Can your portfolio survive a 5% cash rate?

Michael Houghton

Lucerne Investment Partners

With the RBA again raising the cash rate in August, many are currently wondering how high rates can go. Recent numbers show the market pricing in a top of 3%, down slightly due to lower than expected inflation figures.

I put this to Chris Murphy, an economic modeller, and long-time consultant to governments and central banks He currently consults for the Singapore central bank and has ties with ANU.

Chris was explicit in his belief that 3% is as low as it can go, and anything less will simply throw fuel into the fire, i.e. inflation.

'The Reserve Bank's still got its foot on the accelerator'

Chris has been able to trace the genesis of the current inflationary period, and his models suggest the RBA's cash rate climbing as high as 5%.

In this wire, we got into the nitty gritty of how exactly we got here, just how concerning the current situation is, and what can be expected next. We also discussed what investors could do to insulate their capital from this inflationary environment.

Key topics:

  • 0:23 - Inflation - What caused it, and how did we get here?
  • 2:31  - The role of government policy in creating high inflation.
  • 8:00 - The blunt instrument of monetary policy
  • 10:18 - Small, large, largest; what's next for interest rates?
  • 12:30 - Is inflation all our own fault?
  • 15:46 - How investors can avoid the worst of the inflationary environment.

How did we get here?

The first thing Chris and I discussed was interest rates. Elevated rates are hurting the hip pockets of consumers, exercising the minds of governments, and are driven by current inflation levels, which seem likely to continue climbing. This situation hasn't emerged without cause, however.

Chris believes that the seeds for heightened inflation were sowed by government policy mistakes made in response to the COVID-19 pandemic. He believes government restrictions caused an earnings shortfall for particular services (hotels, restaurants, gyms, etc.). The result of this shortfall was an earnings reduction of A$120bn for business owners and employees in those sectors.

'That was the shock the government had to contend with; It was a big economic shock.'

Our discussion then shifted to how this shock was handled. 

Did the Government do the right thing? Could they have done better?

Chris reckons (with the admitted benefit of hindsight) that the Government should have aimed to compensate individuals whose incomes were impacted by social distancing restrictions. This, in his view, is the equitable solution, preventing those in locked-down industries from bearing the brunt of financial impacts from mandates. 

Further, this would have been good economic management, as replacing income losses would mitigate the reduction in demand as affected individuals go into survival mode.

According to Chris, the issue is that the Government overcompensated. If nothing had been done to mitigate losses, private sector incomes were expected to be reduced by A$120bn from 2020-2021. In reality, over this period, private sector income grew by around A$146bn. 

'The government actually pumped in more than $2 for every $1 of income that was lost, so in aggregate households and businesses were well and truly over-compensated.'

Did that stimulus at least end up where it needed to?

Early government interventions, Chris explained, had very little targetting towards those individuals who really needed support. The first intervention was called 'Boosting Cashflow', which was paid out to small and medium-sized businesses, regardless of industry.

Next came JobKeeper, through which the government gave compensation in line with the minimum wage to those who had lost work as a result of COVID-19 restrictions. This meant that higher income earners were under-compensated, but more commonly, part-time or limited-hour employees were overcompensated.

'A woman who lives on the same street as me works only a few hours a week at a restaurant, bringing home $200-$300 a fortnight. She got job keeper of $1500 a fortnight.'

Chris believes that this illustrates the true purpose of Job-Keeper; not to compensate lost income but rather to keep employees connected to their employers. While this is a worthy objective, Job-Keeper was too "single-minded" in that objective. The result was disproportionate levels of remuneration for those whose work was impacted by restrictions.

Another misstep in Chris' view was the duration of payments. While most businesses endured an income loss for three months, Job-Keeper continued for six months on average. As a result, there were many small to medium-sized businesses that were in fact over-compensated.

How has the RBA contributed to managing the economy during this period of time, and what's its impact now?

For this kind of economic downturn, monetary policy was never the key response. What was necessary was a targeted, accurate response to compensate those that had lost income due to covid. Interest rates, as we all know, are an extremely blunt tool.

"By the time we got to November 2020 the cash rate was down to .1%, and the reserve bank was promising to keep it there for at least three years. Now if we go back to the cause of the economic downturn, you have to ask yourself 'Why did they do that'."

Recessions in the past, explained Chris, have been brought about by weak investment of one form or another, and so low-interest rates are an obvious solution to drive up investment. In this case, however, the recession was caused by a loss of income to specific households. To combat this, fiscal policy should've been the tool of choice. 

Covid-19 restrictions were largely gone by the end of 2021, and Chris believes that monetary policy should have returned by then to a 'neutral' level, with a cash rate of 3%. Instead, the RBA is a long way behind the curve in its current position.

So far we've had small, large, and larger rate hikes. Will that trend continue?

For Chris, predicting what the RBA will do next, because they haven't been doing what he thinks they should have been. In his view, the cash rate is still low enough that it is contributing to inflationary pressures. As he puts it;

'The Reserve Bank's still got its foot on the accelerator'

He also said that the RBA must strive to return the cash rate to have a neutral impact on inflation. As a rule of thumb, he said, this value can be calculated by taking the 10-year bond rate and subtracting a small amount. This would indicate that a neutral cash rate would sit somewhere between 3% and 3.5%.

I asked if this would mean that inflation will still be elevated at this cash rate, and his answer was clear: "Likely, yes."

Labour market tightness (unemployment at 3.5%), supply chain disruptions, and supply shortages all contribute to this thesis. The fact that the RBA hasn't already reached this cash rate, along with budget policy remaining relatively loose indicates to Chris that cash rates could conceivably climb as high as 5%, and will certainly get above 3% in order to put downwards pressure on inflation.

Globally inflation rates are higher than domestically. Is there any chance that Australia can avoid the worst of the cash rate climb?

In response to this, Chris told me about some research from the San Francisco branch of the Federal Reserve in the US which estimated that 3% of US inflation resulted directly from excessive fiscal stimulus in the US.

According to Chris' own models, of the ~6% inflation currently facing Australia, half can be attributed to excessive fiscal stimulus for the duration of the Covid-19 pandemic, and the remaining 3% is contributed by external factors including the war in Ukraine and it impacts on supply chains. In the ex-stimulus case there could be a high degree of confidence that inflation would be only transitory.

In reality, however, Chris warned that we should expect elevated inflation rates to continue until the end of 2023 at least, and will require tightened monetary policy to placate.

"So the story that its not our fault, its Ukraine, its the rest of the world is not really true, and in any case we could have insulated ourselves to some degree from that with the reserve bank running tighter monetary policy and pushing the Australian dollar up."

Given all that we've discussed today, what are some places an investor should look at as a destination for preserving capital?

Chris was quick to clarify that he was not an advisor, but from an economic perspective, he believes that the market's expectation of cash rates hitting their maximum at 3% is a material under-estimation.

As a result, risks of capital losses for investors placing capital in fixed interest products and suggests CPI-linked bonds for insurance against inflation.

Chris also explained that growth stocks have generally de-valued recently as a result of higher discounting on future earnings. Given his view that interest rates could go even higher, there could be more bad news ahead for growth stocks.

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Michael Houghton
Executive Director
Lucerne Investment Partners

Over a 25-year career, I've worked with ultra-high net worth investors, family offices, and property investors to provide investment advice, portfolio construction, debt structuring and lending. As an experienced finance and investment executive...

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