Why an RBA pause will be positive for portfolios

The Australian economy is slowing predictably as the RBA’s 3.25% of rate hikes has its way with activity. Monetary policy works with a lag, so expect more slowing to come over the next few months and the RBA is not done yet. Elevated inflation all but guarantees a 0.25% rate hike in March but then it gets interesting. We think the RBA is very close to ending its rate hike cycle. And that means the outlook for H2 2023 may be better than the market has priced in.

Rates up, activity down

The RBA’s aggressive tightening of monetary policy through 2022 is beginning to have an obvious impact on economic activity. From house prices, to credit growth and building approvals, the housing sector is feeling pain. Building approvals have slowed as rates have increased and that is going to get much worse in coming months. That will feed through to construction and GDP growth with a lag.

Chart 1: Building approvals are set to collapse as rates increase – and that will slow economic growth.

Consumer confidence has collapsed and household spending will begin to slow in coming months. Add to this a mortgage cliff as households roll off low-interest fixed-rate mortgages onto high-interest rate variable-rate mortgages, and there is a clear recipe for economic slowdown. The economy maintains some economic momentum and is supported by a terms of trade boost through the commodities sector. But I think there is a good chance that quarterly economic growth slows to be close to zero percent by Q4 2023.

Chart 2: Very weak consumer confidence will likely lead unemployment lower.

No sign of a wage price spiral

The RBA wants the economy to slow. It is achieving that. But a recession is neither necessary nor desirable. The RBA has managed to cool the domestic economy and that will have the desired impact on domestic demand-pull inflation. The other fear that keeps the RBA awake at night is a wage-price spiral.

Chart 3: There is no real sign of a wage-price spiral in Australia.

But there is no evidence of it in Australia. Wage price inflation is tepid. There has been a welcome pickup from very low wage growth over the past decade. But that has simply not translated through to entrenched wage pressures.

Prepare for the pause

The RBA’s job is almost done. We think the neutral cash rate in Australia is around 3.00%. Another 0.25% rate hike in March, and possibly one more in April, will take the cash rate 3.85%. That is restrictive, given standard-rate variable mortgages have a spread over the cash rate around 4.00%. If the data allow it, the RBA may take the cash rate to above 4.00% in May. But by then, the Bank’s job will be done. It will time for a pause that will probably last throughout 2023.

Risks are balanced for 2023

The RBA is not going to go back to a 0.50% pace of rate hikes. This would be unnecessary and credibility destroying. The RBA is approaching the end-game and needs to move cautiously to prevent an avoidable recession from taking place in 2023.

Chart 4: Markets have priced aggressive rate hikes.

The RBA has managed successfully to bring terminal rate pricing to around 4.25%. We think the RBA may get to 4.10%, but probably will go no higher. From April or May, we expect the RBA will be on pause. If the Bank is still hiking in May, then there is a considerable risk of over-tightening.

Position portfolios for the pause

The next few months are very important. If the RBA controls the narrative, recession can be avoided, and equities will likely perform quite well through 2023. There will still be winners and losers. Rates will be elevated for some time. Mortgage debt service costs will be high. The unemployment rate will begin to move higher from April or May, we expect. Consumer spending is going to slow further, and that will be challenging for consumer discretionary sectors.

If the RBA does not pause or allows expectations to move materially higher from current levels, then outcomes will likely be worse. We have aimed to manage these risks by improving the quality exposure of our portfolio and introducing some variable beta.

On the other hand, now that expectations for rates have repriced higher, we once again see government yields at outright attractive levels. The back-up in yields provides reasonable income and important downside protection against the RBA mishandling the pause. From our perspective, this will be a very important asset class in the months ahead.