Economic update - September 2021

Key points

• US Fed likely to start tapering its $120 Bn per month bond buying program this year
• As Delta cases rise in NSW and VIC, Australia relinquishing hopes of 0 cases and pins hopes on vaccinations
• Rushed Afghan evacuation and terrorist bombing sees risk of humanitarian disaster and potential for increased terrorist activity.

The Big Picture

The S&P 500 has closed the day at record highs 53 times this year but many of the gains were only marginally higher. The June quarter reporting season gave US listed companies lots of encouragement for the future. Naturally some are starting to ask when the rally will end. Since the low in the March quarter of 2020, the S&P 500 just recorded the fastest ever doubling of the index.

While it is easy to get vertigo at these levels, the fundamentals in the US remain positive. There are, however, three ‘known knowns’ that could cause a pull back.

The Federal Reserve (“Fed”) is about to start to taper (reduce the bond buy backs that aimed to keep longer rates lower and keep abundant liquidity in the banking system) this year. A few years ago, talk of tapering caused the so-called ‘taper tantrums’ that negatively impacted bond and equity markets. However, this time around, the Fed chair, Jerome Powell, has done an excellent job of managing expectations. The market even rose on his speech about tapering at the annual, global conference of central bankers at Jackson Hole, Wyoming – and followed up with another high on the next close!

Powell was keen to place a disconnect between the concepts of tapering and hiking the short-term interest rate. The latter, he said was well off. 2023 is still the possible date for the first hike in this cycle.

Although nothing is certain, the market looks set to live with tapering giving us well over a year before we have to worry about the Fed.

The second possible fly-in-the-ointment is the pandemic. On a positive note, the US Federal Drug Administration (FDA) gave its full approval of the Pfizer vaccine which should further encourage its use. It can now be given to anybody aged 12 or over.

Nevertheless, new daily infections are running at very high levels. One source was quoted as saying, ‘Full vaccinations blunt, but do not defeat Delta’. Bloomberg stated that, ‘the vaccinated are worried and the scientists do not have answers.’

Israel, the poster child of vaccinations, streaked to an early international lead of 78% of its over 12 million population having had both doses of Pfizer. Nevertheless, their daily infection rates have soared to a higher level now than during the first and second waves six months and more ago.
It is possible the pandemic is the reason why the University of Michigan consumer confidence index indicated that the US consumer is at its gloomiest in over a decade.

There are lots of reports in Australia, the US, the UK and elsewhere of hospitals struggling with the burgeoning COVID-19 cases. However, it seems that the situation is still far better than during the first wave in early 2020, as it appears that while people are still catching the disease, the higher vaccination rates are resulting in proportionally fewer deaths and fewer people needing ICU treatment.

It is very likely that we are going to have to live with the pandemic and mild sickness, social distancing and face masks for a long time to come.

Australia, and NSW in particular, is reacting to rising infections numbers with very tight social mobility restrictions and proactive campaigns for vaccination. It seems the vaccinated are soon to be rewarded some freedom from the Sydney lockdown that started in June.

Nearly two thirds of people in Australia have had at least one dose and over a third have had two doses. While the English Premier League football (soccer) matches have been staging 20 matches a week averaging about 50,000 largely unmasked supporters cheering and screaming with delight (at least for the winning team!) we, in Sydney, are peering through the curtains at largely empty streets.

We cannot rule out market pull backs in any country. The medical experts are far from re-assuring. We are not medical experts. It does seem to us, though, that Australia is more prone to political over-reaction that in the US or UK.

The third current possible problem for the US markets is the Afghan evacuation. Even before the terrorist bombing at the gate of Kabul airport in which 13 US military personnel were killed along with 60 civilians, there was adverse commentary on President Biden’s handling of the withdrawal. The world waits with some trepidation as to what comes next for Afghanistan including in the near term the fate of those unable to be evacuated. There is ample evidence for another humanitarian disaster to unfold let alone the prospect of a resurgence of terrorism without the suppression activities of western military forces.

We continue to see the US market outlook remaining generally positive for the coming 12 months but there are possible dips ahead for the reasons given – and those not yet known.

At home, our first half reporting season has not been going as well as that in the US June quarter reporting. Our forecasts for the ASX 200, while positive, are now pointing to a slightly below average capital gain over the next 12 months but, of course, we can expect some handsome dividends and franking credits.

Australia also has the added problem of our dependence on China. Their growth rates are stuttering a little. Retail sales and industrial output missed expectations last month by quite a bit. The price of iron ore rose to a massive $US 233 earlier in the year but quickly fell by nearly $US 100. It has since rebounded a little, but current forecasts remain skewed to the downside.

Part of our market is heavily dependent on iron ore prices. Energy is struggling too. It was the resources sector that got us through the GFC. Because of our dependence on China and the other global factors, we see the ASX 200 as being more likely to have a correction than the S&P 500. However, it is easy to bail out too early on big market rallies and miss participating in the remaining upside. Investment managers need to keep a watchful eye on both equity and bond markets for the next six months or so as the world hopefully, successfully negotiates its way through to a point of confident management of the COVID-19 pandemic. After that the future may well look brighter.

Asset Classes

Australian Equities

August recorded the 11th consecutive monthly gain on the ASX 200. While there have been some good company results in the profit season, our market didn’t share in the optimism on Wall Street.

All sectors on the ASX 200 did very well in August except for sharp pull backs in Energy and Materials. Even so, the broader index managed a gain of 1.9% on the month and is up 14.4% on the year-to-date.

International Equities

The S&P 500 recorded its seventh consecutive month of gains in August. There were fears that the first mentions of tapering by the Fed might have sent jitters through the market. However, Fed chair, Jerome Powell’s address at the end of the Jackson Hole meeting seemed to lift the market. Powell has learnt a lot in his job, in particular management of the message!

The S&P 500 gained 2.9% in August but much of the gains over the last few months has come from the larger companies and particularly technology stocks.
Emerging markets continued to struggle to eke out gains with that index largely flat over the month. All of the other major indexes we follow performed strongly. The ASX 200 performance was at the weaker end of that set.

Bonds and Interest Rates

The US yield curve has moved quite a lot over the last month or two. After a rapid rise in the 10-year Treasuries yield, it fell into mid-August but it has since rebounded a fraction to 1.31%. The Australian 10-year yield has been below that of the US with consequences for the Australian dollar (against the US) in the near term, particularly prior to the Afghan withdrawal.

The Jackson Hole meeting in August did not offer much in the way of specifics about US Fed policy. After all, it is a global, annual meeting of central banks.

At the last minute, the meeting was switched to virtual which made some think that rising concerns over COVID might stop the Fed from getting serious about tapering.

Nevertheless, Powell gave a calm, reasoned address which allayed market fears. The next Fed’s FOMC meeting is in September. It looks highly likely that Powell will back up his Jackson Hole comment and set an agenda for tapering to start just before the end of the year. Few seem to think that the US economy is weak enough to need any increase to the current level of Fed bond buy-backs.

Because of the way the market handled the Jackson Hole address by Fed chair Jerome Powell, we do not now think there will be much in the way of an adverse reaction to tapering when it is formally announced or started.

The RBA unsurprisingly kept rates on hold at its August meeting. No increases are expected in the foreseeable future. However, South Korea became the first developed economy to raise rates. It did so in August and it is expected to hike again before the end of 2021.

Other Assets

The steep fall in the price of iron ore was reversed somewhat towards the end of August. There are conflicting reports of China’s needs in coming years but it does seem likely that China is trying to move away from its dependence on Australian iron ore.

The prices of copper and oil made losses over August while the price of gold was largely flat. Despite the fall in oil prices over August, oil prices are up over 40% on the year-to-date. The price of copper is up over 20% on the year-to-date but iron ore prices are largely flat over the same period.

The Australian dollar recovered from a low of US$ 0.7133 during August to a range in the mid-73 cents, possibly more a case of the $US weakening on the back of the Afghan withdrawal than economic fundamentals.

Regional Review

Australia

Consumers and businesses are much less optimistic according to the NAB and Westpac sentiment indexes. Any further extension in the Sydney lockdowns will not help that pessimism. There is still disarray in public health policy but the government is borrowing 500,000 doses of Pfizer from Singapore for a few months to try to speed up the vaccination programme this year.

Australian unemployment fell to 4.6% from 4.9% in July with a strong increase in employment. However, the impact of the current lockdown has not yet been fully felt in these data series.

A major problem in confidence and the shutdowns is the perceived disparity between how the different state and territory leaders are handling the pandemic. The PM appears to be at odds with some of the regional leaders.

Although we are a much smaller country our 1,200 or so new infections per day seem tiny compared with the around 35,000 figure for the UK and 150,000 for the US. Despite this, Australia was slow to the party in getting vaccinated. Much of that tardiness was at the doorstep of the federal government’s failure to plan early enough for the pandemic and secure sufficient supplies of vaccine – and then the delayed reaction to shutdowns by state leaders.

Our vaccination rates are now ballpark where the US and UK were as they started to open up their economies a few months ago. Social unrest is mounting against lockdowns and Sydney has at least another four weeks to go. We need better communication and analytical comparisons with other countries to help residents understand the basis of the respective state’s COVID 19 restrictions.

It is pretty clear that infections will not go away even when we are mostly up-to-date with two jabs. We will have to learn to live with COVID-19. We cannot wait for, or expect to achieve, close to zero infections before we re-open.

Given the current direction of policy, and the China impact on our resources demand, we are likely to soon get some soft economic data. Some are even suggesting a quarter of negative growth is on the horizon.

China

China’s economy has softened in the last month or so. Retail sales at 8.5% for the month missed the expected 11.5% and industrial output at 6.4% missed its expected 7.8%. The China manufacturing PMI expectations index closed August at 50.1 from 50.2 the month before, both reads are only just above the 50 level that divides optimism from pessimism. These figures are not so much bad as just not good!

China CPI inflation came in at only 1% for the year but that was on the back of a 43% fall in pork prices! Producer prices increased by 9% for the year.

US

The US inflation rate is still elevated and the jury is still out on whether or not it will just turn out to be a blip or something more long term. Powell is still in the blip camp but some of his regional Fed presidents are not. At any one meeting of the Fed, only four of the twelve regional presidents get to vote on policy changes. However, all 12 go out and freely express their opinions to the media.

It has been said that current non-voting members are encouraged to canvas extreme views to soften up the market and then Powell aims to produce a consensus after gauging public reaction to media reporting.

While we have again witnessed some extreme views from the regional Federal Reserve banks, we believe that Powell will hold a steady line and formally announce the start of ‘gentle’ tapering at the September meeting. The following meeting is not until November which would be too late to announce and then start tapering this year – as previously stated.

The Fed currently buys back $120bn of bonds per month. That could be reduced by say $10bn per month with the programme ending in late 2022. We think interest rate hikes will not start until at least 2023 unless the economy really starts to boom.

The latest jobs report showed that 943,000 jobs were created in July and the unemployment rate fell to 5.4%. Wage inflation was 0.4% for the month or 4.0% over the year. This report was strong but nowhere near strong enough to cause a panic about the resurgence of wage inflation. There are reports of pockets of difficulty in hiring but there are still close to five million people who lost jobs in the pandemic who need to come back to the workforce before real bottlenecks start to appear.
Many people are struggling in balancing working from home and home schooling. And wage inflation is probably elevated by the absence of some lower paid food and drink servers in the latest workforce.

Europe

The European economy continues to post mixed results. On balance, economic growth is below what is expected but they too suffer from the temporary price inflation and some labour market bottlenecks.

Rest of the World

Afghanistan faces a possibly turbulent future. The Taliban reportedly worked with the US to make the US evacuation happen but splinter groups, notably ISIS-K, has created major problems and violence. Without the US presence, there may be many Afghans who helped the US over the last two decades who will now face hardship and worse.