Economic update – November 2022
By Infocus Author
In this month’s update, we provide a snapshot of economic occurrences both nationally and from around the globe.
Key points:
– Central banks close to contractionary interest rate policies – the US raised 0.75% in early November
– Reserve Bank of Australia moves cautiously again raising rates by 0.25% to 2.85% on Cup Day.
– US earnings season contains some surprises positive (banks) negative (big Tech)
– Share markets have a positive month in some cases recovering all of Septembers losses
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 our team.
The Big Picture
The ASX 200 and the S&P 500 both had stellar months in October. However, September for both of those indexes had been very bad. Does this cancellation of much of the September woes mean that a bottom has been reached and the next rally has begun? We think it is too early to draw that conclusion – but it is possible.
Markets at the end of bull and bear markets often display amplified volatility but, this time, there is more information about future conditions than usual. The dominant feature so far of 2022 has been the possible success or otherwise of central banks’ ability to control inflation without causing a recession.
The US and Australian economies are currently far too strong to think about imminent recessions but the UK and Europe certainly have deep-seated problems. China, largely because of an insistence on a zero-Covid policy, has found itself with slower growth than in recent times but it is self-induced and could easily be reversed if China wants.
Monetary policy was never designed to control many of the current sources of inflation: the Russian invasion with consequent food and energy price inflation; and covid-induced supply chain issues such as the current chip shortage for cars and so many other modern technologies.
The strength of labour markets suggests that some ‘demand induced’ inflation exists in various countries and that variant might respond to interest rate hikes.
Because rates were so low – zero or negative in many cases – the recent sharp increases in rates have only taken rates up to what is often referred to as the neutral rate – the rate that divides expansionary from contractionary policies. We think no major Western economy has yet crossed that line in any material way. However, continued hikes at the recent pace could take some economies into significant slowdowns and possibly recessions. We will know a lot more by the end of this year.
The IMF and some noted fund managers have started to talk about a possible recession in the US but not necessarily in Australia. Based on what we currently know we would largely agree with that assessment.
The Reserve Bank of Australia (RBA) has been far less aggressive in its policy stance than the US Federal Reserve (Fed) who again increased their cash rate by 0.75% on 3 November accompanied by a statement that easing off the pace of policy tightening was not supported by recent data. In both countries, a slowdown and pullback in house prices are well underway. While house prices were getting out of hand, a pronounced downturn in house prices would reduce perceived and actual household wealth. Such a loss of household wealth could accelerate and deepen any recession.
If central banks deftly avoid recessions, markets may well have already bottomed and the next big rally could get underway. If central banks push interest rates too far, a second market downturn could easily start.
However, the S&P 500 is about 20% below its 2022 peak; the ASX 200 is about 10% below its peak. There is plenty of room for upside if and when the dust settles after the volatility created by central bank policy tightening subsides. Despite equity markets having corrected this year prudent investors wouldn’t just ‘pile in’ now as it would be a big gamble in the short run.
The US third quarter company earnings reporting season is well underway. While there have been a number of really good results, there have been some notable underperformers – particularly among the big tech companies. Microsoft, Apple, Amazon, Meta (formerly Facebook) and Alphabet (formerly Google) amongst others lost significant company value on their announcements. Do these falls make them good buying opportunities? Maybe – but they could have just been too expensive before.
Some are asking if we are in a repeat of the dotcom boom and bust over 20 years ago. We would say no. All of these big tech companies currently experiencing downturns are well established with revenue streams. The dotcom boom was about ideas and hopes for future revenue. Many of those ideas just didn’t cut the mustard.
The era of ‘cheap money’ is over for now. Investors must now weigh up alternatives. 10-year government bonds in the US and Australia have come from very low values to yields fluctuating around 4%. Equities, while not as attractive relative to bonds as they once were, more selectively still present opportunity. Getting the asset allocation right for the next while is important, as appropriate diversification is a proven way of assisting to mitigate investment risks in uncertain times.
Of course, lurking in the background is the impact of the ongoing Russian invasion of the Ukraine. Few, if any, are sufficiently skilled to predict outcomes on that basis. It does seem that the Ukraine is now holding its own and Russia has not had the success it must have expected. Maybe that is why they just stopped the grain shipments again!
Europe and the UK are heading for a dismal (northern) winter. Energy prices are out of control and recessions seem inevitable if, indeed, they haven’t already started.
Our economy is doing well and Jim Chalmers just delivered a sensible, if not boring, budget. The RBA seems to be in control and China is not doing as badly as some predicted. We in Australia can escape a recession but growth might well be sluggish for a while. Markets typically focus on expectations rather than actual current conditions – so markets could turn up before economic data confirm that the worst is behind us.
Asset Classes
Australian Equities
The ASX 200 had a positive month rising 6.0% but that gain was on the back of a 7% loss in September. Most sectors did well in October though Materials, Staples, Health and Telcos performed poorly.
While we believed the ASX 200 was attractively valued a month ago, much of that mispricing has been erased by recent gains. While Refinitiv forecasts of company earnings are softer than earlier in the year, there is some optimism for capital gains over the next year in addition to possibly eroding the remaining perceived over-pricing. Expected dividend yields, grossed up for franking credits, are around 6%.
International Equities
The S&P 500 gained 8.0% in October almost offsetting the 9.3% loss in September. The World index was up 7.7% in October but Emerging Markets lost 3.1%.
The Dow Jones had its best month since 1976!
Many of the big international banks did particularly well in the current reporting season but Credit Suisse took a big hit. By and large big tech stocks did not fare well.
Bonds and Interest Rates
The RBA went against market opinion and hiked rates by only 0.25% rather than the expected 0.50% in October and followed this same course in November increasing the official cash rate by 0.25% on Melbourne Cup Day. The RBA cash rate now stands at 2.85%. Few would argue that the RBA was already in line to cause a recession. However, inflation is persistent with the latest read being the highest since 1990.
The Fed has been extremely aggressive with a number of back-to-back 0.75% hikes taking the Fed Funds Rate (official cash rate) to a range of 3.0% to 3.25% at the end of October. Future hikes will take the Fed almost certainly into contractionary territory. There is no sign yet of any impact on inflation but there are considerable lags between rate hikes and inflation decreases – if, indeed, the sources of inflation are responsive to interest rates.
There is significant danger that the Fed will keep hiking for too long. If that happens, at some point, a significant deterioration in the US economy may occur.
The European Central Bank made its second successive increase in its base rate of 0.75% to 1.50%.
Japan continues to buck the developed world central banks trend of increasing interest rates opting instead to hold their cash rate steady at -0.10% at its October meeting. While recognising that inflationary pressure is building, an inflation rate of 2.9% p.a. up from 2.3% p.a. in July, this was not enough to spur them to raising interest rates yet.
Other Assets
Oil prices rose strongly in October – up by around 10% – possibly because of the OPEC+ decision to cut supply by 2 million barrels per day. Iron ore prices fell by over 15% over the same period. The Australian dollar against the US dollar finished down 1.3% but there had been a significant depreciation during the month as bond yields swirled on central bank activity.
Despite the significant volatility in market indexes calculated using closing prices, the VIX volatility index fell markedly. The VIX measures implied volatility based on option prices which are used to insure against market falls. Perhaps, this behaviour is indicative of investors and traders getting ready for the next upswing in markets.
Regional Review
Australia
The September jobs report released in October showed that the unemployment rate was 3.5% which is a 50-year low. There were no new jobs created or lost but this report was indicative of a very strong labour market.
The quarter three CPI report revealed an inflation rate of 7.3% or the highest since 1990. The RBA had predicted earlier in October that inflation would come in at 7% and yet it only raised its rate by 0.25% rather than the 0.5% anticipated by markets. To us, this behaviour demonstrates that the RBA is aware that a substantial proportion of Australian inflation would not respond to interest rate hikes.
The trimmed mean of the CPI inflation read preferred by the RBA – in much the same way that the Fed prefers the core variant – came in at 6.1% when energy and food prices were stripped from the relevant basket of goods.
The impact of China’s Zero Covid policy and the Ukrainian invasion – together with the impact of devastating floods in the east coast of Australia – are clear headwinds for the economy. Despite this the RBA remains focused on defeating inflation and increased the official cash rate by 0.25% again in November.
The Federal Budget handed down by Treasurer Jim Chalmers didn’t do anything to upset markets. At this point in time, it is better to wait until May next year to deliver a carefully crafted budget that can deal with what, by then, should be a clearer picture of where recessions, invasions, Covid and interest rate policy stand.
China
The People’s Congress that meets every five years to set policy and elect a leader was held in October. Unsurprisingly, President Xi was re-appointed for an historic third five-year term. What did surprise was that the GDP data due out during the Congress was delayed. It was not delayed at the previous meeting five years prior when the planned release also coincided with the Congress.
When the GDP data was finally released after the conclusion of the Congress, it was found that the read was better than expected, 3.9% against an expected 3.4%. Industrial output rose at a rate of 6.3% for the month beating expectations but retail sales fell short rising only 2.5%. The China Purchasing Manufacturing Index (PMI) came in at 49.2 from 51.1 in the previous months. Prior to that release the PMI was 49.4.
While these data were not unequivocally good, they did show that the economy is far from plummeting into recession. With the People’s Congress behind them, Xi might now craft policies to get the economy back on a stable post-pandemic path.
US
The US Fed increased the US Federal Funds rate by 0.75% again on November 3 and Fed Chair Powell indicated that it was apparent that inflation is yet to respond to the higher interest rate settings and, as a consequence, the current rate of tightening was likely to continue until data indicated that inflation was indeed slowing.
US jobs data have repeatedly shown the labour market to be very strong indeed. In the previous month, the unemployment rate had risen from 3.5% to 3.7% but, in the latest report, the unemployment rate had fallen back to 3.5%. 263,000 new jobs had been created.
At the start of the month, CPI data were released showing that prices grew by 0.4% over the month or 8.2% over the year. The core CPI read was 0.6% for the second month in a row. The core Personal Consumption Expenditure (PCE) read was 5.1% at the end of October.
Inflation is well above the target rate of 2% and many Fed members are calling for aggressive action. However, three members at the last meeting voted for only a 0.5% hike rather than the 0.75% consensus. The tide could be turning.
So far, GDP growth has held up. The first two quarters of 2022 were negative reads but the provisional Q3 read was a reasonably impressive 2.6% against an expected 2.3%. One of the major causes of this growth resulted from slower import growth than expected.
Europe
The UK parliament has been in turmoil for most of 2022. Boris Johnson did not have a great profile and attending parties against Covid rules was the last straw. After a protracted selection process, Liz Truss was the chosen successor. Importantly she did not have the support of the parliamentary members. Her ridiculous policy of proposing tax cuts for top earners by borrowing got named ‘Trussonomics’. The backlash was amazing and she lasted in charge for less than seven weeks.
The new prime minister Rishi Sunak has an impressive track record in both his education and work in the finance sector. He is married to a woman who is heiress to her father’s multibillion-dollar company. Together, the Sunaks reportedly have a combined wealth greater than the Queen had on her death. He might find it difficult to win over the hearts and minds in the impoverished regions of the UK but he could do some good work before the next election.
Germany is reconsidering its nuclear policy in an attempt to offset energy prices. The UK is attempting to cap energy price increases for vulnerable consumers.
