Market Strategist
Summary: The plot thickens, for Australia’s central bank to pause rate hikes, with the market also expecting almost 20 bps of rate cuts in 2023. This is because inflation cooled more than expected, while Australia’s households, the second most indebted in the world behind Sweden, are showing signs of financial stress after the RBA’s 10 rapid rate hikes. Big banks are allocating capital for bad and doubtful debts, and the RBA themselves noted insolvencies and bankruptcies have risen, yet the ‘full effect’ of its interest rate rises have yet to be seen. Business surveys are pointing to weaker conditions and spending ahead, while 1 million mortgages are deemed ‘at risk’. What’s next and what does it mean for investors and traders?
Following the RBA’s 10 rapid rate hikes, inflation has cooled more than expected with underlying inflation falling, and being revised down, to 4.9% year-on-year. Still, we need to consider, inflation is at 30-year highs. Financial conditions are also quite restrictive. And this is why the RBA Governor Philp Lowe said a pause in rate hikes may be near, which would allow time for the central bank to “assess the state of the economy”.
That said, the RBA projects inflation falling to 4.75% over 2023, which shows that inflation will remain sticky this year. And that is something investors and traders will need to navigate.
We also argue that RBA will not be in a rush to cut rates this year, even though the RBA says points to Australians experiencing financial stress with the full-interest rates hikes not yet being felt in full.
Has the RBA caused a pressure cooker moment for Australian households?
The RBA’s Christopher Kent also points to tough times ahead too; with 880,000 Australians with fixed rate mortgages, rolling over to variable this year and potentially succumbing to financial stress. He said these Aussies will be impacted by a ‘sizeable jump’ in their mortgages and forced to adjust their spending and saving behaviour. This means, there will be less money flowing in the Australian economy, and we will likely see the reverse wealth effect crescendo. On top of that, 25.3% of mortgage holders in Australia, or 1.23 million of mortgages are deemed as ‘at risk’, according to research house Roy Morgan.
In summary, the RBA will be forced to pause hikes, to avoid further distress on households, which are the life blood of the nation, with the services sector making up some 70% of GPD. In saying that, we don’t see the RBA cutting rates any time soon, as that would deteriorate the financial ecosystem and some Australian banks have already started to cut home loan rates. The RBA’s Christopher Kent conceded that higher interest rates also act as an incentive for Australians to save money and pay down mortgages quicker.
Monthly inflation data showed that February CPI fell to a 6.8% annual pace, down from the 7.4% prior print. This marks the second straight month of price cooling and reinforces the RBA’s view, that inflation peaked last quarter. Beneath the surface, we can see some trends occurring. New dwellings annual price growth hit 13%, which is the smallest pace in a year, as building material costs ease. Fuel prices also slowed, to the lowest level in two years, while other CPI items also moderated, with recreational price inflation cooling, led by holiday travel and accommodation.
Earlier this week retail sales data showed Australian household activity and confidence is falling, crimped by higher interest rates, and 30-year high inflation. Retail sales only rose a modest 0.2% In February. This points to diminishing consumer spending power, with higher costs of living causing households to slow their spending.
Importantly this week’s retail sales and the monthly CPI numbers, are the final two inputs that RBA policymakers will review, ahead of next week’s meeting
As for other FX pairs, given the ECB is expected to keep rising rates, to tame persistent inflation in Europe, you might consider looking at the Euro dollar against the Australian dollar (the EURAUD pair). The pair has already risen 3.4% this year, but should theoretically be supported higher, as the ECB has power to hike, while the RBA is likely to pause rate hikes.
As you approach the new quarter, reflect on the basics of investing; cash flow and earnings growth, traditionally drive share price growth.
Consider, the health of some lending banks in Australia could weaken, and earnings could contract, not only from the ripple effects from overseas. Importantly, as we highlighted above, there are greater risks of some Australians defaulting on their mortgages, with over 1 million at risk. It could be worth considering putting options in place for downside protection in banks, but also on property sector stocks.
Consider that Australian GPD this year, is likely to be eroded from inflation. So consider typical defensive sectors as defined by business cycle investing. These include Consumer staples, Health Care, Telcos and Utilities. These sectors typically do well and outperform sectors such as Industrials and Technology and Financial Sectors when corporate profits fall, credit is scarce and monetary policy is starting to be less restrictive.
Also consider, as mentioned in our daily commentary, we have observed investors playing the defensive game, favouring companies with strong cash flows and those that should be able to withstand a potential recession. Although we've seen clients increase positions in Mega-cap tech stocks with robust cash flows, such as Apple, Microsoft, even Tesla and Meta, we have still seen clients use protection, with protective puts, should the market correct.
Also consider, a considerable amount of flows have moved into the defence sector, and stocks such as Rolls Royce, Saab, Rheinmetall, which are all up 50%, along with BAE Systems, Lockheed Martin Raytheon which are up 20% or more YTD. These stocks as just some of the names in Saxo’s Defence equity basket that are seeing significant gains amid the NATO push for countries to pledge 2% of nation spending toward defence.
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