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Written by George Lin/Senior Investment Manager CFS
Over the month, a run of disappointing US economic data raised some doubts about the strength of the US economic recovery, while at the same time, concerns about inflation remained a dominant theme in financial markets. Still, share mOver the June quarter, the world economy continued its uneven recovery – particularly as less-developed nations struggled with coronavirus. As concerns about inflation escalated in the US, the central bank – the US Federal Reserve (the Fed) – surprised markets by appearing to change its tone regarding monetary policy. And despite some volatility for bond markets, share markets performed well. By quarter’s end, the ASX 300 was up 8.5%, while the Australian Dollar traded at 75.08 US cents.
KEY ECONOMIC DEVELOPMENTS
The global economy continued to recover at an uneven pace over the quarter, particularly as developed nations such as the US drew closer to achieving herd immunity while less developed nations such as India continued struggling to contain the latest wave. Many developed economies followed a similar pattern of recovery – that is, a recovery in the manufacturing sector followed by the services sector as social-distancing measures were eased. Most importantly, growth in the European services sector was positive at quarter’s end and, assuming continuing improvement with the pandemic, this should accelerate as these economies re-open.
Financial markets focused largely on economic data in the US and the implications for central bank monetary policy. The combination of higher-than-expected inflation and weaker-than-expected employment sparked concerns about the strength and outlook for the US economic recovery.
As to employment, two consecutive US labour force reports indicated that growth in employment was below market expectations. While this was disappointing, it has likely overstated the weakness in the US job market, particularly as the trend in jobs creation has been strong. For instance, on a three-month basis, jobs increased at a rate of around 550,000, which is robust by historical standards. The data was only disappointing given the high expectations of monthly job growth of about 900,000. The weaker-than-expected data has also been caused by supply constraints and temporary ‘dislocations’ (meaning, temporary disruptions or influences in the market), such as the generosity of unemployment benefits compared to the minimum wage in some states, as well as the ability of working parents to return to work given the closures of schools. These barriers should disappear over the next few months. Other data points also paint a more positive picture. For example, the number of job openings has steadily increased since November and the latest data has indicated there are 9.8 million job vacancies in the US.
As to inflation, which looks at the price increases of goods and services in an economy, a string of US Consumer Price Index (CPI) data showed that inflation was running above the Fed’s desired target. For instance, CPI rose 5% year-on-year in May, which was the highest since August 2008 when CPI rose 5.4%. The Fed seemed to change its tone on inflation and interest rates, with the forecast for policy rates (equivalent to Australia’s cash rate), revised upward. If inflation continues to rise, the central bank may raise policy rates in 2023, with a 2022 rate hike also possible.
The economic recovery in Australia continued over the quarter despite outbreaks of coronavirus. Employment growth surged to 115,000 in May – the highest level since October 2020. The unemployment rate fell to 5.1%, which was slightly above the pre-pandemic level – with all jobs lost during the pandemic now recovered. Leading indicators of employment have pointed to further job growth. The level of corporate confidence also improved over the quarter – a positive signal for future corporate investment. Finally, consumer confidence has surged since August 2019, while retail trade has grown steadily since the start of 2020 despite some volatility.
The Federal Budget for 2021-22 announced over the quarter seemed to be a continuation of the existing policy to support the economy for longer. A better-than-expected economic recovery and higher commodity prices resulted in a $37 billion lower fiscal deficit for the 2020-21 financial year compared to previous estimates. Among other things, the improvement allowed the government to announce a number of measures ranging from the continuation of the Low and Middle Income Tax Offset to additional infrastructure spending totalling $96 billion over the next five years.
KEY MARKET DEVELOPMENTS
Share markets had a somewhat volatile quarter as investors struggled to interpret conflicting US economic data and decipher the Fed’s sentiment. Key developed share markets all finished higher, however. In particular, the ASX 300 rose 8.5% over the quarter and was one of the best performing developed markets over the period. Surging commodity prices, especially the iron ore price, were some of the drivers behind the performance. US share markets also had another strong quarter, with the S&P 500 up about 8% and the NASDAQ up more than 9%.
A key short-term risk that investors may consider is the impact of the lockdowns in Australia. Investors have so far reacted calmly. The consensus is that while the level of confidence and consumer spending may be impacted, this should be minor and short-lived. This confidence may change, however, if the lockdowns last longer than originally established by state governments.
US economic growth is still positive, but weaker than expectations. Investors have largely factored in the good economic news (particularly in the US), which suggests that unless there is a considerable acceleration in the pace of the economic recovery, returns in share markets should be more restrained. However, there are opportunities for other economies, such as Europe, to play “catch-up” with strong performers like the US as different countries continue re-opening their economies.
The threat of higher cyclical inflation in the US is real and there is a reasonable possibility that it will overshoot market expectations over the next year. The risk is that while inflation may eventually decline, it may still be too high for markets’ liking. However, the Fed’s June meeting indicates that the central bank has a limited tolerance of higher-than-target inflation. A more aggressive approach to monetary policy by the central bank, with an interest rate hike in the second half of 2022, is a real possibility if US inflation accelerates further and does not decline as rapidly as the Fed expects.