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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:

– 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.

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

Key points:
– US Fed considers slowing down rate hikes as inflation data eases for October.
– China sees increasing protests over its Covid lockdowns as Covid cases rise.
– Oil prices could face turbulence and the EU caps the price of Russian oil at US$ 60 per barrel.
– Despite the higher interest rates the US and Australian jobs markets remain resilient.

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

The Big Picture

The second anniversary of the start of the pandemic in China is about to take place. While Western countries largely now seem to be on top of Covid – through strong vaccination programmes and selective lockdowns – China is still struggling with the virus. Indeed, now the people of certain large Chinese cities are starting to protest against more lockdowns.

China is very different from the West in that the China vaccines are not very effective. Just as we in Australia suffered at the start from the then government putting all of its vaccination eggs in the less effective AstraZeneca basket, China apparently has no major access to the mRNA vaccines (such as Pfizer and Moderna) that proved very effective in much of the rest of the world.

The ’knock-on’ impact of China lock-downs for the West has been supply-side disruptions such as semiconductor chip shortages. In turn, supply-side shortages fuelled inflation in the West that has been resistant to monetary policy – especially interest rate hikes.

It has been argued by ‘experts’ on CNBC that Premier Xi does not want to back down on his lock-down strategy because he wants to show he was right in his call. That does seem to be a major obstacle to resolving China growth issues and our ability to deal with inflation at home. However, the new protesting in China cities may have a positive impact.

The start of December may also witness inflation volatility from various oil supply decisions. The OPEC+ Russia oil meeting scheduled for December 4th will be immediately followed by the introduction of the EU policy on Russian oil imports. The problems will further be compounded by price capping on Russian oil exports.

It is less than obvious from the news wires that anyone has a clear idea of how these December events will play out in the oil market. One thing for certain is that one shouldn’t rule out the possibility of an oil-price spike.

Stock markets have now witnessed what have turned out to be five or six bear market rallies this year and more may follow before a clear market direction emerges.

Meanwhile, the US Federal Reserve (the “Fed”) has seemingly walked away from its successive 75 bps rate hikes. It now seems like 50 bps is the main call for the December 14th meeting. Some analysts are suggesting that 5% will be the terminal (maximum) US Fed funds rate to be achieved in about May 2023. Since the current rate is in the range 3.75% to 4.0%, only two 50 bps hikes will get them to 5%. There are eight meetings per year!

The Fed doesn’t want to appear to be weak in signalling the end of the hiking cycle given that inflation has not yet dipped by much, if at all. Another strategy might be for the Fed to go well past 5% and then have to retreat quickly when problems emerge.

Jerome Powell, the Fed chairman, reiterated a slower pace for rate hikes in his end-of-November speech. The S&P 500 rallied 3.1% on that confirmation. There is now a blackout on Fed speeches until the December 14th FOMC meeting concludes.

At least our central bank, the RBA, has not yet ‘overcooked’ it with respect to interest rate policy. We do not have to follow the US into recession, assuming one occurs, any more than when we avoided a global recession in 2008-9.

Jobs in the US and Australia are holding up very well. We also had a relatively strong jobs market at the end of 1989 as the overnight cash rate was cut in big moves from around 18% to about 4%. Nevertheless, the unemployment rate then rose steadily to double figures in the following three years and did not return to the late eighties level until around the time of the start of the GFC in 2007.

Monetary policy isn’t easy to conduct. Indeed, it may even be fair to say that it is more of an art than a science. What we don’t want to happen is for central bankers to flock together in raising rates too far, i.e. driving the world into recession, only then to cry out that everybody else got it wrong too.

It is not sufficient for central bankers to use broad statements like ‘keeping the foot on the pedal until inflation pressures ease’. Central bankers should be forced to articulate the mechanism of how that pedal actually causes the desired policy result. Most recessions have been associated with central banks hiking rates too far. With lags between monetary policy changes and its impact on the real economy being at least six months and possibly well over a year, we know it is far too late to wait until we see inflation cooling and unemployment rising before central banks start to cut rates or even pause.

Powell was correct in his recent speech when he said history shows the problems that can occur by cutting rates too soon. He neglected to say that there is more evidence of recessions emanating from rates being held too high for too long.

A consensus seems to be forming that a US recession might start to become evident in the first half of 2023. We think it could take a little longer to emerge. If the Fed goes beyond a funds rate of 5%, we might see a more serious recession than many are considering.

However, much of this gloomy outlook may well have already been priced into the stock market so that new lower market lows may be avoided. The similar market lows in June and October of 2022 may again be tested but we do not, at this point, anticipate material falls to below these levels.

An unusually large release of important economic data and events is expected in the first two weeks of December. We doubt if there could be enough good news to spur the market materially higher into 2023 but there could be enough to help us relax over the festive season. In particular, the last Fed meeting of the year on December 14th could be pivotal.

Asset Classes

Australian Equities

The ASX 200 had another great month in November with a 6.1% gain, after October’s 6.0% gain, but this two-month bounce-back followed a 7% loss in September. Most sectors did well in November and Utilities (20.8%) and Materials (16.2%) were standouts.

We no longer believe that this market is under-priced compared to its fundamentals. If the rally continues into the close of the year, there could be opportunities to take a little off the table if recession talks heighten.

International Equities

The S&P 500 also gained in November by a similar amount of 5.2%. However, the ASX 200 did not get the chance to react to Powell’s speech in the month of November as our first trading session post the speech was on 1 December. The third quarter company earnings season turned out to be better than many had expected. However, earnings expectations were being modified downwards by analysts before the season began.

The Shanghai Composite (8.9%) and the Emerging Markets (9.6%) indexes performed particularly well during November as optimism grew over a less stringent lockdown policy in China taking effect.

Bonds and Interest Rates

The Australian 10-yr yield peaked at 4.2% in 2022 but that yield has since retreated to 3.5% as less alarmist expectations about RBA rate hikes emerged. The RBA surprised some in the market by only hiking the overnight cash rate by 25 bps to 2.85% on Melbourne Cup Day. With the bank not meeting in January, and the strong likelihood that the RBA will not now hike by 50 bps again, they did increase the official cash rate one last time for calendar year 2022 with an increase of 0.25% on Tuesday 6th December.

The Fed seemed to be backing away from hiking the funds rate by 75 bps again. However, it is talking tough so that inflation expectations do not take hold. Consensus is for a ‘terminal rate’ of about 5%, or slightly above, sometime in mid-2023.

The Bank of England did hike by 75 bps to 3.0% in November. This was its biggest hike in 40 years and the UK’s latest GDP growth came in negative.

A lot of the current optimism around interest rates possibly stems from the latest US CPI data release. The month-on-month increase for October was lower that consensus estimates, coming in at 0.4% for the month and 7.7% for the year. The all important ‘Core’ inflation variant that strips out volatile items such as energy and fuel inflation were 0.3% for the month and 6.3% for the year to 31 October respectively.

We are less enthusiastic about the US inflation beat because of a couple of unusual results. Medical insurance costs contributed a negative amount for the month but, as they are set only once a year, October inflation was possibly temporarily under-estimated as a result. Used car prices had surged by 45% in the two years to mid-2022 on the back of a lack of chips needed to manufacture new cars. Used car inflation was down 4% in the latest quarter.

Other Assets

Oil prices fell nearly 10% in November but there could be a rebound in December after OPEC+ (includes Russia) and the EU decisions for a price cap of US$60 per barrel for Russian oil. Iron ore prices (25.5%) rose sharply. Copper (6.8%) and gold prices (7.0%) rose a little more modestly.

The Australian dollar rose by 4.3% against the greenback during November and peaked at $US 0.6775 before retracing to just below 67 cents on the Fed optimism that the October inflation data pointed to inflation responding to higher interest rates. As a result, the market responded by reducing expectations that interest rates will go as high in the US than initially thought hence, a smaller than anticipated interest rate differential leading to a softening in the $US.

Regional Review

Australia

The October jobs report released in November showed that the unemployment rate was only 3.4%, down from 3.5% the month before. There were 16,800 new jobs created. These results were very strong indeed.

With the RBA seemingly not in a hurry to raise rates too far, we are better positioned to withstand the impact of any recessions in other parts of the world.

China

Mainland China witnessed unusually strong anti-lockdown protests starting at the end of November. Citizens are concerned about further lockdowns to try to avoid the spread of Covid – particularly among older people who, if infected, might then test the capacity of the hospital system.
China has reduced the length of the quarantine period for international travellers from seven to five days.
CNBC estimates the impact of the lockdown on chip production for Apple’s iPhone may mean Apple may produce 5m – 8m units less in the last quarter of 2022.

US

Yet again, US jobs data were particularly strong with 261,000 new jobs being created with an unemployment rate of 3.7%. Since the Fed rate rises only started in the middle of March – and initially at a gradual pace – we are not surprised that the lags in the system have prevented any noticeable impact yet appearing in the labour market statistics.

There are now 1.7 job openings in the US for each unemployed person. One of the major reasons for this ratio has been the increase in retirement rates possibly because of having been laid off in the pandemic or people do not want to return to work because of health issues.

Retail sales in the latest month also performed well with a growth of 1.3% for the month against an expected 1.2%. Since these data are not adjusted for inflation, the ‘real’ increase in sales would have been much less. Quarter three GDP growth was revised upwards from 2.6% to 2.9%.

Although some optimism greeted the latest US CPI inflation data, the outcome was well above the target 2% at 7.7%. We do not see inflation falling to acceptable levels in 2023 unless there is a big turnaround in both the supply-chain shocks and the impact of the Russian invasion on energy and food prices.

The mid-term elections did not produce the ‘red wave’ that many had predicted. As a result, the Democrats kept control of the Senate and the Republicans only gained a slim majority in the House of Representatives.

Europe

The UK inflation rate came in at 11.1% which is at a 41-year high. With the latest economic growth negative, the official interest rate climbing at a record pace and energy prices soaring, partly because fossil fuels were being aggressively removed from supply, the prospects for the UK economy are, at best, bleak.

Rest of the World

The Governor of the Reserve Bank of NZ (RBNZ) increased the overnight cash rate from 3.5% to 4.25% while predicting economic growth will fall to 1% for 2023 and inflation will remain above 5% until after the end of 2023. However, he did predict an inflation rate of 3.0% for 2024.

Seasons Greetings

As this is our last economic update for calendar 2022, we would take this opportunity to thank you for your many comments, feedback and discussion over the year. From all in the Research and Investment team, we hope you and your families have a very happy, healthy and safe Christmas and New Year.

We look forward to returning in 2023 to continue our observation and commentary on what is a very interesting period.

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

Key points:

– Central banks close to contractionary interest rate policies – the US raised 0.75% in early November
– Reserve Bank of Australia moves cautiously again raising rates by 0.25% to 2.85% on Cup Day.
– US earnings season contains some surprises positive (banks) negative (big Tech)
– Share markets have a positive month in some cases recovering all of Septembers losses

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

The ASX 200 and the S&P 500 both had stellar months in October. However, September for both of those indexes had been very bad. Does this cancellation of much of the September woes mean that a bottom has been reached and the next rally has begun? We think it is too early to draw that conclusion – but it is possible.

Markets at the end of bull and bear markets often display amplified volatility but, this time, there is more information about future conditions than usual.
The dominant feature so far of 2022 has been the possible success or otherwise of central banks’ ability to control inflation without causing a recession.

The US and Australian economies are currently far too strong to think about imminent recessions but the UK and Europe certainly have deep-seated problems. China, largely because of an insistence on a zero-Covid policy, has found itself with slower growth than in recent times but it is self-induced and could easily be reversed if China wants.

Monetary policy was never designed to control many of the current sources of inflation: the Russian invasion with consequent food and energy price inflation; and covid-induced supply chain issues such as the current chip shortage for cars and so many other modern technologies.

The strength of labour markets suggests that some ‘demand induced’ inflation exists in various countries and that variant might respond to interest rate hikes.

Because rates were so low – zero or negative in many cases – the recent sharp increases in rates have only taken rates up to what is often referred to as the neutral rate – the rate that divides expansionary from contractionary policies. We think no major Western economy has yet crossed that line in any material way. However, continued hikes at the recent pace could take some economies into significant slowdowns and possibly recessions. We will know a lot more by the end of this year.

The IMF and some noted fund managers have started to talk about a possible recession in the US but not necessarily in Australia. Based on what we currently know we would largely agree with that assessment.

The Reserve Bank of Australia (RBA) has been far less aggressive in its policy stance than the US Federal Reserve (Fed) who again increased their cash rate by 0.75% on 3 November accompanied by a statement that easing off the pace of policy tightening was not supported by recent data. In both countries, a slowdown and pullback in house prices are well underway. While house prices were getting out of hand, a pronounced downturn in house prices would reduce perceived and actual household wealth. Such a loss of household wealth could accelerate and deepen any recession.

If central banks deftly avoid recessions, markets may well have already bottomed and the next big rally could get underway. If central banks push interest rates too far, a second market downturn could easily start.

However, the S&P 500 is about 20% below its 2022 peak; the ASX 200 is about 10% below its peak. There is plenty of room for upside if and when the dust settles after the volatility created by central bank policy tightening subsides. Despite equity markets having corrected this year prudent investors wouldn’t just ‘pile in’ now as it would be a big gamble in the short run.

The US third quarter company earnings reporting season is well underway. While there have been a number of really good results, there have been some notable underperformers – particularly among the big tech companies. Microsoft, Apple, Amazon, Meta (formerly Facebook) and Alphabet (formerly Google) amongst others lost significant company value on their announcements. Do these falls make them good buying opportunities? Maybe – but they could have just been too expensive before.

Some are asking if we are in a repeat of the dotcom boom and bust over 20 years ago. We would say no. All of these big tech companies currently experiencing downturns are well established with revenue streams. The dotcom boom was about ideas and hopes for future revenue. Many of those ideas just didn’t cut the mustard.

The era of ‘cheap money’ is over for now. Investors must now weigh up alternatives. 10-year government bonds in the US and Australia have come from very low values to yields fluctuating around 4%. Equities, while not as attractive relative to bonds as they once were, more selectively still present opportunity. Getting the asset allocation right for the next while is important, as appropriate diversification is a proven way of assisting to mitigate investment risks in uncertain times.

Of course, lurking in the background is the impact of the ongoing Russian invasion of the Ukraine. Few, if any, are sufficiently skilled to predict outcomes on that basis. It does seem that the Ukraine is now holding its own and Russia has not had the success it must have expected. Maybe that is why they just stopped the grain shipments again!

Europe and the UK are heading for a dismal (northern) winter. Energy prices are out of control and recessions seem inevitable if, indeed, they haven’t already started.

Our economy is doing well and Jim Chalmers just delivered a sensible, if not boring, budget. The RBA seems to be in control and China is not doing as badly as some predicted. We in Australia can escape a recession but growth might well be sluggish for a while. Markets typically focus on expectations rather than actual current conditions – so markets could turn up before economic data confirm that the worst is behind us.

Asset Classes

Australian Equities

The ASX 200 had a positive month rising 6.0% but that gain was on the back of a 7% loss in September. Most sectors did well in October though Materials, Staples, Health and Telcos performed poorly.

While we believed the ASX 200 was attractively valued a month ago, much of that mispricing has been erased by recent gains. While Refinitiv forecasts of company earnings are softer than earlier in the year, there is some optimism for capital gains over the next year in addition to possibly eroding the remaining perceived over-pricing. Expected dividend yields, grossed up for franking credits, are around 6%.

International Equities

The S&P 500 gained 8.0% in October almost offsetting the 9.3% loss in September. The World index was up 7.7% in October but Emerging Markets lost 3.1%.

The Dow Jones had its best month since 1976!

Many of the big international banks did particularly well in the current reporting season but Credit Suisse took a big hit. By and large big tech stocks did not fare well.

Bonds and Interest Rates

The RBA went against market opinion and hiked rates by only 0.25% rather than the expected 0.50% in October and followed this same course in November increasing the official cash rate by 0.25% on Melbourne Cup Day. The RBA cash rate now stands at 2.85%. Few would argue that the RBA was already in line to cause a recession. However, inflation is persistent with the latest read being the highest since 1990.

The Fed has been extremely aggressive with a number of back-to-back 0.75% hikes taking the Fed Funds Rate (official cash rate) to a range of 3.0% to 3.25% at the end of October. Future hikes will take the Fed almost certainly into contractionary territory. There is no sign yet of any impact on inflation but there are considerable lags between rate hikes and inflation decreases – if, indeed, the sources of inflation are responsive to interest rates.

There is significant danger that the Fed will keep hiking for too long. If that happens, at some point, a significant deterioration in the US economy may occur.

The European Central Bank made its second successive increase in its base rate of 0.75% to 1.50%.

Japan continues to buck the developed world central banks trend of increasing interest rates opting instead to hold their cash rate steady at -0.10% at its October meeting. While recognising that inflationary pressure is building, an inflation rate of 2.9% p.a. up from 2.3% p.a. in July, this was not enough to spur them to raising interest rates yet.

Other Assets

Oil prices rose strongly in October – up by around 10% – possibly because of the OPEC+ decision to cut supply by 2 million barrels per day. Iron ore prices fell by over 15% over the same period. The Australian dollar against the US dollar finished down 1.3% but there had been a significant depreciation during the month as bond yields swirled on central bank activity.

Despite the significant volatility in market indexes calculated using closing prices, the VIX volatility index fell markedly. The VIX measures implied volatility based on option prices which are used to insure against market falls. Perhaps, this behaviour is indicative of investors and traders getting ready for the next upswing in markets.

Regional Review

Australia

The September jobs report released in October showed that the unemployment rate was 3.5% which is a 50-year low. There were no new jobs created or lost but this report was indicative of a very strong labour market.

The quarter three CPI report revealed an inflation rate of 7.3% or the highest since 1990. The RBA had predicted earlier in October that inflation would come in at 7% and yet it only raised its rate by 0.25% rather than the 0.5% anticipated by markets. To us, this behaviour demonstrates that the RBA is aware that a substantial proportion of Australian inflation would not respond to interest rate hikes.

The trimmed mean of the CPI inflation read preferred by the RBA – in much the same way that the Fed prefers the core variant – came in at 6.1% when energy and food prices were stripped from the relevant basket of goods.

The impact of China’s Zero Covid policy and the Ukrainian invasion – together with the impact of devastating floods in the east coast of Australia – are clear headwinds for the economy. Despite this the RBA remains focused on defeating inflation and increased the official cash rate by 0.25% again in November.

The Federal Budget handed down by Treasurer Jim Chalmers didn’t do anything to upset markets. At this point in time, it is better to wait until May next year to deliver a carefully crafted budget that can deal with what, by then, should be a clearer picture of where recessions, invasions, Covid and interest rate policy stand.

China

The People’s Congress that meets every five years to set policy and elect a leader was held in October. Unsurprisingly, President Xi was re-appointed for an historic third five-year term. What did surprise was that the GDP data due out during the Congress was delayed. It was not delayed at the previous meeting five years prior when the planned release also coincided with the Congress.

When the GDP data was finally released after the conclusion of the Congress, it was found that the read was better than expected, 3.9% against an expected 3.4%. Industrial output rose at a rate of 6.3% for the month beating expectations but retail sales fell short rising only 2.5%. The China Purchasing Manufacturing Index (PMI) came in at 49.2 from 51.1 in the previous months. Prior to that release the PMI was 49.4.

While these data were not unequivocally good, they did show that the economy is far from plummeting into recession. With the People’s Congress behind them, Xi might now craft policies to get the economy back on a stable post-pandemic path.

US

The US Fed increased the US Federal Funds rate by 0.75% again on November 3 and Fed Chair Powell indicated that it was apparent that inflation is yet to respond to the higher interest rate settings and, as a consequence, the current rate of tightening was likely to continue until data indicated that inflation was indeed slowing.

US jobs data have repeatedly shown the labour market to be very strong indeed. In the previous month, the unemployment rate had risen from 3.5% to 3.7% but, in the latest report, the unemployment rate had fallen back to 3.5%. 263,000 new jobs had been created.

At the start of the month, CPI data were released showing that prices grew by 0.4% over the month or 8.2% over the year. The core CPI read was 0.6% for the second month in a row. The core Personal Consumption Expenditure (PCE) read was 5.1% at the end of October.

Inflation is well above the target rate of 2% and many Fed members are calling for aggressive action. However, three members at the last meeting voted for only a 0.5% hike rather than the 0.75% consensus. The tide could be turning.

So far, GDP growth has held up. The first two quarters of 2022 were negative reads but the provisional Q3 read was a reasonably impressive 2.6% against an expected 2.3%. One of the major causes of this growth resulted from slower import growth than expected.

Europe

The UK parliament has been in turmoil for most of 2022. Boris Johnson did not have a great profile and attending parties against Covid rules was the last straw. After a protracted selection process, Liz Truss was the chosen successor. Importantly she did not have the support of the parliamentary members. Her ridiculous policy of proposing tax cuts for top earners by borrowing got named ‘Trussonomics’. The backlash was amazing and she lasted in charge for less than seven weeks.

The new prime minister Rishi Sunak has an impressive track record in both his education and work in the finance sector. He is married to a woman who is heiress to her father’s multibillion-dollar company. Together, the Sunaks reportedly have a combined wealth greater than the Queen had on her death. He might find it difficult to win over the hearts and minds in the impoverished regions of the UK but he could do some good work before the next election.

Germany is reconsidering its nuclear policy in an attempt to offset energy prices. The UK is attempting to cap energy price increases for vulnerable consumers.