Macro Picture: Rising Inflationary Pressures, Falling Growth and Hawkish Central Banks

The key global pattern through 2022 has been:

• Progressively more hawkish central banks

• Rising inflationary pressures driven principally by a lack of global supply

• Falling GDP growth outlook as spending is “crowded out” by inflation

No region has been entirely immune from the above.

On the 7th of June, the RBA raised interest rates by 0.5%, their first double rate rise since the early 2000’s. Broadly speaking however, rising commodity prices and a healthy demand continue to support the domestic economy.

The picture is more murky over the Pacific: rate rises have now spurred talk of possible recessions, as consumers grapple with much higher food and energy costs, sky-rocketing mortgage rates. Wages are rising at over 5%, suggesting more of a risk of a wage-price spiral, which is the key factor in driving longer term inflation expectations.

Where do we stand in the economic debate? First and foremost, our view on the health of the domestic economy is little changed: we still see healthy growth for this year and next, as we pull away from lockdowns, and high commodity volumes and prices spur forward government coffers and consumer spending.

The RBA is doing the right thing: it can afford a short sharp shock now given the resilience evident, in exchange for both retaining its credibility and managing longer term inflation expectations, which can be so damaging to main street if they are allowed to rise unfettered. The US and global picture is more complex. Firstly, the US is in danger of tipping into recession in our view, simply because the Fed will have to act more aggressively, as they are further behind the curve: wages growing beyond 5% are testament to that.

We are watching the US very closely; as we see a mild recession perversely as a positive for risk assets; runaway boom or runaway bust are disastrous for all equities. Europe is grappling with energy costs. Because Europe is a more open economy than the US, it is struggling even more so with inflation. Rate rises will be difficult as debt levels in Italy remain very elevated. German manufacturing is struggling with skyrocketing input costs. This uncertain picture makes for a difficult portfolio management environment.

What Now for Bonds?

We believe the RBA’s rate move is a good one for long term rates. The key part of the RBA logic is that short term sticker shock will cool demand sufficiently to avoid having to ultimately raise rates into the fives and sixes.

We think the RBA is right in its approach, especially when you consider the vulnerability of the housing market to rates much beyond 3.5%. Back of the envelope calculations suggest an additional $30,000 in after-tax income per annum to service a $1M mortgage at those levels. That would be hard to digest, even with wages rising beyond the 2-3% long term benchmark.

On the basis that the RBA is acting now to prevent an elongated rate rise cycle, we would anticipate the current interest rate of 4% implied by bonds more than covers bond investors for the longer-term inflation risk. On that basis we are buyers of longer-term interest rate exposure or duration as it is often referred. The key advantage of the current bond pricing is that, should economic conditions deteriorate significantly, say in a US catastrophic bust type scenario, they should provide a positive return. This is an important buffer for a balanced investor. Global bonds are another matter.

We can’t rule out that:

• The fed will raise rates to 5 or 6% if wages and inflation remain sticky – this is not our base case but a scenario we cannot refute easily

• The fed will prioritise tackling inflation over Growth – a “Volker” moment – this seems to be where their political priorities lie

• The ECB will prioritise tackling inflation (Germany) over the solvency of Southern Europe (Italy).

• There aren’t more credit defaults on the back of all the above. This rebalance, we are dramatically increasing our duration throughout the domestic fixed income asset class. We refrain from exposure to credit and international fixed income at this stage, until a clearer picture on terminal rates and global economic conditions eventuates.

Equity Markets

The price action in much of the world so far has been a steady de-rating, bringing valuations in line with interest rate realities. The way we think about this is simple. Our long-term models use 12 month forward P/Es, and cash futures, and a handful of other key fundamental factors, to calculate an implied risk premium – the long term return one is most likely to receive should one take passive exposure in the asset class.

Dragging down the Equity Risk Premium for MSCI World ex Australia is the US Equity Market. When the US Market was at nearly 25x times earnings at the end of 2021, implying a 4% long term nominal return, it looks reasonable when the cash rate is 0 on a relative basis. This is the whole point of the TINA (there is no alternative) trade. However, as rates pick up to sharply, equities no longer stack up when a term deposit can deliver 3% risk free. Equities need to drop to adjust, to afford investors a higher implied return. As a result, the market “derates”, from a P/E of 25x to 17x. This is however a steady orderly process, as the market re-appraises gradually the rates picture, and adjusts its probabilities around higher long-term rates.

This process has yet to fully play out for the US in our view – the de-rating is still far from complete at 17x, and the P/E could fall another 20%, especially if the Fed is forced to be more aggressive than expected. We also need to bear in mind that equity market earnings are nominal. By that we mean they should growth naturally to some extent with inflation – recent sell-side earnings estimates in the chart below are testament to that fact. Unlike bonds, equity cashflows (dividends) have the capacity to increase to some extent in inflationary environments. As long as we are not facing an out-and-out collapse in economic conditions (and we do not); then this is our preferred asset class.

We continue to favour domestic over international equities, as valuations look attractive, and the backdrop more supportive.

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