WED 15 JUN 2022
The prevailing bias on short term interest rates ahead of the June FOMC meeting tonight clearly has a hawkish skew. Of course, only a “10 year market veteran” would be shocked at the observation by a famous bond manager that the Fed ought to hike rates by 200 basis points to 3% today. As we have often noted, the policy error was committed last year when the Fed kept conditions too loose for too long. As a result, the Fed will now be forced to hike the policy rate much faster and take the terminal rate much higher until inflation moderates in a convincing way. For this reason we do not believe that the recent price action in liquidity beneficiaries was an emotional over reaction, but warranted. The additional point to note is that the terminal rate has already increased to around 4%. Therefore, consensus beliefs are already well calibrated for an assertive policy meeting.
Switching gears, to identify the greatest vulnerability to higher interest rates, the key is to follow the leverage. An episode we have been monitoring for some time has been the household leverage in former British Colonies. Clearly that’s a function of our home bias, but the risk is also evident in Canada and elsewhere. In the developed world, Australia has extremely high household leverage. Debt to disposable income is almost double the United States and the United Kingdom.
While Australia’s debt servicing ratio has also moderated since the last crisis, it remains much higher in relative terms (chart 1). Moreover, the moderation is mostly a function of lower interest rates. Put another way, a moderate rise in interest rates of around 2.5% would take debt servicing back near peak levels.
Australia’s housing market has also experienced extraordinary gains over the past two decades. The national median house price has gained over 276% over that period, with the gains much greater in the major capital cities. On a price to rent or a price to income ratio Australian house prices are much more overvalued compared to the United States. Moreover, median house price gains have outpaced wages over the period by around 2 percentage points per annum. The good news is that Australia’s inflation is lower than the United States and the other Commonwealth countries. However, if there is a meaningful acceleration in wage growth, the Reserve Bank of Australia will be forced to hike rates. Wage growth and inflation is critical to the central bank reaction function. Note that the minimum wage was increased by 5.2% today.
As we noted recently, house prices can essentially be thought of as the price of a long-term inflation protected bond, where the yield is determined by the inflation-adjusted long term mortgage rate and the ability to service the monthly coupon payments depends on the trajectory of households’ real wages. It is also the case that housing is the business cycle in many markets. On a tactical basis, there has already been weakness in auction clearing rates in Australia (a large proportion of homes are sold via auction) which is a leading indicator of home prices (chart 2).
For equities, our sense is that the greatest near term sensitivity to higher interest rates and debt servicing is in the Australian consumer discretionary sector. While the sector is down 27% from the 2021 peak, it still trades on 26 times current earnings and clearly an elevated multiple compared to the broader market. Historically, the performance of the sector has tended to be correlated to consumer sentiment which is clearly influenced by inflation and the cost of debt (chart 3). From our perch, there is material downside risk to the sector, given the valuation starting point, if confidence, house prices and activity deteriorates further. A meaningful rise in rates could also end the secular boom in house prices and related assets.