Rapid rate rises to rein in stubbornly high inflation are clouding the global outlook. Despite this, prospects for the Australian economy are bright.
The local economy grew better than consensus in the June quarter. This was fueled by strong household spending. The spending growth is expected to continue, evidenced in higher than expected retail sales growth in August of 0.6% MoM.1 Consumer spending is being underpinned by a tight labour market. The ANZ job ads series came in at 240k in September, nearly 27%2 higher than its pre-pandemic trend.
In spite of the bearish global sentiment we believe that prospects for the next 12 months in Australia are bright. We expect the Australian economy to grow at 4.0% in 2022 behind robust consumer spending and favorable terms of trade before moderating to 2.4% in 2023. The outlook for the next year is clouded by weakening external demand as global monetary tightening nears a peak. Australian inflation came in at 6.8% YoY in August, lower than the July number. Additionally, Australian inflation remains lower that its peers (US inflation of 8.3% August YoY).3
At its last meeting, the Reserve Bank of Australia (RBA) provided a sign that they will moderate the pace of hikes in contrast to the hawkish stance of peer central banks. Despite this dovish surprise, we think the policy rate could climb to 3.0% by December and peak near 3.60%, as we expect price pressures to stay above RBA’s target for longer. Hence, there is some room for the RBA to hike into 2023, with a diligently hawkish Federal Reserve (Fed) exacerbating this view.
The main downside risk for the local economy is the possible stress on the housing market as a result of rate hikes. The Australian economy is far more exposed to housing stress than global peers. The household debt to income ratio of Australia is almost twice that of the US. An increase in mortgage costs will impact consumer spending, the main stalwart for the local economy.
Developments in the property market will be closely watched with prices having moderated slightly. One indicator to watch is new home loan commitments, which fell 3.4%4 for the third month in a row in August. These are down 17.5% from the peak in January indicating that property prices could correct by nearly 20% from their peak, which in our estimation, the RBA and the economy may tolerate.
Comparatively, the US is undergoing a technical recession. The Purchasing Managers Index (PMI) in the US has dropped and is hovering just above 50.5 The September reading of the University of Michigan consumer sentiment index fell short of expectations. Despite core inflation continuing to climb in the US, there is a downward trend in global inflation evident in some data releases. Commodity prices have come off recent highs with the S&P GSCI Commodities Index down 4.1% in the previous quarter.6 While there are some bright spots, like the strong labour market, these have just cemented the view that the Fed could hike further until substantial downside surprises emerge. This suggests there will be a drag on short-term corporate profitability.
Looking ahead, we expect the RBA to remain hiking through H1 2023, albeit less aggressively than global peers. We expect rates to then be on hold for the rest of 2023 as inflation returns near target and growth remains resilient to cooling external demand.
The Australian equity market has fared poorly in 2022. The S&P/ASX 200 Index has outperformed global markets (e.g. S&P 500 Index is down 13.9%) but it is still down 9.6%.7 This performance is decoupled from the positive performance of the local economy.
The global bearish market sentiment has impacted the local equity market. The near term uncertainty is inflation over-run and the volatility this will cause. The economy is also deleveraging due to monetary tightening. Higher costs of inputs and lower support for leverage are obstacles for businesses and it is a challenge to maintain earnings growth in such an environment.
With heightened geopolitical tensions, higher inflation and central banks raising interest rates, defensive equity allocations are gaining attention as a way to navigate such a volatile environment. Defensive equity investing involves focusing on less risky stocks. These companies have strong cash flows, high margins and stable operations with the ability to weather weakening economic conditions. These attributes also offer protection in inflationary environments and potentially cushion the stock's price during a broad market decline. This is mainly due to their lower cash flow duration and lower exposure to market risk (lower beta).
To be able to implement a low-risk or defensive equity strategy, the broad equity index has to be broken down into characteristics, or factors, that drive returns. There is a long history of research on factors which concludes that long-term equity performance is explained by various factors which earn an associated premium. Each of these factors performs better at certain times than others. Common examples of these factors are value, profitability, quality, momentum, growth, volatility (risk) and size.
The chart in Figure 1 captures the returns of select factors over stagflation periods (high inflation, low growth). The chart supports our outlook of choosing defensive themes in the current environment. The chart shows the Low-Risk and Profitability factors outperforming all other factors in the first year of stagflation.
Figure 1: Past Stagflationary Environments & Select Factor Returns (1969-2022)
Source: Fama French. All returns are in USD.
Past performance is not a reliable indicator of future performance.
The rise in interest rates saw drawdowns in bond prices. The Australian Government Bond index is down 10.6% YTD.8 The drawdown shows that markets are pricing in further rate hikes. While the recent less than expected rate hike by the RBA shows a decrease in hawkishness, we still expect rates to go higher in the short term and interest rate risks to remain. A possible way to insulate fixed income allocations from rate rises is to lean on Floating Rate Notes (FRNs).
The consequence of increasing interest rates is increased volatility and reduced bond price performance. FRNs are effective against both risks. The price performance is more stable due to the yield resetting to the market rate and increasing income as rates rise. Moreover, FRNs are inherently low duration. The low-duration provides additional protection against interest rate risk.
The chart below summarises performance of FRNs against Government Bonds, Credit Bonds, and Equity Markets. The forward yields for the assets are based on Yield to worst and 12M Expected Dividends. The risk of the asset is based on the historcial standard deviation (2000 to 2022). FRNs are expected to generate similar yields compared to other assets but at a lower risk. The yield per unit of risk is substantially superior for FRNs. A similar efficiency is observed when historical returns and risks are compared.
Figure 2: Forward Yields vs Risk
Source: Bloomberg Finance, L.P. as of September 30, 2022. Australia FRN: Ausbond Credit FRN 0+ Index, Australia Govt: Ausbond Govt 0+ Index, Australia Credit: Ausbond Credit 0+, Australia Equities: S&P ASX 200 Index. All Returns are in AUD. Past performance is not a reliable indicator of future performance. Index returns are unmanaged and do not reflect the deduction of any fees or expenses. Index returns reflect all items of income, gain and loss and the reinvestment of dividends and other income as applicable.
1 Australian Bureau of Statistics as of 30 September 2022.
2 Bloomberg Finance L.P., as of 30 September 2022.
3 Bloomberg Finance L.P., as of 30 September 2022
4 Australian Bureau of Statistics as of 30 September 2022.
5 Bloomberg Finance L.P., as of 30 September 2022.
6 Factset as of 30 September 2022.
7 Factset as of 30 September 2022.
8 Factset as of 30 September 2022.
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The "Value" style of investing that emphasizes undervalued companies with characteristics for improved valuations, which may never improve and may actually have lower returns than other styles of investing or the overall stock market.
Floating rate securities are often lower-quality debt securities and may involve greater risk of price changes and greater risk of default on interest and principal payments. The market for floating rate securities is largely unregulated and these assets usually do not trade on an organized exchange. As a result, floating rate bank loans can be relatively illiquid and hard to value. Diversification does not ensure a profit or guarantee against loss.
The value of the debt securities may increase or decrease as a result of the following: market fluctuations, increases in interest rates, inability of issuers to repay principal and interest or illiquidity in the debt securities markets; the risk of low rates of return due to reinvestment of securities during periods of falling interest rates or repayment by issuers with higher coupon or interest rates; and/or the risk of low income due to falling interest rates. To the extent that interest rates rise, certain underlying obligations may be paid off substantially slower than originally anticipated and the value of those securities may fall sharply. This may result in a reduction in income from debt securities income.
Bonds generally present less short-term risk and volatility than stocks but contain interest rate risk (as interest rates rise bond prices usually fall); issuer default risk; issuer credit risk; liquidity risk; and inflation risk. These effects are usually pronounced for longer-term securities. Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss.
Government bonds and corporate bonds generally have more moderate short-term price fluctuations than stocks but provide lower potential long-term returns.
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Tracking: 5040216.1.1.ANZ.RTL Exp. Date: 31/10/2023