Insights navigating the complex economic landscape
The economic outlook both in Australia and abroad remains complex, with the lags from material monetary policy tightening proving to be longer than expected. The U.S. economy is showing remarkable resilience, with the consumer benefiting from savings buffers, fixed rate mortgages and rising real wages.
The labour market is strong and while goods inflation is moderating, there is a persistence to services inflation. We see the Federal Reserve very close to peak rates, but markets need to prepare for the reality that the opportunity to ease monetary policy seems a long way off.
In contrast, economic growth is faltering in China, financial stability concerns are again front of mind, and, to date, there has been slower, smaller, and more piecemeal policy support. Australia is very exposed to this, largely through the terms of trade, services exports, and manufactured food exports. Resource export volumes typically hold up. The Australian dollar has responded, falling below U.S. 64 cents, and is currently 3.8 per cent lower than mid-June on a trade-weighted basis. Historically, the currency has acted as a very effective automatic stabiliser – although this time that could be complicated by the high inflation backdrop.
The domestic economy is showing some signs of responding to the 400 basis points of tightening by the Reserve Bank of Australia (RBA). Annual growth in retail spending has slowed to just 2.1 per cent in July from 19.2 per cent in August 2022. In per capita terms, consumer spending is contracting. We continue to expect a rapid and material slowdown in household discretionary spending – mortgage holders are around two thirds of the way through the interest rate adjustment even if the RBA is on hold; renters are being squeezed; and real wages are falling.
The strength of the labour market is providing some offset – hours worked are up 5.2 per cent year-on-year and a record 6.6 per cent of workers have more than one job but we expect that to soften. The leading indicators of labour demand are weakening, and record participation and strong migration is lifting labour supply by around 50,000 people per month. The applicant to job ad series from Seek is now above pre-pandemic levels.
Population growth is also an important tailwind – revisions in the labour force survey reveal that migration is running hotter than even the Government’s upgraded projections in May. Indeed, we estimate population growth in those aged 15 and above is running at 2.7 percent. This will provide support to essential spending but add price pressure to rents.
Despite a projected housing shortfall and elevated work yet to be completed, the outlook for residential construction is being challenged by tighter financial conditions. Building approvals are 45 per cent lower than the mid-21 peak. Nationwide house prices are up 4.9 per cent since the February low as a small number of high-quality borrowers transact with low supply. Listings have lifted of late, which combined with reduced borrowing capacity, should slow house price momentum. We expect housing turnover to remain lackluster well into 2024.
We remain constructive on parts of business investment and the latest CAPEX survey showed firms still plan to increase investment (although some of this reflects higher prices) – including spending on technology, transition, plant and machinery and some aspects of non-residential construction, ‘beds and sheds’ to put it colloquially. Tourism and international students will make a material contribution to services exports.
Inflation has peaked and is moderating, with monthly consumer price index (CPI) up 4.9 per cent year-on year. However, our new sectoral model of inflation, combined with Barrenjoey’s economic price stickiness index, warning of persistence. We think inflation can fall to 3.5 per cent but falls from there will be harder won. The RBA is clearly watching this persistence, and has a close eye on rents, utilities, and unit about costs (wages and productivity). Our assessment is that the window to hike in August was wide open and the decision to hold the cash rate at 4.1 per cent indicates that the bar to further tightening is high. It will take an accumulation of data to drag the RBA back to the tightening table. We see another rate hike as possible but not probable, but do not expect the first rate cut until May 24 and the risk is that this comes even later.
Thinking strategically
Themes to position for include: (1) sticky inflation and higher-for-longer rates; (2) Chinese stimulus; (3) higher equity volatility (VIX) and wider credit spreads; (4) cost and margin pressures.
Our economists are of the view that Australian core inflation will take some time to return to the RBA’s target band. They also think that the full effects of policy tightening on the consumer are yet to materialize. As such, they see weak per capita consumption, consistent with downside to consumer discretionary exposures.
Globally, core services inflation numbers (i.e., excluding imputed items like rents and medical care services), are proving somewhat stubborn to fall, consistent with elevated wage inflation pressures. Beyond the cyclical, our concerns are about structural forces on inflation: de-globalisation, de-dollarisation and de-carbonisation. We think that the traditional negative relationship between commodity prices and the U.S. dollar (USD) is getting weaker. Similarly, we think that the liquidity tightening effects of USD strength on emerging market economies are not policing the spread of global inflation outcomes as well as they used to. Reflecting these changes, U.S. 5-year forward inflation expectations are at risk of breaking out.
If inflation is stubborn to fall, then the risk is rates need to stay higher for longer. Real rates may become more variable. Higher-for-longer inflation and rates are historically consistent with tighter multiple dispersion in equities. Tightening could happen in several ways – expensive growth and quality stocks de-rating, or the earnings of cheap cyclicals getting cut, or both. We envisage that value will add value as multiple dispersion tightens, provided we apply certain overlays to screen out value traps. If real rates uncertainty trends higher, we would expect long-duration growth stocks, most sensitive to the term premium component of the market discount rate, to underperform. Historical relationships suggest it could take a little while for higher real rates uncertainty to filter through to growth factor underperformance but we think we are amid a transition now, where investors “to and fro” between value and growth, with the right kind of value ultimately prevailing. We think that the right kind of value must be able to thrive or survive in a higher-for-longer rates environment. Therefore, we like insurance for its cheap and positive rates leverage. We like energy because oil is cheap considering structural inflation risks and physical market tightness.
We are also partial to miners. Lithium, gold, and base metals names screen more highly than iron ore names and are cleaner plays on structural rather than cyclical inflation stories. Lithium and base metals could also get cyclical support from Chinese energy transition initiatives and stimulus. Also, large iron ore miners are very close to the top bracket of stocks. Importantly, Chinese policy seems to be moving more firmly in the direction of property stimulus at a time when there is a lot of pessimism about the sector and economy. Moreover, on spot valuations, large iron ore miners look relatively cheap.
We think that VIX is too low and needs to rise. This is because cross-asset valuations are extended, correlation risk in multi-asset portfolios at high levels, risk parity investors are over-positioned in stocks and the yield curve is continuing to flag tight financial conditions. Overtightening, inflation, or geo-political shocks could easily upset the applecart. And if the VIX rises, history suggests that credit spreads could too. More generally, we think that credit is expensive considering that banks are tightening lending standards, private credit is trading at a material discount to public credit, and defaults are on the rise. Within the Australian equity market, to hedge against higher equity volatility and credit spreads, we are underweight leveraged exposures like banks and real estate. The recent reporting season tells us that the direct effects of higher rates on corporate interest payments and funding costs have been largely underappreciated by investors. So, there are other leveraged, companies with floating rate debt to be wary of too outside financials.
Finally, on cost pressures … the recent reporting season suggests that they are pervasive. They should be weighing the most on labour-intensive sectors operating at high levels of capacity utilisation. Among these are construction and consumer sectors. So far, larger builders are managing these cost pressures, aided by pricing power and easing supply chain pressure. But we are seeing cost pressures manifest among staples. We are therefore very selective in the space, even though we have a defensive bias.
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.
