In this month’s update, we provide a snapshot of economic occurrences both nationally and from around the globe.
Key points:
– Inflation has undeniably come down but is higher than Central Banks’ preferred range
– Is there something different about this inflation and interest rate hiking cycle?
– The road ahead for the economy, inflation, interest rates and markets
We hope you find this month’s Economic Update as informative as always. If you have any feedback or would like to discuss any aspect of this report, please contact your Financial Adviser.
The Big Picture
The latest inflation data in Australia, the US and indeed, many other economies is showing inflation has declined from their respective peaks. So the question is, how low does inflation need to be before the mindset of central banks transition away from inflation fighting and a bias to lower interest rate settings? And, assuming this transition occurs, the obvious question then becomes; when are they likely to start cutting interest rates?
We have previously documented the source of this bout of inflation. To recap, prices rose post Covid as demand increased rapidly but, because of Covid lockdowns, the supply side e.g. shipments of manufactured goods from Asia, were unable to respond to the sudden rise in demand. Consequently, competition for the limited supply available resulted in price rises which fed into a corresponding jump in inflation.
Central bankers, economists and many others assessed that the drivers of this inflation were transitory. The rationale being that once the supply side responded to the Covid created demand imbalance, prices would recede to ‘normal’ levels and inflation would return to manageable levels in the 2% to 3% p.a. range. That being the case, the need for interest rate policy tightening at that time was not required as the period of elevated inflation would indeed be temporary.
As a consequence of this assessment central banks did not respond to the initial price surges. Dr Philip Lowe, Governor of the Reserve Bank of Australia (RBA), throughout much of 2021 said that rates would not rise until at least 2024. So why was there a change of heart?
There are a range of reasons, key among these were:
• The timing of the Russian invasion of the Ukraine exacerbated inflationary pressures through food and energy price inflation as instability in supply of these fundamental resources drove their prices higher.
• The general supply demand imbalance lasted longer and remained more severe than anticipated as much of the developing world continued to grapple with Covid, long after the developed world had contained the pandemic as mass vaccination programmes proved effective.
• Central banks saw inflation rising as they anticipated and, in keeping with their ‘transitory’ assessment, were unresponsive with interest rate policy. By the time inflation data confirmed that inflation was not as transitory as anticipated and that it had become more entrenched, they then had the well documented change of heart.
The RBA first raised interest rates in May 2022 while the US Federal Reserve (Fed) started increasing US interest rates in March 2022. Fed chair, Jerome Powell, has since said he regretted ever using the word ‘temporary’. With the exception of Switzerland and Japan, most developed world economies have seen their central bankers walk a similar path.
Part of the problem has also been data dependency i.e. Central Bankers waiting for the data to confirm what was already known before responding with policy changes. The risk of this delay now being an economic recession. Some developed economies are already there.
A major risk is that, as central bankers delayed interest rate tightening on the way in to this bout of inflation, they will be slow in cutting rates on the way out as they wait for longer timeframes of inflation data to confirm that it has indeed receded. Look back to the experience during the 1989 to 1991 period in Australia when there was the interest-rate-induced ‘recession we had to have’. The recession persisted even though the RBA were sharply cutting interest rates throughout that period!
But is this time different?
That phrase, or its affirmative variant, is used too often but there are some differences worth noting for the current cycle. Prior to this bout of inflation interest rates had been low and even negative in some countries for a very long period. That is extremely unusual!
In economics, there is a concept of a ‘neutral rate of interest’ – one which is neither expansionary nor contractionary. Economist consensus is that in Australia and the US, that neutral rate is about 2.5% to 3.0% p.a.
In the current cycle in Australia, the RBA cash interest rate did not get into ‘tightening’ mode until December 2022 i.e. RBA taking the cash interest rate above 3.0% – the first seven rate hikes from 0.1% to 3% merely reduced and then removed the existing ‘loose monetary policy’. One reason we haven’t seen economies falling into recession is that interest rate increases only became restrictive in the last 12 months. Using the same metric, the US monetary policy became restrictive i.e. higher than 3.0% p.a. in September 2022 after the Fed started hiking in March of that year. What is different this time is that tightening cycles do not usually start from such a low base.
There is also another important fact to consider. Fixed rate mortgages don’t ‘exert any pain’ on borrowers until the loans roll over or a new loan is initiated. The so-called ‘mortgage cliff’ is just starting in Australia as borrowers on fixed interest rate loans move to variable interest rate loans. In the US, where fixed rate loan terms are much longer (up to 30 years) the effect of such a short sharp rates’ upswing is diluted even more.
In the current environment the data is not all pointing to the same outcome. Some key data points indicate ongoing strength (upward inflationary pressure) which is adding to the complexity for Central Bankers trying to manage inflation back to preferred or neutral levels.
Key among these in both Australia and the US is the labour markets which are still holding strong but the same is not true for other inputs. The US has experienced several months of contraction in retail sales and Australia’s GDP, in the March quarter 2023 (reported in June), was barely above zero (and was negative when population growth is taken into account). The recent June quarter 2023 estimate of growth for the US was an impressive 2.4%, but that includes a lot of fiscal stimulus (government spending) from the Biden administration, which is actually stimulatory and is fighting against the Fed policy.
The economic outlook remains opaque as we transition from tightening monetary policies through to a plateau phase (it feels like we are entering the plateau phase now), before interest rates decline to support economic growth/recovery post inflation returning to its neutral range.
The outlook for share markets is somewhat brighter even though earnings forecasts for companies were revised down for the June quarter in the US and the half year ending June 30 in Australia. So, the current forecast for corporate earnings is not that high and, as a consequence, not that hard for companies to achieve.
Markets can look through the malaise and rise before a downturn in the economy is over, and, based on the historical experience, often do. Refinitiv, one of our data providers, surveys hundreds of stock broker forecasts of company earnings for the three years ahead. The analysis of that data is, on average, supportive of current share market valuations and prices.
Asset Classes
Australian Equities
The Australian share market as measured by the ASX 200 Index was up +2.9% in July. The index of Energy shares led the way rising 8.8% whereas the Indices of Financial and IT companies rose 4.9% and 4.4% respectively. Good results all things considered. The indices for Staples and Healthcare went backwards in July.
It would appear that equity investors have gradually moved to be more accepting of a ‘soft-landing’ scenario for the economy and are allocating capital back into shares as markets are trending more positively. While a ‘hard landing’ remains a risk for markets, data, particularly in the US, continues to support a ‘soft-landing’ outcome.
International Equities
The US S&P 500 Index of the largest 500 companies listed on the US share market had a strong July rising +3.1%.
Much attention continues to be paid to the magnificent 7 large cap technology stocks listed in the US and, while they have performed well and largely carried the market to its loftier heights, the positive move in the market has been broader than these stocks alone. This broadening provides a degree of comfort in the general health of the share market.
Bonds and Interest Rates
In a widely telegraphed move the Fed raised its cash interest rate by 0.25% to a range 5.25% to 5.5% (the highest level in 22 years). The RBA, on the other hand, decided to leave our cash interest rate on hold at 4.1% p.a. at its meeting on August 1. The European Central Bank (ECB) took its base interest rate to a record high level of 3.75% p.a. The Bank of Japan (BoJ) unsurprisingly stayed at -0.1% p.a. but it did adjust the allowed movement around its longer maturity bond rates (e.g. 10-year Government bond).
It appears that the mood across developed economies at least is that central banks are at or near their expected highs for interest rates. The US Fed has an estimated probability of 20% for one more interest rate increase to be announced at its next meeting on September 20th. With inflation seemingly coming under control, there is a growing belief among many analysts that the Fed might already be ‘done’ raising rates.
The US 10-year Government bond rate has moved both up and down in recent months. The latest move was to briefly rise back above 4%. We note that after a period of volatility the US bond market is stabilising somewhat.
Other Assets
The price of oil moved sharply higher in July (+14%) fuelling gains in the energy sector of the ASX 200.
The price of iron ore was down a little (-1.9%). The price of copper was up +3.6%. The price of gold was up +2.7%. The Australian dollar appreciated 0.8% over July.
The VIX volatility index, a measure of share market volatility, closed July at 13.6, a level that is in the normal range.
Regional Review
Australia
Our jobs report for June was strong with 33,600 new jobs being created and the unemployment rate at 3.5%. Of course, immigration is strong perhaps helping the increases in the demand for labour.
Dr Philip Lowe was not reappointed for a second term as RBA Governor. He is to be replaced by the current Deputy Governor, Michele Bullock, on September 17th. We do not think that change will make a material difference to the conduct of monetary policy, particularly as inflation is now receding.
We do not think the RBA will start cutting interest rates any time soon unless, or until, more of a material slowdown in economic growth is observed. Retail sales fell by -0.8% over the last month but rose 2.3% on the year. In other words, the annual growth in retail sales at current prices is about the same as the general level of prices so inflation-adjusted retail sales have been flat.
China
China data are a little mixed. The latest GDP growth for the June quarter came in at 6.3%, 1% below the expected 7.3%. Both figures are well above the long run expectation of a little over 5% p.a. because of the ‘base effect’ of coming out of the three-year long lockdown. However, the quarterly growth was 0.8% against an expected 0.5%. That bodes well for the September quarter.
The usual monthly growth statistics of retail sales, industrial output and fixed asset investment were at or above expectations but weaker than pre-pandemic rates. Exports and Imports both contracted in the latest month and were worse than expected. Youth unemployment was reported to stand at 22.3%! No doubt a concern for Chinese authorities.
China manufacturing PMI came in at 49.3 making it the fourth successive reading below 50 (a reading below 50 indicates contraction). However, the index has risen slightly in the last two months from a low of 48.8 in May.
US
US employment growth (non-farm payrolls) increased by 209,000 in June slightly missing the expected 225,000, but the unemployment rate fell from 3.7% to 3.6%. Importantly, around 150,000 of the jobs created were in government positions and lower-level healthcare. This change in the mix could be a sign of weaker job growth to come and, hence, to a softer monetary policy stance from the Fed.
The US has two more Consumer Price Index (CPI) reports and two more employment reports before the next interest rate setting meeting on September 20th. The Fed will also be hosting the Jackson Hole global conference for Central Bankers in late August. Should we expect a joint statement that the bulk of the work on inflation is over?
US June quarter GDP growth surprised to the upside at 2.4% when 2% had been expected. We recall that March quarter growth was 1.1% for the preliminary estimate reported in April which was then revised upwards to 1.3% and then 2% in June, indicating some resilience in the US economy.
US retail sales were weak at 0.2% for the month and industrial output went backwards at -0.5%. Despite this the mood continues to remain sanguine.
Europe
UK wage inflation grew the equal fastest on record in the three months to June 30 at 7.3%.
France’s GDP growth for the June quarter came in at 0.5% against a forecast of 0.1% and a previous reading of 0.1%. Inflation came in at 4.3% from a previous reading of 4.5%.
There is little in Europe data to give us much joy but they seem to be struggling through rather than collapsing. The latest European Union GDP growth data for the June quarter ended the run of two consecutive quarters of negative growth rates with a rate of 0.3% against an expected 0.2%.
Rest of the World
Japan’s inflation is off its recent high at 3.3% and core inflation was 4.2%. The Tokyo core inflation read was 3% which beat expectations. Japan retail sales came in at 5.9% above the expected 5.6%. However, industrial output at 2.0% was slightly below forecast.
Russia has reportedly ended the food corridor for ships carrying Ukrainian grain exports to pass freely through the Black Sea. There are many reports of the Ukraine fighting back by firing missiles at Russian targets. There seems to be no peace in sight. There is an elevated chance of a hike in food and fertilizer prices from these recent moves but we do not see it as having the same effect as at the start of the invasion in February 2022. Alternative sources of supply have, to some extent, been found.
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