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.