Economic update – January 2024

In this month’s update, we provide a snapshot of economic occurrences both nationally and from around the globe.

Key points:

– US Fed pivots its interest rate policy
– Current estimates are for between three and eight interest rate cuts in the US in 2024
– The RBA while most unlikely to raise rates again does not appear to be in a hurry to start cutting
– Share markets respond positively to the Fed pivot and finish 2023 well into positive territory

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
Given how markets finished up in 2023, there was a lot of pain endured in getting there.

The US 10-year Government Bond yield went from 3.8% to 3.8% via just above 5.0%

ASX 200 screamed up in January 2023 only to shed all those gains, and more, as the US regional bank crisis shook confidence. But the ASX 200 rallied back and gained 7.8% on the year (without dividends and franking credits)!

The S&P 500 was dominated by the so-called ‘Magnificent 7’ – 7 mega cap tech stocks like Apple, Amazon and Nvidia. The ‘other 493’ did not fare so well but they did finish the year with a little bit of a flourish. The index gained 24.2% on the year.

The Dow Jones reached an all-time high in the last week of 2023. The S&P 500 and the ASX 200 each came very close to all-time highs in the final week of the year.

There were plenty of obstacles along the way in 2023 that prevented markets moving in a straight line. US Regional banks’ crises, Israel-Gaza conflict, Red Sea drone attacks and the rest. But the big one was trying to second-guess central banks as they bobbed and weaved in their battle with inflation. The US Federal Reserve (Fed) stuck to its guns of reiterating higher for longer until mid-December. It even stated on December 2nd that it was ‘premature’ to talk about interest rates cuts. Then a slew of favourable data on US inflation convinced it to ‘pivot’ (change its mind) at its last meeting and press conference for the year – just two weeks after the ‘premature’ statement! The Fed dot plot forecasts for cash rates at various intervals for the coming few years (from 19 Fed members) suggested there might be three 0.25% interest rate cuts in 2024.

While the above is the view of the Fed board members, the US Government bond market is taking a different view with current interest rates implying a 96% chance that the Fed will cut interest rates between five and eight times in 2024. Needless to say, the Fed ‘pivot’ in December has seen the US bond prices rally strongly (interest rates falling).

Surprisingly, the RBA minutes revealed that Australia’s central bank was still considering a rate increase at its December 5th board meeting, this approach puts it at odds will all other developed world central banks. Despite this, in Australia, for four of the last five quarters, per capita GDP went backwards, the household savings ratio nearly fell to zero and retail sales showed lots of weakness.

While the RBA clearly has some concerns regarding the stubbornness of inflation there is growing evidence that the economy is slowing and interest rate policy has done enough to contain inflation. The concern now is that unless the RBA joins in with its developed world peers and begins easing monetary policy (reducing interest rates) then it risks sending the economy into a more sever slowdown than is otherwise anticipated.

The RBA interest rate tracker app on the ASX website assigns an 8% chance of a rate hike at its next meeting in February. The predominant outcome currently predicted is ‘no change’ to the RBA cash interest rate.

Media reports have possibly led many astray as they portrayed the Fed increasing interest rates from 0% to 5.5% in less than two years as being aggressive and strongly contractionary and will ultimately result in an economic recession, which hasn’t happened yet.  This narrative is ignoring the whole point of monetary policy.

There is an economic concept of a ‘neutral’ central bank interest rate that neither causes the economy to slow down, nor is it accommodative. Most economists would agree that the neutral rate for the US and Australia – among others – is about 2.5% to 3.0%. That means the first set of Fed hikes shouldn’t have slowed down the economy until 3% was exceeded in September 2022! They’ve only had 2.5% points of tightening and not 5.5%! The first 3% of hikes were simply being less accommodative.

The other key insight is that at least from the late 1960s, it has been widely thought that the implementation of this sort of monetary policy acts with ‘long and variable lags’. Conventional wisdom is that this time frame is around 12 – 18 months. Even central bankers have agreed on occasion!

Putting these two concepts together and applying it to our current cycle, the first interest rate tightening that started in September 2022 shouldn’t have had any material impact until September 2023 to March 2024. So, the media tell us economists ‘got it wrong’ by stating that the anticipated recession never happened, when the more considered statement is ‘it hasn’t happened yet’. From an economic perspective it is just too early to say ‘it didn’t happen’, notwithstanding that it may not. Some reasons for this are that, US consumers were awash with Covid stimulus cheques and a student loan moratorium until October 2023. And fourth quarter US GDP data, even its preliminary form, is not available until late January 2024 so we don’t yet know how the US economy is travelling in late 2023.

There is likely to be plenty of pain in the pipeline for 2024 from rate hikes not yet felt. By reasonable definitions, Australia has been in recession for most of 2023 but massive immigration – running at about 2.6% of population – has distorted the headline data from revealing the hardship facing many.

The US economy is doing better than ours but there seems to be cracks appearing in the data picture. There has been solid job growth but increasingly this growth has not been in those sectors usually associated with a strong economy. Both the US and UK official statistics agencies have had to change their data collection methods to get normal response rates to survey methods. It is very difficult to measure what the unemployment rate really is!

It’s not obvious that recent labour force data can usefully be interpreted in the traditional manner. Moreover, with the growth in options to work in casual food and ride delivery, it is much easier for those who want to work to do so. The definition of work has changed.

With regard to market forecasts – particularly for the ASX 200 and S&P 500 – earnings forecasts are quite strong. LSEG (formerly Thomson Reuters) collects broker-forecasts of earnings for the relevant companies in the indices. Companies are required to report material changes in their expectations and they share their view of their futures with the brokers.

We have found over nearly two decades that these earnings expectations give useful guides to market direction. Of course, there is always the possibility of a ‘black swan’ event or some geopolitical upheaval.

Asset Classes

Australian Equities
The ASX 200 had a very strong December (+7.1%) to back up a strong November (+4.5%) to make a two-month total of near 12%.

The Materials sector did well at +8.8% in line with strong iron ore prices (+7.3%).

Total returns for the year were 12.4% making it a well-above average year. By our metrics we have the market overpriced by +3.3% making that a bit of a headwind for 2024. However, news of actual interest rate cuts might still spur on the market to new highs. Markets usually lead the real economy!