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Read our takeouts below from the 2023 Federal Budget and what it means for you, as individuals and/or businesses; for tax, superannuation, and social security—this may impact your wealth creation and retirement funding strategies. As always, if you have any concerns with the announcement of the 2023 Federal Budget, please feel free to contact us to discuss.

This was Treasurer, Dr Jim Chalmer’s second budget since Labor came to power a year ago. Unlike last year’s October budget which was set against a backdrop of economic disruption, commodity-driven inflationary pressures, anaemic wages growth, skills shortages, underemployment and energy costs rising out of control during the current transition from fossil fuels to renewable energy, the Treasurer was keen to spruik a modest return to surplus for the first time in 15 years (and the first by a Labor Government since Paul Keating) of $4billion (bn) for 2022-23. The Government has benefitted from a surge in revenue driven by high materials prices (iron ore, coal and gas), alongside record low unemployment (and some wages growth), a sustained increase in household spending, and sustained corporate profits.

If things are looking a bit better from a revenue perspective, does that mean that the Government is looking to splash some cash? A key pain point for most people is the sustained inflationary pressure affecting the cost of living; particularly, energy, food, and transport. While subsiding from a high of 7.8%, we all continue to feel the financial strain.

The Treasurer was keen to make the point that we still have high inflation; and the Government has been very keen not to make any spending decisions which might exacerbate inflation and cause more pain to families and potentially lead to a recession. The Treasurer referred to targeted, responsible, affordable cost-of-living relief for the most vulnerable. The legislated Stage 3 tax cuts will apply from 1 July 2024.

The high level

The announced targeted cost-of-living relief was very targeted indeed, aimed at eligible social security recipients. Around 5.5 million Australian households and one million businesses are set to receive financial support with their rising energy bills under a $14.6bn package.

From July 2023, eligible households will receive up to $500 in electricity bill relief and eligible small businesses up to $650. The Government also announced low-cost loans for double glazing and solar panels to assist with managing the high cost of gas and electricity.

Looking further at the most vulnerable, the Treasurer announced an increase of $40 per fortnight for recipients of JobSeeker, Austudy and Youth Allowance, and noted the extra difficulties many people over 55 years old have getting work (many of whom are women) so announced that the higher rate of JobSeeker that currently applies to people over the age of 60 will now apply to those aged over 55. He also announced measures for Single Parenting Payment and for more affordable housing with a 15% increase in the rate of rental assistance.

Cited as the “centrepiece” of this budget to help ease cost-of-living pressures for the most vulnerable was the announcement of the tripling of the Medicare bulk-bill incentive to allow more people to seek medical care from their General Practitioner (GP) (which might also reduce the strain on hospital emergency departments).

The Treasurer also reiterated his pre-budget announcement regarding an $11.3bn package to provide 250,000 aged care workers with a 15% increase in the award wage.

For small businesses, the Treasurer announced the Small Business Energy Incentive providing businesses with an annual turnover of less than $50 million with an additional 20% bonus tax deduction on spending supporting “electrification and more efficient use of energy” where eligible assets are deployed/installed in financial year 2024 (FY24). The Government has also committed to the $20,000 instant asset write-off for FY24 to help improve cash flow and reduce compliance costs for small businesses.

Specific to superannuation, the Government had already announced the introduction of payday super which will require employers pay superannuation at the same time as salary and wages (with a proposed start date of 1 July 2026) in order to stop some employers underpaying super, particularly for short-term and casual staff.

The Treasurer also confirmed the announcement made in February that the government intends to increase the concessional tax rate applied to accumulation-phase earnings from 15% to 30% for individuals with super balances exceeding $3 million from the 2025–26 financial year. The Government expects the changes to apply to less than 80,000 individuals and should generate approximately $2 bn in additional revenue in the first 12 months of operation.

There was a range of other spending measures announced but none really relevant from a tax, superannuation, or retirement income perspective. Looking at how the Government will pay for these proposals, the Treasurer was happy to quote a figure of $17.8bn in savings coming largely from increased taxes on smokers, multinationals, wealthy superannuants and gas producers – the liquefied natural gas (LNG) industry coming under the spotlight as part of a review of the Petroleum Resource Rent Tax.

The macro

While the Treasurer was keen to talk about a small return to surplus for 2022-23, he did warn that the global economic outlook is not all rosy, and Treasury expects that our $4bn surplus for 2022-23 will be followed by a deficit of $13.9bn in 2023–24. However, Dr Chalmers noted “lower deficits across the forward years compared to recent budgets leading to a $125.9bn improvement over 5 years and a much lower public debt burden”. He confirmed that gross debt to Gross Domestic Product (GDP) is now expected to peak lower and earlier at 36.5% of GDP in 2025–26, where it will be $154bn less than was expected in March 2022.

“And because we are returning most of the welcome improvement in revenue to the budget, debt will be almost $300 bn lower by the end of the medium term, saving $83 bn in interest costs over the next 12 years.”

Conclusion and where to from here?

From a financial planning perspective, there were no major reforms to the taxation or superannuation laws. Of the spending measures announced, most Australians will not get any direct benefit and will need to rely on the inflation numbers continuing to trend downwards to realise some cost of living relief, plus the benefit of the Stage 3 tax cuts coming into play from July 2024.

The government had to face the hard task of what potentially irresponsible spending might do in a high-inflation environment and it has certainly chosen the more “responsible” and conservative route, targeting cost-of-living relief measures to the most vulnerable in our community.

As with all budget announcements, the measures are proposals only and need to be enacted by Parliament.

Please contact our office with any specific questions you may have.

Key points:
– What impact has the banking crisis had on interest rates and markets?
– Who/what caused some of the failures in the US regional banks?
– Economy showing resilience – key employment data still strong in US and Australia
– Inflation still above objectives but growing evidence that the high point is in the past

The Big Picture

There is a lot going on in the world of finance and to make some sense of it, we will do our best to walk you through it in a calm and rational manner. Cutting to our conclusion, we do not think we are in a crisis – like in 2008 – or anything like it. Yes – some did/will get hurt but the problem is well-contained – at least until the next ‘crisis’ emerges.

Going back to our previous Economic Update of March 1st, no one was talking about banking crises. Indeed, the month started calmly with our growth data release and the RBA decision to increase the cash rate seemingly just as we all expected.

Indeed, the first nine days of March were largely ‘business as usual’. Then, unbeknown to us at the time, a moderately-sized bank in California, called Silicon Valley Bank (SVB) had a $42bn run on its deposits in only one day – a record of sorts. Still unbeknown to us at the time, the next morning, SVB contacted the regulator that it had about $100 bn more of requests to withdraw deposits and it couldn’t make them good. The bank was shut down and events escalated quickly.

Before we get into the details, it is important to refresh our understanding of how banks work. Around the 1960s, life was a lot simpler in terms of financial products and technology. Depending on the jurisdiction, a bank would accept deposits and establish customer accounts then allow customers to transact on them to facilitate their lives and businesses. The bank would only hold about 10% of those deposits in cash (when cash really was cash – i.e. notes and coins) and lend out, or invest, the other 90% often in the form of loans to businesses, home loans and personal loans.

Cash could usually be withdrawn at call (i.e. immediately, when the bank was open – no 24 hour internet banking!) but the loans usually had fixed, much longer investment terms. If depositors suddenly demanded their money back, the first 10% of assets could be offset against the cash holding. 10% then was thought to be a reasonable buffer to withstand the whims and needs of depositors. If more funds were to be withdrawn, there was a problem as the longer-term loans could not usually be reversed at will.

Banks exist for many important reasons. We couldn’t have an efficient society without them. They make their profits on the difference between the interest paid out on deposits and that received on longer term loans. Banks compete with one another on both deposit rates and loan rates to make the system work efficiently.

As we all know, depositors don’t get much interest on simple deposits but they pay quite a bit on home loans and the like. The bank pockets the difference and this is called the ‘net interest rate margin’ (NIM). What happens to fresh deposits that have not yet been lent out in the traditional way? They would usually be parked in safe assets such as long-term government bonds and the like until prudent loans could be made to clients.

Under normal conditions, long-term bonds have a higher yield than short-term bonds and deposits. All is then good for the banks. However, from time to time, particularly when a central bank is trying to slow down its economy, a central bank might force up short-term rates such that there is a so-called ‘inverted yield curve’. That is, short-term yields are higher than long term ones. When this happens, part of the traditional banking model doesn’t work. Such inversions are usually short-lived and there are complex financial products that allow banks to deal with the inverted situations.

Because a bank exists on this model that does not keep 100% of deposits on call, if a situation arises where depositors lose confidence in the bank and are concerned for the safety of their money, they collectively and actively withdraw their capital. This results in a ‘run on the bank’. In the ’old days’ this might have amounted to a queue at a cashier’s counter to take out bundles of notes and coins. Runs do not require logic or fact. Older readers might recall John Laws, the one-time famed Sydney radio announcer, started a run on a bank from some slack comments he made on his show and he got into trouble for it.

Dialling forward many decades and deposits can be removed electronically and moved directly to another financial institution – within seconds or less. No queues; no notes; and no coins!

Let’s return to the SVB case in particular. It has been reported in mainstream media that SVB was ultra successful in attracting new customers. Indeed, they specialised in ‘tech start-ups’ and the like, and some of the venture capitalists who funded these start-ups located around Silicon Valley, even insisted that they use SVB as their bank. As a result, the SVB client base was not diversified in any reasonable sense and the clients were largely very well educated and very well connected (including via social media and other rapid contact methods). Some have suggested SVB was more of a hedge fund than a bank in this regard.

That SVB was particularly successful in attracting deposits was arguably its downfall. It attracted deposits so rapidly that it couldn’t match those assets quickly enough with sound loans so they parked these large amounts of excess assets in seemingly safe long-term US Treasuries – often thought of as the safest assets on the planet.

Let’s now introduce the US Federal Reserve (The Fed). Whether rightly or wrongly, the Fed has been on a mission since March 2022 to raise the Fed Funds rate (short-term interest rate) to bring down price inflation which has undoubtedly been above its policy objective of 2% – 3%.
For many years before, the Fed rate was low and often close to zero. The rapid rise in its rate from just above zero to nearly 5% in less than a year caused the yield curve to ‘invert’. That is, the yield on short bonds became substantially higher than those of long-term bonds. That was a deliberate action to (hopefully) control inflation.

Let’s get back to SVB. It had a rapid run on its deposits for whatever reason. It was rapid because the depositors were sophisticated and well-connected. We saw analysis from reputable experts on CNBC saying that the deposits withdrawn did not go to cash or anything like it. The deposits largely went to the bigger well-known banks or the money market to earn higher returns on savings. This was not a run on ‘the banks’ as a whole, but simply reflected clients making a choice of which bank or institution to deal with.

We have noted evidence to suggest that SVB was not squeaky clean in a number of regards but it also got caught out on the presumption that US Treasuries are all but riskless. If a Treasury is held to maturity (like holding a 10-year bond for 10 years), the holder will reasonably expect to get all of their money back and all of the yield payments along the way. Corporate bonds might well have quite different probabilities of default. However, if a Treasury is not held to maturity, its (mark-to-market) price fluctuates on a daily basis responding intraday to changes in interest rate expectations.

SVB, when faced with a run on its deposits, would have needed to sell its long-term Treasuries at an unexpected loss (on a mark-to-market basis) because the price of a Treasury is inversely related to its yield and yields were being forced sharply upward. As the Fed forced up yields, they forced down the value of SVB’s (and others) Treasuries and the gap was enormous because of the aggression of the Fed policy. Selling a Treasury early can always result in a profit or a loss on capital.

To start a run, it wasn’t necessary for SVB to actually crystalise a loss through selling the long- dated bonds it owned at a loss. Any qualified financial analysts could view the SVB portfolio and realise the increased risk that SVB was facing.

Some have suggested that SVB should have been subjected to the same stress tests that bigger banks faced after the GFC – and that would have prevented the problem. Seemingly expert analysts on CNBC suggested that SVB would have passed such stress tests because the existing stress test was about how a bank could deal with falling rates. There was no stress test for rising rates. Whose fault is that?

So where does this leave us? Several smaller banks have been subjected to runs. That is no different in substance in Australia from people and businesses moving deposits from small banks to the big four or five. We may not like it, but that is business.

Contrast that to 2008 or so when there were complex financial products that no one seemingly fully understood and who owed how much to whom. In the panic most financial institutions then stopped lending to each other – called a credit freeze. Central banks freed up liquidity from the end of 2008 and commercial banks then got back on track. This time around, government agencies merely ‘insured’ the deposits over the traditional $250,000 limit. Problem solved!

This run on SVB and a few regional banks was not nice but it will not knock the global economy off track – or at least that is what we think.

Having hopefully dealt with the ‘banking crisis’ let us focus on analysing market behaviour and possible projections – including any ongoing implications from the ‘crisis’.

At the start of March, Australian GDP growth came in at a respectable, but not stellar, 0.5% for the quarter or 2.7% for the year. The RBA hiked its rate by 25 bps to 3.6% and foreshadowed more hikes to come. This action was largely anticipated.

China surprised a little with some strong economic data and policy objectives.

The US then reported its very strong labour market data which followed an even stronger prior month.

Even the UK dodged the recession bullet with positive growth in Q4, 2022 rather than the expected pull-back and the start of a recession.

Before the SVB collapse, Fed chair, Jerome Powell, was talking about maybe returning to a 50-bps hike at the March 22nd meeting following the smaller 25- bps hike in February. The market started pricing in an e o y 2023 Fed rate even higher than the Fed’s projection of 5.1%. Back in January, the market thought 4.4% was the level. Expectations were swirling; then the story about SVB broke!

Market expectations for the e-o-y Fed rate were rising to the point in time of the SVB collapse but then fell from a high of 5.84% to 3.44% in a week. Panic was permeating the markets. In normal times a small fraction of that change would have been considered big.

US regulators moved swiftly to insure (guarantee) all necessary bank deposits so that depositors were insulated from the collapses. Moves were initiated for bigger banks to absorb some of the stricken smaller peers. Credit Suisse also got into financial trouble but for different reasons. The European Central Bank (ECB) reportedly ‘leant on’ the other big international Swiss bank, UBS, to buy Credit Suisse out and absorb much of its losses. Another problem solved!

Of course, the inflation story had not gone away. New data in the US and Australia pointed to slightly better inflation data – so what would the Fed do on March 22nd? Many suggested the Fed would not hike because of the SVB problems. In the end, the Fed hiked interest rates by 0.25% (25 bps) rather than the 0.50% or 50 bps, touted before the SVB collapse. However, Powell stunned some, including us, in his press conference.

Powell pointed out that there would be a tightening of credit resulting from the problems in the regional banks. He went on to say [paraphrased] that such tightening would act in the same direction as a rate hike and might amount to the equivalent of a 25 bps or maybe 50 bps or more hike. We cannot say with any precision!

So, what Powell has admitted to is a much bigger than anticipated effective policy tightening. That sounds like a recession is on its way to us (if it wasn’t before). The Fed’s 25 bps hike, plus another 25 or 50 (or more) bps from credit tightening spells trouble when we’ve already witnessed problems from the Fed’s prior hiking policy.

We have been arguing for some time that the US couldn’t avoid a recession (either later this year or next) but we think that has already been priced in by the market. That does not mean that share markets can’t go higher from here – with a little bit of volatility thrown in. In due course, we think the Fed will review its policy and go easier on interest rates.

We are (and have been) somewhat sceptical about the tight US interest rate policy for two reasons. First, the supply side problems in inflation (from the Ukraine invasion and the pandemic etc) do not respond to rate hikes. Secondly, because we all agree that interest rates – if they work at all – act with a ‘long and variable lag’. In other words, it might be too soon to know whether the first hikes that occurred in March 2022 in the US and May in Australia, have yet had any impact let alone the subsequent hikes!

But there is a possible lesson from Japanese actions (or lack thereof). Japan just released its inflation print of 3.1% (as expected) which was down from 4.2% the month before (a recent record). You might ask how high did they force rates up to get that effect. The answer is that their official cash interest rate is still 0.1% and the Bank of Japan hasn’t hiked since 2016. Go figure!

The market expects (has priced in) that the Fed will have to cut rates this year as ominous signs of a slowdown in economic growth start to build. However, the Fed is still clinging on to a policy of no cuts to the Federal Funds (Cash) interest rate in 2023!

To summarise – markets have recovered well following the dip after SVB failed. There hasn’t been a material impact on broker forecasts of company earnings as published by Refinitiv. But that could be because brokers do not yet know how to react to recent changes in macro effects.

There is no longer ‘no alternative’ to equities as both bond and cash yields have recovered so a portfolio containing both shares and bonds may have greater merit than in recent years.

The RBA looks like it might be ‘on hold’ after these events. Either way, Australia could dodge the bullet owing to having a smarter central bank and China’s nascent resurgence.

Asset Classes

Australian Equities

The ASX 200 didn’t have a good month – it was down 1.1% – but it has recovered from the mid-March low. Financials ( 5.1%) got hammered – probably because of the irrelevant knock-on fears from US regional bank woes. Property ( 6.9%) and Energy ( 4.8%) also saw losses.
We have the market as being slightly cheap and earnings forecasts are continuing to hold though we think the risk is, on balance, to the downside.

International Equities

US equities were up on the month (S&P 500 rising 3.5%) after a big wobble in mid-March. Other international markets had a mixed month. It is too soon to see any new trend emerge but we are of the opinion that markets will work their way through a difficult March and beyond.

Bonds and Interest Rates

The US Fed did equities no favours in its about-face on interest rate hikes. There is a general consensus that the sharp rise in the Fed funds rate caused (at least in part) longer term Treasury yields to rise sharply. Those rises in yields directly caused big falls in the value of portfolios of supposedly safe bonds. Had investors been able to hold on to maturity, investors would have been rewarded but, in this mark-to-market world, assets of many financial institutions caused a mis-alignment between assets and liabilities.

The Fed and the RBA each hiked their base rate by 25 bps. The ECB, not to be outdone, went +50 bps. The Bank of Japan (BoJ) didn’t blink as it hasn’t for around seven years. Its rate is still 0.1% and its inflation rate fell from 4.2% to 3.1%.

The RBA is widely expected to be ‘on hold’ for a month but then go again.

The Bank of England (BoE) raised rates by 25 bps to 4.25% but their inflation rate rose to 10.4%.

Other Assets

The price of gold was well up on the month (8.2%) but that of oil was well down ( 5.5% for Brent). The prices of copper and iron ore each grew modestly.

The Australian dollar against the US dollar fell by 0.3%.

The VIX, an index that measures US equity market volatility, returned to a level below 20, a more normal level after a period of higher volatility recently. This gives an indication that investors seem to be getting more comfortable with the direction of the market.

Regional Review

Australia

Our unemployment rate dropped back to 3.5% from 3.7% and a bumper 64,600 new jobs were created in February. The number of full-time jobs increased by 74,000 while part-time jobs fell by 10,300. These are incredibly strong labour force figures and indicate a reasonably robust economy during the period.

While the RBA might have wished for weakness in this data as a sign that inflation might soon ease, it has only been 10 months since the tightening cycle started. If the RBA maintains a tight monetary stance, we fully expect the unemployment rate to shift higher quite quickly but at some unspecified future point in time. After a bout of higher unemployment, the rate usually returns to levels consistent with full employment rather slowly.

Our 2022, December quarter GDP growth came in at 0.5% for the quarter or 2.7% for the year. The more important figure from that statistical report was that the household savings ratio, it fell to 4.5% from 7.1%. This fall demonstrates that households are not adding to their savings – whether for retirement or consumer durables – as they do in general.

China

The Purchasing Managers Index (PMI) for manufacturing expectations came in at 52.6 at the start of March and 51.9 at the end, after having been as low as 47.0 at the beginning of the year. The re-opening of China’s economy after a three-year semi lock-down appears to be going well. The People’s Republic announced that it is targeting 5% or more growth in the coming period.

China seems to be committed to stimulus but with a focus oriented to a consumption led recovery as opposed to development as it has in the past. Evidence of its stimulatory approached was a cut to the Required Reserve Ratio (RRR) by 25 bps for banks, this enables them to lend a little easier.

Retail sales came in at 3.5% p.a. for January-February which was on expectations. Industrial output at 2.4% p.a. missed the expected 3.6% p.a. Fixed asset investment was 5.5% p.a.

US

The US recorded yet another bumper new jobs number of 311,000 – compared to a typical range of 200,000 to 250,000 in good times. The unemployment rate came in at 3.6% following the previous month’s 3.4%. Wage growth was moderate at 0.2% for the month.

CPI inflation came in at 0.4% for the month or 6.0% for the year. Core inflation – which strips out energy and food price inflation – came in at 0.5% for the month or 5.5% for the year.

Producer Price Index (PPI) inflation was actually negative at 0.1% for the month, 0.0% for the quarter and 4.6% for the year.

Personal Consumption Expenditure (PCE) inflation also showed nascent signs of recovery. The core version – which is the Fed-preferred measure of inflation – came in at 0.3% for the month against an expected 0.4% and 4.6% for the year. The headline rate was also 0.3% for the month but 5.0% for the year. While these data do not yet mark a victory for the Fed in its fight against inflation, it does seem to be getting close.

Since wages growth is now modest and PPI inflation shows input prices are not increasing, we expect consumer inflation (both CPI and PCE) to start falling to acceptable levels in the near future. Hence the Fed might soon pause and even consider cuts to its rate.

Both Powell and US Treasury Secretary Janet Yellen are reporting that banks have stabilised after the flurry of activity surrounding the SVB collapse. Fed data on its balance sheet reported at the end of March supported that view. There has been some outflow from banks of various sizes but they are largely offset by inflows to the money market. Some prefer to earn around 4% from the money market rather than close to zero in a bank deposit but the former is not insured as the latter is.

Europe

UK growth came in at 0.3% for Q4, 2022 when a negative result was widely expected. Its inflation rate jumped back up to 10.4% from 10.1% despite continued increases in the Bank of England interest rate from 4.0% to 4.25%.

The ECB vigorously addressed the inflation issue with a 50-bps hike to its interest rate even though banking problems had just come to light in the US and Switzerland.

Rest of the World

Japan’s rate of inflation fell from 4.2% to 3.1% while the Bank of Japan has kept its rate at 0.1% since 2016.

Key points:

– Will the much-anticipated recession eventuate? If so, how much does it matter?

– The United States of America (US) and Australian economies still look strong, based on growth and employment data.

– US inflation appears to have peaked (for now).

– 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.

Some events are impossible to predict but are there ways to mitigate some forecast errors? The obvious ‘rule’ in finance is to diversify but what about in economics? 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 Price to Earnings 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 Information Technology 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 two 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 Consumer Price Index (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 downside 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.

One thing is close to certain. Sitting totally out of the market while waiting to pick the bottom will likely result in getting back in too late and missing out. Our analysis of US and Australian company earnings’ forecasts from major stockbrokers 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.

Asset Classes:

Australian Equities 

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%.

International Equities 

The S&P500 also had a bad December (5.9%) and a bad year (19.4%). The mega tech sector of the S&P500 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.

Other Assets

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%).

Regional Review:

Australia

The latest jobs report in Australia continued to show that the unemployment rate is near a 40-year low at 3.4%; and 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.

China

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%.

USA

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.

Europe

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

Japan’s CPI came in at 3.8% with the core value stripping out energy and food prices at 3.7%. Japan has been able to control prices better than most because it had in place long-term policies to control energy supply and prices. The BoJ’s reference interest rate is 0.1%.