Dealing with Inflation and Interest Rates: A Close Watch on Australia
Over the past months we have repeated three things:
- Our concern over wage price inflation
- The danger of the effects of increased interest rates on the broader economy
- The low rate of unemployment being the different factor in this economic slowdown.
As we have said before, we feel wage price inflation is not being tackled in Australia as it is in other developed nations.
The announcement earlier last month by the Fair Work Commission that effective the 1st of July the minimum wage would increase by 5.75 per cent, cemented our fear that this is not being tackled in Australia. This decision sets a floor for wage negotiations across industries, and to say that it is not inflationary is voodoo economics.
The Reserve Bank of Australia (RBA) and the Inflation Challenge
RBA (Reserve Bank of Australia) minutes released in late June reinforce this message stating that “members observed that some firms were indexing their prices, either implicitly or directly, to past inflation,” and that “These developments created an increased risk that high inflation would be persistent, which would make it more difficult to keep the economy on the narrow path.”
For this reason, we feel interest rates had to rise and there is another interest rate increase to come beyond the existing official cash rate of 4.1 per cent.
The Interest Rate Divide: US Vs. Australia
We also reiterate our view from the last few months that whilst US interest rates will see several decreases in 2024, the RBA will not cut anywhere near as aggressively. As a result, in the second half of 2024 we expect Australian rates will cross over those in the US (therefore Australian rates will be higher), and this will support a stronger Australian dollar.
We believe our view is supported with inflation in Australia in April increasing to 6.8 per cent from 6.3 per cent whilst core inflation in the US for May slowed to its lowest level since November 2021 at 5.3 per cent.
Capital Economics in London point out that declines in inflation reflect decreasing energy inflation whilst food inflation is still running at double digit rates.
The effects of interest rates on the broader economy are starting to be felt with retailers reporting softer sales across the board, however the effects are not broad, as the housing market at this stage remains extraordinarily strong.
Unemployment: The Silver Lining in Economic Slowdown
One reason is this economic slowdown is not being broadly felt, as unemployment sits at just 3.5 per cent in May.
We see three factors as to why unemployment is low and will remain low and continues to be the key factor in why this cycle is different.
- Many firms are still struggling to hire and are still trying to restore headcount after the pandemic.
- As firms struggled to hire, despite feeling the effects of a slower economic environment they are hesitant to let people go.
- If we are near peak interest rates this further confirms our point above as they assume a modest effect on our economy from this point.
Our Stance: Cautious Asset Allocation
We enter the second half of 2023 with our asset allocation remaining cautious.
And our scenario analysis reinforcing our position above.
Equities: An Optimistic Outlook Amidst Known Risks
Equity market performance has been robust in the face of a cautious consensus.
There are a lot of known unknowns and markets are simply ignoring them, which is both confusing and concerning. The overall health of global economies must be considered against a background of interest rates continuing to be raised by central banks, but markets are ignoring them at present.
However, as we have often noted, markets always look forward and the bulls simply see that we are “near” the peak of interest rates, meaning more supportive interest rate settings are getting closer.
Artificial Intelligence (“AI”) driven euphoria has led to the robust performance of the US equity market over the quarter, with the outperformance of the technology heavy NASDAQ index over global markets being the largest seen since 2010 (per Bank of America Merrill Lynch). Headline valuation metrics have swiftly moved into expensive territory, with growth stocks compared to value stocks, on some measures, reaching levels not even seen during the dotcom bubble (per Capital Economics)
Capital Economics see AI driving the S&P 500 to “significantly” higher levels in 2024, however prior to this they also see the weak economic environment taking the “heat” out of markets in the second half of this calendar year, resulting in an end of 2023 target for the S&P500 of 4,000, or approximately 10% lower than current levels. The Capital Economics end of 2024 target for the S&P500 is for a bullish 37.5% rebound to 5,500 and an even loftier 6,500 by the end of 2025.
The Appeal of Fixed Income
With short maturity Term Deposits at 5.0 per cent and running yields for fixed income funds of 5-10 per cent, depending on the level of risk, fixed income is a valid alternative for the first time in years.
Central banks remain determined to “do whatever it takes” to tame inflation and their commentary became progressively more hawkish (higher interest rates) during the quarter but, that said, we are now much closer to the end of this rate hiking cycle. Two-year bond yields sold off aggressively during the quarter (from 3.85 per cent to 4.75 per cent in the US and from 3.10 per cent to 4.20 per cent in Australia). Ten-year bond yields also sold off (from 3.30 per cent to 3.85 per cent in the US and from 3.3 per cent to just over 4.0 per cent in Australia).
Recession now looks likely in the US and more possible in Australia and, with inflation having peaked, longer term bond yields look attractive again. We will be increasing our tactical overweight in Fixed Income.
Unlisted Property and Alternative Assets: A Mixed Bag
Domestic unlisted property valuations are primarily driven by comparable sales, as opposed to market sentiment, and the lack of property transactions during 2022 and early 2023 has limited the price discovery process, and this was a key driver of our cautious view towards the sector. Our decision to reduce unlisted property allocations in late 2022 and early 2023, where liquidity was available, was validated during quarter two 2023, as managers commenced revaluing assets following core Melbourne and Sydney office buildings exchanging hands around 10-15% below their most recent book valuations.
Stickier domestic inflation has led to a higher for longer view on interest rates, which feeds directly through to property valuations, as the cost to service debt increases and the relative attractiveness of property yields to risk free rates diminishes. Elevated office vacancy rates have emerged due to a lacklustre return to office by workers adopting longer term flexible working practices, with this trend more prevalent in markets across the US.
It has not been all doom and gloom however, as not all sectors are created equally, and Industrial & Logistics assets continue to perform well, having been buoyed by strong rental growth and low vacancy rates. These assets are increasingly playing critical roles in supply chains and the availability of assets located adjacent to population centres with superior connectivity is limited, which has supported valuations.
Infrastructure asset valuations drifted sideways over the quarter, as uplifts from CPI linked revenue streams were offset by modestly higher capitalisation rates being applied by valuers.
Select Domestic agriculture strategies commenced the process of reducing exposure over the quarter by crystallising gains following several years of outsized returns. Having gained exposure to the sector during the later years of drought in Australia, we believe better opportunities are now presenting themselves in other agriculture markets, such as water.
Real asset investments in non-traditional and uncorrelated areas such as transportation continue to deliver attractive and consistent yields and have provided portfolios with asymmetric risk outcomes during a period of heightened volatility for traditional asset classes, such as equities and fixed interest.
To Sum Up
Remember that every cycle is different, in this case it is unemployment.
We see the next move in asset allocation for risk-based assets as up, but the big question is when, as we do see a pause in equity markets based on the reality of “higher for longer” interest rates.
Bond markets in the US have an inverted yield curve with 2-year bond yields more than 100 bp higher than 10-year bond yields. This is telling us that an economic slowdown is coming.
However, equity analysts are not seeing broad economic capitulation. Many parts of the economy are holding steady and recent data has been quite strong. As a result, equity markets have rallied in this second quarter of 2023.
Who is right? We do not know but we continue to remain cautious, and we believe interest rates will have a broader effect on the economy, a mild recession being the result.
We saw a reset in valuations in both equities and fixed income in 2022. High interest rates will continue to slow the economy over the coming quarters but this, together with moderating inflation, will eventually lead to more favourable (lower) interest rate expectations, lower bond yields and will lead us to start increasing risk asset weightings on equity market weakness, supporting an entry point into equities later this calendar year.
Login to …