The RBA’s decision to lift cash rates by 0.5% was both expected and factored into markets. At the current 1.35% level and the expected rise in inflation to 7% by year-end, there can be no claim that the RBA is on the front foot in fighting inflation. Arguably, both Monetary Policy (negative real interest rates) and Fiscal Policy (deficit of 2.5% of GDP) are supportive of economic activity. However, the problem for markets is that the level of support has been severely cut back.
Since the GFC, Central Banks have been pumping their economies with liquidity and a range of unconventional support mechanisms. Over that period the theoretical economic expectation was that inflation would develop as a natural consequence of printing money (QE) and/or excessive credit creation that drove demand against limited supply.
However, the actual outcome for the inflation cycle was dramatically different. Extremely low levels of inflation evolved, and consumer and corporate credit demand was a significantly lesser problem than investor credit demand. The result was asset price inflation.
Asset price inflation was seen across investment and speculative asset classes. Negative yielding bonds, the emergence of bitcoin (with no intrinsic value), PER expansion in equity markets and yield compression across debt, credit and property markets, were all indicative of asset inflation.
Some of that asset inflation should have been captured in consumer price inflation. However wage rates were relatively stable and residential property surges were offset by the historic low cost of mortgages. The Consumer Price Index became a construct where manipulation of weightings gave the impression that the cost of living was stagnant. As the cost of healthcare, childcare, aged care, education, power and other basic services kept climbing, the cost of goods imported from China and emerging economies fell. Oil and therefore petrol prices were held down by abundant supply.
This benign consumer price inflation period has now come to an end. Consumer prices are surging just as asset price inflation has collapsed. The surge in consumer inflation is occurring as Central Banks talk of a necessary adjustment to interest rates to subdue inflation. The outlier is the Bank of Japan, which has steadfastly retained its long held QE and interest rate targeting policy. It seems to be ignoring inflation and inflation appears to be avoiding Japan – at this point!
The answers are drawn from a few observations. These are:
First, the extended length of time that Central Banks maintained supportive or loose policy.
Second, the excessive dropping of interest rates to levels that should never have been reached.
Third, the rapid change in energy management by governments targeting decarbonisation in an effort to combat climate change; and
Fourth, the emergence of inflation from China and energy markets (set off by the Ukraine war) and exacerbated by COVID lockdowns.
The causes of consumer inflation are well captured in the next chart. Across the US and Europe, the cost of energy has generated 30% to 60% of the inflation surge. The cost of imported goods from China has had some effect, and in the US the cost of labor (wages) is feeding into the cost of services.
At this point, Australia’s inflation surge is driven mostly by petrol, energy and food. It will be added to by wages (following the Fair Work Commission judgement in mid-June that minimum wages should increase by 5.2%) that will feed into services costs as we battle with a unique shortage of labour supply.
Initially, the reaction of asset markets was acute with severe bond and equity market corrections. However in the past few weeks, long term bond yields have declined (bond prices rise) as fear of recession replaces fear of inflation. In the US, the 10 year Treasury bond peaked at 3.5% in mid-June and has retreated to 2.9%. Meanwhile the interest rate futures that trade off expectations of future cash rate settings have also receded markedly.
The US bond market yield curve is becoming flatter between 2 year and 10 year maturities. The bond market pundits say that a recession is likely in the US (if not across the developed world) if shorter dated yields (up to 3 years) trade above longer dated yields, creating an inverse yield curve.
The following charts show the contraction in investment asset values and places them in historic context.
First, the return from US ten year Treasury bonds over the last 6 months was the worst in 240 years!
The world bond index over the last 12 months has delivered the worst return since the Second World War.
PER contraction and the risk of recession (where corporate earnings generally decline) has created the worst return for the US stock market – over the June half year – in the last 100 years! The June half decline in 2022 was greater than the June half year of 2008 (during the GFC), but of course the US market cratered through to February 2009. Australian markets were not quite as bad.
Against these observations is the recent history of commodity prices captured in the next chart. The extraordinary rise in commodity and energy prices corresponds to the 1970s, where cost inflation resulted in recession in the early 1980s. That recession was created by aggressive interest rate adjustments that took interest rates above inflation. Importantly, that is not the case today. However, input prices have fed cost inflation in the current surge, and a recession would affect demand and bring down prices – at least over the short term.
So what does this mean for Australian households and the outlook?
We see in the in the chart below that Australian households are highly indebted. Household debt as a percentage of household income has been steadily rising for decades, and now sits above other countries such as Canada, the UK, the US and Japan.
Australia has amongst the highest proportion of household borrowers with variable rate mortgages, meaning they are especially vulnerable to interest rate increases. Thus an increase in official cash rates, which feeds through to mortgage rates, has a rapid and powerful effect on those households with large mortgages.
Roughly 85% of Australian mortgages are variable rate mortgages, unlike most other countries where the majority of mortgages are fixed rate. This creates a unique vulnerability to rising rates amongst certain groups of highly leveraged borrowers.
The RBA has maintained that household balance sheets are generally in reasonable shape, and that is true as far as it goes. Many households accumulated savings during the pandemic lockdowns, and some pre-paid mortgage obligations. And of course, all (except new buyers) enjoyed the increase in house prices.
However there is a rump of households that will be particularly vulnerable in this shifting environment, particularly those that borrowed heavily during the late stages of the housing boom, and who may be exposed to a downturn in economic activity. It is noteworthy and worrisome that over $10 billion of residential loans were written in the March Quarter with just a 10% deposit. Those loans will likely dip into negative equity as housing prices decline.
Therefore, the “wealth effect” created by rising house prices (up till March 2022) is likely to be reversed with some serious consequences for over-borrowed segments of the population.
It remains to be seen how well debt-laden Australian households will cope with the triple stress of rising prices, higher mortgage payments and falling house values. Low consumer confidence and falling home prices indicate that monetary policy and rising interest rates are already having an effect, and this means that the RBA may in fact not be required to lift rates quite as high as the market now expects.
Therefore, equity markets are trading in a perplexing state and the future direction in values ( and therefore prices) lays firmly in the hands of Central Banks and our RBA. One sector that is highly reliant on the RBA policy settings are the financials and particularly banks. If cash rates are set above 2.5% then mortgage stress will be added to negative equity as an issue. However, if cash rates stabilise below 2.5% than the banks will be trading profitably. From this point only time will tell.
