Economic Update and Q+A

Coming next is our highly anticipated guest speaker.

He's the Chief Economist of BetaShares.

BetaShares is an Australian exchange-traded product manager with $28 billion under management.

He's an ex-federal treasury escapade and spent time sipping coffee at the Paris-based OECD, ex-colonist at the Australian Financial Review and co-founder of a Paris-based Aussie-themed cafe.

He's the author of Australia's most comprehensive book on exchange-traded funds, The Australian ETF Guide, Cheap and Easy Investment Strategies Using Exchange-Traded Funds.

We're giving away 10 copies of this book across to our lucky attendees.

Welcome, Mr. David Bassanese.

Thank you.

Great to be with you today and thank you for that very kind introduction.

So I think I'll just progress with my presentation today and thank you for the opportunity

I'm going to talk for around about 30 to 40 minutes on the global and economic outlook.

Just obviously just general economic information, general economic and financial information.

Certainly don't constitute this as personal advice.

So the usual disclaimer applies.

Let me get straight into it.

And look, I'm going to dwell a little bit firstly on the United States economy.

It's still the most important

economy in the world.

The financial market is still the most important one in the world.

When Wall Street sneezes, as they say, the rest of the markets catch cold.

So what's happening in the US does remain pretty critical for Australia.

And firstly, we can see here some, I guess, good and bad news.

This is US inflation, the consumption deflator.

It's the measure that the Federal Reserve, the US Central Bank focuses on in particular.

And you can see that as we've seen in Australia, many parts around the world, inflation has surged in the last couple of years on the back of the disruptions caused by COVID.

And with hindsight, excess monetary and fiscal stimulus, we really let demand get away coming out of COVID.

But the good news, and you can see inflation on this measure, headline inflation,

got up over 6%, around 7% or so, and core inflation stripping out food and energy got up around just over 5%.

Now the good news in the US is that inflation looks to have peaked, it is coming down, at this stage it's coming down almost as, certainly headline inflation is coming down as quickly as it went up, if you look at that orange line.

Now one of the, I guess,

ongoing concerns in markets is that core inflation, as seen in the grey line, is off its peaks but hasn't fallen as quickly.

So it's this sticky core or underlying inflation which is still the lingering concern for financial markets.

And concern here is if inflation remains too high for too long, central banks are worried it will get embedded into inflation expectations, wage and price setting behaviour,

And then what we hope was temporary inflation becomes more ongoing in a way we saw in the 1970s, for example.

So central banks are saying they don't want to repeat the mistakes of the 1970s.

And so if it takes a recession to break the back of inflation before it gets into inflation expectations, so be it.

We are debating whether or not a recession is needed because inflation at this stage is at least coming down.

But we are still hoping that core inflation there can come down a bit more quickly than we've seen to date.

So that is probably the principal major factor driving global financial markets at the moment.

Does the US need a recession to get inflation down or will it come down of its own accord?

And just on that front,

Just got another slide here.

And just with that, we can see this is a snapshot of what's been happening in global financial markets over the past year or so.

Firstly, you can see if you look at the US share market index, I mean, look, I'm sure all of you know that the 2022 was really characterised by very aggressive interest rate increases.

You can see 10 year bond yields in the US went from,

around about 1%, under 1% at one point to up over 4% on the back of very aggressive central bank interest rate increases to slow economic growth and ideally bring down inflation.

That did see the equity market sell off through the first three quarters of last year, but we have had a rebound in equity markets since about October, coinciding with a broadly a peaking of interest rates and also helped by the fact that

After Russia invaded Ukraine early last year, we got an initial surge in commodity prices and energy prices, which added to the inflation concerns.

But perhaps surprisingly, we've seen oil and energy and food prices come back over the course of the past year, which has helped bring down inflation.

Basically, and at the same time, as I'll touch on in a minute, the US economy and many economies around the world have not gone into recession.

So we had very aggressive interest rate increases.

We had a fear of recession building through much of last year, which is why equity markets have fallen.

But basically, two things have happened following those rate rises.

Firstly, global economy has not gone into recession, the US economy in particular.

And inflation, as I showed in the first slide, has started to come down.

And so markets have been trading on what's called the hopes of a soft landing, i.e.

inflation coming down without a recession, until evidence proves otherwise.

And that's the sort of situation we're in at the moment.

So again, the ongoing debate is, can this equity market route rebound continue?

If we can avoid recession, it will.

But if ultimately we need to have a hard landing and bring inflation down, then this is probably only a bear market rally.

And so that's the situation on that front.

So this is the, I guess, the challenging, the case for a recession in the US, the case for another leg down in the equity market.

And if you look at the orange line here is the US unemployment rate.

And you can see it's very low, around about three and a half percent, as low as we've seen going back several decades.

The grey line is US wages growth.

Average hourly earnings comes out monthly in the monthly payrolls report.

And you can see, look, it's come down, but it's still quite high from a long run perspective.

So we've got low unemployment, high wages growth,

These grey areas are periods of US recession in the past and you can see that every time wage inflation has accelerated historically and the unemployment rate has reached a very low level, it's basically taken a recession to resolve the problem, to get wage inflation back down again,

And once the unemployment rate starts going up, it really goes up by only a little bit.

There's a rule in the US, historically it's true that once the US unemployment rate has gone up by at least half a percent, the economy tends to get weaker and tumble into a recession.

And so the unemployment rate eventually goes up by more than half a percent.

And so the idea that maybe we can get a little bit of a slowdown, get the unemployment rate up a little bit, which would take the edge off wage inflation, help bring down inflation, and we can avoid a recession.

That's a really nice hope.

But again, it's something that we haven't seen historically.

Every time the US has had a so-called soft landing historically on the back of central bank policy tightening, the unemployment rate has basically gone, hasn't gone up, as you can see here in the mid 1980s.

the mid 1990s, even in the 2018 when the Fed was raising rates, all these periods of central bank tightenings in the past associated with soft landings, we never saw the unemployment rate go up.

And so that is the challenge today is can the unemployment rate stay this low and yet wage inflation come back down again, which is important for the services sector side of things.

And just to drill into that a little bit more, or sorry, that is the case for, I guess, pessimism and that, you know, ultimately wage inflation is too high, it's underpinning inflation and we've got to get the unemployment rate up to bring down the wage inflation.

But what I've got here is a chart of average and median wages in the US in grey and black on the first chart here and the US unemployment rate.

Now, it,

A lot's happened since COVID, but it bears being reminded that prior to COVID, back in 2019, the US unemployment rate was actually under 4%.

It was actually close to where it is today.

And at that point, wage inflation was a lot more benign than it is.

So it is possible to have low unemployment and pretty benign wages growth.

I mean, we saw it as recently as 2019.

And at that point, we saw that services sector inflation, if you look at the next slide there, that score underlying inflation, if you like in the US, was running at only 2%, whereas today it's running at 4%.

So the problem here is wages growth at the moment still too high, underpinning service sector inflation, which is still too high.

So how can we get this down without this necessarily going up?

Now, what is the difference between today and 2019?

And that's just, I can show you on the next slide.

This is a chart of job vacancies in the US, so the total number of reported vacancies, jobs being advertised as a percent of the labour force, against the unemployment rate here.

And what we've seen is that

Basically, since the collapse in the economy during the lockdowns in early 2020, we've had a period where the unemployment rate obviously in 2020 blew out in the US to about 15%.

Vacancies are very low.

But we've had an economic expansion such that the unemployment rate has been falling and job vacancies have been rising.

Now, the question was, and as a result, we had a very tight labour market, i.e.

very low unemployment and very high job vacancies.

The situation in 2019 was down here in black, where we had equally low unemployment rate but lower level of vacancies, so there was less labour mismatch, if you like, in the US labour market.

So, but here is the hopeful news is that what we've seen over the past year is that the number of job vacancies as a percent of the labour force has been falling.

We've actually been falling back toward this 2019 situation.

So, so far at least the excess demand for labour in the US, very high job vacancies relative to available workers has been narrowing without any increase in the unemployment rate.

And so the labour market, so basically businesses have been able to find the workers they've needed or at least give up on finding the workers they need without jettisoning or letting go of the workers they've already got.

So that is a tantalising prospect.

If this can continue and we go back to this sort of situation here, we could very well go back to a 2019 situation.

And one of the reasons job vacancies have been falling in the US is that more workers have been

fronting up looking for jobs.

Labor force participation in the US in the last six months or so has rebounded.

Immigration, importantly, has also started to pick up in the US.

So it's not just a slowing economy that's led to a decline in job vacancies.

It's an increase in labor supply and businesses actually finally being able to find the workers that they were after.

So that is, again, just to summarise, that is the debate in global markets at the moment.

go back to a 2019 situation and avoid a hard landing, or will wage inflation remain uncomfortably high with this unemployment rate so low, such that the Fed would have to conclude, we've got to slow the economy, we've got to push up that unemployment rate.

Because if we don't, then there's a risk that inflation becomes entrenched.

For a long time, I was concerned that the US would ultimately need to go into recession.

And I still think it's a pretty close call.

I think it's probably still a 50-50 proposition over the next year.

But I would concede that the grounds for a possible soft landing

given the developments we're seeing here are strengthening.

So, you know, it's not necessarily all doom and gloom in markets.

We need to see how this situation plays out in the United States.

just in terms of the equity market.

So we can see here that the challenge for the market is that equity markets have rallied.

So the US share market, you can see here on the first slide, has bounced back quite nicely.

It's more than recovered half its losses, but is now trading at high valuation.

So the PE ratio for the market, the price to earnings ratio,

has now pushed up to around about 19.5 times earnings, because all of this rebound has come at a time when earnings, this orange line, which is a measure of corporate earnings in the US, have been flattening off.

So there's been no earnings growth really in the market over the past year.

And all of this rebound in the market has been PE valuations expanding.

At the same time, interest rates have stayed at a high level, and so this equity risk premium, this is a measure of the valuation of the market relative to the bond market, is pretty expensive.

It's just over 1%, basically it's around about 1.2%.

The long run average of this equity risk premium has been around three and a half, four percent.

So we're basically less than half our longer run average equity risk premium.

So again, it doesn't necessarily mean the market needs to collapse in a heap because if earnings rebound, if we avoid a recession and earnings start to rebound and or the Fed can basically pivot and start cutting interest rates as priced into the market, then

you know, equity markets can at least hold up and valuations can, well basically this valuation issue can be resolved by interest rates declining and or earnings recovering.

But that's what we need to see to justify the market sort of holding up at these levels.

And just from a longer run perspective, this is the US market's PE ratio today.

You can see here right about 19 times earnings.

with a 10-year bond yield around about four.

So in terms of where PE ratios have been historically with bond yields around about 4%,

you can see that we're at the top end of that range.

So the market is certainly pricey, even with a 10-year bond yield around about 4%.

This was the dot-com bubble valuations in the late 1990s, early 2000s, so certainly not there.

This was COVID, where we had a P ratio at over 20, but interest rates were a lot, lot lower than they were today.

And this is sort of where we sit today.

Just in terms of interest rates in the US, you can see here, this is the market's expectations for what the US will do.

We've got basically the market pricing in one more rate rise and then aggressive rate cuts through next year, basically 100 points of easing on a 12 month view once we get through this year.

And basically,

My expectation is that's probably pretty correct.

I actually think the Fed will raise rates once, possibly twice more.

But as inflation comes down, they can cut interest rates next year such that, and I've got the projections here, even allowing for another 50 points of tightening, even allowing for two tightenings in the US, this is the Fed funds rate here.

Importantly, by year end, I expect the markets to be pricing in 100 points of easing over 24.

And then as the Fed starts to cut interest rates, continuing to price in further rate cuts through the course of next year, such that 10-year bond yields using my model, based on these expectations, can come down gradually over the course of the coming year.

So I think the worst is over in terms of the bond market bond yields.

as we're getting closer to the end of the policy tightening in the US.

Now, all of that is contingent on either growth slowing on the back of these interest rate increases or inflation

continuing to come down so that the Fed can pivot even if the economy doesn't go into recession.

But again, I think there are grounds for...

So one way to think about it, the two most plausible scenarios for the US is either a recession, in which case interest rates will come down, or a soft landing or inflation coming down without a recession, in which case the Fed can also probably cut interest rates next year.

So either way, I think

you know, the outlook for interest rates is starting to look quite encouraging.

In terms of Australia, just a snapshot of our economy.

And you can see here, growth has slowed over the last couple of quarters, but not by enough to actually see the unemployment rate go up.

So in fact, we just got an update on this number last week.

It was now down to 3.5%.

So we've had a slowing of growth, but we still have a relatively tight labour market.

We've also had, you can see here, underlying inflation seems to, obviously got very high, but the good news is it's starting to come down.

A bit like, very similar to the US, we have high inflation, but at least it's starting to come down from its peaks.

What's also interesting, the house prices nationally declined by about 10% last year, according to the government.

the core logic measure of house prices, it's a monthly index.

But already, just with the hopes that we may be near the end of the tightening cycle here in Australia, we've had a bit of a bounce back just in the last few months, which probably premature, something the RBA wouldn't wanna see at the moment, because the RBA ultimately does want the economy to slow somewhat to take the pressure off inflation.

Just a bit of a snapshot further on terms of the various inflation measures in Australia.

Here is the quarterly CPI in orange.

See, the year-on-year rate is 7%.

That's for the March quarter.

Now, encouragingly, we do get a monthly CPI now that's only been out in the last year or so.

And the last couple of numbers are pointing to a further deceleration in annual inflation.

The monthly number for May, the annual rate was 5.6%.

We actually get the June quarter CPI on Wednesday.

and it's likely to show headline inflation annually slowing from about seven to around about six.

And there's a chance it could drop under six.

So that's pretty good news.

Look, if it does drop under six, I think the threat of the RBA raising rates maybe is again in August will be reduced, but we'll obviously just have to see how that plays out.

The underlying inflation measures

You can see the quarterly measure, the quarterly number as at March is at 6.6.

Some monthly indicators are suggesting further easing, such that that number, when it's reported on Wednesday, could potentially get down to six or maybe even a little bit less.

So that's the situation on the inflation front.

And look, compared to say the US, we do have a few challenges.

You can see here electricity prices are going up on the back of the high gas prices of last year, particularly in New South Wales and Melbourne.

We've got very tight rental markets.

Rents have been going up.

And so that is adding to the, I guess, the underlying inflation cost pressures here.

So it is a challenging environment.

compared in some regards compared to say the United States.

And at the same time, capacity utilisation is measured by the national, the...

National Australia Bank Business Survey, they measure how tight, you know, how close to capacity are businesses operating and businesses are saying they're operating at a very high level of capacity.

At the same time, the unemployment rate is low.

So we've got not a lot of, you know, spare resources in the economy at the moment, adding to those inflation challenges.

which is why growth does need to slow.

Just in terms, I've already showed you the housing.

This is from a longer run perspective.

You can see that 10% decline in house prices that we've seen.

Look, of an order to what we've seen in the past, so if that's the worst, it's certainly a garden variety type housing market correction, certainly not the doom and gloom that many were suggesting last year, and already tentative signs that the market is bottoming out.

And it goes to the point that at the end of the day, we're very tight.

We've got ramping up of immigration in Australia at the moment, new building, certainly in areas where people want to live close to the major capital cities is very scarce.

It's a lot of development constraints.

And so affordability is very poor.

given the increase in interest rates.

But there is just the shortages of available housing is just limiting the downside in terms of prices.

You can see here just what we're seeing across various states.

You can see the bounce has been fairly broad based, particularly in Sydney, Melbourne, to some extent Brisbane, Perth a little bit flatter at this stage, but Perth itself never had a major house price correction in the way that other cities did have through last year.

Now, so here is the challenge for Australia.

We're operating at a very high level of capacity, low unemployment.

So that would suggest, oh, the RBA has got to be aggressive in continuing to raise interest rates.

But at the same time, we are seeing signs of a softening in the economy.

And with inflation also easing, the RBA is in this, you know, treading carefully in terms of how much further it raises interest rates.

So we're seeing business conditions from the NAB Business Survey starting to ease.

consumer confidence from the Westpac survey, you can see here, is at recessionary levels.

So consumers are as despondent today as they've been in past recessions, even during COVID.

despite the unemployment rate being at 50 year lows.

And that's because of high interest rates pressuring a lot of people with a mortgage and others high inflation, you know, hurting the real incomes of many other households.

So high inflation and high interest rates have been hurting consumers confidence, helping to slow consumer spending, even though the unemployment rate at the moment still remains relatively low.

Other signs of softening, the NAB, this is a survey of businesses hiring attentions.

You can see they've come off.

They're still at a reasonable level, but they're certainly off from their peaks.

And a measure of job advertisements as estimated by the ANZ.

Job ads are certainly off their peaks as well.

So certainly not at recessionary levels, but at least past their peaks.

So that would suggest that over the next three to six months, there should be some slowing of employment growth.

and some upward pressure on the unemployment rate.

And the big driver of our economy, of course, is consumer spending.

It's about 60% of the economy.

And I've got here in orange is disposable income, and here the dotted line is consumer spending.

So it's real consumer spending.

So a couple of things have been happening in the last few.

So firstly, you can see the collapse of consumer spending during COVID, and then the collapse during the, I guess, the lockdowns that were imposed

particularly in New South Wales and Melbourne in the second round of lockdowns of 2021.

So we've had two periods of collapse.

But in between that, we've had a very strong bounce back of consumer spending, such that overall spending is sort of back to its trend levels, its pre-COVID trend, as you can see here.

So that in and of itself would be one reason for consumer spending to slow, in that the bounce back from the COVID-related collapses has restored consumer spending back to trend.

The other thing that's been happening, of course, is that the lift in inflation has been hurting real income.

So you can see here, household disposable income

has actually been falling since mid 21.

Consumers have been keeping spending up because they've been running down their savings rate.

So we've had a high, a big buildup in savings during the COVID lockdowns.

But you can see since mid 21, consumers have been running down their savings to try to support consumer spending in the face of downward pressure on real incomes.

due to the surge in inflation.

But either way, it's been these two factors, I guess the easing of pent up demand plus the pressure on incomes from inflation.

And I would add also the increase in interest rates that have helped to slow consumer spending.

And so it's slowed to a crawl basically in the last couple of quarters.

In fact, this just breaks it up into services versus goods.

You can see that the collapse in consumer spending was most acute in the services sector.

The inability to travel, couldn't go to restaurants and cafes and whatnot.

So the collapse in spending was a lot stronger for services and hence the rebound in spending of late has been a lot stronger in the services sector.

which is added to the, you can see here goods consumption.

has actually been falling.

Now that's because of A, the pressure on consumer spending generally, but also we're switching from goods back into services as we've reopened the economy.

So there's a few moving things going on.

Overall consumer spending is slowing, but there's also been a switching from goods consumption into services consumption as the economy has been able to reopen.

Just in terms of interest rates, similar story to the US, I mean I've got the RBA raising rates twice more and thereafter you can see the markets are pricing in two rate rises and thereafter a pretty flat outlook.

I think there's probably a good chance the RBA can cut rates next year after having raised rates this year as the economy slows and in fact my projections are down here.

You can see even with the cash rate going from 4.1 to 4.6,

What's important is that by the end of the year, the market will be pricing in rate cuts in 24.

This is what the market expects on a 12 month forward basis.

So if the market expects three interest rate cuts in 24 as at the end of this year, my model of bond yields, 10 year bond yields,

can have them falling back down to 3.5% by the end of the year and progressively falling all the way back to 3% next year.

So again, a bit like in the US, it's an encouraging outlook for bond markets, although whether this happens because of a big decline in inflation without a recession or it is because of a recession remains to be seen.

I'm hopeful that we can now avoid a recession in the US and hence also in Australia.

Look, I'll leave it at that.

I think that's pretty much my time, but I'm happy to open it up to some questions.

Thank you, David.

That was a very good analysis of the global and the domestic economic outlook.

And I do have some questions for you.

The first one was regarding, again, you talk a lot about inflation and interest rates.

I feel that markets remain fixated on where interest rates are heading with the global inflation remaining elevated.

So do you believe the RBA, the Fed, and the rest of the world's central banks are in control of inflation at this junction?

Or are some external factors such as energy and supply constraints more likely to influence the direction of inflation rates?

Well, ultimately central banks, I think, are in control of inflation, not on a quarter to quarter basis, but basically on a one to two year view.

If central banks wanted to get inflation down by next year, it's an easy way to do it.

A painful way to do it, but an easy way to do it is by pushing up rates and sending the economy into recession.

So ultimately, yes, I believe central banks can control inflation.

Now, they can't control

Some of the drivers so one of the you mentioned energy prices and to some extent food prices now to the extent there are Supply shocks, you know factors that are pushing up inflation Irrespective of demand that is a very tricky situation for banks because on the one hand they you know If it's not a demand driven thing they can sort of look through it because hopefully it would pass if there's a one-off increase in all prices

thereafter they go sideways, ultimately the increase in inflation, it drops out of the system.

But what they are concerned about is it, even if it's a supply shock, even if petrol prices go up because OPEC restricts supply, for example, if that leads businesses and consumers to expect inflation to hang around for longer and they respond by increasing their own prices and their wages, it gets embedded into

inflation expectations, then central banks have to respond.

So even if it's a supply shock, even if it's something that central banks can't control, they need to react to it if they think it's going to get embedded into inflation expectations.

And ultimately, effectively offset that upward pressure on inflation by reducing inflation in other areas by reducing demand.

So there's a few moving parts in that answer, but it's not, again, some people say, higher interest rates aren't gonna solve inflation if it's caused by supply shocks, if it's caused by rising oil prices.

No, but what it can do is limit the risk of it becoming embedded in a more ongoing sense by operating on other elements of inflation.

That makes sense.

And for me, inflation is a very fascinating and very complex subject.

So can you talk us through the process of how inflation becomes entrenched in the global system via second-run wage and price claims?

And once it does become entrenched, what are the key implications from an investment perspective?

Yes, so it can become entrenched.

You can get a one-off increase.

Inflation took off initially around the world in 2021 because we had an excess demand for goods.

Basically, if you think about it, government said to businesses and workers, look, we want to limit the spread of COVID, so don't go to the

office, don't go to the factory, you can't produce anything.

You got to stay at home and isolate.

But we feel sorry about you losing your job.

So here's a bucket load of money to go and you know, spend.

And so we had everybody, you know, spending trying to buy goods,

typically online and, you know, having it imported from Asia.

So people were buying, you know, furniture, clothes, cars, computers, but there wasn't the supply ability to meet that demand.

So, you know, economics 101, when demand exceeds supply, prices go up, and that's what happened.

Then we had a reopening of the services sector, and so the excess demand for travel, excess demand,

in areas like restaurants and cafes not able to find workers.

And so service inflation picked up.

So it's been that COVID driver.

Now all of that can get, we saw goods inflation get restored because finally supply did catch up with demand and demand itself also eased once people were able to go and do other things with their money, such as go on holidays and eat at restaurants.

The problem is that that initial increase in inflation at a time when unemployment is very low, it hurts workers' real income.

I mean, if your income doesn't go up and prices go up by 10%, suddenly you're 10% poorer.

Now, if you've got a strong bargaining position because there's a shortage of workers,

you can go and demand a wage rise from your employer to compensate.

Now, if you do that, businesses may say, well, okay, I can give you that wage increase because I myself can put up my prices to compensate.

And all of a sudden we get into this round robin of, you know,

wages going up and prices going up and therefore prices have gone up so wages need to go up more.

And that's how a one-off effect of inflation can get embedded through these secondary effects.

And we've seen a taste of that in Australia, I mean you only need to look at the headlines

where various groups of workers are demanding.

And look, and potentially in some cases quite legitimately, because there were wage freezes on in place during COVID.

So some people didn't get any wage rise for a couple of years, but now they want a catch-up wage increase.

And we're seeing businesses passing on big price increases as well.

So that is the problem.

And if it does become entrenched in the way it did in the 1970s,

you can get high and variable inflation, and then businesses tend to, once you're not sure what inflation is gonna be doing, it tends to cause businesses to reduce their investment, it reduces their employment, and basically it's a negative to economic growth.

And that's why central banks ultimately don't want it to become entrenched.

Well, you mentioned the 1970s.

How is the world different now as compared to the 1970s where inflation was in change in the system at that time?

And what are the implications of those differences for the global economic outlook?

Yeah, there are some important differences.

Firstly, if you look at, for example, labour unionisation is obviously a lot less today than it was in the 70s.

So workers, generally speaking, don't have the collective bargaining power they had back in those days.

So that increase in inflation in the 70s

was more easily translated through to higher wages with unions collectively striking and demanding wage increases.

Globalisation is obviously a lot higher today.

Businesses, to the extent there are cost pressures domestically, have a greater ability to source cheaper products from overseas or even outsource production to overseas if they find that wage increases locally

are basically making local production uncompetitive.

So in theory, it's harder to get a 1970s situation today because of the greater competition in both product and labour markets.

Now having said that,

What we're seeing, inflation is a global phenomenon.

So, you know, outsourcing is not as easy because everybody's dealing with inflation.

Unemployment is low in many parts of the world.

So COVID and the response to COVID, if you like, was a global shock that has left labour markets tight and inflation high in many developed markets around the world.

Except some places like China, though.

Sorry?

except some places like China?

Europe, Canada, the UK, Australia, New Zealand, all of these countries do have high inflation.

Now, what are the implications?

I mean, the implications are if we do go back to a 1970s situation, interest rates are going to stay a lot higher for a lot longer, equity valuations will be crunched down.

So there's going to be a negative for the equity market.

as a result.

And ultimately, you know, central banks are probably going to respond by, you know, pushing economies into recession.

Well, they say they will, we'll see, because in the 1970s, you know, one of the arguments is that in the 70s, they didn't bite the bullet and they didn't sort of break the back of inflation quickly enough.

Today they say they will, but we'll see whether, if push comes to shove, whether they do ultimately respond or do they end up tolerating a higher level of inflation for the sake of at least delaying an economic downturn.

Well, that makes sense.

And despite these rising interest rates, unemployment remains low in Australia and in the US.

Well, you did talk about the job vacancy comparison in most developed countries.

So why has it been so resilient today and how high can interest rate go before the unemployment trends upwards in a meaningful way?

Yeah, I think, you know, one of the surprise, I mean, there've been so many surprises with COVID.

The first surprise, I mean, COVID itself was a surprise, of course, you know, the virus hitting us all and then having to go into lockdown.

The V-shaped recovery from COVID was a surprise.

Many expected the economic global economy to take some time to recover.

The inflation surge in 21 was a surprise and the fact that it hung around.

And now the interest rate increases and many thought we would tumble into recession quickly.

Globally, we've had economic resilience.

So there's been one surprise after another.

And so why is that this resilience?

A number of factors.

Firstly, consumers, you know, we've got we had pent up demand during COVID.

So if, you know,

People want to travel again.

People want to eat out.

And with hindsight, we had excess stimulus.

We had a lot of fiscal stimulus, a lot of tax cuts, a lot of fiscal handouts.

We had central banks cut interest rates to zero.

And many businesses and households in Australia, and particularly the United States, were able to lock in very low interest rates

for a long time.

So in the US, you can lock in a 30-year mortgage.

And so during COVID, when rates were slashed to zero, many households availed themselves of that opportunity to lock in a very low fixed rate mortgage.

So it's taken some time for interest rate increases to feed through into the cost of financing for many, because they've locked in their mortgages.

So pent-up demand,

the ability to lock in rates during COVID, excess fiscal stimulus.

These are all factors which in hindsight we can see has made global growth so far at least resilient to the interest rate increases.

Now at the same time, so I would actually think central banks, I think central banks really around the world are probably surprised that we're not in recession already.

They're probably a little bit surprised by that, but at the same time,

It hasn't, we've also had inflation coming down.

So funnily enough, they probably thought a year ago that they would need a recession to get inflation down.

It's turned out a recession hasn't come, but it's looking, you know, possible that we maybe after all don't need a recession to get inflation down.

So that's sort of see how I think things have evolved over the past year.

Hmm.

And the equity markets has climbed a wall of economic worry in recent months as share prices have climbed.

Do you believe equity investors have become too optimistic about the global economic outlook and recent bankers' ability to engineer a soft landing?

Talk about soft landing a few times.

they become too optimistic?

Look, I think the way markets work is they rally on the hopes of the worst case being averted.

And so far, at least the worst case hasn't been averted.

So the challenge for investors, you know, looking at the market today is, you know, a lot of the good news is already priced in, you know, the PE ratios are elevated,

The markets are expecting interest rates to fall.

Now all of that could happen if you do get a soft landing.

So if it is a soft landing, then those who invested in the equity market back in late October last year and have been hoping for this outcome are so far right and may well be right.

But of course, if it is a hard landing, then they'll all be wrong.

It'll all turn to tears and we'll get a second leg down in the equity market.

So as I said, if you seriously believe that a recession is needed to get inflation down, you would not be wanting to wade into the equity market here, because it's certainly not pricing that.

But if you think, and again, I think there is a growing hope that the chance that this happens, that a recession can be avoided,

and interest rates can be cut next year and earnings can recover, then maybe we won't see a stronger equity market gains over the next year as we've seen over the past year, particularly in the US.

But nonetheless, a collapse in the prices is looking less likely in that scenario.

And in fact, we may get catch up in other markets like Australia.

like Europe, which have lagged the US over the past six months or so.

So I'm probably neutral on the equity market at this point.

I know it sounds a little bit of a fence sitting, but I was anticipating a recession.

But, you know, there have been some encouraging developments, particularly in the US labour market, as maybe I

laboured over in a good part of my presentation purely because it is the most critical aspect to the global economy.

How that labour market imbalance in the US resolves itself in particular is just so critical to this whole hard landing, soft landing debate that we're still dealing with.

Hmm.

And how do you believe the equity in the fixed income markets will respond once the Fed and the RBA reach the end of this rising cycle, whenever that happens?

We're debating whether that's probably another two rounds.

Well, again, look, it ultimately depends on why it ends.

I mean, if it ends because the global economy crashes into recession,

Look, then the equity market, we're seeing historically every time the Fed, every time central banks stop raising interest rates because we're going into recession, the equity market might rally on one day because of the confirmation that at least the rate cuts are over, but then it's got to face the earnings declines and the uncertainty of how deep the recession might be.

And so equity markets, if it is a recession, rarely bottom

you know, before the recession's even begun.

Whereas for the bond market, all the bond market needs to be confident of is rate rises are over and the next major move in interest rates is down, be it because of a soft landing or a hard landing.

So again, either way, that's why I think the bond market is probably the better, most obvious value opportunity in terms of major asset classes at the moment, because either a soft landing or a hard landing is okay for the equity market.

Whereas for the, obviously for the bond market, but obviously for the equity market,

a hard landing won't be okay, a soft landing will be okay, but again, you're probably not looking at super fantastic returns of the order that we've already seen.

So how markets respond to the end of central bank tightening, you know, all of it depends on why they end it.

If they end it because of recession or do they end it because there's no recession, but inflation is coming down nicely and wage inflation is coming down nicely.

That would be a pretty good situation, right?

Fingers crossed.

Yeah, fingers crossed.

And are there any non-consensual economic outlook scenario in investment markets that are dismissing as unlikely that you believe warrant greater attention?

Yeah, yeah, for sure.

I mean, the pain trade really over the past six months or so has been to be underweight equities believing a recession is coming and so far, at least that hasn't happened.

So that's been the pain trade.

The pain trade now might be

that we do get a rebound in energy and food prices.

We've seen oil prices tick up in the last few weeks.

We've seen Russia starting to restrict supply.

Now they've also ditched their grain deal that allowed Ukraine to export a lot of food to parts of the world.

So basically if food and energy prices back up over the next few months and headline inflation starts to back up from what is already a very high level,

will be very painful for bond and equity markets.

So that is a non-consensus, something to certainly look out for.

Well, to conclude, can you please share a game-changing lesson you've learned this year in your position as BetaShares Chief Economist?

Sorry, can you say that again?

Can you share a game-changing lesson you've learned this year in your position as BetaShares Chief Economist?

Look, I think the lesson learned, COVID has just been a series of very challenging environments for macroeconomics.

It's been a sort of shock to the system that we haven't seen in history.

Maybe have to go back to the 1915 Spanish flu situation.

But I guess what I've learned is how resilient

economies are to higher interest rates.

That has been the big surprise packet over the past, really since late last year.

We did fear the rate rises would cause a recession, but so far it's not happened.

So you've got to be open minded to economies being a lot more resilient than initially expected.

That's so true.

Well, thank you, David.

It's so wonderful to see you.

Take care.

No worries.

Thank you.

Thanks for the opportunity.