Economic update – February 2023

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

Key points:

– Short-term market volatility is expected.
– Major central banks are nearing their points of pausing interest rate policy.
– China’s economy starts to recover but the removal of lockdowns is seeing Covid cases explode.
– Recessions are possibly already price in to equity markets but Australia might again prove to be the lucky country and slow, but avoid a recession

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

Now that the dust has settled on 2022, we can better see what the returns were in different asset classes. The S&P 500 (including dividends reinvested) lost 18% on the year while the equivalent return on the ASX 200 was a loss of only 1%. Global bonds lost 12%. Australian residential property took a bit of a beating but the losses depended very much on the suburb as much as the city or state – broadly down around 10%.

In short, there was nowhere really to hide in 2022. But investors might take some reassurance that global bonds and equities have only lost material ground, such as they did in 2022, three times in the last 100 or more years.

We see the first half of 2023 as possibly containing a few more bumps in the road but we anticipate that, by the end of 2023, the returns on the ASX 200 and S&P 500 could be on a par with historical norms when measured over the whole year noting January was a particularly strong start to the year for equities.

Most of the carnage on the S&P 500 in 2022 (and possibly beyond) was caused by big falls in the value of many of the mega-tech stocks. In the US, the December quarter reporting season is now well underway and suggests that those losses are not yet over. Indeed, at least half a dozen of these companies announced big job cuts in the thousands – and in some cases, over 10,000.

The macro jobs picture in the US and Australia still remains very strong but it would be foolish in the extreme to think other sectors won’t participate in this trend as the lagged effects of high interest rates start to bite. Even the US Federal Reserve (Fed) expects its unemployment rate to rise from the current 3.5% to 4.6% by December this year.

And few are talking about the impact of QT (Quantitative Tightening). The US Fed is letting $95bn per month run-off the balance sheet i.e. it is repaying the principal of the bonds at their maturity and not reissuing new bonds to replace them. This is the opposite of QE (Quantitative Easing) which was used post the GFC to provide much needed economic support. This is unknown territory!

The consensus view is that the Fed will slow down its rate hikes and is almost ready to pause. The Fed does not expect to cut rates (the so-called ‘pivot’) at any time in 2023. It expects to end the year with its cash rate at just over 5% (the so-called ‘terminal rate’). On the other hand, the market thinks the Fed will cut its rate during the second half of 2023 to finish the year at more like 4.5%, or at about the current rate, after having risen to around 5% in mid-year.

The first few days of February have been very busy in terms of the release of economic reports. In terms of official interest rate settings, the Fed increased by 0.25%, the Bank of England (BoE) increased by 0.50% and the European Central Bank (ECB) also increased by 0.50%. The Reserve Bank of Australia (RBA) followed suite on February 7th increasing Australia’s official cash rate by 0.25% to a rate of 3.35%

On the evening of the 3rd of February, the all-important US jobs data report – the so-called non-farm payrolls – was released. The market was expecting 185,000 new jobs to be created in January. The result of 517,000 came as a big surprise with the increase being quite broad based. The immediate impact of this obvious strength in US employment data make another interest rate increase at the Feds March meeting more likely now.

Inflation, as measured by the CPI, continues to be stubbornly high in the US but only when the ‘annual figure’ is analysed. For simplicity, we can think of the annual inflation rate to be the average of the last twelve monthly-rates.

Our analysis suggests the monthly rate for the US CPI was around 1.0% per month up until July 2022 and about 0.2% to 0.3% per month since. If this pattern continues, the annual figures will decline markedly from July 2023. Therefore, the annual figure declines slowly and will seem ‘stubborn’ because of the design of these poorly-conceived calculations. That slow decline will go on until the July 2023 data point by which time the high monthly inflation readings form June 2022 and before will no longer be in the annual data series.

Since it is widely thought that interest rate hikes do not affect the real economy immediately – many think that there is a 12 to 18-month lag – the Fed could be at risk of over tightening interest rates if it overly fixates on the annual inflation data as a key input to setting current interest rate policy.

Our quarterly inflation print was released in January for the December quarter. It was 1.9% (not annualised) for the quarter and 7.8% for the year. Interestingly, domestic travel and accommodation was up 13.3% on the year and 7.6% for the overseas equivalent. Pent-up demand from three years of limited opportunities to travel would seem to have been a culprit in vacationing demand and cost.

Another major critical factor in trying to plot the course for markets in 2023 is how the China re-opening will play out. There has been a surge in infections and some reports suggest in excess of 50% of the population has been infected. The government is clearly reluctant to close the country/economy again so its impact is more a case of how its healthcare system can deal with the problem.

China economic data before the re-opening were largely weak but there are some nascent signs of recovery. If the recovery continues, it will be particularly good news for Australia and its large resources sector.

Some of the recent pandemic-induced supply chain issues were due to issues in Taiwan causing a global semi-conductor chip shortage. As a result, President Biden launched an initiative to make the US more secure from future problems by building chip factories in the US.

Intel is now producing in the US but it is reported that its inventories are building up because of over-supply. Intel reported its December quarter company accounts in January and the market did not like them – slashing the share price on the announcement. It may be some time before all of these issues are worked through.

The International Monetary Fund (IMF) stated in January that it thinks one third of the global economy will go into recession in 2023. We re-iterate our view that the US and Europe look likely to go that way but we are cautiously optimistic that Australia may avoid that fate. Australia is well behind the US in raising rates and China seems to be coming back on stream quickly enough to assist the Australian economy as it did in the 2008/9 global recession.

Importantly, share markets do not have to follow the real economy. Indeed, many analysts, including us, believe that share markets often lead the real economy and it could well be that recessions in various regions have already been priced in.

Our analysis of Refinitiv earnings forecasts – a key benchmark data-source in finance – support the view that company fundamentals, in aggregate, are moderately strong but, share prices will experience volatility as various announcements – such as declarations of recessions or otherwise – are made.

Asset Classes

Australian Equities

The ASX 200 started the year with a very strong month rising 6.2% in January which was underpinned by growth in Materials (8.9%) on the China re-opening. Consumer Discretionary (9.8%) and Financials (5.6%) were also major contributors. The Utilities sector was the only one to go backwards ( 3.0%).

We have noted a modest but material improvement in relative earnings expectations from the Refinitiv survey of broker forecasts since the start of the year. These data can be a little volatile around the lead-in to our February reporting season, the so-called ‘confession season’, so caution should be exercised until a clear trend emerges.