Economic update February 2023
Unlike in other regions, inflation still appears to be accelerating in Australia. Headline inflation rose at an annual rate of 7.8% in the December quarter, while the ‘trimmed mean’, the favoured measure among Reserve Bank of Australia officials, quickened to 6.9% year on year. This was the highest level since the series was introduced in 2003.
Prices for ‘discretionary’ items surged over the period, with particularly strong demand and prices seen for cars, clothing, and travel.
Despite sluggish retail sales in December, the latest inflation data will almost certainly concern policy makers and suggest the Reserve Bank of Australia will continue to raise interest rates in the months ahead.
The quarterly Survey of Business Opinions suggested firms are expecting profitability to collapse this year. This does not augur well for the investment and growth outlook.
Consumer confidence is also subdued, owing to higher mortgage interest costs and general weakness in the residential property market. The volume of home sales was 39% lower in December from the previous year and prices were down 7.2%.
The annual rate of inflation in the US has now slowed for six straight months.
In turn, there were suggestions that the Federal Reserve was preparing to slow the pace of its policy tightening cycle. Interest rates were raised by a quarter of a percentage point on 1 February. This compared to the past six rate hikes, all of which saw borrowing costs increased by either 0.5 or 0.75 percentage points.
Consensus forecasts suggest US officials might raise borrowing costs once or twice more in the next six months or so but any further moves are expected to be modest. That said, policy makers have emphasised the need for interest rates to be held at elevated levels for an extended period.
In other news, US GDP growth slowed less than expected in the December quarter, to an annual rate of 2.9%. So far, the economy has been more resilient than anticipated following significant increases in interest rate hikes in 2022.
Some other indicators were less encouraging. A closely watched gauge of activity levels in services sectors deteriorated, for example.
The weather in Europe in the Northern hemisphere winter has been milder than anticipated. This has resulted in lower than expected demand for energy for heating and, in turn, seen wholesale energy prices trend lower. The outlook for inflation in the months ahead is therefore not as bleak as some observers had previously feared.
Gas storage in Europe has risen quite sharply; from the lower end of the historical range a year ago when Russian gas was flowing freely, to the higher end of the historical range during a period when Russian supplies have almost entirely ceased.
Lower energy prices are also feeding through to official inflation data. Consumer prices rose at an annual rate of 9.2% in the Eurozone in December, below the double digit annual inflation rates seen in each of the previous three months.
Nonetheless, European Central Bank officials remain steadfast in their fight against inflation and raised official interest rates by half a percentage point on 2 February.
The Bank of England raised borrowing costs by a further half percentage point the same day, taking the base rate to 4.0%. UK interest rates are now expected to peak around 4.5%.
In other news, the UK will be the only economy in the G7 group of nations to shrink in 2023, according to the IMF.
The ‘China reopening’ story dominated attention in Asia. Officials finally appear to be softening their stance on COVID, removing a range of virus related restrictions.
The Chinese economy grew ‘only’ 3.0% in 2022; the second slowest annual growth rate since the 1970s and well below Beijing’s 5.5% annual target.
Activity levels could accelerate immediately following the Lunar New Year celebrations as restrictions are relaxed. This could be good news for neighbouring countries in the Asia Pacific region, including Australia, which tend to be reasonably reliant on growth in China to drive their own economies.
The general ‘risk on’ tone benefited the AUD. The currency strengthened by 3.6% against the US dollar, closing January above 70 US cents for the first time in nearly six months.
The AUD has now appreciated by more than 10% against the US dollar in the past three months.
The ‘Aussie’ also appreciated against other currencies, including the euro, the UK pound and the Japanese yen. Collectively, the AUD gained 1.6% against a trade-weighted basket of currencies, adding to strength from late 2022.
Australian shares started 2023 positively, with all but one sector posting gains. As a whole, the S&P/ASX 200 Accumulation Index added 6.2%.
A combination of moderating inflation expectations, lower bond yields both locally and offshore and an increasing number of large international firms announcing cost cutting initiatives helped spur a renewed sense of optimism.
The Consumer Discretionary sector (+9.9%) was the strongest performer over the month.
Market sentiment towards mining stocks improved on expectations that an acceleration in growth in China will benefit demand for bulk commodities. This supported index heavyweights with increases of more than 8.0%. Strong performances from lithium companies also supported an 8.9% return from the Materials sector.
Utilities (-3.0%) was the only sector to register a negative return in January.
Small caps outperformed their larger peers for the first time since October, with the S&P/ASX Small Ordinaries Index closing the month 6.6% higher.
All sectors in the small cap index posted gains. The Consumer Discretionary sector (+11.2%) was a standout.
Global property securities appreciated in January, consistent with the upward move in share markets globally. The FTSE EPRA/NAREIT Developed Index returned 8.0% in Australian dollar terms, comfortably outperforming wider equity markets.
In general, sentiment was supported by moderating inflation expectations in key regions. In turn, there were hopes that we might be nearing the end of monetary tightening cycles in the US, Europe and Australia.
The best returns from international property markets were found in Germany (+16.8%), France (+10.7%) and Sweden (+10.7%). Laggards included Hong Kong (+5.2%) and Spain (+6.0%).
Japan was the only country to register a negative return (-1.6%), following a surprise change to the Bank of Japan’s yield curve control policy in December.
Overseas share markets fared well too. The MSCI World Index added 6.5% in local currency terms, although strength in the AUD reduced the return to 3.1% for Australian based investors.
The NASDAQ performed extremely well in the US, adding 10.7%. This was the best January return for the technology heavy index in more than 20 years.
The broader S&P 500 Index added 6.3%, essentially reversing December’s weakness and closing around its end November level.
All of the major indices in Asia also posted positive returns.
There was a fair degree of dispersion among European markets, although all made positive progress.
Global and Australian Fixed Income
Suggestions that inflation may have peaked or being close to peaking in major regions saw investors reassess their interest rate forecasts. In general, the peak in borrowing costs is now expected to be a little lower than anticipated before Christmas.
These evolving expectations saw bond yields trend lower in most major regions, which supported gains from global fixed income.
Comments from Federal Reserve policy makers attracted the most scrutiny, especially since developments in the US tend to set the tone for other bond markets worldwide. Ten year Treasury yields closed the month down 37 bps, to 3.51%.
There were similar moves over the Atlantic. Ten year yields on UK gilts and German bunds closed the month 34 bps and 28 bps lower, respectively.
Japan was an outlier. Yields on 10-year JGBs rose 8 bps over the month, to 0.49%.
Australian bond yields fell sharply; by 50 bps in the 10 year part of the curve. This aided returns from the local bond market. The Bloomberg AusBond Composite 0+ Year Index added 2.8%, clawing back some lost ground from 2022.
Credit spreads narrowed quite sharply over the month, which was consistent with gains in major share markets and with a general increase in risk appetite among investors.
Spreads on investment grade securities closed the month 14 bps tighter, at 1.33%.
Spreads on high yield credit also narrowed sharply.
We saw a good level of new corporate bond issuance over the month. Encouragingly, all of this new issuance was comfortably digested by the market.
Early indications from the latest corporate earnings announcement season suggest most firms remain in healthy shape financially.
Source: Bloomberg. Issued by First Sentier Investors.
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