despina

Key points:

– Central banks continue to remove policy easing at a rapid rate

– Slight easing of supply-side bottlenecks is hoped to result in a softening in inflation data

– Australian unemployment rate now the lowest since 1974!

The Big Picture

After a dismal June in equity markets, July was like a breath of fresh air. Wall Street’s S&P 500 was up 9.1% on the month while our ASX 200 rose 5.7%. Of course, it’s a long way back to the top, but this is a step in the right direction.

Though, we think it is too early to be convinced that it’s just onwards and upwards from here. A few positive things happened in the last week of July but some, or all of them, could slide back to lower levels.

While we don’t see markets revisiting their June lows however, a meteoric rally like the one from the last week of July needs a bit more substance to sustain it. These short sharp rallies are often referred to as bear-market rallies – and can fizzle out as quickly as they start. In our opinion, the jury is out on this one. It could go either way.

Central banks are at both the heart of the problem and the solution. As analysts we have to try and guess what they will do and measure that against what they should do.

There was a flurry of central bank activity in the first part of July. The Reserve Bank of Australia (RBA), the European Central Bank (ECB), the Reserve Bank of New Zealand (RBNZ), the Bank of Korea (BoK), and the Bank of Singapore (BoS) all hiked their base rates by 50 bps (or 0.5% points). Singapore didn’t even wait for their scheduled meeting. It jumped in, out-of-cycle! The Bank of England (BoE) hiked rates for the fifth month in a row. But there was a notable exception.

The Bank of Japan left rates on hold. They argued, as they did in the 1970s when the two big oil price shocks occurred, that higher interest rates do not cure inflation caused by supply-side shocks. Japan had two stellar decades of growth in the 70s and 80s. Most of the rest of countries hiked rates sharply with the result of being stuck in stagflation. That is, there was high inflation because interest rate policy could not work against the cause and slow economic growth because high interest rates cripple the economy.

When the United States (US) Federal Reserve (“Fed”) met towards the end of July, they hiked the Fed funds rate by the expected 0.75% but they were softer in their tones than in previous recent meetings.

Fed chair, Jerome Powell, stressed that some parts of the economy were looking a little weaker and the Fed might be less aggressive going forward. This statement at a press conference immediately inspired a very strong rally in US equity markets.

There are few among us that would not acknowledge that major supply-side blockages have contributed greatly to global inflation: the Russian invasion of the Ukraine (gas pipeline to Europe and blockade of Black Sea ports stopping grain exports, and oil supply from Russia) and supply-chain disruptions caused by pandemic shut-downs.

There are pockets of demand-side inflation caused by mismatching of workers and vacancies as well as workers in general seeking wage increases to compensate for higher energy and food prices.

Of course, Australia has also suffered significant supply disruption from the major flooding along large stretches of the east coast. Various produce, such as lettuce, have had prices skyrocket.

We do not think any of the major central banks have taken us to the brink. They have largely just removed the emergency settings that were introduced more recently because of the pandemic. It is only when rates are pushed past the so-called ‘neutral rate’ that separates ‘expansionary policy’ from ‘contractionary policy’ settings that trouble may emerge. Most seem to agree that the neutral policy interest rate is between 2% and 3%. The US rate is now a range of 2.25% to 2.5%. For them, walking the plank starts from here.

In earlier issues of this monthly update, we argued that the central banks might be intent on doing one thing while saying another. The media and others were howling for rate hikes to crush inflation. Is this first round of hikes and the magnitude of the increases in part to placate the media? We won’t really know until the 21st September Fed meeting. Will they keep going?

The RBA is still way behind the US with its overnight rate at 1.35% even if it hikes as expected on August 2nd to 1.85%.

The US Consumer Price Index (CPI) inflation came in at 9.1% annualised for June and even the core measure that strips out food and energy prices was 4.9%. The US Private Consumption Expenditure (PCE) alternative measure, preferred by the Fed, was 6.8% with the core at 4.8%. But it does seem that the increases in inflation rates may have ended or even peaked. Perhaps that was the sentiment that drove equity markets higher in late July.

The fly-in-the-ointment might be US economic growth as measured by Gross Domestic Product (GDP) growth. It was 1.6% in Q1 and 0.9% in Q2. That, for non- economists, might signal a recession. Fed Chair Powell, former Fed Chair Yellen (and now Secretary to the Treasury) and President Biden all stated firmly that the ‘US is not in recession.  We strongly agree.

The proper definition of a recession is based on deterioration of economic conditions in many sectors of the economy including the labour market and consumer spending.

The US has witnessed six months of job increases in excess, on average, of 400,000 per month. Before the pandemic, 200,000 new jobs created in a month was considered to be very strong. The unemployment rate in the US is 3.6% or as close to full employment as anyone could wish for. There are about two job vacancies for every one unemployed person. Consumer spending is also holding up.

The official body that ‘dates’ recessions in the US, the National Bureau of Economic Research (NBER) does not even refer to GDP growth in its deliberations.

In Australia, we just recorded the lowest unemployment rate since 1974 and 88,000 new jobs were added for the latest month. While conditions can change rapidly, there is no evidence that the US or Australia are currently anywhere near a recession.

So, when will the supply disruptions end to put an end to the high inflation regime? We don’t know but there are signs we are moving in the right direction.

Turkey brokered a deal to get the gas pipeline from Russia to Germany working again after a 10-day so-called ‘period of maintenance’. It worked, but it looks likely that Putin might manipulate the flow to cause rationing at times.

Turkey was also there with the UN to get a deal going on grain shipments out of the Black Sea ports of Ukraine. There are reportedly 80 ships loaded with 20 million tons of grain, but we have not yet seen a report that the ships have set sail through the UN-supported shipping corridor.

For very different reasons, ships are lying idle off the US east and west coasts in large numbers. The queue is reportedly about four times normal. There is industrial action in Oakland California that has blocked container movement there but, more generally, ports were working at full capacity, so it is hard to step up turnaround when there aren’t enough resources. One reported blockage is the supply of drivers for the trucks that move the containers. Some of that is due to Covid-related absences.

China is well past its big lockdown for Covid but since they are maintaining the zero Covid policy, there are plenty of pockets of supply disruptions.

While we feel that a supply-side inflation problem is far from being solved, we could be close to improving from a bad place – and that means inflation would fall even if it remains high. Like Japan, we and the US can use fiscal policy to cope with high inflation.

We see the underpinnings of the July equity rally as fragile rather than doomed. Markets critically depend not only on what the central banks do, but also what they say.

Asset Classes

Australian Equities

The ASX 200 had a bad month (8.9%) in June but clawed back 5.7% in July. IT and Financials down (15.2%) and (9.3%) respectively led the pack. In spite of a strong finish in the prices of oil, copper and iron ore, a poor month for those commodity prices saw our resources sector underperform at the bottom of the pack.

With earnings season almost upon us, it is comforting to note that the Refinitiv survey of broker-forecasts of dividends and earnings are holding up well. There is scope for a strong finish to the year if central banks incorporate a reduction in supply-side inflation into their interest rate policy setting deliberations.

International Equities

The S&P500 also had a bad June (8.4%) but cancelled out these loses in July with a gain of 9.1%.

The UK FTSE, the German DAX and the Japanese Nikkei retuned similar amounts to the ASX 200 while China’s Shanghai Composite actually fell 4.3% after a strong June (+6.7%). Emerging markets were flat in July.

Bonds and Interest Rates

The RBA lifted its overnight borrowing rate from 0.85% to 1.35% at its July meeting. The market is pricing in a further ‘double’ hike for August but that would still leave the overnight rate well below the neutral rate.

The Fed was expected to hike by 100 bps after the record-breaking inflation read at the start of July. However, by the time of the meeting, the market had come back to expect a 75-bps hike.

With Jerome Powell calming expectations for future hikes there is a long wait before the 21 September meeting. Important comments might be made at the annual Jackson Hole gathering of global central bankers in the interim.

A plethora of other banks hiked during July: ECB, RBNZ, BoK, BoS and BoE. Although they hiked by 50 bps, the ECB reference rate is still only 0.0%.

10-year rates on government bonds in Australia and the US experienced some wild gyrations in July. They are now back well below the recent highs.

The US 30-yr mortgage rate experienced major falls immediately following the Fed’s 75 bps hike. The market might be paving the way for a pause in the hiking cycle.

Other Assets

Iron ore, copper, gold, and oil prices again retreated in July but rallied in the last week of the month. The Australian dollar rose 1.7%. The VIX ‘fear gauge’ almost retreated to an historically normal range by the end of July.

Regional Review

Australia

There were 88,000 new jobs reported for the month and the unemployment rate dropped sharply from 3.9% to a near 50-year low of 3.5%.

CPI inflation came in at 6.1% or 1.7% for the June quarter but the trimmed-mean variant, favoured by the RBA, was 4.9% annualised or 1.5% for the quarter.

Pensioners are set to receive some larger CPI indexed increases based on these data.

China

China continues to grapple with its zero Covid policy. As a result, most economic data were weak.

GDP growth came in at 0.4% while retails sales (3.1%) and industrial output (3.9%) also missed expectations.

US

There were 372,000 new jobs created as reported in the latest monthly labour report while 250,000 had been expected. The unemployment rate remains at an historically low 3.6%.

CPI inflation came in at 9.1% for the year against an expected 8.8%. Core CPI inflation was 5.9%. The Fed-preferred PCE inflation stands at 6.8% and the core variant at 4.9%

The preliminary estimate for GDP in the June quarter was negative at 0.9% in the wake of a 1.6% final estimate for Q1. This does not amount to a recession in and of itself as the US has an economically sound definition of what constitutes a recession.

Fed Chair Powell, President Biden and Treasury secretary Yellen all took great pains to express their view that the US is not in recession. Retail sales in June were up 1.0% for the month but that is less than the current rate of inflation!

Europe

The ECB has, at last, hiked its rate to 0.0%! Germany was suffering somewhat from the temporary closure of the Russia gas pipeline.

Britain seems to have come to terms with a rapidly slowing economy. Boris Johnson is to be replaced in the near future as British PM.

Rest of the World

Turkey has been active in brokering deals between Russia and the Ukraine over both gas and grain supplies. While this news has been received positively, it is too soon to comment on the success or otherwise of the deals.

The Central Bank of Russia cut its base rate by 150 bps. At the start of the invasion, it raised rates from 9.5% to 20% in a single hike to defend the rouble. The latest cut simply took the lending rate back to 9.5%.

It comes as no surprise that the elevated level of volatility in both equity and bond markets in recent weeks has unsettled many clients as they experience capital declines in both their share and fixed interest investments. These recent declines are not without cause, as we appear to be transitioning through a period of regime change within markets and economies.

If Covid wasn’t enough—what is going on with markets? It started earlier this year with the United States (US) reporting an annualised inflation rate of 7.0% in December 2021. This came about because the developed world was reopening post the supposed Covid peak and required an increased supply of manufactured components and goods from the developing world, largely China. However, because supply chains take time to restart and due to China’s zero Covid policy, both production and logistics (shipping) have not been able to respond to increased demand. This has resulted in price increases, leading to higher inflation, particularly in the US, but also in Europe and the rest of the developed world. Inflation has also been magnified and prolonged by the Ukraine War which has driven energy and wheat prices much higher. The April read for US inflation came in at 8.3% p.a. down slightly from the 8.5% p.a. reported in March. Encouragingly, the monthly number for April of 0.3% is well below the March level of 1.2%.

The increase in the rate of inflation now looks to have caught central banks on the back foot, after initially believing that inflation was ‘transitory’ and would decline as global output rose post the Covid peak. This has not eventuated as a result of the outbreak of the Omicron variant which has taken hold in China and authorities there have persisted with their Covid zero policy – and continue to do so to this day. Currently in China, 27 cities and circa 185 million people remain in full or partial lockdown, so supply problems have continued largely unabated from late 2021.

While some central banks have been increasing interest rates from their lows, the US Federal Reserve (the Fed) has had a significant change in its appreciation of inflation and is no longer prepared to say it is transitory. This being the case, the Fed has responded with a substantive policy change choosing to quickly wind back the bond buying program (reducing stimulus) and embark on a rapid tightening of monetary policy, increasing interest rates by 0.25% in mid-March and then 0.50% last week, the largest single increase since the year 2000. Markets have responded and are now expecting that, by the end of calendar year 2022, the US cash rate will be in the range of 2.75% to 3.00%. Similarly, in Australia, RBA chair Philip Lowe had a mea culpa last week admitting their view that official rates would not rise in Australia until at least 2024 was wrong. As we write this, the RBA has already increased rates by 0.25% earlier this month, well ahead of the previous expectations.

This change of heart by the US Federal Reserve, Reserve Bank of Australia and others has happened reasonably quickly (in about the last 8 weeks) and has been quite dramatic. So, fundamentally it is the abruptness and magnitude of this change of attitude of the central banks that has seen market interest rates take off. The US 10-year bond yield has risen from 1.7% on 7 March 2022 to 3.14% on Monday this week. That means a US 10-year bond purchased for $100 on 7 March is now worth $93.84, a fall of 6.16% in 63 days. The Australian experience is similar, starting from the recent low on 2 March of 1.98% closing out on Monday this week at 3.51%, the price impact being a fall of $6.96 per $100. This recent experience highlights the driver of negative performance of many traditional bond funds over the past 12 months.

Equities, which had benefited from accommodative monetary policies and low interest rates, also got caught in the down draft of the swift change in interest rate expectations. The MSCI Global Share Index has fallen 14% in the 35 days to Monday 9 May as markets react to factor in expectations of higher inflation and higher interest rates. Australia fared relatively better, the ASX 200 falling just 6.3% over the same 35-day period. By contrast the US NASDAQ Index which lists the world’s largest technology stocks who were the market darlings during the first year of Covid, fell 19.6% over this same 35-day period to Monday 9 May.

So, where to from here? The simple answer is we are not sure, but we do anticipate continued volatility as markets adjust to a higher inflation rate, exacerbated by higher energy prices courtesy of the ongoing Russian invasion of Ukraine and a higher interest rate environment. While the Omicron outbreak in China seems to be waning, there does not appear to be any marked improvement to disruptions in global supply chains. As a result, inflation is likely to stay elevated and support continued upward pressure on interest rates and ongoing volatility in equity markets.

We are encouraged by the corporate earnings results from the latest US reporting season with many companies exceeding broker estimates and reporting higher earnings. However, for the moment investors remain firmly focused on inflation (which remains high but is showing signs of peaking) and interest rates, the outlook for which is heavily biased to the upside. That said, if corporate earnings continue to hold up then, at current prices, there are some attractive opportunities within equities, but that is not what is driving investor sentiment and markets in the short term.

While the combination of these macro forces are driving inflation concerns, there are reasons to maintain the course.

1. Long-term investors are seeing the corrections in bond and equity markets as an opportunity, as lower prices mean improved valuations and higher future long-term returns.
2. In general, key economies remain strong and unemployment is very low. While the market has concerns about economic growth in 2023, the growth outlook is less concerning over the remainder of 2022.
3. Balance sheets remain strong and debt is not a major concern for many corporates.
4. Inflation is expected to reduce as supply side disruption eases as China will not remain locked down forever.

Key points:

– US inflation pushes higher, and the US Fed starts hiking interest rates.

– The Ukraine invasion by Russia has not escalated beyond expectations but has become more protracted.

– Commodity prices and $A bounce on the Ukraine invasion and Australian economic data very strong.

– The world re-opens despite Omicron and now BA2 but lockdowns in China continue to impact supply chains.

– China economy bounces back from a weaker second half of 2021.

The Big Picture

While the devastation and casualties continue to mount in the Ukraine, worst-case scenarios seem thankfully to have been avoided – at least so far.

The resilience of the Ukrainian people has reportedly been outstanding. The West has contributed in many ways, though it has not attempted to inflame the situation by moving troops too close to the action – or firing our own missiles.

As is usual, markets fell sharply on the first bad news but recovered after having realised they had priced in a worse outcome. With media outlets almost calling a stalemate in the Ukraine with Putin having failed, so far at least, to achieve his objectives (whatever they may have been), it would take fresh bad news to shake the market again. There is opinion forming that Putin might even be at risk of being ousted as leader.

Some of the success in preventing a worse outcome can be attributed to the co-ordinated sanctions being placed on some trade and the assets of the so-called seven oligarchs that amassed great wealth from links with Putin.

Superyachts, planes, and property have been seized by various countries. The impact on the Russian economy has reportedly been massive. At the start of March, the Russian Central Bank increased its base interest rate from 9.5% to 20% in an attempt to cushion the rapid depreciation of the rouble.

As March drew to a close, there was some optimism that Putin was considering a ‘lesser objective’ and, indeed, recent talks between the two sides is offering a little more hope than previous talks.

While Ukraine is rightly taking centre stage on TV news, the great economic news from Australia, the US and China might have largely flown under the radar.

The US Federal Reserve (the ‘Fed’) raised its cash interest rate by 0.25% points to a range of 0.25% to 0.50% at its March meeting. It also signalled that it now expects six more hikes this year rather than the three in total it expected for 2022 at its December meeting. The forwards’ markets that price these outcomes have been swirling as each statement is made by a Fed member. US Federal Reserve (Fed) Chair Jerome Powell recently came out and predicted possible ‘double hikes’ of 0.50% points. As a result, markets have priced in a double hike at its next meeting on May 4th as being more than twice as likely as a single hike. There is no appetite for more than a double hike or conversely, staying on hold.

This interest rate news has also affected the US mortgage market. Unlike in Australia, their most common type of mortgage is a 30-year fixed-rate loan. It gives perfect foresight to the borrower as to what payments can be expected for the entire length of the loan. Moreover, as inflation builds over the 30 years, the repayments fall in inflation-adjusted terms.

The US 30-yr mortgage rate jumped sharply twice in the last week or so of March to 4.95%. Contrast that to our floating rates in the low two percent range. The US mortgage rate hikes and the recent increases in property prices mean that people are now paying 20% more a month than others were quite recently. That’s got to hurt! Existing mortgagees, of course, pay the same as they previously did because they bought a while back at the old prices and the rate was then fixed for the entire term. Only the new buyers suffer with the higher rate and this in turn might help cool the US property market.

With this change in monetary policy stance, the important question, now canvassed by even ‘sensible’ economists, is will this change by the Fed cause a recession? They have certainly been found guilty on a number of previous occasions!

In general, as a central bank raises rates to cool an economy – known as ‘monetary policy tightening’ – the rates for short terms, like 3-months to 12-months, rise in unison. For longer terms – say 10-yrs or more – interest rates may not move as much or at all. Most agree that expected inflation is the major determinant of longer-term interest rates.

The ‘normal’ situation is that short term rates are lower than long term rates reflecting the increased risk to capital return over the longer term. These yields typically rise smoothly with the term of the bonds/term deposits. The array of yields for the different terms from short to long is called the yield curve when all plotted on the same chart, longer term yields typically flatten out after about 7-10 years. When rates at the short end are higher than at the longer end, the so-called yield curve is said to be inverted.

Back in 2019 the yield curve got close to being inverted and some called a recession would follow. While it is true that most recessions are preceded by an inverted curve, it is also true that not all inverted yield curves are followed by a recession.

It usually takes several factors to cause a recession. We argued in 2019 that the inverted yield curve was on its own not sufficient to justify a recession. As it turned out, there was a recession in 2020 but that was caused almost entirely by the unexpected shutdown in response to the Covid 19 pandemic – and not interest rates!

It is also important to note that some people consider the yield curve ‘spread’ for inversion to be the difference between the very short yield and the 10-yr yield while others focus on the difference between the 2-yr and 10-yr yields. Obviously, as the yield curve flattens out, the latter indicator is dominated more by very small movements in yield and hence is more likely to invert in turn increasing the potential for it to give a false signal. That said, any inversion of the yield curve should not be ignored and the reasons for it investigated.

It is equally important to note that the actual yield, rather than the yield ‘spread’ alone, must play a big role. If all rates were pretty close to zero (say less than 0.10%) it is difficult to see how any recessionary problems could emerge from an inverted yield curve. On the other hand, back in 2000 and 2006-2007, the 2-yr yields were over 5% when those yield curves inverted (on the ‘2yr-10yr’ spread definition) and each was followed by a recession. Today the 2-yr yield is closer to 2.5% – hardly the stuff of expensive borrowing costs compared to current inflation at around 6% to 7%.

Obviously, the Fed could cause a recession this time around so we shouldn’t rule it out. The Fed funds rate has a long way to go before inversion gets close (using the spread over the whole curve i.e., cash vs. 10 yr) so we shouldn’t worry yet. Increasing the rate from the ‘emergency’ rate range of 0.00% to 0.25% by a little is not really tightening. Tightening doesn’t really start until the rate gets above the so-called ‘neutral rate’ which neither slows down nor speeds up the economy. There is no precise estimate of what the neutral rate might be, but most well-informed analysts say it was somewhere around 2.5%.

We are convinced many commentators do not properly understand the linkage between interest rates and inflation. There is no magic string that joins the two together. Rather, increasing the Fed funds rate (US cash rate) increases in turn the cost of borrowing for households and businesses. Those increases in costs slows down growth and take ‘demand side’ inflation pressures away. Importantly, the US government debt is in the trillions of dollars; so, the Fed won’t want to shoot itself in the foot by recklessly hiking rates and increasing its debt funding costs.

A large contributor to current inflation in the US is due to supply-chain disruptions caused by the pandemic and surges in energy and ‘soft’ commodity prices (such as wheat) which are due to the Ukrainian situation and related causes. There is no linkage between the US funds rate and those two causes of inflation. Therefore, if the Fed kept trying to crank up interest rates until inflation collapsed, the economy would collapse before inflation dropped significantly.

We think that it is quite plausible that the Fed chair, Jerome Powell, fully understands these arguments. He has almost said as much. By cranking interest rates up just a little, he gets a lot of people off his case without causing a problem. Smart move! Let‘s not worry about the Fed funds rate until it gets to around 2.5% and that’s probably 2023.

Towards the end of the year Ukraine and supply-chain issues might be receding and inflation may then fall – but not in response to any modest rate rises. If that happens, Powell can then keep rates on hold until domestic causes of inflation really are a problem. If inflation does not fall because of the reasons given, he can point to the disconnect, so that more rate rises won’t help.

Recessions are always possible and typically come out of the blue. We see no reason to increase our expectation of a recession any time soon.

Getting back to the real economy; US jobs data were very strong, and the unemployment rate is down to 3.8%. Wages growth came in at 5.1% in March but that is less than even the ‘core’ rate of inflation that strips out volatile energy and food prices. It is good that wages are rising because, otherwise, workers would be much worse off. There are no obvious signs of a wage-price spiral based on expectations (yet?).

At home our central bank, the Reserve Bank of Australia (‘RBA’), kept rates on hold. Our inflation is in the preferred ‘zone’ so we don’t need to raise rates at the moment. However, for the same reasons as the Fed, they might choose to make a very modest hike or two this year to get people off their case.

Our Gross Domestic Product (GDP) growth came in at +3.4% for the quarter (Q4, 2021) which was distorted by a bounce-back from the Delta virus lockdown. Growth was +4.2% for the whole of 2021 and GDP is now +3.4% (not annualised) above where it was before the pandemic.

Home prices from the Australian Bureau of Statistics (ABS) surged in 2021 in Australia – by 23.7% for the year. There is evidence from a private data source, CoreLogic, that house price growth has slowed to close to zero in the first three months of 2022. (No RBA interest rate rise was needed to cause that!)

Our unemployment rate fell to 4.0% which is the equal lowest in 48 years; 121,000 new full-time jobs were created — 20,000 would usually be called a big number. That is very good news, indeed.

March ended with our Federal Budget. There was no clear long-term policy direction – more of a mish mash of handouts in a typical election mode push. The Treasurer forecast growth of 4.25% in this financial year and 3.5% in the following year. Thereafter, to 2025-26, he forecast growth of 2.5% p.a. He also expects the unemployment rate to fall to 3.75%.

Even China data have been ‘on the bounce’. Retail sales were up 6.7% (for Jan/Feb combined) compared to an expected 3%; industrial production was up 7.5% compared to an expected 3.9%. China data got a bit soft last year as they pursued a zero-Covid policy. Indeed, China is now forcing a short, sharp shutdown for Shanghai in a bid to stop a new wave of infection. China is reportedly pumping stimulus into the economy which may account for the recent strong economic data.

Thankfully, China has not become too involved in the Russian invasion of Ukraine. Perhaps they appreciate the possible impact of sanctions on them if they were to pursue a reunification of Taiwan by force.

Stock markets are charging towards their all-time highs on the basis of good data and not too much economic impact in the West from the Ukraine invasion. Bond yields are now getting to the mid to high 2% range in the US and Australia but that is no match for the expected return in equities. Share markets are still supported by the TINA – there is no alternative – principle!

Asset Classes

Australian Equities

The ASX 200 gained +6.4% during the month of March which puts the index just up on the year-to-date (+0.7%). Much of the gains were due to the Resources sectors – Energy (+9.6%), Materials (+8.2%) – doing very well on much higher commodity prices. The Financials (+8.3%) and IT (+13.2%) sectors also performed particularly strongly.

International Equities

The S&P 500 (+3.5%) also had a strong month but not matching the gains on the ASX 200. Probably due to the Ukraine invasion, the London FTSE and the Frankfurt DAX struggled to keep pace. China and the broader Emerging Markets indexes went backwards in March. Over the year-to-date, the S&P 500 lost 4.9%.

Bonds and Interest Rates

The US Fed increased the Fed funds rates by 0.25% points in March – at their first meeting since December. In the December meeting, the Fed thought that they would need three hikes this year. The update to now is significantly different, one increase just done and six more to come. The reason for the shift is a material change in inflation expectations supported by a set of chunky inflation figures for recent periods.

We argued elsewhere in this update that much of the current inflation problem can simply not be fixed by hiking rates.

But before people panic and rush for the exits, some context is useful. If we look at the yield curve today, 12 months ago, 24 months ago and 36 months ago we see a really interesting evolution.

For 2-yr bonds to 10-yr bonds, the yield curves are just about the same now as in 2019. The difference is that today, the short-term yield is less than 0.5% and it rises steeply to about 2-yrs.

Back in 2019, the whole yield curve was more or less flat.

US Yield Curves at March in each of the past 4 years

In other words, pushing the Fed funds rate up to about 2.50% – a massive change from the current rate, we may just about where we were in March 2019!

In 2020, the yield curve collapsed due to the pandemic across the whole term structure. In 2021, there was some recovery so the recent gains should be compared to the difference from 2019 and not from the crisis data.

In 2019, the world was a happier place – no pandemic; no Russian invasion of Ukraine; no spike in the prices of wheat and oil; no major supply-chain issues. We are simply edging back to normal with historically very low rates – even after a few more hikes. Panic now is the last thing we need.

The RBA did not raise rates at its March meeting, nor do we think it should have done. The core Consumer Price Index (CPI) inflation read was bang in the middle of the 2% to 3% RBA-target band. Unemployment is 4% which is low; though it has been a little below this, and we were still happy then.

The interesting question is why our inflation level is just fine, though it is not so in the US and elsewhere. We live in a global economy.

Our economy is very different from that in the US. We are heavily dependent on resource exports – notably iron ore with a price going gangbusters. And the composition of our production is quite different. To be frank, we cannot explain all of the differences but, to some extent we don’t have to. All we need to know is whether our policy makers and industries are up to the challenges they face. We think they have been and see no reason for this to change.

Other Assets

The price of Brent Crude Oil gained +6.2% over the month. Not only was the invasion of Ukraine a cause but also rebels bombed oil storage facilities outside of the Saudi capital just before they staged the F1 Grand Prix in late March. US President Biden did just order the release of one million barrels per day from reserves to soften fuel prices.

The price of iron ore rose +13.9% and that for copper +5.7%. Importantly, the VIX ‘fear gauge’ retreated to below 20% almost to where it started the year but then just rose a fraction at the close of the quarter during Wall Street’s last hour sell-off. It peaked this year at 36.5% in March.

On the back of the stronger commodity prices, the $A (in US terms) appreciated strongly by +4.2% to nearly $US0.75.

Regional Review

Australia

As Australia lurches towards a federal election, both sides seem to be offering enticements though they are both falling short in other ways. Given what we know so far, it seems to be far less important than last time who wins – especially for folk who have super funds! The March budget delivered a number of handouts but there were no particular fresh long-term policy objectives. Super was largely untouched in a negative sense.

The latest economic growth for Australia covered Q4, 2021 came in at an impressive +3.4% but +3.7% had been expected because of the economic bounce-back. Noting this period was not affected by Omicron or the Ukraine situation and it did pick up the bounce back from the Delta lockdown. The annual figure was +4.2% for 2021 but that figure includes the bounce-back from the first big lockdown in 2020.

When we measure growth across the two years of the pandemic, total growth was +3.4% or about +1.7% p.a. That’s not too bad given the extreme public health responses Australia made.

Another important statistic in the national accounts is the household savings ratio. It is often fairly static, though it bounces around when people’s hopes for the future markedly change. A mid-to-high single digit percentage is usual. It jumped to 19.8% in Q3 reflecting fear and a lack of opportunity to spend. That ratio fell to 13.6% in Q4, though it leaves a lot further to go to get back to normal. We expect strong growth to continue given these cashed-up consumers will have more opportunity to spend – and feel confident enough not to need a bigger ‘rainy day’ fund.

Our latest labour-force data relates to a week in the month of February; so, it doesn’t pick up the Ukraine invasion, though Omicron was around. There were +121,000 new full-time jobs created but, as some part-time jobs were lost, the total number of new jobs was +77,400 – but that’s still very impressive. Having a switch from part-time to full-time work bodes well for growth expectations.

China

China data were much stronger than the last few months and much stronger than expectations. China usually combines data for January and February so that the moveable big Lunar New Year holiday has a more predictable impact.

That the three regular statistics of retail sales, industrial output, and fixed asset investment all smashed expectations bode well for resource demand from Australia and China’s economy. Many commodity prices have boomed along with this recovery.

Two factors in China affect our economy the most. The zero-Covid policy means that it is much harder to make inroads into the supply-chain blockages. The relationship between China and Russia could cause major problems if they align too closely. But, so far so good. We are more than muddling through.

US

Last month we reported a bumper beat on the jobs front. This latest month was an even bigger beat! The +678,000 new jobs statistic was well ahead of the expected +440,000. The unemployment rate was 3.8% but the Fed chair has stated that a number such as this does not equate to full employment.

CPI inflation came in at 7.1% but the core rate that strips out volatile energy and food components was a more acceptable 6.4%. Wage growth was less at 5.1%. Core Private Consumption Expenditure (PCE) inflation – the Fed’s preferred measure of inflation – came in at 5.4%.

It is probably a good idea that Fed chair Jerome Powell is getting a little aggressive on interest rates as he will not want inflation expectations to start to spiral. He seems up to the task.

Europe

All of the action in March was again in Eastern Europe. The Ukrainians are putting up a stronger defence of their homeland than Russian President Putin could have imagined. There are reports that his undefined goals are being reduced. There is also talk of people wanting Putin out.

Rest of the world

In a disturbing turn of events, India is negotiating a banking deal with Russia. Some are worried that this could help Putin circumvent sanctions.