Economic Update July 2024 – Infocus Advisory

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

Key points:
– Four major developed world central banks have already cut interest rates
– The US Federal Reserve and the Bank of England have all but flagged they are ready to start
– Australia’s RBA will be late to the party as inflation data fails to respond to high interest rates

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 the team.

The Big Picture

Many central banks are now claiming at least a partial victory over controlling inflation, but it is far from clear by how much inflation would have fallen without rate hikes. Just through the rolling back supply chain blockages caused by the Covid lockdowns; and the war in the Ukraine not continuing to escalate; and oil prices coming back to more reasonable levels – inflation would likely have fallen – the question is by how much?

Indeed, it is apparent that the interest rate increases may have actually caused inflation in some of the Consumer Price Index (CPI) components, in particular shelter costs such as home rentals. That component makes up about 33% of the US CPI and 7% of the Australian CPI.

Inflation in rents and a few services like energy costs and insurance, are not going to come back to more reasonable levels because of interest rates being higher for longer.

The trouble with economics is that it is not possible to do controlled scientific experiments – as is the case for clinical trials of drugs – to determine what our monetary and government spending policies are doing to the economy. Rather, we must rely on ‘rational arguments’ based on economic theories and past experience.

Nevertheless, there is light at the end of the tunnel. Central banks are starting to cut rates and some economies are bouncing back – if only by a little.

The Swiss National Bank (SNB) started the ball rolling with an interest rate cut of 0.25% on 22nd March this year to a rate of 1.5% p.a. followed by another cut to 1.25% p.a. in June.

The Swedish Riskbank (SR) was the second major central bank to cut its interest rate – on 8th May by 25 bps to 3.75% p.a.

Then, in quick succession, the Bank of Canada (BoC) and the European Central Bank (ECB) each cut rates by 25 bps in the first week of June – to 4.75% p.a. and 3.75% p.a., respectively.

The Bank of England (BoE) came to a different conclusion in June. Inflation fell from 2.3% to 2.0% but they kept their interest rate on hold. However, the UK had a General Election on July 4th so the BoE might have not wanted to get involved in politics. It has all but said it will cut its interest rate at its next meeting in August. Interestingly UK retail sales volumes grew at 2.9% p.a. for the year to 30 June, a rate well ahead of the expected 1.5% p.a.

The US Federal Reserve (Fed) took yet a different approach. It too kept rates on hold but Fed Chair Powell spoke at length about the measurement of shelter inflation problems. Two stories on the news wires amplified that view and one of those even mentioned the possible perverse effect that high rates were having on rents.

Powell made it clear that their shelter inflation measurement is a problem and that other methods exist. Indeed, other methods are used by other national statistical agencies. But Powell said he wasn’t going to change what they do (yet?).

Regular readers might recall that we have been running this rent argument for some months. If Powell has only just caught on, he might need a month or two to digest the problem and investigate alternatives. The official US CPI data, less shelter inflation, is below the 2.0% p.a. inflation target, clearly a data point the Fed is aware of.

The market is betting on a Fed rate cut in November and another in December. Another market indicator is pointing to a possible third cut which would see the Fed start to cut interest rates before its November meeting.

That brings us to the Reserve Bank of Australia (RBA) and its June board meeting. They also kept rates on hold saying that decision was based on the ‘stickiness of inflation’. They said they didn’t even consider a cut at the meeting and they wheeled out the old, ‘We can’t rule anything in or out mantra’. This, in our view, was problematic in terms of meaningful guidance.

More importantly Governor Bullock talked about trying to avoid a recession. While it is true that the simplistic definition of a recession is for two consecutive quarters of negative growth in GDP, most professional economists dig deeper into the data before they are prepared to confirm an economic recession.

We believe that Australia has been in a ‘per capita’ recession for nearly 18 months noting negative per capita growth in GDP and negative absolute growth in retail sales volumes (i.e. sales adjusted for inflation). However, the significant population growth due to massive immigration flows has, at the national level, resulted in GDP increasing modestly (the number of households has gone up in percentage terms more than GDP per household has fallen).

Some say the jobs data for Australia are strong. We note full-time jobs grew by only 1.0% over the last twelve months – far below even normal population growth rates. Part-time employment grew by 6.2% over the same period. Since a large proportion of the immigration flow has been comprised of overseas students, it seems reasonable to consider the massive growth in part-time employment is due to foreign students taking part-time employment to supplement their living costs.

We believe that the per capita data is more representative of the economic experience of actual households and as a consequence of the RBA not responding with cuts to interest rates, the risk of Australia entering a more severe recession continues to grow.

Also, because of the well-known lags in monetary policy taking effect, an interest rate cut now would not stop the pipeline of past high interest rates continuing to slow our economy down for some time to come. Hence our concern in relation to the RBA inaction with its monetary policy.

There are nascent signs of broker forecasts of company earnings in Australia slowing down a fraction – but not enough to indicate an imminent downturn. Indeed, we expect average capital gains in FY25.

The US economy is riding high on the AI boom. Nvidia briefly overtook Microsoft in being the biggest listed company on the New York Stock Exchange (NYSE).

Government Bond yields have been reasonably stable for some months with 10-year yields on Australian and US government bonds being above 4.3%. This stability is indicative of a level of indecision on the part of investors identifying that they accept that the interest rate tightening cycle is likely finished but they are not yet prepared to commit capital to a recession and falling interest rate scenario.

China’s economy is also showing renewed signs of life. If it does manage to engineer a revival, it could mean a strong revival in the Australia resource sector and, indeed, various agricultural commodities as the 2022 restrictions on trade have now been relaxed. Only lobsters are still on that restricted list.

The year to 30 June was a very good one for global equities – by and large – and the dip we had into October 2023 was short-lived. Despite some concerns, momentum in equities generally remains positive for the coming months and equity markets are factoring in lower interest rates without economies falling into deep recessions – and in some cases no recession at all.

But there are some key unknowns for the year ahead. Who will win the US election and how will they shape geopolitics and the economic environment? What will happen in the Ukraine in particular, if Donald Trump is elected president?

The Israel-Gaza issue has polarised global views. We do not recall such vocal opposition to Israel’s actions in the past. What are the implications of this and for the region generally?

China continues to pursue its territorial expansion in the South China Sea and in relation to Taiwan how does this play out? And what of the events that are yet to be revealed, will they be positive or negative?

Without evidence to the contrary, we remain cautiously optimistic.

Asset Classes

Australian Equities

The ASX 200 made strong gains (7.8%) over the year to 30 June despite its October setback. The index was up 0.9% over June.

The index didn’t have a big driver in the year just ended like the rise and rise of Artificial Intelligence (AI) in the US or resources in Australia during China’s growth boom.

Our analysis of LSEG broker-forecasts of companies listed in the ASX 200 indicates a possible average year ahead.

International Equities

In the US the S&P 500 gained 22.7% over the year to 30 June on the back of a small number of stocks from the so-called ‘magnificent seven’ predominantly exposed to the AI theme.

While we do not see the AI boom as a bubble, there is no doubt that market expectations can run well ahead of a company’s ability to deliver on such lofty expectations which ultimately leads to a correction. While this can be a painful experience it is how markets work. In our view this boom is so different from the dotcom bubble experienced in the early 2000’s. The latter was largely based on hype and hope. AI is already producing goods and services across a wide range of industries and as such we believe will persist.

It is impossible to say whether AI will play as big a role as the industrial revolution or ‘the invention of the wheel’. At the start of the industrial revolution in the North of England, threatened hand-loom workers (the Luddites) smashed up the new mechanical looms for fear of losing their jobs. Did anyone then predict trains, motor vehicles, planes, computers and space travel would soon be invented while looms were being smashed? We doubt it. But also, we don’t need such a far-reaching vision as we have a wealth of history which has shown that innovation, disruption and change are the norm not the exception. To not participate in this momentum play could bode badly for those who ignore it.

June was mixed for of the other major indexes we follow. Over the year to 30 June all major share indexes, except for the Shanghai Composite, did reasonably well.

Bonds and Interest Rates

Except for Australia, all the major central banks have cut, or are poised to cut, their prime interest rates. The Fed was on hold at a range 5.25% to 5.5%. The dot plot chart displays the forecasts of the 19-member interest rate setting Federal Open Markets Committee. At the end of June, the dot plots median interest rate is for only one rate cut of 25 bps by December. However, if only one member had nominated two rather than one rate cut, the median would have been for two rate cuts. We do not expect the Fed to be overly concerned by the US election later in the year but we are mindful they do not want to be seen to be supporting either side.

With respect to Australia, there is little guidance being provided by the RBA and while we do not anticipate another interest rate increase in Australia, we do not expect that Governor Bullock will cut interest rates ahead of the US Fed. At this point we do not anticipate an interest rate cut here until 2025.

Other Assets

Iron ore prices ranged over $100 to $143 during the year to 30 June. It settled at US$105 per tonne down just under 9% for the month of June.

Brent oil prices also experienced a wide range over year to 30 June – from US$73 to US$97 per barrel – with the year closing out at US$86 per barrel.

Copper prices ranged $7,824 to $10,801 during year to 30 June closing the year at US$9,456.

Gold prices ranged from $1,818 to $2,432 in the year to 30 June closing the year at US$2,326.

The Australian dollar against the US dollar traded between US62.78 cents and US68.89 cents. It finished year to 30 June 24 at very near the same level as it did in June 2023.

Regional Review

Australia

Employment rose by 39,700 and all of that, and more, was from full-time job creation; part-time jobs were lost. The unemployment rate fell a notch from 4.1% to 4.0% in May.

What we find disturbing is that a longer-term view (over 12 months) shows that full-time employment rose by only 1% when long term population growth was more like 1.6%. Total employment rose by 2.5% which is broadly in line with recent population growth (including immigration) but part-time employment rose by 6.2%.

The massive influx of foreign students perhaps got some part-time work to supplement their cost of living. All good in the Australian spirit but it hinders people analysing the true strength of the jobs market. Jobs growth for the longer-term residents is quite weak.

Our quarterly GDP report was weak. Our economy grew by only 0.1% (and -0.4% after allowing for population growth) over the quarter or 1.1% over the year (-1.3% in per capita terms).

Our household savings ratio fell to a worrying low of 0.9% from an historical average of 5% to 6%. Since this ratio includes superannuation guarantee levies, it is particularly low. Australians are suffering in economic terms. They are not dis-saving but neither are they able to build for their futures.

Fair Work Australia awarded minimum wage and award wage workers a 3.75% pay rise. Since (nominal) wages are lagging well behind cumulative price indexes movements, this increase is not inflationary and, indeed, more is needed to redress the losses most experienced during the pandemic.

Australian CPI inflation was a little higher than the RBA felt comfortable with and flirted with an interest rate increase. Our analysis shows that the main drivers – housing (inc. electricity at home), food, transport (inc. auto fuel), and alcohol & tobacco are largely unaffected by interest rate changes, with the possible exception of food.

The food inflation component has halved in its contribution to headline CPI over the past 12 months. Inflation of so-called tradables (goods and services that are or could be traded overseas) has been below 2% for nearly 12 months.

Since the RBA is charged with the dual mandate of full employment and stable prices, we think it has done more than enough on prices and the true employment picture has been disguised by the big immigration flow.

It is almost too late for a single interest rate cut to save the economy from having a more serious recession, particularly as the backlog of the impact of past interest rate increases has not had time to work through to the real economy.

China

China’s exports rose 7.6% against an expected 6%. However, imports rose only 1.8% against an expected 4.2%.

In the previous month, exports and imports reversed their roles: imports were strong and exports were weak. The manufacturing Purchasing Managers Index (PMI), a measure of manufacturers expectations, was weak.

US jobs were again strong with a gain of 272,000 jobs against an expected 190,000. The unemployment rate was 4.0% and average hourly earnings only grew by 0.4% for the month or 4.1% for the year. No inflationary pressure from there!

The private jobs survey (from ADP) was less flattering and the number of job openings per unemployed person has fallen from 2:1 recently to 1.2:1 this month. The US also has an immigration problem. We conclude that the US jobs market is less strong than the headline ‘nonfarm payrolls’ data suggest.

US inflation, because of the shelter component, does not look that good. But (official) US CPI-less-shelter inflation stands at 2.1! Producer Price Inflation (PPI), inflation for inputs, was negative for the month (at -0.2%). Rents are the only material problem and high interest rates are unlikely to curb that source of inflation in the broader index. Indeed, high interest rates may exacerbate investors willingness to build more supply.

At the end of June, the Fed’s preferred Personal consumption Expenditure (PCE) inflation came in at 0% for the month and 2.6% for the year. The core variant that strips out volatile fuel and food rose 0.1% for the month and 2.6% for the year. We think that this will encourage the Fed into making at least two cuts, but probably after the November 5th election.

The University of Michigan Consumer Sentiment Index fell again to levels well below normal – but not (yet) at historic lows. US retail sales adjusted for inflation rose 0.1% for the month but -0.9% for the year.

The month closed out with the first presidential election debate. Biden performed so poorly that the Democratic Party is reportedly searching for an alternative candidate for the November 5th election. Trump seemed far more composed and assured but many disagree with his policies.

Europe

The UK economy sprang back to life with a +2.9% increase sales volume for May against an expected 1.5%. Inflation fell to 2.0% from 2.3%.

The 14-year-old Conservative government lost the July 4th election to Labour in a landslide.

Rest of the World

While the big players are questioning first and second decimal points on inflation figures, Turkey just posted a 75% read for inflation to May (up from 69.8%) but only 3.3% for the month!

The Turkey central Bank was on hold at an interest rate of 50% while Mexico was on hold at 11%!

Canada GDP grew by 1.7% and it cut its interest rate!

Japan exports grew by 13.5% against a prior month of 8.3% in April.

We acknowledge the significant contribution of Dr Ron Bewley and Woodhall Investment Research Pty Ltd in the preparation of this report.