In this month’s update, we provide a snapshot of economic occurrences both nationally and from around the globe.
– US debt ceiling deliberations coming to an end
– Central banks are still hiking rates despite agreeing that inflation peak now behind us
– China economy not yet out of the woods as indicators remain mixed
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 get in touch with your financial adviser.
The Big Picture
It seems that every time there is a divided Congress in the US, like there is now, both sides engage in brinkmanship. They always come to a solution but is there a better way? It destabilises asset markets and causes consumers unnecessary angst.
President Biden announced that a deal had been reached with Republican leadership on the last weekend in May, and was finally ratified by the US Congress in the past week, ahead of the reported June 5th deadline after which the US government becomes at risk of defaulting on its debt. Despite the apparent risk the US Government does have some wiggle room before they would actually default e.g. public servants and the like get furloughed first, as has occurred previously in response to this issue.
As a result of this squabble, one of the big three ratings’ agencies, Fitch, put US Treasury Securities on ‘negative watch’ meaning that their AAA credit quality status was in jeopardy.
While we make light of the posturing for the TV cameras by the opposing political parties, a huge and very real problem is emerging. The total of US Government debt is now $31,000,000,000,000! (Trillion) As rates rise, the interest bill is becoming dangerously high unless some long-term deficit reduction solution is agreed upon. One day, US debt might become too risky for other nations to hold. What happens then when they’ve all but maxed out their credit card.
It is hard to unscramble all the influences on central banks and bond yields. It seems safe to ascribe a little of the recent uncertainty to the debt ceiling negotiations but a lot must also be due to central banks’ interpretation of the economic and inflation data that are landing on the news wires in rapid fire.
The Reserve Bank of Australia (RBA) surprised markets in May by increasing the official cash rate by 0.25% to 3.85% when the consensus was that they would leave rates on hold. At the June meeting the odds of a rate increase changed markedly during May from a minor chance of an increase in June to the point of ‘much more likely than not’ in the few days prior to the June meeting on Tuesday 6th of June. The RBA decided to go with the majority and increased the cash rate to 4.10%.
Our CPI inflation data did come in a bit high at 7% in the last week of April and that was backed up by 6.8% from a new monthly publication at the end of May. While that figure is well above the target rate of 2% to 3%, we have no real way of knowing what will be the delayed impact of all the previous interest rate hikes in the future.
Everyone agrees that the impact of rate hikes is felt with ‘a long and variable lag.’ So, if Central Banks wait for inflation to be reasonable before they pause or ‘pivot’ down, there is no doubt that some bad economic conditions will inevitably follow. Even swift rate cuts wouldn’t solve that problem as cuts also take time to work their way through the system.
In relation to the large swings in expectations of where Central Banks decide to take interest rate policy settings, when the probabilities change so much from day to day it makes little sense to take each number at face value. We prefer to interpret these probabilities and abrupt changes as evidence of confusion in the market. The next new number could be sufficient to flip expectations back to the RBA being on hold. We anticipate this volatility continuing for the near term at least.
The US Federal Reserve (Fed) also hiked rates by a quarter of a percent at the start of May to a target range of 5.0% to 5.25%. That means the current (average) Fed funds rate is about 5.1% or the figure the Fed forecast its rate would be at the end of 2023 – the so-called ‘terminal (peak) interest rate’. Therefore, any more hikes put them in a more aggressive stance than they were at the beginning of the year. But what has happened since? Most US news this year has been encouraging but the falls in inflation – and there have been some substantial falls – have not been as big as hoped for.
But on top of the Fed’s actions, the regional US banks bailouts have caused a credit tightening which has been acknowledged by the Fed and the market. Fed chair, Jerome Powell, said in a press conference that the credit tightening might be equivalent to one or maybe two hikes – or maybe even more. He claimed not to know.
Professor Jeremy Siegel, a particularly well-credentialed finance academic from the Wharton School (University of Pennsylvania) with both feet firmly on the ground thinks the credit tightening is worth about 0.75% to 1.0% in addition to the 5.1% Fed funds rate.
On top of that, Jamie Dimon, the high-profile CEO of JP Morgan, thinks the Fed rate will have to go to 6% or 7%. Putting all this analysis together, the US could easily be looking at an ‘effective’ Fed funds rate of 7% or maybe even 8% sometime this year. That might spell a big recession for the US. If that were to be the case then there is time to save the economy, but swift action could be necessary but it doesn’t look likely.
At the start of the year, the Fed was predicting a terminal or peak interest rate of 5.1% while the market’s prediction was a little under 5%. By March, the Fed hadn’t shifted its view but the market was then pricing in about 3.5% (due to the regional banking crisis). In the run-up to the June Fed meeting, the market was pricing in a terminal rate at around 5% – just like the Fed.
At one time, the market was pricing in three or four cuts this year. We didn’t see that happening and the chance of cuts is all but off the table. One cut is priced in unless they hike in June and then it will be two cuts!
The probability of a hike in June has gone from about 5% earlier last month to 71% near the end of May and then back down to 35% to close off the month. Again, these probabilities speak more to the difficulty to interpreting current data in this economic climate.
Our economic future in Australia looks a little brighter than that for the US but a lot is riding on how the China economy plays out. The last GDP reading for China was reasonable at 4.5% and the June quarter read could be very strong as opposed to the same quarter last year which was very weak. In recent data imports just came in at -7.9% for the month when 0% was expected; industrial profits were down -18% for April; but exports were on track at +8%.
Then, the Purchasing Manager’s Index (PMI) came in well below expectations for both manufacturing and services with the manufacturing variant indicating a contractionary sentiment at 48.8. However, this recent weakness could well cause a reaction from the Chinese government to stimulate the economy.
We are cautiously optimistic about China’s economy as it exits the pandemic lockdown but there could be some speed bumps along the way.
All-in-all, Financial Year (FY) 2023 looks like producing strong returns for the ASX 200 and the S&P 500. FY23-to-date capital gains are 8.0% and 10.4%, respectively. Dividends and franking credits in Australia put both returns well into double figures.
So far, surveys of company earnings’ expectations are looking moderately strong for FY24 but there are a lot of unknowns that could upset these expectations.
The ASX 200 had a bad end to the month on the back of the US debt ceiling deliberations, our inflation data and the patchy weakness in the Chinese economy. The broad index was down 3.0% in May making it all but flat for the calendar year to date. Except for the IT sector, there was little in May to celebrate on the ASX.
US equities just managed to close May with a positive return which gives an 8.9% calendar year to date capital gain.
Japan’s Nikkei index had a spectacular month rising +7.0% but Emerging markets were flat. The German DAX, UK FTSE and China’s Shanghai Composite Indices were well down.
Bonds and Interest Rates
The market has now capitulated on its stance against the Fed’s ‘higher for longer’ position. Gone are the expectations of three or four cuts this year.
The market thinks it is more likely than not that the Fed will pause in June after having leant towards a hike for much of May.
The ECB is on a tear to keep hiking rates to fight inflation despite its largest economy, Germany, falling into recession in the March quarter on the back of a downward revision to growth.
The Bank of England (BoE) at last got some slightly good news as UK inflation fell from 10.1% to 8.7% in one month. Now at 4.5%, the latest quarter point increase took its interest rate well above the ECB’s 3.25%.
Perhaps the biggest danger in the Fixed Interest sector is the possibility of increased defaults in corporate credit.
OPEC has just opened the door to allow Iran back into the club after sanctions are removed. The price of oil has been a little volatile of late but it is well down on the prices that caused much of the global inflation spike. Brent Crude oil was well over US$100 per barrel a year ago and is now just over US$70.
The price of iron ore has also retreated from around US$130 per tonne a year ago to close on US$100 today.
Over the month of May, the prices of copper, iron ore and oil were all well down but gold was only down by -1.0%.
The Australian dollar against the US dollar fell by -1.7% in May to US$0.65 cents.
On the face of it, our jobs report looked weak but it followed an extremely strong prior month. Taken together, the labour market seems to be holding up against higher rates.
Our unemployment rate jumped from 3.5% to 3.7%. Total jobs fell 4,300 but part-time jobs rose 22,800 reversing the big switch to full-time work in the prior month. Wages grew modestly at 0.8% for the quarter and 3.7% for the year.
Retail sales volumes again fell in the March quarter making for two consecutive quarters of negative growth: -0.3% and -0.6%.
While the Federal Budget made attempts to redress the cost-of-living crisis there wasn’t a lot for economists to agree or disagree with.
The China trade balance improved sharply as exports met strong targets but imports fell well short. The economy seems to be quite patchy with some areas of strength – mainly in services – but industrial profits falling by 18% in April did attract attention.
The manufacturing PMI came in at 48.8 at the end of May which was a big miss compared to the expected 49.2. However, the services PMI was well in expansionary territory at 54.5 – although that statistic did mark the second month of decline. It is quite possible that this weak manufacturing outcome will push the government into an expansionary policy phase.
China inflation came in light at 0.7% from 2.8%. The Producer Price Index (PPI) inflation was -3.6%, less than the -3.2% expectation.
The forecast for US new jobs to be reported at the start of May was 180,000 with a range of 95,000 to 265,000. The outcome, at 253,000, was at the top of the range. The anticipated weakness in the labour market is yet to appear. Wages growth was quite strong at 4.2%. The unemployment rate fell from 3.6% to 3.5%.
Nevertheless, the New York Fed calculator estimates that there is a 68% chance of a recession in the US.
Core inflation is above the headline variant as energy and food prices that are stripped from the headline measures are currently falling. Our calculation of quarterly CPI inflation at 3.2% (annualised) is not that far from the 2% target but the annual figure, as represented in official data, is stubbornly high because of the hangover effect of the high mid-2022 inflation spike. That should pass through the data measurement ‘window’ in a few months.
The Bank of England is still intent on trying to suppress inflation with interest rate hikes. There is some slight evidence that it is winning.
Now that Germany is in recession it is not bringing any confidence to those who thought EU inflation could be supressed with interest rate hikes without causing a hard landing.
Rest of the World
Japan’s inflation was a little higher than expected at 3.4% and that is the highest inflation has been there since 1981. After the ‘lost decade’ and beyond characterised by deflation, Japan’s experience may have swung the other way. However, as Japan’s central bank has not meddled with interest rates – which are unchanged since 2016 at -0.1% – growth is doing moderately well.
Japan’s growth in the March quarter came in at 0.4% and 1.6% for the year when 0.2% and 0.7%, respectively, had been expected.
Japan’s industrial output fell by -0.5% while +1.5% had been expected. Retail sales grew strongly at +5.0% but missed the +7.0% expectation.
The Tokyo CPI inflation index pointed to inflation falling to 3.2% from 3.5% when 3.3% had been expected.
With a new governor at the Bank of Japan, we await a clear signal of a possible change in interest rate (monetary) policy.