RBA Way Wrong on Unemployment

Christopher Joye

Coolabah Capital

In the AFR today I explain why long-term forecasting is a waste of time; why Australia's jobless rate in December 2018 will likely be 0.75% to 1.0% lower than the 5.5% rate the RBA is currently forecasting; why the enigmatic Guy Debelle might one day make a great governor; and why Challenger Life's newly issued Tier 2 bond is dirt cheap and should be trading 20 to 30 basis points tighter than its levels this morning---indeed, it is rallying as I write (click on that link to read for free or AFR subs can use the direct link here).  Excerpt below:

"While the RBA expects the unemployment rate to be at 5.5 per cent in December 2018, it is 90 per cent confident that it will be somewhere between 4.5 per cent (below its current 5 per cent "full employment" estimate) and 6.5 per cent, which would be the worst labour market Australia has experienced in 15 years. As it turns out, Australia's jobless rate dropped to 5.4 per cent in October and is already lower than the RBA's forecast for the end of next year. Debelle concedes that the RBA's unemployment rate forecasts "have been negative more often than positive", which means that "the [real] unemployment rate has been lower than we had forecast". And yet it is a critical variable for the RBA to get right because of its value as a proxy for spare capacity in the labour market. "The unemployment rate [is] a particularly useful guide to the current state of the economy," Debelle says. Repeated forecast misses to the downside on the jobless rate just before the global financial crisis coincided with massive upside misses to core inflation (ie, inflation was much higher than the RBA expected), which represent the RBA's worst errors since 1993. While I believe that the RBA's 5.5 per cent estimate for the December 2018 jobless rate will prove way wrong (specifically 75 to 100 basis points above the true level), there is no certainty at what time this labour market tightening will pressure wage inflation. After all, the RBA's 90 per cent confidence interval around the NAIRU, or the "non-accelerating inflation rate of unemployment", extends from 3.5 per cent to 6.5 per cent! The RBA's 90 per cent confidence interval for economic growth at the end of next year is similarly wide, spanning year-end real GDP of between 1 per cent and 5 per cent. So we're either heading into a boom or bust. This is why despite its hundreds of analysts, the RBA has no idea where interest rates should really be 12 to 24 months ahead. It is also why interest-rate traders usually blow up over the long run...In this context there have been several attractive new bond deals. The standout was Wednesday's Tier 2 issue by the A rated Challenger Life Company, which Standard & Poor's has just put on "positive" watch for a potential upgrade to A+. The $8.2 billion Challenger Limited (ASX: CGF), which owns Challenger Life, is a widely misunderstood business I have long admired.  Even though it has much lower leverage than the banks, Challenger has punched out 18 per cent plus returns on equity (RoEs) with modest risk. Challenger Life's RoE is around 14 per cent with less than seven times leverage (compared to a major or regional bank's 15 times to 20 times leverage). And I believe the Challenger guys are better credit risk managers. The life business has a quasi-monopoly on the booming annuity market that will only become more important as the population ages. Challenger has also built one of the world's most successful fund incubation businesses via its $53 billion subsidiary Fidante Partners, which has nurtured many excellent boutiques, including Greencape, Ardea, Bentham and Kapstream. What really attracts me to Challenger is the quality of its management team led a posse of former BT stars including the brilliant Richard Howes and Brian Benari (and, before he retired, Dominic Stevens). Like Macquarie's leadership, these guys are all substantial shareholders in the business. The execution of Challenger's Tier 2 bond issue, which I bought, was sublime. Despite only needing to print $400 million, they allowed the book to build to almost $1 billion to maximise tension. The issue margin of 210 basis points over bank bills (tightened from the initial guide of 220 basis points) was perfectly priced with exactly the right new issue concession for Challenger's inaugural over-the-counter Tier 2 deal in the domestic domain. Smart issuers always leave value on the table for their creditors, especially when it comes to higher beta (volatility) securities like Tier 2. The last major bank deals in the Australian wholesale market have all provided spreads 20-60 basis points back from secondary valuations, which can get artificially tight on retail flows. Challenger's Tier 2 bond is almost identical to the Suncorp-owned AAI Tier 2 issue that is trading around 160 basis points, or 35 basis points, inside Challenger's 195 basis point level. In overseas markets it normally works the other way around: life company bonds typically trade inside insurance companies because annuities have much lower portfolio risk profiles compared to the catastrophic tail events that can cripple an insurer's business." Read full article at AFR here.

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Christopher Joye
Portfolio Manager & Chief Investment Officer
Coolabah Capital

Chris co-founded Coolabah in 2011, which today runs $7 billion with a team of 33 executives focussed on generating credit alpha from mispricings across fixed-income markets. In 2019, Chris was selected as one of FE fundinfo’s Top 10 “Alpha...

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