Investment Ideas From the Edge of the Bell Curve
RBA governor Philip Lowe discussed his concept of the ‘narrow path’ on June 7th, in his efforts to explain how the central bank is trying to cool the economy by aggressively raising interest rates without having Australia fall into a recession.
Here we will explore why the RBA was right to raise interest rates.
Australia saw inflation peak at 7.8% last year — with the latest figures showing it down to 7%.
Although headline inflation has continued to decline as energy prices fell and food price inflation eased — core inflation has remained sticky and shown little sign of easing.
According to the RBA board:
‘Services inflation, which had become the primary source of inflationary pressures across advanced economies, had continued at a high rate. This partly reflected strong wages growth, which remained above rates consistent with inflation targets in many economies.’
‘This, in combination with subdued growth in labour productivity, had resulted in a rapid rise in unit labour costs over the preceding year.’
This isn’t the first time Phillip Lowe and the RBA have sounded the alarm about falling productivity in Australia.
Source: ABS National Accounts
However, the answer is not simply for Australians to ‘work harder’ —let’s look again.
COVID had a huge impact on the Australian labour market.
Against a backdrop of the shutdown of non-essential businesses and restrictions, employment contracted by 870,000 (6%) between March and May of 2020.
Since that time, there has been a significant increase in labour participation, with the hype surrounding the ‘great resignation’ greatly exaggerated.
Source: RBA
With extremely low unemployment this past year, Australians’ hours worked surged 5% to an all-time high.
However, with at-home work becoming the norm at the height of the pandemic, many don’t want to return to the office.
These factors combine into an at-home workforce, struggling to find productivity gains at economic scales while unemployment remains low and capital looks elsewhere.
For a full breakdown of Australia’s productivity woes, review the nine-volume 5-year productivity report here.
As workers’ expectations of inflation remain and labour is short in demand—higher wages begin to work into the economy, further pushing up inflation.
The RBA expressed its concerns in the minutes:
‘Wages growth has picked up in response to the tight labour market and high inflation. Growth in public sector wages is expected to pick up further and the annual increase in award wages was higher than it was last year.’
So where does that leave the RBA?
Central banks are not celebrating the knock-on effects of rising interest rates resulting in higher unemployment. Rather, it is viewed as a necessary evil to prevent stagflation.
As the RBA board concluded, ‘if inflation was not confronted, more aggressive rate-hiking action later could lead to a sharp rise in unemployment.’
So, it seems the crux of the argument is a little pain now — to avoid more in the future.
Here we will look at the two sides of the ‘finely balanced ideas’ that the RBA considered in their June interest rate hike.
Firstly why they should not have raised rates 25 basis points to 4.1%, the highest level since 2012.
As the board said, there are ‘…significant risks and uncertainties’ to staying on this path.
‘In taking the decision to increase interest rates again, [board] members acknowledged the considerable uncertainty regarding the outlook for household spending and the financial stresses facing some households.’
April’s monthly household spending indicator highlights the scale of the problem for RBA moving forward.
Source: Australian Bureau of Statistics
The index from the ABS tracking household spending using bank transactions is far from perfect — but highlights the pain being felt by households nationwide.
In the board’s own words:
‘Members noted that consumption growth was already quite weak, especially in per-capita terms,’ the minutes said. ‘Real disposable incomes were falling, especially for home-loan borrowers, and many renters were experiencing difficult financial conditions.’
Let’s dig into that a bit—
Household consumption growth is falling as mortgage rate rises and high food costs eat into Aussy’s disposable income.
Scheduled mortgage rates have increased — equating to 9% of household disposable income in April.
Projections indicate that by the end of 2024, mortgage payments could amount to 10% of disposable income.
Variable mortgage rates may see further increases — due to past rate hikes’ impact not yet felt by the economy.
An example from a previous rate hike shows how the rate changes lag.
Source: CBA
With consumers feeling the pinch and tightening their purses — retail volumes declined in the March quarter, and indicators point to worse April figures.
This has hit consumer services— including cafes and restaurants struggling with empty tables and rising mortgage rates.
The problem is worse in Australia’s capital cities — where rent remains around 30% of weekly salaries.
Both consumers and retailers are struggling to keep up.
As RBA governor Phillip Lowe’s said earlier this year, ‘…The other risk is that we move too fast or too far, and the economy slows by more than is necessary to bring inflation down in a timely way.’
According to the ABS, the annual inflation rate dropped to 7% in Q1 of 2023 — down from an over-30-year high of 7.8% in the previous period.
With inflation already on its way down, were there other indicators showing reducing inflation without heavy RBA intervention?
Low commodity prices are a start. As the RBA board remarked:
‘Members noted that the price of iron ore had been broadly stable over the prior month..’
‘..More broadly, the soft outlook for global growth had led to falls in a range of commodity prices since the start of the year. Bulk commodity prices had declined and were now close to pre-pandemic levels’
‘…If sustained, these declines would further dampen consumer price inflation globally over the second half of the year.’
Due to the global economic downturn, the prices of several commodities have dropped significantly. This decline can be attributed to the reduced demand from China, where the post-COVID recovery has stalled.
Source: Reserve Bank of Australia
Lower commodity prices mean lower shipping and upstream costs — resulting in reduced business expenses and a flow-on effect to lower consumer prices.
So why are the RBA aggressively pushing forward with rate hikes?
That’s coming up next in part 2.
#AUDUSD Analysis: Aussie pairs move lower following the #RBA minuteshttps://t.co/RAhyyhnUEZ
— FOREX.com (@FOREXcom) June 20, 2023
RBA minutes published this morning from June 6th Meeting showed cautious determination from RBA board members.
The decision to raise interest rates 25 basis points to 4.1 was described as ‘finely balanced’ by the board— the 12th since May last year.
The board’s decision to continue aggressive hikes seemed focused on unseating inflation psychology — where firms’ and household expectations of prolonged inflation affected budgets.
‘If this occurred, high inflation would become persistent with the result that interest rates would need to be higher for even longer. This would increase the risk of a sharp rise in unemployment,’ the minutes warn.
‘An extended period of high inflation would distort the economy and exacerbate cost-of-living pressures, hurting those on low incomes the most.’
RBA members acknowledged subdued household consumption growth in the first half of 2023 as families struggled with rising costs and mortgage rates climbing.
Scheduled mortgage rates increased to 9% of household disposable income in April and are projected to hit 10% by the end of 2024.
The board also looked closely at the Fair Work Commission’s decision to increase award wages by 5.75%.
Saying it was ‘understandable’ that the lowest-paid workers should be compensated for high inflation but warned against wider wage increases.
‘It would be concerning if wages across a broad range of jobs were to become implicitly indexed to high inflation,’ the minutes said.
RBA board members reaffirmed their ‘determination’ to do ‘whatever is necessary’ to return inflation to the bank’s target range of 2 to 3 per cent ‘within a reasonable time frame’.
With repeated mentions of global inflation targets unmet by central banks and sticky core inflation, the sentiment remains cautious but points to more potential hikes.
Australian shares were up 0.2% this morning on the back of positive news from energy and miners — plus hopes of stimulus from China’s rising commodity prices.
ASX futures are flat at 7285.5 near 10:30am
Woodside Energy [ASX:WDS] greenlights 10.5 billion Mexican oil project — Shares are up 0.86% on ASX as of 10.50am, trading at $35.80 per share.
Latin Resources [ASX:LRS] announces a 241% increase for the Colina mineral resource. MRE sits at 45.2Mt @ 1.34% Li2O, including 30.2Mt @ 1.4% Li20
European and Asian stocks fell as concerns for the global economy continue after hesitation from China to signal a stimulus plan to help refire the Chinese economy.
China is expected to cut its benchmark loan prime interest rates today after a similar reduction in medium-term loans last week.
Chinese industrial production increased by 3.5% YOY in May, down from a 5.6% rise in April and lower than forecast.
This was the 13th straight month of growth in industrial output —but the slowest seen in three months.
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Investment ideas from the edge of the bell curve.
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