Stephen Miller

The December quarter wage price index (WPI) was pretty much on Reserve Bank of Australia (RBA) and market expectations, with the private sector WPI coming in at 0.7 per cent for the quarter for an annual increase of 2.4 per cent.

Taken at face value, such an outcome should ease some of the pressure on the RBA that has been implied by market pricing which had been indicating an increase in the policy rate a move mid-year and as much as five 25bp increases by year-end.

Some wage pressure evident and RBA forecasts still rooted in the downside end of the inflation risk continuum

However, there are some indications in yesterday’s release that suggest labour market pressures were intensifying as 2021 came to an end. For example, the private sector WPI that includes bonuses showed annual growth of 3.0 per cent – the highest rate of annual increase in 8 years.

Curiously, in my view, the RBA focuses on the ex-bonus measure of the WPI. Measures that include bonuses are likely to be more obviously pro-cyclical and more indicative of inflation currents than measures that exclude them. Measures that exclude bonus or incentive payments are likely to be more subject to the “wage inertia” features (both upwards and downwards) that RBA Governor Philip Lowe has previously referenced.

My own view is that the RBA forecasts are firmly rooted in the downside end of the inflation risk continuum and, as such, a policy rate rise around mid-year is tenable. A clear acceleration in the March quarter WPI released on 18 May would further enhance that prospect, particularly if it follows another upward surprise in the consumer price index (CPI) to be released on 27 April. Both of those outcomes are in my view firmly still within the realm of the probable and an increase in the policy rate therefore in the realm of the possible.

The unemployment rate in January was almost as low as it has been at any time since the mid-1970s, validating anecdotes of a very tight labour market. And as mentioned, the forward indicators of the labour market remain strong. Accelerating wages can’t be far away if they are not already here.

RBNZ raises the policy rate for the third time this cycle. Foreshadows higher terminal rate; balance sheet reduction commencing in July

Proving itself among the more aggressive of central banks in meeting the current inflation challenge faced by all developed countries, the Reserve Bank of New Zealand (RBNZ) raised the policy rate by 25bps to 1 per cent. Such a rise represents the third policy rate increase this cycle and the third in as many meetings.

As if to emphasise its aggressive credentials the RBNZ released projections showing the cash rate rising to 2.5 per cent over the next 12 months and peaking at about 3.25 per cent at the end of 2023.

In November, the bank forecast a peak of about 2.5 per cent. It further stated that policy makers considered whether to lift the official cash rate (OCR) by 50 bps, describing the decision to opt for 25bp as “finely balanced” and further stated that the committee is “willing to move the OCR in larger increments if required over coming quarters.”

The RBNZ also announced that it will start to reduce its balance sheet foreshadowing that from July it will commence a gradual reduction of the bonds purchased under its Large-Scale Asset Purchase (LSAP) program. That process will take place via bond maturities and “managed” sales.

Limited portents for the RBA

The portents for the RBA are limited to say the least. Whereas the RBNZ has been at the forefront of the retreat from the historically high levels of monetary accommodation applied by central banks in the wake of COVID, the RBA has been among the most determinedly laggard.

To a large extent this is understandable: New Zealand has much more of a clear and present problem with inflation (a headline rate of 5.9 per cent versus 3.5 per cent in Australia) and has what looks to be a tighter labour market (an unemployment rate of 3.2 per cent versus 4.2 per cent in Australia).

However, as outlined above in the discussion of the WPI, it is still tenable that the RBA come around to an increase in the policy rate around mid-year.

Russia/Ukraine

Clearly Russia / Ukraine tensions remain an intense focus for markets leading to episodic bouts of risk aversion. This has been most manifest in struggling equity markets. Perhaps what is a little different in the current environment is that developed sovereign bonds are not as effective a ‘safe harbour’ asset.

For one thing persistent inflation undermines their attractiveness as a ‘safe’ asset in the current environment and therefore their long assumed quality of a good diversifier for ‘riskier’ assets in a portfolio becomes questionable. Moreover, with the potential for a further escalation in energy prices and other commodity prices more broadly, as a consequence of Russian incursions into Ukraine, inflation could well become a much larger problem.

Potentially profound implications for multi-asset portfolios

If the Russia / Ukraine tensions amplify growing concerns regarding the durability of long-held assumptions regarding asset price correlation, the potential implications for multi-asset portfolio construction are quite profound.

For much of the 21st century, returns between equities and bonds have been negatively correlated. But much of this century has been dominated by the ‘Great Disinflation’.

However, in the 20th century, more often than not, equity and bond returns were positively correlated.

A sustained burst of inflation may upset that assumed recent negative correlation. As stated above, that suggests bonds become a less reliable source of diversification for ‘riskier’ portfolio assets. In the worst of worlds, bond and equity returns become positively correlated in the worst possible way – both deliver negative returns.

The Russia / Ukraine conflict intensifies the problem via the potential inflationary (‘stagflationary”?) consequences of rising energy and other commodity prices. The longer the tension exists the more intractable inflation consequences become.

Attention to portfolio diversification is paramount

In this context, investors need an enhanced focus on the first principle of investing: diversification.

A salutary take-out for investors is that the traditional 60:40 equity:bond portfolio needs re-thinking insofar as equity and bond beta are heading into a more challenging environment.

Investors need to seek sources of return uncorrelated with either equity or bond beta.

This would include long/short bond and equity funds and global macro hedge funds. It might also include exposure to commodities, perhaps via exchange-traded funds (ETFs) offering exposure to a basket of commodities. Traditionally gold has been an effective inflation hedge as well as a ‘safe’ asset during periods of heightened geo-political tension

The question marks hanging over the performance of equity and bond beta suggests that active managers (blessed with the requisite acumen) might also come into their own. Should equity beta struggle, then the potential upside of good active equity management becomes way more important.

The forgoing is not an exhortation to abandon equity and bond beta but rather to tweak the portfolio so as to add further diversification. Importantly, those uncorrelated with equity and bond beta.

By Stephen Miller, Investment strategist

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