The outlook for global growth has stabilized, with backward looking measures of economic activity showing resilience, supported by strong demand and labour markets. However, forward looking measures are weakening, showing a contraction in manufacturing output and low levels of consumer and business sentiment. The OECD has upgraded its projections for global growth to be 2.7% for 2023 before gradually increasing through 2024 with easing inflation and stronger real incomes.
US GDP growth has been stronger than other developed economies, growing 7.2% yoy in the first quarter of the year. A tight labour market and accumulated savings have supported strong spending in the service sector. US headline inflation has peaked and moderated to 3% yoy in June. Lower energy prices and easing supply chain pressures have contributed to lower inflation readings; however,
shelter costs remain the main driver of headline inflation. Core inflation remains sticky and is now higher than headline.
Europe has had its growth forecast upgraded after a better than expected Winter and positive GDP growth in the first quarter. Lower energy prices, easing supply chain pressures, and strength in the labour market have supported the economy. Headline inflation has eased to 5.5% yoy in June. In contrast, headline inflation in the UK remains elevated at 7.9% yoy in June, the highest amongst the G7 nations.
China’s rapid post-pandemic recovery is showing signs of slowing. GDP grew 2.2% in the first quarter due to an initial rebound in consumption but has slowed to 0.8% in the second quarter. Manufacturing activity has fallen into contraction. While non-manufacturing activity growth has eased to the slowest pace since the reopening, suggesting a slowdown in services and construction. So far stimulus measures announced by the government have not had a significant impact on the economy.
“The International Monetary Fund expects to see a pronounced slowdown in global growth.”
Australian economic growth slowing but labour market remains strong
Australia’s GDP grew 0.2% in the March quarter, the weakest result since the beginning of the pandemic. Domestic demand remained strong, while an increase in imports relative to exports detracted from growth. Capital investment was the strongest contributor to growth, while household consumption slowed, as consumers cut back on discretionary spending due to rising rates cost of living pressures. The household savings ratio fell from 4.4% in December, to 3.7% in March, the lowest level seen since June 2008.
The Australian labour market remains tight, with the unemployment rate holding steady near historic lows of 3.6% in May. 75,900 jobs were added to the economy, which is above the 31,000 required to stop unemployment increasing based on current rates of population growth, assuming the participation rate remains unchanged. The figures indicate that the slowdown in economic activity has yet to flow through to the local jobs market. The participation rate hit a record high of 66.9% supported by an increasing share of women in the workforce.
Residential house prices have rebounded in recent months. Corelogic’s Median Home Value index rose 1.2% MoM in June, after successive increases of 1.4% and 0.7% in the previous months. Overall listings have fallen 12.9% over the past year. The rebound in house prices can be attributed to increased demand pressures from migration and high rents. While there has been a shortage of supply from lower construction and a drop in household size.
Chart 1 - Source: ABS
Chart 2 - Source: CoreLogic
Challenges for the RBA
The RBA is trying to engineer a soft landing for the economy, where inflation falls back within the target band and economic growth slows but not to the point of a recession. While there are positive signs that inflation is easing towards the target band of 2-3%, there are challenges ahead that the RBA will need to consider for the future path of monetary policy.
Governor Lowe has flagged that the mismatch between rising nominal wages and falling labour productivity remains the key upside risk to inflation. Wages have risen 3.7% yoy, pressured by the Fair Work Commission’s increase to minimum wages. While labour productivity has fallen 4.5% yoy in March. The decline has resulted in a 7.9% yoy rise in unit labour costs, which is the difference between wage growth and productivity growth. There is no clear reason why the economy has not seen productivity gains in the past 3 years. Some economists say that companies hoarding labour could be a reason for a fall in productivity. This is when companies keep more employees than required as they are uncertain about future economic conditions, especially with the recent labour shortages making it difficult to hire skilled employees.
Residential house prices have stabilised and increased in recent months, while expectations for future increases in house prices have strengthened. This will provide support to consumption if the trend continues as households see an increase in the wealth effect, where consumers will spend more as the value of their assets rise. Strong population growth and a lack of supply can be seen to be supporting the rebound in house prices. Expectations that rates are near their peak could be another factor. Further strength in house prices could also pressure rents, which make up a large portion of the CPI basket and add further upside risk to inflation.
Electricity prices have risen 15.5% over the past year and are expected to see even larger increases in the year ahead. This comes as energy rebates are being unwound in Queensland, Western Australia, and Tasmania. The Australian Energy Regulator has announced an increase to the maximum price that retailers can charge, which is up to 25% higher in some states. The additional energy costs add further upside risk to inflation.
Despite raising the cash rates 10 times in the last year, the RBA clearly still has work to do in its fight against inflation. The current cash rate is lower than that in the US, if the Fed remains hawkish it would put further pressure on the RBA to continue raising or risk weakening the Australian Dollar, which would drive up the cost of imported goods.
Chart 3 - Source: ABS
Chart 4 - Source: ABS
“The RBA has become more data dependant and will continue to assess incoming data on inflation, jobs, business sentiment, and consumer spending”
Long and variable lags in monetary policy
With central banks undergoing some of the fastest monetary policy tightening in history, there has been debate over how much of these rates have flowed through to the economy so far. Both the RBA and the Federal Reserve have acknowledged that there are long and variable lags in the transmission of higher rates into the economy. Empirical research by Milton Friedman has found that on average it takes between 4 to 29 months to see the full impacts of monetary policy in previous economic cycles. There is no consensus view even amongst Federal Reserve officials, with Atlanta President Bostic saying it could take 18 months to 2 years, while Governor Waller has an opposing view that full effects could be seen as soon as 9 months to one year.
The larger proportion of fixed rate mortgages can be seen as a reason for longer lags in this cycle. In Australia, fixed rate mortgages made up 35% of total home loans in early 2022, compared to an average of 20%. The unusually large portion of these fixed rate mortgages has led to a delay in the effects of a higher cash rate on home loan payments. Most borrowers don’t plan ahead for the increased repayments when the mortgage inevitably rolls over to a much higher variable rate, which means that there has been no pre-emptive reduction in spending. Due to this effect, it is estimated that only 45% of the rate hikes so far have flowed onto mortgages.
Another factor leading to longer lags is the large savings buffer that consumers have built up over the pandemic lock downs. According to the RBA, household liquid assets relative to household income has increased by around 50% since 2010, with prepayments in offset accounts and redraw facilities making up a large proportion of these liquid assets. The savings buffer supports current spending levels, while allowing mortgage holders to continue meeting their obligations.
These two channels means that it will take longer than usual to see the full effect of higher rates on household cashflows and spending. This presents a challenge to central banks who need to rapidly raise rates to fight inflation before it becomes engrained, without tightening to the point where their decisions lead to a recession. Central banks base their decisions on historical data, and there is already evidence from the recent banking crisis that negative effects from monetary tightening can show up unexpectedly in certain parts of the financial system.
Chart 5 - Source: ABS
Chart 6 - Source: Bloomberg
"As shelter costs are a lagged component of CPI, moderation in this component is expected to flow through later this year”
China’s recovery is losing steam
The Chinese economy had a strong initial rebound after the sudden lifting of covid restrictions at the end of 2022. GDP grew 4.5% yoy in the first quarter of the year and the government set a yearly growth target of 5%. Early optimism around the recovery has faded, as latest economic data points to stalling growth. Usually the economy relies on exports, real estate, and construction to support growth, but this year it has relied heavily on domestic consumption. Manufacturing activity contracted in June, while non-manufacturing and services activity was the weakest since the reopening. Exports fell 12.4% and imports fell 6.8% in June, suffering from lower global demand.
Youth unemployment in the country is at a record high of 20.8% in May, compared to the 5.2% total unemployment. Graduates who cannot find a relevant job have preferred to stay at home or travel instead of settling for a job in another industry, presenting challenges to consumption and consumer confidence. The country also faces ongoing challenges from a struggling property market. According to a study from Harvard, real estate and construction accounted for nearly 30% of China’s GDP in 2016. The sector faces headwinds from falling sales, developer defaults, and weak confidence.
Unlike other developed nations struggling with inflation, China is facing deflationary pressure due to a fall in demand for its goods. Headline CPI was unchanged yoy in June, while Core CPI rose just 0.4% yoy. Slowing global economic growth means that China can no longer rely on exports to support the domestic economy. Factory gate inflation China has fallen 5.4% yoy. While this is not a good sign for China, it may further ease global inflationary pressures.
The weak economic data pressures policy makers to implement stronger stimulus measures to support the economy. So far, support has been limited to a small cut in the key policy interest rate and minor tax breaks to support consumption. Rate cuts have had little impact as rates are already very low. Possible further measures include business tax reductions and special government bond issuance. Policy makers are wary of too much infrastructure stimulus, which could provide short term support but lead leading to another property and credit market bubble. Cutting rates presents the challenge of further depreciating the Yuan as global rates remain far above China’s. Policy makers have so far pledged targeted and coordinated policy measures but have provided no further details on what these will be.
Above 50 indicates expansion, below indicates contraction
Chart 7 - Source: Bloomberg
Chart 8 - Source: Bloomberg
“Three years of pent-up savings is expected to support the recovery in Chinese domestic demand, and as such the recovery is expected to be driven by a rebound in consumption"
Our global macroeconomic economic views are set out in the following table:
Inflation has peaked but upsides remain from wage growth and housing dynamics. Consumption growth is slowing as households face higher cost of living pressures. The labour market remains strong, however falling job advertisements suggests labour easing labour demand pressures. Headwinds for the economy include the lagged transmission effect of the RBA’s rate hikes, a large amount fixed rate mortgage rollover, and China’s faltering economic recovery.
A tight labour market and accumulated savings have supported the US economy. Headline inflation has peaked and continues to moderate. Shelter costs remain a key risk to inflation, as a stabilizing housing market could contribute to upwards pressure. The excess savings buffer could last until the end of the year and continue to support consumption, which could also contribute to a resurgence of inflation.
Europe & UK
The European economy weathered a mild Winter recession due to a spike in energy prices from the conflict in Ukraine. The outlook has improved as energy prices have fallen and inflation has moderated. The ECB is seen to be close to the end of its hiking cycle. However, geopolitical risk and persistent inflation remain key risks for EU and UK Region.
Economic growth is stalling after the initial post pandemic rebound. Household savings can support consumer spending, however weakness in the property sector and slowing global trade remain as headwinds to growth. The current policy environment is pro-growth, however stimulus measures announced so far have been small relative to past recoveries.
Upside and Downside Case
The table below shows the opportunities and risks around our base case. The following shows the opportunities and risks around our base case. The short-to-medium term outlook is still dependent on the outcome of the Ukraine war, the trajectory (and pace) of monetary policy tightening, China’s economic recovery and global inflationary pressures.
- Soft landing scenario, where central banks can get comfortable with inflation being controlled and start to reduce policy rates
- Significant economic stimulus from China supporting global economic growth
- Economic growth deteriorates meaningfully, and central banks are forced to cut rates even if inflation remains elevated
- Stagflation, where inflation remains elevated, but the global economy goes into recession
- Central banks do not cut rates even as economic growth contracts
Total Portfolio Positioning and Key Implication for Market
“Financial markets remain volatile with an increasing probability of an economic downturn"
Financial markets remain volatile with an increasing probability of an economic downturn. Central banks may retain restrictive monetary policy even as inflation is moderating or loosen policy in response to an economic downturn. In either scenario equities would be seen to underperform. Against this backdrop, CCIAM continue to advocate for a more defensive positioning.
We have reduced the cash overweight position and increased our overweight position to Fixed Income for downside protection and as real government bonds have become more attractive. We retain our underweight positions in equities and property.
We increased the duration of the fixed income portfolio as central banks move closer to the end of their rate hike cycles.
“Financial markets remain volatile with an increasing probability of an economic downturn.”
Key: Our asset class views are considered when positioning the portfolio against its Strategic Asset Allocation (SAA).
Positive views would likely lead to an overweight position against the SAA.
Negative views would likely lead to an underweight position against the SAA.
Valuations are currently trading at low multiples, largely due to lower valuations in the materials sector from a fall in commodity prices. Consumers are cutting back on spending due to higher cost of living pressures, creating headwinds for consumer discretionary and staples sectors. A deterioration in the housing market remains the key risk to the local banking sector.
Equity valuations in the EU, UK, and Japan are trading at reasonable levels. US valuations are trading at a premium over other regions. The recent performance in US equities has been driven by a handful of technology stocks. Company profits have peaked, and margins are declining from the impact of high inflation and interest expense costs. Market pricing remains optimistic for earnings expectations despite the relative downside risks.
Fixed interest - Gov’t Bonds
Government bond yields have been volatile and have increased pricing in further rate hikes. There is little term premium between shorter and longer dated bonds. A hawkish bias from the RBA will continue to put upwards pressure on yields.
Fixed interest - Credit
Credit spreads are trading around historical mean levels, which does not appear to reflect the negative economic outlook and significant tightening in credit conditions. Corporate fundamentals remain reasonably strong with low default rates but are expected to deteriorate from the impact of higher rates and slowing growth.
Valuations are under pressure from rising bond yields and property yields are at very low premiums to bonds. The office property faces headwinds from work from home, and there have been recent market transactions completed at discounts of more than 10% to book values. Industrial and healthcare related property have a more positive outlook from demand and supply imbalances.
Cash provides capital protection and reduce portfolio volatility. Yields have increased in line with rate hikes which improved returns.
USD volatility has been driven by inflation and rate uncertainty but remains significantly overvalued against other major currencies. Further hawkishness from the RBA could support the value of the AUD, but increasing recession risks and China’s faltering recovery may put downward pressure on the AUD.
CCI Asset Management does not guarantee the repayment of capital or the performance of any product or any particular rate of return referred to in this presentation. The information contained in this presentation is current as at the date of preparation but may be subject to change.
While every care has been taken in the preparation of this document, CCI Asset Management makes no representation or warranty as to the accuracy or completeness of any statement in it including, without limitation, any forecasts.
The information contained in this presentation is intended as general commentary, view and perspective by CCIAM, and CCIAM’s Asset Consultant, Frontier Advisors Pty Ltd, and should not be regarded as financial, legal or other advice.
This presentation has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this document, and seek professional advice, having regard to the investor’s objectives, financial situation and needs.
Should you require specific advice on the topics or areas discussed please contact the presenter directly or an appropriate advisor. This presentation may contain forward-looking statements. Past performance is not a reliable indicator of future performance.
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