In a few weeks’ time, Clime will publish a detailed “Letter to Investors” that will present our outlook for investment markets in FY23. In this edition of The View we make some observations drawn from a range of charts in the May edition of the RBA Chart Book. In particular, we cover:
- Cash and bond yields, and QE
- Household balance sheets
- Australia’s international trade accounts.
The recent surge in inflation in Australia and across the world is well documented. The following table shows that Australia’s inflation (current reading of 5.1%) has exceeded the levels recorded prior to the GFC and is expected to rise further.
Inflation across the developed world has leapt to levels not seen since the turn of the century. Whilst US and European inflation surges, in Japan reported and forecast inflation remains at a more moderate level of 2% to 2.5% (forecast).
Looking more specifically at Australia, we note that imported inflation has picked up significantly in recent months with the major factors being energy (petrol) and the cost increases of many imported consumer goods (mostly from China). International supply bottlenecks, worsened by pandemic closures in China, are adding to the inflation surge.
Recently, the RBA forecast that inflation will lift above 6% (on a trailing 12 month basis) in the second half of 2022. From there, the RBA expects the inflation rate to ease back to below 3% in 2023. However, since that forecast, the AUD has weakened significantly against the USD and this will add to imported inflationary pressures. There are many moving parts to inflation at present and this makes forecasting difficult. We believe that inflation in Australia will remain at an elevated (above 3%) for most of 2023. However, we are doubtful that the RBA will lift cash rates to levels currently expected by futures markets.
Cash rates are beginning to rise across the developed world in response to surging inflation. In Australia, the RBA has begun its tightening rate cycle with a 0.25% increase in early May, and it has warned household borrowers that the cash rate could rise to 2.5% by mid 2023.
The chart below shows that until 2014, it was “normal” for cash rates to be 1% to 2% above inflation readings ( a “real” yield). This “normal” relationship fell away as the RBA followed the lead of overseas Central Banks in pushing cash rate settings towards zero. The final collapse of cash rates in 2020 occurred as a consequence of the COVID crisis and took “real” rates deeply into negative territory.
The next chart tracks the recent history of cash rates (policy rates set by Central Banks) in advanced economies. It is noteworthy that in 2006, US cash rates peaked at 5.25% when inflation was approximately 4% (see chart above). Therefore, at that point, the “real” cash rate (compared to inflation) was positive 1.25%. The cash rate was subsequently adjusted downwards during the GFC and there it sat until 2015 - when the Federal Reserve attempted a normalization of rates (that failed). It has recently begun a process to adjust rates upwards again and this process is upsetting markets and causing a surge in the USD.
Cash rates in both Europe and Japan have been negative (below zero) for the last eight years. Recently, the Japanese Central Bank (BoJ) indicated that it will not adjust its cash rates and will target 0.25% for ten year bonds (in the face of rising inflation). Meanwhile, the European Central Bank (ECB) is caught in a bind. The Ukrainian war is adding to an inflation surge and has already created a broad decline in the outlook for Europe’s GDP. With government debt across the Eurozone averaging above 100% to GDP, the ECB knows that interest rate rises will severely affect Government budgets – particularly those in southern Europe.
Despite maintaining its QE program, the ECB has not been able to limit the rise of Italy’s or Greece’s 10 year bonds, which have recently lifted above 3%. In contrast, German 10 year bonds are yielding 1% - that is, 4% below inflation readings of 5%. The divergence of bond yields across Europe suggests a potential default risk, but we think that is unlikely. In our view, the ECB is once again directing pressure on southern Europe to adjust their fiscal outcomes – as it did ten years when Greece was in economic crisis.
The chart below shows that Chinese long dated bond yields have fallen below US bond yields. That is justified by the relative inflation readings (US above China) when there is no QE program operating.
In Australia, the 10 year bond yield has lifted to 3.5%, well below the 7% yield observed in 2000 or the 6% yield before the GFC. In those periods, 10 year bonds yielded above inflation, whilst now the yield is well below inflation.
I have consistently pointed out that interest rates across the advanced world – whether cash rates or longer dated bonds – are well below inflation. Therefore, the historical interplay between interest rates, inflation and the market Price Earnings Ratio are less relevant. Looking ahead, we do not see how Central Banks can increase interest rates dramatically given the high levels of government and household debt (in Australia). Only Japan is holding firm with a determined QE program and deliberately targetting sustained low rates. If Japan is observed to be coming through this inflation cycle better than others, then expect a pivot from more hawkish Central Banks -particularly the Fed.
Australian Wages and Household Balance Sheets
The table below shows that Australian wages growth has slowed over the last few years in line with declining inflation. Given both current and forecast inflation rates, there is now a heated political debate, driven by the election, regarding the proper adjustment to wages going forward.
With inflation running at between 5% and 6% this year, and over 3% next year, there is a significant risk that wages will begin to feed into an inflationary loop pushing costs higher.
Clearly, the average worker is (and should be) more concerned about their after tax pay and that is where a pro-active fiscal policy should concentrate. The adjustment of tax rates for low income workers and tax rebates targeted to key industries (for instance health care, aged care, child care and green energy) are policies that should enable the control of cost pressures in key industries.
Australia’s household sector is generally in good shape. Our savings ratio is at near historic highs. However, whilst the majority of households do not have mortgage or personal debt, those households that do have debt have a lot of it ($2.5 trillion).
The surge in residential property has been funded by heavy drawings of debt by first home buyers entering the market and upgraders using leverage. As cash rates rise, so too will mortgage rates. The RBA will be well aware that parts of the household sector simply cannot afford mortgage rates if they rise by more than 2%. The effect of each 1% rise in mortgage rates equates to $0.5 billion per week in additional mortgage costs. That represents a significant diversion of discretionary income for affected borrowers. To offset this will require a drawdown in the savings ratio, but this will only occur when and if consumer sentiment rises.