Have investors considered less dynamism in interest rates?
I have a great deal of respect for the team that has been assembled at Barrenjoey, and I have every confidence they will add enormous value to investors through their insights and contribution to the ongoing conversation about the economy and markets. Barrenjoey recently penned a note revealing their outlook for economies and markets, and it’s safe to say, it isn’t the consensus view, which makes it particularly compelling reading.
One particularly insightful assessment is that the easy gains, with respect to reducing inflation, have been made, but further gains will be much harder won. In other words, driving inflation down from nine per cent to four per cent is easier than driving it the last one or two per cent lower. There is merit in that idea, especially when central banks are trying to achieve it without inspiring a recession, and services inflation remains persistent.
That alone should compel investors to seek businesses that can grow, have defendable competitive advantages and aren’t absurdly valued.
Meanwhile, the global economic landscape, which is always evolving, continues to shift rapidly, and understanding those changes is crucial for investors.
The U.S. economy stands out with its remarkable resilience. Consumers there are in a favourable position, benefiting from savings buffers, long-term fixed-rate mortgages locked in at ultra-low rates, and a rise in real wages. The labour market’s strength is evident, and while the inflation of goods is showing signs of moderation, services inflation remains persistent. The Federal Reserve, according to Barrenjoey, is nearing its peak rates. However, investors should brace themselves for a prolonged period before any significant easing in monetary policy.
This concurs with our own view, which we have written about here recently: the idea that humans tend to project the recent past into the future and of course, that means they expect interest rates, which have been dynamic recently, to remain dynamic. Predictions have bifurcated – either rates are coming down next year, or rates will need to go higher. Given humans are terrible at predicting turning points, the one thing they aren’t expecting is for recently dynamic interest rates to now be ‘undynamic’ and do nothing for a year. And that’s a distinct possibility; interest rates remain on hold, at these elevated levels, for some time.
On the other end of the spectrum to the robust U.S. picture, China’s economic growth is showing signs of strain. Financial stability concerns have resurfaced, the property sector has tanked, construction has collapsed leaving 21-25 per cent youth unemployment, and major building companies are bankrupt, vaporizing home building deposits among millions of uncompleted homes. Despite this, the nation’s policy support appears to be more cautious and fragmented than previous episodes when massive stimulus was forthcoming. This slowdown in China is evidence of the failure of an approach that sought to drive 70 per cent of gross domestic product (GDP) growth through centrally planned construction of infrastructure.
There are direct implications for Australia, given our intertwined trade relations, especially in services exports, manufactured food exports, and terms of trade. While resource export volumes from Australia remain steady, Barrenjoey points out the Australian dollar’s recent dip below U.S. 64 cents, a 3.8 per cent decline since mid-June, is noteworthy. Historically, the currency has been an effective stabiliser, but the current high inflation scenario might complicate this role.
Meanwhile, Australia’s domestic economy is also undergoing significant shifts. The Reserve Bank of Australia’s (RBA) 400 basis points tightening is beginning to show its effects. Annual growth in retail spending has decelerated sharply, and consumer spending, on a per capita basis, is on the decline.
A friend of mine who works in a senior position at a major Australian retailer confirmed on the weekend smaller basked sizes seem to be the order of the day.
Mortgage holders are still adjusting to the interest rate changes, renters face financial pressure, and real wages are dropping. However, the labour market’s strength offers some respite. The number of hours worked has increased year-on-year, and a record number of workers are juggling multiple jobs. But this strength might wane as leading indicators suggest a weakening labour demand. Indeed, redundancies at my friend’s retail chain are frequent and accelerating.
Population growth, driven by higher-than-expected migration, acts as a tailwind for the Australian economy. This growth, especially in the 15 and above age bracket, will bolster essential spending but might also push up rent prices.
The housing sector presents a mixed picture. Despite a projected housing shortfall, tighter financial conditions challenge the outlook for residential construction. Building approvals have seen a significant drop since their peak in mid-2021. However, house prices have risen, driven by transactions involving buyers, who either don’t require a mortgage or are high-quality borrowers, amidst low supply. Barrenjoey anticipates this momentum to slow, with housing turnover likely remaining subdued till 2024.
On the business front, there’s optimism in certain sectors. The latest CAPEX survey indicates that firms are planning to ramp up investments in technology, transition, plant machinery, and specific non-residential construction areas. The return of tourism and international students will also significantly boost services exports.
Inflation, a critical concern for investors, is moderating. However, Barrenjoey’s new sectoral model of inflation, combined with their economic price stickiness index, suggests underlying persistence. The Reserve Bank of Australia’s (RBA) decision to maintain the cash rate at 4.1 per cent indicates a high threshold for further tightening.
Strategically, investors should be prepared for persistent inflation and extended higher rates. Barrenjoey’s economists believe that Australian core inflation will take time to align with the RBA’s target band. Globally, core services inflation remains stubborn, hinting at persistent wage inflation pressures. Structural forces, including de-globalisation, de-dollarisation, and de-carbonisation, are reshaping the inflation landscape. This shift means that traditional economic relationships, like the one between commodity prices and the U.S. dollar, are evolving. Specifically, Barrenjoey believes the traditional negative relationship between commodity prices and the U.S. dollar is weakening.
In this changing environment, Barrenjoey sees potential in sectors like insurance, energy, and certain minerals like lithium, gold, and base metals. They also anticipate a rise in the volatility index (VIX), indicating a potential increase in market volatility. Credit, they believe, is overpriced, given the tightening lending standards and rising defaults. The recent reporting season has also highlighted the underappreciated effects of higher rates on corporate interest payments and funding costs.
Amid the ongoing complexities, there are always opportunities. Our small caps team see potential in names such as Bapcor (ASX: BAP), Hub24 (ASX: HUB), Macquarie Telecom (ASX: MAQ) and AUB Group (ASX: AUB), while our All-Cap team like the Commonwealth Bank of Australia (ASX: CBA), Rio Tinto (ASX: RIO), Cochlear (ASX: COH), Macquarie Group (ASX: MAQ), and Altium (ASX: ALU).
The Montgomery Small Companies Fund own shares in Bapcor, Hub24, Macquarie Telecom, and AUB Group and The Montgomery Fund own shares in the Commonwealth Bank of Australia, Rio Tinto, Cochlear, Macquarie Group, and Altium. This article was prepared 05 October 2023 with the information we have today, and our view may change. It does not constitute formal advice or professional investment advice. If you wish to trade in these companies, you should seek financial advice.
Roger Montgomery is the Founder and Chairman of Montgomery Investment Management. Roger has over three decades of experience in funds management and related activities, including equities analysis, equity and derivatives strategy, trading and stockbroking. Prior to establishing Montgomery, Roger held positions at Ord Minnett Jardine Fleming, BT (Australia) Limited and Merrill Lynch.
This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.
