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Wednesday 14 February 2024 by Philip Brown wooden cubicles with q&a written on them

Macroeconomic Questions and Answers

As part of the recent FIIG webinar on the Macroeconomic Outlook, we opened the (digital) floor to questions. There were far more questions than we could attempt to answer in the limited time available. Working on the theory that if one person is curious enough to publicly ask the question, a lot more people are curious enough to know the answer, we present the questions from that webinar with answers written by FIIG’s Head of Research, Philip Brown.

There was a clear interest in inflation shown in the questions, but also a clear awareness of the global risk backdrop.

Where does CPI need to be to allow RBA to start reducing interest rates?

The RBA now has access to a lot more information about the CPI and on different time frames – the ABS recently started producing some monthly CPI data.  However, the quarterly CPI is still the main measure. There is nothing particularly magical about annual CPI. The RBA is more interested in what might be happening in the next year than what did happen a year ago. 

What the RBA needs to see to feel comfortable cutting rates is clear evidence that the inflation rate in the coming period is likely to be in the 2-3% target band, preferably in the middle or lower part of the band.

The RBA could conceivably cut rates with the annual CPI sitting at around 3.25-3.5%, provided the trend within the quarterly prints suggested inflation had moved.  Let’s say that at some future point the RBA board meets and sees a set of quarterly CPI prints that are, in order, 1.2%, 1.0%, 0.6% and 0.5%. That suggests an annual rate of 3.3%, but it also shows that the last six months have seen low inflation of only 2.2% annualised – near the bottom of the target band. 

I think the highest annual CPI that is consistent with a rate cut is something around 3.25%.  

What is the accepted long-term CPI rate we could expect in the future, from past data?

Last time Australia had high inflation it was inflation expectations that the RBA needed to dampen, what is the current measure of inflation expectations and what is its direction?

There are many ways to measure inflation expectations. After peaking at 6.7% in June 2022, the Melbourne Institute survey of expected inflation has dropped to only 4.5% in the most recent publication (January 2024). The RBA also has some recently published work on inflation expectations here. The RBA survey suggests most people expect inflation to be around 5% both now and in three years.

In financial markets, the pricing for anticipated CPI is much lower, seeing inflation drop to 2.7% by the year after next and then stay there for a number of years:

Market Price of CPI in the year ending on a nominated date

The RBA will attempt to target inflation between 2% and 3% over time and specifically around 2.50%. Since 1996, when the RBA started explicitly targeting inflation, they have been reasonably successful at that. I would expect inflation to return to that level in the future – though deviations will occur from time to time.

Source:  FIIG Securities, ABS

What would you see as an impact on bond investment in the event of an expanded war between NATO countries and Russia, heavily supplied by China and Iran together with a prolonged conflict in the Middle East. What strategies one might consider in that scenario?

That’s a nasty scenario and one we hope doesn’t come to pass. That hypothetical scenario would likely see a large fall in Australian Government bond yields, since there is so much extra risk in a global sense, but Australia would be relatively well protected.  If you were a European or US investor, Australia might suddenly look like a great place to invest.  However, such a conflict would likely also see a material widening of credit spreads.  For example, many FIIG clients own bonds issued by large European banks. Those bonds would not perform well in a fully-fledged, broader war in Europe and many global companies would suffer similar problems.

The best strategies here would be to ensure diversification (the C from our LOCK strategy) and to keep control of the risks you can manage.  

Do you think there will be new issues of Inflation-linked bonds? SYDAIR and AGN in particular are not long to run.

I hope so but I am not certain. 

Inflation-linked bonds haven’t been a common issuance strategy for bond issuers in recent years - but there may well be more investor demand for inflation-linked bonds thanks to this recent bout of inflation. I think there will be occasional issues, but not many. Also, it is worth remembering that as the bonds that are currently inflation-linked mature, there may well be some desire for those companies to re-issue inflation-linked debt.  

Where do you think interest rates will bottom out?

Do you think long-term Australian Government bond yields are likely to drop and by how much? And how soon?

I think the RBA will likely lower rates only very gently, at first. We are looking at a situation where inflation is back under control, rather than a catastrophe situation.  I think the RBA will first lower rates to something in the order of 3.50%, then stop to see how the economy reacts. It’s possible that things weaken further and the RBA lowers rates again as a truly stimulatory measure, but that is not something that is currently evident in the data. There are plausible scenarios for the RBA to lower rates from “contractionary” to “mid-level” over 2024 and 2025, but for the moment there are few obvious arguments for the RBA to take rates to outright “low” levels.

That RBA outlook leads me to believe that the longer-term bond yields should drop too. The bond yields tend to drop around three months before the RBA moves. So, if the RBA is likely to drop rates in late 2024 or early 2025, I would be expecting moderately sized bond yield changes in mid-2024 or late 2024.  

Do you expect floating rate notes rated BBB to outperform inflation in Australia?

Yes, I do. Bonds like that should be yielding around 90-150bp more than BBSW, depending on the maturity.  At present, BBSW is sitting quite near inflation at 4.35% or thereabouts, but the CPI rate should drop materially in the next 6-12 months while the BBSW rate will likely only drop a little. 

Asset prices (theoretically) always have the collective knowledge of investors priced in. How can FIIG provide undervalued opportunities?

FIIG has a number of competitive advantages that allow us to identify opportunities. 

·       The research team has significant experience and skills, equal to many of the larger houses.

·       FIIG’s position as a deal arranger allows FIIG research direct access to company management teams.

·       Unlike most investors, FIIG is watching the market all the time, allowing us to identify opportunities and bring them to clients faster.

    In your view, what is the outlook for shares?

Once again, this is a question that will depend on your individual circumstances and what your individual investment goals are. 

That said, the recent increase in yields means that, for the first time in a decade or more, bonds provide yields that compare favourably to equity dividend payout ratios but with much lower price volatility. Bonds will always struggle to offer the possibility of 50% or 100% returns that come with risky equity investment, but significant losses are far less common too.

The correct mix is a question for each individual, but the opportunities in bonds are greater now than they have been for a good long while.

I believe shares may struggle as the economy slows. There are a lot of risks that could affect share prices in the short-term. Many of the geo-political ones have already been discussed at other points in this Q+A, but there are also climate risks and plain old, global economic slowdown risks. At present, in both Australia and most of the world, labour markets are incredibly strong. As that weakens over coming years it reduces the profitability of companies and that shows most in the riskiest investments, which are normally shares. 

The final risk Is China. I see more and more commentary around the weakening outlook for China. Over time, that will be (rightly or wrongly) registered internationally as a weakness in risky assets in Australia. That probably causes some global sentiment problems for Australian equities.

What modified duration for a portfolio is currently recommended?

This is greatly dependent on individual circumstances – and I am not providing individual advice. We do recommend that most investors look to add duration at this time (it’s the L in our LOCK strategy).  

On purely duration grounds I would be comfortable suggesting a duration of around 6-7 years as a general guide. (Note that the overall Australian bond index has a duration of around 5 years.) However, the overall bond index is mostly made up of government bonds and so has much lower credit risk than a well-diversified corporate portfolio. 

I would not recommend a fully corporate portfolio have a duration anywhere near that long, since it would entail a great deal of credit risk too.