In this month’s update, we provide a snapshot of economic occurrences both nationally and from around the globe.
– China abandons zero-Covid policy and is experiencing a significant rise in case numbers
The Big Picture
At the start of a new year, it seems a good time to reflect on lessons learned from the one that just ended. Most forecasters got bond and equity market forecasts wrong – and many by a big margin.
It is easy to blame poor market performance on China and Russia, amongst others. But, to some extent, the actual problems were of our own making.
For decades the talk was all about globalisation and the push to outsource the production of output and services to China and the rest of South East Asia. As a result, when the pandemic hit China, globalisation became the problem. The supply chain – particularly for semiconductors – broke and with demand outstripping the constrained supply, became a significant catalyst for inflation in the last couple of years.
Now that the horse has bolted, the US and others are building semiconductor plants elsewhere so that future country-specific problems will be partially offset as manufacturers can then switch their supply sources.
Although the Russian invasion of the Ukraine caused tragic loss of life, injuries and devastation, the economic impact on global inflation was caused, in part, by the reliance many countries placed on the Russian supply of oil and food. Not much could have been done about the food supply from the Ukraine but Europe is now backing away from the energy crisis seeking as quickly as possible to significantly reduce its dependence on Russian oil and gas, particularly for heating through the winter – again, after the horse has bolted.
The energy problem was exacerbated by the hectic switch to renewable energy. While a laudable target, it (in hindsight) wasn’t a smart idea to decommission fossil fuel power plants until the renewables sector was sufficiently strong. The UK, Europe and California are now bringing fossil fuels back to fill the void caused by Russia controlling the supply of energy, particularly to Europe. New England in the North East of the USA switched from using almost zero oil in electricity generation in October 2022 to 30% on Boxing Day!
At the stock and sector level of share markets, many investors were unduly affected by the sell-off in the mega tech sector in the US and its impact on the S&P 500 index. Even the ‘market darling’, Apple, hit a 52-week low in the last week of 2022. The falls in Tesla, Amazon, Meta (formerly Facebook) and many others lost a massive amount from their valuations. This reversal of the 2021 upward trend in tech wiped out much of the big gains of 2021 in particular for those who didn’t take enough off the table before the fall.
There was a useful discussion at the year’s end on CNBC about Tesla. It was pointed out that the share price of Tesla was about 21 times its earnings (the so-called P/E ratio) while that for the car industry as a whole was more like five times. So, after a massive fall in value over 2022, it has a lot further to go if one believes it is mainly a car manufacturer. If, however, Tesla is viewed as an IT company, its P/E ratio is in closer harmony with other stocks in that sector.
It is almost as though a number of ‘cult heroes’ came undone in 2022. The Green movement went too far too quickly on fossil fuels, Elon Musk devotees got their fingers burnt and Musk, himself, also got burnt on his Twitter purchase.
Parts of the crypto world also came undone. Sam Bankman-Fried’s (“SBF”) FTX exchange went from a valuation of over $30 bn to close to bankruptcy in rapid order as a ‘scam’ was unveiled. Two of SBFs lieutenants have pleaded guilty and SBF is reportedly about to seek a plea deal.
Elizabeth Holmes’ blood testing scam got her an eleven-year prison sentence. The 2021 ‘rock star’ fund manager, Cathie Wood, lost more than two thirds of the value of her ‘disruptor’ ARK fund over 2022. It has been reported that most investors didn’t get on board in her fund until near the peak so most lost more than those who gained during the rock-star growth phase.
We are not suggesting that people should not have invested in any of these companies. There may have been some red flags but investing always comes with risk. The essential point is that it is important not to go overboard on any one risky company. A managed fund, or broad-based stock market index, invests in many companies thus limiting losses when only a few component companies suffer badly.
As we launch into the new year, most are focusing on whether or not there will be a recession in the US and elsewhere, and what impact this may have on our investments. In Australia, a recession is defined as 2 consecutive quarters of negative economic growth as measured by Gross Domestic Product (GDP). It is worth noting that different countries use different methodologies for defining a recession. With the US Federal Reserve (“Fed”) and the Reserve Bank of Australia (“RBA”) looking to back-off hiking rates sooner rather than later, either the damage has already been done or, there won’t be much damage i.e. a mild slowing but not a recession.
But, as a word of caution, only a year ago the RBA said they wouldn’t raise rates until 2024! The overnight rate was then 0.1% and now it is 3.1%. The Fed one year ago predicted three 0.25% hikes. It actually made one 0.25%, two 0.50% hikes and four 0.75% hikes. It is not surprising, therefore, that equity market forecasters and others ‘got it wrong’.
Economic growth and the jobs markets in Australia and the US are currently unquestionably good so what then is the problem? It is widely accepted that monetary policy takes a long time to filter through to the real economy – 12 to 18 months was a generally accepted lag from the nineteen seventies onwards, however some are now saying the lag is shorter but there is no evidence yet to support such a claim. Interest rate hikes didn’t start until March 2022 so there’s probably a long way to go before the full effect is felt.
Some are arguing that because short-term yields (i.e. two-year bonds) are higher than long-term yields (i.e. ten-year bonds) a recession will follow. Again, the data on this hypothesis does not support that a recession is a forgone conclusion. It is also important to take the impact of inflation into account.
With rising prices, perhaps a more useful way to measure the cost of borrowing is to use the so-called ‘real rate’ which is the difference between the actual interest rate and inflation. With inflation having run well above government bond yields until recently, there was not much impost on the borrower unless the borrower’s wages or earnings weren’t keeping pace with price inflation.
In December, the US quarter three (Q3) GDP growth was revised upwards to 3.2% (annual). The Q3 result for Australia was 0.6% (for the quarter) and 5.9% annualised – both good results. The unemployment rates in both countries are near 40-year lows.
The trouble with relying just on these data points is that they can mask the ‘true’ underlying rate. Companies might hold on to workers longer than maybe they should because it is hard to re-hire good workers if a downturn turns out to be short. Consumers can borrow (or save less) to smooth out consumption. As a result, when a recession gets underway, the labour market and consumption can turn quickly. This is not a time to be complacent but fear doesn’t help either.
There is much discussion and conjecture around whether inflation has peaked. Because many people – particularly in the US – rely on calculating inflation over a 12-month period, any return to ‘normal’ rates will be masked by the very high inflation experienced in 2021 and the first half of 2022. Until this data ‘rolls out’ of the annual reporting period, it artificially skews the current reported level of inflation higher than it actually is.
Our analysis of monthly US CPI data shows quite clearly that inflation in that country got back to around 2% p.a. from August. In that sense, it is not a case that inflation has peaked (using a poor statistical tool) but 2% is back! Some of that return is due to the fall in oil prices. If that fall ends or some other burst of inflation works itself into the economy, inflation can go back up. There are no guarantees in economic forecasting.
In China, the government has walked away from its zero-Covid policy. This relaxation of restrictions could go in one of two opposing ways. On the good side, the supply chain could start to get fixed and China residents can start to travel to other parts and spend. The down side is that the rate of infection might continue to snowball and get out of hand. That could cause a global recession on its own.
We have not seen any reputable forecasters predicting the world will look rosy in the first half of 2023 although inroads might well be made. Data are already out from 24 well-known forecasters for the end-of-year 2023 value of the US S&P 500 share index on Wall Street. The range goes from around 15% to about +30% with a median consensus of +6% not including dividends.
The range is big because the known uncertainties are many and varied – and there are some unknown ones that might come and spoil the party! A positive year on Wall Street is not inconsistent with there being a recession. Markets get priced on expectations and some probability of a recession has already been factored into the current price.
We still think Australia can avoid a recession but it could be a close call. The US seems likely to be heading at least for a mild recession. It will all depend largely on how the RBA and the Fed conduct monetary policy from here on in, and all else unfolding without significant unanticipated disruption.
Our analysis of US and Australian company earnings’ forecasts from major stock brokers is positive. Our forecasts of the two markets (Australia and the US) including dividends, are comfortably above those of government bonds.
The biggest known downside risk (apart from a more serious escalation of the Russian invasion of the Ukraine) is the possible impact of quantitative tightening (“QT”) in the US. For many years the US pumped trillions of dollars into the bond market through quantitative easing (“QE”) or bond buying. QT is a reversal of the QE policy so it is hard to think it won’t have some impact – but we have no past experience of such a policy. The first six months or so of QT do not seem to have had much of a detrimental effect. Of course, the Fed could slow down QT if it sees a problem emerging.
The ASX 200 had a poor month in December ( 3.4%) and an even poorer year ( 5.5%). Nearly all sectors went backwards in December with just Telcos making a slight gain.
As we get closer to the next reporting season in February, we note that the broker-based earnings’ forecasts have improved a little when compared to the current estimate. We now expect 2023 to show capital gains just below their long-term average of 5%.
The S&P 500 also had a bad December ( 5.9%) and a bad year ( 19.4%). The mega tech sector of the S&P 500 brought the index down in the first part of the year as rising bond yields made growth stocks less attractive.
The FTSE was the only major index we cover to post a gain in 2022, albeit a modest one at 0.9%.
Bonds and Interest Rates
The Fed eased back to a 0.5% increase in its fund’s rate from 0.75% at the December meeting. With an expected terminal (or peak) rate of 5.1%, the Fed should now be close to pausing its current regime of tightening monetary policy. The RBA also made a more modest hike of 0.25% in December. The RBA does not meet in January and the Fed’s next meeting is scheduled for February 1st, 2023.
In sharp contrast, the Bank of Japan (“BoJ”) kept its rate on hold at 0.1% in December. It has not changed its rate since early in 2016! Inflation in Japan is currently around 3.7%. The BoJ did however change its target rate range on 10-year government bonds from 0 ± 0.25% to 0 ± 0.5%.
The European Central Bank (“ECB”) and the Bank of England (“BoE”) each hiked rates by 0.5% to 2% and 3.5%, respectively.
Many longer-term government bond rates have come down from their 2022 peaks as investors increasingly believe that the inflation problem is coming under control.
The price of iron ore did quite well in December (+16%) but the price of oil was flat. The prices of copper and gold made modest gains. The Australian dollar against the US dollar made a slight gain (+1.1%).
The latest jobs report in Australia continued to show that the unemployment rate is near a 40-year low at 3.4%. 32,600 jobs were created.
The third quarter National Accounts showed that Australian GDP grew by 0.6% in the quarter and 5.9% over the year. Australian households continued to lower their savings ratio – this time from 8.3% to 6.9%. The cutting back on savings has undoubtedly helped buoy economic growth. Since 6.9% is close to recent pre-pandemic savings ratios, there may be less support for future growth from this source.
President Xi lost face to some extent over the dropping of the zero-Covid policy following public unrest. China does not have access to the mRNA Covid vaccines that have worked so well in the US and Australia. China’s infection rate has been climbing and it is not clear how infections will play out over 2023.
Chinese residents are now largely free to travel again but the US and Europe, among others, are seeking negative tests or more evidence of travellers from China being Covid free before allowing them to enter their countries. China is not responding well to the introduction of these policies.
Retail sales fell by 5.9% for the 11 months to November when a fall of 3.5% had been expected. Industrial production also missed expectations at 2.2%.
As with Australia, the US jobs report was again very strong. 263,000 jobs were created and the unemployment rate was 3.7%. Wages rose by over 5% suggesting workers are starting to get some claw-back on the real wage losses experienced earlier in the year.
Retails sales were 0.6% for the latest month when 0.3% had been expected but the Q3 GDP growth estimate was revised upwards to 3.2% from 2.6%. The US household savings ratio has been in the range of 2% to 3% in recent quarters giving US consumers less wiggle room to smooth consumption into the years’ end for 2022 and then 2023. The average savings ratio between 1959 and 2022 was 8.9% and peaked at over 30% at the start of the pandemic.
The Fed is predicting US growth to be 0.5% in each of 2022 and 2023 from previous forecasts of 0.2% and 1.2%. We believe that the Fed is fundamentally committed to reducing inflation to its target of 2.0% p.a. more than it is concerned about preventing a recession should one result from policies settings designed to achieve its inflation objective.
The plethora of US inflation data released in December caused most to think that inflation has peaked. We think CPI inflation returned to the target of near 2% possibly as early as the September quarter but future blips are possible if global policies again adversely impact domestic prices.
The UK inflation rate came in at 10.7%, down from 11.1%. There is clearly an energy crisis which is impacting on the cost of living in the UK. Europe is also facing a bleak winter as it struggles to replace Russian energy supplies.
Rest of the World