on company earnings in the US and Australia for us to move away from our current asset allocations in any meaningful way.

Australian Equities 

The ASX 200 had an abysmal month falling by around 7%. The sell-off was largely across the board. As a result, we have the index as currently being cheap but cheap markets can fall before they rise! We believe that far more certainty over inflation and the Ukraine invasion may be needed for a sustained rally to take hold.

Our analysis of the Refinitiv survey of company earnings forecasts suggests that fundamentals are still improving albeit at a slower pace than the historical average.

International Equities 

Major indexes sold off by around  5% to  10% over September. Many have put the sell-off down to the stubbornness of inflation in the face of interest rate hikes and a consequent heightened risk of a global recession.

We see some glimmers of hope on the inflation front but not by enough to feel confident of an early resolution to the volatility in equity markets. Our most optimistic expectation is for stronger signs of falling inflation by Christmas and a realisation by central banks that further rate hikes would most likely cause an unnecessary recession. If such a scenario came to pass, a hard landing might be avoided with equity markets then rising to erode what we see as a material degree of under-pricing.

Our analysis of the Refinitiv survey of US company earnings remains optimistic with expectations of above average capital gains in the coming 12 months. Such an outcome seems inconsistent with the expectation of an impending recession. The brokers who supply the forecasts to Refinitiv might actually not believe in the elevated odds of a recession occurring soon or they may believe any recession might be pushed back to 2024. It all depends upon the lags between monetary policy and the real economy.

Back in the seventies when a similar high interest rate policy was unsuccessfully used to control the fall-out from the OPEC oil price shocks, economists generally agreed that monetary policy took between 12 – 18 months to take effect. Some obviously believe the lags are now much shorter but there is no clear evidence for that. Since US rates have only just moved into contractionary territory, the 12 – 18 months hypothesis would lead one to speculate that a recession, if it occurs, will not take full effect until 2024.

Bonds and Interest Rates

There has been elevated volatility in bond markets around the globe mainly because of the almost co-ordinated aggression by central banks about trying to use interest rate hikes to control inflation.

The yield curve in the US is flat to inverted over much of the curve. The Fed yet again hiked rates by 0.75% to a range of 3% to 3.25% in September. Many economists would agree that the current Fed funds rate is firmly in contractionary territory.

The CME Fedwatch tool that prices future Fed rate hikes is giving almost equal weight to a 0.5% and a 0.75% hike on November 2nd at the next meeting.

The RBA raised rates by 0.5% to 2.35% which is probably just under the neutral rate and, therefore, not yet contractionary. Nevertheless, the 10-yr yield rose above 4% towards the end of the month. The differential between the Australian and US 10-yr yields is still positive but much reduced compared to earlier in the year. There is a growing sentiment that the RBA is lessening its resolve to continue hiking and may well pause soon. Since much of inflation is sourced from overseas supply problems, such a move by the RBA, if it occurs, might prove to be an excellent decision.

The BoE seemingly just averted a currency crisis on September 29th by starting to purchase its own long bonds again. Earlier in the month it had increased its official rate by 0.5% to 2.25% – its highest rate since 2008. And it seemed on a path to do more. After the recent intervention, it is less clear what its next move will be.

The ECB at last hiked its rate above zero in a 0.75% increase to 0.75%. Japan is still on hold (at  0.1%) but its inflation is well-contained at 2.8%. Japan largely went against raising rates in the seventies and eighties with the result that its economic growth did not stall as it did in much of the rest of the developed world.

Other Assets 

The US dollar has gone from strength to strength against many currencies. The Chinese yuan fell to a fourteen-year low and the pound sterling fell to an all-time low against the US dollar. The Australian dollar has lost about 10% during the current year-to-date of which 6% was in this last month. Much of this currency weakness is due the increasing yield on long dated US treasuries compared to those of other nations. In turn, the higher US yield is due to Fed action and the strength of US price inflation.

Many commodity prices fell in September. Oil prices are down around 10%. Copper, iron ore and gold prices are down around 1% to 3%.

Australia

Last month we reported a sharp fall in Australian employment but pointed out that it could just have been a statistical blip. This month (for August) 33,500 new jobs were created more or less cancelling out the  40,900 jobs lost in July. The unemployment rate rose to 3.5% from 3.4%.

The GDP economic growth rate for the June quarter was released last month. It came in at an impressive +0.9% for the quarter or +3.6% for the year. As we have been arguing since 2020, some of the growth is coming from households running down their savings plan made in the early part of the pandemic.

The household savings ratio has fallen from a peak of 23.7% in the June 2020 quarter to 8.7% two years later. Since this ratio was tracking between 4% and 8% in the years before the pandemic, we do not think there is much more to be gained from a falling savings ratio in quarters to come.

Retail sales again performed strongly in the latest month delivering a growth of +0.6% following the previous month’s +1.3%. Of course,these two months come from the September quarter. There is a substantial lag in computing and publishing GDP accounts.

While a recession is always possible in any country almost at any time, we do not think the recent economic data and the RBA action are consistent with an imminent recession here. Naturally, if the US and Europe head towards recession, and if China does not pick up some more speed in its economy, a global slowdown would impact an otherwise and currently healthier Australian economy.

An experimental monthly inflation series was launched by the Australian Bureau of Statistics in September. It has a much smaller coverage than the preferred quarterly series which will continue to be published. We have chosen to wait a few months before we take the new data series fully into account so that we will have a reasonable history on which to base our analysis.

China 

The China data on retail sales, industrial production and fixed asset investment that are published each month all beat expectations. Retail sales at 5.4% was impressive in absolute terms and against its benchmark expectations of 3.5%. Industrial production at 4.2% beat its expected value of 3.8% and fixed asset investment at 5.8% beat the expected 5.5%.

China’s official PMI (Purchasing Managers’ Index) came in at 50.1 just above the 50 mark that divides expansion from contraction. The previous month’s value was 49.4 and the expected value for the latest month was also for a contractionary reading.

On October 16th the China Communist Party is expected to re-elect President Xi for an historic third term. Whether such a result leads to further economic stimulus is yet to be seen. However, it is reasonable to expect some major policy initiatives. Of course, the West would not want that to include any move on Taiwan. However, Xi draw on his observation of the experience Russian President Putin has had with his attempt to annex Ukraine in forming his approach to the reunification of Taiwan.

US

Yet again, the US posted a really big nonfarm payrolls number. 315,000 new jobs were created in August but the unemployment rate rose from 3.5% to 3.7%. Wage inflation came in at 5.2% which is comfortably below the inflation rate meaning that spending power in general continues to go backwards.

Powell, in his desperate attempt to control inflation, sees not only the unemployment rate jump up to 4.4% from the recent low of 3.4% but GDP growth falling to 0.2% for 2022 from his forecast made only three months ago of 1.7%. The Fed sees growth rising to 1.8% for 2023. This 2022 forecast is an open admission that his monetary policy tightening is increasing the risk of a recession.

Biden’s push for student debt forgiveness has just been priced at $400 bn. And that is for $10,000 of forgiveness for people under an annual income of $125,000 (in most cases). Largesse does not come cheaply. We hope this does not start to lean towards engaging in ‘Trussonomics’ in the US as it has in the UK.

Retail sales, which are not adjusted for inflation, only came in at 0.3% for the month of August which does not stack up well against the CPI inflation rate of 6.3% for the year.

Europe 

Perhaps the severity of the fighting in the Ukraine is far from its peak but the consequences for energy and food supply are not seemingly much diminished. Putin’s objectives were never well articulated but whatever they were, the direction of his policies seem to be shifting.

There are now reportedly four breaches of the under-sea gas pipelines from Russia to Europe. Not only is this a major loss of resources but it is also a major obstacle for shipping in the Baltic. Russia is denying any involvement but sabotage by seems more likely than a naturally occurring fault.

Rest of the World

Japan inflation came in at 2.8% which is the highest level since 2014. Of course, Japan has not been playing the interest-rate-hiking game and yet most central bankers would die for such a low rate of inflation at the moment – particularly with its official interest rate still being negative!