Economic update – November 2021

Key Points

• Australian inflation above 2%
• US Federal Reserve set to act on inflation fears
• Chinese economy slows further

The Big Picture

As Sydney, Melbourne and other places start to emerge from very long lockdowns, a new set of economic woes confronts Australia.

There is much confusion over the implementation of the stages of recovery as state Premiers and the federal government square up for control. We’ve lost count of how many times Novak Djokovic’s possible exclusion from the Australian Open has changed. But there are far more important COVID issues to consider.

Governments had to end lockdown as the ‘populous were getting restless’ but the global situation has started to shift. The daily infection rate in the US peaked a month or two ago and then started to fall rather sharply. The current rate is now about half of the rate at that peak. The UK rate peaked in July but its recovery stalled and has arguably worsened in October.

The UK situation has concerned many and possible new lockdowns around Christmas are being discussed in their media. So why the big difference between the US and UK experiences? And what does it mean for Australia as we start to open our borders to international travel?

This question is particularly complex and possibly nobody has a really good understanding of what is going on. From a markets’ perspective, we need to form a view about the future of equity and bond investments at least in Australia and the US. At the moment we are positive about both equity markets providing we can get through the ‘inflation scare’ that has just started to build. But if either or both of these countries need to restrict practices – even including lockdowns – we need to factor in some market reaction.

There are, in our opinion, two major differences between the UK and the US that might account for the different infection rates. Vaccination rates are quite high in both countries. We see the prevalence of the ‘delta plus’ variant of COVID-19 and the vaccines used as potential explanatory factors.
Many point to the spread of delta plus in the UK as a primary cause for the persistence of their infection rates. However, that variant has been reported to be present in at least five US states as well as in 30 other countries. The first case in Australia was reported at the very end of October.

Health officials in the UK have suggested that delta plus spreads 17% faster than the plain delta variant but, it was noted, the data are not yet that reliable. If the UK experience is, indeed, mainly due to the spread of the newer strain then we can expect similar problems to start to emerge in the US, Australia and elsewhere.

Another important difference is the dependence or otherwise of the AstraZeneca (AZ) vaccine on infection rates. AZ is not approved in the US. They have mainly depended on Pfizer and Moderna which had much stronger clinical trial results than AZ. The UK, like Australia, had a high degree of dependence on AZ. Both countries adopted Pfizer for certain groups as supplies became more readily available.

Since the US was much quicker to reach strong vaccination rates than the UK, the possible ‘waning’ of the vaccine’s efficacy cannot be a material explanator. If AZ is not good enough to cope with either delta or delta plus then there are big implications for Australia’s future. We note that the US population is about 400% bigger than the UK but the infection rate for the US is only 50% higher. These are serious differences. However, death rates are more in line with the broader population comparison. That is, a smaller proportion of the infected in the UK die.

Whether delta plus or the choice of vaccine (or both) is a major factor in the UK being able to live with COVID, the implication for Australia is not as rosy as many had hoped for. While we do not see recessions arriving as a result, we have learnt a lot over the past 18 months so it will be easier to deal with any emerging problems. However, we do need to work on our coordination between the state and the federal governments.

We are also facing renewed economic pressures. The last week of October was pivotal in how the world views inflation; the first week of November might produce some unexpected policy responses.

The latest inflation read for Australia was 3% which is at the top of the target band used by the Reserve Bank of Australia (RBA) to monitor interest rate policy. The RBA prefers to focus on the so-called ‘trimmed mean’ that removes outliers and volatile elements like energy costs. Given that fuel prices surged 7.1% in the last quarter, there is a lot of merit in focusing on the trimmed mean.

That ‘trimmed’ measure was expected to come in at 1.8% or just below the 2% to 3% target band. The actual number was 2.1%. While 2.1% is at the very bottom of the range and ordinarily would require no reaction, it is the highest value of the trimmed mean since 2015! Markets started to react with very large bond sell-offs so yields started to rise.

The RBA has been engaging in a modest Quantitative Easing (QE) policy that is used to purchase government bonds to help to keep yields low at medium-term tenors of around two to three years duration. The RBA aimed to keep the three-year yield down to around 0.1% with its QE. It lost control after the latest inflation data release and then it capitulated. The three-year yield rocketed up to 1.25% and the ten-year to 2.09%. The US ten-year yield was stable at around 1.55% and had been comfortably above the Australian yield for some time.

This increased yield may well start a round of home loan rate increases. In the meantime, the RBA has to make its monthly board meetings on the first Tuesday of each month (except January) and announce the results of its deliberations. The market has got the RBA on the ropes. The pressure must be enormous.

The RBA recently repeated its aim was to keep the official overnight interest rate on hold (at 0.1%) until at least 2024. The reason to raise rates would supposedly be to control inflation. But an interest rate hike would do nothing to control energy prices or supply-chain disconnects that are at present plaguing the world.

We think the RBA should stay ‘on hold’ as planned, but a statement that placates the market would help. Given that the first meeting after this bond reaction is on Melbourne Cup Day, there is some chance the message might get lost in the festivities – but not a lot.

We are far from alone in this inflation-rate-hike conundrum. The US also released its inflation number in the last week of October. At 4.4%, it was the highest number in thirty years. The preferred ‘core inflation’ read that strips out energy and food prices, etc was a more modest 3.6% which was the same read as in August but still the highest since 1991.

The US Federal Reserve (the “Fed”) has its next meeting also scheduled for the first week of November. The market has now priced in a 95% chance of at least one rate hike in 2022 and more likely two or three hikes. The Fed was expected to announce the start of tapering (of QE) at that meeting and for tapering to be complete by mid-2022. The Fed chair, Jerome Powell, was forceful in his pronouncement that tapering should end before interest rate hikes are considered. He, too, is now on the ropes. The previously planned 2023 start to the next cycle in rate hikes looks increasingly unlikely.