Economic Update - January 2022

KEY POINTS:

• The Omicron variant displaces Delta – not as debilitating – but a lot more contagious
• Covid plus Supply chain disruptions keeping upward pressure on inflation
• Interest rate rises are getting closer in the US, forecasts for 3 rate rises in 2022
• Inflation is a problem but rate hikes won’t help contain it - yet

THE BIG PICTURE

It is hard to imagine anyone who was not affected to some extent by Covid-19 during 2021. Everybody was impacted to some degree be it working from home, social lockdowns, access to goods and services or more directly through contracting the virus which has significantly impacted health for many and sadly fatal for some.

This time last year there was a lot of optimism because we now had a vaccine (Pfizer) with distribution getting under way, while others were in late-stage development. Elsewhere the US Capitol building came under attack for extreme elements supportive of outgoing president Donald Trump.

2021 was not plain sailing with many developed countries having to go through lockdowns and other restrictions in efforts to control the spread of Covid. We started 2021 dealing with the Alpha variant of the virus but spent most of the year trying to ward off the more debilitating Delta variant to finish the year trying to manage the apparently less harmful but more contagious Omicron variant. Despite the very high vaccination rates particularly in the developed world, Covid remains very much alive and dominating the community and the economy.

In Australia, major cities went through exhausting lockdowns with consequent effects on the economy (growth was  1.9% in the September quarter) but people responded to the call to be fully vaccinated with gusto. We reached 90% fully-vaccinated on Christmas Day. We also then found out that fully vaccinated wasn’t as effective as hoped.

A UK study demonstrated that 15 weeks after the second injection, protection only amounted to 0% to 20% compared to the unvaccinated. We had been told that we needed to wait six months for a booster. That interval was cut to five, then four, then only three months from January 31st this year – all of these changes were announced in a few weeks!

The good news is that Omicron – at least as we know so far – has been less debilitating than Delta but it is many times more contagious. It would be foolish to take all the new preliminary research at face value but one recent study suggests Omicron infection might make one more resistant to Delta.

One doesn’t need much of a crystal ball to predict 2022 will bring more restrictions from time to time and other strains might rise to prominence. Scientists and medics are now much better prepared than they were last year. Facilities to make the newer vaccines, such as Pfizer, are to be built in Australia and reportedly scientists are working on how to make vaccines more effective for the newer strains.

Israel is contemplating a second booster (or fourth dose). More and more people are coming to the realisation that we may have to live with Covid for a very long time. But we live with the seasonal flu and annual flu shots now and there is reason to hope that the treatment for Covid will eventually become similar to these in time.

We are hopeful that any future Covid-related disruptions in 2022 will not cause a recession and, consequently, we do not anticipate a bear market directly resulting from Covid impacts on either the ASX 200 or on developed world equity markets. Our basis for this view is the very high vaccination rate; the availability of boosters; experience in dealing with Covid; and the possibility that Omicron is less debilitating than Delta and might even protect us from it!

To put things into perspective, the ASX 200 rose 13% over 2021. Over the same period, the S&P 500 rose 27%. Historical averages for each of these indexes are around 5%. Of course, dividend payments should be added to those capital gains figures. On the other hand, bond yields and cash did nothing but, in general, 2021 was an excellent year for investors if they had set their asset allocations appropriately for the conditions – and didn’t meddle with them!

For the year going forward, we think Australian and Developed World equity markets may achieve returns in line with their long run averages in the higher single digits. Despite the effects of Covid, equities continue to remain relatively attractive when compared to the yield on traditional fixed interest investments such as term deposits. This aspect continues to provide some support for equity prices.

The US Federal Reserve (the ‘Fed’) has started tapering its quantitative easing (‘QE’) programme by reducing the volume of its monthly bond purchases. It now plans to cease bond buying and end its QE by about March 2022. The Fed now expects to increase for Federal Funds rate (official rate) by 0.25% three times in 2022 taking the end-of-year official rate to 0.9%. Our Reserve Bank of Australia (‘RBA”) is continuing its QE programme for the moment – at least until February – but, at time of writing, it is not expected to raise our cash rate until at least 2023 and possibly 2024. In the US, the ‘neutral rate’ of interest is thought to be approximately 2.5%, so the actions of the Fed described above amount to a reduction in the level of economic support as opposed to a tightening of policy. Similarly in Australia, whilst monetary policy remains accommodative, the RBA has no plans to increase the support to the economy but nor is it planning on a reducing it either.

The main economic problem facing most policy makers is inflation. Much of monetary policy in recent years was designed to lift inflation back up to target rates (2% for the US and 2% - 3% for Australia). Australian inflation only just limped into the bottom of the target range in the latest quarterly release. We have no CPI inflation problem – at least not yet.

Jerome Powell, the US Fed chair, has said he has lived to regret using the word ‘transitory’ to describe the inflation situation in the US (and, indeed, Europe). The problem arose as 12 months post Covid becoming a pandemic, prices fell in response to much weaker demand as the world locked down which then formed a very low base for the measurement of inflation. However, as vaccination rates rose and lockdowns eased as the world began to ‘reopen’, demand for goods rose far quicker than suppliers were able to satisfy causing a supply/demand imbalance i.e. disruptions to supply chains. Consequently, prices rose as people bid up the price of goods leading to higher inflation. This is the circumstances that led to Powell calling inflation ‘transitory’ as he anticipated a stronger response from supplies easing inflationary pressures. However, ongoing localised Covid lockdowns have in part resulted in inflation remaining more persistent that initially anticipated.

The other important cause of inflation to emerge was fuel prices. Both oil and gas prices in certain parts of the world jumped for a number of reasons including inadequate stock-piling. Oil prices eventually fell towards the end of the 2021 but kicked up again in December.

However, the main culprit in the inflation story is the result of ‘supply-chain’ issues. In years gone by, the globalisation of economies led companies to locate the manufacture of certain basic components – like computer chips – in one place. By and large they chose the cheapest location in the world rather than diversifying their sources of supply, which, while lower risk, tends to come at a higher cost.

With manufacturing disruptions due to Covid, shock waves reverberated across the global economy. One of the major problems was with processor chips that have become a key component in somany goods – including cars. Since new cars couldn’t be manufactured at an appropriate rate, demand surged for used cars in the US. A major driver of inflation at 30 year or more highs in the US is the price of a used car! Another casualty of Covid is the price of air travel.

One thing seems certain. These supply-chain issues, which are driving inflation, will not go away by raising interest rates and, so far, there is no major increase in wages from the knock-on effect. In that sense we do not see any official interest rate increases in 2022 as being the start of something bigger. They are merely the start of the return to normality.

Perhaps a bigger worry for the Australian economy is China. China is struggling to assert itself in the world order as it would like. The huge import tariffs placed on China by Trump, and much derided by most at the time, have not been removed or even reduced by Biden.

China tried to disrupt trade with Australia as a punishment for our support for the US request for the World Health Organisation (WHO) to investigate the source of Covid. Over a year ago, it stopped accepting coal (and many other) imports from Australia, notably not iron ore. But the recent cold start to the Chinese winter caused them to take our coal exports out of bond! There is no doubt that the China economy has slowed in recent months. In normal times, China would just add stimulus but there is now an additional problem for them to address.

Evergrande, a massive property development company in China, got itself into debt problems in late 2021 and it has since defaulted by failing to make some coupon (interest) payments on its debts. China is afraid that stimulus at this time might cause too lax an attitude in the property sector and it is trying to walk a fine line balancing debt responsibility with growth for the rest of the economy.

While much was expected from a Biden government after the Trump years, hope has at least partially been dashed. A recent poll put Biden as the most unpopular US president on record in his first year except, of course, for Trump. The new catch cry of ‘Let’s go Brandon’ – a euphemism for a negative sentiment against Biden – has become rooted in modern American culture.

Biden did get a big infrastructure package through Congress but an even bigger package for more general economic and climate purposes keeps stalling. Law makers are rightly worried about adding yet more trillions of dollars to the national debt. With interest rates close to zero, debt is not currently a great issue. When rates start to climb, the debt pile could severely hamper future US growth as debt servicing costs will increase with interest rates. The Fed is unlikely to want to contribute to this problem and so will not raise rates without due caution.

To us, 2022 looks like a transition year in the return to normal conditions. Low rates underpin reasonably strong equity markets; rates are unlikely to rise enough to cause problems; and we are getting on top of living with covid, if not eliminating it.

We expect ‘bumps’ along the way in equity markets; we always do! There are more than enough known causes of future bumps to warn prudent investors to be ready to ‘ride the waves’ in 2022 rather than sell in the dips. It is never too soon to evaluate the appropriateness of an investment strategy and allocate capital accordingly.

We are yet to mention the Australian Federal election! Although it is likely to be very soon (certainly before the end of May), both sides float policies at first to see which resonate with the electorate. Only then do they come up with the final package of ‘promises’.

Either way, both sides will be keen to stimulate the economy and neither is likely to come out with a left-of-field policy such as the big changes to super put forward last time around. And besides, it would be hard to enact any major policies before the end of 2022 that would derail what we think will be a solid but not spectacular year for the local economy and markets. We will comment on the election when we have seen what is at stake.

ASSET CLASSES

AUSTRALIAN EQUITIES

The ASX 200 had a strong month (+2.6%) after it got over the Omicron wobbles. Utilities (+6.9%), Materials (+6.4%), Financials (+4.3%) and Property (+3.8%) were the strongest performers over the month. IT ( 5.2%) was the big laggard.

Over the year 2021, Financials (+20.2%), Property (+21.5%) and Telcos (+34.0%) were the above-average performers. There was no particular theme (such as growth, value, etc) that performed consistently. It was a tough year for some fund managers.

We have the ASX 200 currently priced at about fair value. Our forecast for the year ahead is a little above average. With the impact of Covid still quite uncertain, and central bank’s likely to tighten monetary policy by increasing interest rates, there may well be some wobbles along the way which could present buying opportunities. The next company reporting season beginning in February will be keenly watched for how companies are seeing their respective futures.

INTERNATIONAL EQUITIES

December was a very strong month (+4.4%) for the S&P 500. The VIX ‘fear index’ at 17 is only just a little above average but our mispricing signal suggests that the index has run a little too hard.

Without a mispricing correction we see a slightly above average 2022 for the S&P 500 but that forecast is somewhat lower when we subtract our estimate of over-pricing.

The S&P 500 had an extremely strong year (+26.9%) in 2021. It far surpassed that of the ASX 200 (+13.0%) and other major indexes. Emerging Markets, largely due to China, went backwards ( 3.0%) in 2021.

BONDS AND INTEREST RATES

The Fed closed its December meeting with a statement that both sped up the tapering of their bond buying program and brought forward the next cycle of interest rate hikes. Both were met with enthusiasm by Wall Street.

The RBA no longer mentioned 2024 as the probable start to rate hikes – but it didn’t have the fortitude to mention 2023 either. With no measurable inflation pressures (yet) there is no reason for the RBA to try and get ahead of the game.

But The Bank of England couldn’t wait any longer. It hiked from 0.10% to 0.25% in its first upward move in three years. It did this in response to higher inflation data and it obviously doesn’t agree with us that rate hikes won’t cure supply-chain and energy price problems.

The Australian 10-year government bond yield peaked at 2.09% at the end of October but finished the year at 1.67%. Well up from the circa 0.80% of 2020 but still well below the 2.65% of 2017 and 2018.

OTHER ASSETS

The prices of oil ended the month sharply higher after the previous month’s steep declines. But oil prices finished the year well below the 2021 peaks.

The price of gold was rather flat as was that for copper.

Over the course of 2021, copper and oil prices were very strong. The price of iron ore was down sharply over the year but rallied somewhat in December. The price of gold was down  4.0% over the year, after having fallen to just over $US0.70, our dollar drifted back up to just above where it started the month – at $US72.7.

REGIONAL REVIEW

AUSTRALIA

The Australian economy September quarter GDP growth at  1.9% was much better than expected and a rebound is expected in the December quarter as restrictions were starting to lift through the period.

Residential property prices surged another 5% in the recent quarter making for a 21.7% gain over 12 months.

Our unemployment rate fell back from 5.2% in the previous month to 4.6%. A massive 366,000 new jobs were created but that only brought total employment back to where it was before the start of the lockdown in July. There are no serious signs of capacity constraints in the Australian economy yet.

The government is currently leading in the polls on key aspects but the electioneering isn’t quite in full swing yet. In spite of our massive national debt, neither side seems likely to propose anything but a bit more stimulus. It is important for the economy to keep the momentum going. Any tightening at this point could lurch the economy into very slow growth – or worse, a recession.

There seem to be some moves to simplify testing for Covid for interstate travel. The queues in certain regions were totally unreasonable. And testing everyone who wanted to travel probably took testing away from people who really needed it because of sickness. A solution seems to be near at hand.

CHINA

Last month we wrote that China’s economy may have turned the corner. That seems to have been a premature conclusion.  The latest retail sales were only 3.9% against a modest prediction of 4.6%. Industrial output at 3.8% was slightly ahead of expectations. China needs to move on from the Evergrande affair and guide its economy to stronger growth.

US

The US jobs data weakened again to only 210,000 new jobs from 546,000 in the previous month; expectations were for 573,000 new jobs. The unemployment rate fell to 4.2%. Retail sales were a big miss at 0.3% as 0.8% had been expected.

The final revision to September quarter GDP growth improved from the earlier estimate; 2.1%, to 2.3%. But it was the inflation picture that really disappointed.

CPI inflation was up 6.8% but that reduced to 4.9% when volatile items such as fuel and food were stripped out to produce the ‘core’ reading. The ‘wholesale’ measure of price inflation came in at 9.6% the highest level since 1982 however, the Fed’s preferred ‘core’ Private Consumption Expenditure (PCE) inflation measure came in at a more respectable 4.7% for the year.

For inflation to stay high, prices have to keep rising and not just lift from one level to a new higher level. We expect inflation in the US and elsewhere to drift back to levels near targets as the year progresses.

EUROPE

Europe has been hit particularly hard by Covid with many countries in some form or other of lockdown. Britain has so far avoided the inevitable. Plan B from Boris Johnson is expected shortly after New Year’s Eve. Masks are already back in vogue.

UK inflation came in at 5.1% from 4.2% and the Bank of England lifted its rate from 0.1% to 0.25% for the first hike in three years.

REST OF THE WORLD

Turkey, facing inflation of over 20%, cut its central bank rate and its currency – the Turkish lira – dropped sharply.

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