Economic Update

Economic Update June 2022

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

Key points:

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

– China is stimulating its economy as Covid case numbers decline

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

The Big Picture

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Australian Equities 

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

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

International Equities 

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

Bonds and Interest Rates

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

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

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

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

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

Other Assets 

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

Australia

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

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

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

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

China 

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

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

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

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

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

US

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

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

Europe 

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

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

Rest of the world

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

Economic Update May 2022

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

Key points:

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

We hope you find this month’s Economic Update as informative as always. If you have any feedback or would like to discuss any aspect of this report, please contact our team.
The Big Picture

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

International Equities 

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

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

Bonds and Interest Rates

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

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

Other Assets 

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

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

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

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

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

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

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

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

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

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

US

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

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

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

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

Europe 

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

In France, President Macron was re-elected.

Rest of the world

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

Economic Update April 2022

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

Key points:

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

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

The Big Picture

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Asset Classes

Australian Equities

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

International Equities

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

Bonds and Interest Rates

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

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

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

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

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

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

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

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

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

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

Other Assets

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

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

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

Regional Review

Australia

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

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

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

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

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

China

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

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

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

US

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

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

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

Europe

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

Rest of the world

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

Market volatility & Europe

In this update we provide an overview of the market volatility and the impacts of the Russian invasion of Ukraine.

Why has Russia invaded Ukraine?

Russian President Vladimir Putin’s main motive for launching the invasion of Ukraine appears to be to prevent NATO’s expansion going further East into the Balkan states. That said, there is also another motive which is much closer to home for President Putin. Ukraine’s people and culture have drifted to the West and have become more European since independence from the former Soviet Union and Putin is also concerned about the impact of having a Western leaning democracy on Russia’s border. This is because economic success in Ukraine would highlight the corruption, underperformance and inequities of autocratic Russia. So, the invasion of Ukraine is also about protecting Putin’s reign from enemies within Russia and to strengthen his position in the upcoming Russian elections this year.

What has been the response of the rest of the world?

Ukraine is not a member of NATO, so Europe and the USA are not obligated to defend Ukraine militarily. To date it seems that the West is unwilling to engage Russia militarily, which is wise given Russia’s substantial nuclear arsenal. To date, the main response to the invasion by the West has been economic sanctions, which are targeted to hurt Russia’s economy and the Russian oligarchs.

How is the Ukraine war likely to play out?

While Ukraine has a strong military, it is not a match for the Russian army. That said, the Ukrainians are willing fighters and will provide strong resistance. While the actual invasion and defeat of Ukraine’s military is expected to come relatively quickly, much like the US occupation of Iraq, many military analysts believe that a full longstanding occupation of Ukraine (including taking Kiev) could prove to be very costly for Russia. Though Putin has said he does not intend to occupy the Ukraine.

The war with Ukraine does not seem to be that popular in Russia, Putin’s plan may therefore be to play the long game, seeking to only take part of the country (not including Kiev) and destabilise the Ukrainian government with the goal of putting in a Russian leaning leader in charge.

How does Russia’s invasion of Ukraine impact the markets?

Russia’s economy is only marginally bigger than Australia’s and less than 2% of the world economy. This is despite Russia having nearly six times as many people as Australia. So, the economic impact of the war is likely not material in terms of the global economy.

However, Russia’s economy has some similarities to Australia and is driven by commodity prices, with Oil and Gas being Russia’s main exports. From a market’s perspective, the key concern about the Ukraine war is Energy prices. Energy prices are a key driver of inflation, which is already very high in the USA and the West. Given that interest rates are already set to rise this year in developed economies to quell inflation, so the focus of markets is on how the Ukraine war will impact the decisions of central banks.

On this point, since the situation in Ukraine has escalated, the implied chance of a 0.50% interest rate hike by the US Fed in March has dropped from 60% to 11% today. (Essentially the markets are implying that a hike of only 0.25% is now all but guaranteed and the implication here is that central banks will not hike rates as aggressively as was expected prior to the invasion.)

How are we thinking about the impact of the war on portfolios?

While we obviously don’t know how the Ukraine war will play out, there are a few lessons from history we should head from previous geopolitical events:

  1. Markets are unpredictable in the short run and market timing is difficult
  2. Growth assets outperform over the very long run and being out of the share market on its best days can be extremely costly
  3. Markets tend to overreact to geopolitical events and then rebound over the next few months (see table below)

 

Geopolitical Events and Stock Market (S&P 500) Reactions

Generally, we believe that the best approach is to stay the course with our investment strategy/asset allocation, unless an impending major market failure in the near term is apparent (i.e. the global shutdown at the start of the COVID pandemic or the Lehman Brothers collapse) or if the markets reach a state of hyper panic.

The Key Questions We Are Asking Ourselves

  • Are we seeing any evidence of an impending market failure spiraling from the Ukraine war? No, we think the impact on markets will be not significant unless the war escalates to include fighting by another nuclear power (i.e. direct intervention by NATO).
  • Is the Ukraine war going to send the world into recession in the next 6 months? Probably not given Russia’s economy is almost insignificant in terms of the global GDP.
    Are the markets in a state of hyper panic now? No. Measures of market volatility are elevated, as expected, but not markedly so.
  • How will the Ukraine war impact the Fed’s decision on US interest rates in March? Even prior to the situation in Ukraine escalating, we expected the Fed to be less aggressive than the market in raising interest rates and did not anticipate the US to hike interest rates by 0.50%. We are now in line with the market’s implied forecast and believe that the most likely change is a 0.25% hike.

 

Conclusion

While our sympathy is clearly with the Ukrainian people at this time, from an investment perspective, our assessment is that this event as destabilising as it is and for the reasons expressed above will not be material for investment markets in the near term. Hence, our view is that based on the information we have and continue to monitor very closely, current portfolio positioning remains appropriate, not withstanding that we could revisit this assessment if the situation escalates further.

General Advice Warning

The information in this presentation contains general advice only, that is, advice which does not take into account your needs, objectives or financial situation. You need to consider the appropriateness of that general advice in light of your personal circumstances before acting on the advice. You should obtain and consider the Product Disclosure Statement for any product discussed before making a decision to acquire that product. You should obtain financial advice that addresses your specific needs and situation before making investment decisions. While every care has been taken in the preparation of this information, Infocus Securities Australia Pty Ltd (Infocus) does not guarantee the accuracy or completeness of the information. Infocus does not guarantee any particular outcome or future performance. Infocus is a registered tax (financial) adviser. Any tax advice in this presentation is incidental to the financial advice in it.  Taxation information is based on our interpretation of the relevant laws as at 1 July 2020. You should seek specialist advice from a tax professional to confirm the impact of this advice on your overall tax position. Any case studies included are hypothetical, for illustration purposes only and are not based on actual returns.

Infocus Securities Australia Pty Ltd (ABN 47 097 797 049) AFSL No. 236 523.

Economic Update April 2021

Within this month’s update, we share with you a snapshot of economic occurrences both nationally and from around the globe.

Vaccination nationalism!

– US COVID-19 infection rate starts to climb again despite vaccine rollout
– US and global economic growth strong – but not yet inflationary
– Bond yields rise strongly as inflation expectations increase in response to economic recovery and maintenance of stimulatory policy settings

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

The Big Picture

The race against COVID-19 continues but at very different speeds around the globe. Some countries have not yet started a vaccination programme and we have only just begun ours. We sadly found out at the end of March we hadn’t yet vaccinated all of the front-line health workers in Brisbane! The NSW and federal governments are in a stoush about vaccine shortages and misinformation.

The UK is well ahead of the US in terms of the proportion of their populations having been vaccinated but the US has delivered 150 million shots ‘into arms’.

While it might seem like a priority to get a whole nation’s population vaccinated first, the virus can only be eradicated when a sizeable proportion of the whole world’s nearly 8 billion people are immune through vaccination or having contracted the virus. And the longer some countries stay behind the vaccination curve, the greater is the chance of new, more virulent strains of the COVID-19 virus developing.

It is also important to note that those who have been vaccinated are not necessarily immune. The clinical trials data provide clear evidence that vaccinated people can contract the virus. Indeed, the efficacy rate of a vaccine is calculated from the relative infection rates of those who have been vaccinated versus those who haven’t (the placebo or control group).

Only 100% efficacy implies total immunity from vaccination. The best vaccine so far is about 95% effective. It is widely thought that 60% is the minimum rate to make a vaccine worthwhile.
One of the major public health problems now emerging is that some countries are practicing ‘vaccination nationalism’. They are unwilling to share the doses they have control over.

The European Union (EU) is pressuring member states not to supply orders from its production to nations outside the EU while there remains a backlog of unfulfilled orders within the EU. Australia’s orders for the vaccine have been hindered at least by France and Italy. We are well behind our objectives stated by the government a few months ago.

The US, from President Biden’s speeches, has on order many more doses than it needs this year. Bloomberg reported that the US had secured twice the number of doses needed to vaccinate everyone. Given many in the US do not want to be vaccinated, it is logical that some of the US’ stockholding would be better directed elsewhere. The US just offered 1.5 million doses to Canada ‘on loan’ even though it has secured so much more than it needs in the immediate future.

The third wave of US infections peaked after its holiday season at around 250,000 new cases per day on a 7-day moving average. That infection rate almost got down to 50,000 per day in early March but it has started to climb steadily to around 65,000 per day in spite of the success of its vaccination programme.

There have been other issues hampering the fight against the virus – specifically regarding the AstraZeneca (AZ) vaccine. This vaccine is especially important as it is the planned solution for most of the world including Australia. AZ is reportedly new to the vaccine business and seems to have over-promised. Deliveries are reportedly well behind schedule.

Three unrelated problems have emerged with the AZ variant. The first was that, due to a bungle over administering the correct dosages, it emerged that it might not be sufficiently efficacious for the over 65s – the people who are at most risk.

A significant number of countries in the EU and beyond then stopped vaccinating that age group with the AZ vaccine – and some suspended the vaccine altogether. It later appeared that the evidence wasn’t sufficiently strong to warrant suspension of its use consequently, many countries started reversing their earlier decisions.

The second issue related to blood clots. Some people – but not that many – suffer from blood clots whether or not they have been vaccinated with any relevant drug. In the trials, some thought too many people in the AZ vaccinated group – as opposed to the placebo or control group – contracted blood clots.

The numbers of people so affected in each group are so small that it was hard to form a compelling statistical relationship. The jury is now swinging back to the fact that AZ does not cause blood clotting but, perhaps, those with certain pre-existing conditions might avoid AZ.

Nevertheless, effective from the end of March both Germany and Canada have suspended vaccinations for the under 60 and 55 age groups, respectively. There seems to be no consensus!
The third issue with AZ is the manner in which the results of the trials have been disseminated. It seems to have been a case of distributing information by press release rather than by the traditional scientific reports.

AZ had produced a number of sets of seemingly conflicting data. Then, in late March, AZ announced again by press release that it had concluded its large US trials and the vaccine was 79% efficacious – quite a good number and better than in some other earlier trials. Then, two days later at 12:20 am (Washington DC time) a US regulator called AZ to task over the nature of the data they were using!

While AZ came back and lowered its efficacy rating from 79% to 76%, we expect there is more to come on this matter.

We reasonably surmise from all of these events that AZ is as safe to take as any other vaccine but there isn’t great clarity over its efficacy. It certainly seems to be a lot better than nothing but, perhaps, we should continue to practice social distancing etc after having been vaccinated with AZ – or, until we know better.

The major prevailing economic fear at the moment is that inflation will return and require central banks to start hiking interest rates sooner than previously expected. It is true, much of the economic data has exceeded expectations but catch-up is different from reaching new highs.

The US Federal Reserve (Fed) is now expecting 6.5% US growth in 2021. Since US GDP ended 2020 behind its 2019 level, 6.5% in 2021 will only have the US, by the end of 2021, where it would have been after two years of ‘normal’ growth in 2020 and 2021.

There are also 9.5 million unemployed in the US who haven’t yet got the jobs back that they lost in the shut-downs. Inflation woes look a very long way off to us. But it is encouraging to see strong economic progress.

China released an encouraging plan for ‘quality’ growth over the next five years at a rate above 6% per annum. While there are many significant geopolitical concerns about China, the strength of its economy is not one of them.

Australia is also experiencing strong growth in GDP and in house prices – but GDP is still largely playing catch up. The house-price conundrum is causing many to scratch their heads. Latest data also put US house price growth over the last 12 months at 11.2% which is the strongest in 15 years.

Our overall assessment is that the developed world is starting to return to normal but we see occasional resurgences of infections and shut downs here and elsewhere for at least the rest of 2021. And markets seem set to follow recent momentum along with all of the ample stimulus from both central banks and governments.

Asset Classes

Australian Equities

The ASX 200 had another strong positive month – making it six in a row – but the index stands well short of its February 2020 peak.

We are noting that returns in different sectors have been behaving quite differently in recent months. Investors are presumably trying to work out how best to set their portfolio ‘styles’ for a post-pandemic world or, indeed, see their way through any consequent volatility.

International Equities

The S&P 500 reached fresh all-time highs again in March. This index had a very strong month along with the London FTSE and the German DAX. China and emerging markets did not fare well.
The US Federal Reserve (Fed) has clearly stated that it will support quantitative easing (QE) or bond purchases for some time to come and it will give clear warning long before it plans to start to ‘taper’ the programme. That, and the trillions of dollars of fiscal stimulus being pumped into the US economy should ensure the momentum in US equities continues.

Our current estimate for the yield on the S&P 500 is about 1.6% (a little lower than historic averages) which is about the same as the 10-yr US Treasury yield. Given the prospect for capital gains in equities, we see the yield comparison still very much favouring equities for this year and possibly a lot longer.

Bonds and Interest Rates

The US 10-yr bond yield surge in February this year has largely dissipated. Since the yield is only back to pre-covid rates which we all thought at the time were low, we don’t see the current near 1.75% as problematic.

The Fed came out from its March meeting with a more optimistic view of the US economy. It upped its 2021 growth forecast from 4.2% (made in December) to 6.5%. It predicted 2022 and 2023 growth to be 3.2% and 2.2%, respectively. It expects the unemployment rate to fall to 4.5% by the end of this year.

The growth forecasts might have been enough to ‘frighten the horses’ a little but its inflation forecasts certainly did. Because of the price effects at the start of the COVID-shutdowns, there will be a ‘base-year’ effect in the inflation data series in 2021. The Fed expects a temporary increase to 2.4% (above the old target but not what the Fed has more recently been discussing) in the middle of 2021. That it expects inflation to then immediately dip down to below 2% means that we shouldn’t be bothered about consequent rate hikes. The bond market appears somewhat sceptical of this on the basis that ‘why would you have consequent interest rate rises if it were not in response to rising inflation?’

All seems more or less settled on the interest rate front again but we did observe a couple of weeks of jitters in bonds and equities during March.

The Reserve Bank of Australia (RBA) announced a doubling of its QE purchases to help lower longer run yields on its government bonds. We are not expecting the RBA to raise its overnight rate to stem the recent house price surge. Up 3% in one quarter is a big house price leap but the latest prices are only slightly above those at the March 2020 peak.

In spite of all of the chatter during February and March this year, we fully expect interest rates to stay relatively low for at least up to 2023 both here and in the US.

Other Assets

Prices of the major commodities (copper, iron ore and oil) had risen strongly in the year-to-date but they have all seen some pull back in March. Gold prices were down over the year and the month.

The Australian dollar against the greenback lost a little ground in March and is at a low point for the year-to-date.

Regional Review

Australia

The GDP growth for 2020 December quarter came in at 3.1% p.a., down from 3.4% in the previous quarter. While the last two quarters of 2020 were indeed strong, GDP is still 1.1% below the 2019 level. In a normal year we might expect growth of, say, 2.5% so we finished 2020 at about -3.6% behind where we would have been in a normal year. Hence the stronger level in the short term is not the basis for inflation fears!

The household savings ratio, which is also published in the GDP report, showed a fall from 18.7% to 12%. That is still quite a bit above what we think is healthy for a strong economy. It’s rapid return following the spike in the shutdown is warmly welcomed. Our economy is starting to get back on track. People are feeling more secure about spending and have more options on which to spend!

Our labour force data too are improving. The latest unemployment rate was down to 5.8% after 89,000 jobs were created in the month. The peak in March 2020 was 7.5%. JobKeeper payments ceased near the end of March so there could be some fall out from that.

We have a lot to thank state and federal government policies for over the pandemic outbreak. There was another 3-day lockdown announced for Brisbane because of four people having tested positive. Rapid response, short-lived shutdowns have kept off public health control at the top end of comparable nations.

With very few residents having been vaccinated we are relying on limited interaction with people from outside of our group. Until we – and those who wish to visit – are close to herd immunity we cannot get back to ‘normal’ life. Masks, hand washing and social distancing will be needed for many months to come.

The OECD published updated forecasts for Australian growth. In December 2020, the agency predicted growth of 3.2% for 2021. That prediction is now 4.5% with 3.1% predicted for 2022.

China

China set its new five-year plan during March. It is targeting a modest 6% plus growth in an attempt to focus on quality (sustainable) growth rather than some of the boom-bust policies of recent years.

The monthly data on retail sales, industrial output and fixed asset investment shot the lights out at over 30% in each case for the latest 12-month period. Of course, the numbers are so high because it is 12 months since the data plummeted on the start of the fierce China shut-down brought on by its COVID-19 response.

US

President Biden was initially aiming to oversee 100 million vaccinations in the first 100 days in office. It looks like that figure will turn out to be more like 200 million. Since each person needs two doses for maximum immunity there is still quite a way to go. Indeed, as nearly half of certain groups such as ‘male republicans’ say they will not or may not take the jab, it is far from clear that herd immunity will be reached any time soon.

From boisterous interchanges in congress, it seems that some senators want those vaccinated to freely meet without masks etc. Indeed, Biden, said as much for gatherings indoors of fully vaccinated people. We fear that US citizens may push back too soon against distancing measures in turn slowing the elimination of COVID-19.

The rate of infections did start to climb again in the last couple of weeks of March even though vaccinations were well ahead of plan. The seven-day average of new infections ended March at over 25% above the March low!

US economic data are quite reasonable given the shutdown. 2020 December quarter growth was revised up to 4.3% from 4.1% and inflation (core personal consumer expenditure) was only 0.1% or 1.4% over the year.

The $1.9 trillion relief package only just started to be distributed in mid-March. Its full effect will not be seen for some time. On top of that, Biden wants a further $2 trillion dollars spent on infrastructure. Somebody is going to have to pay for this and people aren’t queueing up for the opportunity. He is recommending to hike the corporate tax rate to 28% from the 21% that Trump had introduced by cutting the previous rate from 35%. That discussion could mark the end of the presidential honeymoon.

Once the infrastructure bill goes through – as it does seem to be popular – Biden plans to turn to health and other personal issues. They will have to be paid for too!

In an unusual turn of events, Biden stated in a speech in March that he now plans to stand for re-election in 2024. He ruled that out before the last election. He will be 81 next time and 85 at the end of that term if he is successful. Sadly, he tripped three times on global TV trying to do ‘an Obama’ running up the steps to Airforce 1. As anyone in their seventies or older will tell you – it isn’t easy – which is why the rest of us all use the sky-bridge! While athleticism is not a prerequisite for good government it is not a good look for confidence building.

Europe

The UK and the EU are going toe-to-toe over vaccine supply. The EU is restricting export of vaccines while they have unfulfilled orders. Italy and France interfered with exports to Australia. A regulator ‘found’ 49 million doses of AZ suspiciously not on display in an Italian factory! Big political games are being played. And AZ is well behind its production targets.

Nonetheless, the UK is ahead of the curve in its vaccination programme and it is maintaining its ‘roadmap’ for re-opening its economy by June. Germany, on the other hand, is just considering new lockdowns.

Rest of the World

After six days blocking the whole of the Suez Canal, the massive container ship, Ever Given, has been re-floated and an end to the blockage disruption is in sight.

Japan has announced that it will not allow overseas spectators at the Tokyo Olympics. That means there are of the order of 900,000 tickets to be refunded. That has to hurt. It’s not clear what happens with hotel reservations and travel bookings. Somebody has to lose a lot of money. In hindsight it might have been better to have cancelled the games last year.

Economic Update – March 2021

Within this month’s update, we share with you a snapshot of economic occurrences both nationally and from around the globe.

Bond yields spike

– US inflation fears bubble up and the 10-year bond interest rate rises to reflect this

– Globally COVID 19 cases have declined for 6 weeks, millions vaccinated in the US and UK

– Corporate earnings strongly surprise on the upside and governments continue spending

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

The Big Picture

As if there wasn’t enough to contend with in coping with the pandemic, US 10-year bond yields spiked at the end of February and that sent Wall Street into a tail spin. The two phenomena are actually connected but not in an obvious way.

President Biden and his team are making great inroads into vaccinating all US adults who want the vaccine sooner than many expected. That was the bad news! Such was the glee at starting to put an end to the pandemic (or so many think – but more of that later) investors and analysts started to think about a rapid recovery for the US economy.

If/when the US economy fully recovers, that will/might bring with it inflation – a problem that the US has not struggled with for more than a decade. Significant inflation means that the US Federal Reserve (“The Fed”) will have to start raising its federal funds rates from almost zero up to something a bit more in line with historical norms.

With participants suddenly confronted with the possibility of tighter monetary policy, the yields on longer-dated US Treasuries started to rise – and quickly. The next piece in the jigsaw is that 10-year yields are just about up to dividend yields on the S&P 500. At long last there seemed to be some alternative to investing in shares!

While this sequence of events seems logical, we think the argument is flawed. And the Fed chairman, Jay Powell, agrees.

Markets react harshly when they are blinded-sided. The S&P 500 fell  2.5% on the last Thursday of February and then fell a further  0.5% the next day. Ouch!

For the US to achieve “herd immunity” where the virus dies out on its own, it is widely accepted that the US needs to vaccinate around 70% or more with an “efficacious” vaccine like the ones from Pfizer and Moderna they are using.

Biden has assured us that he will have 600m doses available by the end of July but that’s a long way away from getting two jabs into well over 200m American arms. There are two major problems that Biden is not yet addressing.

First, there is a lot of push back in the US to being vaccinated. Whatever their reasons, it is not likely that the US can get enough people vaccinated quickly enough especially as two jabs are required. How do you find the person for the second jab and how do you record a successful pair of vaccinations – on a digital passport?

Tracking may well offend some US citizens as they might see it as another case of big brother. Tracking is, however, working well in Australia for finding sources of COVID infection.

The second problem is even bigger! People who have been vaccinated can still get infected and pass it on but they won’t get sick themselves! Masks and social distancing aren’t going away any time soon. Coupled with this problem is the fact that the rest of the world is not moving at the same rate. We only just started our vaccinations in the last week of February while the US had reportedly already vaccinated over 60 million people. And what about poorer nations?

For the US economy to boom again it also needs people and goods crossing its international borders. And what about Mexico? How many new illegal immigrants will have been vaccinated. How many illegal immigrants in the US will come forward for a jab? And then we have the problems about new strains emerging. If there are pockets of people scattered around the world being exposed to COVID, new, more virulent strains such as the UK and SA variants (and worse) may be created.

We applaud the work the US is doing in trying to eradicate the virus. We just think it will take a lot longer before they are back to ‘normal’.

We did not see all of Jay Powell’s testimony to the two chambers of Congress but we did see his conclusion. Paraphrased he said that it will be at least three years before we can reach the inflation target. And he thinks it will be a similar length of time before they achieve full employment.

So, if the inflation scare was a false dawn, what might we expect about bonds and share dividends? The US 10-year yield was around 1.8% to 1.9% in the weeks around the start of 2020 – before most of us knew anything about COVID. This yield fell to around 0.6% to 0.7% in the middle of 2020 and started to rise gently from when the vaccines were announced in November 2020 to about 1.0% to 1.1% in mid-February.

That was a massive fall in yields to 0.5% and a massive rise to 1.1% on the way back. But the even more massive rise to a short-lived 1.614% near the end of February is what spooked the markets.

We think some people extrapolated the recent short, sharp rise in yield without context. If the yield gets back 1.9% that is still only where it was positioned before the pandemic. Why should it continue to rise above that without a new big impetus? And if, as we suggested, the economy will only glide back to pre-COVID strength, why should it have even got to 1.6%? We think it was an over-reaction. It fell to 1.41% in just over 24 hours!

With bond yields getting back to near dividend yields on shares, we should also ask the question of why dividend yields fell so low. Historically, yield on the S&P 500 was around 2.5%, a full 1% point above where they are now.

Earnings fell in 2020 (from where dividends are paid) and companies became more risk-averse as they found it hard to predict where the economy was going. So, they retained a bigger share of earnings than normal.

Reporting season for quarter 4 (Q4) in the US was very strong and, on average, beat earnings estimates. Earnings are predicted to rise from here so we expect dividend yields to start to rise. That means bonds are not a great alternative to shares going forward – at least for a year or two.

As we have highlighted previously, we expected any number of shocks to equity markets as news about the pandemic emerged. This recent sell off in the bond market was just one of them. There will be more. These events are disconcerting for investors and while we don’t know the exact outcome in the short term, we do know having a well-founded long term investment strategy is the prudent approach to look through bouts of volatility.

Turning to Australia, our situation is quite different from that in the US. They vaccinated over 60 million people in the US before Scott Morrison got his jab at the head of the queue.

We only have enough efficacious Pfizer vaccine for less than 10 million people in Australia and no Moderna, a similar and equally efficacious vaccine. We were not able to secure more of these two vaccines used in the US so we are left with 53.8 million doses of AstraZeneca’s (AZ) vaccine.

Importantly, the US has not yet approved AZ for the US and South Africa has suspended the use of AZ. A dozen or more European countries are not recommending and/or allowing over 65s to be given AZ. The reason is that there is great debate about its efficacy (or usefulness). Nobody is suggesting it will harm anyone; it’s just much less useful than the Pfizer/Moderna formulations. Indeed, many say that AZ is not strong enough to produce herd immunity – the end game.

We clearly need a plan B but approval has not yet even been given for the 50 of the 53.8 million doses of AZ being manufactured in Melbourne by CSL. We have 51 million doses of Novavax on order but that is not only yet to be approved but there is very little known about the trial results.

Australians and the authorities have done a spectacular job in containing COVID. But, without an efficacious vaccine, it may well be 2022 before we start to tackle the underlying problem. Not only will Americans have to continue with masks and social distancing, etc we will have to be even more vigilant and for longer.

Our labour market is, however, continuing to improve. The latest unemployment rate fell from 6.6% to 6.4% and over 29,000 now jobs were created. Our Westpac and NAB confidence and conditions surveys are still pointing to a mildly optimistic sentiment across consumers and businesses. However, our retail sales only grew by 0.6% for the month when 2.0% had been expected.

Our government and central bank (RBA) continue to work hard at keeping the economy together. The RBA just extended its Quantitative Easing (QE) programme by $100bn from mid-April at $5bn per week buying long-dated bonds that they estimate keeps the bond yield down by about 30 basis points (bps) or 0.3 percentage points.

In conclusion, we believe that the US and Australia are doing enough to promote economic growth or at least keep it above what it would have otherwise been. The US Congress is close to putting another $1.9 trn into the system in the form of cash payments, top-up benefits and COVID needs. Much of that expenditure just perpetuates what was already passed but would have run out by March 14th without it.

We do not feel the need to alter our investment strategy for the year ahead at this point however, we must expect more speed bumps along the way.

Asset Classes
Australian Equities 

The month of February was good for the ASX 200 in that the harsh sell off on the last day still left the index up by 1.0% for the month. The Energy sector (+2.1%) had a good month but Financials (+4.5%) and Materials (+7.2%) were spectacular; Utilities ( 8.8%) was the main laggard.

The last few months have been difficult for investors as the ‘style’ of stocks (growth, value, cyclicals, defensives, etc) in favour have switched back and forth, largely on news about the pandemic.

The second half of 2020 reporting season is all but over. The results were not only largely very strong relative to forecasts but historical estimates of earnings were revised upwards as actuals were published.

International Equities 

The S&P 500 (+2.5%) gained strongly in February despite losing  3.0% in the last two days of the month. Most other major indexes also did well.

US fourth quarter reported earnings were also strong but there have been some major moves in certain sectors. Technology had been the poster child of the index for some time. It is always hard to value high growth stocks and some tech stocks were sold off quite heavily during the month. That means the tech-based Nasdaq underperformed the Dow and the S&P 500 for the first time in a while.

Bonds and Interest Rates

We discussed the bond yield spike in some detail in the overview – such is the importance of the topic. Suffice it to say here that the short duration end of the US yield curve has been well anchored out to about two years duration. The yield curve has been steepening quite sharply (yields on long durations securities e.g. 10-year bonds rising faster than short duration instruments such as cash) since around the time of the presidential election in November 2020 and the announcements of vaccines being approved.

The Australian 10-yr bond stands at 1.9% or a full 50 bps above the US yield. The RBA has about six months of Quantitative Easing (QE) ready to help keep yields on longer dated government bonds in check, but there is the possibility that more may be needed.

We do not expect the Fed or the RBA will try to lift Official interest rates anytime this year and probably next – if not even longer. We think much of the recent rally in bond yields is already incorporated into central bank’s view of interest rate policy.

Other Assets 

February has been a big month for some commodity prices. Oil prices were up about 18% and the iron ore price was up 10%. The copper price was up 16%. The price of gold was down 7%. Partly as a result, the Australian dollar rose 2.4% against the US$ (from 76.45c to 78.29c) passing through 80c on the way through the month.

The VIX (equity market volatility Index) ‘fear index was down from 33 to 28 over February but hit a low of 20 along the way!

Regional Review

Australia

The unemployment rate just prior to the pandemic bottomed at 5.1% and then peaked at 7.5% in later 2020. This rate has now fallen back to 6.4% last reported in February. Of course, we could debate measurement issues concerning hidden unemployment and the like however, such problems always exist so we should just compare apples with apples. That aside the government seems to have made a reasonable fist of tackling the problems.

Because of COVID 19 vaccination problems we do not expect to have seen the last of partial shutdowns but the future looks brighter than it did prior to Christmas.

There is now talk of an early federal election for the coalition to capitalise on its perceived handling of the pandemic. That is not for us to speculate on but the main worry for many investors in the last election was the opposition’s intent to remove franking credits and increase capital gains tax. They have now renounced those plans so the main differences are now the usual social positions rather than financial – especially for self-funded retirees.

China 

If China was expecting Biden to rescind Trump’s tariffs and other restrictions, they were sadly mistaken – and they have hinted at that. Biden doesn’t seem to be in a hurry to placate them even though the Democrats were vocal opponents of the introductions of the tariffs at the time.

The ongoing trade war with China seems to have softened but not reversed. China needs our high-grade coal but seems to be prepared to suffer a little more rather than let our ships unload.

The Chinese Purchasing Managers Index (PMI) – a measure of activity and by implication confidence for manufacturing – came in at 51.3 which was just a little off the expected 51.6.

US

The House of Representatives has passed the US$1.9 trn relief package to aid the economy to deal with the pandemic, but it seems that the doubling of the minimum wage missed out on being part of the bill.

The Biden administration is proposing a bill that will avoid needing any Republican support – it is a quirk of the US system that allows a limited number of bills to pass the Senate without the 60% majority normally required for a vote to pass.

Although US$1.9 trn sounds a lot – and it is a lot following hot on the heels of the US$0.9 trn package passed in December – it is largely keeping current financial assistance levels going for a lot longer. It is far too soon to remove the economy from life support.

The latest monthly retail sales growth was a bumper, up 5.3% as that month included the $600 cheques that went to millions of people. With another $1,400 cheque almost in the mail, we can expect even bigger numbers sometime soon.

The latest Consumer Price Index (CPI) inflation measure was only +0.3% but that reduces to 0.0% core inflation when energy and food are removed from the basket of goods and services comprising the index. And some folks thought inflation was getting out of control?

The nonfarm payrolls (jobs) data were on expectations at 49,000 new jobs and an unemployment rate of 6.3% (when 6.7% had been expected). The market is expecting over 200,000 new jobs in the next release due on the first Friday in March. The outcome could be a lot bigger than that without causing a problem. 200,000 was a ball-park average before the pandemic set in. There are still millions of jobs lost in the shutdown that haven’t yet been recovered.

Europe 

We still have not seen any significant fallout from Brexit at the start of the year. Britain is having lots of trouble with controlling COVID 19 but they are planning to get spectators back at football matches from May onwards.

Different countries have reacted quite differently to the use of the AZ vaccine. Clearly, what is needed is more data so that a prudent and informed decision can be made. There are real issues with the clinical trials that are in turn causing confusion.

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