30 June 2023 – The Reserve Bank of Australia’s (RBA) June interest rate increase to 4.1% surprised the two-thirds of surveyed economists who predicted no move. Rates are now at a level not seen in Australia for over a decade.
Having said that, the RBA has been slower to raise rates than their central bank peers, with global rates now averaging 5%. The European Central Bank (ECB), which less than a year ago was maintaining an interest rate of 0%, now has a policy rate of 4%. This contrasts with the long-term historical difference between the RBA and the ECB in which Australia’s interest rates have averaged 2% higher than in Europe.
We expect that the RBA will continue to hike rates by at least another 0.5% with risks leaning towards even more – an outcome that will not be out of step with historical precedent.
What is driving the higher level of interest rates around the world? House prices. After everything governments have spent in the two years, handing out money to all and sundry, the sugar high has been stronger and longer than most economists predicted. Cash-flush savers have continued to drive the housing market, despite mortgage rates nearly tripling over the last two years. The sting in the tail: house prices have continued to increase.
Why do central banks, including the RBA, care so much about house prices? The answer is twofold: firstly, housing is the largest component in the basket of goods used to calculate inflation, accounting for nearly a quarter of the weight. Simply put, without lower house prices the RBA will be unable to reduce inflation and achieve its mandate of financial stability. Secondly, the main lever of central bank policy is its ability to influence mortgage rates. Mortgages tend to be the largest line item of monthly household expenditure: by raising (or lowering) the cost of a mortgage the RBA can influence the economy by influencing the ability of people to consume.
How have investment markets reacted to this ongoing and unexpected (for many) increase in interest rates around the world? They shrugged them off. Equity markets were a mixed bag, the US and Japan continued their march higher while European and Australian stocks were slightly weaker over the quarter. Government bond yields were higher over the quarter as investors digested continued higher interest rates. Currencies moved within a range over the quarter mostly ending the period in a similar place to where they started, with the notable exception being Japanese yen (JPY) which depreciated around 8% as investors continue to sell JPY for more attractive yields elsewhere as the Bank of Japan has kept their interest rate at -0.1%.
Overall, we remain firmly of the opinion that investors are not correctly pricing in the risks of an approaching recession. We are taking the central bankers at their word – higher rates for longer. So we are increasing our defensive positioning across our investments sticking with our current capital preservation stance. The ongoing (and increasing) level of interest rates is likely to slow economic activity, and our base case is for a recession later this year. In recent weeks we sold more growth assets, increasing our defensive assets, taking advantage of higher bond yields. Should the expected recessionary scenario crystalize, we’ll be well-positioned to buy back growth assets at prices more attractive than today. Should the downturn take longer than we predict the higher income we are generating within our defensive exposures will continue to move us closer to our investment objectives.