Earlier this week I attended the Australian Securitisation Forum Conference in Sydney. In the opening panel discussion, Luci Ellis, Chief Economist at Westpac (also past Assistant Reserve Bank Governor) and Sally Auld, of JBWere, Annette Beacher of Hesta, Emily Dabbs from Oxford Economics, and Sharon Zollner from ANZ New Zealand talk about the most important aspects of the Australian economy. Here is an abridged version of the session.
Moderator Annette Beacher
Sally, what happened to our US recession? Did we avoid it? Did we delay it? Where are we?
Sally Auld
So, it’s sort of missing in action, and I think you’re right, if we go back to the beginning of the year and we look at consensus forecast for US economic growth, the consensus didn’t even think that the US would get 1% GDP growth over the course of 2023. And if you look at the evolution of those forecasts as we’ve moved through the year, it’s been a constant drip feed of upward revisions. They just told us that the economy grew close to 5% annualized in the third quarter.
Alongside low growth was a genuine expectation that 2023 would bring a recession in the US, which hasn’t happened. We’re tossing up between two scenarios. I think the 2024 one is that ultimately the recession does eventually come, and the 500 basis points plus of rate hikes that have been injected into the system actually start to have their effect and growth slows in a meaningful fashion. Or alternatively, we’re having the fable soft landing and the Fed has been able to engineer something where inflation comes down a bit more quickly than they expected, which has been the case this year, and that happens without creating too much damage to the broader growth outlook.
I think at the moment it’s hard to tell between both of those. So, it doesn’t surprise me that the markets oscillate from one to the other quite quickly. But I think at JBWere our view has always been that soft landings are historically rare, and while history doesn’t repeat, it certainly rhymes.
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I think we’ve always felt that to engineer disinflation of that magnitude, you probably would have to force some sort of adjustment on the economy. I think we’re just at the point where we’re starting to see some interesting signs that the labor market is softening. And I guess the key barometer that we’ll watch is really how far the unemployment rate rises over coming quarters.
Personally, I wouldn’t be at the point where I’m ready to say that’s it. The Fed’s definitely given us a soft landing, and so perhaps the recession that we all thought was coming in ’23 is maybe coming in ’24.
Annette Beacher
I know sometimes we talk about the RBA being a reluctant hiker, you certainly can’t say that of Adrian Orr. Of course, RBNZ jumped in with quite a big, aggressive tightening cycle. So, Sharon, walk us through the cycle. Are we done? Do you have a fully employed recession? I mean, whoever thought that would be the case?
Sharon Zollner
The economy has flowed less than expected, and the Reserve Bank itself has acknowledged that. And they perhaps haven’t got the traction that they thought they would, in so far as they’ve been revising up their estimate of the neutral OCR and of the output gap. Revising down their estimate of how much money they’re sucking out of people’s pockets, because incomes have grown more quickly. So that debt servicing burden is not as great as they thought. But at the same time in recent months, the data really has cooled, particularly anything to do with retail has been very, very weak. And of course, that is the plan you have to remember.
So, I do tell businesses it feels pretty rough out there, but actually this is what a soft landing feels like. This doesn’t feel like a recession. And I ask businesses to put up their hands, are things are getting better or worse? And it’s 50-50 actually.
So I think the question has the Reserve Bank done enough damage, or are we even leveling up too soon? I think that’s still live, but that is not where the market is at. And indeed, we’ve actually just pulled our forecast for further hikes, while absolutely pointing out to a market that doesn’t want to hear it, that it could still happen, but it is a slower burn story. And recently the data has been going the Reserve Bank’s way, and the market of course heavily extrapolates, but things can turn.
And so, it’s going to be a really interesting few months, particularly for the housing market, because like Australia, we’ve had a huge immigration boost.
Annette Beacher
That’s certainly something in common across the ditch.
It felt like the RBA was done and then we know they hiked again in November. Where to from here, do you think?
Emily Dabbs
I have to admit, earlier in the year when there was a pause, we were a bit surprised by that. We felt that there likely needed to be more hikes. And what we ended up seeing is a lot of that data on inflation surprising to the upside and the good old Melbourne Cup hike coming through.
Our view is that there’s enough in there, as well as with recent labor market data, to suggest another hike is warranted. Now the question in our mind is when that will occur. The RBA does seem a little bit reluctant to go, they may want to wait until they see a few more data points, with the lack of a January that suggests maybe a hike in February. Our view is that there is enough there that they should be considering one in December, but we’re probably likely to see that more in February at this stage.
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Annette Beacher
With your Westpac Chief Economist hat on Luci, what happened to the mortgage cliff,? Is it still there? Or is it savings buffers?
Luci Ellis
The way I always saw the mortgage cliff was more a mortgage- time-to-plan. You’ve got to remember everyone on a fixed rate mortgage has been able to delay the inevitable hike in their mortgage payments, relative to everyone else who didn’t. Certainly, in our own results we talked about the fact that people have actually managed that switch into variable rates very well. It turns out most people who did that, or a large chunk of the people who did that, had split loans. So, they knew that the rate rise was coming, because one half of their mortgage was seeing that and the other half wasn’t.
The other thing we are seeing, and that was the bit you didn’t really have visibility over until it actually happened, was a lot of people had savings somewhere else, perhaps with another bank, and a lot of them brought those savings into their offset and redraw facilities as part of managing the increase.
I think the other thing to bear in mind of course, is people with mortgages are typically the good credit risks. That’s by design. They have higher incomes, they have more stable income growth, and the jobs market is really strong in a level sense. I mean the last time unemployment was this low, I was in preschool. So, we talk about long phases in the economy and long phases in the profession, but this is actually a 50-year tie point in the labor market, though it is turning. The kind of people who already had mortgages are going to be in a position to continue servicing them.
But what is different in Australia, and I think where we are seeing in our own consumer spending data, is that, unlike New Zealand and unlike the United States and many other economies, in Australia we’re seeing a substantial squeeze. Real household disposal income is declining in aggregate and that’s despite the strong population growth that we’ve seen.
On a per-household basis, that is really significant. And the important point to note about that is that inflation, the higher cost of living, and the indirect effects of inflation from bracket creep and the tax drag, are actually doing more to suck income, real spending power, out of the household sector, than the increase in net interest payments coming from monetary policy.
So, at some level, by design or by construction, fiscal policy is not working against monetary policy. There are certainly views that it could do more, but in Australia you’re actually seeing the two arms of policy working in tandem, at least directionally. You’re not seeing that in the United States.
So it shouldn’t surprise us that in trying to get a better balance of supply and demand, which is the rhetoric the RBA talks about, it gets easier when you are already sucking a lot of income out of the household sector. But coming back to the mortgage cliff, it wasn’t a mortgage cliff and it never was.
Annette Beacher
Let’s jump into our favourite topic, housing. You either want one, want to sell one, or are trying to look after your children who expect you to die in order to afford one.
Where to from here Emily?
Emily Dabbs
There are household pressures, but it does seem to be relatively manageable at this stage. And even with further rate hikes, really what we’re anticipating is that household finances will benefit from the effect that has on slowing inflation, and with continued wage growth over the medium term, supporting household finances and the market.
From a house price perspective though, we do expect that it’s quite a thin market at the moment. People are doing everything they can to service their mortgage to limit defaults. We expect that it will be a little bit choppy for a little bit longer, potentially a bit more downward pressure through next year with rates remaining higher for longer. And really we won’t see any further significant price growth until 2025 and onwards, when we see certain interest rate improvement.
Annette Beacher
So Sally what dynamics are you seeing in the housing market? Is it as crucial as it used to be for the outlook?
Sally Auld
I think it’s important. I mean it’s the biggest asset that Australian households own, so it’s not surprising that there’s, I guess, both a sentiment and probably a wealth effect with house prices. And the RBA has been pretty explicit about saying, “We don’t target house prices, but we are cognizant of that transmission mechanism where if prices are going up, households are feeling wealthier and maybe that translates through to stronger consumer spending.”
So they are keeping an eye on it and it’s pretty unusual to have house prices annualizing at double-digit price growth when you’ve had a hiking cycle. But my sense is really, for the housing market, probably what it wants is just certainty on the outlook. So just want to reach the point where it’s like, “Okay, we’re done on rate hikes.” And I’m not sure that we’re there yet for the RBA.
It’s going to be a little bit choppy. But fundamentally, I think we all know the story. There’s huge demand for housing, it’s inelastic in supply in the short run, so there’s a lot we can do to build it. And the only release valves for that are rents and house prices. And so I think in order for anything really to change, it’s got to be something around the demand and supply dynamics. Overall it’s a market that’s going to be pretty well-supported.
And I think going forward it’s a bit like the US. I think what you have to ask yourself is, do you think the RBA can get inflation down without forcing some sort of adjustment on the labor market? And that’s ultimately what will matter for defaults.
I still think one of the things we need to be mindful of here is that maybe a cash rate of 4.35 is just not restrictive enough to get inflation down. And the RBA have outlined their approach very clearly. But the caveat that comes with that is that you’ve got no tolerance for upside surprises.
It’s not the most scientific way to think about things, but I think there’s a logic or intuition behind it. Other countries that we might compare ourselves with, like New Zealand, Canada, US, UK, they all have a cash rate that sits somewhere between 5% and 5.5%. And I don’t think that’s a coincidence. I think there’s probably a story there. They’re all economies where inflation is coming down, unemployment rates are going up, and yet we’re at a hundred basis points below that. And as Luci said, we’re still sitting at generational lows in the unemployment rate and our inflation trajectory feels a little bit challenging.
And so maybe the conclusion there is that rates don’t have to go to 5.5, but they might have to go a bit higher, it feels like it’s going to be a pretty drawn-out process.
Annette Beacher
Speaking of unemployment rate and labor market dynamics, we have record high female participation rates, hours of work going through the roof.
Luci, is this part of what Emily was alluding to? People will do anything to pay this mortgage.
Luci Ellis
I think there is some element of an income effect. People are increasing their labor supply precisely because they’re facing higher cost of living, but they’re doing it because the opportunities are there, and that’s also important.
We’re also seeing strong youth participation for the same reason, the jobs are there.
But one thing I would just remind everybody is, monetary policy doesn’t work by making people default on their home loans. Monetary policy works by making people change their choices around spending, and that’s a much milder, and can be a much more widespread process. And it doesn’t only have to involve people who have mortgages.
This is just what you do to maintain your housing.
And I suspect consumption and the consumer is going to stay very weak. Where we’ve seen the unexpected resilience in the economy has not been in consumption. It has been in business investment and government spending. And so I think that’s the way to frame it, rather than monetary policy working through putting people out of their homes. If that’s how monetary policy is working, you’re doing it wrong.
Annette Beacher
Yeah, I don’t think anyone wants that. Sharon, what’s the dynamic there in the labor market?
Sharon Zollner
We’ve imported nearly 200,000 non-New Zealand citizens in the last 12 months, and yet firms are still saying that finding skilled labor is their number one problem, as of September. But absolutely the labor market has been really key.
The unemployment rate is now rising, it’s 3.9%. And it would have been comfortably at a 4 handle if we hadn’t seen that fall in the participation rate. So that was actually loosening more quickly than the Reserve Bank was expecting, or than we were expecting. And that’s our key input into our change of call.
Annette Beacher
So, in terms of that change of call, just walk us through.
Sharon Zollner
It’s fair to say that pretty much all of those inflation, cost and wage indicators, the whole lot, are going the right way, but still have a long way to go.
And that’s that second part of that, that the market I think is overlooking. They’re happily extrapolating, and we just have to look at inflation in the 70s to see the dangers of extrapolation.
Annette Beacher
So let’s switch gears and talk about the things that can go wrong. I mean as we know we’re well into the Russian-Ukraine war. That doesn’t look like it’s going to end anytime soon. Now we have geopolitical tensions in the Middle East. So it doesn’t matter what policy you have these international impacts are something we need to consider. Now at Oxford Economics, do you have scenarios and risks? How do you deal with geopolitical risks?
Emily Dabbs
We are a global firm, so we are looking at it from a global perspective. The main risks that we continue to monitor are definitely those geopolitical risks that impact oil prices. Obviously here in Australia, particularly, as an energy importer that has a big impact on inflation, monetary policy, et cetera. Generally, our view is that at the moment the geopolitical environment is such that we won’t expect an impact on oil prices that would be enough to derail the economy. We do think that that puts upward pressure on inflation and definitely poses a risk.
No matter what’s happening in the global economy, we look at China. The real estate sector there and how it might play out. Australia and New Zealand have significant trade ties with China. We ran a scenario where we looked at an additional slowdown in the Chinese property market, how it would affect different economies. Australia and New Zealand are taking a greater hit, than say our US counterparts, simply because of the type of trade relationship that we have with them. But it’s definitely the biggest risk that we monitor at the moment.
Annette Beacher
Yeah, China’s a tough one. Every time there’s a green shoot, we have iron ore up like 20% in a heartbeat. I think it ended last week at about $120 a ton. Happy days for our energy exporters.
So, in terms of China risks, for example, Sally, the whole China-Taiwan is a risk. It’s like the epitome of a black swan event. Do you spend much time thinking about such risks, and what do you think are the top risks for next year?
Sally Auld
Yeah, I think that’s one. I guess I would look at all of these in the context of a very different regime or environment for investing full stop. So, I think it’s quite possible that if we’re still alive in 40 years time, we might look back at the period we’ve just been through with what an economist called “The Great Moderation”, as a period that was actually quite unique in many respects.
There are good arguments to believe that we’re going into a world where we’re going to have more volatility and key macroeconomic indicators, probably shorter cycles. But we’re going to have to live with a lot more geopolitical risk than perhaps we might’ve done in the last couple of decades. And obviously, China-Taiwan is one, and for the first time for us here in Australia, that’s right in our backyard.
I don’t think you have to stretch too far to try and think about why the government for the first time in many decades is spending huge amounts of money on securing military hardware for us. They wouldn’t be doing that if they didn’t think there was a meaningful threat that they had to protect against. So that is a very different world for us.
From a portfolio construction perspective, one of the risks we worry about is what if central banks just give up? So we have taken central banks at their word, that they are going to get inflation back to target over a reasonable timeframe. But I think we also acknowledge that the environment in which they’re doing that feels different, particularly here in Australia. It feels like that trade off maybe isn’t as steep as it used to be, in the sense that they feel like there are political and social constraints to it. So what would happen if we just didn’t ever get to 2.5% inflation here in Australia, or 2% in the US? That would be pretty meaningful for I think all asset classes.
And so, one of the things we worry about is how do you protect portfolios against that tail risk? Do you need to own lots of inflation linked bonds? Do you need to own more commodities? So on and so forth. Because I think it’d be a pretty horrible adjustment for bond markets, and for a while, equity markets too. So that’s another one we think about. But the main one for us is geopolitics.
I think the risks that are potentially significant for commodity prices are probably the ones you should spend more time worrying about.
Annette Beacher
Sally, you alluded that maybe policy isn’t tight enough, maybe neutral interest rates are higher. Sharon, I think you dropped a hint there. What are you looking at in terms of neutral rates and why are they higher?
Sharon Zollner
Yes, that’s interesting. The Reserve Bank has been revising up its estimate of neutral. I think that was one of the reasons that they raised their track for the official cash rate by nine basis points, which falls well short of a threat to raise rates again, but it was a shot across the bows. And that was largely due to a 25 basis point increase in the neutral rate. The neutral rate is creeping higher.
And what’s also really interesting is that the range of estimates around it from their suite is nearly 300 basis points wide. So, we’re all sitting here debating 5.5 or 5.75. And the real question is, where should it be in a band of five to eight? Would it actually be a more realistic depiction of the uncertainty that’s out there. Now of course you can trade off the height, the level of rates and how long you hold them, to a point, but at some point you’ve got to acknowledge you haven’t done enough. And of course the RBA’s reached that point already, and the RBNZ may do the same.
You know we’ve got the same policy rate as the US, but on average over history, we have not. We’ve had much higher rates. And New Zealand and Australia do stand out in an international comparison for not having raised policy rates to anything like the level that they went to in 2008. And the reasoning is that the neutral rate is that much lower. But of course it moves and we won’t know where it is today for a couple of years. So it is a tricky one. They’re trying to engineer a soft landing through heavy fog.
Annette Beacher
Yeah, it’s an intangible concept, and yet I’ve got 50 models for portfolio construction. What’s the Westpac view? Does it feel like neutral rates are higher?
Luci Ellis
There’s an enormous omitted variable in all of the models about the so-called neutral rate. I mean the neutral rate is simply whatever level of the risk-free rate balances savings and investment globally. So, you’ve got to think about global factors, you’ve got to think about that very big sector that’s demanding or not demanding, called the fiscal position. And that’s an enormous omitted variable in all of these models. And you’ve also got to think about what’s happening to people’s perceptions of risk and risk premium. Because of course while you are measuring a risk-free rate, what is actually being arbitraged against is savings and investment where there’s a risk premium.
And so, fundamentally yes, it probably has increased.
Annette Beacher
Where do you stand at the moment? In terms of interest rates, at HESTA, we think the Fed is done, but staying higher for longer through to Q3 next year.
I’m not ruling out another rate hike at the RBA. We’ve pencilled one in for Q1 next year. I do think wages and inflation is suitably sticky.
Is the RBNZ done Sharon, but high for longer? What about cuts? Where are they coming in?
Sharon Zollner
The market is very keen to know when they’re going to be cutting. I think Reserve Bank’s probably going to push back quite aggressively against that, because they’re already worried about the housing market with the very strong migration and potentially some policy changes coming. The new government, they’re friendly to investors, so the last thing they’ll want to see is fixed mortgage rates really tanking.
I think calling a pause back in May, was quite a stimulatory thing to do, because if perception of interest rates risk suddenly plunges, and if people start to think that cuts are on the way, then that would actually be quite stimulatory I think.
But they could push out the cuts in their forecast, but they’ve already got them in early 2025.
Annette Beacher
Yeah, because markets need to price themselves, I mean, don’t they Sal? Where do you see it on the spectrum?
Sally Auld
Yeah, so I think in the US, the Feds is in a nice spot at the moment, so relative to its forecasts that are put out in September, unemployment is actually a bit higher than where they thought it was probably going to be by the end of the year, and inflation has done a bit better. So, there’s no real impetus I think for them to do anything for the next quarter at least. I suspect there’s a good chance that they’re done, and they’d be encouraged by some signs of cooling in the labor market. I don’t think they’ll cut as early as the market has priced in.Mid year give or take.
Locally, I think the RBA probably has more to do, but it’s going to feel pretty drawn out. And I wonder we might get to the end of it, and the lesson we might’ve learned might’ve been, if you’ve got an inflation problem, just get on with it. And just do what the Kiwis did and the Fed did, which was just to execute a whole lot of hikes over a reasonably short period, rather than dragging things out and playing this game of fine-tuning or calibrating monetary policy.
And I worry a bit, like you, that there’s a stickiness in wages and inflation that could prove a bit challenging for us.
Emily Dabbs
I think one more hike definitely. And I think that point you made though Sally, about the difference between Australia, and New Zealand is really important. Lots of people, when we’re talking, particularly in the consumer space, about interest rate hikes and the impact on mortgages and serviceability and household finances, is problematic. But there’s also the impact of higher inflation as well, higher for longer.
And so, the way up between hikes and this soft landing versus the potential risk that inflation is stickier for longer because we haven’t gone harder, I think is a real challenge for the RBA. And that’s one where you see households who aren’t mortgage holders under this inflationary cost of living pressure, that probably aren’t in love with the RBA right now.
But it’s a challenging line and we think that at least one more hike probably early next year. We think that there’s enough there to say they should do it, but they’ll probably wait until early next year.
Luci Ellis
Well, I think firstly we need to make the distinction between what they should do and what they will do.
And the way we’re seeing it at the moment is if things from here turn out broadly as they expect, if inflation continues, if inflation does start coming down on the trajectory they’re wanting, well then they’re done. But if they continue to be surprised on the upside by inflation risks, deep inflation outcomes, then February’s live and they will probably have more to do. But we really need to see that run of inflation numbers to know how they’re going to respond.
The thing I worry about in the inflation trajectory is that prices just aren’t rolling over in the way you see. Where prices should be falling, given what’s happened in global pricing, you’re not yet seeing that in Australia. And why that’s been slower to come down is the thing I’m quite focused on.
Audience questions: “To what extent will a Federal and State pull back in infrastructure spending, lead to quelling demand and therefore inflation?”
Emily Dabbs
We do a lot in the construction space in our business here in Australia, and the infrastructure pipeline is something we have been calling out for a long time. And we actually forecast the amount of work done on these infrastructure programs, and have had our forecast well below the announced amounts for about a good nine months now. Just the capacity within the sector to deliver is just not there.
Even with the recent announcements, I think it 55 projects were called, there was a redistribution of money. Ultimately, we’re still seeing a lot of pressure on the construction sector. And it’s at a time when, at the moment the housing construction sector is quite weak, that tends to happen when you’ve got a downturn, but we know that there needs to be demand there, that there needs to be additional supply there. But when you’ve got such cost pressures for materials and wages, because there’s so much tightness in that sector, it’s really hard to make those add up.
I think it’s one of the factors that, when we’re talking about immigration and other things around inflationary pressures, the construction infrastructure pipeline often gets left out. And it’s something that while it may not be as front of mind and as clear on rental prices, et cetera, it definitely puts a lot of upward pressure on costs more broadly. And it’s something where we think there still is a significant pressure there and will be for a number of years to come.
I don’t think you can sustainably dial down infrastructure spend when population growth is 2% or whatever the magic number is over the long run, without investing or expanding the fixed capital stock by the same amount, otherwise you end up with bottlenecks and inflationary pressures.
So, it’s something we have to do. And I guess what the government is understanding, and what Emily alluded to, is that maybe that process needs to be a little bit more coordinated and managed, so you can manage through some of the supply constraints with goods and also skilled labor constraints as well. But if one of the things that we are striving for as an economy is to lift productivity, then infrastructure is a big part of that. So not something that we can forego.
