Key points:
- US Fed considers slowing down rate hikes as inflation data eases for October.
- China sees increasing protests over its Covid lockdowns as Covid cases rise.
- Oil prices could face turbulence and the EU caps the price of Russian oil at US$ 60 per barrel.
- Despite the higher interest rates the US and Australian jobs markets remain resilient.
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 second anniversary of the start of the pandemic in China is about to take place. While Western countries largely now seem to be on top of Covid – through strong vaccination programmes and selective lockdowns – China is still struggling with the virus. Indeed, now the people of certain large Chinese cities are starting to protest against more lockdowns.
China is very different from the West in that the China vaccines are not very effective. Just as we in Australia suffered at the start from the then government putting all of its vaccination eggs in the less effective AstraZeneca basket, China apparently has no major access to the mRNA vaccines (such as Pfizer and Moderna) that proved very effective in much of the rest of the world.
The ’knock-on’ impact of China lock-downs for the West has been supply-side disruptions such as semiconductor chip shortages. In turn, supply-side shortages fuelled inflation in the West that has been resistant to monetary policy – especially interest rate hikes.
It has been argued by ‘experts’ on CNBC that Premier Xi does not want to back down on his lock-down strategy because he wants to show he was right in his call. That does seem to be a major obstacle to resolving China growth issues and our ability to deal with inflation at home. However, the new protesting in China cities may have a positive impact.
The start of December may also witness inflation volatility from various oil supply decisions. The OPEC+ Russia oil meeting scheduled for December 4th will be immediately followed by the introduction of the EU policy on Russian oil imports. The problems will further be compounded by price capping on Russian oil exports.
It is less than obvious from the news wires that anyone has a clear idea of how these December events will play out in the oil market. One thing for certain is that one shouldn’t rule out the possibility of an oil-price spike.
Stock markets have now witnessed what have turned out to be five or six bear market rallies this year and more may follow before a clear market direction emerges.
Meanwhile, the US Federal Reserve (the “Fed”) has seemingly walked away from its successive 75 bps rate hikes. It now seems like 50 bps is the main call for the December 14th meeting. Some analysts are suggesting that 5% will be the terminal (maximum) US Fed funds rate to be achieved in about May 2023. Since the current rate is in the range 3.75% to 4.0%, only two 50 bps hikes will get them to 5%. There are eight meetings per year!
The Fed doesn’t want to appear to be weak in signalling the end of the hiking cycle given that inflation has not yet dipped by much, if at all. Another strategy might be for the Fed to go well past 5% and then have to retreat quickly when problems emerge.
Jerome Powell, the Fed chairman, reiterated a slower pace for rate hikes in his end-of-November speech. The S&P 500 rallied 3.1% on that confirmation. There is now a blackout on Fed speeches until the December 14th FOMC meeting concludes.
At least our central bank, the RBA, has not yet ‘overcooked’ it with respect to interest rate policy. We do not have to follow the US into recession, assuming one occurs, any more than when we avoided a global recession in 2008-9.
Jobs in the US and Australia are holding up very well. We also had a relatively strong jobs market at the end of 1989 as the overnight cash rate was cut in big moves from around 18% to about 4%. Nevertheless, the unemployment rate then rose steadily to double figures in the following three years and did not return to the late eighties level until around the time of the start of the GFC in 2007.
Monetary policy isn’t easy to conduct. Indeed, it may even be fair to say that it is more of an art than a science. What we don’t want to happen is for central bankers to flock together in raising rates too far, i.e. driving the world into recession, only then to cry out that everybody else got it wrong too.
It is not sufficient for central bankers to use broad statements like ‘keeping the foot on the pedal until inflation pressures ease’. Central bankers should be forced to articulate the mechanism of how that pedal actually causes the desired policy result. Most recessions have been associated with central banks hiking rates too far. With lags between monetary policy changes and its impact on the real economy being at least six months and possibly well over a year, we know it is far too late to wait until we see inflation cooling and unemployment rising before central banks start to cut rates or even pause.
Powell was correct in his recent speech when he said history shows the problems that can occur by cutting rates too soon. He neglected to say that there is more evidence of recessions emanating from rates being held too high for too long.
A consensus seems to be forming that a US recession might start to become evident in the first half of 2023. We think it could take a little longer to emerge. If the Fed goes beyond a funds rate of 5%, we might see a more serious recession than many are considering.
However, much of this gloomy outlook may well have already been priced into the stock market so that new lower market lows may be avoided. The similar market lows in June and October of 2022 may again be tested but we do not, at this point, anticipate material falls to below these levels.
An unusually large release of important economic data and events is expected in the first two weeks of December. We doubt if there could be enough good news to spur the market materially higher into 2023 but there could be enough to help us relax over the festive season. In particular, the last Fed meeting of the year on December 14th could be pivotal.
Asset Classes
Australian Equities
The ASX 200 had another great month in November with a 6.1% gain, after October’s 6.0% gain, but this two-month bounce-back followed a 7% loss in September. Most sectors did well in November and Utilities (20.8%) and Materials (16.2%) were standouts.
We no longer believe that this market is under-priced compared to its fundamentals. If the rally continues into the close of the year, there could be opportunities to take a little off the table if recession talks heighten.
International Equities
The S&P 500 also gained in November by a similar amount of 5.2%. However, the ASX 200 did not get the chance to react to Powell’s speech in the month of November as our first trading session post the speech was on 1 December. The third quarter company earnings season turned out to be better than many had expected. However, earnings expectations were being modified downwards by analysts before the season began.
The Shanghai Composite (8.9%) and the Emerging Markets (9.6%) indexes performed particularly well during November as optimism grew over a less stringent lockdown policy in China taking effect.
Bonds and Interest Rates
The Australian 10-yr yield peaked at 4.2% in 2022 but that yield has since retreated to 3.5% as less alarmist expectations about RBA rate hikes emerged. The RBA surprised some in the market by only hiking the overnight cash rate by 25 bps to 2.85% on Melbourne Cup Day. With the bank not meeting in January, and the strong likelihood that the RBA will not now hike by 50 bps again, they did increase the official cash rate one last time for calendar year 2022 with an increase of 0.25% on Tuesday 6th December.
The Fed seemed to be backing away from hiking the funds rate by 75 bps again. However, it is talking tough so that inflation expectations do not take hold. Consensus is for a ‘terminal rate’ of about 5%, or slightly above, sometime in mid-2023.
The Bank of England did hike by 75 bps to 3.0% in November. This was its biggest hike in 40 years and the UK’s latest GDP growth came in negative.
A lot of the current optimism around interest rates possibly stems from the latest US CPI data release. The month-on-month increase for October was lower that consensus estimates, coming in at 0.4% for the month and 7.7% for the year. The all important ‘Core’ inflation variant that strips out volatile items such as energy and fuel inflation were 0.3% for the month and 6.3% for the year to 31 October respectively.
We are less enthusiastic about the US inflation beat because of a couple of unusual results. Medical insurance costs contributed a negative amount for the month but, as they are set only once a year, October inflation was possibly temporarily under-estimated as a result. Used car prices had surged by 45% in the two years to mid-2022 on the back of a lack of chips needed to manufacture new cars. Used car inflation was down 4% in the latest quarter.
Other Assets
Oil prices fell nearly 10% in November but there could be a rebound in December after OPEC+ (includes Russia) and the EU decisions for a price cap of US$60 per barrel for Russian oil. Iron ore prices (25.5%) rose sharply. Copper (6.8%) and gold prices (7.0%) rose a little more modestly.
The Australian dollar rose by 4.3% against the greenback during November and peaked at $US 0.6775 before retracing to just below 67 cents on the Fed optimism that the October inflation data pointed to inflation responding to higher interest rates. As a result, the market responded by reducing expectations that interest rates will go as high in the US than initially thought hence, a smaller than anticipated interest rate differential leading to a softening in the $US.
Regional Review
Australia
The October jobs report released in November showed that the unemployment rate was only 3.4%, down from 3.5% the month before. There were 16,800 new jobs created. These results were very strong indeed.
With the RBA seemingly not in a hurry to raise rates too far, we are better positioned to withstand the impact of any recessions in other parts of the world.
China
Mainland China witnessed unusually strong anti-lockdown protests starting at the end of November. Citizens are concerned about further lockdowns to try to avoid the spread of Covid – particularly among older people who, if infected, might then test the capacity of the hospital system.
China has reduced the length of the quarantine period for international travellers from seven to five days.
CNBC estimates the impact of the lockdown on chip production for Apple’s iPhone may mean Apple may produce 5m – 8m units less in the last quarter of 2022.
US
Yet again, US jobs data were particularly strong with 261,000 new jobs being created with an unemployment rate of 3.7%. Since the Fed rate rises only started in the middle of March – and initially at a gradual pace – we are not surprised that the lags in the system have prevented any noticeable impact yet appearing in the labour market statistics.
There are now 1.7 job openings in the US for each unemployed person. One of the major reasons for this ratio has been the increase in retirement rates possibly because of having been laid off in the pandemic or people do not want to return to work because of health issues.
Retail sales in the latest month also performed well with a growth of 1.3% for the month against an expected 1.2%. Since these data are not adjusted for inflation, the ‘real’ increase in sales would have been much less. Quarter three GDP growth was revised upwards from 2.6% to 2.9%.
Although some optimism greeted the latest US CPI inflation data, the outcome was well above the target 2% at 7.7%. We do not see inflation falling to acceptable levels in 2023 unless there is a big turnaround in both the supply-chain shocks and the impact of the Russian invasion on energy and food prices.
The mid-term elections did not produce the ‘red wave’ that many had predicted. As a result, the Democrats kept control of the Senate and the Republicans only gained a slim majority in the House of Representatives.
Europe
The UK inflation rate came in at 11.1% which is at a 41-year high. With the latest economic growth negative, the official interest rate climbing at a record pace and energy prices soaring, partly because fossil fuels were being aggressively removed from supply, the prospects for the UK economy are, at best, bleak.
Rest of the World
The Governor of the Reserve Bank of NZ (RBNZ) increased the overnight cash rate from 3.5% to 4.25% while predicting economic growth will fall to 1% for 2023 and inflation will remain above 5% until after the end of 2023. However, he did predict an inflation rate of 3.0% for 2024.