Economic Update February 2023

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

Key points:

– Short-term market volatility is expected.
– Major central banks are nearing their points of pausing interest rate policy.
– China’s economy starts to recover but the removal of lockdowns is seeing Covid cases explode.
– Recessions are possibly already price in to equity markets but Australia might again prove to be the lucky country and slow, but avoid 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

Now that the dust has settled on 2022, we can better see what the returns were in different asset classes. The S&P 500 (including dividends reinvested) lost 18% on the year while the equivalent return on the ASX 200 was a loss of only 1%. Global bonds lost 12%. Australian residential property took a bit of a beating but the losses depended very much on the suburb as much as the city or state – broadly down around 10%.

In short, there was nowhere really to hide in 2022. But investors might take some reassurance that global bonds and equities have only lost material ground, such as they did in 2022, three times in the last 100 or more years.

We see the first half of 2023 as possibly containing a few more bumps in the road but we anticipate that, by the end of 2023, the returns on the ASX 200 and S&P 500 could be on a par with historical norms when measured over the whole year noting January was a particularly strong start to the year for equities.

Most of the carnage on the S&P 500 in 2022 (and possibly beyond) was caused by big falls in the value of many of the mega-tech stocks. In the US, the December quarter reporting season is now well underway and suggests that those losses are not yet over. Indeed, at least half a dozen of these companies announced big job cuts in the thousands – and in some cases, over 10,000.

The macro jobs picture in the US and Australia still remains very strong but it would be foolish in the extreme to think other sectors won’t participate in this trend as the lagged effects of high interest rates start to bite. Even the US Federal Reserve (Fed) expects its unemployment rate to rise from the current 3.5% to 4.6% by December this year.

And few are talking about the impact of QT (Quantitative Tightening). The US Fed is letting $95bn per month run-off the balance sheet i.e. it is repaying the principal of the bonds at their maturity and not reissuing new bonds to replace them. This is the opposite of QE (Quantitative Easing) which was used post the GFC to provide much needed economic support. This is unknown territory!

The consensus view is that the Fed will slow down its rate hikes and is almost ready to pause. The Fed does not expect to cut rates (the so-called ‘pivot’) at any time in 2023. It expects to end the year with its cash rate at just over 5% (the so-called ‘terminal rate’). On the other hand, the market thinks the Fed will cut its rate during the second half of 2023 to finish the year at more like 4.5%, or at about the current rate, after having risen to around 5% in mid-year.

The first few days of February have been very busy in terms of the release of economic reports. In terms of official interest rate settings, the Fed increased by 0.25%, the Bank of England (BoE) increased by 0.50% and the European Central Bank (ECB) also increased by 0.50%. The Reserve Bank of Australia (RBA) followed suite on February 7th increasing Australia’s official cash rate by 0.25% to a rate of 3.35%

On the evening of the 3rd of February, the all-important US jobs data report – the so-called non-farm payrolls – was released. The market was expecting 185,000 new jobs to be created in January. The result of 517,000 came as a big surprise with the increase being quite broad based. The immediate impact of this obvious strength in US employment data make another interest rate increase at the Feds March meeting more likely now.

Inflation, as measured by the CPI, continues to be stubbornly high in the US but only when the ‘annual figure’ is analysed. For simplicity, we can think of the annual inflation rate to be the average of the last twelve monthly-rates.

Our analysis suggests the monthly rate for the US CPI was around 1.0% per month up until July 2022 and about 0.2% to 0.3% per month since. If this pattern continues, the annual figures will decline markedly from July 2023. Therefore, the annual figure declines slowly and will seem ‘stubborn’ because of the design of these poorly-conceived calculations. That slow decline will go on until the July 2023 data point by which time the high monthly inflation readings form June 2022 and before will no longer be in the annual data series.

Since it is widely thought that interest rate hikes do not affect the real economy immediately – many think that there is a 12 to 18-month lag – the Fed could be at risk of over tightening interest rates if it overly fixates on the annual inflation data as a key input to setting current interest rate policy.

Our quarterly inflation print was released in January for the December quarter. It was 1.9% (not annualised) for the quarter and 7.8% for the year. Interestingly, domestic travel and accommodation was up 13.3% on the year and 7.6% for the overseas equivalent. Pent-up demand from three years of limited opportunities to travel would seem to have been a culprit in vacationing demand and cost.

Another major critical factor in trying to plot the course for markets in 2023 is how the China re-opening will play out. There has been a surge in infections and some reports suggest in excess of 50% of the population has been infected. The government is clearly reluctant to close the country/economy again so its impact is more a case of how its healthcare system can deal with the problem.

China economic data before the re-opening were largely weak but there are some nascent signs of recovery. If the recovery continues, it will be particularly good news for Australia and its large resources sector.

Some of the recent pandemic-induced supply chain issues were due to issues in Taiwan causing a global semi-conductor chip shortage. As a result, President Biden launched an initiative to make the US more secure from future problems by building chip factories in the US.

Intel is now producing in the US but it is reported that its inventories are building up because of over-supply. Intel reported its December quarter company accounts in January and the market did not like them – slashing the share price on the announcement. It may be some time before all of these issues are worked through.

The International Monetary Fund (IMF) stated in January that it thinks one third of the global economy will go into recession in 2023. We re-iterate our view that the US and Europe look likely to go that way but we are cautiously optimistic that Australia may avoid that fate. Australia is well behind the US in raising rates and China seems to be coming back on stream quickly enough to assist the Australian economy as it did in the 2008/9 global recession.

Importantly, share markets do not have to follow the real economy. Indeed, many analysts, including us, believe that share markets often lead the real economy and it could well be that recessions in various regions have already been priced in.

Our analysis of Refinitiv earnings forecasts – a key benchmark data-source in finance – support the view that company fundamentals, in aggregate, are moderately strong but, share prices will experience volatility as various announcements – such as declarations of recessions or otherwise – are made.

Asset Classes

Australian Equities

The ASX 200 started the year with a very strong month rising 6.2% in January which was underpinned by growth in Materials (8.9%) on the China re-opening. Consumer Discretionary (9.8%) and Financials (5.6%) were also major contributors. The Utilities sector was the only one to go backwards ( 3.0%).

We have noted a modest but material improvement in relative earnings expectations from the Refinitiv survey of broker forecasts since the start of the year. These data can be a little volatile around the lead-in to our February reporting season, the so-called ‘confession season’, so caution should be exercised until a clear trend emerges.

International Equities

The S&P 500 (6.2%), along with the FTSE (4.3%), Nikkei (4.7%), DAX (8.7%) and Emerging Markets (7.6%) all had very strong returns in January. We think it is premature to read the start of a new bull market into these trends as there are many central bank decisions to come in the first half of the year and talks of recession in the US and Europe still abound.

The S&P 500 greatly under-performed the ASX 200 in 2022. Therefore, there may well be some catch up for that index in 2023. At the end of January, there were big rebounds in some of the mega-tech names. However, bear-market rallies can occur in sectors as well as broader indexes.

Our analysis of Refinitiv earnings forecasts for US companies show that we have stable expectations for the index over the course of January for the year ahead subject to short-term volatility.

It is widely reported that earnings forecasts are being reduced but we only measure earnings forecasts relative to current and past estimates. Past estimates are not usually known until a month or two after the event. Therefore, if future earnings forecasts are reduced by a little – and so are current and past forecasts – we can produce a more relevant view of the future.

The VIX ‘fear index’ (a measure of the cost of down-side protection insurance for the S&P 500) fell sharply in January finishing at a level under 20 indicating investors are becoming more comfortable with the market, or as some market watchers question, are investors becoming complacent?

Bonds and Interest Rates

While none of the major central banks met in January there has been a flurry of activity early in February, the outcomes of these meetings already reported above.

The CME Fedwatch tool at time of writing, assigns the highest probability (34.4%) of a US Cash rate of 4.75% to 5.00% at the Feds December 2023 meeting. Second highest probability (32.9%) is for 4.50% to 4.75% i.e. the same as it is now. What is interesting is that the Fed watch tool has a 97% chance that the Fed will increase rates by 0.25% at its next meeting on 22 March. Currently this implies that there will be no further increases to the US Cash rate by the Fed for the rest of the year with a reasonable prospect of a 0.25% rate cut at some point before year end.

With the US 10-yr Treasury yield at close to 3.5%, the US yield curve is heavily inverted (that is, the short end or cash rate is greater than that of the longer date maturities e.g. 10-year bonds). Since the 10-yr yield is thought to be strongly related to inflation, it appears that the market thinks that the inflation problem will soon be overcome.
While the RBA hiked its cash rate by 25 bps to 3.35% on February 7th, it does not seem to be fully on a course with the US Fed to keep hiking interest rates, this is despite the elevated Australian rate of inflation.

RBA Governor, Dr Philip Lowe, has his position up for renewal or otherwise in September. The stated RBA interest rate policy position is not nearly as aggressive as that espoused by the Fed. Will Governor Lowe want to push a more overt inflation fighting interest rate policy before September? We think not.

Australian house prices do not appear to have stabilised since their 2022 falls and this may put weight on the RBA not to hike the cash rate much further. However, as previously observed, our inflation data is remaining high ensuring interest rate policy setting remains finely balanced.

Other Assets

The prices of iron ore, copper and gold all rose strongly in January. The price of oil was down fractionally. The Australian dollar against the US dollar also rose strongly (3.9%); it briefly rose above US 71c.

Regional Review

Australia

The retail sales data for November 2022 were very strong at 1.4% for the month or 7.7% for the year. The update for December released at the end of January however was somewhat disappointing at 3.9% for the month but +7.5% for the year. Has the consumer turned or is this a statistical blip? The fact that the two annual rates are very similar suggests that maybe the seasonal pattern has changed a fraction. Perhaps consumers are buying earlier for Christmas than before?

The jobs reports in Australia also continued to show that the unemployment rate is still near a 40-year low at 3.5%. Total employment did fall by 14,600 but full-time employment rose by +17,600 with the remaining fall of 32,300 jobs being part-time.

The Q4 CPI inflation print showed that the pricing pressure problem has yet to start to dissipate with a quarterly rate of 1.9% and an annual rate of 7.8%. It is less than obvious that interest rates will attack the underlying inflation drivers.

China

The China re-opening continues with some positive signs for its economy. GDP for 2022 was 3% against an expected 2.8%. The result for the December quarter was 2.9% against an expected 1.8% (both annualised). While this growth is below the government projections from earlier times, green shoots of growth do seem to be emerging.

Retail sales came in at 1.8% which was clearly not a good number but massively better than the expected 8.0%. Industrial output at 1.3% comfortably exceeded the expected 0.2%.

Naturally, if the Covid infection rates cause even greater problems, a continuing pandemic could derail expectations.

China has reopened importing coal from Australia after shutting it down during the Trump tariff regime.

US

As with Australia, the US jobs report was again very strong. 517,000 new jobs were created against an expected 185,000. The unemployment rate was 3.5% following 3.5% the month before. Wages grew at 4.4% for the year.

The headline CPI came in at 0.1% for the month and 6.5% for 2022 owing to the much higher monthly rates in the first half of 2022. The core CPI, which strips out energy and food prices, was 0.3% for the month and 5.7% for the year.

Of note, rolling quarterly headline CPI inflation rates since August have not exceeded 3% pa.

The Personal Consumption Expenditure (PCE) variant of inflation measurements had a headline rate of 0.1% for the month and 5% for the year. Core PCE was 0.3% for the month and 4.4% for the year.

The producer price index (PPI) in the US came in at 0.5% when +0.1% had been expected. This deflation further underscores our assessment that upward pressure is fast dissipating. Further, retail sales came in at 1.1% when 1% had been expected.

The preliminary GDP reading for the December quarter of 2022 was 2.9% against an expected 2.8%. Clearly the US economy is yet to slow meaningfully but the services PMI did shock the market when it came in at 49.6 showing weakening growth prospects in that sector (a reading being below 50 indicates contraction).

The big job cuts in mega-tech are yet to be fully felt in the economic data. As is typical going into a recession, firms hang on to skilled workers as long as they can hoping to avoid laying them off owing to the cost of search and re-training when an upturn arrives. In the latest PCE report, it was noted that real (inflation adjusted) consumption fell 0.2% in the latest month.

Europe

Europe to some extent dodged the full impact of the energy crisis owing to an unseasonably warm start to winter. The full impact of the ongoing Russian invasion of the Ukraine on energy prices may not occur until this coming 2023/24 winter.

Eurozone inflation did fall a fraction from 10.1% to 9.2%. The zone narrowly avoided a recession in the latest GDP figures. Despite this the European Central Bank (ECB) increased its cash rate by a further 0.50%.

Rest of the World

The IMF started 2023 with a prediction that one third of the world will go into recession during 2023. They ended the month with a slight uptick in its global growth forecast to 2.9% but still below the 2022 estimate.

The West is reportedly starting to send tanks to the Ukraine to help them with their defence likely ensuring a continuation of that conflict. There is so much to play out in that arena, we cannot make any predictions of how the invasion and its effect on the global economy will play out.