despina

The Big Picture

Up until near the end of November, most of the market chatter was about the persistence of inflation – or otherwise. Central banks – in particular, the US Federal Reserve (the Fed) – were insistent that inflation was likely to be above target levels only for a short time.

The start of this inflation ‘blip’ coincided with the lifting of the US COVID restrictions, but it was subsequently fuelled by supply-chain blockages and energy price inflation. There is little doubt that most central bankers are now getting nervous.

The Reserve Bank of New Zealand (RBNZ) has already hiked rates twice in this cycle – the first country in the developed world to do so. The Czech central bank just did its biggest rate hike in 24 years. The Bank of England looks set to raise rates very soon.

The Reserve Bank of Australia (RBA) had been saying that it didn’t expect to raise rates until 2024. It removed reference to that year in the latest minutes, but it did end its so-called ‘yield curve control’ by which it attempted to hold down medium-term bond yields of two to three years in duration by buying bonds (by buying bond the RBA kept upward pressure on bond prices which move in the opposite direction to yield i.e., higher bond prices equal lower bond yields).

President Biden nominated Jerome Powell for a second four-year term as the Fed Chair – rather than recommend Lael Brainard, the other favoured candidate, giving her the Vice Chair instead. Brainard is thought to be more dovish. That is, Brainard was more likely to put off hiking interest rates.

The market, as measured by the CME Fedwatch tool, now expects one to four interest rate hikes by the Fed in 2022 with very high probability. Previously the Fed had been leaning towards 2023 for the first hike – or possibly just one at the end of 2022. It has already started the tapering process of reducing the bond-buying programme. Indeed, it is already talking of speeding up that plan.

Our position throughout this debate has been that raising interest rates would not reduce supply-chain blockages or energy prices. Monetary policy is not the way to tackle these problems. Biden has been trying to improve the landing and distribution of containers arriving at US ports.

At the end of November, the game changed. A new strain of COVID-19, labelled Omicron by the World Health Organisation (WHO), sprung onto the scene in Southern Africa. The ASX 200 fell sharply on the news last Friday (and again on the open of the following trading day) and Wall Street fell in tandem on that last Friday. However, during Monday’s trading, US futures were strengthening, and our market responded positively. Wall Street was buoyed by Biden’s comment that a fresh lockdown was unlikely. The S&P 500 roared to life and the ASX 200 followed suit on the last day of November. But Powell burst that bubble the next day in his Senate hearing testimony. He spoke of the need to discuss a faster tapering of the Feds bond buying programme and markets did not like that.

There have been 12 previous strains given names by WHO before Omicron but only Delta has caused heightened concern since the original Alpha variant. It is far too early to judge how Omicron will affect public health, but many countries swiftly moved to close borders.

The Netherlands and Austria had already gone into forms of lockdown prior to Omicron being brought to our attention owing to increasing infections from the Delta variant. The USA also put Germany and Denmark on ‘no fly’ lists.

One good thing to come out of this latest scare is that oil prices fell very sharply which may help contain global inflation fears.

We have held the position since early in the pandemic that we should ready ourselves for ‘aftershocks’ as new outbreaks or lockdowns arise. It is quite possible that this new more transmissible variant will not worsen the severity of health outcomes. Markets are just taking precautions. The scientists say that it will take some time to assess the effectiveness of current vaccines against Omicron.

The possible good news being floated in some quarters is that Omicron might indeed be more transmissible but less severe and so the unvaccinated will rapidly build up some immunity at low risk. Of course, it could turn out that Omicron is worse than Delta. It will take time to follow cases and produce statistical analyses. So far there have not yet been significant reports of more serious health issues.

We feel almost certain that this will not be the last pandemic-related scare in this round of COVID-19. Prudent investors should be positioned to withstand market volatility.

Our market was, perhaps, more nervous about the Omicron news since market analysts knew that our quarter 3 (Q3) GDP growth number would be released on December 1st and that it would be bad. The ‘whisper number’ was a substantial decline 3%, its magnitude due to the prolonged lockdowns during the period.

Although expectations are meant to be factored into markets, it is common for such really bad news, even if it comes out as expected, the news release would cause at least a little extra volatility.

Growth came in better than expected at 1.9% for the quarter and the market barely reacted. The household savings ratio jumped from 11.8% in Q2 to 19.8% in Q3. Presumably, people had less reason, or less opportunity, to spend given the size and length of the lockdowns. This bodes well for a Q4 bounce as people get back closer to normal – Omicron notwithstanding.

Our latest retail sales growth figure was particularly strong at 4.9% for the month. Our unemployment rate did rise from 4.6% to 5.2% but that was more due to a statistical aberration in the previous month. We lost 46,000 jobs and one million hours of labour. The economy has a long way to go before we could pronounce a strong and stable labour market at full employment.

Our Q3 data were greatly affected by the long Sydney and Melbourne lockdowns and other restrictions. Without Omicron we were looking forward to a reasonable Q4 and a good 2022. We still expect a bounce back in Q4 but we need to know more about Omicron before we can reasonably reset our forecasts.

US data were generally strong. 531,000 jobs were created, and the unemployment rate was reasonable at 4.6%. Wage growth for the month was high at 0.4% reflecting the incentives being offered to get people back into the workplace.

A variety of US wholesale and consumer price inflation data were published, and all were on the high side. US retail sales rose 1.7% just for the month but consumer confidence was at a 10-year low.

Biden signed the $1.2 trillion infrastructure package into law and the more general $1.75 trillion economic and climate change package moved through the House. These packages will help boost the economy through 2022 and beyond.

The new puzzle is to work out what will happen because of Omicron. It could mean little change from our previous forecasts. However, it could slow down people wanting to return to the workplace. It could also mean that supply-chain blockages could continue or even get worse – this is Fed Chairman Powell’s current fear.

Previously we reported that the Chinese economy had been slowing down. This last month saw retail sales and industrial production beating expectations. This improvement might mark the beginning of the move to return the economy to strength. However, so far, the improvement is only slight. The China manufacturing Purchasing Managers Index (PMI) crept back up above the 50-mark indicating mild expansion as opposed to contraction denoted by a level below 50. The expectation was for a reading of 49.6.

A week or two ago we were expecting to write a fairly optimistic economic update for the year ahead. Now, we must put our enthusiasm on hold until we find out more about the Omicron variant and governments reaction to it.

Scientists are not going into panic mode, and neither should we. Given the last two years of the pandemic it is simply prudent to react first and adjust back to something more ‘normal’ as the real impact becomes clearer. We’ve had a great year to date in share markets. While visibility in to 2022 is clouded, at this point we anticipate a continuation of positive equity markets returns but at a more measured pace than we have experienced in 2021.

Asset Classes

Australian Equities 

The different sectors of the ASX 200 followed no common pattern in November. Some sectors, like Financials (8.0%), were well down while others – such as Materials (+6.2%) and Telcos (+6.2%) – made strong gains. The net result for the broader index in November was 0.9%. The ASX 200 is up +10.2% over the year-to-date.

It is no surprise to see that energy sector (8.4%) was well down given the dramatic fall in the price of oil. Financials were possibly down on margin expectations as interest rate hikes were being factored in.

International Equities 

After a volatile month, including a record daily fall for the year, the S&P 500 finished down only 0.9% over November. The European, Japanese and Emerging Markets major indexes were down between 2% and 4% over October. The S&P 500 is up +21.6% year-to-date whereas Emerging Markets were down 2.8% over the same period.

Bonds and Interest Rates

Australian 10-year bond yields started November at 1.80% but drifted down closer to 1.7% at the end as inflation and rate fears subsided.

The Fed tried to reassure markets that the pace of rate hikes will be slow and steady. Pressure is building up to end tapering before the mid 2022 plan and maybe even start hiking rates at the same time.

Omicron might have put some plans on hold, but the mood has definitely changed. However, it looks unlikely that US Treasury yields will rise sufficiently to worry equity investors as an alternative asset anytime soon.

Other Assets 

The prices of oil fell sharply (Brent 16%, West Texas Intermediate crude 21%) over November as airlines would have to scale back operations again. The price of iron ore fell again and settled down at well below $100 per tonne but rallied in the last period back above $100. Gold and copper prices were relatively flat. In the currency market the Australian dollar fell by more than 5% against the US dollar.

Regional Review

Australia

The Australian economy is emerging from the effects of lockdown but the lag in the quarterly data makes the September quarter GDP growth at 1.9% out of sync with the optimistic, latest monthly retail sales at 4.9%.

The Westpac consumer sentiment index was only marginally stronger at 105 but both NAB business conditions and business confidence indexes improved and sit at reasonably optimistic levels.

Our labour force data were mixed. The unemployment rate rose to 5.2% from 4.6% and 46,000 jobs were lost. Wages growth over the year was up 2.2% with 2.4% for the private sector and 1.7% for the public sector. Wages did not keep pace with price inflation.

China 

China’s economy may have turned the corner. Both retail sales and industrial output beat expectations, but they were only marginally stronger than the data in the previous month.

The manufacturing PMI (50.1) surprised forecasters whose estimates averaged 49.6. This index a month before was only 49.1.

US

The US jobs data were reasonably strong. There were 531,000 new jobs verses an expected 450,000, The unemployment rate was 4.6% and wage growth over the year was 4.9%.

While accommodative monetary policy starts to get dialled back, fiscal (government spending) policy is on a tear. Nevertheless, Biden continues to do poorly in the polls. His polling puts him as the most unpopular US president during their first year – other than Trump! It was also announced in two separate polls that Trump would be ahead of Biden if they both were to run in 2024. We see this not as a boost for Trump but as an indicator of the depth of the division between electoral groups across the US.

 Europe 

EU inflation was 4.1% and it was 4.2% in the UK. With big spikes in COVID-19 infection rates across Europe, a wave of new restrictions has started.

Latest news reports that the Omicron variant was in the UK and the Netherlands before the announcement in South Africa and before travel restrictions were put in place. Masks are now compulsory again in the UK on public transport and elsewhere.

Rest of the World

South Africa has called for help from developed countries to help them and others secure COVID vaccine supplies – rather than just place seven Southern African countries on ‘no fly’ zones. Until much of the world is vaccinated, or has gained natural immunity from infection, the problem will not go away.

Key Points

• Australian inflation above 2%
• US Federal Reserve set to act on inflation fears
• Chinese economy slows further

The Big Picture

As Sydney, Melbourne and other places start to emerge from very long lockdowns, a new set of economic woes confronts Australia.

There is much confusion over the implementation of the stages of recovery as state Premiers and the federal government square up for control. We’ve lost count of how many times Novak Djokovic’s possible exclusion from the Australian Open has changed. But there are far more important COVID issues to consider.

Governments had to end lockdown as the ‘populous were getting restless’ but the global situation has started to shift. The daily infection rate in the US peaked a month or two ago and then started to fall rather sharply. The current rate is now about half of the rate at that peak. The UK rate peaked in July but its recovery stalled and has arguably worsened in October.

The UK situation has concerned many and possible new lockdowns around Christmas are being discussed in their media. So why the big difference between the US and UK experiences? And what does it mean for Australia as we start to open our borders to international travel?

This question is particularly complex and possibly nobody has a really good understanding of what is going on. From a markets’ perspective, we need to form a view about the future of equity and bond investments at least in Australia and the US. At the moment we are positive about both equity markets providing we can get through the ‘inflation scare’ that has just started to build. But if either or both of these countries need to restrict practices – even including lockdowns – we need to factor in some market reaction.

There are, in our opinion, two major differences between the UK and the US that might account for the different infection rates. Vaccination rates are quite high in both countries. We see the prevalence of the ‘delta plus’ variant of COVID-19 and the vaccines used as potential explanatory factors.
Many point to the spread of delta plus in the UK as a primary cause for the persistence of their infection rates. However, that variant has been reported to be present in at least five US states as well as in 30 other countries. The first case in Australia was reported at the very end of October.

Health officials in the UK have suggested that delta plus spreads 17% faster than the plain delta variant but, it was noted, the data are not yet that reliable. If the UK experience is, indeed, mainly due to the spread of the newer strain then we can expect similar problems to start to emerge in the US, Australia and elsewhere.

Another important difference is the dependence or otherwise of the AstraZeneca (AZ) vaccine on infection rates. AZ is not approved in the US. They have mainly depended on Pfizer and Moderna which had much stronger clinical trial results than AZ. The UK, like Australia, had a high degree of dependence on AZ. Both countries adopted Pfizer for certain groups as supplies became more readily available.

Since the US was much quicker to reach strong vaccination rates than the UK, the possible ‘waning’ of the vaccine’s efficacy cannot be a material explanator. If AZ is not good enough to cope with either delta or delta plus then there are big implications for Australia’s future. We note that the US population is about 400% bigger than the UK but the infection rate for the US is only 50% higher. These are serious differences. However, death rates are more in line with the broader population comparison. That is, a smaller proportion of the infected in the UK die.

Whether delta plus or the choice of vaccine (or both) is a major factor in the UK being able to live with COVID, the implication for Australia is not as rosy as many had hoped for. While we do not see recessions arriving as a result, we have learnt a lot over the past 18 months so it will be easier to deal with any emerging problems. However, we do need to work on our coordination between the state and the federal governments.

We are also facing renewed economic pressures. The last week of October was pivotal in how the world views inflation; the first week of November might produce some unexpected policy responses.

The latest inflation read for Australia was 3% which is at the top of the target band used by the Reserve Bank of Australia (RBA) to monitor interest rate policy. The RBA prefers to focus on the so-called ‘trimmed mean’ that removes outliers and volatile elements like energy costs. Given that fuel prices surged 7.1% in the last quarter, there is a lot of merit in focusing on the trimmed mean.

That ‘trimmed’ measure was expected to come in at 1.8% or just below the 2% to 3% target band. The actual number was 2.1%. While 2.1% is at the very bottom of the range and ordinarily would require no reaction, it is the highest value of the trimmed mean since 2015! Markets started to react with very large bond sell-offs so yields started to rise.

The RBA has been engaging in a modest Quantitative Easing (QE) policy that is used to purchase government bonds to help to keep yields low at medium-term tenors of around two to three years duration. The RBA aimed to keep the three-year yield down to around 0.1% with its QE. It lost control after the latest inflation data release and then it capitulated. The three-year yield rocketed up to 1.25% and the ten-year to 2.09%. The US ten-year yield was stable at around 1.55% and had been comfortably above the Australian yield for some time.

This increased yield may well start a round of home loan rate increases. In the meantime, the RBA has to make its monthly board meetings on the first Tuesday of each month (except January) and announce the results of its deliberations. The market has got the RBA on the ropes. The pressure must be enormous.

The RBA recently repeated its aim was to keep the official overnight interest rate on hold (at 0.1%) until at least 2024. The reason to raise rates would supposedly be to control inflation. But an interest rate hike would do nothing to control energy prices or supply-chain disconnects that are at present plaguing the world.

We think the RBA should stay ‘on hold’ as planned, but a statement that placates the market would help. Given that the first meeting after this bond reaction is on Melbourne Cup Day, there is some chance the message might get lost in the festivities – but not a lot.

We are far from alone in this inflation-rate-hike conundrum. The US also released its inflation number in the last week of October. At 4.4%, it was the highest number in thirty years. The preferred ‘core inflation’ read that strips out energy and food prices, etc was a more modest 3.6% which was the same read as in August but still the highest since 1991.

The US Federal Reserve (the “Fed”) has its next meeting also scheduled for the first week of November. The market has now priced in a 95% chance of at least one rate hike in 2022 and more likely two or three hikes. The Fed was expected to announce the start of tapering (of QE) at that meeting and for tapering to be complete by mid-2022. The Fed chair, Jerome Powell, was forceful in his pronouncement that tapering should end before interest rate hikes are considered. He, too, is now on the ropes. The previously planned 2023 start to the next cycle in rate hikes looks increasingly unlikely.

Given that the latest US GDP read came in well below expectations at 2.0%, any rate hike to placate the markets could create a serious problem for the US economy and the markets. Since Australia is expected by some to post a negative GDP read for the latest quarter because of the lockdowns, any rate rise at home could prolong any downturn.

And while the Western world seems to be facing major decisions, China’s economic data showed further weakness. While China has more flexibility to control its economic outlook than the west, it would not want to stimulate its economy before it has fully dealt with its current property development debt situation.

We think that the Fed and the RBA are more than capable to plot a sound course for their macro-economies but market reaction could produce increased volatility. We consider investors who have a sound long-term asset allocation strategy in place should, barring any unforeseen events, be well positioned to ride out any shorter term volatility until markets settle down again.

Asset Classes

Australian Equities 

The ASX 200 was down just  0.1% on the month but the Financials sector reported modest gains (+0.8%). Since the futures contract price for the ASX 200 index were up nearly 1% for the November open, the fall on the last day of October was nothing to worry about. The index is up 11.2% on the year-to-date.

After the August reporting season worked its way through broker forecasts of earnings and dividends, our analysis suggests we are back to expecting a slightly above average 6% gain in the index over the next 12 months. Dividend yield is expected to be 3.7% in addition to that capital gain with franking credits also available for relevant investors.

We calculated the market was modestly under-priced at the start of November to give the index a little extra boost towards Christmas and the year end. However, the inflation outlook and central bank activity could negatively impact on the market if they are not handled well.

International Equities 

The S&P 500 had a stellar month’s gain of 6.9%. Emerging markets had a far more modest gain of 0.8%.

A lot of the Wall Street market bounce in October was probably due to the particularly strong September quarter earnings reports for a number of the big banks. Indeed, much of the market reporting so far has been for strong earnings and revenue, many of these well ahead of analyst’s forecasts. US market mega cap stocks Apple and Amazon, however, underperformed and stopped the broader index rising further.

Bonds and Interest Rates

Yield curves in the US and Australia have been making some big moves in recent times as analysts try to work out whether inflation really is ‘transitory’ as the Fed would have us believe. The consensus is that the Fed and the RBA will have to act much earlier than previously expected – we believe the jury is still out on this call – and while inflation has risen, we think there will need to be a corresponding sustained lift in growth as well.

We think central bankers appreciate that the major sources of the inflation ‘blip’ would not be improved by hiking rates. Energy prices and supply-chain bottle-necks are likely unaffected by central bank action.

The fights between banks and markets might well cause additional volatility in both bonds and equity markets.

Given the fall in iron ore prices, we might have expected some softness in the Australian dollar but it might be being offset by movements in oil prices and bond yields.

We expect the Fed and the RBA will have to acknowledge the inflation issues but not necessarily act other than the Fed announcing the start of tapering at some modest rate – say $15 bn per month – from December which would have their bond purchasing program cease by mid-2022.

The CME Fedwatch tool that prices market expectations about US rate hikes predicts two or three hikes in 2022 as the more likely outcome with only a 5% chance of no hikes next year. Since hiking interest rates while still tapering the bond buying program goes against Powell’s stance, he will have to be word perfect in his delivery of any amended policies.

The RBA will likely abandon its yield curve management as the market has won that battle. It should take a lot more to make the RBA hike overnight rates as our economy is too weak to take a hit at this time. If our COVID fears are realised, we expect the first hike still in 2024 – along with the RBA – but a little sooner if our economy returns to growth in the last quarter of 2021 and beyond.

Other Assets 

The price of iron ore stabilised somewhat over October after a rapid fall in the prior period. China was forced to take its Australian coal out of bond after a year-long ban on coal imports from us. With winter rapidly approaching, China could not afford to let policy interfere with the global energy crisis.

The price of gold recorded a modest gain of 1%. The price of oil was again up firmly by around 8-11% in October while the $A gained 4.7% against the $US.

Regional Review

Australia

The Labour Force survey again produced mixed results. While the unemployment rate was a modest 4.6%, the number of jobs lost was  138,000. This puzzle is resolved by noting that the participation rate fell sharply indicating ‘discouraged workers’.

Some big firms are reportedly offering inducements to attract workers back to office in the city. One firm is reportedly giving workers who turn up $20 a day to spend on lunch or local businesses. Casual observation of restaurants and cafes in Sydney does not suggest workers are rushing back to normal life – even compared to what was normal in COVID times just before the lockdown in June.

We currently see Australia avoiding a recession but we expect some lumpiness in economic activity. The Westpac and NAB surveys of consumer and business confidence suggest things are ‘okay’ but not good. The run-up to Christmas and the experience of children returning to school will be all-important in determining the strength of the platform on which 2022 economic activity will be based.

China 

China’s economy continued to slow again in October. Its GDP growth came in below expectations at 4.9% and the partial indicators of retail sales and industrial output also missed by quite a bit.

The Evergrande property developer debt default situation appears to be being handled well enough not to upset broader markets. China must do what it takes to avoid this becoming a contagion. We expect China to be successful in its endeavours on this front but at the expense of stimulating the broader economy. Depending on how this plays out Australia’s economy is likely to suffer somewhat as a result.

US

The US nonfarm payrolls again disappointed with a gain of only 194,000 jobs. That number would be good in normal times but many people lost jobs in the lockdown who are not being re-hired. The unemployment rate of 4.8% against an expected 5.1% masks the true state of the labour market.
Retail sales surprised on the upside at 0.7% against an expected  0.2% and wages rose by 0.6%. The economy is patchy by geography and industry sector making these numbers particularly hard to interpret.

Elsewhere, President Biden has slipped to 41% approval against 52% disapproving. The -11% margin between those figures should be contrasted with the +3% in the previous survey.

Europe 

The UK has suffered serious petrol shortages – not because of supply, but because of a lack of drivers to shift the tankers. Apparently, the UK was heavily reliant on Eastern European drivers prepared to work for lower rates of pay compared to British drivers. That foreign labour source dried up with Brexit.

UK Prime Minister Johnson is bravely leading the British economy in a post lockdown world when it is becoming increasingly clear that some restrictions – even a lockdown – might again become necessary.

Europe is suffering fuel shortages, some of which are self-induced by not having stock-piled in the warmer summer months. Russian President Putin stated that a lack of wind in the Russian summer has exacerbated the energy situation. Inflation in Europe has, as in the rest of the developed world, risen markedly in recent months.

Rest of the World

Canada is reportedly ready to end tapering and commence rate hikes. New Zealand has already started hiking rates. We do not think Australia should follow suit just yet.