ECONOMIC UPDATE - JULY 2023

Key points:

- Despite inflation peaking markets are pricing in more interest rate hikes in the US and Australia
- Share markets remain buoyant and to date showing little concern for the recession risk
- Artificial Intelligence (AI) popularised by ChatGPT has boosted the Tech sector, is it a bubble?

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 get in touch.

THE BIG PICTURE

As we start a new financial year it’s good to reflect on the year just past. Despite rising interest rates and the ongoing Ukraine war, returns on many major share markets have been well above average. We all noticed interest rates and bond yields rose sharply.

The start of the last financial year witnessed the early days of the interest rate hiking cycles by many central banks. We didn’t then know how high rates would go in the ‘fight against inflation’ but most would have been surprised by the size of the hikes that eventuated – and there may well be more hikes to come. This uncertainty around interest rates contributed to the share market low last October but need we go back there?

Depending on how you measure inflation, one could be satisfied by how it has fallen in the US. Oil prices are down by more than a third over the year after the spike partly caused by the Russian invasion of the Ukraine. Supply chain issues caused by Covid have largely dissipated.

It is interesting to observe that two developed countries, Switzerland and Japan, have had only a modest inflation problem. Switzerland only just hiked its rate to 1.75% and Japan’s central bank has kept its interest rates on hold since 2016 at -0.1%! Switzerland has a massive dependence on hydro power for electricity and both countries have well-regulated energy prices, which are in part a reason why they have lower inflation.

Swiss inflation stands at 2.3% compared to a recent peak of 3.2%. Japan’s core inflation stands at 3.2% which is down from 3.4%.

What this points to is that the mantra pervading most central banks – that “we must keep rates higher for longer to control inflation” – misses the point that other policy tools could have been employed in the fight against inflation. There is no simple relationship between interest rates and inflation so we believe that central banks are employing their largest and primary instrument, interest rates, and in the process are running the real risk of taking their economies into recession as a result of their inflation fighting approach. Deutsche Bank has assigned a 100% probability to the US going into recession. While we don’t think anything is certain, it is becoming increasingly difficult to make the argument that the US economy is not heading that way.

The Reserve Bank of Australia (RBA) had promised us that rates would not go up at least until 2024. They did have a brief pause in April this year having started hiking in May 2022, but followed that with two more hikes in this May and June. Many are predicting that there might be two more interest rate hikes in the pipeline.

We thought, at the start of 2023, that the RBA would not have hiked interest rates as much as they have. Had the RBA not been so aggressive with interest rate increases and China’s economy started bouncing back from the three-year Covid lockdown instead of the anaemic recovery it has had so far, we may well be better positioned to avoid a recession than it appears we are now.  

We still think the RBA should have stopped hiking months ago. Our latest estimate of Australian inflation is 3.1% - almost within the RBA target band of 2% to 3%. Why didn’t you know this? The media is lazy.

Australia’s latest economic growth estimates came in at the start of June. Our economy grew by 0.2% in the March quarter. Not great, but positive. Over the whole year, growth was 2.3% which is not far off the historical average.

The problem comes when we adjust growth for population changes. Immigration is going gang-busters so the per capita growth in the March quarter was -0.2%. On average we went backwards!

The household savings ratio fell to 3.7% from 4.4%. It was nearly 20% in the early part of our Covid lockdowns because there was less available to spend income on, and probably because households wanted to put some extra aside for a rainy day – given the uncertainty created by the onset of Covid-19.

The current savings ratio of 3.7% is below what it was before the lockdowns. The stream of falls in savings ratios helped bolster the measured economic growth. That party is now likely to stop.

This savings data does not imply that people are spending more than they earn. They mean that they are not putting away as much for the future as they did before.

It would be remiss of us not to mention AI (artificial intelligence) and its effect on stock markets in the 2023 financial year. The US technology heavy Nasdaq index just experienced the best first half (January to June 2023) in four decades!

AI has been around for years but it only seemed to tantalise investors after ChatGTP was brought to our mainstream attention at the start of the year. Ordinary folk can now easily ask it questions and ask it to write an essay or computer program for us. This is big stuff and it is not going away. But let us be clear what it is.

AI has two major strands – both enabled by the massive increase in computing power in recent times. It can help us search very quickly from what already exists on the internet. That does raise questions of privacy and some are calling for AI development to be regulated.

The other component is image or pattern recognition. By taking, say, a digital photograph and changing each pixel into a number – say on a pantone colour score – one photo’s array of numbers can be compared to a massive number of other arrays. Western Australia just released a machine that can recognise feral cats from native animals and poison them.

Neither of these strands ‘think like a human’ – they just do what humans tell them to do, but extremely quickly!

Image recognition can help (and invade privacy?) identify people walking through immigration or a shopping centre. It can also be used to interrogate, say, aerial photos to work out who has a swimming pool or solar panel. Over time, this form of image recognition can monitor the effects of climate change, population movements and changes in traffic congestion. It will also drive cars without us!

AI has already made significant contributions to society, and it will continue to improve the efficiency of many tasks, but it can’t replace everyone’s jobs. It just doesn’t do that! It will put people with repetitive jobs in jeopardy but even this will take time.

Take the banking industry in Australia as an example. There has been a massive increase in employment at some major banks over the last decade – even as branches were being closed – owing to the switch to AI and a sub-branch of AI called machine learning (or generally data science). Computer models need to be designed, implemented, and monitored. This is a process that will takes years. Research never ends. There will always be a demand for people who can push computing power to its limits.

Many developed countries, including Australia and the US, are currently puzzled by the strength in their jobs markets. But should we be comparing unemployment rates today with those from years ago without adjusting for the types of work? Some restaurants claim they can’t organise home deliveries because they can’t get the workers! So, anyone who loses a ‘good job’ through AI or whatever can become say, an Uber driver or delivery person in a trice. Obviously, compensation and job satisfaction may not be the same in the two segments of the workforce. But unemployment data are not adjusted for happiness.

No one can reasonably assess what the impact of monetary policy has already had since the start of 2022 with any accuracy. Everyone in the profession is aware that monetary policy impacts the real economy ‘with long and variable lags.’ Central banks admit it but most say that rates should remain high until we see inflation back to a reasonable level.

The consensus view is that the lag length is 12 to 18 months. That means we may not even yet have seen the full impact in Australia of the first rate-hike of 0.25% point in May 2022 – let alone the cumulative impact of the next dozen or so hikes! If they wait until inflation returns to its target range, whatever that may be, there will be a dozen or more rate hikes still waiting to have their impacts – presumably then sending many economies into recession. Stopping interest rates hikes, or even cutting rates, will not reverse the economic declines quickly enough.

If the chance of a recession is already priced into share prices, markets can continue to grow as the real economy works its way through the recessionary impacts. Our analysis of broker expectations of company earnings suggests we might expect more of the same over FY24 – average to above average capital gains. A correction or bear market is not an obvious expectation unless one is worried about any ‘AI bubble’ bursting.

Over twenty years ago, we had the dotcom bubble and bust. The current situation is very different. The dotcom boom was based on dreams of making new products that never, in fact, ever got made. People invested in companies with no actual products and no revenue streams. The big US tech companies involved in AI today are already making good money and AI already exists. Of course, there could be new regulation that slows things down a bit but there will also be improvements in AI over time as innovation and development continue unabated.

Investing in share markets is always risky. There is always a possibility that one buys at too high a price. There is also the possibility that one misses out on a great opportunity of not buying now. Prudent investors manage these risks and expected rewards. And over, say, five-year periods, the timing of buying and selling become much less important.

The founder of modern portfolio theory, Nobel Laureate Dr Harry Markowitz, passed away at the end of June, aged 95. By and large, the same theory is as relevant today as it was when it was first published 70 years ago – just the investment products on offer have changed! Harry was reportedly a good, humble man. His contributions were massive. R.I.P.

ASSET CLASSES

Australian Equities

The ASX 200 was up +1.6% for June and +9.7% for the 2023 financial year. When dividends are included, those (total) returns increase to +1.8% and +14.8%, respectively. Of course, many investors also have franking credits available to them making for a very solid FY23. All eleven sectors produced total returns in excess of 5% and three (Materials, Information Technology (IT) and Utilities) produced total returns in excess of 20% for FY23.

We currently have the broader index approximately priced as ‘fair value’ and broker forecasts are pointing towards capital gains of above the historical average for the 2024 financial year.

International Equities

The S&P 500 had capital gains of 6.5% for June and 17.6% for the 2023 financial year. The gains were certainly not even across the component sectors. It was the top 10 companies on Wall Street that led the charge in the S&P 500 this year. The other 490 companies’ share prices didn’t do that much. The top 10 companies are largely mega-tech companies with some focus on AI.

The Russell 2000 index is commonly used to track where US small cap stocks are going. This index started to underperform the top 50 stocks from March when the Silicon Valley Bank and others went under and credit conditions tightened.

Emerging markets were flat over the 2023 financial year but they had a good June rising +2.6%.

Our analysis of the US company earnings forecasts points to another strong financial year but a lot will depend on the depth to which any recession hits the country – and the extent to which any bubble, assuming there is one, in AI bursts.

Bonds and Interest Rates

The US Federal Reserve (“Fed”) paused its hiking cycle for the first time in June. In a confusing press conference, Fed Chairperson Jerome Powell emphasised that this was a “pause” and not a “skip” (presumably meaning we shouldn’t automatically expect a hike in July). However, the dot plot forecasts of the members of the Federal Open Markets Committee (FOMC) clearly showed that the Fed expects two more hikes this year – with only four meetings to go. And that is two more hikes than they expected at the prior meeting!

The market is pricing in an 85% chance of an interest rate hike by the Fed in late July. Gone are the market expectations of three or four interest rate cuts this year – the market expects more rate hikes. Any rate cuts are a little unlikely with a market probability of 1.1%.

The RBA paused again at its July meeting and left the official cash rate unchanged at 4.10%. In the lead up to the decision market economists and pundits had been divided as to the outcome as data can be found to support either case.

With money market account interest rates having risen substantially the ‘there is no alternative’ (“TINA”) to equities is no longer the case. Share markets continue to have better long-term prospects than bonds or cash but a blend of these assets may well be appropriate for prudent investors who want to manage the risk of their asset allocations.

Other Assets

The price of oil has fallen by more than a third over FY23 but they were up over 2% during June.

The price of iron ore was much the same at the end of the financial year ($112 / tonne) as it was at the beginning ($121 / tonne) but the range over that period was enormous ($80 to $133). During June, the price was up about 13% as China comes back out of the lockdowns.

The price of copper was flat over the 2023 financial year but up about 1% during June.

The price of gold was up 6% over the 2023 financial year but down 3% in June.

The Australian dollar appreciated 2.1% over June but was down about 4% over the 2023 financial year.

REGIONAL REVIEW

Australia

We again got a bumper monthly labour report. Two of the last three were extraordinarily strong. Because of sampling error in the way that the data are collected, we are comfortable to accept the middle month’s weak result as an anomaly.

76,000 new jobs were created in the latest month. The unemployment rate fell from 3.7% to 3.6% which is historically very low indeed.

GDP growth was a different story. The March quarter was weak and we were possibly saved from going negative by the cut to household savings. Per capita growth was negative at -0.2%! We cannot reasonably expect further falls in the savings ratio to support our growth estimates. However, strong immigration might keep headline growth positive.

In contrast, retail sales, that are not adjusted for inflation, came in strongly at 0.7% for the month or 4.2% over the year. However, we note that inflation was running at about 7% p.a. (April) (or 5.6% p.a. from the May monthly series) so real (i.e. adjusted for inflation) sales were down around 3% (or 1.4%), over the last 12-months.

We have been experiencing higher inflation than even the US. The Fair Work Commission gave a 5.75% wage increase to those on minimum wages. Owing to a technicality, that translates to about 8.5% for some.

Will this wage increase be inflationary? It certainly puts costs up and some or all of this increase will be passed on. However, the increase does not help those workers keep up with the inflation that has already occurred. Not to give such a wage hike might have slowed down inflation but at what human cost?

There is some evidence being presented that companies have been increasing profitability in this inflation round so hopefully such companies will be able to absorb some of the wage increases.

The latest quarterly inflation read (for the March quarter published in April) was 1.4% for the quarter or 7.0% for the year. Many think it was this number that prompted the RBA to hike interest rates again after their April 4th pause. There is a new official monthly, as opposed to quarterly, series that aims to provide a more timely view of price movements.

The May monthly inflation rate came in below expectations at 5.6% for the 12-month period published at the end of June. It was the lowest in 13 months but the new monthly series does not correspond very closely to the established quarterly series.

Our in-house analysis, in which we calculate a rolling quarterly inflation series – rather than the official rolling annual series – shows that the latest quarter came in at an annualised 3.1% (only just above the RBA’s inflation target range of 2% to 3%) but core inflation (that strips out the more volatile food and fuel prices) is still stubbornly high at 5.2%. We expect that the next quarterly inflation reads will continue to trend lower but the monthly data are a little volatile.

China

China is struggling to get its economy back on track. It cut a couple of key interest rates in June and seems likely to do more to stimulate the economy.

China’s Consumer Price Index (CPI) inflation came in at 0.2% and the producer price variant was -4.6%. The government is trying to be selective in how it stimulates the economy. While some agencies are downgrading their forecasts of growth for 2023, estimates generally are still comfortably above 5%.

However, the manufacturing Purchasing Manufacturer’s Index (PMI) was below 50 (indicating a contraction) for the third month in a row showing that the stimulus packages have not yet filtered through to expectations that will take the economy back into a more sustained growth path. The latest read of 49.0 was better than the previous month’s read of 48.8 but below the April read of 49.2. In that sense, the economy is more likely struggling with getting back to stronger growth rather than falling into worsening conditions.

US

US jobs again impressed at 339,000 new jobs and an unemployment rate of 3.5%. Only 190,000 new jobs had been expected. Wage growth was 0.3% for the month or 4.4% for the year.

US GDP growth for the March quarter was revised upwards from 1.1% to 1.3% to 2.0% in each of the last two months.

When we calculate CPI inflation on a quarterly basis – as we do in Australia – the read was 2.2% (annualised) compared to the target 2% but the Fed seems very likely to hike again. And this low read was not a one off. Rolling quarterly reads have been drifting lower from 4% for several months. The problem is that the US focuses on a rolling 12- month inflation figure. At 4.0% for the headline rate and 5.3% for the core reading, the high inflation period up to the middle of 2022 is still biasing the annual estimates upwards.

The Fed prefers the Personal Consumption Expenditure (PCE) to the CPI variant of inflation because the weights attached to each expenditure segment evolve over time. The latest monthly headline read was only 0.1% or 3.8% for the year. The core variant that strips out the more volatile energy and food prices was 4.6% compared to an expected 4.7%.

US President Biden’s student debt forgiveness plan was not supported by the Supreme Court. Biden plans changes which he hopes will get the plan through but, for the moment that is an extra impost on spending power for those struggling with student debt. Add to that the effect of credit tightening and the repaying government debt programme (called quantitative tightening) and the economy has a lot to deal with without having more interest rate hikes.

Europe

UK inflation was stuck at 8.7% and the Bank of England surprisingly hiked interest rates by 0.5% points rather than the expected 0.25%. Britain, along with Germany and the EU have had two consecutive quarters of negative growth. The ECB hiked by 0.25% to 3.5% but its President, Christine Lagarde, stressed that she wants rates to stay high until inflation, currently 5.5%, falls to 2%. She did not acknowledge the policy lag in her statement.

Rest of the World

Japan’s growth in the March quarter was revised upwards to 2.7% from 1.6%. Its core inflation read was 3.2% from 3.4% and the Bank of Japan interest rate is  0.1%.

New Zealand growth came in at -0.1% giving it claim to being in a recession after this second quarterly negative read.

The Royal Bank of Canada had paused after its January interest rate hike but proceeded to start hiking again in June with a 0.25% increase to 4.75%.

Turkey raised its rate by 6.5% from 8.5% to 15% in order to try and save its currency, the lira. The rate was 19% in the early phase of the pandemic and it was progressively cut to the previous month’s 8.5%.

In a puzzling state-of-affairs, the Wagner private army comprised mainly of former Russian soldiers marched on Moscow and got to within 300km before turning back. The leader, Prigozhin, cut a deal with Putin to stand down in exchange for safe passage to exile in Belarus. All of this happened over the weekend when markets were closed!

Wagner played a major role in the Ukraine offensive. Putin did not look good in this and it is not clear what the aim of the ‘mutiny’ was. Charges against the mercenaries have reportedly been dropped. Reportedly residents in Poland, Latvia and Lithuania are extremely worried by having these ‘serial killers’ in neighbouring Belarus. The army is not expected to return to fight in the Ukraine. However, the Pentagon claims some of the army is in the Ukraine.

Markets did not seemingly respond to this chain of events.

‍