The Australian share market remains in a trading range of 6,500 to 7,500 since 2021 as shown in Figure 1. Over these past three years, there have been market rallies and there have been sell-offs of equal proportions, keeping the market range-bound.
As of the writing of this letter on 21 December, the Australian share market has grown by 7% in the 2023 calendar year.
Figure 1: Retail Sales growth has dropped right back
Similarly, the US equity market, which holds the majority of global equity exposure for investors, grew by 23% in 2023. Incidentally, the US share market (i.e., the S&P 500) has also been trading within a range since 2021, i.e. between 3,700 and 4,700.
Much of the gains in both equity markets in 2023 came from the recent rally over the past six weeks. Some refer to it as the annual ‘Santa rally,’ while others hope that the markets have rallied on forecasts that there will not be an economic recession next year. They anticipate that inflation will fall sufficiently to prompt rapid interest rate cuts, and that economic growth and business profitability will return to normal as consumers revert to their previous consumption patterns. However, we urge caution—’Not so fast, Jack!’
Slowing inflation does not necessarily mean that interest rates will be cut significantly or in tandem. The reason is that with employment remaining fairly tight in the economy, every dollar returned to employed consumers by the central banks—through potential rate cuts—could quickly reignite inflation, particularly services inflation, as consumers rush to spend the returned dollars. For this reason, we believe that the central banks will be slow to cut rates in a tight employment market.
The chart in Figure 2 indicates that inflation in Australia is much stickier than in the U.S. and is only gradually trending downward. This is partly because the Reserve Bank of Australia (RBA) did not raise its official interest rate as sharply as the Federal Reserve did in the U.S. The cash rate in the U.S. is 5.5%, while in Australia, it is 4.35%. Part of Australia’s persistent inflation can be attributed to its red-hot job market, with labour costs rising by 7.1% over the past year.
Figure 2: Core Inflation in Australia and US
Over the past year, the RBA has worked tirelessly to shift consumer sentiment toward a more pessimistic outlook in an effort to engineer a slowdown in consumption and thereby cool down inflation in an economy with tight resources. As illustrated in Figure 3 below, this strategy appears to have been effective, as there is a noticeable emotional toll on consumers due to the rate increases to date.
Figure 3: Consumer Confidence remains at GFC lows
More importantly, consumer retail spending growth has slowed considerably. However, with unemployment remaining low at 3.9% and the job market still robust, it is unlikely that the RBA will cut rates as significantly as recent market rallies might suggest, potentially reversing the progress made on inflation over the past year.
Figure 4: Retail Sales growth has dropped right back
More broadly, let’s keep reminding ourselves that the upside risk to inflation and interest rates remain from the two wars currently underway with little hint of slowing down. Additionally, ongoing tensions between China & U.S. could easily cause supply chain disruptions and sudden spike in inflation.
The ageing demographic causing labour shortage remains a key input to wage pressures in advanced economies. The global transition to renewable energy infrastructure will likely continue to create excess demand for key inputs such as materials, labour, and capital. Military build-up in deeply divided world is another area of increasing demand for labour and funding. And finally, bulging government debts globally is unlikely to receive willing funding from the debt markets on low rates with a cheer! Investors will and are questioning the interest rates they would require as adequate compensation.
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