Finding the crunch point – RBA raising rates? What? 

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In our recent communications, we have suggested that the RBA, while it can reduce interest rates and mortgage costs through 2024, could benefit significantly by following the rest of the world’s lead in reducing rates. This approach would result in a longer pause at current rate levels, particularly in the face of higher or persistent domestic inflation. 

The Markets

This week: ASX v Wall Street

FYTD: ASX v Wall Street

Significant shifts are underway in the RBA’s interest rates stance 

Recent discussions with experts indicate a potential shift in the RBA’s focus, with inflation taking precedence over household incomes or employment. While we initially harboured doubts about this possibility, we are now observing a more hawkish (higher rates) inclination in the RBA’s communications. This development demands our immediate attention and analysis.  

Raising interest rates could lead to a significant policy error, indicating a fundamental misinterpretation of the prevailing economic conditions. It’s crucial to understand that the current factors driving inflation, such as the post-COVID money growth, excessive migration, and demand surplus in key sectors, should not be linked with a segment of the domestic sector, mortgaged households, that is highly responsive to interest rates. This scenario could pose substantial risks to the economy.  

It’s crucial to understand that interest rate increases can disproportionately affect different segments of the economy. They often hurt the part of the economy that is already disadvantaged while doing little to reduce demand in the remainder.  

In a traditional economy, younger families generate demand growth and raise families, which helps to grow infrastructure and public spending. In today’s economy, they are sidelined. Instead, migration directly drives demand, putting downward pressure on wages and increasing rent and mortgage costs. The only mitigating circumstance for this generation is the degree of direct assistance that can be provided by older generations or birth circumstances. 

Meanwhile, middle-aged individuals, who were once responsible for generating the capital needed for economic investment, are no longer as crucial. Indeed, after they have paid off their household debts and nurtured their children still living at home into their late 20s, there is little left. 

Finally, older cohorts, already beneficiaries of covid money creation, are now seeing rising incomes through higher rates, the smallest tax increases, and the lowest effective inflation (based on actual purchases). 

Fiscal dominance (the need for government spending in the face of high debt) and corporation dominance (by large corporations with significant market power) prevail. Dominance refers to both the disproportionate effect and the environment in which. This creates a fabulous backdrop for equities investment, as long as we can avoid those companies that rely on traditional growth drivers such as consumer demand and low inflation. 

Higher rates: the deeper dive 

The remainder of today’s Investment Matters will highlight evidence of the pressure described above, using current economic statistics and this week’s reported company results. 

As 2024 passes, we note that the higher rates required at the beginning of this cycle are already biting hard. Without relief from interest rates or the other drivers of inflation, we will remain wary of all but the cheapest consumer-facing businesses. 

Where is the crunch in household income? 

As economic data nerds, we all have our favourite measures for evaluating the economy’s performance. Ours is real per capita household disposable income. This economy-wide measure is the total income earned by the household sector from all sources (including social security, interest, and dividends), less the amount taken in taxes and transfers, interest payments, and other levies. It even includes a measure that allows for the growth in effective income from owning your own home and allowances for its upkeep. 

The chart below outlines Australia’s weak performance (blue line) in per capita disposable income since 2016 and the rapid fall in incomes over the past two years. We have not seen such falls in Australia for more than 20 years. Given the headline fall of more than 5%, it is essential to note that many households will have experienced a much larger fall. 

Figure #: ABS Household disposable income per capita: International comparison. 

Household disposable income per capita: International comparison.  effect of interest rates can be seen, RBA

This chart clearly points to stress in the household sector.  

How is this crunch affecting consumer sentiment? 

The collapse in household economic conditions is having a fascinating impact on different generations.  

Melbourne Institute: Consumer Sentiment by Generation 

consumer sentiment movment in line with  RBA raising interest rates

Baby Boomers (1946-64) and Gen X (1965-1980) households have reported the weakest consumer sentiment results for 30 years. Consider the GFC, the covid collapse and the tumultuous period of Rudd Gillard Rudd-Abbott-Turnbull; none of these periods produced such a collapse in consumer sentiment! 

Millennials (born 1981-1996) have been perpetually happy (seemingly) for the past 20 years, as indicated by the higher dark blue line in the above chart. Since being included in the analysis in 2004, Millennial sentiment has rarely fallen below the 100 mark, the level splittingly optimism and pessimism. However, recent economic changes have finally hit Millennials’ outlook, dipping towards the 90 levels in recent years.  

Gen Z, (born 1997 -2012) who, along with the Millennials, have never experienced trying economic conditions, have consistently failed to appreciate the economic downturn.  

The following chart breaks down the overall sentiment results into their components. Millennials, who are most disadvantaged in the modern economy, have the least capacity to afford a house, and face the steepest rises in costs, are the most positive about their finances and the economy. Almost incredibly, they are also the most likely to say it’s a good time to buy a house. 

Melbourne Institute: Consumer Sentiment by components by generation 

In one simple chart, we see the divergence in the economy. Older cohorts are pessimistic but actively spending their higher incomes, middle-aged households are sad and constrained, and younger households are disadvantaged and ambivalent. 

How is the rising cost of living impacting different household types? 

Part of the explanation undoubtedly lies in the differences in the experiences of various cohorts with inflation. The chart below looks at the differences in inflation faced by different household types, especially those between employees and households outside of the working-age population. 

Figure#: Australian inflation (Living Cost Index) by various household types 

Over the past year, employees have faced 3% more inflation than average households. These are huge differences, partly driven by housing costs and partly by a range of services inflation that has been particularly hard for families to avoid. 

At the same time, employee households, often facing higher rents or mortgage costs, have also paid a record level of taxation. On the other hand, older households may have received higher income from savings and suffered less from the tax impact of bracket creep. 

The impact of interest payments and income tax is shown in the following chart. Income tax payments as a percentage of disposable income are at record highs, and interest payments are also at much higher levels. Note that net interest payments are lower than their peak. The problem, of course, is that those households that pay the most in interest are usually the ones who have the least interest! 

Interest rates. Household tax and interest payments

How has the evolving economy changed the way people live? 

Part of the success of a vibrant economy, especially one in which regulatory constraints are limited, is the capacity for an economy to adapt. We may not “like” the adaptation but adapt it will.  

Part of the adaptation in Australia has been the necessity for intergenerational transfers. While transfers may once have been a gift on your 21st birthday or day of marriage, today, the interconnectedness of finances that is now required to battle structural intergenerational inequity is vast. 

The most obvious example is the “Bank of Mum and Dad,” the assistance provided by parents in securing housing or housing finance for their children. In the 1980s, only around 15% of first-home buyers received support from their parents. Today, according to Australian Housing Monitor research, that’s leapt to a whopping 40%. 

Housing assistance isn’t just a matter of cash transfer; there is the implied subsidisation that comes from adult children living at home. The following chart clearly shows the horrific (my view) increase since 2001. How could a successful progressive economy allow circumstances in which 29.4 per cent of all adults aged between 26 and 29 need to live with their parents? 

For those without the bank of Mum and Dad, the capacity or desire to rent vs buy has become harder to defined by income. The chart below shows.  

In addition to staying at home, it is five times more likely that the highest-income earners will be renting rather than buying.  

The lack of housing affordability for society’s highest income earners began emerging in the period since 2006. 

Figure# Distributions of private renter household incomes, Australia, 1996-2021 

Adding huge migration-driven rent increases to such a wide range of households will definitely impact the economy’s spending patterns, retail sales, and service provisions. Whereas for the past 25 years, we have relied on strong spending growth from households that had high incomes but chose to rent or live at home, this is no longer guaranteed. 

Interest rates Impact on stocks and our investments? 

First Samuel‘s clients continue to avoid excessive exposure to two sectors of the economy most impacted by these trends in the short and long term. 

  • Discretionary retail 
  • Big four domestic housing-oriented banks 

The economic conditions described above are inconsistent with the most prominent Australian banks’ record share prices (on an earnings basis). We foresee weak credit growth, higher defaults, and poorly performing loans. Current share prices imply none of these outcomes are likely. 

We remain constructive on the parts of the economy that benefit from pure growth in,  

  • the sheer number of people in the country, and the infrastructure they require 
  • the total amount of spending, especially in insurance and supermarkets,  
  • the amount of people required to fix and maintain public investment and service provision. 
  • the provision of products required for and completion of the energy transition – whose cost will likely vary little regardless of household income 

The information in this article is of a general nature and does not take into consideration your personal objectives, financial situation or needs. Before acting on any of this information, you should consider whether it is appropriate for your personal circumstances and seek personal financial advice.

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