Talking Points.
- The Reserve Bank of Australia (RBA) has more work to do to bring inflation back to its target range of 2%-3%, and may need to raise interest rates further in the near future.
- Inflation pressures are receding globally, but core inflation remains high and sticky in some regions, posing challenges for central banks and markets1.
- Growth has been more resilient than expected, but there are signs of a slowdown in consumer spending, business conditions, and housing activity in Australia and other countries.
- Markets are running with a soft-landing narrative, meaning that inflation will come down without causing too much damage to the real economy or unemployment2. This has boosted equities beyond mega-tech stocks3.
- Achieving the fabled soft-landing faces challenges, such as the potential persistence of core inflation, the uncertainty over the impact of higher interest rates and quantitative tightening on borrowing costs and credit conditions, and the geopolitical tensions over trade and security.
Cash and Fixed Interest
The RBA alluded to higher rates in early July, and recent data signals the same, with the most recent unemployment figures of 3.5% well below where the RBA puts the nonaccelerating rate of inflation (around 4.5%). Employment growth in June came in double expectations. Like many other countries, strength in the Australian labour continues to surprise and remains an inflationary risk/reality.
Markets are erring between one or two more 25-basis-point increases in the cash rate. Beyond that, there has been growing acceptance that where cash rates peak is only part of the equation that we need to think about in terms of central banks, and how long they might need to remain at or near peaks is the real question. Financial markets have eased back from anticipating aggressive cash rate reductions by central banks in 2024 to the prospect of rates perhaps moving modestly lower.
Projections for long-term interest rates in Australia have been raised, though the consensus remains a declining trend over the latter part of 2023 and 2024. With inflation proving more sticky, terminal cash rate expectations being pushed higher and for longer, longer-term yields are also expected to be a tad higher. Westpac remains at the more aggressive end, anticipating the Australian 10-year bond easing to 3.1% by the end of 2024, whereas National Australia Bank is projecting 3.5%.
Australian and International Property
Rising inflation and interest rates have been affecting capital values globally for commercial property. With interest rates still rising in many countries, and the full impact of rising rates yet to really bite both economically through tenant demand and financially through interest costs and leverage ratios, pressure is expected to continue, at least in the near term. Working-from-home trends continue to undermine office space demand, while the shifting nature of trade is buoying industrial property.
Some take a glass-half-full approach, such as Knight Frank’s senior partner and group chair, Will Beardmore-Gray, who notes that a “a return to stronger economic growth” in the upcoming year, combined with declining interest rates, is expected to lead to an improvement in market conditions.
Others are more guarded. Morgan Stanley analysts forecast that US commercial real estate prices will fall by more than they did in the financial crisis. Invesco’s 2023 Mid-Year Investment Outlook noted that “While continued downward pressure on real estate prices in the near term is expected, commercial mortgage rates may be lower and credit conditions may improve through 2024, at which time a significant portion of commercial real estate loans mature and need to be refinanced.” Hence, a lot depends on lower interest rates and a smooth landing being able to mitigate potential refinancing challenges.
Australian Equities
Growth in the Australian economy has eased, and there are tentative signs of a turn in the labour market. Firms report that labour shortages have moderated. SEEK job ads fell 2.3% in June, with the
number of ads 24% below the May 2022 peak. Unemployment nonetheless remains very low. While the Reserve Bank of Australia paused in July, expectations are the interest-rate cycle has not yet peaked, with “some further tightening of monetary policy may be required,” and market pricing reflects this. The usual suspects feature:
• The risk that expectations of ongoing high inflation will become embedded in larger increases in both prices and wages.
• Limited spare capacity in the economy and a continued low rate of unemployment.
• Elevated unit labour costs.
• The price-setting behaviour of firms.
Despite recent interest-rate increases and prospects for more, projections for the Australian economy are consistent with positive growth, though the Reserve Bank of Australia notes the path to achieving both growth and 2%-3% inflation “is a narrow one” with a substantial slowdown in household spending underway.
Westpac economists have the economy barely skirting an official recession, with annual growth dropping to 0.3% for June 2024. National Australia Bank is similar, projecting growth to be flat over the next three quarters and 0.5% in 2023. Consumer confidence remains weak, and in fact consumers are leading the downturn, clipped by high inflation and rising interest rates. There is emerging weakness in business conditions, aligning two sides of the economy. The NAB business survey showed that the soft business conditions apparent in May continued into June. Forward orders showed successive declines, while business confidence remains soft. This is expected to flow into subdued business investment.
Within a subdued economic environment and rises in interest rates, housing market activity is constructive on some levels. CoreLogic’s home value index managed to post another gain in June. Positive factors include a rebound in population growth courtesy of strong migration, a tight rental market, and weaker supply side, with building approvals moderating.
International Equities
Can the global and United States economies pull off the fabled soft-landing, that combination of dissipating inflation without too much collateral damage for the economy, and avoid a recession?
Sentiment has swung that way with consumer price inflation, producer price inflation, and bank earnings pointing to the soft-landing. Headline inflation in the United States receding to 3% and core inflation dropping to 4.8% from 5.3% received attention. The disinflation narrative gathered more steam, with the producer price index rising just 0.1% year on year. A tense regional banking situation has given way to strong bank earnings. June’s larger-than-expected drop in inflation “means a narrow path to a soft
landing is modestly wider,” JPMorgan’s Marko Kolanovic noted.
Fed Chair Jerome Powell had also expressed optimism about the US economy and downplayed the odds of a recession. While acknowledging that a recession is “certainly possible,” he said such an outcome is “not the most likely case.”
The immaculate disinflation theme faces challenges. Core inflation remains at 4.8% in the United States and stickier elsewhere. Continued labour market tightness, a shifting world with globalisation facing pressures—from economic dictated trade to security influenced trade—and moving from efficiency to resilience across supply chains is not the environment we have been used to in taming or maintaining low inflation.
Central banks remain alert to movements in inflation expectations and the last read from The University of Michigan Consumer Sentiment Survey showed a rise in consumer confidence and rebound in inflation expectations, with the one-year measure rising to 3.4% from 3.3% versus expectations of a drop to 3.1%.
If there is going to be alignment between disappearing inflation and durable growth, productivity growth will be a key variable. Productivity mitigates cost pressures. Unit labour costs in the US nonfarm business sector rose an annualized 4.2% in the first quarter of 2023—elevated, though less than preliminary estimates of 6.3%. Nonfarm productivity, which measures hourly output per worker, dropped at a 2.1% annualized rate in the March quarter. That adds to cost pressure. This is where artificial intelligence could be profound for companies with high staffing costs or a large share of tasks with automation potential.
Central banks remain on a disinflation mission and talk in stern tones. Financial markets are anticipating one more 25-basis-point hike from the US Fed, two from the European Central Bank, and four from the Bank of England. Real interest rates are finally starting to turn positive. We are now in the difficult zone for many central banks where the signals are mixed; core inflation says keep hiking, but each increase brings a nontrivial chance of the hard landing, which the bond market is alluding to, but not equities.
Can big tech maintain momentum? Divergent views are apparent, but suffice to say, a lot needs to go right.
The market had broadened beyond big tech anyway in recent months, which makes the economic outlook more important. Economic gauges are giving differing messages in the United States and many nations including New Zealand and Australia. Bonds are downbeat (curve inversion), whereas equities are upbeat, and cyclicals have joined in. Manufacturing is weak, services are not. Hard data has outperformed “soft” leading data sentiment. Construction—a hugely procyclical sector—is showing weakness in housing starts but strength elsewhere. The Conference Board’s leading indicator for the US economy is pointing to recession in the near future, even as its coincident indicator says growth is fine for now.
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