Global inflation is running hot and Australian households have not been spared the pain. As at the end of December, consumer prices (‘CPI’) had risen +7.8% over the year, more than double the growth rate from a year earlier (+3.5% YoY), and well north of the RBA’s target range (+2.0% - 3.0% YoY). Economic reality is such that inflation is bad, accept it. In order to contain inflation, the RBA has hiked the official cash by +325 bps from 0.10% in April last year, to 3.35% at the February meeting. This represents the most aggressive rate hike cycle on record, and as Tim Shaw would say, “But wait, there’s more.” At its last meeting the RBA signalled the need to raise rates a “couple” more times to combat inflation, which is generally assumed to be two more +25 bp hikes at a minimum, which would take the cash rate to 3.85% (base case). Subject to how the data plays out, there is risk of rates going higher again, potentially reaching 4.10% or even 4.35% as the absolute worst-case scenario.
The surge in inflation has been driven by various factors, although three core reasons are generally accepted as the main drivers. First, supply chain disruption in the face of surging demand post the pandemic. Second, many advanced economies made a stronger-than-expected recovery from the pandemic thanks to an abundance of fiscal stimulus (i.e. JobKeeper payments) and extraordinarily loose monetary polices (i.e. very low interest rates). And third, commodity prices have risen sharply, which was exacerbated by Russia’s invasion of Ukraine.
Most of these inflationary influences would normally be considered temporary. However, there is risk that with tight labour markets, wages will increase to compensate for higher prices, which could trigger a ‘wages-price spiral’. This could in turn entrench inflationary expectations, keeping prices elevated, and in turn keeping interest rates higher for longer.
The Australian Wages Price Index (‘WPI’) published earlier today, indicating that wages for local workers have risen +3.3% YoY to the end of December, a ten-year high and up from the +2.8% YoY a year earlier and higher than the long run average of +3.1% YoY (1998 – now). With the RBA in the midst of an arm wrestle with inflation, upwardly trending wage growth is an area of focus and concern for the central bank.
Historically, growth in the WPI has exceeded the prevailing CPI growth rate more often than not, which could arguably be put down to productivity gains given inflation over time has typically been trending lower, or at least within target ranges. Wage inflation without productivity gains is a concern, which is the risk we’re seeing now. With CPI running at +7.8% YoY, well outside the RBA’s +2.0% - 3.0% target range, the central bank is sweating moderate sized bullets that wages growth could get out of hand and spark a ‘wage-price spiral’. This remains a contributing factor to the RBA’s continued hawkish rhetoric on monetary policy settings and will keep the cash rate trending higher for at least another 2 – 3 months. Further, we do not expect the RBA will pivot on a dime and begin cutting rates any time soon. The ‘higher for longer’ narrative persists.
Where does one park their ‘defensive’ capital allocation during such times?
As a firm, we’re a strong believer in floating rate notes, which largely immunises investors against interest rate risk vs say a fixed rate bond. Monetary policy rhetoric remains hawkish, and it’s hard to argue against the likelihood of higher interest rate over the near to medium term.
Since the RBA kicked off the current rate hike cycle (April 2022), fixed rate bonds have lost between -2.80% and -3.33% across Australian Government Bonds and State Government Bonds (Bloomberg AusBond Indices). The fixed rate credit index has lost -0.61%.
Over the same period, Mutual Limited’s various retail funds have delivered returns of +2.18% for the Mutual Income Fund, +3.08% for the Mutual Credit Fund, and +5.51% for the Mutual High Yield Fund. Based on market pricing for forward cash rates and expectations around credit spread trends, these funds are expected to return +5.90% YoY, +6.60% YoY, and +9.40% respectively for calendar 2023.
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