Economic Update August 2024
In this month’s update, we provide a snapshot of economic occurrences both nationally and from around the globe.
Key points:
– Has the US and Australia finally reached a turning point in their interest rate cycles?
– Despite conjecture we think the RBA is done
– The US Federal Reserve has clearly changed its rates position but no cuts until September
– Stock markets finish July with a rally
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
So much new macro and company-specific data are released each month, it would be easy to lose sight of the big picture. Many analysts and commentators react on the same day as a data release; and another day’s data arrives before they can properly digest the previous set of numbers.
It is no wonder, therefore, that different analysts and commentators reach different conclusions from the same data. We think it is not possible to provide a balanced view without a very strong background in at least statistics, economics and finance. And then it still takes time to mull over the big issues.
This monthly is our attempt to take a step back and take stock of, not just of this month’s data and central bank comments, but also have a deeper reflection of previous months of such inputs.
And research, as opposed to commentary, often requires new methods and techniques to be developed to challenge the orthodoxy. Just because someone says raising interest rate quells inflation doesn’t mean that statement should be adopted without challenge. And often, qualifiers are needed to express fully how ‘things work’.
Our monthly investment committee is one forum we use to challenge current popular views. This month, we had a particularly lively interaction. This economic update benefits from the result of that interchange.
There is no doubt that the US Federal Reserve (Fed) chair, Jerome Powell, has modified his view on what monetary policy action is currently appropriate. And others from that institution have also recently changed tack.
In last month’s update we reported that Powell had at last acknowledged that there are serious problems in the way the US data agency calculates the rate of inflation in shelter (specifically rent). This component takes up about one third of the index so it is important to get it right. But Powell said he isn’t currently interested in changing his metrics. But he must now consider that the number he has been fed might be misleading! The official inflation rate prints are severely biased upwards and Powell acknowledged that similar agencies in other countries do a better job.
Next, Powell acknowledged the so-called “Sahm rule”, named after a former Fed economist, Dr Claudia Sahm, which is used to call an impending recession. The rule came close to triggering such a call at the start of July.
The rule is a simple. It measures the increase in unemployment over a year in a particular manner. The media has also picked on this rule and we all await a recession signal (and a recession?) following the August 2nd jobs data.
This indicator was not conceived until 2019 and it didn’t attract any significant attention until December last year. Sahm’s claim is that a recession followed every time the signal called one. While that analysis appears to be correct, it is only based on correlations and not causation – and it has not been tested on a new recession [what we call out-of-sample-testing in econometrics]. The 2022 splutter in the global economy was not a recession in the usual sense as it was caused by lock-downs in the face of the pandemic.
Interestingly, two members of our investment committee independently came up with a similar set of criticisms of the Sahm rule. One of the fundamental problems is that the nature of work has changed since the pandemic arrived. People now often work from home – or in hybrid form – and the proliferation of travel and delivery options from the likes of Uber means that it is so much easier to get part-time work now – even if it is only a temporary solution to pay bills and put food on the table. During the post-Federal Open Markets Committee (FOMC) media conference, at the end of July, Bloomberg reported that Sahm is aware of this issue.
We have no evidence that the Sahm rule will work this time if, indeed, it is triggered. But we agree we would be foolish to ignore it. The media thrives on simple rules, whether they make economic sense or not. If the market reacts to a signal that doesn’t have a strong academic pedigree, others still need to be aware of it. We only have to think back a few years to the false-positive from the inverted yield curve to amplify this point.
If the US unemployment rate goes up one 0.1% point to 4.2% (and there are no revisions to past data) on August 2nd (or later) many people will expect an impending recession (in 6 – 24 months) in the US – and that group looks like including current Fed chair Jerome Powell. We will watch from the side-lines not sure whether the rule needs some tweaking for the new economy. If it is triggered that will force Powell to bring it into his thinking.
Indeed, at his last appearance in Congress, he stressed that the Fed has a dual mandate of maximum employment and stable prices. We don’t recall the last time he stressed that by so much.
And, to complete the warning signals, Powell reiterated that there are long and variable lags between monetary policy changes and their effect on the real economy.
Importantly, William Dudley, a former Governor of the New York Federal Reserve, has flipped a 180 degree turn on policy. He had been one of the prominent ‘higher for longer’ advocates. Towards the end of July, he suddenly said that rates should be cut as soon as possible. There was an FOMC rates meeting on the last day of July. Almost everyone thought that was too soon. September looms large. Powell even said that if things go well, “a cut is on the table” for that meeting.
The probability of a US interest rate cut in September has risen to 87.5% for one cut and 100% for two cuts – as measured by the well-respected CME Fedwatch tool. There is over a 70% chance of two or more cuts by November 7th and a 75% chance of three or four cuts by December 18th.
We think a rate cut would have been good but we didn’t expect one. September 18th is the date of the next FOMC meeting. Importantly, the annual central bank conference at Jackson Hole, Wyoming, is scheduled for August 22nd – 24th. This year’s agenda is titled “Reassessing the Effectiveness and Transmission of Monetary Policy” and it seems like an excellent opportunity to set the stage for a September cut. There are two jobs and two Consumer Price Index (CPI) inflation measure reports due by the September FOMC.
In the last month or so, the Swiss and Canadian central banks have cut interest rates twice and the list of one-cut-banks is long and growing: China, ECB, and Sweden. Britain seems almost set to cut in August.
Japan just made its second hike in this cycle. Japan is struggling to get back to normal behaviour but from a below-normal rate level.
Australia is the stand out. The RBA rate tracker tool on the ASX website puts the price of a rate increase (hike) on August 6th at 25% as recently as two weeks ago. While there are plenty of commentators supporting an interest rate increase because they think that a hike is needed to bring inflation down, we think they are incorrect in their thinking. The RBA at its meeting on August 6th determined to leave its official cash interest rate on hold at 4.35%.
It is a fact that the latest inflation rate (3.8%) is above the target 2% to 3% zone. But there are two well-argued causes of inflation – demand pull and cost push, or demand and supply causes.
All the big problems in the Australian CPI inflation are due to supply-side factors in: rents, insurance, education, electricity and the like.
The Federal Government did act to alleviate some pressure from electricity and rent inflation. Almost everyone expected the high read for Q2 inflation but, looking to Q3, Westpac has calculated that quarterly inflation will fall from 1.0% in Q2 to 0.1% after the government changes take effect. Westpac is not arguing that the fall in inflation is because of interest rates.
We mention in each of our recent monthly updates that Australia has been in a per capita (household) recession for over a year. Quarterly per capita GDP growth is repeatedly negative. Retail sales volumes (price-adjusted but not by population) just posted its 17th successive monthly negative annual growth rate.
But there is new, even more alarming data. ASIC reported that the number of companies going into administration in the 2024 financial year (FY24) was a third more than in the previous year. Indeed, the FY24 number was greater that the sum of the numbers in FY23 and FY22 combined. It has been reported that around a quarter of the companies in trouble are in the construction sector. That won’t help the rental crisis.
Australia is not alone with corporate difficulties. The US just reported that the number of first-half 2024 filings for bankruptcy and related difficulties was the highest half-year number since 2010!
When we were writing about long and variable lags quite a while ago, we suggested that monetary policy takes 12-18 months to work through the economy. That cumulative effect of rate hikes from 0% to 0.25% to the current 5.25% to 5.50% in the US is now taking its toll – and it will get worse. Australia should not ignore these issues. We believe the first interest rate cut in Australia is needed now and 0.5% would be a good start.
Although politics is outside our remit, we cannot ignore some of the events of July. An assassin got very close to killing former president, Donald Trump. Whatever your politics, there is no room for violence on the streets.
Markets did take a bit of a dive a few days after the shooting. Some say it was related but we don’t know. What we do know is that some markets shrugged off ‘these July blues’ and returned to solid gains. US small cap stocks had a brilliant month (over +10%) so it is not a case of analysts being shy of equities – it’s just a rotation from magnificent-7 (Artificial Intelligence and Technology) type stocks into the rest of the market. And the ASX 200 closed the month above 8,000 again.
The calls for President Biden to step aside from his own supporters eventually had the desired effect. Almost too swiftly, nearly all the major Democrat figures threw their weight behind Kamala Harris.
The betting odds (according to sports betting websites) are still firmly in favour of a Trump victory but there are endless media stories about how Harris has closed the gap. We don’t know if this is fact or wishful thinking. We will find out in November.
Providing all the central banks, including our own, start easing interest rates at a reasonable rate, the extent of any recessions might be contained.
There were some very poor company results filed to the US stock market from mega-cap tech-stocks – but also some good ones! What was refreshing is that, in the sell-off of some big names, the Russell 2000 index – representing small cap stocks – made some good gains (11.1%) during July – as did the ASX 200 (4.2%). Perhaps the market is broadening out rather than pausing.
Asset Classes
Australian Equities
The ASX 200 climbed 4.2% during July and closed the month at a record 8,092. The utilities sector was down 2.9%; resources and IT were all but flat; there were strong gains across the other seven sectors which included the banks.
International Equities
The S&P 500 was looking at a slightly down month in July but the FOMC-induced last day rally saw the index gain 1.1% over the month. Other markets were mixed and the World Index was flat at 0.1%.
Bonds and Interest Rates
The US Fed did what was expected of it and more at the July 31st FOMC. There was no change in interest rates but there was a distinct dovishness (easier or lower interest rate policy) in the statement and Powell’s media conference. There is a chance that a soft landing will have been engineered but, as Powell pointed out, there is a long and variable lag on the way down for rates too.
The Bank of Canada and the Bank of China cut rates in July. The Monetary Policy Committee of the Bank of England is divided over whether to cut in August or not. The ECB was on hold in July.
The RBA despite remaining on ‘hold’ has not ruled out the notion of hiking rates despite its twin mandate of full employment and price stability.
Since, in our opinion, the RBA is not appearing to heed the guidance being provided in publicly-available data, we find it difficult to predict what they will do. However, we can say that the longer they keep the overnight cash rate at its current (or a higher) level, the worse will be the impact on the Australian economy.
Other Assets
Iron ore prices just held above $US 100 per tonne despite falling 4.5% over the month.
Brent Crude oil prices fell 9% over the month to under $US80 per barrel but, popped to $80.72 on the news that Iran’s leader has pledged retaliation against Israel’s attack.
Copper prices fell 6.5% but the price of gold jumped 4.1% over the month.
The Australian dollar against the US dollar depreciated by 2.0% in July.
The VIX index, being a proxy for the cost of an insurance policy against falls in the S&P 500, climbed from a ‘normal’ 12.4 at the beginning of July to 17.7 at the end of the month.
Regional Review
Australia
Employment rose by 50,200 in the latest report (for June) but in percentage terms, the growth was worrying. The annual growth in full-time employment has been falling over the past year and it is now 1.2% which is less than the natural rate of population growth in this country. However, part-time annual growth in employment has been above 6% for the past year, making total annual employment growth look respectable at 2.8% in June.
It has also been reported that the average working week in Australia is running at just over 32 hours compared with nearly 38 hours for the US and around 35 hours for the UK and Canada, such is our dependence on part-time work.
In a separate report, it has been noted that around half of our part-timers would rather be working full time. The current situation is not one of full employment even though the unemployment rate of 4.1% might seem low by historical standards. The world has changed since the pandemic and the RBA needs to be more cognisant of this.
Retail sales quarterly volume came in at 0.3% for the quarter and 0.6% for the year. That makes for seven of the last eight quarters being negative! And that does not allow for the effect of the 2.5+% population growth. Aussies are consuming less ‘things’.
The NAB and Westpac business and consumer sentiment indexes are at low levels but above those at the worst points in past economic cycles.
The monthly and quarterly CPI series were updated on the last day of July. As widely predicted, they were not going to be good but the problem is not excess demand – it is all about supply conditions. The RBA should cut interest rates but we don’t think they will in the near term.
China
The China Purchasing Managers’ Index (PMI) for manufacturing was steady at 49.5 at the beginning of July. Below 50 is indicative of a weakening economy.
Imports unexpectedly fell by -4.9% but exports rose by 1.5%. Inflation as measured by CPI was 0.2% for the headline rate when 0.4% had been expected. The core inflation read, which strips out volatile items like food and fuel, rose by 0.6% when 0.7% was expected.
Probably because of this weaker data, the People’s Bank of China cut its key lending rate by 0.1% points to 3.35%. We expect further stimulus to follow.
US
The assassination attempt on former president Trump at a Republican rally was fortunately unsuccessful. Since the would-be assassin appears to be a young person who was attached to both the Republican and Democrat parties – and to no known extremist group – there is no reason for us to expect any further fallout. Apparently, the young man’s father (who has 20 guns at home) took him out to a shooting range to practice shortly before the assassination attempt. The US Constitution’s ‘Second Amendment’ (the right to bear arms) has a lot to answer for.
President Biden succumbed to extreme pressure from high-ranking members of his own party to step aside from the nomination for the November presidential election. Biden’s performance in the first presidential debate with Trump was seemingly the catalyst in starting the demand for an alternate nominee.
Perhaps too swiftly, Vice President Kamala Harris was endorsed by just about every major figure in the party. There are conflicting reports about the gap between Harris and Trump in the polls but it is accepted that, despite a strong bias to Trump, the gap (odds on betting sites) has closed since Harris became the Democratic party’s presumptive nominee.
US jobs data deteriorated a little in June. The unemployment rate rose to 4.1% which is just below the 4.2% trigger point for calling a recession under the Sahm rule. We expressed some reservations about using this largely untested rule elsewhere in this update. Since we believe others, possibly including the Fed, are more confident in the rule, it could play a major factor in affecting monetary policy and, as a result, market behaviour.
Economic growth as measured by the change in Gross domestic Product (GDP) jumped out of the blocks at 2.8% (for the year) in the June quarter when a more modest 2.0% had been expected. But retail sales volume over the year came in at -0.7%!
Of the many inflation rate indicators published each month, two seem to have given markets and the Fed some optimism. The CPI for the month was 0.1% (largely because gasoline price inflation was -3.8%); the Personal Consumption Expenditure (PCE) reading at the end of July was 0.1% (or 2.6% for the year).
As we repeatedly state, the shelter component is poorly estimated and distorts the CPI and PCE measures. In our opinion, the inflation rate of ‘everything but shelter’ has been contained for a year and is consistent with the Fed target of 2%. Since Powell clearly stated that he does not have to wait until the aggregate measure is 2%, we think he has opened the door for an imminent interest rate cut.
Europe
The UK economy rebounded with a 0.4% GDP growth rate in May following 0.0% in April and 0.7% for the March quarter. Inflation came in at 2.0% but 1.9% had been expected.
The Bank of England and the European Central Bank (ECB) are behaving cautiously about relaxing monetary policy (reducing interest rates further).
A Labour government took office in the UK in a landslide victory in July. The Tories (Conservative party) had been in office for 14 years!
Rest of the World
Japan missed on both its imports and exports predictions. These data were not enough to cause concern over its economy – but it does make us sit up and wait for the next numbers. The Bank of Japan (BoJ) increased interest rates for the second time in this cycle but only to 0.25%.
Canada’s interest rate cut in July was its second such cut in two months.
The conflicts in the Ukraine and the Middle East show little sign of an imminent resolution.
We acknowledge the significant contribution of Dr Ron Bewley and Woodhall Investment Research Pty Ltd in the preparation of this report
