There’s no such thing as a free lunch.
So don’t feast if you’re not prepared to foot the bill.
With the market betting on a soft landing despite high interest rates winding their way through the economy, are markets expecting a free lunch?
And are they prepared for when the bill comes due?
In today’s episode of What’s Not Priced In, Greg Canavan and I discuss the outlook for interest rates, stretched stock valuations, the Aussie market’s paltry equity risk premium, US tech stocks, and moves in the energy market.
What’s not priced in?
The cost of lunch.
Reserve Bank may well be done hiking rates
If there’s one thing Greg likes to remind viewers of, it’s the long and variable lag of monetary policy.
Greg’s not the first — nor the last — to say this.
Milton Friedman popularised the idea decades ago.
And our Reserve Bank is now very conscious of the straggling effects of its rapid rate cycle.
In his latest statement announcing the decision to keep rates unchanged at 4.10% at the August meeting, Philip Lowe said (emphasis added):
‘There are also uncertainties regarding the lags in the operation of monetary policy and how firms’ pricing decisions and wages will respond to the slowing in the economy at a time when the labour market remains tight. In aggregate, consumption growth has slowed substantially due to the combination of cost-of-living pressures and higher interest rates.’
And in the released July meeting minutes, the RBA Board again mentioned the delayed impact of rising interest rates (emphasis added):
‘Members noted that the lags in the transmission of monetary policy through the economy meant that the full effects of the policy tightening that had occurred over the preceding year were yet to be observed. They acknowledged that it takes time for households and businesses to adjust their spending and investment plans, and that there were still significant resets of low fixed-rate loans ahead. Similarly, demand for labour typically responds with a lag, which implied that the current tightness in the labour market might also ease.’
The RBA’s wait-and-see approach in recent months suggests the central bank is nearing the end of its hiking cycle.
Greg certainly thinks so.
And he’s not the only one.
Outgoing Westpac chief economist Bill Evans came out on Thursday saying:
‘We now think it is very likely that we’ve seen the peak in interest rates at 4.10% … The hurdle for more rate hikes looks very high.’
Peak in rates no cause for celebration
Should markets rejoice?
No, let’s not celebrate too early.
Even if the RBA is done raising rates, it won’t be cutting them any time soon.
We may have summited the peak, but we’ll be trudging through a plateau at high altitude for a while yet before making any descent.
Rates don’t have to rise any further to hurt, either.
Just look at the latest retail sales volumes.
Australian retail sales volumes fell 0.5% in the June quarter, the third-straight quarter of declines.
It’s the first time since 2008 that retail sales volumes fell for three consecutive quarters.
It gets worse…
Retail sales volumes are down 1.4% year-on-year. Outside the pandemic years, this is the first time since 1991 that sales volumes fell year on year.
Bob Hawke was Prime Minister and ‘Everything I Do, I Do for You’ by Bryan Adams was top of the Aussie charts then.
We’re even making less trips to cafes and restaurants.
Cafes, restaurants, and takeaway food services sales fell for the first time since the COVID-19 lockdowns in September 2021.
It’s not a great sign when we’re spending less on smashed avo, acai bowls, and lattes.
Aussie stocks not cheap
All this would suggest that Aussie stocks should be trading at pessimistic discounts.
But that’s far from the case, as Greg diligently laid out in the pod.
We can look at the equity risk premium for clues.
The Aussie risk-free rate is around 4%.
Given the ASX 200 has an earnings yield of 6.7%, the Aussie stock market’s equity risk premium is a diminutive 2.7%.
In other words, Aussie stocks are expensive.
That’s something Greg covered with Katana Asset Management’s portfolio manager Romano Sala Tenna a few weeks back.
Here’s another wrinkle.
Ex-banks and resource stocks, the median expectation for ASX 100 EPS growth, is 10%! That’s a hefty growth assumption in times like these.
An earnings miss here is not priced in.
What does this mean for Aussie investors? Watch the full episode to find out!
But it’s not all doom and gloom.
There’s one commodity breaking out that Greg’s keeping a close eye on. And he thinks it has long-term headwinds underappreciated by the market.
Again, watch the full episode for the details!
Free lunches are as rare as soft landings
Both here and in the US, a belief is firming that central banks will pull off a ‘soft landing’, avoid a recession, bring inflation to target, and keep unemployment low.
Markets are betting on a resolution as neat as a Hollywood ending. Villainous inflation will be defeated…with minimal cost.
But how realistic is that, really?
Take the US.
Despite the highest Fed funds rate in 22 years, financial conditions have loosened to levels not seen since the Fed just started raising rates…from near zero.
Yet as Greg and I discussed, a higher-for-longer interest rate environment is a clear and ongoing risk.
Hope you enjoy this week’s episode!
Regards,
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Kiryll Prakapenka,
Editor, Money Morning
