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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!

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

– Central banks continue to remove policy easing at a rapid rate

– Slight easing of supply-side bottlenecks is hoped to result in a softening in inflation data
– Australian unemployment rate now the lowest since 1974!

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.

After a dismal June in equity markets, July was like a breath of fresh air. Wall Street’s S&P 500 was up 9.1% on the month while our ASX 200 rose 5.7%. Of course, it’s a long way back to the top, but this is a step in the right direction.

Though, we think it is too early to be convinced that it’s just onwards and upwards from here. A few positive things happened in the last week of July but some, or all of them, could slide back to lower levels.

While we don’t see markets revisiting their June lows however, a meteoric rally like the one from the last week of July needs a bit more substance to sustain it. These short sharp rallies are often referred to as bear-market rallies – and can fizzle out as quickly as they start. In our opinion, the jury is out on this one. It could go either way.

Central banks are at both the heart of the problem and the solution. As analysts we have to try and guess what they will do and measure that against what they should do.

There was a flurry of central bank activity in the first part of July. The Reserve Bank of Australia (RBA), the European Central Bank (ECB), the Reserve Bank of New Zealand (RBNZ), the Bank of Korea (BoK), and the Bank of Singapore (BoS) all hiked their base rates by 50 bps (or 0.5% points). Singapore didn’t even wait for their scheduled meeting. It jumped in, out-of-cycle! The Bank of England (BoE) hiked rates for the fifth month in a row. But there was a notable exception.

The Bank of Japan left rates on hold. They argued, as they did in the 1970s when the two big oil price shocks occurred, that higher interest rates do not cure inflation caused by supply-side shocks. Japan had two stellar decades of growth in the 70s and 80s. Most of the rest of countries hiked rates sharply with the result of being stuck in stagflation. That is, there was high inflation because interest rate policy could not work against the cause and slow economic growth because high interest rates cripple the economy.

When the US Federal Reserve (“Fed”) met towards the end of July, they hiked the Fed funds rate by the expected 0.75% but they were softer in their tones than in previous recent meetings.

Fed chair, Jerome Powell, stressed that some parts of the economy were looking a little weaker and the Fed might be less aggressive going forward. This statement at a press conference immediately inspired a very strong rally in US equity markets.

There are few among us that would not acknowledge that major supply-side blockages have contributed greatly to global inflation: the Russian invasion of the Ukraine (gas pipeline to Europe and blockade of Black Sea ports stopping grain exports, and oil supply from Russia) and supply-chain disruptions caused by pandemic shut-downs.

There are pockets of demand-side inflation caused by mismatching of workers and vacancies as well as workers in general seeking wage increases to compensate for higher energy and food prices.

Of course, Australia has also suffered significant supply disruption from the major flooding along large stretches of the east coast. Various produce such as lettuce have had prices sky-rocket.

We do not think any of the major central banks have taken us to the brink. They have largely just removed the emergency settings that were introduced more recently because of the pandemic. It is only when rates are pushed past the so-called ‘neutral rate’ that separates ‘expansionary policy’ from ‘contractionary policy’ settings that trouble may emerge. Most seem to agree that the neutral policy interest rate is between 2% and 3%. The US rate is now a range of 2.25% to 2.5%. For them, walking the plank starts from here.

In earlier issues of this monthly update, we argued that the central banks might be intent on doing one thing while saying another. The media and others were howling for rate hikes to crush inflation. Is this first round of hikes and the magnitude of the increases in part to placate the media? We won’t really know until the 21st September Fed meeting. Will they keep going?

The RBA is still way behind the US with its overnight rate at 1.35% even if it hikes as expected on August 2nd to 1.85%.

The US CPI inflation came in at 9.1% annualised for June and even the core measure that strips out food and energy prices was 4.9%. The US Private Consumption Expenditure (PCE) alternative measure, preferred by the Fed, was 6.8% with the core at 4.8%. But it does seem that the increases in inflation rates may have ended or even peaked. Perhaps that was the sentiment that drove equity markets higher in late July.

The fly-in-the-ointment might be US economic growth as measured by Gross Domestic Product (GDP) growth. It was  1.6% in Q1 and  0.9% in Q2. That, for non- economists, might signal a recession. Fed Chair Powell, former Fed Chair Yellen (and now Secretary to the Treasury) and President Biden all stated firmly that the ‘US is not in recession.  We strongly agree.

The proper definition of a recession is based on deterioration of economic conditions in many sectors of the economy including the labour market and consumer spending.

The US has witnessed six months of job increases in excess, on average, of 400,000 per month. Before the pandemic, 200,000 new jobs created in a month was considered to be very strong. The unemployment rate in the US is 3.6% or as close to full employment as anyone could wish for. There are about two job vacancies for every one unemployed person. Consumer spending is also holding up.

The official body that ‘dates’ recessions in the US, the National Bureau of Economic Research (NBER) does not even refer to GDP growth in its deliberations.

In Australia, we just recorded the lowest unemployment rate since 1974 and 88,000 new jobs were added for the latest month. While conditions can change rapidly, there is no evidence that the US or Australia are currently anywhere near a recession.

So, when will the supply disruptions end to put an end to the high inflation regime? We don’t know but there are signs we are moving in the right direction.

Turkey brokered a deal to get the gas pipeline from Russia to Germany working again after a 10-day so-called ‘period of maintenance’. It worked, but it looks likely that Putin might manipulate the flow to cause rationing at times.

Turkey was also there with the UN to get a deal going on grain shipments out of the Black Sea ports of Ukraine. There are reportedly 80 ships loaded with 20 million tons of grain but we have not yet seen a report that the ships have set sail through the UN-supported shipping corridor.

For very different reasons, ships are lying idle off the US east and west coasts in large numbers. The queue is reportedly about four times normal. There is industrial action in Oakland California that has blocked container movement there but, more generally, ports were working at full capacity, so it is hard to step up turnaround when there aren’t enough resources. One reported blockage is the supply of drivers for the trucks that move the containers. Some of that is due to Covid-related absences.

China is well past its big lockdown for Covid but since they are maintaining the zero Covid policy, there are plenty of pockets of supply disruptions.

While we feel that a supply-side inflation problem is far from being solved, we could be close to improving from a bad place – and that means inflation would fall even if it remains high. Like Japan, we and the US can use fiscal policy to cope with high inflation.

We see the underpinnings of the July equity rally as fragile rather than doomed. Markets critically depend not only on what the central banks do, but also what they say.

The ASX 200 had a bad month ( 8.9%) in June but clawed back 5.7% in July. IT and Financials down (15.2%) and (9.3%) respectively led the pack. In spite of a strong finish in the prices of oil, copper and iron ore, a poor month for those commodity prices saw our resources sector underperform at the bottom of the pack.

With earnings season almost upon us, it is comforting to note that the Refinitiv survey of broker-forecasts of dividends and earnings are holding up well. There is scope for a strong finish to the year if central banks incorporate a reduction in supply-side inflation into their interest rate policy setting deliberations.

International Equities 

The S&P 500 also had a bad June ( 8.4%) but cancelled out these loses in July with a gain of 9.1%.

The UK FTSE, the German DAX and the Japanese Nikkei retuned similar amounts to the ASX 200 while China’s Shanghai Composite actually fell  4.3% after a strong June (+6.7%). Emerging markets were flat in July.

The RBA lifted its overnight borrowing rate from 0.85% to 1.35% at its July meeting. The market is pricing in a further ‘double’ hike for August but that would still leave the overnight rate well below the neutral rate.

The Fed was expected to hike by 100 bps after the record-breaking inflation read at the start of July. However, by the time of the meeting, the market had come back to expect a 75-bps hike.

With Jerome Powell calming expectations for future hikes there is a long wait before the 21 September meeting. Important comments might be made at the annual Jackson Hole gathering of global central bankers in the interim.

A plethora of other banks hiked during July: ECB, RBNZ, BoK, BoS and BoE. Although they hiked by 50 bps, the ECB reference rate is still only 0.0%.

10-year rates on government bonds in Australia and the US experienced some wild gyrations in July. They are now back well below the recent highs.

The US 30-yr mortgage rate experienced major falls immediately following the Fed’s 75 bps hike. The market might be paving the way for a pause in the hiking cycle.

Iron ore, copper, gold and oil prices again retreated in July but rallied in the last week of the month. The Australian dollar rose 1.7%. The VIX ‘fear gauge’ almost retreated to an historically normal range by the end of July.

There were 88,000 new jobs reported for the month and the unemployment rate dropped sharply from 3.9% to a near 50-year low of 3.5%.

CPI inflation came in at 6.1% or 1.7% for the June quarter but the trimmed-mean variant, favoured by the RBA, was 4.9% annualised or 1.5% for the quarter.

Pensioners are set to receive some larger CPI indexed increases based on these data.

China continues to grapple with its zero Covid policy. As a result, most economic data were weak.

GDP growth came in at 0.4% while retails sales (3.1%) and industrial output (3.9%) also missed expectations.

There were 372,000 new jobs created as reported in the latest monthly labour report while 250,000 had been expected. The unemployment rate remains at an historically low 3.6%.

CPI inflation came in at 9.1% for the year against an expected 8.8%. Core CPI inflation was 5.9%. The Fed-preferred PCE inflation stands at 6.8% and the core variant at 4.9%

The preliminary estimate for GDP in the June quarter was negative at  0.9% in the wake of a  1.6% final estimate for Q1. This does not amount to a recession in and of itself as the US has an economically sound definition of what constitutes a recession.

Fed Chair Powell, President Biden and Treasury secretary Yellen all took great pains to express their view that the US is not in recession. Retail sales in June were up 1.0% for the month but that is less than the current rate of inflation!

The ECB has, at last, hiked its rate to 0.0%! Germany was suffering somewhat from the temporary closure of the Russia gas pipeline.

Britain seems to have come to terms with a rapidly slowing economy. Boris Johnson is to be replaced in the near future as British PM.

Turkey has been active in brokering deals between Russia and the Ukraine over both gas and grain supplies. While this news has been received positively, it is too soon to comment on the success or otherwise of the deals.

The Central Bank of Russia cut its base rate by 150 bps. At the start of the invasion, it raised rates from 9.5% to 20% in a single hike to defend the rouble. The latest cut simply took the lending rate back to 9.5%.