– US Fed maintains hawkish stance increasing interest rates by 0.75% again.
– Volatility persisted and, in some instances, increased for equities, bonds and currency.
– Economic data remained mixed but the prospect of a recession rose over the month.
The Big Picture
The fledgling bounces off the June lows into mid-August reversed to give all of the gains back. The ASX200 and the S&P500 both more or less touched the June lows in late September after an impressive mid-period rally.
The biggest relevant change for markets over the past couple of months has been the United States (US) Federal Reserve’s (“Fed”) stance on monetary policy.
In mid-September, the US core Consumer Price Index (CPI) inflation (that strips out volatile items like energy and food) actually rose from 5.9% the previous month to 6.3% for August. Wall Street fell 4% over the session following this data release.
There were a number of relatively good US inflation prints in September, but the media and investors focused on the worst. It is true that the monthly wholesale price inflation was 0.1% and monthly headline CPI inflation was only 0.1% but these two prints did not receive the attention that they deserved.
What is possibly happening is that energy and food prices are falling but the indirect effect of these items on inputs to other goods and services is following through with a lag.
Nevertheless, Fed chair, Jerome Powell, is beating his drum even louder about doing whatever it takes to rid the US of this “scourge” called inflation.
He openly admits there will be ‘pain’; to the tune of the unemployment rate rising from a recent low of 3.5% to 4.4%. That rise translates to about one million people losing their jobs. A Yahoo Finance columnist pointed out that deliberately inflicting pain is called ‘cruelty’.
So, what should be the trade-off between jobs and inflation? The latest annual core Personal Consumption Expenditure (PCE) inflation figure—the Fed’s preferred measure—was only 4.5%. Does bringing that rate down from 4.5% to 2% (if, indeed, that can be achieved from the high interest rate policy) justify the loss of a significant number of jobs as the economy slows, and possibly enters recession?
Many analysts, including ourselves, are becoming increasing convinced that a US recession in 2023 or 2024 is almost inevitable. A recent Bloomberg survey put the odds for a US recession at 50% and those for the United Kingdom (UK) at 60% while Australia only attracted a 25% chance. Some big names in finance are now making stands about an imminent US recession.
Our official interest rate is still at a modest 2.35% following the 0.5% increase at the start of September. Retail sales grew by just 0.6% in the latest month (August) following 1.3% in the previous month. Our latest Gross Domestic Product (GDP) figure for the June quarter was 3.6% for the year. These data are not at levels that indicate immanent recession.
While we do not seem to be at risk of recession in the near term, caveat being the Reserve Bank of Australia (RBA) does not implement a major policy mistake. So far, the RBA governor, Dr Philip Lowe, looks far more in tune with the realities of current policy than Jerome Powell, his Fed counterpart. In Australia, there is even a groundswell of opinion supporting the view that Lowe could pause the current rate hiking programme. Prior to the RBA policy announcement on Tuesday 4 October to increase the RBA Cash rate by 0.25% instead of the anticipated 0.50%, So it is clear Dr Lowe taking a softer line on interest rates which surprised the market somewhat. However, in his brief commentary that accompanied the decision he noted that further rises are likely if inflation is to be returned to the 2% to 3% band.
There are still significant supply-side issues affecting inflation courtesy of the Covid lockdowns. Besides the supply-chain problem, caused to a significant extent by China’s zero covid policy, the situation is further exacerbated by US dock unions who are into their fourth month of industrial unrest at major west coast ports.
Despite these impediments, supply side issues are dissipating slowly, food prices seem to be better contained than earlier in the year. But the Russian invasion of the Ukraine continues to impact on energy supply volatility and, hence, prices. Notwithstanding oil prices have retreated to levels below those prior to the start of the war, and Organisation of the Petroleum Exporting Countries (OPEC) is meeting to discuss production cuts.
Russia cut off much of its energy supply to Europe until, reportedly, sanctions on Russia are removed. At the end of September there were significant leaks from the gas pipelines under the Baltic Sea which some are claiming could be the result of sabotage. Perhaps the more significant invasion issue is Russian troops being forced out of parts of the Ukraine as the now better armed Ukraine army reclaims recently relinquished territory, China’s Premier Xi met with Putin in Uzbekistan and, apparently was less than sympathetic with Putin’s stance regarding Ukraine.
Nevertheless, Putin has ordered a ‘partial mobilisation’ (read mini conscription) of 300,000 new troops to add to the original 150,000 sent at the start of the invasion. There are reportedly of the order of 70,000 – 80,000 Russian casualties so far from the initial 150,000 deployed.
Two new big problems have emerged for Putin. Many of the original soldiers that joined on short-term contracts have now been made ‘indefinite’ in the partial mobilisation bill. Many new conscripts are poorly trained and some are reportedly people who were arrested for opposing the invasion. These factors do not make for a cohesive fighting force. Putin might find it very difficult to maintain his offensive, particularly as winter approaches.
If it were not for the ability of Russia to affect a nuclear weapons response, it would seem that the invasion of the Ukraine may lose its potency. No one seems to know if Putin can, or really wants to, resort to the nuclear option, albeit a limited one.
At the end of September, Putin declared that four regions of the Ukraine had voted in referenda to be annexed to Russia. He signed a treaty confirming the new status.
There is widespread condemnation that these referenda were rigged. Regardless of this Putin might now claim he is defending Russian soil in these ‘previously’ Ukrainian regions. That could drastically alter the positions of the West on the one hand and Russia on the other. There is as yet no clear opinion about how this latest move will play out.
China economic data showed some resilience in September but Europe is not faring well. The Bank of England (BoE) had largely lost control of its monetary policy with the pound sterling in all but free-fall. The BoE has pushed its official rate up to 2.25% which is the highest since 2008 and inflation is running at 9.9%, albeit down from 10.1% the month before. UK retail sales came in at 1.6% for the month with 0.5% having been expected.
The UK government is trying to find many solutions for the economic malaise including unfunded tax cuts for higher income brackets though it appears these have been rescinded. There are caps and subsidies being applied to help make energy costs more palatable as heating bills start to mount. There is widespread condemnation of the new UK parliament’s policies.
Indeed, the BoE on September 29th was forced into averting a crisis by buying over one billion pounds of long dated (20 – 30 yr) bonds and promising to buy around five billion a day until the middle of October. It is being forced to do this because of the profligate government policies now being labelled as ‘Trussonomics’ after the newly sworn-in prime minister, Liz Truss.
Of course, the BoE, along with the Fed, RBA and most other central banks was trying to do the opposite of bond buying (or quantitative easing, QE). The upshot of the new BoE action is likely to be even higher inflation for even longer.
Wall Street and the ASX 200 did start an impressive 2% bounce back near the end of September but that was cancelled out, and more, over the following days. We do not think this is the start of a solid rally. It is more likely that inflation and central bank news over the next couple of months would have to be very positive for a sustained rally to get going at this juncture. Rather we see some choppy trading for a couple of months or more and then, if the Russian invasion impact dissipates and supply-side factors come back into line, a share market rally could well start before the end of this year or early into next However, the situation remains very fluid.
As always, we don’t advocate investors trying to time the market. We saw a big rally from mid-June until mid-August get reversed. That could happen again. Long-term asset allocations that evolve with conditions are preferred to possible trading solutions.
With Australian 10-year government bonds yielding around 4% near the end of September, equities are less compelling. However, ASX 200 equity yields have been reasonably stable at over 4% in addition to franking credits for many investors. There is not yet any evidence from Refinitiv’s survey data on company earnings in the US and Australia for us to move away from our current asset allocations in any meaningful way.
The ASX 200 had an abysmal month falling by around 7%. The sell-off was largely across the board. As a result, we have the index as currently being cheap but cheap markets can fall before they rise! We believe that far more certainty over inflation and the Ukraine invasion may be needed for a sustained rally to take hold.
Our analysis of the Refinitiv survey of company earnings forecasts suggests that fundamentals are still improving albeit at a slower pace than the historical average.
Major indexes sold off by around 5% to 10% over September. Many have put the sell-off down to the stubbornness of inflation in the face of interest rate hikes and a consequent heightened risk of a global recession.
We see some glimmers of hope on the inflation front but not by enough to feel confident of an early resolution to the volatility in equity markets. Our most optimistic expectation is for stronger signs of falling inflation by Christmas and a realisation by central banks that further rate hikes would most likely cause an unnecessary recession. If such a scenario came to pass, a hard landing might be avoided with equity markets then rising to erode what we see as a material degree of under-pricing.
Our analysis of the Refinitiv survey of US company earnings remains optimistic with expectations of above average capital gains in the coming 12 months. Such an outcome seems inconsistent with the expectation of an impending recession. The brokers who supply the forecasts to Refinitiv might actually not believe in the elevated odds of a recession occurring soon or they may believe any recession might be pushed back to 2024. It all depends upon the lags between monetary policy and the real economy.
Back in the seventies when a similar high interest rate policy was unsuccessfully used to control the fall-out from the OPEC oil price shocks, economists generally agreed that monetary policy took between 12–18 months to take effect. Some obviously believe the lags are now much shorter but there is no clear evidence for that. Since US rates have only just moved into contractionary territory, the 12–18 months hypothesis would lead one to speculate that a recession, if it occurs, will not take full effect until 2024.
Bonds and Interest Rates
There has been elevated volatility in bond markets around the globe mainly because of the almost co-ordinated aggression by central banks about trying to use interest rate hikes to control inflation.
The yield curve in the US is flat to inverted over much of the curve. The Fed yet again hiked rates by 0.75% to a range of 3% to 3.25% in September. Many economists would agree that the current Fed funds rate is firmly in contractionary territory.
The CME Group is an American global markets company; its Fedwatch tool that prices future Fed rate hikes is giving almost equal weight to a 0.5% and a 0.75% hike on November 2nd at the next meeting.
The RBA raised rates by 0.5% to 2.35% which is probably just under the neutral rate and, therefore, not yet contractionary. Nevertheless, the 10-year yield rose above 4% towards the end of the month. The differential between the Australian and US 10-year yields is still positive but much reduced compared to earlier in the year. There is a growing sentiment that the RBA is lessening its resolve to continue hiking and may well pause soon. Since much of inflation is sourced from overseas supply problems, such a move by the RBA, if it occurs, might prove to be an excellent decision.
The BoE seemingly just averted a currency crisis on September 29th by starting to purchase its own long bonds again. Earlier in the month it had increased its official rate by 0.5% to 2.25%—its highest rate since 2008; and it seemed on a path to do more. After the recent intervention, it is less clear what its next move will be.
The European Central Bank (ECB) at last hiked its rate above zero in a 0.75% increase to 0.75%. Japan is still on hold (at 0.1%) but its inflation is well-contained at 2.8%. Japan largely went against raising rates in the seventies and eighties with the result that its economic growth did not stall as it did in much of the rest of the developed world.
The US dollar has gone from strength to strength against many currencies. The Chinese yuan fell to a fourteen-year low and the pound sterling fell to an all-time low against the US dollar. The Australian dollar has lost about 10% during the current year-to-date of which 6% was in this last month. Much of this currency weakness is due the increasing yield on long dated US treasuries compared to those of other nations. In turn, the higher US yield is due to Fed action and the strength of US price inflation.
Many commodity prices fell in September. Oil prices are down around 10%. Copper, iron ore and gold prices are down around 1% to 3%.
Last month, we reported a sharp fall in Australian employment but pointed out that it could just have been a statistical blip. This month (for August) 33,500 new jobs were created more or less cancelling out the 40,900 jobs lost in July. The unemployment rate rose to 3.5% from 3.4%.
The GDP economic growth rate for the June quarter was released last month. It came in at an impressive +0.9% for the quarter or +3.6% for the year. As we have been arguing since 2020, some of the growth is coming from households running down their savings plan made in the early part of the pandemic.
The household savings ratio has fallen from a peak of 23.7% in the June 2020 quarter to 8.7% two years later. Since this ratio was tracking between 4% and 8% in the years before the pandemic, we do not think there is much more to be gained from a falling savings ratio in quarters to come.
Retail sales again performed strongly in the latest month delivering a growth of +0.6% following the previous month’s +1.3%. Of course, these two months come from the September quarter. There is a substantial lag in computing and publishing GDP accounts.
While a recession is always possible in any country almost at any time, we do not think the recent economic data and the RBA action are consistent with an imminent recession here. Naturally, if the US and Europe head towards recession, and if China does not pick up some more speed in its economy, a global slowdown would impact an otherwise and currently healthier Australian economy.
An experimental monthly inflation series was launched by the Australian Bureau of Statistics in September. It has a much smaller coverage than the preferred quarterly series which will continue to be published. We have chosen to wait a few months before we take the new data series fully into account so that we will have a reasonable history on which to base our analysis.
The China data on retail sales, industrial production and fixed asset investment that are published each month all beat expectations. Retail sales at 5.4% was impressive in absolute terms and against its benchmark expectations of 3.5%. Industrial production at 4.2% beat its expected value of 3.8% and fixed asset investment at 5.8% beat the expected 5.5%.
China’s official PMI (Purchasing Managers’ Index) came in at 50.1 just above the 50 mark that divides expansion from contraction. The previous month’s value was 49.4 and the expected value for the latest month was also for a contractionary reading.
On October 16th the China Communist Party is expected to re-elect President Xi for an historic third term. Whether such a result leads to further economic stimulus is yet to be seen. However, it is reasonable to expect some major policy initiatives. Of course, the West would not want that to include any move on Taiwan. However, Xi draw on his observation of the experience Russian President Putin has had with his attempt to annex Ukraine in forming his approach to the reunification of Taiwan.
Yet again, the US posted a really big nonfarm payrolls number. In August, 315,000 new jobs were created, though the unemployment rate rose from 3.5% to 3.7%. Wage inflation came in at 5.2% which is comfortably below the inflation rate meaning that spending power in general continues to go backwards.
Powell, in his desperate attempt to control inflation, sees not only the unemployment rate jump up to 4.4% from the recent low of 3.4% but GDP growth falling to 0.2% for 2022 from his forecast made only three months ago of 1.7%. The Fed sees growth rising to 1.8% for 2023. This 2022 forecast is an open admission that his monetary policy tightening is increasing the risk of a recession.
Biden’s push for student debt forgiveness has just been priced at $400 bn. And that is for $10,000 of forgiveness for people under an annual income of $125,000 (in most cases). Largesse does not come cheaply. We hope this does not start to lean towards engaging in ‘Trussonomics’ in the US as it has in the UK.
Retail sales, which are not adjusted for inflation, only came in at 0.3% for the month of August which does not stack up well against the CPI inflation rate of 6.3% for the year.
Perhaps the severity of the fighting in the Ukraine is far from its peak but the consequences for energy and food supply are not seemingly much diminished. Putin’s objectives were never well articulated but whatever they were, the direction of his policies seem to be shifting.
There are now reportedly four breaches of the under-sea gas pipelines from Russia to Europe. Not only is this a major loss of resources but it is also a major obstacle for shipping in the Baltic. Russia is denying any involvement but sabotage by seems more likely than a naturally occurring fault.
Rest of the World
Japan inflation came in at 2.8% which is the highest level since 2014. Of course, Japan has not been playing the interest-rate-hiking game and yet most central bankers would die for such a low rate of inflation at the moment – particularly with its official interest rate still being negative!
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