US Interest Rates, Omicron and China: Happy New Year

As I write this commentary many of the forces we discussed last year are playing out in the way that was predicted. The 10-year US bond rate hit 1.88 per cent and the S&P 500 US index was down 1.8 per cent which flowed into Australian shares which are now not far above the levels at the start of 2021-22—i.e., there has been only token overall gains apart from dividends.

What I did not canvass was the combination of the Omicron impact and US inflation which made the Christmas New Year break one of the most dramatic that I can recall. The Omicron threat came home to me on Christmas Day. We had had a wonderful family Christmas dinner that reached the plum pudding stage when one of the couples announced that they were off to be tested because they had been a “close contact”.

There was an initial horror. With the plum pudding the couple had received a text on their mobiles. Later it turned out that they were not infected. But in the days that followed just about every group of people that I know has been touched by the virus, including members of our immediate family. It is clearly having a major effect on the economy. My wife and I have been fortunate but are still cautious, although we have received the booster.

I will come back to COVID later but when we look back at the end of 2021 and start of 2022, we will isolate the US bond market and inflation plus China as dramatic events that ranked alongside it. 

As the US Federal Reserve cut back their bond buying, bond traders looked at the exploding US inflation rate and shouted “sell”. With bonds trading just below 1.9 per cent it still represents a negative rate of return with US inflation between 6 and 8 per cent.

A year ago, when the bond rate was down around one per cent, if I had been told it was headed towards 1.9 per cent, I would have predicted a big fall in the US and global stock markets. Despite today’s fall, that hasn’t happened because of the enormous liquidity in the US economy. With official interest rates at token levels share buyers are punting that somehow, some way everything will turn out roses.

This makes our market very dangerous particularly as COVID is hitting earnings around the world.

The second major event was, of course, China. The close of 2021 was not a pleasant time for President Xi Jinping. The wealth of the middle class in China is in property and although Evergreen problems dominated the headlines last year, problems in property development are far more widespread and serious.

Given the changes that Xi is making in education, online gaming and personal freedoms, this was a dangerous event for the Communist party. So, China is now lowering interest rates, instituting enterprise rescues and stimulating its economy – exactly as it has done every other time there has been economic pressure.

At the World Economic Forum Xi was preaching free world trade and urging America not to lower its economic activity by lifting interest rates and curbing its economy. Very clearly Xi needs the US market to help its country in its current dangers.

That means demand for our commodities is going to be strong which is good news for our miners and the overall economy.

Our government was perfectly entitled to stop Novak Djokovic from entering the country on vaccination grounds. But it made a complete hash of the process and did our nation great harm. We are therefore in no position to be spruiking criticism at other nations including China.

In the new environment, if Australia can keep its mouth shut for a while, we might be able to sort out some of our China trade problems. My guess is, despite its more recent anti Australian rhetoric, there is at least now a respect for the Australian nation which has not only started to fix up its defence equipment mess but is mobilising other countries in the region in a way China could never have imagined.

Accordingly, there is just a chance – and that is not a forecast – that China will ease some of its restrictions on Australia.

Clearly the possibility of a war in Taiwan and the Ukraine remains which would hit markets. The most immediate danger is Ukraine but at least talks are going on. For the moment China looks to be more concerned about its economy than war.

Back home in Australia, the Australian economy is like a coiled spring. Back in November we were roaring ahead under the stimulus of incredible liquidity amongst many Australian households. Then came Omicron which as I discussed earlier affected far more people than previous versions of the virus.

I believe the official figures substantially understate the real spread of the virus because it is just too hard to get tested. This is restricting people’s mobility. The first public company casualties are in the big retail sector, but it will spread.

My guess is that in about two months we will develop a way with living with this virus and we will see a substantial recovery under the impetus of the underlining prosperity of so many Australians.

While further US bond rate rises will hit our share markets, official rates in Australia will stay low until after the election. The rising bond US interest rates are impacting our bank profits because they borrow overseas but apart from increasing fixed rate home loans, banks will be very reluctant to increase the variable home loan rates until after the election. That may cause a number of profit disappointments. But at least, in my view, we are headed for a strong economy later in 2022 but higher interest rates.

My builder friends tell me that the housing market can stand flexible home loan interest rate rises of between 1.5 and 2 per cent without significant damage. But once housing loan rates go up by more than 2 per cent and certainly if the rise is 2.5 per cent or greater then there will be substantial impact.