Record immigration key to avoiding more rate increases

Christopher Joye

Coolabah Capital

In the AFR I write: Let’s start with the shocker that was the latest US inflation report for September, which initially triggered a savage 3.5 per cent drop in US equities only to be superseded by one of the most bizarre, five percentage point plus intraday rallies this column has observed.

On average, the 67 analysts surveyed by Bloomberg expected the monthly core CPI report on Thursday to print at 0.4 per cent, with the distribution skewed towards a lower 0.3 per cent outcome. In practice, core CPI rose by a stonking 0.6 per cent, which just one of the 67 economists forecast.

The US Federal Reserve will be greatly concerned by the fact that there is no sign of core inflation decelerating. If you chart the monthly core inflation prints, they have been trending higher since mid-2021.

The year-on-year pace for US core inflation rose from 6.3 per cent in August to 6.6 per cent in September. This is the highest core inflation since 1982.

Fed officials have in the past week publicly worried about inflation spreading from the supply-chain-driven goods sector to the much more wage-intensive services domain, which would signal the advent of a more difficult-to-constrain wage price spiral.

This is precisely what the September report delivered. Goldman Sachs economists commented that “the composition was strong, with broad-based strength in cyclical and wage-sensitive services categories including shelter, medical services, daycare and car repair”.

The Fed’s preferred proxy at The Wall Street Journal, Nick Timiraos, argued that “another uncomfortably high inflation reading for September is likely to keep the central bank on track to increase interest rates by 0.75 percentage points at its meeting next month” and further “raises the risk officials will delay an anticipated slowdown in the pace of rate rises after that”.

Before the news, financial markets were pricing in a peak Fed policy rate of about 4.6 per cent, which they lifted to 4.9 per cent. Fed officials shocked investors at their last meeting when they increased their projected terminal cash rate to 4.5 per cent, and there is now every risk the Fed will start entertaining a five-handle unless the monthly inflation and labour market data start to demonstrably roll over.

Higher interest rates are positive for investors in cash but negative for virtually everything else. And dopey equity investors appear not to have fully digested the news. The S&P 500 has only declined by 26 per cent from its post-pandemic peak. After it slumped more than 3 per cent following the inflation news, touching 3502 points, the market embarked on a bizarre five percentage point rally, piercing 3700 points before the session was over.

There was no clear explanation for the huge bounce other than pundits pointing to put options moving into the money and/or the index moving into technical “oversold” territory.

While the Reserve Bank of Australia had until its October meeting sought to ape the Fed’s moves, it has belatedly come to recognise that local circumstances are radically different. In contrast to the US, the Aussie housing market is blowing up while wages growth remains anaemic notwithstanding the hysteria on the subject.

In rationalising one of the most aggressive monetary policy tightening cycles in the world, the RBA claimed it possessed private “liaison” data that pointed to a much more worrying wage growth picture than the official data published by the Australian Bureau of Statistics.

And yet when the RBA published its liaison data for the first time, it showed wage growth that was very similar to the ABS numbers – specifically, increasing at a rate approaching 3 per cent that is notably below the long-term historical trend and the 3 to 4 per cent growth the RBA has claimed is required to generate sustainable inflation within its target band.

After forcing interest rates up by 250 basis points in just six meetings (or over five months), Martin Place has started to acknowledge that it makes sense to assess the withering impact of what is a record increase in the share of borrowers’ income that is being consumed by repayments of interest and principal on their debts.

This is, in fact, a similar-sized shock to the one that the regulator has historically required banks to estimate when stress-testing the capacity of borrowers to repay their debts in a scenario when they were subject to extreme interest rate increases.

Another example where the Aussie economy is different is in the behaviour of our housing market. In most other countries, the vast majority of debt is in fixed-rate format, and often fixed for 20-30 year terms. In Australia, most loans are floating-rate, and immediately adjust alongside changes to the RBA’s cash rate, which makes its monetary policy movements more potent.

Whereas US house prices have only just registered their very first post-pandemic monthly decline of merely 0.3 per cent, Aussie house prices are cratering at 16 per cent a year. More precisely, dwelling values across Australia’s capital cities have declined by more than 6.2 per cent since their peak in May and are well and truly on track to hit our forecast of a total 15 to 25 per cent peak-to-trough loss.

In Sydney, home values have lost more than 9.7 per cent and are depreciating at more than 21 per cent a year based on the last three months of data. Brisbane is not far behind with a similarly savage three-month annualised loss north of 19 per cent. In the first half of October, Brisbane has overtaken Sydney as Australia’s worst performing capital city.

The losses in Melbourne are more modest, melting at a lower 13 per cent annual rate. There is certainly zero evidence that the bottom is in sight for what will be the Aussie housing market’s biggest-ever decline.

The most positive thing one can say is that the rate at which house prices are falling nationally seems to have stabilised at about 16 per cent.

But this is before borrowers feel the full impact of all the RBA’s interest rate increases (which are being only gradually passed on by banks) and before Martin Place has (imprudently) slugged households with the additional rate rises it is signalling.

One silver lining is that the RBA might be nearing the end of this cycle. If it raises rates by another 50 basis points over November and December, its target cash rate will be sitting at 3.1 per cent, which is notably above its minimum estimate of the neutral rate around 2.5 per cent. This means borrowers will have eaten an incredible 300 basis points of rate rises in a very short period of time.

There is every chance that this unprecedented increase in the cost of borrowing will crush demand across the economy and eliminate the risk of a wage/price spiral emerging, which is obviously what the RBA wants to achieve.

This dynamic will be reinforced by a huge increase in immigration, which this column has been forecasting for some time. In July 2021, we argued that “opening borders to vaccinated and rigorously tested human capital flows, presumably after a March 2022 federal election, will precipitate a wave of skilled, and much needed, overseas talent coming into Australia”.

And so it has proved. Our chief macro strategist, Kieran Davies, has documented the largest quarterly increase in net overseas migration into Australia in over 20 years. This has been powered by a record increase in students coming back to study in Australia coupled with strong growth in individuals on skilled/work visas.

With among the lowest jobless rates in half a century, the nation has desperately needed to attract more global talent to alleviate prospective inflation pressures. This should buy the RBA time to avoid lifting its cash rate to the 4.1 per cent plus level currently priced by markets.

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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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