So far, 2023 has been a surprisingly good year for equity markets and investors. While there are some positive signs in the global economy, there are many more reasons to remain cautious. China’s economic slowdown, corporate debt defaults, retail slow down and office property valuations are just a few examples. The good news this year has been that inflation rates across much of the world have fallen reasonably quickly from their peak in mid-late 2022. The big question for the rest of 2023 and beyond is whether inflation continues to fall and ultimately gets to a sustainable 2%-3%. There is still some way to go until victory can be declared. Central banks are hoping they have done enough and are banking on the lag effect on rate hikes coming through to finishing the job. The danger being that after the pause in rate hikes, inflation is lower but still elevated.
Unemployment is the key.
The unemployment rate realistically needs to be in the range of 4%-5%. Then you get a balance in the power dynamic between employees and business. When the economy is operating at 3.7% unemployment, it creates distortions and difficulties for businesses in a multitude of ways. No one wants to see people out of work, but the reality of the world is that labour is driven by supply and demand like any other force in the market. If there is no supply, prices go up, but then company profit falls, businesses start to struggle, and they stop expanding and investing and growth falls.
It’s a fallacy that unemployment is always better being lower. The opposite is true when unemployment is too high of course. Everyone understands that when too many people are unemployed, in other words an oversupply of labour, that shifts the power balance to the employers. They increase profits but also find there are no longer enough consumers with jobs to spend so business and the economy falter. There comes a point where balance is lost if unemployment is either too high or too low. Finding the balance between inflation and unemployment is the current conundrum for central banks across the world.
Of course, it’s always a very delicate and misunderstood topic when you are effectively saying it’s better for the overall economy if unemployment is higher. High profile property investor, Tim Gurner, found this out the hard way last week when he outlined exactly this in more blunt terms. His message was broadly right in my view, but the backlash was significant. New RBA chairperson, Michelle Bullock has previously stated on the record that unemployment will have to rise to 4.5% in order to tame inflation. She also articulated it far more diplomatically when she said that the RBA needs to rein in inflation while keeping as many jobs as possible. That is a far more politically correct way of saying that to beat inflation it will cost jobs. It doesn’t matter how you say it, the reality is there will be a cost to the economy and the people to beat inflation and job losses will occur. But higher inflation is worse.
At times like this, it’s the prospect of higher interest rates being required later that unnerves the stock market when stronger than expected jobs data comes through. Ordinarily, good jobs data means a strong economy. A strong economy generally means good conditions for business, and typically that is good for the value of the shares in those businesses. However, when central banks are increasing interest rates to slow the economy enough to reduce inflation, the by-product is going to be job losses. So, when the jobs data is strong, and unemployment stays low, it’s a sign that the rate increases are not having the desired impact on slowing the economy. It’s hard to know if that is just a lag effect or if it means interest rates ultimately need to go higher. For investors, it’s worth keeping this in mind as it’s the primary reason the share market tends to fall if unemployment data is stronger than expected in this environment.
Overall, two of the key areas to watch are obviously inflation and unemployment but there are many other variables at play that all impact these as well. Recently the price of oil has jump and there are going to be adverse implications from this on the headline rate of inflation. While at the same time the retail slowdown is real, and I expect it to be the catalyst in the months ahead to push the unemployment rate higher and subsequently then see inflation fall further in in 2024.
General Advice Disclaimer: This information is of a general nature only and may not be relevant to your particular circumstances. The circumstances of each investor are different, and you should seek advice from an investment adviser who can consider if the strategies and products are right for you. Historical performance is often not a reliable indicator of future performance. You should not rely solely on historical performance to make investment decisions.