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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 – 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.

Economic Update May 2022

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

Key points:

– US Fed talks of bigger and quicker rate increases than recently anticipated
– US growth surprised on the downside with the economy actually contracting in the March quarter of 2022
– Australian inflation rises strongly on the back of fuel prices and construction costs

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

Just when it seemed that the markets had settled down after an updated rate hiking strategy from the US Federal Reserve (“Fed”), Fed chair Jerome Powell spooked markets with a strong statement about “front loading” the hiking process i.e. more rate rises earlier in the cycle.

Markets had already priced in a double hike (0.50%) for May 4 but the idea of front loading brought forward further double hike expectations. The market is now expecting a Fed funds rate of 2.75% by the end of 2022 from the current 0.25% to 0.5%.

We think the initial savage sell-off in late April was uncalled for. Perhaps that’s partly why the market bounced back sharply in the close to April – egged on by some splendid big tech earnings’ reports – until Amazon missed expectations and the markets tanked on the last day of the month.

What makes it harder to disentangle the forces that are currently driving markets is that the bounce back started on the release of a US economic growth rate of  1.4% (annualised) for the March quarter of 2022. Economists had expected +1.0% so this figure was a big miss. However, most dismissed the negative read as “noise” and not a “signal”.

The three usual suspects of the pandemic, inflation and the Ukraine invasion complicated the analysis. There was a record US trade imbalance as the post pandemic world tries to get back into shape. The Fed’s preferred “core Private Consumption Expenditure” (PCE) inflation read that strips out volatile energy and food prices was a substantial 5.2% – well above the Fed’s target rate of 2%.

Australia also posted an inflation read in the last week of April. The quarterly rate was 2.1% (not annualised) making for an annual rate of 5.1%. The Reserve Bank of Australia’s (“RBA”) target range is 2% to 3%. Before the last few quarters, inflation had been below 3% for about a decade. For about six years of that decade inflation had struggled below the RBA’s target range.

Some economists are clamouring for the RBA to hike rates aggressively to control inflation. This strategy is not without some risk. In the latest quarter, the price of automotive fuel rose by 11.0%. That increase is due to the supply effects emanating mainly from the Russian invasion of the Ukraine in the March quarter. A rate hike in Australia cannot have any meaningful impact on such a supply constraint occuring on the other side of the world.

Skyrocketing fuel prices are an important input cost component for most business. When the RBA, or the Fed, tries to strip out volatile energy and fuel prices it cannot isolate business input costs from the impact of higher fuel prices so volatile items do feed into the ‘core inflation measure. As a result, core inflation and the RBA’s “trimmed mean” inflation are over-estimates of underlying inflation when all energy cost are stripped out.

Similarly, the pressure on prices of soft commodities such as wheat caused by the Ukraine invasion pervade not just the obvious grocery price increases but also restaurants, cafes and take-aways amongst other businesses.

The RBA’s trimmed mean measure of inflation was only 3.7% which is only just above the target range – and that is without stripping out the indirect impact of the Russian invasion.

The RBA rate is very low and the Fed has only just made a very modest start to increase its rate. There is plenty of room for both countries’ rates to rise without causing growth problems. When rates are below the so-called neutral rate (of around 2.5%) rate hikes do not really equate to policy tightening. Rather such hikes equate to “less slackening”.

The fear some have is that the US – and/or Australia – could cause a recession by increasing interest rates too far and/or too quickly. We – like many others – are yet to be convinced that the latest negative read in US growth will lead to a recession. However, an unnecessarily aggressive set of rate hikes – to even below the neutral rate – could frighten equity markets and, in turn, impact the real economy through a wealth effect. We currently do not think that measured interest rate hikes should hurt the economy.

The IMF posted its updated 2022 growth forecasts for the world and major countries in the last week of April. World growth expectations were downgraded to 3.6% with Australia at 4.2% and the US at 3.7%. The IMF sees strong growth here and the US for 2022 and not a recession!

There is no doubt that consumers are hurt by high inflation even if it is sourced from volatile food and energy prices resulting from geopolitical, as opposed to macroeconomic, events. Increasing rates might even compound the problem by forcing up mortgage payments which in turn puts downward pressure on property prices, erodes the wealth effect resulting in slowing consumption and economic growth.

Labour markets are strong in the US and Australia. Both countries posted strong jobs growth and low unemployment rates. There is some evidence that big companies like Amazon are fiercely competing for labour – particularly as it is mooted that its labour force might become unionised. Wages seem set to rise in the US but there is little to support that notion in Australia just yet.

While it is true that some big US tech companies’ share prices were slashed on their Q1 earnings’ reports – particularly Netflix and Amazon – there were many more strong statements – notably Meta (formerly known as Facebook). We track earnings expectations collected by Refinitiv and we note that earnings remain broadly healthy enough to be supportive of valuations well into the second half of 2022 – notwithstanding markets will experience bouts of elevated volatility through this period. Similarly, the ASX 200 has earnings support from its leading companies.

China posted a strong 4.8% economic growth rate for the March quarter of 2022. However, the economy is being held back by its Covid Zero policy. Shanghai, in particular, is in virtual lockdown which contributes to the supply-chain problems that are partly causing high global inflation.

The invasion of the Ukraine by Russia seems to be taking a turn. Russia seems to be narrowing its interest to just annexing the coastal land-bridge near Crimea. But the rhetoric from Putin is just as strong and he is speaking of not wanting a diplomatic solution. President Biden is asking Congress to appropriate $US33 bn in aid for Ukraine of which $US20 bn is for armaments.
Asset Classes
Australian Equities 

The ASX 200 has come through the year-to-date relatively unscathed experiencing a minor decline of at  0.1%, a strong result given the Ukraine invasion, the Fed’s new hiking policy and the continuing pandemic. Capital gains, while modestly negative over the month were quite well contained at  0.9%.

The Energy and Materials sectors have had a strong year-to-date which has provided good support for the Australian share index. The Energy sector is up 28.1% and Materials up 7.0%. Much of this strength is due to strong commodity prices and China’s demand.

Despite the heightened volatility in the index, the broker-based forecasts of company earnings surveyed by Refinitiv have remained strong over the month and year-to-date. When, or if, the major impediments to normal volatility subside, earnings expectations should return to be a dominant force in the share price discovery process.

International Equities 

The S&P 500 is ‘officially’ in correction territory having fallen  13.3% over the year-to-date. April ( 8.8%) turned out to be particularly bad for Wall Street having stock prices buffeted by a handful of spectacular ‘misses’ on earnings and outlook from big tech companies Netflix and Amazon performed particularly poorly but Meta was a big outperformer. Most companies had a strong report for the March quarter but sentiment seems to have been buffeted by some ‘tech darlings’ suddenly underperforming. Our analysis of Refinitiv’s broker forecasts remains positive over the next 12 months.

London’s FTSE was slightly positive for the month but most other major markets had a poor April. But the US is still a standout in this comparison. Wall Street has boomed on the performance of big tech and some of those lofty expectations have rationalised recently as investor expectations have become more grounded.

Bonds and Interest Rates

After the 0.25% increase in the Fed funds rate in March, expectations of a double hike of 0.5% in May (99.6% probability from the CME Fedwatch calculator) and possibly in subsequent months has increased markedly. The interest rates for US 10-year Treasuries climbed to almost 3% later in April. Our 10-year government bonds now yield in excess of 3%.

There is now some slight justification for the RBA to start its interest rate-hiking cycle. However, at time of writing we think that the governor, Dr Philip Lowe, is unlikely to get too aggressive in this regard.

Other Assets 

The prices of a number of commodities pulled back a little in April after a surge in the March quarter of 2022. Oil prices are, however, still above $US100 / barrel and iron ore is hovering around $US140 / tonne.

If oil prices remain high but do not increase further, that will bring energy price inflation down and not then contribute so significantly to the various consumer inflation statistics going forward.

This year the $A against the US dollar rose from just above 70 cents to over 76 cents and then back to 71.5 cents in recent weeks, yet another indication of heightened volatility and uncertainty in markets currently.
Regional Review
Australia

Australia will hold its federal election on May 21. Earlier this year, Labour was starting to look like it was its election to lose but things have changed. A few blunders and the usual in-fighting have made the outcome less certain. Some are seeing the possibility of a hung parliament.

Meanwhile, the economy looks reasonably strong. The unemployment rate is down to an historically low 4.0% after another 17,900 jobs were added in the latest month. The main question around economic growth relates to one’s belief in how fast the RBA might raise rates. The first hike from the historically low 0.1% to 0.25% or possibly 0.5% would be benign for growth. It is more a question of what the RBA would do after that.

The latest quarterly inflation rate comprised some big increases to some components e.g.  automotive fuel prices 11.0% higher and new dwelling construction was up 5.7% to produce the aggregate figure of 2.1% for the quarter.

While we argue that rate increases will do little to cure, or ameliorate the current inflation we are experiencing, it won’t stop the speculation by many that it will. This poses an interesting dilemma for the RBA in relation to actual inflation cause and effect vs popular expectation.
China 

The China economy continues to be constrained by its desire to purse a zero-covid policy using lockdowns. President Xi, is urging for more infrastructure spending to balance the covid policy for promoting growth.

Its GDP growth for the March quarter was a respectable 4.8%. The elevated iron ore price of around $140 / tonne suggests that China demand is strong enough to support the 4.8% p.a. growth level though it is below President Xi’s target of 5.5% for 2022.

On a political front, the recent security agreement with the Solomon Islands is yet another disturbing example of China increasing its presence and potential influence in the region and much closer to Australia.

US

There were 431,000 new jobs created as reported in the latest monthly labour report and the unemployment rate is at a low 3.6%.

Inflation is a big problem in the US but, as we discussed elsewhere, the main problems flow from Covid management, supply-chain disruptions, energy costs and the Russian invasion of the Ukraine.

Inflation came in at 8.5% over the year but the March increase was 1.2% and the core inflation read was only 0.3%. Core inflation is starting to look less of an issue without monetary policy tightening.

The March quarter GDP growth read of  1.4% (annualised) was unexpected by most, if not all, commentators. The market seemed to ignore this figure and focus instead on some of the stellar earnings’ reports from the big Nasdaq stocks.

Europe 

Russia has reportedly stopped energy supplies to Poland and Bulgaria. Poland retorted it had plenty of coal at hand and would not suffer as a result.
The IMF growth forecasts highlighted the extent of the economic damage to the Ukraine and Russia from the invasion. The IMF predicts growth over 2022 in Russia to fall by  8.5% and for the Ukraine by  37%.

In France, President Macron was re-elected.

Rest of the world

New Zealand increased its base interest rate by 0.5% points to 1.5%.

Economic Update April 2022

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

Key points:

– US inflation pushes higher and the US Fed starts hiking interest rates
– The Ukraine invasion by Russia has not escalated beyond expectations but has become more protracted
– Commodity prices and $A bounce on the Ukraine invasion and Australian economic data very strong
– The world re-opens despite Omicron and now BA2 but lockdowns in China continue to impact supply chains
– China economy bounces back from a weaker second half of 2021

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

The Big Picture

While the devastation and casualties continue to mount in the Ukraine, worst-case scenarios seem thankfully to have been avoided – at least so far.

The resilience of the Ukrainian people has reportedly been outstanding. The West has contributed in many ways but it has not attempted to inflame the situation by moving troops too close to the action – or firing our own missiles.

As is usual, markets fell sharply on the first bad news but recovered after having realised they had priced in a worse outcome. With media outlets almost calling a stalemate in the Ukraine with Putin having failed, so far at least, to achieve his objectives (whatever they may have been), it would take fresh bad news to shake the market again. There is opinion forming that Putin might even be at risk of being ousted as leader.

Some of the success in preventing a worse outcome can be attributed to the co-ordinated sanctions being placed on some trade and the assets of the so-called seven oligarchs that amassed great wealth from links with Putin.

Superyachts, planes and property have been seized by various countries. The impact on the Russian economy has reportedly been massive. At the start of March, the Russian Central Bank increased its base interest rate from 9.5% to 20% in an attempt to cushion the rapid depreciation of the rouble.

As March drew to a close, there was some optimism that Putin was considering a ‘lesser objective’ and, indeed, recent talks between the two sides is offering a little more hope than previous talks.
While Ukraine is rightly taking centre stage on TV news, the great economic news from Australia, the US and China might have largely flown under the radar.

The US Federal Reserve (the ‘Fed’) raised its cash interest rate by 0.25% points to a range of 0.25% to 0.50% at its March meeting. It also signalled that it now expects six more hikes this year rather than the three in total it expected for 2022 at its December meeting. The forwards’ markets that price these outcomes have been swirling as each statement is made by a Fed member. US Federal Reserve (Fed) Chair Jerome Powell recently came out and predicted possible ‘double hikes’ of 0.50% points. As a result, markets have priced in a double hike at its next meeting on May 4th as being more than twice as likely as a single hike. There is no appetite for more than a double hike or conversely, staying on hold.

This interest rate news has also affected the US mortgage market. Unlike in Australia, their most common type of mortgage is a 30-year fixed-rate loan. It gives perfect foresight to the borrower as to what payments can be expected for the entire length of the loan. Moreover, as inflation builds over the 30 years, the repayments fall in inflation-adjusted terms.

The US 30-yr mortgage rate jumped sharply twice in the last week or so of March to 4.95%. Contrast that to our floating rates in the low two percent range. The US mortgage rate hikes and the recent increases in property prices mean that people are now paying 20% more a month than others were quite recently. That’s got to hurt! Existing mortgagees, of course, pay the same as they previously did because they bought a while back at the old prices and the rate was then fixed for the entire term. Only the new buyers suffer with the higher rate and this in turn might help cool the US property market.

With this change in monetary policy stance, the important question, now canvassed by even ‘sensible’ economists, is will this change by the Fed cause a recession? They have certainly been found guilty on a number of previous occasions!

In general, as a central bank raises rates to cool an economy – known as ‘monetary policy tightening’ – the rates for short terms, like 3-months to 12-months,rise in unison. For longer terms – say 10-yrs or more – interest rates may not move as much or at all. Most agree that expected inflation is the major determinant of longer term interest rates.

The ‘normal’ situation is that short term rates are lower than long term rates reflecting the increased risk to capital return over the longer term. These yields typically rise smoothly with the term of the bonds/term deposits. The array of yields for the different terms from short to long is called the yield curve when all plotted on the same chart, longer term yields typically flatten out after about 7-10 years. When rates at the short end are higher than at the longer end, the so-called yield curve is said to be inverted.

Back in 2019 the yield curve got close to being inverted and some called a recession would follow. While it is true that most recessions are preceded by an inverted curve, it is also true that not all inverted yield curves are followed by a recession.

It usually takes several factors to cause a recession. We argued in 2019 that the inverted yield curve was on its own not sufficient to justify a recession. As it turned out, there was a recession in 2020 but that was caused almost entirely by the unexpected shutdown in response to the Covid 19 pandemic – and not interest rates!

It is also important to note that some people consider the yield curve ‘spread’ for inversion to be the difference between the very short yield and the 10-yr yield while others focus on the difference between the 2-yr and 10-yr yields. Obviously, as the yield curve flattens out, the latter indicator is dominated more by very small movements in yield and hence is more likely to invert in turn increasing the potential for it to give a false signal. That said, any inversion of the yield curve should not be ignored and the reasons for it investigated.

It is equally important to note that the actual yield, rather than the yield ‘spread’ alone, must play a big role. If all rates were pretty close to zero (say less than 0.10%) it is difficult to see how any recessionary problems could emerge from an inverted yield curve. On the other hand, back in 2000 and 2006-2007, the 2-yr yields were over 5% when those yield curves inverted (on the ‘2yr-10yr’ spread definition) and each was followed by a recession. Today the 2-yr yield is closer to 2.5% – hardly the stuff of expensive borrowing costs compared to current inflation at around 6% to 7%.

Obviously, the Fed could cause a recession this time around so we shouldn’t rule it out. The Fed funds rate has a long way to go before inversion gets close (using the spread over the whole curve i.e. cash vs 10 yr) so we shouldn’t worry yet. Increasing the rate from the ‘emergency’ rate range of 0.00% to 0.25% by a little is not really tightening. Tightening doesn’t really start until the rate gets above the so-called ‘neutral rate’ which neither slows down nor speeds up the economy. There is no precise estimate of what the neutral rate might be, but most well-informed analysts say it was somewhere around 2.5%.

We are convinced many commentators do not properly understand the linkage between interest rates and inflation. There is no magic string that joins the two together. Rather, increasing the Fed funds rate (US cash rate) increases in turn the cost of borrowing for households and businesses. Those increases in costs slows down growth and take ‘demand side’ inflation pressures away.

Importantly, the US government debt is in the trillions of dollars so the Fed won’t want to shoot itself in the foot by recklessly hiking rates and increasing its debt funding costs.

A large contributor to current inflation in the US is due to supply-chain disruptions caused by the pandemic and surges in energy and ‘soft’ commodity prices (such as wheat) which are due to the Ukrainian situation and related causes. There is no linkage between the US funds rate and those two causes of inflation. Therefore, if the Fed kept trying to crank up interest rates until inflation collapsed, the economy would collapse before inflation dropped significantly.

We think that it is quite plausible that the Fed chair, Jerome Powell, fully understands these arguments. He has almost said as much. By cranking interest rates up just a little, he gets a lot of people off his case without causing a problem. Smart move! Let‘s not worry about the Fed funds rate until it gets to around 2.5% and that’s probably 2023.

Towards the end of the year Ukraine and supply-chain issues might be receding and inflation may then fall – but not in response to any modest rate rises. If that happens, Powell can then keep rates on hold until domestic causes of inflation really are a problem. If inflation does not fall because of the reasons given, he can point to the disconnect, so that more rate rises won’t help.
Recessions are always possible and typically come out of the blue. We see no reason to increase our expectation of a recession any time soon.

Getting back to the real economy, US jobs data were very strong and the unemployment rate is down to 3.8%. Wages growth came in at 5.1% in March but that is less than even the ‘core’ rate of inflation that strips out volatile energy and food prices. It is good that wages are rising because, otherwise, workers would be much worse off. There are no obvious signs of a wage-price spiral based on expectations (yet?).

At home our central bank, the Reserve Bank of Australia (‘RBA’), kept rates on hold. Our inflation is in the preferred ‘zone’ so we don’t need to raise rates at the moment. However, for the same reasons as the Fed, they might choose to make a very modest hike or two this year to get people off their case.

Our GDP growth came in at +3.4% for the quarter (Q4, 2021) which was distorted by a bounce-back from the Delta virus lockdown. Growth was +4.2% for the whole of 2021 and GDP is now +3.4% (not annualised) above where it was before the pandemic.

Home prices from the Australian Bureau of Statistics (‘ABS’) surged in 2021 in Australia – by 23.7% for the year. There is evidence from a private data source, CoreLogic, that house price growth has slowed to close to zero in the first three months of 2022. (No RBA interest rate rise was needed to cause that!)

Our unemployment rate fell to 4.0% which is the equal lowest in 48 years (see Federal Budget statement). 121,000 new full-time jobs were created. 20,000 would usually be called a big number. That is very good news, indeed.

March ended with our Federal Budget. There was no clear long-term policy direction – more of a mish mash of handouts in a typical election mode push. The Treasurer forecast growth of 4.25% in this financial year and 3.5% in the following year. Thereafter, to 2025-26, he forecast growth of 2.5% p.a. He also expects the unemployment rate to fall to 3.75%.

Even China data have been ‘on the bounce’. Retail sales were up 6.7% (for Jan/Feb combined) compared to an expected 3%; industrial production was up 7.5% compared to an expected 3.9%. China data got a bit soft last year as they pursued a zero-Covid policy. Indeed, China is now forcing a short, sharp shutdown for Shanghai in a bid to stop a new wave of infection. China is reportedly pumping stimulus into the economy which may account for the recent strong economic data.

Thankfully, China has not become too involved in the Russian invasion of Ukraine. Perhaps they appreciate the possible impact of sanctions on them if they were to pursue a reunification of Taiwan by force.

Stock markets are charging towards their all-time highs on the basis of good data and not too much economic impact in the West from the Ukraine invasion. Bond yields are now getting to the mid to high 2% range in the US and Australia but that is no match for the expected return in equities. Share markets are still supported by the TINA – there is no alternative – principle!

Asset Classes

Australian Equities

The ASX 200 gained +6.4% during the month of March which puts the index just up on the year-to-date (+0.7%). Much of the gains were due to the Resources sectors – Energy (+9.6%), Materials (+8.2%) – doing very well on much higher commodity prices. The Financials (+8.3%) and IT (+13.2%) sectors also performed particularly strongly.

International Equities

The S&P 500 (+3.5%) also had a strong month but not matching the gains on the ASX 200. Probably due to the Ukraine invasion, the London FTSE and the Frankfurt DAX struggled to keep pace. China and the broader Emerging Markets indexes went backwards in March. Over the year-to-date, the S&P 500 lost 4.9%.

Bonds and Interest Rates

The US Fed increased the Fed funds rates by 0.25% points in March – at their first meeting since December. In the December meeting, the Fed thought that they would need three hikes this year. The update to now is significantly different, one increase just done and six more to come. The reason for the shift is a material change in inflation expectations supported by a set of chunky inflation figures for recent periods.

We argued elsewhere in this update that much of the current inflation problem can simply not be fixed by hiking rates.

But before people panic and rush for the exits, some context is useful. If we look at the yield curve today, 12 months ago, 24 months ago and 36 months ago we see a really interesting evolution.
For 2-yr bonds to 10-yr bonds, the yield curves are just about the same now as in 2019. The difference is that today, the short-term yield is less than 0.5% and it rises steeply to about 2-yrs. Back in 2019, the whole yield curve was more or less flat.

US Yield Curves at March in each of the past 4 years

In other words, pushing the Fed funds rate up to about 2.50% – a massive change from the current rate, we may just about where we were in March 2019!

In 2020, the yield curve collapsed due to the pandemic across the whole term structure. In 2021, there was some recovery so the recent gains should be compared to the difference from 2019 and not from the crisis data.

In 2019, the world was a happier place – no pandemic; no Russian invasion of Ukraine; no spike in the prices of wheat and oil; no major supply-chain issues. We are simply edging back to normal with historically very low rates – even after a few more hikes. Panic now is the last thing we need.

The RBA did not raise rates at its March meeting nor do we think it should have done. The core CPI inflation read was bang in the middle of the 2% to 3% RBA-target band. Unemployment is 4% which is low but it has been a bit lower and we were still happy then.

The interesting question is why our inflation level is just fine but it is not so in the US and elsewhere. We live in a global economy.

Our economy is very different from that in the US. We are heavily dependent on resource exports – notably iron ore with a price going gangbusters. And the composition of our production is quite different. To be frank, we cannot explain all of the differences but, to some extent we don’t have to. All we need to know is whether our policy makers and industries are up to the challenges they face. We think they have been and see no reason for this to change.

Other Assets

The price of Brent Crude Oil gained +6.2% over the month. Not only was the invasion of Ukraine a cause but also rebels bombed oil storage facilities outside of the Saudi capital just before they staged the F1 Grand Prix in late March. US President Biden did just order the release of one million barrels per day from reserves to soften fuel prices.

The price of iron ore rose +13.9% and that for copper +5.7%. Importantly, the VIX ‘fear gauge’ retreated to below 20% almost to where it started the year but then just rose a fraction at the close of the quarter during Wall Street’s last hour sell-off. It peaked this year at 36.5% in March.

On the back of the stronger commodity prices, the $A (in US terms) appreciated strongly by +4.2% to nearly $US0.75.

Regional Review

Australia

As Australia lurches towards a federal election, both sides seem to be offering enticements but they are both falling short in other ways. Given what we know so far, it seems to be far less important than last time who wins – especially for folk who have super funds! The March budget delivered a number of handouts but there were no particular fresh long-term policy objectives. Super was largely untouched in a negative sense.

The latest economic growth for Australia covered Q4, 2021 came in at an impressive +3.4% but +3.7% had been expected because of the economic bounce-back. Noting this period was not affected by Omicron or the Ukraine situation and it did pick up the bounce back from the Delta lockdown. The annual figure was +4.2% for 2021 but that figure includes the bounce-back from the first big lockdown in 2020.

When we measure growth across the two years of the pandemic, total growth was +3.4% or about +1.7% p.a. That’s not too bad given the extreme public health responses Australia made.

Another important statistic in the national accounts is the household savings ratio. It is often fairly static but it bounces around when people’s hopes for the future markedly change. A mid to high single digit percentage is usual. It jumped to 19.8% in Q3 reflecting fear and a lack of opportunity to spend. That ratio fell to 13.6% in Q4 but it leaves a lot further to go to get back to normal. We expect strong growth to continue given these cashed-up consumers will have more opportunity to spend – and feel confident enough not to need a bigger ‘rainy day’ fund.

Our latest labour-force data relates to a week in the month of February so it doesn’t pick up the Ukraine invasion but Omicron was around. There were +121,000 new full-time jobs created but, as some part-time jobs were lost, the total number of new jobs was +77,400 – but that’s still very impressive. Having a switch from part-time to full-time work bodes well for growth expectations.

China

China data were much stronger than the last few months and much stronger than expectations. China usually combines data for January and February so that the moveable big Lunar New Year holiday has a more predictable impact.

That the three regular statistics of retail sales, industrial output and fixed asset investment all smashed expectations bode well for resource demand from Australia and China’s economy. Many commodity prices have boomed along with this recovery.

Two factors in China affect our economy the most. The zero-Covid policy means that it is much harder to make inroads into the supply-chain blockages. The relationship between China and Russia could cause major problems if they align too closely. But, so far so good. We are more than muddling through.

US

Last month we reported a bumper beat on the jobs front. This latest month was an even bigger beat! The +678,000 new jobs statistic was well ahead of the expected +440,000. The unemployment rate was 3.8% but the Fed chair has stated that a number such as this does not equate to full employment.

CPI inflation came in at 7.1% but the core rate that strips out volatile energy and food components was a more acceptable 6.4%. Wage growth was less at 5.1%. Core Private Consumption Expenditure (PCE) inflation – the Fed’s preferred measure of inflation – came in at 5.4%.

It is probably a good idea that Fed chair Jerome Powell is getting a little aggressive on interest rates as he will not want inflation expectations to start to spiral. He seems up to the task.

Europe

All of the action in March was again in Eastern Europe. The Ukrainians are putting up a stronger defence of their homeland than Russian President Putin could have imagined. There are reports that his undefined goals are being reduced. There is also talk of people wanting Putin out.

Rest of the world

In a disturbing turn of events, India is negotiating a banking deal with Russia. Some are worried that this could help Putin circumvent sanctions.

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