Economic Update January 2025

In this month’s update, we provide a snapshot of economic occurrences both nationally and from around the globe.

Key points:

• The Fed cut US interest rates in December and the economy remains resilient
• The RBA remains on hold, but the chance of a February 2025 rate cut is rising
• The rally in AI related shares looks set to continue
• Trump policies appear to be positive for equities but also inflationary – how this plays out is unclear

We hope you find this month’s Economic Update as informative as always. If you have any feedback or would like to discuss any aspect of this report, please contact your Financial Adviser.

The Big Picture

In early 2024, it became obvious that the performances of a small number of stocks were dominating growth in the US S&P 500 Share Index. The market has been led by the so-called ‘Magificent Seven’ (or, later, the ‘Mag 7’), which are the biggest mega-cap technology companies and includes Microsoft, Apple, Amazon Nvidia, Alphabet (Google) Meta (Facebook) and Tesla.

At the same time, in the popular press, ChatGPT, became the poster-child of the Artificial Intelligence (AI) industry. However, the so-called ‘generative AI’ applications that could write a resume or even an assignment at school or university wasn’t the main game; it was just an easy-to-understand, visible application.

Generative AI applications are only a segment of the entirety of AI innovations. Think facial recognition on CCTV cameras, detection of who is using a mobile phone while driving and the universe of applications is rapidly expanding. Then add on some serious scientific work in medicine, exploration and defence and we quickly conclude that it is almost impossible to even try to guess the magnitude of the impact of the AI-led new industrial revolution.

So, when some corners of the media and finance commentators were obsessing with the notion of a speculative bubble in the price of shares related to AI in early 2024, we felt that this rally was for real and that relevant share prices were supported by commensurate growth in earnings. Of course, all rallies are not a straight-line event and have dips along the way but what we are experiencing now is not like the dotcom boom and bust that occurred at the turn of the twenty-first century. In 1999-2000, companies were launching on the share market on the dream of some new, unproven idea. In 2024, NVIDIA, the major AI-chip manufacturer, was already scaling up production and making big profits. By mid-2024, NVIDIA was the biggest company in the world by market capitalisation.

To inform our views we base some of our market analysis on the survey of broker-forecasts of company earnings by LSEG (formerly Thomson Reuters). Led principally by the Mag 7 the S&P 500 index quickly got ahead of its ‘end of year’ 2023 forecast in 2024. Australia has much more limited exposure to AI and the forecasts of the ASX 200 were a much closer fit to what was actually achieved.

The question we now face is – where do we go from here? The S&P 500 gained 23% in 2024 when historical averages have been single figure growth rates. And that 23% was on the back of 24% growth in 2023! The AI rally started before most realised it! In two years, the S&P 500 index had gained 53%! Any investor who exited the market at the end of 2022 for whatever reason (wars, pandemics, etc) has failed to participate in this significant rally.

Broking analysts have caught up – to some extent – with the possible impact of the AI revolution. Forecasts of the growth in the S&P 500 for 2025, based on the broker survey, are at about half the gains experienced in either 2023 or 2024. But that is still a double-digit growth and greatly in excess of previous historical averages.

Many things are likely to buffet the market in 2025 but investors with an appropriate understanding of the risks involved might consider staying with the momentum trade currently in play in the US – at least for a while to come.

Another huge change in sentiment over 2024 was in the opinion of when (or indeed if) central banks would start cutting interest rates. Inflation was falling – but not initially quickly enough for everyone.

The US Federal Reserve (Fed) was not the first to start its cutting cycle but, on 18 September 2024, the Fed started off with a ‘double cut’ of 0.50% (or 50 basis points (bps)) and everyone took note. The latest and third Fed rate cut was in December and by 25 bps to have the Federal Funds cash interest rate in the range 4.25% to 4.50% at year end, a full 100 bps below the level before the interest rate cuts started.

The Reserve Bank of Australia (RBA) hasn’t started cutting its official cash interest rate yet and has maintained an interest rate of 4.35% since early November 2023 – this is about the same level as the Fed after its extensive 100 bps of rate cuts.

The RBA is claiming our rate of inflation has been too stubborn in falling to its target range of 2% to 3%. That might be true, but some of the components – such as rents – are unlikely to be reduced by higher interest rates. In fact, the opposite is true if landlords are trying to maintain their margins by raising rents because of higher mortgage rates.

The Royal Bank of New Zealand (RBNZ) learned its lesson the hard way. It was particularly aggressive and vocal in raising rates higher for longer because it stated it wanted to see inflation fall first before it started cutting rates. It was forced to do two 50bps cuts back-to-back but that didn’t save the economy – it just slipped back into recession. Further evidence that monetary policy takes effect with long and variable lags.

So, did the RBA dodge a bullet and do the right thing over the last couple of years? Using a simplistic definition of a recession (two consecutive quarters of negative growth in GDP), Australia hasn’t yet slipped into one – but that is because of our unusually high immigration following the pandemic. When we look at per capita (per household) GDP growth, we have just experienced seven consecutive quarters of negative growth. Soft retail sales bear this out.

Our peer group of developed world central banks such as the Bank of England (BoE), European Central Bank (ECB), Bank of Canada (BoC), Swiss National Bank, and the Swedish National Bank, have all started cutting their interest rates. Indeed, the BoC has now cut by a total of 175 bps from 5.0% to 3.25%. Canada, like us, has experienced a string of negative per capita growth rates.

If there was any credibility to the ‘theory’ of how monetary policy works, this array of different actions and responses should not have happened.

The impact of interest rates on GDP also requires some assessment of what has been happening to fiscal (Government economic) policy. The Australian government had a big influx of revenue (tax) from the impact of a very fast ramp up in economic activity following the relaxing of Covid restrictions. These tax revenues in part were used to provide additional fiscal stimulus. This in turn kept upward pressure on prices due to rampant demand but still constrained supply which fed inflation and led to the RBA increasing interest rates in response.

We can see the impact of government spending on GDP by examining the latest National Accounts. The latest (not per capita) GDP was 0.3% for the September quarter. Since government expenditure contributed 0.3% to GDP, it would have been 0.0% without it. On top of that contribution, another 0.3% was due to government investment. In other words, without the government contribution, our GDP would have fallen by ?0.3%. Because of the windfall gain in government revenue, the government deficit did not blow out! Treasurer Jim Chalmers is claiming this as a victory for the government as it helped to avoid a recession.

If we dig deeper, the government pump-primed the economy for possibly very good reasons (pandemic slow down). However, the RBA was trying to do the opposite. We can argue that the excess demand that the RBA thinks is causing inflationary pressures is not from households (private sector) but the government or public sector. Households are hurting in the continued cost-of-living crisis.

The average wage price index is down about 7% since the end of 2019 – after we allow for inflation. If all wages were spent on the consumer basket of goods and services that would be a bleak signal for households. They would be consuming 7% less ‘things’ like quantities of meat, number of weekends away, education and the rest. But the situation is even worse than that for many, particularly those with variable interest rate mortgages.

Some of the wages are spent on mortgages or rents (only about one third of the population are immune from both). Huge jumps in mortgage rates combined with largely variable rate mortgages have taken a big slice from wages so the impact on consumer goods and services is much worse than the picture we just painted. In the US, most mortgages are fixed rate and are based on 30-year interest rates so Australian households hurt much more than their American counterparts in a monetary policy tightening cycle.

For renters, we know that rents are running well ahead of the Consumer Price Index (CPI) Inflation due to pandemic-related supply issues and higher than average immigration. Renters are also hurting more than the 7% fall in inflation-adjusted wages would suggest. What about the much-maligned baby boomers in, or going into, retirement who own their own homes? Many of them do not earn wages anymore; they are living off past savings, superannuation and government pensions. They are also negatively impacted by the cumulative impact of inflation. The RBA argument about households (particularly boomers) causing inflation is a difficult one to make.

And the argument that boomers are better off from higher interest rates is a misnomer as Bank account interest rates, while higher now, never-the-less have been consistently below the rate of inflation, meaning that the purchasing power of their savings is dwindling and most do not have enough super to maintain a comfortable lifestyle.

It might be heretical to raise, but some leading economists have argued interest rates do not affect inflation. Could inflation have fallen as it did – across the globe – because the supply constraints dissipated? Its quite possible but not provable. But to argue that some of the pain caused by central banks was for nought cannot be dismissed by economic evidence.

Returning to the US Fed, it does seem almost a miracle that growth and the labour market still seem strong, and inflation excluding shelter, has been under 2% for months. What about US President Biden’s Inflation Reduction Act? It has been liberally scattering cash around to households. This may be a good thing but economics never gives clear cut outcomes. When central banks (monetary policy, interest rates) work against governments (fiscal policy government spending) it is difficult to determine cause and effect.

So which way are the central banks heading in 2025? The Fed cut back its ‘indicative’ four US interest rate cuts in 2025 to two at its last meeting. Market rates suggest that there is little chance (11%) of a rate cut at its next meeting in January but a cut before mid-year is quite possible. Another rate cut might be forthcoming in the second half of 2025.

Market interest rates (government bonds and corporate debt) now are pricing a greater than 50% chance of an RBA interest rate cut at its February meeting and more cuts might follow quickly. It is harder to predict RBA activity because we do not yet know the full extent of the impact of recent policy decisions i.e. to not cut interest rates. The US might have pulled off a miraculous economic ‘soft landing’ as economic growth and employment are so far holding up. Conversely, Australia is already in a per capita recession.

We see 2025 setting up to be a good but not great year for investors. There are a combination of positives and negatives for investment performance that will impact the outcome.

On the negative side, growth in some large economies is slowing which could see corporate margins come under increasing pressure. Also, some sectors of share markets are considered expensive e.g. IT and financials which could make further increases in share prices somewhat harder to achieve.

On the positive side, corporate balance sheets are not over stretched and margins have been maintained which is supportive of share prices. Trends in markets remain positive driven largely by bigger technology companies and, in particular, those exposed to AI.

In relation to AI, revolutions happen from time to time. There was the invention of the wheel, weaving machines to make cloth, and transport was massively sped up by applications of the internal combustion engines in ships, trains, cars, and aeroplanes. While we cannot predict whether AI is a revolution, there is no doubt it is a significant innovation and technological advancement. What we are confident of is that it would be foolish to ignore it or dismiss it as a fad. 2025 will see further developments in, and applications for, AI. Whether these developments continue to support the rally in share prices and markets is a separate question which will be addressed as the year unfolds.

Elsewhere, conflicts in the Ukraine and the Middle East continue. China’s economy is struggling a little but the government has started a major economic stimulus programme – which we expect to continue in 2025 and be a positive fillip for Australian exports, resources in particular.

Incoming US President Donald Trump will be inaugurated on 20 January 2025, heralding what we think will be a presidency similar in character to Trump’s first term from 2016 to 2020. There are three of Trump’s key policies that are getting our serious attention: tariffs, immigration and government expenditure.

It is hard to argue that Trump’s motives do not reflect his believes but the method and extent needs analysing. Trump placed tariffs on many countries and goods in his first term. The world did not end and President Biden seemingly made no attempt to remove them. We suspect Trump wants to negotiate better deals with the world and is brandishing his big tariff stick as his chosen method of persuasion.

Illegal immigration was getting out of hand even before Trump’s first term. A government department estimated that there were over 11 million illegal immigrants in the US three years ago – and Biden opened the floodgates quadrupling the flow but then cut that flow to ‘just’ doubling the previous immigration rate.

Trump started to build his ‘Border Wall’ in his first term. A bit more of a wall and other restrictions might help. But as to ejecting those 11 million plus illegals, is ambitious in the extreme. To suggest that the authorities could even find them all, transport them to some other country, and have that country accept them is a monumental challenge let alone the cost of it. While this policy is popular with voters, we do not see how it can be effectively implemented.

As to the Elon Musk led Department of Government Expenditure (DOGE) cutting massive amounts from expenditure immediately is also fanciful but someone needs to try and address the 36 trillion-dollar debt. The US Government deficit was recently reported as being $1.8 trillion of which $1.16 trillion were interest payments on that debt. That situation cannot continue and growth in the deficit needs to be addressed. The problem got a lot worse over the last four years. Some of that worsening was necessary as it helped the US economically survive the pandemic but that level of Government expenditure was not pulled back as the pandemic receded. Indeed, the massive Inflation Reduction Act just kept the problem growing.

Besides these three pillars of Trump’s policies, it seems to be widely accepted that Trump will cut the corporate tax rate from 21% to 15% and emphasise deregulation for US companies. It is yet to be established how the tax cut would be funded. Trump may think revenue from tariffs might cover part of the tax shortfall but, as yet, costings do not seem to be available.

Here in Australia, we are soon to vote on who will govern our country. The suites of competing policies have not yet been announced. The electorate, based on recent polling, does not appear to be too happy with Albanese’s government so the election has the potential to deliver a close outcome.

Since we must always make our investment decisions based on what we currently know or reasonably expect, we are comfortable with a portfolio diversified across a range of higher quality assets. The future is uncertain and our goal is to manage the portfolio to be positioned to benefit from changes in the economic, geopolitical and investment environment as they occur.

Asset Classes

Australian Equities 

The ASX 200 had a strong 2024 – up 7.5% and up 11.4% when reinvested dividends are included. However, the index lost ground in the final month (?3.3%). Most sectors were down in December.

If the newly announced China stimulus package takes hold, it could help our resources sector to play catch up.

International Equities 

The S&P 500 recorded many all-time highs during 2024 finishing the year up 23.3%. However, the index lost ground in December (?2.5%).

The LSEG survey of broker-forecasts on US company earnings points to above average returns in 2025 – but not as good as the last two years.

Bonds and Interest Rates

The Fed cut in September (50 bps), November (25 bps) and again in December (25 bps) – but it cut back its dot plot insight into future rates from four to two cuts for 2025. The market is comfortable with that.

The RBA stood firm again at its December board meeting but almost flagged a first cut in February. Some modelling is suggesting a second cut in quick time. Only recently, three of the big four banks pushed out their forecasts for a first cut from February to mid-year. The market is very uncertain and such uncertainty is not good for sound planning.

The Bank of Canada is all but in panic mode with its cutting cycle. It has now cut rates from 5.0% to 3.25%. Sweden also cut in December (?25 bps) and the Swiss National Bank by a double cut of 50 bps. The Bank of Japan and Bank of England were on hold. The RBA is emerging as a central bank that is behind the curve!

Other Assets 

Brent (2.3%) and WTI (5.3%) oil prices were up in December but largely flat over the year.

The price of gold pulled back (?1.3%) in December but up 27.1% on the year.

The price of copper was down in December (?1.1%). The price of iron ore also fell in December (?3.2%) but finished the month just above $US100 /tonne.

The VIX ‘fear’ index ended December at an elevated level (17.4) after starting the month in the normal range,

The Australian dollar further depreciated against the US dollar by -4.6% for December and ?9.2% for the year.

Regional Review

Australia

Australian jobs data remained in a ‘normal’ range. 35,600 jobs were created of which 52,600 were for full-time positions and ?17,000 were for part-time positions. The unemployment rate fell to 3.9% from a recent high of 4.3%. Wages are not acting as though the labour market is tight.

When the employment data are transformed into year-over-year growth rates, full-time, part-time and total growth all converged on 2.3% indicating that the part-time bubble might be behind us. Only a few months ago, part-time positions were growing at 6.8%!

CPI inflation looks to be in the range at 2.4% but some of this reduction is due to a statistical artefact introduced by the ABS to include government energy subsidies.

GDP growth came in at 0.3% for the quarter and 0.8% for the year. In per capita terms, those rates are ?0.3% and ?1.5%, respectively. The household savings ratio rose to 3.2% from 2.4% suggesting households have been able to restore some sort of reasonable savings plan. An indicative range in ‘normal times’ for households is 5% to 6%.

China 

The China manufacturing PMI improved to 50.3 from 50.2 in November; a modest value but, nonetheless a slight improvement. The December PMI slipped to 50.1. Industrial profits fell over a 12-month period to November (?7.3%) – the fourth such consecutive negative read.

Retail sales missed expectations at 3% compared to expectations of 4.6% and from a previous read of 4.8%. Industrial production matched expectations at 5.4%. We expect China to continue to monitor the situation and add more stimulus as necessary.

US

The nonfarm payrolls (jobs) data came in at 227,000 after a hurricane-affected very low number the month before but the unemployment rate climbed to 4.2% from 4.1%.

Inflation is largely contained in the US. If we exclude shelter from the CPI, the inflation read would have been 1.6%, or well below the target 2% rate.

Retail sales volumes showed some strength at +1.0% for the latest 12 months. The final (revised) GDP read for the September quarter was 3.1% up from the preliminary read of 2.8%.

The expected Trump corporate tax cuts and an emphasis on deregulation should support profitability in the US.

Europe 

UK inflation rose to 2.6% from 2.3% and the Bank of England remained on hold at 4.75% after recently making its first cut. The ECB cut its rate to 3.0%.

Rest of the World 

Canada, like Australia, is experiencing positive GDP growth. However, Canada has posted six consecutive negative quarters of per capita growth (compared to Australia’s seven). Yet Canada has made 175 bps worth of cuts to end 2024 with a terminal rate of 3.25%. Australia has not yet made any cuts and its overnight cash rate at the end of 2024 stands at 4.35%!

The US commenced attacks on Iran-backed Houthis based in Yemen who are in turn attacking shipping in the Red Sea.

We acknowledge the significant contribution of Dr Ron Bewley and Woodhall Investment Research Pty Ltd in the preparation of this report.