FIIG research has published a detailed analysis of the outlook for 2024 (click here for the document) and then followed it up with a detailed webinar on the same topics (click here for the recording).
For both the outlook for 2024 and for analysis of the RBA, the key to understanding is, in our view, to take a second look at the question to understand the details a little below the surface.
For example, when looking at the economy in 2024, many people see that the single most important feature is that the RBA cash rate has probably peaked, and the economy will likely slow from here. That’s true, but you need to take a second look
to see a little deeper. The economy has peaked but it has peaked in part because both the RBA and the Government took significant steps in 2022 and 2023 to slow the economy when it was running too hot.
The RBA actions are well-known: they raised the cash rate from 0.1% to 4.35%. But the Government contributed too – more via inaction than action. A newly elected Government that was positively itching to spend money and seek to create policy instead
chose to wait and allow a lot of extra tax revenue to fall through to the bottom line. That inaction was surprisingly important. But it’s also coming to an end. The tax cuts in 2024 will be a significant source of stimulus to the consumption
side of the economy.
It’s not only about the total sum of the tax cuts, which at around AUD20bn a year are substantial, it’s about the change in behaviour. Up until now, the Federal Government had been pushing back against the overheating by increasing the tax
take. That contractionary policy now reverses and instead, the Federal Government will be stimulatory.
The state governments, meanwhile, have stopped announcing new spending but have not stopped increasing their spending. State Government capex spending will grow over the current fiscal year and the next.
State Government Capex Spending
Source: FIIG Securities, State Government Budget Papers.
It’s not just the tax cuts pushing back against the cost of living in 2024. In the final quarter of 2023, Australia experienced positive real wage growth. That is to say, wages grew more quickly than inflation, as measured by CPI. With CPI falling and wage growth normally “sticky” it seems very likely that real wages will grow over coming quarters too. There’s also the annual re-assessment of the award wages coming in mid-year.
None of this is to suggest that the cost-of-living problem is solved – far from it – but the pressure does seem to be easing, at least in aggregate. A first glance at the economy suggests that there is a weakening happening. That is true,
but the weakening is coming from a place of multi-decade strength and a second look suggests there are already three clearly identifiable factors that will push back against the weakening in the coming months.
The RBA reaction
Which brings us to the RBA. The easy first glance at the RBA suggests that inflation is falling and therefore the RBA will be cutting rates soon. However, the second look (particularly a second look at the RBA’s press conference) will emphasise
that the RBA has a dual mandate. They are seeking to bring inflation back down into the 2-3% target band, but they are seeking to do so while supporting their second mandate: maintaining full employment.
These two objectives are not in true conflict at present, but there is a nuance. To bring inflation down as quickly as possible the RBA would seek to raise rates incredibly high and incredibly quickly. That would work to bring down inflation, but it would
do so by triggering a recession that would see significant job losses. The RBA did not follow this path. Instead, they raised rates quickly, but as cautiously as they could manage and slowed as soon as there was any sign that inflation was falling.
Previously, the RBA might have kept raising rates as long as inflation was above the band. They clearly haven’t done that. The last rate rise was in November, and that was the sole rate rise in the last eight months. Meanwhile, the annual CPI
rate remains above the target band. The RBA has shown a much gentler touch in this rate rise cycle than they might have (or, indeed, did many other Central Banks around the world display).
Instead, they raised rates quickly, but as cautiously as they could manage and slowed as soon as there was any sign that inflation was falling. Previously, the RBA might have kept raising rates as long as inflation was above the band. They clearly haven’t done that. The last rate rise was in November, and that was the sole rate rise in the last eight months. Meanwhile, the annual CPI rate remains above the target band. The RBA has shown a much gentler touch in this rate rise cycle than they might have (or, indeed, did many other Central Banks around the world display).
Cash Rates Around the World
Source: FIIG Securities, Bloomberg.
So how is the Australian Labour market doing? There has been some clear weakening in labour market indicators. But the indicators are weakening from exceptionally strong levels. The number of job advertisements, the unemployment rate, and the vacancy rate
are good examples of the phenomenon (note that the unemployment rate is inverted in the left-hand chart).
Labour Markets in Australia: Unemployment and Vacancies
Source: FIIG Securities, Bloomberg, ABS, ANZ.
Is there a clear weakening in the labour market? Absolutely. Might the strength seen in 2023 not be repeated for 30 or even 50 years? Also, yes.
The key problem in the labour market is momentum. As the charts make clear, turning points in the labour market are few and far between. We saw a turning point last year in the labour market, but we only want a marginal weakening, not a full-scale
slowdown.
The RBA is trying to tell a nuanced story that covers the inflation rate but also gives space to the labour market. Looking at only the inflation rate without giving a second look at the employment situation will leave you with only half the story.
When presenting the Macro Outlook, FIIG emphasised that although we believed the peak in the RBA rate had been reached, we noted the interest rate market had been zealous on the chance the RBA would cut rates quite soon. Since we presented that outlook
there has been a market repricing. Rather than mid-year rate cuts, the market is looking for cuts in late 2024, which seems more reasonable. FIIG research continues to look for rate cuts in late 2024 or early 2025.
As part of the Macro Outlook, we suggest a LOCK strategy, which is a set of general principles to guide successful bond market investing in 2024. The four elements of the strategy are:
L: Lock in fixed returns. Although the big drop in rates might not come as soon as priced, the underlying story is clear. The turning point has arrived and the next large move in rates will very likely be down and will cause a sharp increase in bond prices. While we can’t be sure precisely when that movement will come, the high yields at present largely make it a moot point. The high yields mean investors are rewarded with significant interest while waiting for a move that should make them money in the medium term.
O: Obtain Real Yield. With inflation high but dropping, it might seem an unusual time to suggest buying inflation-linked bonds. However, inflation-linked bonds are still bonds – they profit from falling interest rates. They also profit from indexation if inflation proves just a touch stickier than anticipated.
C: Check your portfolio risk. While FIIG does not expect the coming slowdown to be too bad, it’s also clear that there will
be an economic slowdown. To prepare for that it’s best to make sure your portfolio has as much diversity as possible. Check your bond portfolio for concentration risk or excessive exposure to sub-investment grade credits.
K: Keep your cool as the economy cools. Bonds generally perform relatively well in an economic slowdown as interest rates generally fall. By making sure that you are diversified
and invested in bonds with strong links to the ongoing economy (like infrastructure or utilities) your bond portfolio should be able to negotiate the coming slowdown fairly well.