Amidst ongoing economic uncertainties, the RBA has seen fit to keep rates on hold for a consecutive month and wait to see how the lagging effects of 12 rate hikes play out.
While inflation is decelerating, uncertainty abounds over consumer spending, falling productivity and wage growth. Will the central bank's aim to deliver a soft landing make it harder to get inflation back to target, meaning that this pause is short-lived?
Darren is joined by special guest Phil Strano, Senior Portfolio Manager in charge of credit research, to explore this and more in episode 41 of The Rate Debate.
Amidst ongoing economic uncertainties, the RBA has seen fit to keep rates on hold for a consecutive month and wait to see how the lagging effects of 12 rate hikes play out.
While inflation is decelerating, uncertainty abounds over consumer spending, falling productivity and wage growth. Will the central bank's aim to deliver a soft landing make it harder to get inflation back to target, meaning that this pause is short-lived?
Darren is joined by special guest Phil Strano, Senior Portfolio Manager in charge of credit research, to explore this and more in episode 41 of The Rate Debate.
Hello and welcome to the RAID debate. I'm Darren Lange, co-head of Fixed Income at Yarra Capital. Joining me this month is our head of credit, phil Strammo. Welcome, phil.
Speaker 2:Thanks, darren. Hello everyone, it's great to be here. We're looking forward to debating, darren, and disagreeing, on occasions on some pretty important topics.
Speaker 1:Well, it's the first Tuesday of August and that means the RBA has just met. Unsurprisingly, the RBA has left interest rates on hold for a second time in a month. Sorry, second time in two months. So I don't think there was too much in the statement, phil. There was different from last month. We seem to be pretty comfortable that the RBA is going to get inflation back into the band by 2025. Some of the things I sort of saw in the statement were that they seemed to be looking at overseas for evidence of what could go wrong in services, of inflation. But in general, uncertainty abounds would be the way I would read that statement. They don't seem to know much about where inflation is going. They don't seem to know too much about what's happening with the consumer. They're uncertain about wages. They mentioned policy lags. Yet again they're supposed to be out of forecast and sort of stuff. I mean, what did you sort of see in the data today?
Speaker 2:It is interesting. I mean, from my perspective, I kind of feel that obviously the monetary policy lags that we all know about need time to come through the system and they have increased rates by 4% in little over a year. It doesn't hurt to kind of sit and wait and look where things are at. We do know that there's quite a bit of pressure out there for the consumer. We do know that there are still quite a significant number of households coming off fixed rates on the floating. So it certainly doesn't hurt to just hold fire for a while.
Speaker 1:Yeah, I think we're back in this data dependent world, which is probably sensible. I mean, we've seen it through a particularly consumer lending. Even corporates are probably starting to get a little bit cautious on what they do going forward. So it's not really a sign of things picking up. That requires higher and higher rates. So I've called this once or twice too many times before, but I think it's probably close to the top, if not there, and I reckon we could see it yet another month, unless we get some really strong data in September or late August. Anyway, for them to go on hold again, yeah Look.
Speaker 2:I agree with that. I think they've certainly done a lot, and it doesn't hurt to kind of sit there and just wait for the data and see how it looks.
Speaker 1:So one of the things to having you on the podcast for the first time obviously you and I have discussed certain things over the last year or two, particularly around inflation and sort of our outlooks for what we think might happen longer term. It's probably a good time to sort of delve into the crystal ball and have a look at what some of those themes are. You know my view around things that demographics, several other things in terms of the way populations are aging, are going to have really big drag on inflation. China will continue to probably maybe not export as much disinflation as what they have, but I don't think the world is suddenly going to change where we get away from this just in time manufacturing model like we've had for the past few years. Covid sort of put a spanner in the works, but personally I don't think that's going to change dramatically heading forward. You obviously have some different views around this, so where are you seeing things in the next 10, 15 years?
Speaker 2:I just think that we've come through an extraordinary kind of 30 period of call it matrism where certainly the focus has been on small governments, budget surpluses certainly in Australian context and also the impact of China entering the WTO and globalization basically taken to its maximum level, I feel.
Speaker 2:And what we're seeing now, I think, is the beginning of a call it a regime change, if you like, where you are going to see resources allocated not necessarily at its most efficient means from a cost perspective, where other considerations will come into play, whether that be around sustainability, around national security, around keeping people employed and, off the back of that, I just think that that's likely to be probably more in-facering than what we've experienced over the past 30 years.
Speaker 2:I also think that Aging is, if from a Western context, it's not necessarily going to be as disinflationary as people think. I think there's a lot of resources that will be dedicated towards looking after retiring baby boomers and that is basically going to suck a lot of resources out of the economy and reduce labor supply, in addition to the labor supply that's already going to be taken out of the system from an aging population. I also think that China could continue to push disinflationary forces. I mean that's definitely going to be reduced and I also think China is going to have its own issues around a shrinking labor force and I think ultimately that's going to mean there's fewer workers out there and there's more competition for labor and that's going to kind of increase wages pressures over, certainly over the medium to longer term.
Speaker 1:I don't disagree that those things are out there.
Speaker 1:But then you also look at some of the sort of other problems we're likely to have now, whether it be climate change, which is probably likely to be inflationary or disinflationary, but the advent of artificial intelligence, there's probably likely to be a large change in the way work is done. And I guess, from the way I sort of think about things, if you actually reduce down certain parts of the workforce, you may actually have the opposite effect, where there's actually people looking for work which brings down wages rather than increasing it. So I think it's really hard to sort of see a world where inflation becomes problematic. I don't disagree. Maybe we see a little bit of inflation where we have for the last 10, 15 years we haven't had any. But to see it become a massive problem, like we had the last few years, which I honestly believe has really been more a problem with monetary policy than necessarily a change in social structures To me it just seems really difficult to get to a world where we're going to have problematic inflation like the 70s.
Speaker 2:Yeah, no, I don't think we're heading into a 70s kind of environment because I just don't think that we have the structures in place. I mean, what is strange is that potentially kind of the RBA is kind of sitting there thrilling about inflationary expectations into kind of wages and a potential for wages spiral which I just don't think we're set up for. When you've got unionism in the low teens percentage wise, you don't necessarily have the structures of arbitration that are in place in the 70s for that mechanism of higher inflation to be immediately transferred into wages. It's just not there. So I'm with you on that.
Speaker 2:But I just kind of feel like we are in a different paradigm here Now. Nothing moves in a linear fashion. So it will take time, but it kind of feels like we're at the end of this kind of 30 year period and I also think that going forward you're not going to see people feeling wealthier from risk assets or, principally, house prices the way they've sort of felt wealthier over the past 30 years of house prices continually going up. I don't think you're going to necessarily see that kind of consistent growth going forward. As a consequence of that, people will probably want more income growth to make them feel like they're getting ahead and they will vote that way, and provided unemployment remains at a manageable level, you're likely to see wages being probably stickier on the upside, certainly more than we've been used to, certainly over the last 10, 20 years.
Speaker 1:Certainly, yeah, that sounds like a very favorable world for a fixing home investor, doesn't it Income? Not too much worried about capital growth, and that sort of world would be no vana to us, I would imagine.
Speaker 2:Look, I definitely think so and I, just for that reason I kind of don't necessarily believe that rates are going to potentially fall all that quickly, even if we go into next year. Obviously it's going to be data dependent on what kind of slowdown we have.
Speaker 1:If we look over long term history of interest rates, it's always hard to make generalizations, but rates are probably back to what I would say is a more normal level. Now If they go terribly much higher, they are starting to get to a point of view where they're restrictive and abnormal. But obviously what we've seen in the last two years is also abnormal. I don't think anybody ever wants to see rates go back to that sort of level. But it's also interesting that from an interest rate point of view we've had horribly inverted curves where longer term rates are actually lower than short term rates. Normally you would expect longer term rates to actually offer you a premium for investment. How do you sort of see that playing out in a world if you believe inflation is going to be slightly higher? What do you think the shape of the curve is going to look like? And will we go back to something that's a little bit more normal to what we would expect?
Speaker 2:I think we are in a certainly a more normal environment and I don't think anyone should really be crying about the previous period. I think having rates at these levels kind of makes sense, kind of more reflective of opportunity costs, and we'll ultimately probably allow for a more efficient allocation of resources, so it's something to be welcomed. Now we've had this debate and certainly just one thing we agree on that the curve is probably too flat and probably needs to steepen. So when you look at the yield curve and the question sort of becomes what kind of steepening are we looking at? Is it the steepening where the front end basically rallies because of the economy slows down significantly? Or is it an economy that is particularly robust, where rates don't necessarily fall too much and the long end sells off? Where do you sit on that, darren?
Speaker 1:Definitely in the front camp only because I think so many corporates, and particularly governments, are so indebted that they can't afford to have long term rates go up too high. That's always been my sort of view on things is that we're in a world now where we have so much debt that it's very hard for long term rates to go dramatically higher. You'd need to see something dramatic start to happen defaults, that kind of world where you probably see longer term rates go up, where the cost of borrowing for most people becomes abnormally difficult in that environment to see steeper yield curves from a bearish sort of case like that. I think corporate world we've sort of discussed probably looks pretty good still, but it's still the government world that I get the most worrying sort of feeling about and the consumer. They just have so much debt that. Can we really afford to have long term rates sort of 7, 8, 9%? I'm not so sure.
Speaker 2:So when you think about that, then what do you think that the RBI cash rate should be within, say, 12 months from now?
Speaker 1:If we saw it slightly lower, it would probably make life a lot easier for those heavily indebted borrowers. But I think it really depends on what happens with inflation. If we continue to see inflation bubbling along, I think there's almost no chance of seeing rate cuts early. But I still think in the longer run we're going to see the front end lead the rates market. I think again too, for all of those borrowers over the years who've got used to free money or really cheap money, it would be really difficult to see them survive a world where you had a really steep borrowing curve.
Speaker 2:So is that an RBI cash rate still for three? Handle in your eyes.
Speaker 1:I wouldn't want to say go below that personally. Again, we talked about income you had. The balance between credit spreads and rates at the moment is probably about as good as it's ever been for 15 years, and I don't think that's a bad thing. There's enough tension between the cost of borrowing plus providing decent income versus the alternative where we were a couple of years ago where the only return was from taking credit risk and things like that. There was an absolutely no return from rates at all, and I don't want to get back into that situation either.
Speaker 2:Yeah, you don't get me disagreeing with that, 100% behind you on that one. But yeah, when I think about my credit hat on. Investment-grade issuers look fine, their balance sheets are in a really good shape and their businesses are particularly robust that they will be fine through this cycle. I am more worried about a default cycle in high yield where they'll be across the US spilling into Australia and potentially seeing the first sort of private debt cycle in Australia where there are a number of segments of the market that there's been some lending done with some pretty loose lending standards at some levels that kind of seem pretty uneconomic now.
Speaker 1:Yeah, I think we've talked about this before. Property seems to be problematic in some respects. You've got I shouldn't say property in general, but commercial property. You've got a lot of things happening which are not working in favor. I mean, we've seen property cycles before. It's probably not going to be the end of the world for commercial property, but you wonder again whether those sort of you're going to start to see people defaulting a little bit more in those areas and then you have a cycle that makes that very difficult to navigate for a little while, yeah, we kind of think about commercial property and you know I've had this discussion internally and you know the focus has been on excess supply and what makes this cycle very different is that you've got structural issues around demand destruction from the work at home trend.
Speaker 2:Potentially that's going to create the excess supply, not necessarily from building but from kind of a lack of demand. When I think about the kind of re-space from a credit perspective, most of the re-credits are fine and that's because the gearing is quite modest, so it's somewhere between 25% and 35%. From that perspective we're quite comfortable that any kind of adjustments and evaluations are going to be worn by equity holders and equity holders alone. But when you're kind of thinking about the mes properly lending space and we do know that there's been quite a bit of lending done in that space since the GFC, as the banks have kind of pulled away from lending to commercial property anywhere above an LVR of 50%, a lot of that lending that's been done anywhere between 50% and 80% is potentially at risk as you see rising vacancies and evaluations decline meaningfully.
Speaker 1:I think we would have to go back to the 90s to see a very similar sort of cycle, and it certainly wasn't dominated by high interest rates. We certainly had higher rates than we have now, but it certainly wasn't what I would consider a high interest rate cycle and, if anything, we've been getting lower and lower ever since. But is there any where else you sort of see those sort of problems that come about from actually having a higher interest rate cycle.
Speaker 2:Well, I mean there are certain kind of sort of limit line space in the Australian marketplace, those kind of vehicles that have directly exposed to discretionary cash flow. So it's a consumer in particular. I mean their funding costs have basically doubled most of these structures, and having kind of variability in revenues off the back of consumers retrenching their spending because of interest rates principally, but also cost of living, is likely to be quite challenging for some of them. So I mean that's another area that we're acutely aware of. So anything broadly relate to the consumer that's also got a fair bit of leverage applied Given those set of circumstances.
Speaker 1:And hey, obviously you can't pick longer term. But would you suggest that the RBA now is unhauled for a while? Or do you think they're still going to keep tightening interest rates, Given that back drop that they may start to create even more cracks if they do?
Speaker 2:Personally, I think they should be unhauled. So I think they've done more than enough and, as we know the way the Australian psyche or Australian households work, they certainly prioritise their mortgage payments above everything else. They keep a roof over their head. That certainly, keeping a roof over your head is certainly non-discretionary, but they tend to retrench spending everywhere else and I don't think this cycle is going to play any differently. So we are likely to see the impact from consumption spending and discretionary spending as we go through the second half of this year. I think it will become pretty transparent or apparent that the RBA has done more than enough here.
Speaker 1:Yeah, I was going to say it's a good way to end, where suddenly we actually agree on. Well, that's it for the month. Thank you for joining me today, Phil, and I look forward to the next opportunity we get to chat. Oh, thanks.
Speaker 2:Darren, it's been an absolute pleasure and hopefully I'll get invited to come on again. It's been a fantastic opportunity to just talk through our views on the RBA and all things economics in relation to Australia, so thank you for the opportunity.
Speaker 1:So tune in next month, where we'll be joined by another guest to help deliver our latest thoughts on the RBA September rate decision and provide an update on what's happening in markets. Until then, stay safe.
Speaker 2:The rate debate podcast content may contain general advice. Before acting on anything in this podcast, you should consider your own objectives, financial situation or needs and seek the advice of an appropriately qualified financial advisor.