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The challenges ahead
As we begin the new financial year (FY), we take the opportunity in this week’s Brief to reflect on the FY just past. It was a year where global central banks, including the RBA, have appeared to pull off the seemingly unachievable soft landing, in an environment fraught with geopolitical risks in addition to stubborn inflation. It also occurred amidst doubts among many commentators of the ability of the global economy to avoid recession, let alone achieve an almost trend-like rate of growth (see our recent WEB Soft landing for the global economy).
Financial markets similarly expressed doubt over central banks’ ability to pull-off the soft landing. The halt in the decline in inflation around October and November last year, fuelled concerns that central banks were falling behind the curve. To their credit, several major central banks including the US Federal Reserve (Fed), the Bank of England (BoE) and the Bank of Canada (BoC) didn’t blink, keeping policy rates at their earlier established peaks. This enabled laggard Banks, such as the ECB and the RBA to “catch up” and raise policy rates to levels more appropriate for the inflation risk in their economies without the added pressure of falling further behind the Fed in the tightening cycle.
Of course, this period of uncertainty over the direction of inflation and monetary policy led to equity markets jumping the gun and global equity prices (as measured by the Bloomberg World Large & Mid Cap Index) fell by around 10%. Although, to be fair, equity markets also had to absorb the impact of the Hamas’ October attack on Israel. Bond markets also lost faith in central banks and US 10-year bond yields surged to 5% (Australian yields were at 4.9%). However, as inflation recommenced its downward trend in December, and the US economy continued to outperform expectations, all was forgiven, and global equity markets recovered their lost ground and steamed higher to finish the FY up around 20% (although Australia’s S&P/ASX 200 lagged with a more modest 8% increase over the FY).
Bond markets also settled down, with US and Australian 10-year bond yields currently around 4.4%. Similarly, break even inflation (BEI) rates, which are financial market’s view on future inflation rates, appear to be well anchored at close to central banks’ targets. The US 10-year CPI BEI has hovered around 2.2% (which is consistent with the Fed’s 2% PCE inflation target) and the Australia CPI BEI has been around 2.5% (consistent with the RBA’s 2.5% CPI target). So, what does the new FY promise? Having averted a scare back in March that inflation was on the rise, the global rate of inflation appears to be trending gradually lower.
Consequently, markets are factoring in rate cuts by most major central banks by the end of 2024, including two 25 basis point (bp) rate cuts by the Fed, the BoC and the BoE, and one or two more 25bp rate cuts by the ECB. Here, the RBA stands as the odd man out, with current market expectations split almost 50/50 over a rate hike before the end of 2024. Growth is expected to slow in the US to a more sustainable rate, while the UK and Europe are expected to lift toward more trend-like rates over the second half of 2024. Similarly, the Australian economy is expected to recover from its current malaise but at a more gradual pace, returning to trend in the first half of 2025.
But significant risks to this cosy Goldilocks outlook are brewing. Geopolitics are at the forefront. Naturally, incumbent governments are feeling pressure at the polls from the high cost of living and high interest rates. Europe has seen a lurch to the populist right as the centrist parties have been unable to address voter concerns around the erosion of living standards, in addition to concerns around immigration and the high cost of transitioning to renewables. In the US, the pressure of inflation and interest rates on living standards is less than in Europe. Nonetheless, Donald Trump appears poised to return to power as the Democrats’ shift to the Progressive Left has alienated too many voters in the political centre and as confidence in President Biden’s ability to serve a second term further erodes the Democrats’ appeal. In Canada, the LDP looks likely to lose 2025 Federal elections to the Conservatives (although the election is more than a year away). The UK has shifted to a Labor government as the Conservatives failed at their calling-card strength, which is sound management of the economy and public finances. What is the upshot of these political shifts?
The rise of the European populist right comes with an agenda of increased government spending and a more restrictive attitude towards immigration and international trade. Similarly, the election of Donald Trump comes with the promise of a crack down on immigration, tariffs and tax-cutting pressure on the government budget. This suite of policies (migration restrictions, higher tariffs and fiscal expansion) is certainly inflationary and likely negative for growth. In the case of Europe, the policies will bring individual countries in conflict with the governing bodies of the European Union, where centrists continue to hold the balance of power.
In the US, Trump’s stated tariff policies, including a 60% tariff on all Chinese imports, is likely to escalate tensions with Chinese authorities and weaken the economic leverage the US currently possesses over China given China’s dependence on the US as a source of export revenue. What about Australia? Being a small economy, dependent on international trade for our high standard of living, the greatest threat is posed by deglobalisation. In a world where political reality dictates trading blocs, Australia would need to realign its trading partners. Given current trade flows and dependencies, this would take time, although it is not impossible.