Economic Update

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

Key points:

–  Recent inflation numbers suggesting that inflation remains ‘sticky’.

–  Central Bank interest rate increases are back on the table but still less likely than cuts.

–  US economic growth softens in the March quarter.

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 the team.

The Big Picture

If March was the month that central banks started to cut rates – or at least foreshadow cuts – April witnessed at least the US Federal Reserve (Fed) and the Reserve Bank of Australia (RBA), talking of pushing the timing of cuts back – and even introducing the chance of more interest rate increases. Market pricing moved the first Fed interest rate cut from June out to September at the start of the month. Even September is now looking uncertain unless clear new economic data come to hand that is sufficient to support the Fed to cut interest rates. One rate cut in December is becoming the dominant call priced into money markets.

By and large, new inflation data in the US and Australia were lower than in the previous month/quarter. So, what was the problem? The key word is ‘stickiness’.

Late last year there was lots of optimism of inflation rates making serious progress towards central bank inflation rate target zones.

We have done quite a bit of research into the reasons for this stickiness. In the US, we found that by far the main problem is with the ‘shelter’ component which comprises about 33% of the broad Consumer Price Index (CPI). Official US data of CPI excluding shelter makes it clear that the inflation problem has been solved in everything except shelter. This shelter excluded index was in the target zone (of 2% or less) for each month from May 2023 to February 2024. The latest reading of 2.3% can reasonably be accounted for by a slight blip in oil prices as a result of the ongoing Middle East conflict.

The US shelter index is based on actual rents plus ‘owner equivalent rents’ (OER) which provides a proxy for the cost of home ownership. Not only does the US use a rolling 12-month window to calculate the annual window, individual rental ‘prices’ are typically held constant over the term of the lease – say 12-months or more. This method of calculating inflation has the effect of locking in any big change for two years or more.

Rents however seem impervious to fed rate policy. Shelter inflation is largely due to the supply-demand imbalance during a period of strong immigration and dislocations through the reaction to the pandemic. The ‘formula’ for calculating shelter inflation means that it is highly unlikely that the shelter component will reach 2% by the end of the year – even if ‘underlying shelter’ inflation was fully solved in early 2023!

If the Fed cuts interest rates, it is not likely that shelter inflation will alter its course. Wages and input prices in the US are behaving quite well.

Many cite the strength of the US economy as a reason for not cutting yet. The preliminary estimate of US GDP growth for the March quarter (Q1) was 1.6% against an expected 2.4%. The previous two quarters’ growth rates were 1.2% and 0.8% with Q1 growth at 0.4%. There is a clear trend emerging!

While the latest US GDP data could just be a blip, it should at least put the Fed on ‘amber alert’. The June quarter (Q2) is already well underway and monetary policy takes about 12-18 months to work its way through the economy.

US monetary policy did not become ‘restrictive’ until September 2022 – when the Fed funds rate climbed above the ‘neutral rate’ of, say, 3%. That first restrictive hike has only just worked its way fully through the economy and there are 2.25% points of additional hikes still in the pipeline and yet to be fully felt.

US employment data have seemingly held up but it has been well supported by quite a lot of financial stimulus spending by the Biden administration. Even so, there have only been 34,000 new jobs created in US manufacturing since October 2022.

Many reputable commentators are questioning the appropriateness (or accuracy) of US labour data. Each month a very big chunk of new jobs is in the government, health care and social administration sectors. And how many jobs do they need to create to be able to accommodate immigration flows? We are living in a new era for understanding labour movements: work from home (WFH); gig economy; GenZ reluctance to work in the traditional model; early retirement, etc

We came across an interesting statistic about US interest rates this month. The average interest rate paid across all mortgages is 3.8% but the rate for new loans is 7.1%. Because of the very long fixed-term loans favoured in the US, typically 30 years, they have been cushioned from rate rises much more so than those borrowing in Australia (who typically borrow at a floating interest rate) – so long as they don’t move home!

Australia’s jobs data were all over the place from November through to February – we suspect due to statistical seasonal adjustment procedures that have a more marked impact over the summer student school leaver / holiday period.

Our latest change in total employment over a month was ?6,600! However, there were 27,900 new full-time jobs offset by a big loss in part-time employment. The unemployment rate was 3.8%.

Our economic situation can be effectively monitored through changes in retail sales. In March, retail sales fell ?0.4% for the month and was up 0.8% for the year. When we allow for inflation, sales (i.e. volumes) fell by ?0.8% for the month and ?2.8% for the year. If we also allow for population growth of about 2.5%, the volume of sales attributable to the average person has fallen by ?4.5% for the year.

The cumulative fall in retail sales (volume) is ?4.9% from September 2022 which increases to nearly ?10% when we account for population growth. The average person in Australia is consuming about 10% less ‘things’ than they were in September 2022 and this trend in foregone consumption has continued to build month after month.

The average Australian resident is also carrying a mortgage burden far greater than that held in any recent period. Australian consumers are hurting yet some ‘experts’ are calling for rate increases. How much more pain do they want to put on the consumer and, for what?

Our latest CPI data was a bit of a miss at 1.0% for the quarter against an expected 0.8% but we also have a shelter (or household) category that is causing some stickiness. Lower rates would make it more viable for developers to build more houses and apartments to alleviate the rental crisis. Higher interest rates are more likely to exacerbate the rental situation.

Markets – both bonds and equities – have been buffeted by reactions to higher than anticipated inflation data and central bank commentary. However, there have been many strong company earnings’ reports in the US that underpin the S&P 500 valuations.

China produced some mixed economic data. Q1 growth came in at a brisk 5.3% compared to a more modest expectation of 4.6%. However, both monthly retail sales and industrial output missed expectations.

Asset Classes

Australian Equities

While most of the major markets are well up on the year-to-date (y-t-d), the ASX 200 ended April y-t-d up only +1.0%. For the month, the ASX 200 was down ?2.9%.

Our analysis of LSEG broker forecasts for Australian listed companies’ earnings is strong, but some expected weak macro data along the way could make share markets jittery.

Most sectors on the ASX 200 – save for Materials (+0.6%) and Utilities (+4.9%) – were in negative territory in April.

The narrative of the RBA governor’s press conference on May 7^th could be key in guiding near-term movements in the index.

International Equities

The S&P 500 was down ?4.2% on the month but the London FTSE was up +2.4%. China’s Shanghai Composite (+2.1%) and Emerging Markets (+1.6%) also had gains in April.

The S&P 500 swirled over sessions during the month as news, which was difficult to interpret, was digested. Towards the end of April, some strong earnings data lifted investor spirits.

Bonds and Interest Rates

In our opinion, investors and traders are finding it difficult to interpret ‘new’ news. There is little doubt that inflation has been easing – at least in general – but the difficult (almost impossible) question is whether it is improving sufficiently quickly that central bankers will be moved to reduce interest rates.

Central bankers seemed to be worried that, if they start cutting interest rates too soon – and inflation returns (whether or not due to the policy change) then they will need to begin the inflation fight again by increasing interest rates, in an environment where they will have lost credibility.

For the reasons stated, we think the central bankers are being overly cautious. But when billionaire, and much revered banker, Jamie Dimon states that rates might have to go to 8% to quell inflation, it is hard for dissenters to be taken seriously.

Nevertheless, for the reasons given in the opening section, we are reasonably confident that the next move for interest rates should be down, not up. However, if interest rates are cut and then a new supply shock happens, like heightened military action or oil price shocks, inflation would come back – but not because of interest rate cuts. Interest rates have almost no impact on wars and oil prices.

There is little chance (as priced in by the fixed interest markets) that either the Fed on May 1^st, or the RBA on May 7^th will adjust interest rates.

The latest Fed ‘dot-plot’ chart (each dot is the interest rate forecast of a Fed board member) released in March showed three cuts in 2024. With the market now pricing in only one, or possibly two interest rate cuts, it will be interesting to see the Fed’s stance when the dot-plot is refreshed in June.

When analysing interest rate policies, there are two very separate questions. Firstly, what should the central bank do? Secondly, what will the central bank do?

The first question is much easier to answer. And the two answers could imply moves in opposite directions.

We think macro data – particularly in the USA and Australia – will present a much clearer picture over the next quarter or two. By then, all else being equal, that without central bank interest rate policy easing we could be closer to recession.

The ECB and the BoE are expected to cut their interest rates in June after some supportive (softening) inflation data.

Other Assets

Iron ore (+15.6%) and copper (+14.8%) prices jumped out of the gates in April. That backs a recovering China story.

Oil (+1.1%) and gold (3.7%) prices were up but by more modest amounts. The Australian dollar (?0.1%) was flat but the VIX (equity market ‘fear’ index) was well elevated earlier in April but started to retreat in the last week or so to 14.8 – or just above normal.

Regional Review

Australia

The federal budget will be handed down in mid-May. Some fiscal stimulus seems likely but, again, this is the government fighting the RBA and the latter seems uncertain as to what course to plot.

Because immigration has been so strong, the usual statistics do not show the extent of the economic pain that the average person is feeling.

Fortunately for investors, company earnings depend on total revenue and not on revenue per capita. Therefore, the ASX 200 can be resilient when the average consumer is not doing so well.

There were 27,900 new full-time jobs created in the latest month but that was offset by a loss of ?34,500 part-time jobs.

The headline CPI inflation rate was expected to come in at 0.8% for the quarter (Q1) or 3.4% for the year. The outcome was 1.0% for Q1 and 3.6% for the year. The market reacted negatively to these data and seemingly encouraged some to call for a return to interest rate rises. The RBA is set to announce its next rate decision on May 7^th. It is highly likely that the RBA will hold the interest rate at the current level but the fixed interest market is starting to price in a chance of a rate hike later in the year.

With the pipeline of past interest rate increases building up recessionary pressure, we might even soon see aggregate GDP (rather than per capita GDP) growth in negative territory.

Retail sales for March came in at ?0.4% for the month and up +0.8% for the 12 months. When adjusted for inflation, sales volume was down ?0.8% for the month and ?2.8% for the year. In inflation-adjusted terms, consumers are purchasing ?4.9% less than they were in September 2022. If we also account for population growth sales volume would be down by near ?10%. There is no demand pressure left for the RBA to quell!

China

Not long after the last People’s Congress had stated a target for growth of 5%, GDP data came in for Q1 at 5.3%, which was well above the 4.6% expected.

However, retail sales came in at 3.1% against an expected 4.6%. Industrial output also missed expectations at 4.5% against an expected 6.0%.

At the end of April, the Purchasing Managers’ Index (PMI) for manufacturing beat expectations at 50.4 when 50.3 had been expected but the index was 50.8 in the previous month (a level below 50 indicates contraction and a level above indicates expansion). The nonmanufacturing PMI was 51.2 against an expected 53.0. While these results are not strong, they are solid.

US

On the face of it, US jobs data were again good. There were 303,000 new jobs created against an expected 200,000. The wage growth importantly was only 0.3%. Producer price inflation was below expectations at 0.2% for the month against an expected 0.3%.

However, for the first time since the recovery from lockdowns, GDP growth disappointed; Q1 growth was well under expectations at 0.4%.

Retail sales surprised to the upside for the month. Growth of 0.4% had been expected but the outcome was 0.7%. However, the US statistical agency put a tolerance of ±0.5% on that estimate meaning that 0.7% isn’t statistically significantly different from the expectations. That didn’t stop the market from responding favourably to the sales data!

In our opinion the market started to react quite strongly to very small differences between expectations and outcomes – both up and down.

Europe

The UK just posted its second month of very small but positive GDP growth data. That could signal the end of the so-called ‘technical recession’. The Bank of England (BoE) held its interest rate steady at 4% in April but it is widely expected to start cutting interest rates from June.

EU and Germany inflation are starting to come close to target at 2.4% and 2.2%, respectively. The president of the European Central Bank (ECB) spent much of last year talking of the need to keep interest rates higher for longer. That stance seems to be softening.

The EU posted a gain in GDP in Q1 but the previous quarter was revised down to give two consecutive quarters of negative growth in the second half of 2023.

Rest of the World

Canada’s unemployment rate rose to 6.1% and its jobs’ creation was negative. Analysts are expecting the Bank of Canada to start cutting interest rates soon.

Japan inflation missed at 2.7% against an expected 2.8%. Core CPI was on expectations at 2.6%. Such is the skittishness of markets, the Nikkei opened down 3% following these data. We think the fall was more due to the general uncertainty about whether or not global monetary policy is working.

The US has passed legislation for US military aid to go to the Ukraine, Taiwan and Israel. Australia has also sent aid.

We acknowledge the significant contribution of Dr Ron Bewley and Woodhall Investment Research Pty Ltd in the preparation of this report.

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

Key points:
– The first developed world Central Bank implements the first interest rate cut.
– The USA economy is still aiming for an economic ‘soft landing’.
– Australia still in a ‘per capita’ recession but RBA still hedging its bet on official interest rates.

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

The Big Picture

The mood among central bankers is changing. The Swiss National Bank (SNB) is the first major central bank to have cut in this easing cycle. The Bank of England (BoE) welcomed its lowest inflation read since 2021 but kept its rate on hold – then flagged that ‘a cut is in play’.

The Fed was also on hold in March but Chair Powell made some very interesting comments. He said ‘there is no sign of a recession’ – which we agree with but neither do we rule one out in the future. He did allude to the fact that he thought some early 2024 US inflation reads may have been distorted (upwards) by statistical adjustment procedures but that he ‘cannot just dismiss inconvenient data’. Smart man!

We take it that Powell thinks he can start to cut if subsequent inflation data confirm his data-distortion hypothesis. We think they will. The market-priced odds for a cut at the next (May 1st) Federal Open Market Committee (FOMC) meeting are only 4% but there is a 36% chance of one or more cuts priced in by the June 12th meeting. There is a 40% chance of three cuts by the end of 2024 with a 24% chance each for two or four cuts.

The FOMC produced its ‘dot plots’ chart with each dot expressing each FOMC member’s expectations for the Fed funds rate at the end of 2024 and the next two years. The FOMC reinforced its December expectation of three cuts in 2024. Nine members voted for two or fewer cuts while 10 voted for three or more cuts. Being a median, the representative expectation is, therefore, three cuts. At last, the Fed and the market are on the same page. Not so long ago the market had pencilled in six cuts!

The Fed’s expected growth forecast for 2024 was raised from 1.4% (published in December) to 2.1% now. The unemployment rate expectation was lowered to 4.0% from 4.1% over the same period. The current unemployment rate is 3.9% and the latest growth figure for the last quarter of 2023 is 3.4% p.a.

The Fed is looking as though it may have dodged a bullet and might steer the economy to a soft landing – meaning no recession. Given that the unemployment rate has already risen to within 0.1% points of the end of year expectation, while growth is expected to fall to 2.1% from 3.4%, doesn’t quite add up for us.

There is a lot of pent up tight monetary policy impact from previous hikes and US fiscal policy has possibly pushed out the effect of monetary policy more than usual. If we go with the commonly expressed lag of 12 – 18 months for changes in monetary policy to work themselves through, the full impact of last interest rate increase made in July 2023 will not be felt until the second half of this year. And, at a range of 5.25% to 5.50%, the Fed Funds interest rate is around nine hikes above the neutral rate that neither slows down nor speeds up the economy. We have not yet seen what the full impact of the tightening cycle will bring. And, interest rate cuts are thought to take a similar time to work their way through when the loosening cycle starts.

If the Fed doesn’t start cutting until June, it might be forced to make some 0.50% cuts in the second half of the year to play catch up.

The European Central Bank (ECB) was also on hold in March but, unlike the Fed, it lowered its expectations for growth. We think Europe is in for a lot more economic pain.

The Bank of Japan (BoJ) increased its rate but only to a range of 0.0% to 0.1% from a negative rate held since 2016. For decades, Japan wanted to engineer moderate inflation and it has only just had a positive response. It is hoping to ‘normalise policy’ meaning that they are aiming for a similar end-point as the Fed but from below rather than above the terminal rate.

The ‘odd one out’ in central bank activity to us is our own Reserve Bank of Australia (RBA). It was on hold in March as was widely anticipated but the data does not support this action. And, based on a response Governor Bullock made at the post RBA meeting media conference, that ‘she doesn’t know whether the next move will be up or down’ is problematic.

As we have reported before, here in Australia, unusually strong immigration is masking the weakness of the economy when population growth is not taken into account.
Our latest growth data for the last quarter of 2023 was only 0.2% for the quarter and 1.5% for the year. Per capita growth was  0.3% for the quarter and  1.0% for the year. The last four quarters of per capita growth were all negative – which is what many mean when they say we are in a ‘per capita recession’.

Even harsher is the impact on retail sales. When inflation is taken into account, the latest so-called ‘real’ retail sales came in at 4% below the level of the October 2022 peak. There has been a stable downward trend in real retail sales over this period.

Since mortgage payments are not included in retail sales, about one third of the population (those with mortgages) are also carrying the burden of much higher interest repayments. While a cut from the RBA would take some time (the 12 – 18 months) to work its way through to the real economy, relief from cuts to mortgage interest rates would probably be felt almost immediately.

Not only does the RBA seem to acknowledge the extent of the damage to the economy, it appears to be seriously misguided. The governor stated that people were hurting even when trying to buy necessities but she argued that demand pressures were forcing up prices in services.

She can’t have it both ways, unless she considers us to have a two-speed economy. The masses are struggling to put food on the table (with no demand pressure) but some are able to push prices up on some services. It doesn’t add up. She only has one rate at her disposal to vary. If she keeps rates up to quell any services inflation, she will have to unduly penalise those who are already struggling with necessities.

We have conducted detailed analysis of Australian CPI inflation to the highest academic standard. We have concluded that the standard (headline) CPI inflation, and the core variant that strips out volatile components, have, on average, been in the middle of the target range (of 2% to 3%) for the last three months.

We think that there was also ‘a game of chicken’ being played out by central bankers in not being the first to blink on rate cuts. The SNB has already cut but we think the RBA won’t go until the Fed does.

The previous RBA governor arguably wasn’t reappointed for a second term because he said that rates wouldn’t go up until 2024. As we have said before, there is always an implicit proviso in a forecast ‘unless something terrible happens’.

On former RBA governor Philip Lowe’s watch, he had to contend with the pandemic, China shutdown, supply chain blockages, and a Russian invasion of the Ukraine. Those were all supply shocks to global inflation which are not impacted by rate rises in any country, let alone in Australia. The impact of supply shocks has largely evaporated by now and too many central banks around the world are claiming success from their policies in fighting inflation while much of the victory should go to the supply side problems having diminished.

Since the Fed is unlikely to move until at least June 12th, we think the RBA will not move until at least the RBA board meeting in the middle of June. Our labour force data seems to have been badly affected by statistical anomalies and so we think we might see a swift jump up in unemployment from the middle of 2024. With headline growth at 0.2% in the latest quarter, negative quarters might start to appear even without allowing for population growth.

The accepted definition of a recession used by the prestigious National Bureau of Economic Research (NBER) think-tank in the US does not include comments on two consecutive quarters of negative growth. The full definition includes an assessment of the health of the consumer and employment prospects. We think we are already in recession in Australia and have been for over a year.

But a recession does not mean our stock market index need go down. A company’s profits are not based on per capita demand but total demand. While all forecasts are subject to risk, our analysis of survey data of broker-forecasts of company earnings and dividends are optimistic. There will be dips along the way, but at time of writing the trend is still up.

Asset Classes

Australian Equities 

The ASX 200 ended the first quarter with another all-time high. At 7,897, the Index is only a whisker away from breaching the 8,000 level! Capital gains in March were +2.6% and on a par with those of the S&P 500 in the USA. Gains were largely across all sectors but Property, at +9.6%, did lead the way. Gains on the broad Index in the first quarter were 4.0%.

International Equities

The S&P 500 was up +3.1% in March and +10.2% over the quarter. The UK FTSE, German DAX and Japan’s Nikkei share market Indices all grew between +2.6% and +4.6% but the Shanghai Composite was flat at  0.1%. Emerging Markets were in aggregate also solid at +2.4%.

Over the quarter, the Nikkei grew by +20.0% after its economy had ‘flirted’ with a recession in the second half of 2023.

Bonds and Interest Rates

After the March FOMC meeting, in which interest rates were kept in hold at 5.25% to 5.5%, Jerome Powell seemed confident there were no signs of a recession. On the basis of the data released to date, we agree with his assessment but, because of the inherent lags in conducting monetary policy, it is far too early to call a victory.

US 10-year Treasuries settled down with a yield of around 4.20%. After a big shift from the end of January 2024, the yield curve, tracing yield against a range of different maturing lengths, has been unusually stable between the ends of February and March.

The SNB made its first interest rate cut but the Swiss inflation rate was never much of a problem.

Turkey increased its interest rate in the hope of fighting off its woes of a depreciating currency.

All year, the BoJ has been positioning to start its ‘normalisation’ of monetary policy after more than three decades of seemingly being unable to rectify the problems of the excesses of its past.

The rise in the BoJ rate from  0.1% to a range of 0.0% to 0.1% was symbolic more than anything else. The interest rate had not been positive since 2016. With the market seemingly accepting of this initial move, we expect further interest rate increases but in a very measured way.

The BoE and ECB were each on hold in March. However, only the former has shown its hand with its future policies. Governor Andrew Baillie stated that ‘an interest rate cut is in play’. Christine Lagarde, the ECB president has been strongly opposed to slackening its tight monetary policy for a long time but the ECB has been forced to cut its growth forecasts.

Australia’s RBA was also on hold but it is not ruling in or out future interest rate increases or cuts. We think the evidence is not only strongly against future increases – and the market agrees – based on the data provided above we think the RBA should not have raised the official cash interest rate last November and quite possibly should have done the reverse and cut rates at this meeting. Indeed, time will tell.

Unlike in the US, where the common mortgage is based on a 30-year fixed interest rate, Australians are mainly facing variable interest rate loans. Therefore, Australians are facing the twin problem of higher mortgage costs and negative per capita growth. US residents are not (yet) really facing either unless they choose to, or need to, move home.

Other Assets

The price of oil was comfortably up over March with the price of Brent Crude closing at just under $US88 per/ barrel.

Copper was up +4.3% but iron ore was down -12.3% but the price still held above $US100 per tonne.

The price of gold was up strongly to finish at $US2,214.

The Australian dollar – against the US dollar – was almost flat, rising only +0.2%.

The VIX volatility index (a measure of US S&P 500 share index volatility) finished March at close to its low at 13.0 – which is around ‘normal’ levels in ‘normal’ times. This low reading implies that market participants, in aggregate, are not taking out extra insurance against expectations of future falls.

Regional Review

Australia

Australia’s GDP growth came in at 0.2% for the latest quarter but the labour force survey claimed 116,500 jobs were created. These data together don’t add up.

The Australian Bureau of Statistics (ABS) surveys a rolling sample of 26,000 households to determine, among other things, how many people are unemployed and how many are in work. From those data, they scale the numbers to be representative of the 27 million or so people in the country. That naturally introduces what statisticians call sampling error. The ABS is up front about this and gives an interval of ‘reasonableness’ around those scaled-up numbers.

The ABS is pretty good at doing this analysis. To reduce the interval of reasonableness by half would require increasing the sample size by a factor of four (a squared rule). It’s not worth the extra cost. The current data are accurate enough.

The ABS then transforms or adjusts these ‘original’ estimates to allow for ‘predictable seasonal effects’. It so happens employment in January in Australia is typically much lower than the months either side. Without the so-called seasonal adjustment, it is meaningless to compare employment in January with that of the months either side.

These adjustment procedures which are employed by relevant agencies and bodies around the world usually work well. But, when there is a change in seasonal patterns, the adjustment process goes awry.

Given the massive volatility of the change in the seasonally adjusted total employment over the last three months (-65k, +0.5k, +116k) – but there was a very reasonable aggregate three months (+23k per month) – it is pretty obvious the seasonal pattern just changed. No one can reasonably blame the ABS; we certainly don’t. So, until new patterns can be established, the best that we can suggest is that employment growth for the last three months has been +23k per month which was reasonable in years gone by but what should it be with a +2.6% increase in population?

Measuring unemployment rates is an easier task as the numerator (number of the working age population who seek work but are out of work) and the denominator (number in the workforce) are subject to the same seasonal adjustment procedure so most, but not all, of the problem cancels out.

The unemployment rate was +3.7% in February. Not bad, but what does being employed mean in this new post Covid world? Work from Home (WFH), GenZ apparently more comfortable with flexible work hours, Uber ride-share and deliveries etc, etc. We interpret current labour market moves apparent in the data with a lot more scepticism than in years gone by.

We think we get a clearer picture of how households are currently faring by looking at retail sales. What do people actually spend? All of the data point to the volume (i.e. after inflation adjustments) we buy is falling. We may be consuming less lamb chops or switching from lamb chops to beef mince, etc.

The ABS in analysing the national accounts commented that (after inflation) Australians spent less in cafes, restaurants, and hotels by -2.8% in the latest quarter than they did in the prior one. The ABS surmises that people are eating and drinking at home instead of going out to save money. We think that is logical given the data. While we don’t know what people are really doing, we do know they have less to spend and the future looks to be one of increased austerity based on recent consumer sentiment surveys, so the ABS hypothesis to us looks on the money.

The average wage is down about 7% from the 2020 peak when adjusted for inflation. Retail sales is down about 4% using the same metric.

With real wages down 7%, workers need big pay rises to get back to par and then they need to claw back the losses made over the last four years. We weren’t in an economic bubble when Covid struck. It is not unreasonable for Australians to aspire to recovering their pre-Covid standard of living.

China

China has had a rocky ride through the post 2019 era with extended lock downs and a crisis among its property developers leading to issues in its property market. Notwithstanding, China’s People’s Congress put out a target of +5.0% p.a. economic growth rate going forward.

The monthly Purchasing Manager’s Index (PMI) for manufacturing had not been above the 50 mark (a level that that separates expansion from contraction) for some time. The latest print for March was 50.8. The latest PMI for non-manufacturing was 53.0, up from 51.4.

There was also a glimmer of hope in the monthly economic data read. Retail sales grew by 5.5% which beat expectations. Industrial output at 7.0% blew away the 5.5% expectation.

There was also good news in China’s trade data. Exports grew by 7.1% easily beating the 1.9% expectation.

For Australia, there is nascent news that the massive tariff on our wine has been lifted. Elsewhere, the Materials sector of the ASX 200 which is dominated by our large iron ore miners was up +2.2% in March.

The really good news from China was that it just found some inflation! Deflation is the enemy of all because falling prices induce people to delay spending while prices fall – hoping to buy the same item for less, later. China’s inflation just came in at 0.7% for the month after months of deflation. China’s economy could be turning. If it is not, then it is too soon to write it off.

US

US jobs data were good. There were +275k new jobs created in February but the unemployment rate went up to +3.9% from +3.7%. We, along with many other analysts, wonder whether these data are as relevant as they once were? Regardless, they are all that we’ve got to work with.

GDP growth was revised up to +3.4% from +3.2% for the December quarter of 2023 but the +3.2% was a downward revision from the original 3.3%.

We think Fed Chair Powell is correct in saying that ‘there are no signs of a recession and that an economic soft landing is possible’. It will be wonderful if that is the case but, as the old saying goes, ‘there is many a slip twixt the cup and the lip’.

It takes ages for economies to respond fully to interest rate increases and then cuts. So far so good. And we will be better off if the US stays strong. But we would be foolish to stop worrying and then be caught out with a left-of-field event. Cautious optimism is the appropriate mindset.

There are so many variants of official measures of inflation a commentary on them all would dominate this narrative. So, let us summarise.

We have determined, reasonably, that the US CPI inflation data has been corrupted by their Owners’ Equivalent Rent (OER) measure for the shelter component. They include rents but they also include estimates of what owned properties could be rented for. This is a massive component – about one third of the CPI index – yet it is arguably the worst in estimation accuracy.

The details are long and boring but we are across the nuances. In essence, in the USA, rents are usually set when a new tenant is found. The rent is usually set for a leasing period of at least one year but landlords are reportedly reluctant to raise rents until there is a new tenant. On top of that, the statistical bureau only samples rents every six months for a given property.

We have also conducted a detailed analysis of the US CPI index. If we take official ‘CPI less shelter’ inflation data, it usually is less than 2% and, since June 2023, it has not once been above 2% – the Fed’s CPI inflation target level. The current official shelter inflation rate is +5.8% but private surveys put that number at more like +3.6%.

We think, and we suspect Powell thinks, that the inflation genie is back in the bottle and he is about to begin cutting interest rates before it destroys the US economy. We think it is line ball between the Fed getting its prized soft landing and having a mini recession. It doesn’t matter too much which it is. But, if some of the Fed members keeps bleating about maintaining higher interest rates for longer, and wins the argument to implement this, then the USA could get the recession that nobody needed.

Europe

The European economy has been in a bit of a mess since Putin invaded the Ukraine. The BoE – now disassociated with Europe – seems to be controlling inflation in the UK, and is ready to cut rates. Europe seems to be behind the eight ball i.e. inflation too high for the ECB to cut interest rates but economic growth slowing to the point where interest rate cuts are needed to stave off recession.

Rest of the World

Japan is seemingly about to start normalising monetary policy after three decades of interest rate controls and, latterly, negative interest rates. It skirted a recession (from the populist definition of a recession being two consecutive quarters of negative economic growth) by revising its latest growth estimate from -0.1% to +0.1%.

Not one Japanese person would know they are better off from such a small change in growth – but the stats look better. The revision says more about the populist definition of a recession than it does about the state of the Japan economy.

Infocus acknowledges the significant contribution of Dr Ron Bewley and Woodhall Investment Research Pty Ltd in the preparation of this report.

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

Key points:

– US inflation ticks up a little but downward trend remains intact, rate cuts further deferred
– Australian inflation close to being back in the RBA target range
– Australian cost-of-living crisis not yet improving

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 the team.

The Big Picture

Only one month ago, the bond market ascribed a 50% chance to a US Federal Reserve (Fed) interest rate cut in March and an 85% chance of two or more interest rate cuts by June. By the end of February, the chance of a rate cut in March was almost zero while only one cut is still deemed likely by June.

In essence, the market has come back closer to the Fed’s way of thinking as espoused at its December meeting. It now appears that three interest rate cuts in 2024 are more likely, rather than the six or even seven the market had toyed with as late as January this year.

The changes in the market’s expectations are due to updated inflation data and recent Fed commentary. Inflation data are ‘noisy’ (prone to short-term volatility) and are also impacted by such things as changes in the oil price. US Consumer Price Index (CPI) inflation data in January and early February were not quite as good (low) as expected but they were not bad or even poor. The Fed’s comments have leant towards their trying to avoid cutting interest rates too soon for fear of a resurgence of inflation that might then force the Fed to revert to a tightening bias from its current neutral or ‘on hold’ stance.

The Fed is important to Australia, not only in terms of the US being a major economic power, but also due to its apparent influence on our central bank, the RBA, which seems likely to wait for the Fed to move before it does. The RBA governor and the committee are new this year and they seem to be still feeling their way a bit.

We see the case for cutting sooner rather than later as being different in the two countries.

The US economic data to date have been much stronger than many had anticipated. Perhaps this is due to savings and government spending (fiscal) policies as having fought against the central bank ‘monetary’ policy in the tightening cycle. However, there are some cracks appearing in the data. US retail sales in value terms only rose by +0.6% over the last 12 months so, with inflation running at +3.1%, inflation-adjusted retail sales (i.e. volume) are going backwards at -2.5% p.a.

US jobs data largely look strong but, as a Bloomberg reporter noted in February, labour market data should be viewed with a ‘dollop’ of salt (rather than the proverbial pinch). Collecting meaningful data is difficult at the best of times. The pandemic has a lot to answer for; the ‘gig’ economy adds new challenges; and the response-rates to data collecting agencies around the world have been tested in recent times.

Here in Australia, massive immigration flows have masked the true state of the economy. When GDP growth is measured in per capita terms, growth in four of the last six quarters has been negative and, even without correcting for population growth, inflation-adjusted retail sales have also been negative in four of the last six quarters. We think that is more than enough evidence to call the Australian economy as, in recession.

On top of the observed aggregate data, we know that mortgage rates have increased rapidly in recent times and any relief from holding fixed-rate mortgages taken during the pandemic has largely dissipated as the ‘mortgage cliff’ rolled over. Contrast the US system that largely depends on mortgagees holding very long-term fixed rates – up to 30 years i.e. the negative cashflow effect of Australian fixed rate borrowers moving from fixed-mortgage rates of circa 2.0% to circa 6.0% as their low fixed-rate terms ended and they began paying the no much higher variable or new fixed rates, did not occur in the US as their mortgages are largely 30-year fixed rate loans.

While the US CPI inflation data released in mid-February was an improvement over the previous month, the data missed market forecasts. The Fed prefers the Personal Consumption Expenditure (PCE) measure because it does not depend on a fixed basket of goods. Rather, the weights in the PCE measure adjust to consumer preferences over time.

The latest PCE inflation read at the end of February was +0.3% for the month of January and +2.4% over the last 12 months. The core variant, that strips out volatile energy and food components, was +0.4% for the month and +2.8% for the year.

The latest wage data in the US, adjusted for inflation ran at +1.4% over the year. While this number might be a little above historical comfort levels, it is necessary for workers to play catch-up in recovering the substantial losses made in the early part of the inflation cycle. We do not see any material evidence for a wage price spiral. Measured inflation expectations in the US have been quite stable at a little above +2%.

Inflation-adjusted wages in Australia have fallen substantially since the onset of the pandemic. However, that fall has since been arrested and there is some evidence of catch-up starting to emerge. If and when inflation falls sustainably back to the 2% to 3% RBA target-band, that does not mean prices return to pre-pandemic levels. Only deflation (negative values of inflation) can restore prices to previous levels or wage increases above inflation for a sustained time are needed to restore cost of living standards.

The latest monthly Australian CPI data for January were released at the end of February. The coverage of this index is around 70% of the quarterly index and that 70% is skewed towards goods rather than services.

The headline rate was +3.4% for the year and +4.1% for the core variant that strips out certain volatile goods like food, energy and vacation travel. We also produce regular in-house measures that better keep track of recent changes in trends. Our latest headline rate was +3.0% and the core was +2.3%. Both were within the RBA target range. We update these estimates every month. Neither variant has been above the target range for the last three, monthly updates.

Australia labour force data posted a second poor monthly reading in a row. Only 500 net new jobs were created following a loss of 65,100 in the prior month. The unemployment rate rose to 4.1% from 3.9%.

Around the world, many countries are suffering relatively poor economic times. Britain and Japan both slipped into recession using the popular ‘two negative quarters of economic growth’ definition. Interestingly, both of their major stock market indexes posted strong gains following these data releases. This type of behaviour underpins our view that our market does not necessarily have to perform poorly if further economic weakness becomes apparent. Markets are based on expectations while most economic data is a view in the rear-vision mirror.

After about a year of Ukraine holding its own against Russia, a lack of decision-making in the US Congress has led to a disruption in military supplies. Probably as a result, a major Ukrainian city fell to Russian forces during February. There has not been much impact of this conflict on economies in the rest of the word. But, without renewed support from the US in particular, that could change.

The Israel-Palestine conflict shows little sign of abating. The human suffering has reportedly been immense. There seems little chance of a resolution any time soon. The Israel GDP fell 20% in the December quarter compared to an expected fall of ‘only’ 10%.

Bond markets have stabilised and Wall Street has powered on following healthy report cards from the AI-chip designer NVIDIA and some others from the so-called ‘Magnificent Seven’ mega tech stocks.

The S&P 500 reached record highs in February as did the ASX 200. Even the Nikkei posted an all-time high that had stood since 1989!

The investing outlook will largely depend on how central banks report conditions and prospects, as much the actual data themselves. But conditions can change rapidly. If they do, we expect heightened equity-market volatility but longer-run prospects seem average to above average for investors in the nearer term.

Asset Classes

Australian Equities

The ASX 200 made a new all-time high in February but finished the month almost flat. The performances of the sectors were polarised. Energy, Materials and Telcos all fell more than -5% over the month. Consumer Discretionary gained more than +5% and IT gained nearly +20%!

Companies reporting earnings in February produced a mixed bag of results and, as a result, the broker forecasts collected by LSEG that we analyse show a slight weaking in earnings expectations for the next 12 months. However, that expectation is still just above the historical average.

International Equities

The London FTSE was flat in February but all of the other major indexes we follow gained around +4% or more. The S&P 500 was up +5.2%.

A lot of the impetus in Wall Street appears to have come from the big beat of the AI-chip designer, NVIDIA, earnings and prospects. This behaviour gives us some faith in the continuance of the Magnificent Seven rally that started a year ago – although one or two of the ‘seven’ seem to have fallen away from the peloton somewhat.

Our analysis of the LSEG broker forecasts reveal that forward expectations have held up through the US reporting season.

Bonds and Interest Rates

After 1 February Federal Open Markets Committee (FOMC) meeting, in which rates were kept in hold at 5.25% to 5.5%, Fed Chair, Jerome Powell stated that they were ‘confident inflation is coming down’ but that ‘they are not confident enough to start cutting’ yet.

The CME Fedwatch tool is pricing in about a 2% chance of a 0.25% interest rate cut at the March meeting. There is a modest chance of a rate cut priced in by the May meeting but there is over a 60% chance of a cut at the June meeting of the FOMC. The median expected number of interest rate cuts by the end of the year is three, but four rate cuts have a broadly similar probability.

Official US inflation data have been steadily improving but the gains are sluggish arguably because of the manner in which the shelter component of the price index is calculated. Currently shelter inflation stands at +6% and its weight in the CPI is around one third. Most commentators believe that the true measure for shelter is more like +3%. Therefore, we expect a big correction of 1% point or more in the CPI when the measure catches up with reality.

The RBA kept rates ‘on hold’. In the first media conference in the new RBA board setting, the governor may have embarrassed the board by trying to walk away from the three cuts in 2024 contained in the notes. She said that these three cuts were not forecasts or expectations but ‘assumptions’ as though this was a new category in policy making. It would be illogical to use anything but expectations for assumptions unless the Board wanted to convey outcomes under clearly differentiated assumptions such as base, best case and worst case.

Australian inflation data measured over the trailing 12-months is still above the RBA target range of 2.0% to 3.0% but it is well within that range when a shorter time period is used. We think there is little to no evidence of wage inflation becoming a problem if rates are cut and the data measuring demand point to a struggling economy for the average Australian. However, very strong immigration flows mask the extent of this economic weakness in the aggregate data.

We believe that the RBA will try to wait for the Fed to cut interest rates first before it takes its own corrective action. Therefore, we see the overhang of tight monetary policy causing even further hardship. Market expectations data support no cuts in the near term.

If we are correct in our analysis of the true state of the Australian economy and its likely course in the short-run, the RBA might be forced to do bigger cuts of say 50 bps when it does start easing policy.

Japan’s inflation rate has pulled back sufficiently for some to suggest that it may at last be able to start returning its benchmark rate to above 0% for the first time since 2016!

Other Assets

The price of oil recovered even more ground in February resulting in Brent ending the month at $US84 per barrel (Brent Crude price). This level is far from the $US95 that caused such problems with our inflation at the end of the September quarter. That oil price spike was caused by the onset of the Israel-Palestine conflict.

The price of iron ore again fell around 10% but, at $US117 per tonne, it is still well above the $US100 level that it came close to in the second half of 2023.

The prices of copper and gold were largely flat over February.

The Australian dollar – against the US dollar – depreciated by -0.8%.

Regional Review

Australia

Australian retail sales (in volume terms) rose +0.3% in the December quarter and fell -1.0% over 2023. Volume sales fell in four of the last six quarters. When population growth is taken into account, sales volumes fell by around -3.5% in 2023. This measure emphasises the extent of the very real cost-of-living crisis.

With the latest household savings ratio at 1.1% (compared to around 4% to 6% in normal times), growth for the December quarter – to be released in the first week of March – will slow appreciably from the +0.2% for the September quarter (+2.1% for the year) – or households will have been forced into no saving – or even dis-saving. A rate cut by the RBA, if passed on to mortgage holders would alleviate some of this burden in future quarters.

The labour force data were again very weak. Only 500 jobs were created in January but there was a switch of around 10,000 jobs from part-time to full-time. We previously reported that data for December were particularly grim but we attributed some of that apparent weakness to inappropriate statistical procedures designed to remove predictable seasonal patterns.

The unemployment rate is less susceptible to these adjustments as it is the ratio of two quantities, so adjusted. The latest unemployment rate is 4.1%, up from 3.9% the month before and 3.5% in June 2023. That makes the average unemployment rate equal to 4.0% for the last three months which is 0.5% above the low over the previous 12 months. A gap of that size is the basis of the Sahm-rule (named after the Fed member who devised the indicator) to predict a forthcoming recession.

The wage price index came in at +4.2% growth for 2023 which is above the +3.1% CPI inflation index over the same period. This 1.1% premium does not show wage demand is problematic. On average, wage growth should exceed price growth as workers are rewarded for productivity gains.

The current inflation-adjusted wage (or real wage) is 7% below its mid-2020 level. Workers are only able to buy 7% less in volume terms and there is the cumulative impact of this real wage-cut over time.

China 

China’s economic data continue to be weak but not so much as to jeopardise our exports of iron ore and other commodities from Australia. The latest official Purchasing Managers’ Index (PMI) for manufacturing was a slight beat at 49.1 but below the 50-level that separates contraction from expansion in expectations.

China did move in February to cut a key interest rate and it seems to be pursuing an expansionary policy, albeit more slowly and carefully than in recent times.

China must deal with the problems of debt levels in its property sector while only stimulating the non-property sectors.

US

US CPI headline inflation came in at +0.3% for January against an expected +0.2% and +3.1% for the year against an expected +2.9%. Core inflation was +0.4% for the month against an expected 0.3% and 3.9% for the year against an expected 3.7%. The actual data were quite good compared to recent history but economists had reduced their forecasts quite sharply. Thus, the outcomes were considered poor (higher inflation being bad) and the chance of an interest rate cut was deferred further.

Our rolling quarterly estimates (annualised) were +2.8% p.a. and +4.0% p.a. for the headline and core CPI variants, respectively. Both were higher than in the prior month.

However, the real issue is how the Bureau of Labour Statistics (BLS) calculates a key component – shelter. Bloomberg reported that the BLS sent out an email to some clients about the problems with this component and then retracted it causing ‘confusion’. It has been suggested that this data problem might take five months to work through the system.

The Fed’s preferred PCE inflation data painted an even better picture. The monthly headline rate was +0.3% while for the year it was +2.4%. It’s getting very close to the target 2%! The core monthly read was +0.4% and for the year it was +2.8%. Given the problems we are experiencing with the shelter component of the CPI data, we are relying more heavily on the PCE measure at this time in our analysis.

US jobs grew by an unexpected and very large 353,000 in January. The expected range was 120,000 to 300,000 showing the high degree of uncertainty in the labour market data. Past data were also revised sharply. The unemployment rate remains at a healthy level of 3.7%.

Retail sales came in at -0.8% for January (expected -0.3%) following a revised +0.4% for December. The annual figure was +0.6% which was well below inflation at +3.1%. In real terms, the consumer is not as strong as some would have us believe.

The December quarter GDP estimate was revised down slightly from +3.3% to +3.2%.

Europe

Britain went into a ‘technical recession’ with its latest growth data for the December quarter. However, its retail sales in value terms grew by 3.4% in January after a ‘grim’ December. These data are very much in line with the recent US sales values that showed January was up 1.1% following a December decline of -2.1%. In short, we firmly believe that traditional seasonal patterns are being disrupted by ‘Black Friday’ internet sales. The Bank of England had kept its interest rate on hold at 5.25%.

Rest of the World

Israel’s December quarter GDP growth plunged by -20% compared to an expected fall of -10%. With so many Israelis mobilised to enter the conflict in Gaza, it might take some time for the situation to get back to normal in both a human and an economic sense.

Russia has taken advantage of a disruption in US aid to take over a large Ukrainian city in their ongoing conflict.

Japan entered a ‘technical recession’ but there seem to be two favourable outcomes. Inflation has dropped leading to a possible return to normal monetary policy settings (rather than the -0.1% base rate that has been in place since 2016). Secondly, after 35 years, the Nikkei share price index reached a new all-time high.

We acknowledge the significant contribution of Dr Ron Bewley and Woodhall Investment Research Pty Ltd in the preparation of this report.

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

Key points:
– The US Federal Reserve has pivoted from a tightening interest rate policy to an easing one
– Markets are looking at growth and inflation data points to estimate first interest rate cuts
– Economic indicators are softening but inflation is still at risk from the Middle East conflict

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 the team.

The Big Picture

The US Federal Reserve (Fed) chairman, Jerome Powell, started last December by pronouncing it was ‘premature to talk about rate cuts’. By the end of December, the Fed ‘pivot’ was locked in (and the Fed had changed from a tightening interest rate policy bias to an easing one). Even the Fed then expected three cuts in 2024 but the market wanted more, forecasting up to 6!

During January 2024 opinions settled into less diverse scenarios. Cuts are still very much on the table but the 31 January meeting was considered ‘dead’, i.e. no change to interest rates throughout the month. However, the market had ascribed about a 50% chance of a cut in March and an 85% chance of at least two cuts by June.

Powell did not disappoint by keeping rates on hold but he did upset the market by saying that ‘he didn’t see a cut in March’. He said he was confident that inflation has been on track over the last six months but that he was not sufficiently confident to start cutting interest rates by March.

After these comments by Powell, the market priced in a 35% change of an interest rate cut in March. But the market is still pricing in two or more cuts by June at around a 90% chance. The bond market is still pricing in six cuts this year but the S&P 500 lost steam after Powell’s post Fed meeting press conference losing -1.6% on the day.

Interestingly, a survey conducted by media company CNBC just prior to the January Fed meeting reported that only 9% of respondents expected a cut by March and 70% said the first cut would be in June! Economists and traders often disagree. Usually only the latter has real skin in the game.

Depending on how one looks at the data – in the US and Australia – one can see a serious slow down or, at the other extreme, a gentle ‘soft landing’. The deciding factor, as we see it, relates to how one interprets the factors that caused the recent slow-down in inflation across the major economies. Those who think it was the deft response of central banks harnessing demand-side inflation with rate cuts, fear letting monetary policy ease – in case inflation then consequently re-emerges. This is Powell’s stated position.

Those who think the source of the inflation, starting in 2020 from the Covid pandemic, largely resulted from the supply side (i.e. global production slowed because of lockdowns, likewise transportation of goods largely stopped and the price of available goods rose materially due to lack of local supply during, and after the Covid restrictions eased, this being further exacerbated by the Ukraine war) are of the view that interest rates could be cut without inflation being reignited because the supply side issues have ceased. This group includes some eminent people – bankers and academics and a Nobel Laureate.

While we subscribe to this view more recently, we agree that rates could be cut without material consequence at this juncture. Failure to cut interest rates from the current restrictive levels could see them rapidly start to bite and cause economies to slow more than anticipated or intended by Central Banks. However, we do not as yet advocate the respective interest rates should move to below the neutral rate of about 2.5% to 3% in this easing cycle and certainly, they should not reduce back to emergency levels.

It has only been a little over a year since monetary policy in Australia and the US has been tightened (above the neutral rate). With the long and variable lags (say, 12 to 18 months) of effect of monetary policy settings, we are only just starting to witness some slowing effects from the interest rate hikes. Fed chair Powell acknowledged this in his January press release.

Of course, the pandemic added its own idiosyncrasies into the mix. People were forced to save because of lack of opportunities to spend under lock downs and governments added stimulus payments to ease the crisis. Those excess savings sheltered economies from monetary policy tightening – for a while. This time was indeed different but those excess savings have now largely been depleted. We are back to normal conditions for assessing monetary policy effects.

The latest Australian labour force data (for December) revealed an apparent massive crack in the economy. Total employment went down by 65,100 but the full-time position loss was even worse. 106.600 full-time jobs were lost in a month while the population grew by 48,200.

The monthly data does jump around somewhat but we have only had six months of decreases in the last 24 and the next worst result was less than half of the December outcome.

The unemployment rate held up at 3.9% but only because of the discouraged-worker effect. People who left jobs and didn’t bother joining the unemployment queues!

Before we jump to a disturbing conclusion, it is important to note that data have regular seasonal patterns (e.g. temperature related demand). The ABS uses averaging techniques to remove the regular seasonal component so that month-to-month or quarter-to-quarter changes better reflect new directions rather than predictable seasonal patterns.

For many data series, the ABS also smooths the seasonal data to produce ‘trend data’ so that longer-run trends become more apparent. While these are useful for a cursory glance, we tend not to rely on trend data in research houses and create our own opinions of underlying movement.

So, in relation to employment the actual number of jobs (original data) went up by 18,400 and not down sharply in December by the seasonally-adjusted 65,100. It was the statistical process designed to smooth out the data that did the damage. What if the seasonal patterns have changed since last year? We have had a year of record immigration and December is a month when lots of students start to enter the workforce. The large loss could be due to a statistical anomaly.

Furthermore, the monthly official data are prone to bounce around as the figure for the population are extrapolated from a very small sample. In addition to the sampling issue, it has been noted in various countries that telephone surveys are becoming less reliable because younger folk are less likely to ‘pick up’ the phone call from a number not familiar to them.

We are not unnecessarily concerned over these employment data but we are on alert to look for more clues when the January data are released in mid-February.

The US jobs data seemed somewhat stronger. 216,000 jobs were created compared to the expected 170,000. The expected range of forecasts was quite wide: 100,000 to 250,000. Importantly, digging deeper, reflected new jobs yet again largely being created in less productive sectors. The three-month average of new jobs was 165,000 compared to 284,000 in the same period a year earlier. And these data have a strong tendency to be revised downwards in subsequent months.

The US labour market is slowing and possibly a little more quickly than the headline data appear to convey.

It seems to be generally agreed that inflation in the US and Australia is returning to target levels more quickly than many had anticipated. Our own calculations based on more timely measures indeed suggest inflation is all but back to target.

However, the big issue on the sidelines might be events starting to cause a second-round oil-price inflation problem like that at the onset of the Ukraine conflict.

We are not experts in analysing military conflicts and their evolution but a simple reading of respectable news sources leads us to note that the Israel-Palestine conflict has involved more countries and groups over the last couple of months.

Some oil tankers and container ships are reportedly being diverted away from the Red Sea route to Europe and the US (and the reverse) because of drone and other attacks. The route via the Cape of Good Hope adds much time and, hence, cost to traded goods.

Brent oil prices declined to about US$75 per barrel before the Middle East conflict after having been US$95 slightly earlier in 2023. Brent oil bounced back to US$85 and has settled to just below that level – so some new inflation pressures must be building.

We have no insight into how, or indeed if, the conflict will be resolved but it is apparent that some of the hard-fought gains in inflation control will be eroded. However, it is equally obvious that keeping interest rates higher for longer will do nothing to reduce oil-price inflation pressure.

Markets have largely performed well in January. The S&P 500 and the ASX 200 reached all-time highs during the month. Bond yields have retraced a little from the late 2023 fall but not alarmingly so.

With the December quarter reporting season in the US and second half reporting season in Australia getting underway, we have a great opportunity to understand better what 2024 has in store for us. Our analysis of LSEG (formerly Thomson Reuters) company earnings expectations suggests that the outlook for 2024 has, if anything, improved over January as brokers update their forecasts.

The early reporting results on Wall Street have produced a bit of a mixed bag of success and failure in the big tech space. United Parcel Service (UPS) is laying off lots of workers because it doesn’t see internet-created demand sustaining the old system. Big Tech might not perform anywhere are strongly as it did in 2023 but we are expecting above average gains in the broad index.

But with recent all-time highs on the US S&P 500 and the local ASX 200, and stable bond markets, 2024 does not look bad! We think the Fed will do what we expected and cut interest rates as it does not want to alarm markets by changing their monetary policy direction and settings too much and too quickly despite it now being characterised as a ‘pivot’.

Asset Classes

Australian Equities

The ASX 200 was modestly up in January (+1.2%), largely because the index started the month at an elevated level following the December rally, but that was not so for the individual sectors. Energy and Financials each grew about +5.0% but Materials (-4.8%) fell by a largely offsetting amount. The broader index closed January at an all-time high.

January and July often witness bigger changes in broker expectations about earnings as the new half-yearly reporting season sets to get underway (for February and August). We did not see much change this January but, if anything, expectations point to a slightly stronger year than we saw for 2024 at the end of 2023.

However, the consensus end of year (eoy) 2024 forecast we have gleaned from published reports (made at January 1st) from reputable houses was, for the ASX 200, 7,600 points or just below the closing value on 31 January (7,681). While we are not expecting a bumper 2024, our analysis suggests that this consensus forecast could be a little too pessimistic. Our expected capital gains in the ASX 200 look reasonable but when dividends and franking credits are factored in, this asset is worthy of serious consideration for 2024.

International Equities

Japan’s share market index, the Nikkei, had a particularly strong month (+8.4%) but the US S&P 500 (+1.6%) was only moderately strong – largely because of the big sell-off on the last day of January following the Fed’s press conference. China (-6.3%) and Emerging Markets (-3.1%) went backwards.

A lot might depend on whether the Artificial Intelligence (AI)-led rally of 2023 continues or, indeed, retraces. Without the so-called Magnificent Seven (big technology stocks), the S&P 500 index would not have been impressive at all in 2023.

However, the consensus eoy 2024 forecast we have gleaned for the S&P 500 from published reports (made at 1 January) was 5,000 points or just above the closing value on 31 January (4,846). While we are not expecting a bumper 2024, our analysis of broker forecasts suggests that this consensus is somewhat pessimistic.

Bonds and Interest Rates

At the end of January the Fed funds interest rate was on hold at a range 5.25% to 5.5%. The CME Fedwatch tool is pricing in about a 35% chance of a 0.25% interest rate cut at the Fed’s March meeting. The same source is predicting that there is only about a 10% chance of the Fed funds interest rate being unchanged by June. The prospect of two or three 0.25% interest rate cuts by June being about the same and collectively by far the most likely outcome.

The European Central Banks (ECB) and the Bank of England (BoE) also kept interest rates on hold in January in spite of their slightly improving inflation outlooks.

The RBA kept our interest rates ‘on hold’ on their meeting on the first Tuesday in February. In our opinion, there is evidence that the Australia economy is in need of some rate relief, as the surging immigration levels are masking the cost-of-living pressures on the average household.

Since company earnings from selling to Australians are determined by aggregate demand – and not by per capita (household) demand – the ASX 200 can grow while a per capita recession takes place.

The 10-year Treasury yield in the US fell from just on 5% in October to a recent low of 3.8%, since then it drifted up a fraction to 4.1%. After the latest Fed meeting this yield retraced to just under 4.0%. The Australian 10-year yield ended January at 4.01%.

We expect some more visibility on Australian monetary policy from the RBA from here onwards, as the new committee appears to be charged with the task of improving communications.

Other Assets

The price of oil bounced back sharply from December’s lows. Both West Texas Intermediate (WTI) and Brent Crude oil were up by about +8% largely on the impact of the Middle East conflict and more recently issues with shipping in the Red Sea.

The prices copper and gold were largely flat over January. The price of iron ore fell by -6.3%.

The Australian dollar – against the US dollar – depreciated by -3.9% which will not help our inflation cause through import prices increases.
Regional Review

Australia

Australian November retail sales (in value terms) published at the start of January surprised at +2.0% for the month – but they grew only +2.2% for the year. This growth becomes negative when inflation is taken into account. In addition, population growth running at about +2.5% p.a. suggests the average citizen was consuming a lot less in inflation and population-adjusted terms.

The monthly retail value data for December were published at the end of January. The seasonally adjusted monthly growth for December was  2.3% (not annualised) wiping out the November gain. But, just as with the change in employment data, retail sales as collected by the ABS were up +14.3% on the month in ‘original terms’. It was the seasonal adjustment process that converted +14.3% into -2.3%.

Non-specialists might ask if the ABS is competent at performing the task at hand. While we think the ABS is world class, their task is very difficult when seasonal patterns are changing. In due course, we believe that the data will be revised. They will still likely not be good but not as bad as we see at first sight.

There were also two reads on the monthly Consumer Price Index (CPI) inflation gauge published in January owing to the delay in reporting November data because of our holiday season.

Both the headline and the core monthly variants for November were +0.3%. The 12-month gains were +4.3% for the headline and +4.8% for the core variant that excludes volatile energy, food and holiday travel. Our rolling quarterly estimates which we produce each month was +3.0% p.a. for both the headline and core variants. That puts these inflation estimates at the top of the RBA target range.

At the end of January, quarterly CPI data were released. The monthly data, in order to be more timely, has only about 70% coverage of the quarterly basket of goods and services.

The official read for the Quarterly index series was +0.6% for the quarter and +4.1% for the year (expected +4.3%). Note that +0.6% for the quarter, if annualised, becomes +2.4% p.a. and is within the RBA target range.

The monthly series official reads over the year for December were +3.4% from +4.3% for the headline and +4.0% from +4.6% for the core. Our in-house rolling quarterly estimates (annualised) were +1.3% p.a. for the headline and +2.4% p.a. for the core. The RBA has over-achieved! +1.3% is below the target range.

The core measures over the last five months have been +5.5%, +5.1%, +4.1%, +2.7% and +2.4%. We think that is a stable downward trend and indicative of the RBA may have gone too far, and at a minimum, far enough, given the lags in the system for interest rate hikes to work through. With the RBA target range being 2-3% the RBA needs to act in a timely manner with rate cuts to prevent overshooting on core inflation.

The jobs data for December showed that the participation rate had fallen from 67.3% to 66.8% reflecting a strong discouraged worker effect. In essence, 41,400 full-time jobs were converted to part-time while, in addition, 65,100 full-time jobs were lost from the workforce. The unemployment rate remained at 3.9%.

China

China’s GDP growth came in at +5.2% against an expected +5.3% but the market seemed to interpret this result as being very weak. Retail sales also missed at +7.4% compared to +8.0% expected but industrial output at +6.8% beat the +6.6% forecast.

The Purchasing Managers Index (PMI) a measure of industrial demand was 49.0 for December which was down from the 49.4 read in November. At the end of January the PMI for January rose slightly to 49.2.

The big problem in China still relates to the debt burden mainly of property developers. The Hong Kong government recently ruled that Evergrande the formally very large mainland property developer should be placed into liquidation. The government is reportedly trying to ring-fence a few of the big developers to stop a spread of the problem. At the end of the January, China noted that it had merged ‘hundreds of rural banks’ to reduce risks of failure.

US

US CPI inflation came in at +0.3% for both the headline and the core variants of the measure.

Over the year, headline inflation has come down to +3.4% and the core to +3.9%. While these numbers are far from the Fed target of 2% the market seemed to breathe a sigh of relief that substantial progress had been made.

Our rolling quarterly estimates (annualised) were +1.8% p.a. and +3.3% p.a. for the headline and core variants, respectively. The headline rate was below the Fed target of 2%! There should be two more releases of the US CPI before the next Fed meeting to make the next interest rate call.

The Fed’s preferred Personal Consumption Expenditure (PCE) inflation data painted an even better picture. The monthly core and headline rates were each +0.2% while for the year they were +2.9% and +2.6% respectively.

The Fed fears a resurgence in inflation if it starts to cut too soon. Supply-side shocks such as higher oil prices and disrupted supply chains due to restricted access to the Suez Canal due to the conflict in the Middle East, are almost unpredictable and inflation expectations data do not support a demand-side surge in inflation.

The US consumer appeared to be somewhat resilient in January. Retail sales (for December) grew by +0.6% – well ahead of inflation. The December quarter GDP growth was +3.3% when only +2.0% had been expected. The household savings ratio fell to +4.0% from +4.2% indicating some pressure on budgets.

Over 2023, economic growth was +2.5% following +1.9% for the previous year. The University of Michigan consumer sentiment survey showed that 28% of Americans thought the economy is in excellent or good shape. The corresponding figure for April 2022 was only 19% but, in January 2020, just prior to the onset of the pandemic, the Michigan figure was 57%.

While some reported that the current 28% figure showed some resilience, we think it would at least be equally plausible to state that the consumer is not as pessimistic as they were but nowhere near as optimistic as they were before the interest rate-hiking cycle began.

Existing home sales were the lowest since 1995 but, that is to be expected when mortgage rates are historically high and expected to fall in the coming months.

Europe

German inflation rose to +3.8% while, for the eurozone, it was +2.9%. The UK recorded +4.6% inflation and its retail sales fell -3.2% when a fall of only -0.5% had been expected.

The Europe economy is clearly in a worse position than the US and it has been paying the price for once becoming so dependent on energy/fuel from Russia.

Rest of the World

The conflict in the Middle East has certainly escalated and the deaths of US soldiers has seen a retaliatory military action against specific targets in the region, in particular to stem the terrorist attacks from inside Yemen on ships in and around the Red Sea and other military targets. To date, the economic consequences of the conflict seem less than that from the Ukraine war as there is a simple, but costlier, option to avoid the Red Sea shipping lanes by diverting round the Cape of Good Hope in southern Africa to access Europe and the US particularly with crude oil sourced from the Middle East.

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

Key points:

– US Fed pivots its interest rate policy
– Current estimates are for between three and eight interest rate cuts in the US in 2024
– The RBA while most unlikely to raise rates again does not appear to be in a hurry to start cutting
– Share markets respond positively to the Fed pivot and finish 2023 well into positive territory

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
Given how markets finished up in 2023, there was a lot of pain endured in getting there.

The US 10-year Government Bond yield went from 3.8% to 3.8% via just above 5.0%

ASX 200 screamed up in January 2023 only to shed all those gains, and more, as the US regional bank crisis shook confidence. But the ASX 200 rallied back and gained 7.8% on the year (without dividends and franking credits)!

The S&P 500 was dominated by the so-called ‘Magnificent 7’ – 7 mega cap tech stocks like Apple, Amazon and Nvidia. The ‘other 493’ did not fare so well but they did finish the year with a little bit of a flourish. The index gained 24.2% on the year.

The Dow Jones reached an all-time high in the last week of 2023. The S&P 500 and the ASX 200 each came very close to all-time highs in the final week of the year.

There were plenty of obstacles along the way in 2023 that prevented markets moving in a straight line. US Regional banks’ crises, Israel-Gaza conflict, Red Sea drone attacks and the rest. But the big one was trying to second-guess central banks as they bobbed and weaved in their battle with inflation. The US Federal Reserve (Fed) stuck to its guns of reiterating higher for longer until mid-December. It even stated on December 2nd that it was ‘premature’ to talk about interest rates cuts. Then a slew of favourable data on US inflation convinced it to ‘pivot’ (change its mind) at its last meeting and press conference for the year – just two weeks after the ‘premature’ statement! The Fed dot plot forecasts for cash rates at various intervals for the coming few years (from 19 Fed members) suggested there might be three 0.25% interest rate cuts in 2024.

While the above is the view of the Fed board members, the US Government bond market is taking a different view with current interest rates implying a 96% chance that the Fed will cut interest rates between five and eight times in 2024. Needless to say, the Fed ‘pivot’ in December has seen the US bond prices rally strongly (interest rates falling).

Surprisingly, the RBA minutes revealed that Australia’s central bank was still considering a rate increase at its December 5th board meeting, this approach puts it at odds will all other developed world central banks. Despite this, in Australia, for four of the last five quarters, per capita GDP went backwards, the household savings ratio nearly fell to zero and retail sales showed lots of weakness.

While the RBA clearly has some concerns regarding the stubbornness of inflation there is growing evidence that the economy is slowing and interest rate policy has done enough to contain inflation. The concern now is that unless the RBA joins in with its developed world peers and begins easing monetary policy (reducing interest rates) then it risks sending the economy into a more sever slowdown than is otherwise anticipated.

The RBA interest rate tracker app on the ASX website assigns an 8% chance of a rate hike at its next meeting in February. The predominant outcome currently predicted is ‘no change’ to the RBA cash interest rate.

Media reports have possibly led many astray as they portrayed the Fed increasing interest rates from 0% to 5.5% in less than two years as being aggressive and strongly contractionary and will ultimately result in an economic recession, which hasn’t happened yet.  This narrative is ignoring the whole point of monetary policy.

There is an economic concept of a ‘neutral’ central bank interest rate that neither causes the economy to slow down, nor is it accommodative. Most economists would agree that the neutral rate for the US and Australia – among others – is about 2.5% to 3.0%. That means the first set of Fed hikes shouldn’t have slowed down the economy until 3% was exceeded in September 2022! They’ve only had 2.5% points of tightening and not 5.5%! The first 3% of hikes were simply being less accommodative.

The other key insight is that at least from the late 1960s, it has been widely thought that the implementation of this sort of monetary policy acts with ‘long and variable lags’. Conventional wisdom is that this time frame is around 12 – 18 months. Even central bankers have agreed on occasion!

Putting these two concepts together and applying it to our current cycle, the first interest rate tightening that started in September 2022 shouldn’t have had any material impact until September 2023 to March 2024. So, the media tell us economists ‘got it wrong’ by stating that the anticipated recession never happened, when the more considered statement is ‘it hasn’t happened yet’. From an economic perspective it is just too early to say ‘it didn’t happen’, notwithstanding that it may not. Some reasons for this are that, US consumers were awash with Covid stimulus cheques and a student loan moratorium until October 2023. And fourth quarter US GDP data, even its preliminary form, is not available until late January 2024 so we don’t yet know how the US economy is travelling in late 2023.

There is likely to be plenty of pain in the pipeline for 2024 from rate hikes not yet felt. By reasonable definitions, Australia has been in recession for most of 2023 but massive immigration – running at about 2.6% of population – has distorted the headline data from revealing the hardship facing many.

The US economy is doing better than ours but there seems to be cracks appearing in the data picture. There has been solid job growth but increasingly this growth has not been in those sectors usually associated with a strong economy. Both the US and UK official statistics agencies have had to change their data collection methods to get normal response rates to survey methods. It is very difficult to measure what the unemployment rate really is!

It’s not obvious that recent labour force data can usefully be interpreted in the traditional manner. Moreover, with the growth in options to work in casual food and ride delivery, it is much easier for those who want to work to do so. The definition of work has changed.

With regard to market forecasts – particularly for the ASX 200 and S&P 500 – earnings forecasts are quite strong. LSEG (formerly Thomson Reuters) collects broker-forecasts of earnings for the relevant companies in the indices. Companies are required to report material changes in their expectations and they share their view of their futures with the brokers.

We have found over nearly two decades that these earnings expectations give useful guides to market direction. Of course, there is always the possibility of a ‘black swan’ event or some geopolitical upheaval.

Asset Classes

Australian Equities
The ASX 200 had a very strong December (+7.1%) to back up a strong November (+4.5%) to make a two-month total of near 12%.

The Materials sector did well at +8.8% in line with strong iron ore prices (+7.3%).

Total returns for the year were 12.4% making it a well-above average year. By our metrics we have the market overpriced by +3.3% making that a bit of a headwind for 2024. However, news of actual interest rate cuts might still spur on the market to new highs. Markets usually lead the real economy!

International Equities
The S&P 500 gained +4.4% for the month or 24.2% for the year. The London FTSE and the German DAX were similarly strong for the month but Japan’s Nikkei was flat. China’s Shanghai Composite fell by -1.8%.

We have the S&P 500 overpriced by +4.6% so, by our estimation, that index also faces a modest headwind starting the year.

Bonds and Interest Rates
It seems that almost every economist and commentator is expecting cuts by the Fed during 2024. 75 bps of cuts seems to be the smallest number being predicted. There is an 11% chance of eight cuts to a range of 3.00% to 3.25%.

We think the Fed might start at the March meeting and then go again in June taking the rate down to a range 4.75% to 5.0%. What happens thereafter would seem to be highly dependent on whether inflation and unemployment stay down and GDP growth remains solid.

US CPI inflation over the last six months was below target at 1.9% pa.

The 10-yr US Treasurys yield fell from just over 5% on October 23rd to 3.88% at the end of the year.

The RBA minutes stated that the board considered a hike at their last board meeting. The newly constructed committee to deal with rate movements is expected to meet on the first Tuesday in February.

The ECB and the Bank of England appear to be on hold. EU inflation fell to 2.4% from 2.9% when 2.7% was expected with the core rate falling to 3.6% from 4.2%. Both economies are flirting with recessions.

Other Assets 
The price of oil dropped sharply again in December with – West Texas Intermediate Crude (WTI) by -5.7% and Brent Crude by -7.0%. Brent ended the year at US$77 per barrel having traded in a range of $72 to $97 over 2023. OPEC+ appears to be losing its grip over controlling oil supply which they have historically used to influence the market price for oil.

The price of iron ore again rose very strongly – at 7.3% in December or +20.7% for the year. Copper and gold prices each rose in December by just under 2%.

The Australian dollar – against the US dollar – appreciated by 2.9% which will further help reduce import prices and, hence, domestic inflation in Australia.

Regional Review

Australia
Australian GDP growth for the September quarter disappointed at 0.2% being less than the expected +0.4%. The growth for the year was 2.1%.

But the really disappointing news was that per capita growth for the quarter was -0.5% and -0.3% for the year. The average resident went backwards in 2023.

The last three quarters of growth were all negative and four of the last five were negative. That should define a recession in anybody’s analysis.

GDP per hour also went backwards for the year at -2.1%. Importantly, the household savings ratio fell to 1.1% from 2.8% in the previous quarter and from 3.5% in the one prior.

These statistics do not mean that households are spending more than they earn – at least not yet – but they are saving less than they did before the pandemic – at around 5%. We interpret these data as meaning households are having trouble maintaining their lifestyle in the face of cost-of-living pressures. They are not saving enough for a ‘rainy day’ or retirement. At 1.1% as a savings ratio, there’s not much room left before households have to start going into debt.

While it is true that (the rate of) inflation has been falling – prices keep rising and wage increases have been insufficient to keep pace with price inflation.

The latest inflation print from the Australian Bureau of Statistics has been held over for a couple of weeks – as has the data for retail sales – owing to the Christmas and summer holidays.

The Labour Force Survey data looked good for November. There were 61,500 new jobs of which 57,000 were full-time positions. The unemployment rate rose to 3.9% from 3.8%. But, with immigration surging, how many jobs constitute a good number?

The Westpac and NAB consumer and business confidence indices were all weak and consistent with being in a recession.

Hopefully the RBA will see past the immigration flows distorting traditional economic statistics and not only not increase interest rates but give serious consideration to cutting them sooner rather than later.

China 
China’s inflation data showed that it is experiencing deflation. CPI inflation came in as expected at -0.5% and wholesale price inflation as measured by the Producer Price Index (PPI) was -3.0% against and expected -2.8%.

While there is much speculation that China’s economy is struggling, the strength in iron ore prices gives us some comfort that China will not be adding to our economic woes.

US
US CPI inflation came in at 0.0% for the month and 3.1% for the year. The core inflation variant that strips out volatile fuel and food prices was 0.3% for the month and 3.4% for the year. PPI inflation was 0.0% for the month.

Our method of calculating CPI inflation, based on sound statistical principles, produced estimates of 2.2% for the headline rate and 3.4% for the core variant.

It is worth pointing out that a major component of CPI inflation is derived from Shelter (housing) estimates. A survey is conducted among owner-occupied housing to ask what they think the rent might be if it were rented out. We see this as a difficult estimate to produce at the best of times but, in a post-pandemic falling market we wonder whether there is inertia in owner’s assessment about what their properties are worth in a rental market. This component is running at around an inflation rate of 6% which could upwardly bias CPI estimates if, indeed, we are correct.

The Fed’s preferred core PCE (Personal Consumption Expenditure) inflation read was 0.1% for the month or 3.2% for the year. Headline inflation was -0.1% for the month and 2.6% for the year. PCE inflation over the last six months was 1.9% which is below the Fed target of 2%.

The second revision to the September quarter GDP growth reverted to 4.9% from the first revision of 5.2%. It should be recalled that the data appeared to be distorted by government infrastructure spending and a possibly unintended build-up in inventories.

Europe 
The Bank of England (BoE) and European Central Bank (ECB) are claiming some success in fighting inflation. For both economies, inflation has fallen rapidly. For the European Union (EU), inflation is now only 2.4% and core inflation is 3.6%

We maintain that much of these and other economies success in inflation might be due to the winding back of supply conditions. The long and variable lags effect might bite in 2024.

Rest of the World 
There is much being said and written about the Israel-Gaza conflict. We acknowledge the human tragedy and hope for a speedy resolution.

The Ukraine war with Russia continues with no apparent end in sight. Escalation of either or both of these conflicts presents a level of risk to the global economy.

It is reported that some terrorists based in Yemen have been using drones to intimidate or damage ships passing through the Red Sea in their quest to pass through the Suez Canal. It is said that this behaviour is related to the situation in Israel.

A number of ship owners have said that they will divert ships via the Cape of Good Hope which might add 10 – 15 days in travel time.

In unrelated reports, the Panama Canal has been very affected by drought limiting the traffic in this waterway potentially up to 50% by February.

A reduction in freight volumes through these two iconic waterways are putting renewed supply pressures on freight costs which in turn will feedback into inflationary pressures.

Canada’s latest GDP growth came in at -1.1% and New Zealand’s at -0.6%. The start of the global recession might be underway.

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

Key points:

• Australian inflation back in the RBA target range
• The RBA seems to be going it alone for another hike
• US inflation all but back to target
• US jobs data almost signal a recession

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

Our quarterly inflation read published in late October signalled a slight uptick which we addressed last month in our Economic Update. However, that was enough for the RBA to hike its overnight cash rate on Melbourne Cup Day, even though most of the other major central banks seem to be done. The odds for a hike – as priced by the market – were only 50% prior to the meeting.

Michele Bullock, the new RBA governor, inflamed the situation in a recent speech when she all but said we should hike again. Indeed, she singled out dentists and hairdressers, among a handful of services, as significant causes in the little inflation spike in August and September. That call was in our view unwarranted in that such a relatively tiny amount is spent on those two services.

We singled out the crude oil price spike, which has since faded and the depreciation of our currency as major contributors to the recent increase in inflation. Our dollar was appreciating back up to around 66c from under 63c almost as RBA governor Bullock was speaking.

To make matters worse, Philip Lowe, the outgoing RBA governor, fuelled the need to hike more. So, what happened to the monthly inflation read that came out at the end of November?

We calculate inflation (annualised) on a rolling quarterly basis using the monthly data series. Miraculously, the headline CPI (Consumer Price Index) came in at 3.0%, at the top of the RBA’s target range – and not above it. It was also down from the recent peak the month before. The Core variant of inflation that excludes such things as food, fuel and certain vacation spending was higher at 4.4%.

Aussie retail sales in current value terms fell by ?0.2% in October so, after, allowing for inflation and population changes, the retail picture is grim. Sales were up +1.2% for the year or about ?3.7% in volume terms. Population grew at around 2.6% so that is about a ?6.3% decline in volume per capita terms. And the RBA now under Bullock is maintaining a tightening bias which we believe is difficult to support based on our assessment of the available data.

Fortunately, the RBA and governor Bullock appeared to take onboard the view of the market and decided to leave official interest rates on hold at its meeting on December 5^th, now all eyes are focused on the RBAs next interest rate policy setting meeting in February 2024.

In the US, the Federal Reserve Board (Fed) is backing away from hiking again and there is speculation that some Fed members are even talking of cuts soon. In support of this view the US CPI inflation came in at 0.0% for the month; the market loved it. Personal Consumption Expenditure (PCE) inflation which is weighted by what is actually being spent was also flat for the month!

In the space of about a month, the US 10-year Government Bond yield popped above 5% only to end November at around 4.3%. In terms of bond yields, that is a big move and it gave US equities a big boost.

The CME FedWatch tool, which uses bond yields/prices to predict future official interest rate movements, looks to be pricing in one or two interest rate cuts for the US by June next year and maybe four or five by the end of 2024. If the US Fed doesn’t cut interest rates and inflation continues to fall, the so-called real rate (being the difference between the headline yield and inflation) will be driven higher making monetary policy even more restrictive.

The US unemployment rate, released in early November, rose to 3.9% from a recent low of 3.4%. There is a ‘rule’ (the so-called SAHM rule after a former Fed staffer) that says if the (average over three months) rate climbs 0.5% or more above the recent low, that is a strong signal for a recession. The unemployment rate is a small move away triggering that rule.

Other aspects of the US labour report also showed weakness – as did retail sales and the outlook statements from some, but by no means all, US retailers.

Although we believe Australia is already in a ‘per capita’ recession and maybe heading for worse as past rate hikes work their way through the economy, companies’ earnings are not based on per capita consumption. Population growth can support the market through bad times and that is what our data is showing. So, markets can remain positive at times when the economy is weakening!

China even published some quite reasonable economic data during November and a strong China is always good for us. However, the end of November read of the China manufacturing activity index, the PMI, again came in below 50 at 49.4 from 49.5, a reading below 50 indicates contraction. A reading of 49.7 had been expected. However, The Materials sector of the ASX 200 and iron ore prices over November were both very strong countering the impact on the Australian share market of a China slow-down!

We are broadly positive about the share markets going forward into 2024. While bond yields might fall in line with expected changes in monetary policy, though we do not anticipate it is highly unlikely that the US Fed and RBA interest rates will fall to neutral levels (in the range of 2.5%p.a. to 3.0% p.a.). In this environment traditional approaches to portfolio construction which have been disrupted by the historically low interest rates following the Global Financial Crisis will make a return with defensive assets, such as bonds, potentially offsetting the volatility of equity markets and paying a more attractive yield.

Asset Classes

Australian Equities

The ASX 200 had a strong November with gains of 4.5% taking the year-to-date into positive territory at 0.7%.

The Healthcare and Property sectors produced double digit gains over the month. At the other end of the spectrum, gains in Telcos were flat and sharply negative for Utilities.

International Equities

The S&P 500 had an extremely strong month, gaining 8.9% and 19.0% for the year-to-date. The German DAX and the Japanese Nikkei moved roughly in line with the S&P 500 over November but the FTSE was a laggard at 1.8%.

If the Fed starts to cut rates from the first quarter of 2024 as some expect, because inflation is falling and not because the economy is going into recession, we expect a stronger 2024 than otherwise. If a recession becomes apparent, we still expect some positive, but more modest returns. Markets are largely still off their recent all-time highs.

It seems reasonable to attribute some of the strength on Wall Street to long bond yields having settled down at well below 5%.

Bonds and Interest Rates

When we look back on history we may see November 2023 as the beginning of the return to less aggressive monetary policy – except possibly for Australia.

As a result of recent changes in sentiment, the price of US Treasury’s rose sharply forcing yields down. 10-year yields were down by about 0.7% points in November – a massive change indeed. Market indicators are pointing to an end in Fed rate hikes having already been achieved and for a reasonable chance of a cut in the first quarter, followed possibly by another in the second quarter. By the end of 2024, the modal rate is expected to be about a full 1% below the current rate.

The Fed chair is not yet acknowledging this breakthrough in expectations but there are rumours that some Fed members are openly discussing it.

Other Assets

The price of oil dropped sharply in November – around ?6% for WTI and ?5% for Brent. Gold prices rose 2% and copper nearly 4%.

The price of iron ore rose very strongly – at 8% –which helped the Materials sector on the ASX 200 achieve a monthly gain of 5%.

The Australian dollar – against the US dollar – appreciated by 4.8% which will help reduce import prices and, hence, domestic inflation in Australia.

Regional Review

Australia

On the surface, Australian employment growth was strong at +55,000 new jobs in October with the full-time / part-time split being +17,000 / +38,000. However, the unemployment rate rose to 3.7% from 3.6%.

When the strong population growth arising from immigration is taken into account, some of the shine is taken off these numbers. However, +9 million hours extra were worked in the latest month. That number cancels out the ?9 million from the previous month but still leaves ?8 million hours lost over the last three months – or about 50,000 full-time-equivalent jobs. The mix is changing making it harder to interpret these data.

Retail sales were unequivocally bad. In volume terms they fell ?1.7% over the year or about ?4.3% on a per capita basis.

The wage price index rose 4.0% on the year or just about in line with inflation. CPI went up 4.9% on the year when 5.2% had been expected and down from 5.6% the month earlier. Core CPI rose 5.1% for the year down from 5.5% from the month earlier. Recent data point to sharply lower levels of inflation.

The so-called cost of living crisis is only really a problem if wages do not keep up with price inflation – which they are not. The crisis is real and workers deserve pay rises at least to maintain living standards including catch-up where appropriate. Wage rises are not the culprit. The old enemies of supply-chain, oil prices, currency depreciation and flood damage were the main causes our inflation problem.

China

China’s retail sales bounced back at 7.6% against an expected 7.0% and industrial output rose 4.6% against an expected 4.4%. Not a bad set of numbers but China must address some very real issues in the property sector.

At the end of November, it was reported that there was a surge respiratory cases in China. Hospitals are struggling to cope and masks are back in play but, so far, there are no travel restrictions in place.

It would be devastating if this was the start of another ‘pandemic scale’ crisis but it could just be a typical seasonal health problem on a larger scale.

US

US inflation data released in November beat expectations. CPI inflation was 0.0% for the month or 3.2% for the year against expectations of 0.1% and 3.7%. Core CPI inflation was 0.2% for the month and 4.0% for the year against expectations of 0.3% and 4.1%. While these numbers were not big beats, it appears the psychological 0.0% for the month caused a big sigh of relief. Bond and equity markets rallied strongly. PCE inflation was also flat for the latest month.

On the wholesale front, PPI inflation came in at ?0.5% for the month and 1.3% for the year (against an expected 1.9%). Wages only grew modestly at 0.2% for the month. If this were a political election, we think inflation would have declared defeat.

150,000 new jobs were created which was well down on last month and expectations. On top of that, the composition of jobs created was skewed towards sectors that are not part of the growth economy. The unemployment rate at 3.9% is now 0.5% points above the recent minimum.

Europe

The BoE was on hold and its inflation rate dropped to 4.6%, a two-year low, from 6.7% in the prior month. Inflation was only 0.1% for the month! However, retail sales volume was down ?0.3% for the month of October.

The UK government announced several stimulus initiatives in the November budget. These stimuli will fight against the inflation story but are most needed to redress the pain that many households have suffered in the last few years.

EU growth was negative in the latest quarter – as was that for Germany. EU inflation was down sharply from 4.3% to 2.9% for the headline rate. The core rate, at 4.2% was down from 4.5%.

Rest of the World

Thankfully a cease-fire in the Gaza-Israel conflict allowed a number of hostages and prisoners to be exchanged and essential supplies to be trucked in by the UN. The Ukraine-Russia conflict still seems nowhere near resolution. Neither conflict appears to be having a major negative influence on markets.

Turkey predicted 2023 inflation to be 65% falling to 36% in 2024. It puts our inflation problem into perspective!

Seasons Greetings

As this is our last economic update for calendar year 2023, we would take this opportunity to thank you for your many comments, feedback and discussion over the year. From all in the Research and Investment team, we hope you and your families have a very happy, healthy and safe Christmas and New Year.

We look forward to returning in 2024 to continue our observation and commentary on what is a very interesting period.