admin

Economic Update October 2022

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.
Asset Classes

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%.
Regional Review

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!

Economic Update September 2022

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

Key points:

– Central banks send mixed messages in their approach to addressing inflation
– Australian retail sales easily beat expectations indicating a level of consumer confidence

– Ukraine exports start to flow which is hoped will dampen food price inflation globally

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 us.

The Big Picture

The price of iceberg lettuce on the east coast of Australia just fell by 80% in a matter of weeks! Was this because the Reserve Bank of Australia (RBA) lifted its overnight borrowing rate from 0.1% to 1.85% this year with the prospect of more to come soon? No!

One doesn’t even need a high school education in economics to realise the iceberg problem was caused by extensive flooding and other adverse weather conditions in the east. Supply was crushed so farmers needed more per head for the smaller quantity they had to sell and some people were prepared to pay up to $13 a head for the privilege. For whatever reason, the supply of icebergs is back to normal – at least for the moment – and the price has returned to $2.49.

We are not trying to trivialise the current policies of various central banks but there is a strong parallel between this example and what some central bankers are saying.

Recently, the US Federal Reserve (Fed) chairman, Jerome Powell, made a strong statement at the annual global central bankers retreat at Jackson Hole, Wyoming. He went from being mild mannered earlier in August to a statement that pointed to the fact that ‘pain’ would be felt by many households and businesses as he kept increasing interest rates to rein in inflation and return it to within the 2% to 3% p.a. range. This, he said, was not a time to stop or pause the hiking cycle. Naturally, the S&P 500 on Wall Street fell over  3% that day and even further over the rest of the month!

We are not aware that the US has an iceberg lettuce problem but the world is suffering from high energy and general food prices partly caused by the Russian invasion of the Ukraine and supply-chain issues partly caused by China’s zero Covid policy.

None of these three supply disruptions will be cured by hiking interest rates. But there is a big difference between the price of lettuce and the price of food, energy or computer chips. Most, if not all households, can readily find a substitute for lettuce in their diets – or just forget about lettuce altogether. No one really needs to spend $13 on a lettuce! People around the globe are suffering big increases in energ¬y and food bills that they can’t afford and they can’t find a substitute for.

On top of the additional expenditure on fuel and food, any increases in interest rates – or holding them at high levels – to wait for general inflation levels to revert to normal causes corresponding hikes in mortgage and credit card repayments – and the cost of servicing business loans. That makes the pressure on the ability to pay for energy and food even greater.

What we have experienced in recent months are wild swings in economic data and a complete turnabout in the policy statements being issued by central banks. The 10-year bond rates in the US and Australia are going up and down in a wide range on these ‘news’ switches. That means households and businesses find it even harder to plan for what loans they can reasonably afford to take out – and that in turn affects the price of most goods and services and, in particular, housing.

To give a concrete example for Australia, at the start of August this year, the market was pricing in an RBA rate of 3.8% by the end of the year (from the then 1.35% rate) and a peak of 4.4% sometime during 2023. Just after the RBA board meeting on the first Tuesday of the month, the market priced in a reduced peak of only 3%. At the end of August, after the Jackson Hole meeting, that peak was raised back up to 4% from 3%. So, what should potential mortgagees and business owners do and what are the implications for investors?

Quite possibly, prudent, risk-averse people would allow for a higher rate than might or might not happen – or even being contemplated by the RBA behind closed doors – which means demand for housing goes down more than it needs and with it house prices. It is a commonly held view that falling equity in residential property from households not actually trading in property puts a dampener on their other retail expenditures.

As it happens, data on Australian retail sales for July just came in very strongly at +1.3% when only +0.3% had been expected. Also, for July, the unemployment rate even fell to a ‘tiny’ 3.4%. What will the changes in central bank ‘jawboning’ do to actual sales and unemployment during and after the August swings in sentiment? We can’t be sure but it is very unlikely that such behaviour by central bankers is helping to smooth the economic cycle.

Let’s also look at some relevant facts. And facts are relatively sparse in these debates. Unsubstantiated opinion counts for little. The Fed’s preferred measure of inflation is known as “core PCE”. Core refers to the fact that volatile energy and food price inflation is excluded from the calculation. PCE stands for Personal Consumption Expenditure. There is also a headline rate that does not exclude the volatile components. On top of that there are the core and headline CPI inflation results to which many other countries mostly relate.

The US usually relies on annual data for GDP growth and inflation that compares the current underlying figure for the level of GDP or the CPI with the corresponding period 12 months before. That means it takes 12 months for a big change in GDP or prices to work its way through the calculations. Of course, the US also produces monthly estimates for inflation and quarterly estimates for economic growth that do not suffer the overhang problem but these more regular data points are more likely to jump about a bit when underlying growth or inflation are not changing much.

As it happened, on the morning of Powell’s Jackson Hole speech, the PCE measures of inflation were released – only hours before he spoke – so he should have known that the latest headline monthly read was actually 0.0% and the core read was +0.1%. Hardly the stuff to inspire panic. Indeed, it is not possible to get a much better read as deflation (indicated by these numbers being negative) is, perhaps, even more scary than inflation!

Earlier in August the CPI reads came in. The headline monthly read was 0.0% and the core read was +0.5%. So, of the eight numbers produced on inflation each month, the Fed focuses on the big scary annual figures that include the overhang and not the benign monthly numbers we just quoted. And the month before (June) the statistics weren’t bad either – but not quite as good. There is building evidence that the worst of inflation may be behind us but it is not (yet) the time to celebrate its demise.

It’s not just the traditional measures of inflation that are giving us some hope. It was reported that US freight prices – one of the supply-chain issues fuelling general inflation because of a shortage of truck drivers amongst other factors – were up +28% on the year but actually down  2% on the month. And monthly house prices are down for the first time in three years. The Case-Shiller index is up 18% on the year but down  0.8% on the month.

So, from a monetary policy perspective we believe that central bankers are in general terms viewing their world, inflation and their respective economies through the following lens:

“All price inflation hurts all households but they (central bankers) cannot control all prices. Some increases are from so-called supply shocks such as the China chip shortage, the Russia energy supply rationing and the Ukraine grain export blockages. But those price increases, as well as some from other sources, are causing some ‘demand-side’ pressure through local wage increases and the like.

They will do what is needed to bring down demand-side inflation with interest rate policies but, after deciding what amount of inflation cannot yet be controlled, they will ease off this policy measure before they cause unnecessary damage to the economy.

They monitor inflation not just by looking at headline numbers but also components, month-by-month, taking care not to over-react to potential statistical blips.

Since households are hurt by prices that are higher from whatever source, governments need to be mindful of the upward pressure this in turn puts on wages. They cannot afford policy that leads to a wage price spiral, such as that which existed in the 1970s and 1980s when wage expectations fed off price increases that circled back into price rises”

At the latest report we have seen, 30 ships had left the Ukraine’s Black Sea ports loaded with grain and have made it to safe harbours in Turkey and beyond. The plan is apparently to increase this flow to 100 ships per month. If this occurs it should take some pressure off food prices – not just grain but, say, egg prices as they rely on the price of grain to feed the chickens.

Since 40% of Germany’s energy comes from Russia it will find a hard time trying to side-step that issue. But in the UK, which also has had major energy price surges, the incoming replacement for Boris Johnson is considering reversing some of the green initiatives regarding reliance on fossil fuel. It is all very well to want to switch to renewable energy but not until sufficient clean energy is available. There is a long, cold winter ahead and little tolerance for those who stopped all fossil fuel developments.

Despite the implications we here in Australia, the US and developed Europe are having in relation to inflation and interest rates, in other parts of the world the same situations exist but the effects and the policy responses are amplified significantly.

For example, Argentina has its cash rate at 69.5% and inflation is at 74%. On the other hand, Turkey has inflation running at 80% but it just cut its reserve rate from 14% to 13%. Japan, which glided through the 1970s and 1980s when most of the world suffered from stagflation (slow or negative economic growth and high inflation) without pursuing tight monetary policy is doing it again.

The Bank of Japan was again on hold in August; it is not falling into the trap of pushing up rates because that is the global trend!

It is difficult to know how to paint an economic picture for 2022/23 without knowing how far central banks will take monetary policy settings with respect to addressing inflation. If they push too hard a recession is likely – almost inevitable. If they ease soon, a recession might be avoided and inflation might come back if and when the supply pressures subside further. If they ease too soon, demand-side inflation might take hold as it did in the recent past. It is not easy being a central banker, particularly now. While the macroeconomic outlook is more uncertain than usual, it is important to remember that informed advice is also experiencing the same challenges but it is founded on proven principles that have been tested many times through history. This does not mean that financial pain will not be experienced, but hopefully that it is minimised.
Asset Classes

Australian Equities 

During the first half of August, the ASX 200 continued the stellar run which began in July. Then, along with the S&P 500 and comments from the Fed, our index plunged sharply, recovered back to its August peak and the fell again to finish just about flat for the month.

The Energy and Materials sectors were the clear leaders in August. The Financials and Property sectors were among the worst performers most likely on the back of interest rate outlooks and property prices.

Although our earnings season is ‘on’ it hasn’t been grabbing the usual attention as bond market movements have taken centre stage. Our analysis of Refinitiv broker-forecasts indicate that capital gains prospects for the next 12 months are now a little softer than average but it is too soon to draw a strong conclusion. Brokers take different amounts of time to update their forecasts and company reports are spread out over many weeks.

International Equities 

The S&P 500 also extended its July run well into August but it faltered as the Fed raised rates, gave a hawkish outlook, and then finished August with Jerome Powell’s Jackson Hole speech.

Unlike the ASX 200, the S&P 500 was well down on the month – by more than 4%. The other major markets were quite mixed in the sizes of their capital gains.

The VIX ‘fear gauge’ almost returned to its normal operating range at the start of the month but rose sharply at the end of August.

Until we see how the Fed performs at its next meeting on September 21, it is hard to see there being any clear direction for Wall Street.

Bonds and Interest Rates

The Reserve Bank of Australia (RBA) again lifted its overnight borrowing rate by 50 bps this time to 1.85%. Other central banks including the Fed, the Bank of England (BoE) and the Reserve Bank of New Zealand (RBNZ) also lifted rates but, interestingly, the Bank of Japan was on hold at the last meeting and the Bank of Turkey actually cut its rate from 14% to 13% even though its inflation is running at 80%.

It is clear to many – not just us – that many central banks are implementing strategies that do not fully recognise that much of the inflation problems is the result of supply-side issues.

The CME Fedwatch tool, which is a standard when it comes to estimating what the market is pricing in for Fed rate hikes, had, until recently, a stable probability of there being a 50 bps or 75 bps hike in September with the latter being a bit more likely at 60%. The Jackson Hole speech by Powell on ‘pain’ from rate hikes has taken that latter probability to more like 72%.

The yield curve across the full range of government bond maturities is now clearly higher than a month earlier. Since most countries have not yet pushed cash interest rates above the neutral rate (2% to 3% p.a. here and in the US) and most real rates (i.e. allowing for inflation) are negative, the impact of higher rates is yet to have a material impact. A recession in the US or here is not our base case but something close to ‘no’ or ‘low’ growth might well occur – the so-called soft landing.

We believe that unless central banks soon pause their interest rate hiking strategies, an economic recession may well follow.

Other Assets 

The prices of Iron Ore and Oil fell in August while Copper was flat. Our currency against the $US softened by  1.5%.
Regional Review

Australia

For the first time in 2022, there were some mixed signals in the labour force data. The unemployment rate fell to 3.4% which is the lowest since the early seventies. But July witnessed the first fall in total employment this year – and it was by a sizable  40,900 jobs. On its own, there should be no alarm for one bad employment result from this small sample survey – but we will keep an eye on it next month. The total number of hours worked fell by  0.8%.

On the wages front, Australia recorded an annual increase of 2.6% including a 0.7% increase for the quarter. While that sits well with the long-term average, the latest CPI inflation read was 6.1% eclipsing the nominal wages read. Workers fell behind by  3.5% (= 2.6% – 6.1%) over the year in so-called real terms. That is the extent of the cost-of-living crisis.

The big data surprise for the month was the beat in retail sales. A rise of +0.3% was expected but the outcome for July was +1.3% and that is well ahead of what might be thought of as a monthly inflation read (Australia does not publish monthly inflation data like the US).

China 

China is highly unlikely to get anywhere near producing the official expectation for economic growth of 5.5% this year.

Retail sales limped across the line at 2.7% against an expected 5.0%. Industrial production fared a little better at 3.8% against the 3.9% of the previous month – but 4.6% had been expected. It is unusual for China data to miss expectations by so much.

Nancy Pelosi, the Speaker of the US House of Representatives, made an unusual visit to Taiwan at such a sensitive time. There were no scheduled official meetings but it drew the ire of China. Just before she departed the island, China flew 25 fighter jets over the area.

Since China is yet to abandon its zero-Covid policy, it is hard to see the supply chain issues – particularly around chips for cars and other machines – easing materially any time soon.

US

The US posted a massive nonfarm payrolls jobs number. 528,000 new jobs were created in July and the unemployment rate was again a very low 3.5%. The strength of this number caused the market to incorporate tighter monetary policy and so another month for share prices got off to a bad start.

The Inflation Reduction Act finally got passed into law. It is a policy concerning climate change, health care and taxation. It doesn’t seem to say a lot about inflation except in the name of the bill.

It has taken a long time for Biden to get his pet project through Congress. In the process, his approval rating has plummeted and the mid-term elections on the 8th of November are looming large.

A recent survey reported by the New York Times, found that only 17% of the population approves of the direction Biden is taking. A massive 77% disapprove of the direction in which the US is heading. That is a lot of unhappy people in a country of 330 million.

With a slim majority in the lower house and the Senate controlled by the casting vote of the Vice President, there is talk reported of needing a new Democratic candidate in two years to stand for President.

The US is also facing a new phase in its post-GFC recovery. From now, QT – or quantitative tightening – starts in earnest. QE – or quantitative easing – undoubtedly helped the economic recovery by lowering longer-term interest rates and increasing liquidity. After a period of pausing the bond buy-back policy, QT is getting underway by removing $95 bn per month from the government debt of $9 trillion. It is uncharted territory but we all probably remember the taper tantrums when QE was first eased – and now it is now being reversed!

We are arguing that there are some nascent signs of a recovery in US inflation. Retail sales came in flat for the month in line with expectations. Sales, excluding autos were up by 0.4% for the month possibly reflecting the chip shortage. There is a shortage of new cars forcing up the price of used cars.

Europe 

Europe is facing a cold, miserable winter unless something can be done about the energy supply from Russia. Germany takes 40% of its supply from that country.

The debate between the two candidates vying to replace Boris Johnson as PM have each flagged reversing some of its green policies. While it is laudable to want clean energy and a zero-carbon footprint, it makes little sense if people can’t afford the energy for heating and cooking.

The Bank of England (BoE) is forecasting inflation of 13.1% for October and the latest reading of 10.1% is the largest number in over 40 years. Interestingly, the BoE is predicting inflation returning to 2% by 2025. Perhaps they know something about Russia’s plans than we don’t.

Rest of the World

The Reserve Bank of NZ (RBNZ) raised its rate again by 50 bps to 3% well above our 1.85% at the same point in time. It is not clear that the NZ population is happy with its economic management.

Economic Update – August 2022

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

Key points:
– 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.
The Big Picture

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.

Asset Classes
Australian Equities
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.

Bonds and Interest Rates

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.

Other Assets
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.
Regional Review
Australia

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

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.

US

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!

Europe

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.

Rest of the World

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%.

Economic Update – July 2022

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

Key points:
– How far will the Fed go in raising official interest rates?
– Russia on the back foot economically as sanctions bite
– Australia jobs data still strong and unemployment remains below 4.0%

The Big Picture

After a pretty miserable financial year for 2022 in most major equity markets, we can but hope for better in FY 2023. But there is more than hope to justify better expected returns going forward. We have reason to believe that much of the negativity surrounding the Russian invasion of the Ukraine, the supply-chain problems as a result of the pandemic and central bank moves to start the next upward leg in the interest rate cycle have been priced in. Markets often react quickly (and ask questions later) when anticipating the impact of such outside events.

While we do not pretend to know how or when the Russian invasion of Ukraine and the supply-chain problems will be fixed, markets have had a good six months to ponder and act. On the other hand, the turnaround in central bank activity in June warrants far deeper scrutiny.

All well-trained economists know that hiking interest rates does nothing to cure the supply issues created by the Covid lockdowns and exacerbated by the Ukraine invasion. Central bankers, including Jerome Powell from the US Federal Reserve (“Fed”) and Dr Philip Lowe from the Reserve Bank of Australia (“RBA”) repeatedly said as much over the first five months of 2022.

It seems one bad inflation print at the start of June in the US caused the “play book” to be thrown out of the window. Suddenly there was a groundswell of support for central banks to say that they can cure the whole inflation problem using aggressive interest rate hiking. That’s not possible!

Economics didn’t change overnight! We just think the central bankers lost their collective nerve. Or perhaps they are trying to jawbone down inflation expectations in current wage negotiations.

Two things are certainly true. Inflation hurts consumers no matter what the source: demand or supply. The drivers of current global inflation include components from both supply-side shocks and demand-side pressures.

One of many complicating factors is that the massive increases in energy costs and grain prices emanating from the Ukraine invasion not only directly affect, say, petrol and food prices, there is also a secondary source of inflation created as the primary sources infect related industries – such as travel and hospitality.
While some central banks attempt to strip out the primary sources of inflation in food and energy prices to produce so-called ‘core’ or ‘trimmed-mean’ inflation measures, they are unable to strip out the secondary effects.

So, the big question is, are central bankers just saying what they think we want to hear or have they lost the plot? If they are playing mind games and plan only to take rates up to just above ‘neutral’, where monetary policy is neither expansionary or contractionary (2% to 3%), we’re probably all fine. If they want to push rates up until inflation comes down (because the supply side causes will not) then we could have a recession to contend with. The ball is in their court.

Recent data suggest that inflation might be near a peak and so some welcome signs could be just around the corner. Indeed, at the very end of June, the Fed’s preferred core PCE measure came in at only 0.3% for the month and 4.7% for the year – which beat expectations and was down 0.2% from the previous reading.
Whatever central bankers are really thinking, the Fed made a massive 0.75% increase to its cash rate, the RBA increased our cash rate by 0.5% and the Bank of England made its fifth successive monthly increase – all in June. The European Central Bank (“ECB”) ended its bond buying program and called for a 0.5% increase in its prime interest rate.

At first, the yields on long dated bonds reacted strongly upwards making equities seem less attractive – particularly the high growth stocks e.g. technology companies. The S&P 500 experienced its worst week since 2020 in mid-June but then the market recovered all of these losses and more in the following week. As is usual, most developed markets followed suit. In the final week of June, markets were a little choppy but largely held on to their previous week’s recovery.
Since company earnings’ forecasts (from the Refinitiv broker-based surveys) are holding up quite well we have good reason to suspect some markets are under-priced and underlying growth is strong. However, that does not translate into deciding that now is a good time to buy. Prudent investing is far more complicated than that.

It is difficult to impossible to assess what Russia is doing or trying to achieve in the Ukraine conflict.  But Russia is clearly struggling in the economic war. The G-7 countries just agreed on banning imports of gold from Russia, which somewhat further stifles its ability to fund further offensives.

Russia just defaulted on government bonds for the first time since 1918 – a year after the Russian revolution and amid the start of the Spanish flu pandemic. The two euro-based bonds that defaulted amounted to $US 57bn. Defaults affect credit ratings and the cost of further borrowings.

And NATO has now decided to put 300,000 extra troops on high alert to be deployed on the eastern front of Europe. There are currently eight centres of mobilisation in that region and the extra troops on standby will effectively increase the troops size by about 10-fold! NATO will be organising battalion-sized groups of 3,000 to 5,000 troops and supplying them with all manner of weaponry and cyber-security. And Turkey’s veto has been lifted, enabling Norway and Sweden to join NATO.

While parts of the world are in turmoil, Australia GDP growth came in at an impressive 0.8% for the quarter and the unemployment rate stayed at an historic low of 3.9%. Even retail sales popped up at 0.9% but some of that monthly gain is due to increased prices as the statistic is not adjusted for inflation.

On the back of the RBA interest rate hike, the CBA revised its forecast for house prices. It now expects a fall of 11% this year and a further 7% next year – down from a 3% fall this year just prior to the RBA interest rate decision. However, those new forecasts are greatly at odds with their forecasts for Australian economic growth. CBA expects growth to be over 2% next year from 3.5% this year. A house price crash and strong economic growth are implausible to us. House prices have softened a little but there currently seems to be little evidence to suggest a price crash is looming – at least not yet.

Many home owners are on fixed-rate home loans and so many will not yet experience any increase in that part of their mortgage payments; some have ‘slack’ in their payment plans to absorb the first few hikes; and the supply of housing still does not seem to be keeping pace with demand. It should be emphasised that the current RBA interest rate of 0.85% is less than it was in October 2019! The first part of the hiking cycle is to remove the emergency rates that were put in place to address the onset of the Covid pandemic. The economy does not now need emergency settings but during the onset of the pandemic, it seems to have been an excellent call by the RBA and, indeed, the federal and state governments!

Going forward, the key dates for monitoring the state of the global economy are July 13th and 27th. The former is the expected date for the next US CPI data release; the latter is the date of the next Fed meeting on rates.

The market is still predicting a 0.75% hike by the Fed in July but the odds have softened somewhat. There is now over a 16% chance of only a 0.5% hike in July.

Asset Classes

Australian Equities 

The ASX 200 had a bad month ( 8.9%) and financial year ( 10.2%). Notwithstanding, the expected dividend yield for FY23 is 4.6% (Refinitiv).
Over FY22, Energy (+24.5%) and Utilities (+29.3%) performed particularly well; Telcos were comfortably positive (+4.3%). IT was the spectacular loser ( 38.7%).

International Equities 

The S&P 500 also had a bad June ( 8.4%) but the Shanghai Composite, by comparison, actually did quite well (+6.7%).Over FY22, the London FTSE (+1.9%) was just above water. Most of the other major markets lost between about  5% and  20% over FY22. The S&P 500 had its worst first half year since 1970.

Bonds and Interest Rates

The RBA lifted its overnight cash borrowing rate from 0.35% to 0.85% at its meeting in early June. Most market analysts seemed to have been expecting a ‘typical’ 0.25% increase or perhaps 0.4% to restore the historical scale of one which climbs in 0.25% increments. This surprise 0.50% increase did not seem to achieve any positive results and, indeed, reflected poorly on the RBA after all of the statements made by the bank in prior months.

The Fed, after saying at its previous meeting that it wouldn’t do more than a 0.5% hike, not only increased the Fed funds rate by 0.75% but flagged such an increase would also be considered at its July meeting.

The expected Fed rate at the end of calendar 2022 is now 3.4% which, in itself, cannot be considered high. 3.4% is about 1% over the estimated ‘neutral rate’ but it is much higher than had been expected a few months ago.

The ECB and the Bank of England also joined in the monetary policy aggression. Perhaps central banks feared being the last to hike ‘enough’ and, hence, be criticised if inflation becomes more entrenched than they anticipated.

10-year interest rates on government bonds unsurprisingly went through gyrations following these early June interest rate moves by central banks. It seems to be the consensus view that the long-bond yields caused the major volatility in equity markets.

Other Assets 

Iron ore and copper prices retreated even further in June – each by falling by over 10% – putting them both into bear market territory having fallen by more than 20% from recent peaks. However, iron ore prices are still well above $100 / tonne.

Oil prices also slipped in June but not as much as the metals. Gold prices were stable but the Australian dollar was down  4.1% over June.

There have been many casualties in the crypto currency space.

Regional Review

Australia

Economic growth in the March quarter was strong at 0.8% or 3.3% for the year. Importantly, the household savings ratio fell to 11.4% after having been above 20% just a few quarters before. Households stored cash in the pandemic – either by choice or lack of options to spend – and this leaching back into the economy is supporting growth prospects. With a ‘normal’ savings ratio of around 7% just before the onset of the pandemic, there is room for further cash injections into consumer spending.

There were 60,600 new jobs reported for the month. This total included 69,400 new full-time jobs accompanied by a small loss in part-time jobs. The unemployment rate was steady at 3.9%.

We have also experienced an additional driver of inflation in Australia. Owing to the floods and frosts at the beginning of winter, and a shortage of seasonal workers, the prices of some produce – such as lettuces – have sky-rocketed. Iceberg lettuces have reportedly risen from around $3 – $4 to a peak of $12 a head. Presumably the people buying these lettuces didn’t first check the price!

Since our CPI inflation is well below that in many developed nations, and we have a large savings buffer, it is difficult to see the Australian economy struggling in the remainder of 2022. What happens in 2023 will depend to a large extent on the wage negotiations that are now underway. Workers have a reasonable expectation of maintaining real (or inflation-adjusted) wages but if the current round of wage negotiations, then gets baked into inflation expectations as in the 1970s and 1980s, we could have a longer-term economic problem with inflation. It took a major recession in 1990-1991 to put the inflation genie back in the bottle.

China 

China continues to grapple with its zero Covid policy. While large numbers of people – even in Shanghai – are fully vaccinated, there are tens of millions of old people who are not.

There was some mild evidence of the Chinese economy bouncing back after the lockdown ended. However, a US-based ‘beige book’ survey rejects that notion.
Chinese retail sales came in at  6.7%, industrial production at +0.7% and fixed asset investment at +6.2%. While these statistics are poor on face value, they did beat expectations. The full effects of China’s new stimulus packages have not yet been felt to any great extent.

US

There were 390,000 new jobs created as reported in the latest monthly labour report and the unemployment rate remains at 3.6%. Since only 328,000 new jobs had been expected, the report card was seen as a positive.

Wage growth at 5.2% was far behind CPI inflation which came in at 8.6% for the year or 1.0% for the month. The core CPI inflation rates that strip out energy and price inflation came in at 6.0% for the year and 0.6% for the month. The 8.6% print was the biggest since 1981.

The University of Michigan consumer sentiment index came in at an historic low of 50 but there was a glimmer of hope on the expected inflation front i.e that it is beginning to soften.

The headline PCE measure of inflation came in at 6.3% for the year and 0.6% for the month. The core variant came in at 4.7% for the year an 0.3% for the month. The expected annual core reading was 4.8% and the pervious read was 4.9%.

The Atlanta Fed, which has a strong reputation for its forecasting ability, is predicting growth of 0.9% (annualised) for the June quarter but that is down from the 1.3% forecast made two weeks before. Since the previous growth read was  1.5% for the March quarter, two consecutive negative quarters (a technical recession) might be avoided but the Fed and many of the regional bank presidents continue to call for major increases in interest rates.

The noted Wharton School professor, Jeremy Siegel,recently said that the US might already be in a recession. He also noted that inflation might be cooling and he thinks the US stock markets are not overvalued.

The Fed’s own ‘dot plots’, which records present Fed members’ individual predictions for the cash rate, show that the consensus is pointing to the cash rate declining in 2024 following substantial increases in 2022 and a flattening in 2023. That might be enough to dodge the recession bullet.

Europe 

The ECB has, at last, joined the monetary policy move to end the accommodative regime that has lasted for a very long time. Interestingly, it has been reported that the UK, which left the EU in “Brexit”, is performing similarly to continental Europe.

With Sweden and Norway close to joining NATO and NATO moves to increase troops and armaments in the region, Russian President Putin is not left with many options for success in Ukraine.

Rest of the world

The World Bank is predicting global growth to be 2.9% in 2022. Emerging markets growth usually keeps that growth forecast quite a bit higher. It will be interesting to see if NATOs push to improve the military support to Ukraine has any spill-over to the private sector economy.

Recent Market Volatility

As you may be aware financial markets have been through a period of elevated volatility in the past couple of weeks, which has served to punctuate the regime change we have been experiencing in markets so far in 2022, in particular, this June quarter. This regime change is coming from the world ‘re-opening’ post the Covid 19 lockdowns, which has led to both rising demand and ongoing disruption to the supply of manufactured products. This has in turn led to rising inflationary pressure and some outsized responses by central banks in the near term, with the expectation of more interest rate rises to come.

In relation to events of the past 2 weeks, share markets began softening from about Wednesday 8 June ahead of the US Inflation data release on Friday morning, 10 June. From a global perspective, the US inflation data for May was critical because its level would provide strong guidance to the US Federal Reserve’s (Fed) interest rate policy setting. The US Consumer Price Inflation (CPI) came in at 1.0% for the month of May (8.6% p.a. for the year), while ‘core’ inflation (which excludes food and energy) came in at 6.0% p.a. The CPI data in particular, was much higher than anticipated by share and bond markets and this led to a heavy selloff both in the US and globally. Further, it was clear evidence that peak inflation and bond yields may still be yet to occur. This contrasted with the views of many market participants who believed this event had recently passed. In Australia, our markets were spooked by RBA Governor Philip Lowe raising our cash rate by 0.50% on 7 June 2022, a larger rise than anticipated by the markets and local shares and bonds responded by selling off.

With the higher inflation data for May, the US Fed determined to increase US cash rates by a very large 0.75% at its meeting on 15 June, to set rates in the range of 1.50% to 1.75%. Fed Chair, Jerome Powell, in his commentary indicated that another increase of 0.75% or 0.50% was anticipated from its meeting in early August. If this occurs, the US cash rate will rise to at least 2.0% and possibly as high as 2.5%. Similarly, in Australia, RBA Governor Lowe commented that inflation could rise to 7.0% by December, from which markets inferred a further 0.50% rate increase was likely here in early July.

While current economic data paints a reasonably positive backdrop (i.e. employment is strong, corporate earnings are holding up and the Chinese economy is turning on again after a 60-day Covid lockdown of major industrial and commercial centres), forward looking indicators are pointing to a slowdown of growth in the developed world. Of these indicators, softening US retail sales, very weak consumer sentiment and continued elevation of oil and energy prices are indicating the increased probability of a recession. This added fuel to the fire of market volatility last week when markets also had to factor in further increases to interest rates in the near term. This confluence of events is largely responsible for the elevated market volatility of the past two weeks.

Despite this, financial markets are forward looking and adjust quickly to new information, a good example being last week. While the risk of recession has risen, the prospect of this occurring in the near-term is not likely. We believe that the global economy can continue grow as the world re-opens from Covid, given demand remains resilient. Also, we are yet to see any broad slowdown in corporate earnings with many companies having beaten analysts’ expectations recently, giving us some confidence in share market valuations.

We also consider inflation is likely to moderate over the remainder of the year. Assuming this occurs, it will reduce the need for the US Fed, the RBA and others to hike interest rates by as much as is now priced into markets. This is the economic ‘soft landing’ outcome we currently think is most probable but is contingent on consumption, corporate earnings and economic growth remaining positive.

Written by Jeff Mitchell, Chief Investment Officer, Infocus

Economic Update June 2022

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

Key points:

– Market volatility has been high driven by inflation and interest rate concerns, Stagflation seen as a risk
– US Fed and Australia’s RBA lift cash rates but bond rates ease from highs achieved early in May

– China is stimulating its economy as Covid case numbers decline

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

We’ve had a turbulent couple of months on equity markets – to say the least! The new source of angst was from the Federal Reserve (“Fed”). Not only did they institute a big (0.50%) rate hike but they talked really aggressively about what might come next.

This policy aggression – or “hawkishness” – spooked bond markets. Yields on longer dated bonds e.g. 10 year Government bonds, jumped up sending the prices of high growth stocks – such as those of large mega-tech companies – tumbling in some cases. That took down the tech-based Nasdaq index to a level just shy of -30% from its December 2021 high, though there was a lesser impact on the S&P 500 because of its inclusion of all of the other industry sectors. The Dow (Jones Industrials index) was much less affected. For similar reasons our market falls were cushioned by our relative lack of a tech sector.

It is really important for investors to understand what is motivating the Fed and many market analysts. Some people have been talking about recession for some time but now the word “stagflation” has become more front of mind.

The term “stagflation” was coined in the mid-1960s in Britain by the then Chancellor of the Exchequer. It didn’t get mentioned again until 1970 and then became the word ‘du jour’ after the absolutely massive 1973 and 1979 OPEC oil price hikes. If you think recent oil price rises are big, check out what happened in 1973. Such a shock to the price system is called a “supply shock” because it is separate from the demand pressures that so often cause inflation.

Stagflation occurs when there is persistently high inflation coupled with sluggish (or worse) economic growth. The simplest explanation for those times and today is the following. A supply shock such as that caused to oil prices by OPEC in the 1970s or Russia in 2022, sparks high inflation. The central banks go out to quell inflation by hitting the monetary policy brakes – that is raising interest rates and possibly other measures.

If the cause of inflation cannot be cured by raising interest rates (as is the case for supply shocks), economic growth falls producing stagflation as inflation is largely impervious to the actions of central bank policy actions.

Conversely, when demand pressures are causing inflation, higher rates can cure an inflation problem. However, because of the long lags between raising rates and the real economy reacting, central banks can (and often do) cause recessions. It needs to be remembered that central bank monetary policy and Government fiscal policy (expressed through the budget) are blunt instruments hence policy mistakes are not unusual.

In the 1970s, when monetary policy supposedly came of age under the leadership of Nobel Laureate Milton Friedman, the lag between raising rates and economic response was thought to be 12 – 18 months. Since then, financial markets have become far more complex.

Many of us now rarely use cash for anything! Most of us didn’t have a credit card in 1970. There are now also complex derivatives in financial markets that allow the size of financial transactions to be scaled up enormously. We doubt if anyone currently has a good handle how long the monetary policy lag is, but we think it would at least be a few months and possibly a lot longer.

Few serious analysts would doubt that we have been experiencing supply shocks for a couple of years: oil price rises from OPEC activity; both energy and grain prices from the Russian invasion of the Ukraine; and the supply-chain problems largely coming out of China because of covid-related lockdowns. There is equally good reason to assume that these supply shocks will not respond to rate rises in the US or Australia.

Because of the past lockdowns in the US, Australia and Europe – and the change in work habits that followed – labour has been harder to find in some sectors as we strive to get back to normal. In a sense, a reduced post-covid-workforce could be thought of as a supply shock. But the wage increases we are seeing are in part demand related.

Workers are being bid away from home or other jobs and workers also want to be compensated for the higher prices they are undoubtedly facing. Higher rates make it more costly for business to raise capital and can put downward pressure on that part of the inflation problem.

For much of the first part of the supply shock inflation problem, the Fed chair, Jerome Powell, sensibly told everyone not to worry about it. But, as the problem got bigger, and seemingly some Fed members were playing political games by saying the Fed was behind the curve, Powell started to lose his nerve.

The Fed hiked a “double notch” of 0.50% points at the start of May but Fed Chair Powell said he was not considering bigger hikes going forward. Markets became volatile as different interpretations of the current regime took centre stage. There was a very big US CPI headline inflation read of 8.3% but the Fed prefers the so-called “core” inflation numbers that strip out volatile energy and food prices. The core read was a more acceptable 6.2% but still very much above the 2% Fed target.

The problem with the US inflation data is that they focus most attention on the annual read comparing say this April’s prices with those in April 2021. In normal times there is no real problem in doing this. Indeed, there can be advantages in smoothing out statistical noise.

But when a big blip of a few months’ duration comes along, it takes months and months to notice inflation has really gone up. Equally, it takes months and months for the annual inflation rate to fall back to normal as the blip passes through the 12-month data window.

The US does also publish monthly data. The latest read for April was 0.3% for the headline rate and 0.9% for the core variant. There are two really important observations to make here.

Firstly, the 0.3% headline rate was the equal lowest in 12 months. Now, it could just be a statistical blip. We won’t know for at least a month or two, maybe more. Second, and more importantly, the core value was above the headline number. This means the volatile energy and food prices actually deflated in April! Could this be indicating the situation already be self-correcting?

Along came another variant of inflation later in May – the so-called PCE (Personal Consumption Expenditure) measure. The Fed has long-held it prefers this variant. The headline PCE monthly rate came in at 0.2% from 0.9% in the previous month. The core version was 0.3% for the second month in a row. This result could be more evidence that the supply shock impact is subsiding.

Now, energy, food and other prices are still high, but inflation measures a relative change from one month to the next. For inflation to remain high, energy prices and the rest would have to keep rising.

We are not yet prepared to make the call that inflation will naturally fall over the course of this year but we, and presumably the Fed, will be monitoring its progress very closely.

The current Fed funds (cash) rate is a range: 0.75% to 1.00%. The commonly held belief is that the neutral rate is somewhere around 2.5% in the US and 2% to 3% in Australia. When rates are below the neutral rate, policy is said to be accommodative (supportive of economic growth). When the cash rate is above neutral, the policy is considered contractionary (restrictive for economic growth).

The Fed has forecast they will make at least another two 0.5% hikes to the Fed funds interest rate before they start slowing the economy down.  This is likely to occur at their next meeting in mid June and again in early August. By then it will be reasonably clear whether or not the inflation problem has started to self-correct and the modest hikes toward the ‘neutral’ interest rate may take some sting out of any demand-pull inflation.

The Reserve Bank of Australia (RBA) is well behind the US in raising it official cash rate. The RBA just lifted its rate from 0.1% to 0.35% in May. In its meeting minutes, it did say that it considered a bigger hike to 0.5% which would have brought its rate back to a scale calibrated in 0.25% increments which is has been historically.

Both the US and Australia have strong but not “hot” labour markets. We are cautiously optimistic that neither central bank will cause stagflation. They have stated that they are aware much of inflation is due to supply-side problems.

In the meantime, consumers are facing higher prices. When inflation runs ahead of wage inflation – which it is – consumers are becoming worse off and need to be compensated. The choice is between wage rises and temporary government payments. The latter might be preferable to locking in wage inflation expectations.

The Bank of England has stated that it thinks they will experience a recession in the UK starting this year. China has been cutting some rates and stimulating the economy to compensate for the Shanghai (and other industrial cities) Covid-lockdown.

The S&P 500 did temporarily enter bear-market territory in May by falling below 20% from the recent peak in early January. The ASX 200 didn’t quite fall 10% to mark a correction. Both indexes made substantial gains in the closing days of May. If inflation pans out as we think it might, both indexes could be well on the way to at least recovering some or all the drawdown experienced so far this year. Despite this more positive outlook there will still probably be a few big wobbles along the way as the Russian invasion of the Ukraine continues.

Bond yields have climbed over the year but even at their recent peak in early May they are not compelling competition for the dividend yields on stocks let alone the prospect of possible capital gains on equities.

Earnings forecasts collected by Refinitiv support the notion that the fundamentals of the underlying businesses of the companies comprising the S&P 500 and the ASX 200 remain strong.
Asset Classes

Australian Equities 

The ASX 200 shed 3% in May despite the very strong two-day rally near the end of May. However, the index has only lost 3.1% over the year-to-date. Given that this index was down 9% at one point, the strength of the rally is encouraging for future gains.

The consumer staples ( 6.7%), IT ( 8.7%) and property sectors ( 8.7%) were the worst hit in May. No sector performed exceedingly well.

International Equities 

The S&P 500 was flat over May despite its turbulent day-to-day movements. Some other major indexes gained over the month, key examples are: England’s FTSE (+0.8%); Germany’s DAX (+2.1%) Japan’s Nikkei (+1.6%); and the Shanghai Composite (+4.6%). Interestingly, broader Emerging Markets ( 0.5%) lost a little ground.

Bonds and Interest Rates

The RBA lifted its overnight cash interest rate from 0.1% to 0.35% at its May meeting. It also said that it would start to reduce the total government debt by letting maturing bonds ‘run off’ in an organised fashion.

Since inflation in Australia is far from the problem it is in many other countries, there should be less temptation for the RBA to just keep hiking in an aggressive fashion.

The governor, Dr Philip Lowe, is particularly well educated in economics and he is of a conservative disposition. We think it will be some time before he will look to push up rates to the neutral rate of 2% to 3% (as recently stated by Dr Chris Kent of the RBA) let alone above that band.

The Fed has put out some seemingly contradictory statements about how US monetary policy might unwind this year. The market is expecting a total increase of more than 2.5% in the Fed funds cash rate in relatively short order and some are expecting this rate to be above 3% by the end of the year. The key to this for us is what happens to the monthly inflation read over the next three or four months. These rate expectations can turn on a pin head.

The US 10-yr government bond yield got above 3% at one time during May but it is now back to around 2.75%. The Australia 10-yr made it to over 3.5% before retreating a fraction to around 3.2% and then up slightly to close the month at 3.4%.

Other Assets 

Gold, iron ore and copper prices all retreated over May but in a measured way. Both West Texas Intermediate Crude and Brent Crude oil prices climbed close to 11% and are back to around the recent highs. Indeed, at the end of May, the EU decided to limit Russian oil imports which seems to be pushing prices even higher.
The Australian dollar was largely flat over May (+0.5%). The Volatility (VIX) fear index, measuring equity market volatility, fell markedly and almost back to the high end of normal levels.
Regional Review

Australia

Australia produced some very unexpected results in its Federal election on May 21. The Labor Party is able to form a majority government. The coalition lost its potential successor to Scott Morrison, Josh Frydenberg, leaving Peter Dutton to lead the coalition.

High profile former Labor Senator, Kristina Keneally, lost a healthy majority and more. She is now in the political wilderness. The “teals”, seemingly a mix of green/LNP independents, gained a number of seats taking the independent member total to 10 in the lower house.

The April labour force data released in May showed the unemployment rate held steady at 3.9%, a multi decade low, even though only 4,000 new jobs were created.

Wages rose by 2.3% for the year lagging far behind the latest CPI Inflation read.

China 

The China monthly data of retail sales, industrial production and fixed asset investment all missed expectations – some by a lot. Much of this negativity comes from the zero-covid policy that led to the shut-down of Shanghai – the commercial and industrial hub.

The China official manufacturing PMI (Purchasing Managers’ Index) came in at 49.6 at the end of May. While below the 50 mark that indicates contraction (above 50 indicates expansion), it was well up on the 47.4 recorded in the previous month.

It has been reported that the Shanghai lockdown has started to be eased – as from the first week of June. Easing should help these economic indicators improve substantially and rapidly.

On top of the easing of restrictions, China lowered a key mortgage rate in May and flagged a $US 21 bn stimulus package to help the economy recover. We think that if this amount turns out to be insufficient, China will not hesitate to keep turning on the tap until stability in growth returns.

The China zero-covid policy has been considered largely a disaster by the western economies. Economically, it will be important that China abandon or at least significantly ease this policy should other outbreaks occur in the future.

US

There were 428,000 new jobs created as reported in the latest monthly labour report and the unemployment rate remains at 3.6%.

The US economy has some room to move as the Fed raises interest rates through this hiking cycle. Fed Chair Powell has stated that he wouldn’t be worried if the unemployment rate went up a notch or two as a result of his rate hikes. Presumably he hopes that his own position wouldn’t contribute to that increase!

Europe 

Norway and Sweden flagged their intent to become members of NATO – a similar issue that possibly sparked the Russian invasion of the Ukraine when it moved to join NATO. However, there does not yet seem any extra hostility following Norway and Sweden’s stated intent.

EU inflation came in at 8.1% at the end of May.

Rest of the world

Oil from Russia to North West Europe has fallen about 80% since the start of the Russian invasion. The volume of oil “at sea” has nearly trebled as Russia goes in search of other, more distant markets such as India and China.

Find an Adviser

Enter your postcode to find your closest adviser

Postcode