Faster and deeper rate cuts are bullish for Australian equities

We think last week's May CPI print, which was better than expected at both a headline and core level and showed a favourable mix with services and housing both stepping down, has provided a green light for the RBA to cut faster and deeper. 

More importantly, the print, provided confirmation that Australia’s inflation fight has been no different to other developed economies. 

We never thought it was. It went up, and despite fears it would remain structurally higher, it came down. Just like every other developed economy.

Yes, there are some nuances to the rise and fall, but timing was not one of the differences, as is evident from the accompanying chart. Australia came out of lockdowns later than many other developed economies, and as a result, the inflation spike (and peak), as well as the start of the RBA policy tightening cycle, came later. Obviously, that meant the deceleration came later and so too did the time for inflation to fall back into the RBA’s comfort zone. 

When all is said and done, we think the RBA has done a great job at taming inflation while also preventing a meaningful labour market slowdown, or more importantly, avoiding an economic, consumption or house price collapse.

Admittedly, there has been some decent pain for the consumer due to falling real incomes and a higher share of the wallet taken up by rising mortgage costs (~40%). But for the most part, everyone still has a job, and so running down excess savings, cutting back on some discretionary items or trading down on necessary items, has allowed the discomfort of missed mortgage payments, defaults and forced selling across the housing market to be largely avoided (SQM estimates put the stock of distressed listings at a cyclical low below 5%!).

What the past few years tell us is that regardless of the amount of expertise and data on hand, the RBA does not operate with a monopoly on accurate forecasting, and neither does it provide a longer lens into how policy is evolving versus the market. There is little upside for the RBA in getting too far over their skis, and so they are incrementalists – taking small steps. We don’t think this is unusual or unique to the RBA. Most other central banks operate in a similar fashion (and this partially explains why there are teams of experts employed to find the hidden messages in central bank communications). 

But ultimately, it’s not about what we think. It’s about what the RBA thinks, and we think they now have a runway to lower rates faster and more aggressively than they had previously signalled. If neutral is around 3.00% and rates are currently at 3.85%, then we think households should expect at least another 100bps of easing. But that would only just put policy settings into easy territory, meaning rates could fall even further than this.

As Gerard Minack (Minack Advisors) points out, in real terms, the cash rate was zero or negative for 6-7 years before the pandemic, and there was no evidence that this was stimulative. If the neutral rate remains zero or less in real terms – and he doesn’t see any reason why it should have risen – then the RBA can cut the nominal rate to 2½% or less – another 125-150bps! That might not fix Australia’s structural growth problems, but it will certainly fire up the domestic equity market and house prices.

As equity market investors, we think this means a lot. 

We remain positive on the outlook despite a long list of concerns that are chipping away at confidence. A rate-cutting cycle outside of an economic recession is bullish. Similarly, corporate profit margins remain elevated and provide significant leverage as revenue growth picks up. In fact, one of the more underappreciated positive drivers when the cycle is turning tends to be operational leverage, and with corporations hoarding labour through the post-pandemic years, we think profit upside will again be underestimated.

Finally, it is not often that Australia is a relative safe haven when the US is softening. But the US is kicking own goals and outside of a recession, we think Australia can avoid the worst of these drags. 

While valuations are elevated, we have repeatedly argued that they are not a constraint to the market trading higher, particularly when cyclical tailwinds are building. Investors do not invest in absolute terms. 

They chose equities over other assets, and they chose one stock over another. As an equity investor, we cannot sit on the sidelines because valuation optics look poor. We have to find where relative value lies, and there is always value when viewed on this basis.