Economic update – January 2022

• The Omicron variant displaces Delta – not as debilitating – but a lot more contagious
• Covid plus Supply chain disruptions keeping upward pressure on inflation
• Interest rate rises are getting closer in the US, forecasts for 3 rate rises in 2022
• Inflation is a problem but rate hikes won’t help contain it – yet

The Big Picture

It is hard to imagine anyone who was not affected to some extent by Covid-19 during 2021. Everybody was impacted to some degree be it working from home, social lockdowns, access to goods and services or more directly through contracting the virus which has significantly impacted health for many and sadly fatal for some.

This time last year there was a lot of optimism because we now had a vaccine (Pfizer) with distribution getting under way, while others were in late-stage development. Elsewhere the US Capitol building came under attack for extreme elements supportive of outgoing president Donald Trump.

2021 was not plain sailing with many developed countries having to go through lockdowns and other restrictions in efforts to control the spread of Covid. We started 2021 dealing with the Alpha variant of the virus but spent most of the year trying to ward off the more debilitating Delta variant to finish the year trying to manage the apparently less harmful but more contagious Omicron variant. Despite the very high vaccination rates particularly in the developed world, Covid remains very much alive and dominating the community and the economy.

In Australia, major cities went through exhausting lockdowns with consequent effects on the economy (growth was  1.9% in the September quarter) but people responded to the call to be fully vaccinated with gusto. We reached 90% fully-vaccinated on Christmas Day. We also then found out that fully vaccinated wasn’t as effective as hoped.

A UK study demonstrated that 15 weeks after the second injection, protection only amounted to 0% to 20% compared to the unvaccinated. We had been told that we needed to wait six months for a booster. That interval was cut to five, then four, then only three months from January 31st this year – all of these changes were announced in a few weeks!

The good news is that Omicron – at least as we know so far – has been less debilitating than Delta but it is many times more contagious. It would be foolish to take all the new preliminary research at face value but one recent study suggests Omicron infection might make one more resistant to Delta.

One doesn’t need much of a crystal ball to predict 2022 will bring more restrictions from time to time and other strains might rise to prominence. Scientists and medics are now much better prepared than they were last year. Facilities to make the newer vaccines, such as Pfizer, are to be built in Australia and reportedly scientists are working on how to make vaccines more effective for the newer strains.

Israel is contemplating a second booster (or fourth dose). More and more people are coming to the realisation that we may have to live with Covid for a very long time. But we live with the seasonal flu and annual flu shots now and there is reason to hope that the treatment for Covid will eventually become similar to these in time.

We are hopeful that any future Covid-related disruptions in 2022 will not cause a recession and, consequently, we do not anticipate a bear market directly resulting from Covid impacts on either the ASX 200 or on developed world equity markets. Our basis for this view is the very high vaccination rate; the availability of boosters; experience in dealing with Covid; and the possibility that Omicron is less debilitating than Delta and might even protect us from it!

To put things into perspective, the ASX 200 rose 13% over 2021. Over the same period, the S&P 500 rose 27%. Historical averages for each of these indexes are around 5%. Of course, dividend payments should be added to those capital gains figures. On the other hand, bond yields and cash did nothing but, in general, 2021 was an excellent year for investors if they had set their asset allocations appropriately for the conditions – and didn’t meddle with them!

For the year going forward, we think Australian and Developed World equity markets may achieve returns in line with their long run averages in the higher single digits. Despite the effects of Covid, equities continue to remain relatively attractive when compared to the yield on traditional fixed interest investments such as term deposits. This aspect continues to provide some support for equity prices.

The US Federal Reserve (the ‘Fed’) has started tapering its quantitative easing (‘QE’) programme by reducing the volume of its monthly bond purchases. It now plans to cease bond buying and end its QE by about March 2022. The Fed now expects to increase for Federal Funds rate (official rate) by 0.25% three times in 2022 taking the end-of-year official rate to 0.9%. Our Reserve Bank of Australia (‘RBA”) is continuing its QE programme for the moment – at least until February – but, at time of writing, it is not expected to raise our cash rate until at least 2023 and possibly 2024. In the US, the ‘neutral rate’ of interest is thought to be approximately 2.5%, so the actions of the Fed described above amount to a reduction in the level of economic support as opposed to a tightening of policy. Similarly in Australia, whilst monetary policy remains accommodative, the RBA has no plans to increase the support to the economy but nor is it planning on a reducing it either.

The main economic problem facing most policy makers is inflation. Much of monetary policy in recent years was designed to lift inflation back up to target rates (2% for the US and 2% – 3% for Australia). Australian inflation only just limped into the bottom of the target range in the latest quarterly release. We have no CPI inflation problem – at least not yet.

Jerome Powell, the US Fed chair, has said he has lived to regret using the word ‘transitory’ to describe the inflation situation in the US (and, indeed, Europe). The problem arose as 12 months post Covid becoming a pandemic, prices fell in response to much weaker demand as the world locked down which then formed a very low base for the measurement of inflation. However, as vaccination rates rose and lockdowns eased as the world began to ‘reopen’, demand for goods rose far quicker than suppliers were able to satisfy causing a supply/demand imbalance i.e. disruptions to supply chains. Consequently, prices rose as people bid up the price of goods leading to higher inflation. This is the circumstances that led to Powell calling inflation ‘transitory’ as he anticipated a stronger response from supplies easing inflationary pressures. However, ongoing localised Covid lockdowns have in part resulted in inflation remaining more persistent that initially anticipated.

The other important cause of inflation to emerge was fuel prices. Both oil and gas prices in certain parts of the world jumped for a number of reasons including inadequate stock-piling. Oil prices eventually fell towards the end of the 2021 but kicked up again in December.

However, the main culprit in the inflation story is the result of ‘supply-chain’ issues. In years gone by, the globalisation of economies led companies to locate the manufacture of certain basic components – like computer chips – in one place. By and large they chose the cheapest location in the world rather than diversifying their sources of supply, which, while lower risk, tends to come at a higher cost.

With manufacturing disruptions due to Covid, shock waves reverberated across the global economy. One of the major problems was with processor chips that have become a key component in somany goods – including cars. Since new cars couldn’t be manufactured at an appropriate rate, demand surged for used cars in the US. A major driver of inflation at 30 year or more highs in the US is the price of a used car! Another casualty of Covid is the price of air travel.

One thing seems certain. These supply-chain issues, which are driving inflation, will not go away by raising interest rates and, so far, there is no major increase in wages from the knock-on effect. In that sense we do not see any official interest rate increases in 2022 as being the start of something bigger. They are merely the start of the return to normality.

Perhaps a bigger worry for the Australian economy is China. China is struggling to assert itself in the world order as it would like. The huge import tariffs placed on China by Trump, and much derided by most at the time, have not been removed or even reduced by Biden.

China tried to disrupt trade with Australia as a punishment for our support for the US request for the World Health Organisation (WHO) to investigate the source of Covid. Over a year ago, it stopped accepting coal (and many other) imports from Australia, notably not iron ore. But the recent cold start to the Chinese winter caused them to take our coal exports out of bond! There is no doubt that the China economy has slowed in recent months. In normal times, China would just add stimulus but there is now an additional problem for them to address.

Evergrande, a massive property development company in China, got itself into debt problems in late 2021 and it has since defaulted by failing to make some coupon (interest) payments on its debts. China is afraid that stimulus at this time might cause too lax an attitude in the property sector and it is trying to walk a fine line balancing debt responsibility with growth for the rest of the economy.

While much was expected from a Biden government after the Trump years, hope has at least partially been dashed. A recent poll put Biden as the most unpopular US president on record in his first year except, of course, for Trump. The new catch cry of ‘Let’s go Brandon’ – a euphemism for a negative sentiment against Biden – has become rooted in modern American culture.

Biden did get a big infrastructure package through Congress but an even bigger package for more general economic and climate purposes keeps stalling. Law makers are rightly worried about adding yet more trillions of dollars to the national debt. With interest rates close to zero, debt is not currently a great issue. When rates start to climb, the debt pile could severely hamper future US growth as debt servicing costs will increase with interest rates. The Fed is unlikely to want to contribute to this problem and so will not raise rates without due caution.