- The Reserve Bank is aggressively lifting interest rates from super-stimulatory levels to levels that more appropriately reflect the strong state of the economy. But could the aggressive moves lead to recession? A “technical recession” being defined as two consecutive quarters of economic contraction.
- The Reserve Bank has warned that it is treading a narrow path in its attempts to get inflation back down to the 2-3 per cent target range while at the same time, keeping the economy on an ‘even keel’.
- The aggressive monetary policy actions aren’t reason to be fearful, but central banks have to keep on ‘listening’ to the economic data.
- A further decline in equity prices could signal weaker company earnings prospects or increased uncertainty about the economic outlook.
Why is the Reserve Bank lifting rates?
- Well, there are broadly two aspects. First, the economy is doing well and there is no need for the current super-stimulatory (pandemic) rate settings to be maintained. So interest rates need to be lifted to more ‘normal’ levels. Second, inflation has risen to multi-decade highs so interest rates need to rise to slow the pace of economic growth and bring demand (spending) back into line with supply (production).
- The second of these factors – interest rate hikes to control inflation – is a global trend. Essentially this a by-product of economies re-opening after Covid with the production response lagging that of spending. Consumer demand has been supported by unprecedented pandemic stimulus, but production has been constrained by worker absenteeism and border closures. And Russia’s invasion of Ukraine has driven up energy and agricultural commodity prices due to Western sanctions and supply disruptions.
- But there are ‘home grown’ inflation issues here in Australia as well, such as those flowing from strong building and construction activity. And flooding on Australia’s East Coast drove up vegetable prices.
- But the Aussie inflation spike is not being driven by a surge in wage growth so far, despite the tightest labour market in almost 50 years. Over the year to June, the consumer price index (CPI) increased by 6.1 per cent with the wage price index (WPI) up 2.6 per cent. The gap of 3.5 per cent represents the biggest drop in real wage growth for Australians since the late 1990s.
- Elevated inflation is eroding the purchasing power of Aussie workers, with the Reserve Bank keen to avoid consumer inflation expectations becoming entrenched. Already, consumer confidence has fallen sharply and consumers’ spending intentions are easing from record levels as cost of living and rising borrowing costs bite.
How does the Reserve Bank determine the size and timing of rate hikes?
- The movement of interest rates up and down is a central aspect of monetary policy. But it is important to stress that there is no playbook or set of rules that govern when and how interest rates should be adjusted. In fact, monetary policy is regarded as ‘art not science’. Every cycle is different. And indeed the current Covid-driven cycle is very much different.
- The Reserve Bank is adjusting interest rates in a very aggressive fashion – the most aggressive policy tightening since 1994. And a number of other central banks are doing the same. The concern is that consumer prices have lifted markedly and in a short space of time. This raises the risk that high rates of inflation could become entrenched, known as consumer ‘inflation psychology’. If consumers and business believe that inflation will remain at 6 per cent and they adjust wages, leases and selling prices accordingly, then an inflation rate near 6 per cent could be locked in for an extended period. The ANZ-Roy Morgan consumer confidence survey shows that inflation expectations over the next two years have been hovering around 5.5 per cent for most of 2022.
- Central banks, like Australia’s Reserve Bank, have worked hard over the last decade to keep inflation low and stable. And that inflation stability has been important in allowing economic expansions to continue. Before Covid came along in early 2020, Australia was in the midst of its longest economic expansion on record.
What past interest rate cycle in Australia is the closest match to the current experience?
- You have to go back to 1994 to find a similar aggressive lift in interest rates. Over a 5-month period, the cash rate was increased by 2.75 percentage points to 7.5 per cent. In the current experience, the Reserve Bank has so far lifted rates by 2.25 percentage points to 2.35 per cent.
- But while both periods have been characterised by ‘short, sharp’ moves, nothing in the past comes close to a tightening period that has commenced from a near-zero cash rate.
Rate hikes are the most aggressive since 1994, so what was happening then?
- When the Reserve Bank started lifting rates in August 1994, Australia was still in recovery mode after the 1990/91 recession. Rates had fallen from 18 per cent in 1990 to stand at 4.75 per cent in July 1993. When announcing the rate hike in August 1994, the Reserve Bank indicated that, while influenced by higher US rates, it was the first hike in five years, and saying that “Economic recovery in Australia is now well established, with total output around 10 per cent higher than its low point in mid-1991.”
- Back in 1994 one of the key issues was the strength in home purchases, responding to the huge drop in interest rates. The Reserve Bank noted: “Housing loans outstanding have grown at over 20 per cent per annum for the past two years and cannot continue at this pace without creating unwanted pressures in the housing market and more generally.”
- Home prices weren’t surging (but they had in 1989). Unemployment had come down from a peak of 11.2 per cent, but it was still high near 9.8 per cent when the Reserve Bank started lifting rates. The jobless rate then dipped below 9 per cent in December 1994 and then broadly held 8-9 per cent through to the end of 1997.
- Inflation was under control with the annual rate at 1.7 per cent and wage growth at 3.3 per cent. The headline rate of inflation lifted to 5.1 per cent in both the September and December quarters of 1995. The rate of inflation eased through to September quarter 1997 when in fact deflation occurred (-0.3 per cent).
- In terms of the broader economy, the annual rate of economic growth (as measured by GDP) lifted to 4.6 per cent in December quarter 1992 and then averaged a firm 4.4 per cent through to the end of 1994.
- The economy avoided recession in 1995 after the rate hikes, but it went close, with zero growth in the March quarter, followed by growth of just 0.4 per cent in the June quarter.
What was happening in the US in 1994?
- Just like in 2022, back in 1994 the US was lifting interest rates at the same time as Australia. In fact, the US began the process first, hiking the federal funds rate in February 1994 from 3.00 per cent to 3.25 per cent. There was a mixture of 25, 50 and 75 basis point hikes in following policy meetings and by February 1995 the fed funds rate was at 6 per cent. The first rate cut was delivered in July 1995.
- As noted earlier, in 1994 the Australian cash rate was lifted from 4.75 per cent to 7.25 per cent in the space of five months. The first rate cut wasn’t delivered until July 1996.
- The US avoided recession just like Australia in 1994 and 1995. Inflation in the US broadly held 2-3 per cent over 1994-96. And the jobless rate actually fell from 6.6 per cent to 5.5 per cent over 1994 while rates were rising. The US economy grew on average at a 3.2 per cent average pace from 1994 to 1995.
So what happened to US and Australian sharemarkets over the 1994 tightening period?
- The US Dow Jones index generally trended sideways as interest rates rose over 1994, falling by 2 per cent. The Australian S&P/ASX 200 fell by 12 per cent.
- But 1995 was a strong year for both markets with the Dow up 35 per cent and the ASX 200 up 17 per cent.
- The Dow rose a further 26 per cent in 1996 and the ASX 200 rose by 10 per cent.
So where to now?
- Central banks just have to keep on ‘listening’ to the data, with policy moves ‘data-dependent’. In fact, the establishment of a monthly consumer price index (CPI) in Australia will enable policymakers to become even more responsive to timely trends in inflation.
- The Reserve Bank has also announced that it will set up a regular panel meeting of private sector economists, academics and central bank officials to help encourage discussion of economic issues and monetary policy forward guidance.
- Policymakers have to know when the economy can take strong medicine, and also know when to temper rate hikes. It’s a delicate balancing act trying to engineer a ‘soft landing’ for an economy when inflation is soaring and home prices are declining sharply. Already, Sydney home prices are depreciating at the quickest pace in 40 years. With borrowing costs expected to lift further, highly indebted homeowners are coming under financial pressure at a time when food, insurance and electricity costs are skyrocketing.
- That said, Australia’s labour market is a key pillar of economic strength at the moment, suggesting that a recession is a long way off. While economic growth is expected to slow to below trend levels next year to around 1.4 per cent, job vacancies are near record highs, the jobless rate is near 50-year lows, and even the more expansive measure of spare capacity in the labour market – underutilisation – is near a 40-year low.
- But the ultimate goal is the same – to keep inflation under control so economic expansions can continue, while maintaining “full employment.” Reserve Bank officials believe the cash rate can be lifted to a “neutral rate” of around 2.5-3.5 per cent – where policy settings are at levels not considered to be too stimulatory or contractionary for economic activity. Commonwealth Bank (CBA) Group economists expect the Reserve Bank to hike the cash rate to these levels by year-end.
- That said, there is no rule book, every economic cycle will be different as will the political and geopolitical background.
And no doubt there are other complications?
- Certainly. The big risk lies with ‘shock’ events such as the current period with the Covid-induced supply-chain issues. Also, the Russia-Ukraine conflict rolls on and tensions in the Taiwanese Strait are building. The US economy is already in a “technical recession” and China’s economic activity has stalled due to turmoil in the property market and mobility constraints on the consumer from its Covid elimination policy.
- That said, supply chain snarls have eased and commodity prices have fallen sharply since May, easing some worries about petrol and food prices. But the lack of precedent makes it harder for central banks to judge the pace and timing of both interest rate hikes and cuts.
- The long recessions in the US in 1973-75 and 1981-82 (and similar recessions in Australia) occurred at a time of oil shocks. These ‘stagflationary’ times (that is, periods of high inflation, sluggish economic growth) complicated the policy response. The sooner that supply can be brought in line with demand – especially in energy markets – the greater the chance of avoiding recession.
So can Australia avoid recession?
- As mentioned above a key factor is jobs. If people can hold on to their jobs and continue to spend, the better the chance of slowdown, not shutdown. But 1994 shows that the aggressive pace of rate hikes is not something to fear in its own right.
- Overall, CBA Group economists expect the annual growth rate of the Aussie economy, as measured by GDP, to decelerate from a 3.8 per cent rate in 2022 to 1.4 per cent in 2023. We expect the strong labour market, excess consumer savings and a long pipeline of residential home building work to support economic activity together with solid non-mining investment, bumper agricultural production, buoyant demand for energy exports and robust government spending.
- In response to a deteriorating global economic backdrop, and slowing domestic economy, we also expect the Reserve Bank to begin cutting interest rates in the December quarter of 2023, which could stabilise the property market.
So what does this mean for sharemarket investors?
- Well, sharemarket investors are forward-looking and the outlook has become more mixed after the worst performance for major US indexes in several decades. Robust US job numbers and upbeat US corporate earnings results helped fuel a rebound in US shares in August but recent inflation data has disappointed. The S&P 500 index has lifted just 2.3 per cent in the September quarter after being up 14 per cent a month ago.
- Similarly market interest rates – as represented by the yield of the US 10-year Treasury bond – have been volatile, falling from near 3.5 per cent in mid-June to 2.6 per cent in early August, supporting the rally in growth-orientated technology shares. But yields have returned to near 3.5 per cent. The US 2-year/10-year Treasury yield curve (gap in yield) – often cited as a leading indicator of a recession – remains deeply inverted with the US 2-year Treasury yield hovering near 3.9 per cent.
- While investors have focused on falling share prices in 2022, the outlook for shares is largely dependent on two key factors – US Federal Reserve rate hikes and the earnings outlook.
- US price pressures linger. But investors still hope that the US central bank can engineer a ‘soft landing’ for the world’s largest economy. The Federal Reserve is widely tipped to lift the federal funds rate by 75 basis points (bp) this week but a 100bp move can’t be ruled out. A more aggressive rate hike would certainly dampen risk asset sentiment.
And what is the outlook for earnings?
- A potential recession signpost is a further decline in equity prices, signalling weaker earnings prospects or increased uncertainty about the economic outlook.
- Investors, therefore, will focus their attention increasingly on US corporate profit results into the back-end of 2022. The downside risk around earnings centres on whether surging inflation, higher wages and changing consumer behaviour will weigh on profit margins.
- So far, US companies have been able to pass on rising input costs to consumers. But consumers are pivoting from spending on goods to services as pandemic restrictions fade, with inventories building at retailers and semiconductor manufacturers.
- Fund manager BlackRock estimates that while goods make up less than a third of US gross domestic product (GDP), earnings tied to goods are expected to account for 62 per cent of S&P 500 earnings in 2022. Therefore, a transition to services spending by consumers will weigh on company profits, requiring downward revisions in earnings estimates.
- Analyst estimates for full-year profit growth have edged lower since the start of July, but solid growth of around 8 per cent is still forecast in calendar year 2022 according to FactSet data.
- But in a sign that earnings downgrades for 2023 are on the way, FactSet reported that 240 US companies cited the term “recession” during their earnings calls for the June quarter, well above the average of 52. In fact, it was the highest number going back to 2010.
Are sharemarkets cheap or expensive?
- The forward price-to-earnings (P/E) estimate for the S&P 500 index has risen to around 17 times after falling below 16 times in June, according to Refinitiv. The ratio is still well below the nearly 22 times level reached at the start of 2022. With prices lifting, there is even greater pressure on earnings results to meet analyst expectations.
- In Australia, the August company reporting season recently concluded with aggregate profits up by 56.3 per cent (excluding BHP, up 36.5 per cent). In fact, all but 8 per cent of full-year reporting companies issued a statutory profit. And just under 63 per cent of companies lifted profits over the year (long-term average 60 per cent).
- But despite the higher profits, cash levels have been cut – by choice or as a consequence of the challenging times. Aggregate cash levels fell compared with a year earlier after soaring to record highs in the February profit reporting season. Only 46 per cent of companies recorded higher cash levels than a year earlier.
- In response, companies adopted different strategies. Some companies have been shoring up operations ahead of the challenges ahead. Some stocked up on inventories or equipment to protect their businesses from supply-chain difficulties. Some companies increased employment and lifted wages. And indeed others lifted, or chose to pay, dividends.
- The S&P/ASX 200 companies reporting either full-year or half-year financial accounts, announced dividends totalling $42.3 billion, broadly in line with a year earlier. But while dividends remain healthy, just over 27 per cent of dividend payers announced cuts in dividends, above the historic average.
- Like the US, Aussie sharemarket valuations have become more attractive with the P/E ratio declining from 17.7 times earlier this year to 13.3 times currently. And the dividend yield of 4.7 per cent is around the historical average since the mid-2000s.
- But aggregate consensus EPS growth is predicted by fall from around 22 per cent in financial year 2022 to around 5 per cent next financial year, according to RIMES and IBES estimates. And the S&P/ASX 200 index is on track to outperform US shares in 2022 for the first time in a decade.
- CommSec estimates that the S&P/ASX 200 index will finish the calendar year near 7,000 points.
Originally published by CommSec