The structure of the financial system could not be more different today to 30 years ago – back then an adolescent financial deregulation, to today as a fully integrated participant in the western financial order. We see that much has been observed and learnt in monetary policy setting, but central bankers exercising their hard-won independence retain a stubborn hubris.  This hubris is at odds with careful examination of data and its analysis, and an erring for caution in their pursuit of their core objective of moderate inflation. 

Ours is an approach to interest bearing strategy which is acutely economically focussed strategy, representing over 30 years of careful management of interest rates and the business cycle. The result is a focus to produce sustainable income returns which adapt to the inflation outlook whilst being exposed to a diversified pool of highly rated and quality risk exposures.   

2022 has been a year of living dangerously for bond markets, marked by rapid and in-sync ‘wholesale’ monetary policy tightening from major free-market central banks around the globe, the main exception being the Bank of Japan.

Commentary from central bank chiefs at the beginning of 2022 was focused on patience in hiking interest and forward rate setting that would see and allow some inflation “overshoot”.  Central banks justified this position to make up for years of undershooting their targets (which perversely was to increase and achieve higher wages growth, which now through restrictive monetary policy, they now seek to reduce the same wages growth through higher unemployment).  And overshoot they surely did. Only six months ago in early May, did the RBA make their first upward interest rate movement since November 2010, following the Federal Reserve’s earlier move in March 2022.

By March 2022, the inflation ‘genie’ was out of the bottle in the United States. What central banks did not and could not have reliably forecast was the Russian invasion of Ukraine in February. The flow on effects from this have exacerbated the already growing inflationary trends that were on foot in late 2021/early 2022. In particular, oil and gas prices rose significantly, along with other soft commodities and base metals.

A year ago, Australian three-year swap rates were priced at 1.4%, effectively a forecast for what interest rates would be in late 2024. Now, that three-year swap rate is priced at 4.2% (14 Nov). This seismic shift in interest rate expectations has been the driver of extreme volatility in share markets, bond markets and currency markets.

As we approach 2023, we see diverging paths for monetary policy between the US and Australian central banks, driven by diverging economic fundamentals, immigration and labour market and mortgage funding sources. The inter-relationship between wage growth, inflation and interest rates is key. Locally, we see the impact of higher rates having a more rapid transmission effect on economic conditions due to exposure to variable (short term) rates, which may cap the extent of interest rate rises by the RBA. In the US, the transmission of higher interest rates to reduce demand is through the next marginal transaction rather than the pre-existing US mortgage system which is financed through long term, 10 and 30 year fixed rates. 

Labour Market
Tightness of labour markets is usually a driver of wage growth; where there are less available workers, their ability to demand higher wages is greater. Higher and persistent wage growth will ordinarily lead to higher and more permanent inflation.  We see the potential labour supply and wages growth divergence between Australia and the United States in the below diagram.

We can distinguish the US to Australia in three areas:

1. Following the election of Trump in 2016, US working visa intakes were in progressive decline and processing resources were defunded. In 2019, close to 2.1 million less visas were issued than in 2016. In Australia, the ‘hole’ left by working visa departures is smaller and being addressed by greater visa intake in the 2023 financial year. 

2. The US did not have JobKeeper program to keep workers tied to their jobs/employer, meaning workers had to re-enter the labour market and re-contract at higher wage levels (as the labour markets had moved).

3. Over 55-year-old workers in the US have permanently left the workforce and labour market.

These factors have meant that the US labour market was tighter pre-COVID and has continued to tighten thereafter. This has supported US wage growth at above trend levels, around 4%-5% annual growth. In Australia, despite the apparent tightness of labour markets we have not seen wage growth above 3.5% yet. Should we see a greater influx of working migrants in 2023 as approved visa permits are indicating, we can foresee reduced pressure on labour market conditions in 2023 and beyond.

Mortgage Funding – Fixed v. Floating
For various reasons, Australian borrowers largely fund themselves through variable rate mortgages. In the US, the status quo is to borrow off a 30-year fixed rate mortgage. Despite a larger uptake of short-term (<3 years) fixed rate loans in 2020 and 2021, just over a third of mortgages in Australia are fixed rate, and typically none will have a term greater than 5 years. In the US, the opposite is true; 9% of mortgages issued in May 2022 were variable rate and 91% were fixed (it is worth noting this level variable rate mortgage issuance is above averages over the past 15 years).

The consequence is the flow-through of central bank rate increases to borrowers is far more immediate in Australia than it is in the US. Ultimately, this has implications for discretionary consumer spending.

Household Debt
Australia’s thirst for household debt is ‘world class’. From 1997, household debt-to-income has increased from 90% to over 180% and was not interrupted by the GFC. Conversely, post-GFC the US household has de-leveraged. The level of household debt in Australia is now at record levels. At a time of rising interest rates, this clearly has implications for borrowers in terms of serviceability of those mortgages. Data to 30 June shows a household savings rate of 8.7% but with mortgage rates having increased by 1.5% since then we can expect that to continue to decline. Ultimately, higher mortgage rates reduce savings rates and the ability of households to spend on discretionary items.

Cameron Harrison’s Interest-Bearing Strategies (Retail Income and Wholesale Income) have been operated for over 30 years.  These strategies seek to provide investors with a well diversified, reliable, high quality source of income, strong economic management, portfolio risk management and with capital security. This is achieved by investing in securities issued by institutions that strongly demonstrate and satisfy our policy parameters and selection criteria.

• Robust and sustainable profitability capable of withstanding economic downturn

• Capital strength, both in equity buffers as well as regulatory capital for APRA-regulated entities

• High credit rating metrics

• Responsible capital management and treasury program

• Has good market liquidity

• Assessed for business strategy and management  

In terms of performance, we seek to achieve a yield-to-maturity that is 2% greater than the yield on a 3-year Australian government bond. We view this as an appropriate risk margin to deliver on our strategy objectives.

The above assessment of economic conditions guides our strategy for 2023.

Australian corporate and financials borrowers are in better financial shape than pre-COVID after having taken the opportunity to refinance balance sheets at the ultra-low interest rate levels in 2020/2021. This sees interest coverage and capital ratios at higher levels than in 2019. However, our medium-term view is that the Reserve Bank of Australia (RBA) will be in an easing cycle by 2024 which will lower yield expectations. In addition, regulatory capital requirements dictate that the major banks issue approximately $16 billion worth of Tier 2 securities in each year from 2023 to 2026, significantly increasing the supply of these securities on market. With reference to these market dynamics, particular strategy actions include:

• Opportunity to increased exposure to AA/AAA rated fixed interest issuers

• Increased exposure to fixed rate bonds with 3 to 6 year maturities

• Reduced exposure to Tier 1 hybrid securities which carry a greater risk of conversion to equity

• Increased exposure to Tier 2 subordinated debt securities that are higher in the capital structure than hybrids

The above chart illustrates the diversity in holdings, yields and maturities. This sees the Retail and Wholesale interest-bearing strategies both yielding above 6.4% p.a. to maturity with reasonably short duration (interest rate risk) and credit risk with maturities averaging 3.8 years.