Let's hit pause for a moment and assess
Posted 17 May 22
Interview with ausbiz, 16 May 2022
The scale of the inflation overshoot and central bank policy undershoot has provided ‘kerosene’ to valuation correction across all asset classes. Bond markets in particular have acted aggressively on the forward curve to mark up their yield expectations very rapidly. If this forward curve becomes a reality, then indeed it will continue to be brutal for valuations, with a ‘take no prisoners’ result for all asset classes.
Markets have reactively swung aggressively to the very worst. Now is a good time to pause and work through the paths ahead and their probability.
Watch the interview and read the summary, below:
1. The interest path in Australia
Bond markets are aggressively pricing rapid increases in the cash rate. Our view is that this is neither necessary nor likely.
We think the RBA will raise rates to 1.25% and then need to pause. There will be a combination of debt and cost of living burdens pressuring households sufficiently into curbing demand (and blowing up an unprecedented amount of household wealth in residential property).
Unemployment figures may also turn upwards, particularly as we suspect COVID part-time employment is flattering the current numbers. Moving forward, and as we have previously stated, we see increased immigration levels will be significant, causing downward pressure on wages and unemployment to go up. We also expect that the rate of growth of supply-side inflation will likely fall through 2022.
The household is more precariously placed in Australia when compared to the United States. Through the post the GFC period and then again through COVID, Australian households simply reverted to more household debt (accommodated by a compliant RBA), whereas the US household consolidated their finances and are in measurably better shape. Australian household well being and wealth are therefore highly sensitive to the RBA cash rate. At a 15% fall in house prices, that would amount to a $1.6 trillion in household wealth. That would be the biggest fall in household wealth in dollar value. We think this will be enough to pause the RBA.
Implication – the RBA cash rate pauses at 1.25% in the face of a sharper deterioration in the household’s activity and the wealth effect from property value falls.
2. US Economic Growth to be lower, but recession?
We repeat our general position that recessions are normally caused by credit crunches and we just don’t see this in the near term.
At the corporate level, non-financials have pretty sound balance sheets having refinanced over the last two years. Corporate confidence is stable, notwithstanding the inflation headwinds. Households also remain in pretty good shape, benefiting from a tight labour market and increased pay or moving jobs for higher pay. The accumulated savings through COVID are also a very useful buffer.
We are seeing reasonable earnings growth but acknowledge the substantial negative movement in PE multiples. The FAANGM represent 23% of the S&P500 and they are leading the market down.
Inflation we anticipate will moderate through 2022 and 2023. This may provide the stabilisation in PE multiple declines. The financial markets’ laissez-faire attitude to financial conditions in late 2021, with monetary and fiscal policy support, has now made way for a short term over-reaction but…
Implication – equity markets stabilise and sustain a reasonable rebound from these levels
3. Longer term bond rates do get higher
Our view is that markets have gone for the jugular and will settle and modestly rise through 2H2022. However, we do think investors need to adjust to a different longer yield curve where longer term interest rates are likely to be somewhat higher.
The world geo-eco-political outlook is unlike the 30 years since the collapse of the Eastern Bloc and China’s reawakening. Through that period we saw a benign environment, with defence spending a reduced burden on the economy. This has now reversed, and combined with increased spending by governments for populist reasons, will result in longer term interest rates being higher over time and greater variability and volatility in the cycle (as compared with the 30-year trend decline in bond rates over the last 30 years).
Implication – long bond rates will be higher over 2023 and 2024. The ‘summer’ for financial markets enjoyed over the last 30 years has now moved to autumn – some nice days, some warm, but others that show what winter is really like!
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