Outlook Q3 2024 & Quarterly review

Slowing to a crawl

The Reserve Bank of Australia (RBA) kept the official cash rate unchanged for the seventh straight month in June and signalled that it was more at risk of rising than falling. The persistence of inflation continues to be a major headache for the RBA with the pace of the decline in inflation stalling in recent months. If rate hikes are indeed on the horizon, the RBA needs a trigger and that would be a high June quarter CPI (due on July 31). The RBA Board next meets on August 5-6, so they have the luxury of time.Overseas, the Fed are yet to commence their easing cycle but the Bank of Canada and ECB have recently cut rates with inflation now back inside their respective target bands.

The RBA took a more hawkish turn at the June Board Meeting but this arguably just reverses the ill-timed dovish pivot they adopted in Q1. Net-net it seems we are now at a ‘neutral’ stance with the recent RBA messaging more an attempt at jawboning consumers and the market. The RBA believes economic risks are evenly balanced, however, there are some hawkish elements such as the positive revisions to household spending and the ongoing upside risks to services inflation. This points to an expected strengthening of the economy into H2 24.

As mentioned above, while the Q2 CPI release could open the door to a RBA rate hike, the trajectory of inflation readings into late 2024 remains interesting. Looking ahead to the Q3 CPI release (30 October) government rebates will subtract sharply from headline CPI. As the prior year’s subsidies unwind, they are more than offset by the new state and federal subsidies. There is an approximate 0.5% subtraction off headline inflation which likely means CPI will end 2024 back in the RBA’s 2-3% target band. However, as the temporary effects of the subsidies roll off in 2025, and assuming they aren’t extended again, the headline CPI will likely rise back above 3% in 2025. Governor Bullock's recent observation that “a lot needs to go our way if we want to get inflation back to the target” might not be as difficult as it first sounds.

Although GDP growth will remain below trend through H2 24 a pick-up is expected from the current 1.1% p.a. pace. Stage 3 tax cuts and cost of living relief measures will add about 1% of GDP through 24/25. An expected uptick in consumer spending, along with expected solid growth in public final demand and business investment should see a modest increase in growth in H2 24. Governor Bullock noted at the June meeting the RBA staff would provide refreshed forecasts in August.

The labour market is also showing signs of weakness, but it remains tighter than is consistent with sustained full -employment and inflation at target. However, there is some optimism with softer hours worked and job vacancies declining. The latest data on wages growth was also positive being described by the RBA as “slower-than-expected”. Consumer sentiment remains 'exceptionally weak'. Personal and investor housing credit growth remains sluggish.

We are still of the view the RBA will hold the cash rate at the current level for an extended period. Their commentary is consistent with a preference to remain on hold if possible, but allow for some near-term tightening risk given lack of progress towards their inflation target. While financial conditions in Australia are thought be restrictive enough for households, the RBA is sounding a lot more cautious and less patient now, noting "the narrow path is getting narrower" and that "a lot needs to go our way [to prevent the cash rate from increasing again]”. The key takeaways heading H2 24 are that the official cash rate is not going down anytime soon and when the easing cycle commences it will be gradual and shallow.

Macro backdrop is still conducive for high quality fixed income

Credit continued to perform well through Q2 as the high demand for credit assets was met with a wall of supply from issuers more than willing to sell debt at tight spreads and in large volume. The underlying theme of investors’ chasing relatively high outright yields persisted. The primary volumes in the local fixed income market are running well ahead of last year’s run-rate which has led to noticeable improvements in secondary liquidity.

The macro backdrop is still conducive for high quality fixed income – government bonds and investment grade credit. Bonds usually exhibit relatively strong total returns in the lead up to, and immediately after, central banks commence cutting rates. This is the benefit of owning duration in a portfolio as that is where most of the return is generated from. As we see in the current environment, spreads have largely done their work by contracting to tight levels vs government bonds, hence the contribution from spreads will be much lower as we move forward.

We expect Australian credit spreads to remain largely range bound over the next 3 months. We have already started to see some signs of de-risking, or trimming, by investors’ who have clearly been overweight credit during H1 24 and this has seen spreads drift a little wider. We expect the economy to hold up reasonably well and there to be little downwards rating pressure in the near term. Investors can continue to pick up carry in a relatively benign macro-outlook with a soft landing being the baseline case.

In terms of risks to credit the obvious concerns are geopolitical risk and increasingly election risks. The recent snap parliamentary election in France hit risk sentiment hard and the US election is drawing ever closer.

AUD remains sensitive to risk-off events

The AUD was marginally firmer through Q2 spending the majority of the quarter in a US$0.66-0.67 cent range. With the RBA adopting a more hawkish and determined posture, the AUD should find a fairly supportive interest rate backdrop. In contrast, US Fed Chair Powell appears to have an asymmetric easing bias, declining to entertain rate hikes and repeatedly emphasizing the need for more time. Given the potential paths for the Australian and US cash rates, i.e. a narrowing, the AUD should increasingly find a more durable downside floor.

Iron ore prices have steadied to around US$100-110/t, however, China's economic recovery remains unbalanced, with steel mills and the property sector still struggling. The AUD remains sensitive to risk-off events like increasing US bond supply and weak Treasury auctions (and higher yields) sapping the AUD's bullish momentum. Pullbacks appear to be well supported around US$0.6480 level. Global geopolitical risks are clearly heading in the wrong direction which is a reason to be somewhat cautious on the AUD.

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