Tim Tooheyt

The RBA clearly wrong-footed financial markets and economists yesterday by electing to keep interest rates unchanged. Only five of the 32 people surveyed by Bloomberg expected the RBA to remain on hold, and financial markets yesterday were 100% priced for a 25 bps reduction.​

This is one of the strangest decisions that the RBA has made in the inflation targeting era. As a reminder, the Australian economy expanded just 1.3% (y/y), remains mired in a per capita recession, and the latest inflation data suggests headline inflation of just 2.1% (y/y) over the year to May and trimmed mean inflation of 2.7% (y/y) – well within the target band of 2-3%. Moreover, there are few signs that the prior 50 bps of easing has created anything other than a tepid response (see Chart 1).

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The RBA decided to make itself the story today. In recent years the RBA decided that a measure of its own success is how well it had communicated its intention to the financial markets, firms and households so as to avoid shocks in expectations. Yet despite overwhelming expectations for an easing and economic data that had continued to undershoot modest expectations, the RBA did not roll back market expectations in any meaningful way in the days leading into the decision.

One can only assume that the RBA chose to remain on hold due to an easing in financial conditions, principally due to the strong rebound in equities and narrowing credit spreads (see Chart 2), and fears that back-to-back rate hikes may ignite the housing market. Of course, the RBA has rolled out the excuse of wanting to wait for further information amid high levels of global uncertainty, however, if anything there is currently greater certainty on geopolitical events than at any time since early April.

It is of note that the vote was far from unanimous. Six of nine voted for the decision, suggesting that three members of the Board likely voted to ease rates yesterday.

If this is merely a tactical pause in an effort to induce a slower cadence of easing to contain asset price growth but ultimately no change in the final destination for rates then today’s pause is small beer, as the easing cycle remains on track albeit just a bit more elongated. However, if this is a sign that the RBA is so unsure of its path that it cannot agree on the strategy to return real interest rate settings towards ‘neutral’ then Australia’s private sector will remain locked in its growth paralysis for longer.

From our perspective the RBA gains little by pausing for a month and has clearly failed in communicating with stakeholders its intentions ahead of time. The Governor suggests that post the RBA reforms it can no longer pre-empt the Board’s decision and seek to guide expectations in the intermeeting period. This is of course a retrograde step, which was one of the criticisms we levelled at the suggested reforms, but it is also nonsense to suggest that in a situation where the market is treating a prospective RBA decision as a certainty and the RBA Board members preference is to pause, that the RBA cannot convey that uncertainty in a timely manner. While the RBA may prefer to say it has retained optionality, yesterday’s decision looks more like an own goal. The RBA has merely allowed real interest rates to drift higher at a time of faltering economic growth and contained inflation risks.

We expect the RBA will ease in August and November in 2025, and we have added a further cut in November 2026, retaining our 2.6% terminal cash rate forecast for this cycle.

By Tim Toohey, Head of Macro and Strategy

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Katie Hudson

The key point is that while we had been expecting a drawdown in equity markets in Q3 and a decent rally in bonds, this was expedited by the US labour market triggering the Sahm rule and a poor ISM report.

While it’s hard to argue too much that the risk of recession in the US hasn’t risen somewhat – let’s call it to ~30% probability – it is not our base case and the key difference is that some of the key aspects that generate recession outcomes are not currently evident, in particular:​

1. Clear policy error: While I was surprised that Fed market pricing for a cut wasn’t higher for July, it’s likely that the Fed will be doing 50bp moves in Sep and Dec (US election may see a skip for the Nov meeting). The Fed has done a pretty reasonable job faced with the information they had available to hand.  It’s clear they discussed easing in July and no doubt they sense a greater degree of urgency to act now to forestall a larger-than-desired easing of the labour market. As such, there is no clear policy error at this point that could lead to non-linear outcomes.
2. A breakdown in credit provision: Credit was already tight heading into this market correction if you use the Fed’s Loan Officers Survey as a guide. There are risks that a financial institution of size gets into trouble as the carry trade unwinds, but at this point there is no evidence that a systemic threat to markets has been breached.
3. Expectation shocks: This is the main mechanism that turns economic downswings into recessionary shocks. It’s important to note that the economic cycle was not coming in ‘hot’ to this event with high levels of enthusiasm and optimism. Instead, business and consumer sentiment are closer to their cyclical lows than highs, and prior strength in US economic growth was more sourced from fiscal stimulus rather than excess private demand growth. That is, an abrupt expectation shock in the private sector is less likely and, as such, a sharp retracement in activity growth is also less likely.

Of course, the starting point mattered.  Equity markets had run ahead of the economic dataflow and the shift in the policy framework in Japan that prompted an unwind of Yen-financed carry trades has also been important in driving this correction.  While it’s relatively easy to calibrate how much the market would need to adjust for the first of these factors, having any reasonable accurate gauge on the second of these factors is difficult.  The movement in $/Yen suggests a further unwind is still likely in the carry trade, but as volatility settles back down you cannot rule out the reestablishment of some of these trades.

Has the correction finished yet? Well, we are closer to some technicals which will entice some buying, but the reality is that the macro landscape will still determine where the market lands in coming weeks.  From our perspective, the US labour market is in a trend deterioration until late 2024 and this will be the rate determining step for risk markets.  Until some lead indicators of the US labour market stabilise, it’s likely that risk assets will have trouble sustaining gains.​

The good news is that we are about 50% through the adjustment in equity markets and that concerns over excess inflation can now be relegated to history.  Rate cuts are clearly coming in size, and once the early signs appear that the easing is having its desired impact and the US election outcome is known, it’s likely that equity markets will be more focused on economic recovery than recession.

​Comments By Tim Toohey, Head of Macro and Strategy

The market sell-off has been largely indiscriminate with little dispersion between sectors and stocks to date. Against that backdrop, we believe there are attractive opportunities to differentiate on fundamentals and take advantage of attractive opportunities.

In particular, we are seeing opportunities to build holdings in the small cap space across the following:

• Well-placed REITs which are trading at significant discounts to asset backing, despite valuations stabilising, and in some cases once again expanding.
• Industrial companies with good business models and strong management teams which have been sold off on cyclical concern.
• High-quality growth companies where valuation support is improving, albeit we are being more price sensitive in this area given the elevated starting point for valuations.

We will continue to exploit the volatility by focusing on the long-term fundamentals.

​Comments By Katie Hudson, Head of Australian Equities Research

The post Why Yarra is not calling a US recession yet appeared first on AdviserVoice.

Rhys Corry will join Yarra as an Investment Manager in the Fixed Income team, and Joshua Ginges will join as an Analyst in the Yarra Australian Equities team.

Rhys has over seven years of experience working in debt capital markets. He joins Yarra from S&P, where he is currently an Associate responsible for a portfolio of Australian and NZ corporate issuers spanning mining, real estate, healthcare and media & entertainment. Rhys will be based in Melbourne, commencing in January 2022.

Yarra also welcomes Joshua Ginges as an Analyst in the Australian Equities team based in Sydney, working with Joel Fleming, Portfolio Manager of Yarra’s Microcaps Strategy. He joins from Minchin Moore Private Wealth, where he is an Associate Portfolio Manager.

Yarra is also pleased to announce two promotions within its Fixed Income investment team.

Chris Rands has been promoted to Deputy Portfolio Manager of Yarra’s Enhanced Income Strategy. Chris has over nine years of experience in fixed income and works with the team on the strategic direction and portfolio positioning for the Australian Bond Fund strategy. Chris will work closely with Roy Keenan, Co-Head of Australian Fixed Income, as the team continues to grow its footprint and clients in Australia and Japan.

Phil Strano has been promoted to Deputy Portfolio Manager for Yarra’s RMBS and LBO strategies. Phil’s deep experience in all major credit segments ensures he’s well placed to support Yarra’s Senior Portfolio Managers John Sorrell and Leo Leslie to further build out both strategies. Phil has over 20 years’ experience managing portfolios as a credit specialist with a deep understanding of the fixed income landscape.

The Yarra Australian Bond, Absolute Credit and Income Plus strategies are unchanged and will continue to be led by Portfolio Managers Darren Langer and Chris Rands (Yarra Australian Bond), Phil Strano (Yarra Absolute Credit), and Roy Keenan and Tim Toohey (Yarra Income Plus).

Edward Eason, Managing Director of Yarra Capital Management, commented: “We are delighted to welcome new team members Rhys and Joshua as we continue to grow the Firm’s Fixed Income and Australian microcap equity strategies. They are standout hires and we’re excited to welcome them into Yarra for a big year ahead.

“We are similarly delighted to announce Chris and Phil’s promotions in recognition of their consistent high performance, growth and development. They are both extremely capable portfolio managers, and these expanded roles confirm the quality, depth and breadth of Yarra’s Fixed Income team.”

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Tim Toohey

In an apparent suspension of collective logic, it appears few people have asked what happens when you provide massive incentives to bring forward an unprecedented spike in house construction while simultaneously choking off future demand by halting net migration.

Away from the fog of COVID, any reasonable minded person would have concluded that unless the starting position was a massive undersupply of housing, then this combination of policy settings would soon generate a large excess of housing. In this note we summarise how large this excess in housing is likely to be and the investment conclusions.

What happens when a Government program is too successful in inducing supply?

The Homebuilder program, in concert with generous incentives from State governments and mortgage rate reductions, has proven successful in bringing forward construction. But have they been too successful?

Recall that upon the introduction of the Homebuilder scheme, the Treasury estimated that COVID-19 would see cancellations of housing projects of ~30%, compared with ~17% during the Global Financial Crisis. This reduced the Treasury’s pre-COVID housing starts estimate of 171k to just 111k. The HomeBuilder scheme was explicitly designed to offset half of the expected decline in starts, with the aim of backfilling 30k starts in 2020-21. That is, the Treasury was hoping to achieve ~140k housing starts once HomeBuilder was fully implemented.

Instead, approvals for houses have exploded to the upside. By the March quarter of 2021 dwelling approvals were annualising at 278k (refer Chart 1), and even though approvals have declined from that peak, by the end of the 2020-21 financial year some 200.4k dwelling were approved. Single home approvals were even more spectacular, with a record 136.6k approved during the year, to be 31% above the prior financial year. Of course, this also excludes the surge in approvals for renovations over the same period.

In the end, 99.3k Homebuilder applications were received by the Government to build a new home and a further 22.1k applications were received for a ‘substantial renovation’. Which means the HomeBuilder program exceeded Treasury’s objectives for new dwelling construction by 330%. The clear lesson being never stand between an Australian household and an uncapped government program! Taxpayers have effectively handed out almost $3bn in ‘free money’ to people to build or renovate their home.

Such Federal government largess was obviously well received. However, what is less well understood is that State Governments were also busily providing their own incentives, especially via stamp duty exemptions for first home buyers. These incentives varied by state and in many instances were in place prior to JobKeeper. To put the incentives in context, we have created separate housing affordability indices for established and first home buyers. This captures all the incentives and taxes by State and Federally in addition to all the standard factors that influence affordability – house prices, mortgage rates, loan to deposit ratio and household income.

Chart 2 shows the enormous boost to housing affordability for first home buyers that was provided principally by shifting government incentives. The subsequent decline in affordability is mostly due to the lapsing of the Homebuilder incentive, although 15%yoy growth in house prices by mid-2021 has also weighed heavily on affordability.

These seismic shifts in housing affordability ultimately determines the near term path of housing approvals. But it is important to recognise that the incentives and inducements do not create new demand for housing. Rather they merely bring forward housing construction that would otherwise have been demanded at a later stage. The bigger the pull forward, the bigger the decline once affordability declines back to its pre-incentive levels.

What happens when a pandemic eradicates future demand?

But what if you not only provide massive incentives to pull forward the supply of new houses, but also simultaneously eradicate one-third of future demand for housing?

Housing can only be demanded by those who have placed themselves in a situation to form a household. We spend a lot of time modelling the demographic structure of the population in Australia and how that relates to future housing demand. It’s a relatively complex process that incorporates factors as diverse as; the relationship type and number of dependants of each household, the type of structural dwelling, the vacancy rate of established dwellings, demolitions, and trends towards second or lifestyle homes.

The census data is an important input for the historical analysis, however, the forward projections rely heavily upon the accuracy of the ABS’s population projections. Although the ABS provides three main scenarios for future population growth, their projections have been rendered useless by the de facto ban on net migration from travel restrictions. As such, we have recast the population projections by looking at the age characteristics of migrants and assumed that net migration doesn’t return to pre-COVID type levels until 2023.

By modelling the future supply of new housing as a function of the change in affordability and comparing that demographic demand for housing adjusted for the unprecedented reduction in net migration, we can solve for the likely future oversupply of Australian houses. We define ‘market balance’ for housing as the most recent year that demographic demand and completions were equal in number. As such the accumulation of the difference between demographic demand for housing and completions of housing from the year of market balance determines the excess or undersupply of housing through time.

We estimate that by the end of 2023 Australia will have 150k dwellings in excess of demographic demand (refer Chart 3). This would be the largest excess of housing since 2008, and this rather sombre forecast embeds as a base case of a 30% decline in dwelling approvals by the end of 2022.

What happens to the excess of established homes if the immigration recovery is delayed or if building approvals remain elevated?

What if housing approvals don’t fall as sharply as our base case? Demand for housing is ultimately determined by demographic demand, but participants in the housing market typically operate with a more limited information set. And what happens if Australians become so enamoured with recent house price gains that Australia continues to build at an excess rate?

If we assume only a 10% decline in approvals is recorded by the end of 2022, then the excess of housing will equal the peak excess of 2006 (refer Chart 4) which on our calculations was greatest excess of housing since our calculations commenced in 1976.

Alternatively, what happens if net migration doesn’t bounce back to 200k by 2023? How would that affect the base case?  If we assume net migration of +20,000 in 2021 and +75,000 in 2022 (instead of +200,000 under our base case) the oversupply of housing will increase from 150k to some 200k by the end of 2023 (refer Chart 5).

What are the investment conclusions?

Just under 70% of all households either own their own home outright or are in the process of paying off a mortgage. Housing remains the largest financial asset that most households own and we estimate that by mid-2021 the value of the housing stock is $8.9 trillion – 3.7 times the market capitalisation of the ASX200 and 4.5 times the size of the Australian economy. Clearly, such large and valuable asset should be managed with care.

Moving into a large oversupply of housing does not necessarily mean that house prices are at risk of significant decline. The prime example is that the peak excess of housing in 2006 did not unleash a sharp fall in prices. Price growth did slow significantly during the 2003-06 period, but two important things happened that avoided the housing excess translate into falling prices.

Firstly, the combination of stronger household formation rates of the local population and a mining-related boom in immigration transformed the demographic demand for housing. In the 10 years to 1996, we estimate the demand for housing averaged 140k per year. In the 10 years to 2006, housing demand had slipped to just 118k per year. However, in the period since 2007 Australia’s annual housing demand has averaged 199k, with a large step change occurring in 2006 due to more Australians moving into key household formation age brackets and the surge in net migration associated with the mining boom. This step change was crucial in gradually absorbing the excess of housing that had previously accumulated.

Secondly, the Global Financial Crisis and the subsequent slow economic recovery saw the RBA cash rate decline from 7.25% in August 2008 to 0.75% pre-COVID and just 0.10% post-COVID. Capitalising low interest rates into house prices has become something of a national sport ever since.

The problem facing Australia today is two-fold: (i) interest rates are today at the lower bound, and (ii) housing demand is now hostage to the evolution of the pandemic and how fast we choose to ramp up immigration in the post-vaccination phase. Quite simply, the RBA cannot cut any further and politicians may be reluctant to open up immigration from low-vaccinated countries.

In our view, repeating the good fortune of the post-2006 period seems highly unlikely. Contrary to the current fervour of house buying, the risk of lower house prices over the next two years is at least as high as further house price increases. As in most financial markets confidence is always highest at the peak in prices. We are not using this analysis of excess housing to suggest a sharp decline in house prices is imminent. Indeed, low real mortgage rates may sustain prices at elevated levels. Rather, we are suggesting that expectations of ongoing house price gains over the next two years may be disappointed and more importantly the boom in new single house construction will be followed by a deep downturn.

The first investment conclusion is that Banks should be thinking in terms of building provisions against the risk of weaker prices, rather than continuing to release provisions as seen over the past 12 months.  The failure to do so may risk P/E multiples de-rating once the oversupply of housing becomes clear to financial markets. Clearly, bank average LVRs and bad debts are low by historical comparison, providing ample protection against any house price declines. Nevertheless, the boom in new borrowers for single homes on the periphery of the major cities are yet to build equity in their home and are more vulnerable to any decline in house prices.

The second investment conclusion is that there is really only one way to avoid a large oversupply of housing, and that is to stop building so many of them. Our base case has a significantly larger decline embedded than the consensus view and is well below that of the RBA which is currently forecasting of dwelling investment declining just 0.5% in 2022, before rising again.

Ultimately, it is on this point where we disagree the most. As stated above, you can’t create new housing demand, you can merely alter the timing of when that demand is realised. No more rate cuts, lapsing of incentives and damaged affordability via recent price spikes will see dwelling approvals fall sharply, particularly single home approvals.

The only way Australia avoids a significant excess of housing by 2023 is if approvals fall far more than anyone expects. With full knowledge that building material company earnings will remain robust as the backlog of homes and renovations to be built remains large, it is the trajectory of housing approvals that has historically governed the share prices of these companies. It has been a great ride up for the building material companies, but we are past the peak, and the outlook today looks increasingly gloomy.

The final investment conclusion is that the RBA will not be tempted to raise interest rates while the housing construction sector – the most interest rate sensitive sector in the Australian economy – transitions from boom to bust. The RBA will only be tempted to commence the rate hiking cycle once inflation has been at target for at least six months, wages are approaching 3% growth, net migration is firmly on the path to recovery and the housing approvals downcycle is complete. These criteria are highly unlikely to be achieved prior to 1H23, so regardless of what other central banks do in the interim the RBA’s record low interest rate setting is set to remain for a long time yet.

By Tim Toohey, Head of Macro and Strategy

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Tim Tooheyt

By now most investors are tiring of their inboxes being filled by sell-side economists and strategists talking about reflation, how much more optimistic they are relative to consensus, and for how much longer the reflation trade will persist.

To be clear, there were very few people talking about a strong V-shaped recovery this time last year. Indeed, a scan of the forecasts of leading sell side economists in April 2020 shows consensus* forecasts of 3% for the CY21 for Australia and 3.8% for the USA.

Indeed, peak pessimism was not reached until September 2020, when economic growth downgrades ceased and modest upgrades commenced. Currently, consensus for CY21 has risen to 5.7% in the USA and 4.4% for Australia.

By contrast, our forecasts for the US in 2021 – which we published in mid-April 2020^[1] – was 6.5% (represented by the cross in Chart 1). For Australia (Chart 2) we were even more optimistic, forecasting 7.0% economic growth. As we moved through 2020, it was clear the expected contraction in economic growth in 2020 was going to be less than expected and hence we reduced our forecast rebound in Australia’s economic growth in 2021 to a still sizeable 6.0%.

Much of our more upbeat analysis was based on: (i) the nature of the shock being more akin to a natural disaster; (ii) the quantum of the fiscal packages; (iii) excess credit growth; (iv) the outlook for vaccine development; (v) and the prospect of pent up demand.

One year on, the clambering to upgrade growth estimates has only intensified. Over the past two months, consensus forecasts for Australian economic growth in 2021 have been upgraded a further 0.7%. In the USA the revision over the past 2 months is a remarkable 1.6%.

In other words, consensus economic growth forecasts are now more realistic, but the upward revisions are not yet complete and there is still scope for consensus to upgrade economic growth further in coming months to nearer our long held forecasts.

Indeed, when we compare our forecasts for economic growth to consensus there are now examples of economic growth forecasts for the US that exceed our forecast. The most notable is the Bank of Canada’s recent upgrade of 2021 US economic growth from 5.0% to 7.0%. Given the US is Canada’s largest trading partner, the Bank of Canada has a strong incentive to get its US outlook near the mark! The Bank of Canada also lifted its global growth forecast in 2021 to 6.8%, which is 1.25% higher than any global growth year since IMF data commenced (1980) and 0.8% above the IMF’s April forecasts!

However, one of the largest gaps between consensus and our own 2021 forecasts is for Australia. We remain 1.5% above the consensus forecast and around 1% above the most optimistic forecaster. Given there remains an appreciable gap between our forecasts and other forecasters, it’s reasonable to ask what supports our optimism?

1. Australia’s data continues to consistently beat economic forecasters

Charts 3 and 4 show our calculation of economic data surprises for economic activity and inflation relative to consensus forecasts (US vs Australia). A positive reading represents economic data beating consensus expectations weighted by data importance and time decay. Clearly, Australia’s economic activity data is not only continuing to beat increasingly upbeat economic forecasts, the positive data surprises are larger in Australia.

2. Real economic growth is expanding at pace

Secondly, our nowcasting techniques (Chart 5) for gauging in real-time how fast the economy is expanding already suggest that real economic growth is expanding at 4%yoy by the end of 1Q2021. That is, we are about to see a very solid1Q GDP print for Australia that we expect will be the catalyst for a further upgrade of the consensus view.^[2]

3. Treasury’s projections have been comfortably exceeded

Much stronger economic growth, much lower unemployment and much stronger commodity prices have combined to already deliver a $23bn better fiscal outcome relative to Treasury’s December projections and closer to a $50bn saving over the next 4 years. The question for Q2 is how much more of an “economic surprise” dividend will likely flow through the Budget and what will the Government do with it?

In simple terms, we believe the Treasury’s growth figures are 0.5% too low for 2020-21 and 1.25% too low for 2021-22. The unemployment rate is likely too high by as much as 2%. And an iron ore assumption of $55/t embedded in the Budget is currently 1/3rd of the current iron ore price. Clearly there are further major revenue upgrades to come.

Our take is that the May Budget will be used mainly to evidence the vastly better Budget and economic outcomes that have been achieved. We expect the true election Budget will come in late 2021 (i.e. mid-year Budget), with more strategic spending and tax changes announced to setup a May 2022 Election.

This strategy allows plenty of time for the Coalition to address its problems in WA, QLD and metro Melbourne, where no doubt most of the Budget windfall will be redirected through 2H21. The combination of the Coalition’s political challenges and the Budget’s economic windfalls will likely spark additional fiscal spending later in 2021, sufficient to bolster economic growth expectations.

Mid-2021 will likely mark the peak of global business sentiment surveys and global economic data surprises. It will also mark the final phase of economic growth upgrades. Nevertheless, we believe there is more oxygen in Australia’s economic recovery and that consensus has long been too slow to recognise the domestic economy’s capacity to expand at close to 6% through 2021. Indeed, we believe there is a high likelihood that the RBA will use the May Statement of Monetary Policy as a platform for a significant upgrade in economic growth forecasts, in a similar vein to the Bank of Canada’s recent upgrade.

While this will set off expectations of a higher cash rate ahead of the RBA’s 2024 guidance, the RBA can be expected to attempt to allay those fears by making the case that inflation expectations and wage growth remains too low to be consistent with their inflation objective. Nevertheless, the likely RBA growth upgrades will almost certainly end the prospect of the RBA rolling the 3-year bond beyond the April 2024 target. Together with the end of the Term Funding Facility in mid-2021 the reality is that a very modest tightening cycle is already commencing.

By Tim Toohey, Head of Macro and Strategy

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[1] https://www.yarracm.com/covid-19-top-5-questions-for-australia/
[2] Our nowcasting methodology is to estimate real time economic growth via both dynamic factor models and principal component models for each of the major economies to provide an alternative underlying picture of economic growth to the often noisier official GDP data.

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