Read the previous week’s Investment matters.
Background
On Wednesday, the ABS released an estimate for the Q2 Consumer Price Index (CPI).
There was significant trepidation around the CPI print for three reasons.
- The RBA has expressed concern that inflation is not falling fast enough, and the probability of an increase in official interest rates in early August is rising
- At the same time, a range of high-frequency economic data is pointing to a slowing economy
- Increasing interest rates and a rapidly decelerating economy would create significant stock risks, especially as company financial reporting season starts this week.
The CPI print was also crucial for medium-term movements in exchange rates. If Australia maintained only weak progress in reducing inflation, while the rest of the world saw quicker reductions in their inflation rates, the Australian dollar could rise appreciably in anticipation of higher relative interest rates.
At First Samuel, our concern is that inflation persists, remaining slightly above RBA target levels, reinforcing the RBA’s too-aggressive stance. We believe that critical parts of the economy cannot sustain current, let alone higher interest rates, increasing recession risks.
A recession from this point in the cycle would be a policy error. Population growth, investment demand and government spending are well grounded in long-term policies that support this type of growth regardless of its merits.
Excess demand in the economy, which may be increasing inflation, is being driven by older household spending and newly formed households. Those with mortgages and the young are already facing the ill-effects of the prolonged per-capita recession.
Constraining an overly-indebted household sector will not help with their deleveraging and instead risks further hollowing out middle-class wealth creation. past 2 financial years, and that has aroused the curiosity of the value-minded investor within us.
The market
What happened?
The data was met with jubilation at 11.30 am on Wednesday. The ASX market (ASX300) rose to close 2 per cent higher on the day, capping off one of the best months for stocks in recent years.
The Australian dollar fell 0.7 cents as the expected opportunity for higher interest rates dissipated. More importantly for clients, the lower risk of recession allowed for a partial unwinding of the outperformance of Australian banks and large capitalisation companies.
| After 11.30 am Wed to Close on Wed Afternoon | After 11.30am Wed to Close on Wed Afternoon | |
| ASX200 | 1.07% | 1.17% |
| Top 20 Companies | 0.89% | 1.02% |
| Smaller companies ex100 | 0.14% | 1.68% |
| AUS USD Exchange rate | 0.655 | 0.648 |
| Change in exchange rate | -0.15% | -0.92% |
Why the jubilation? Some technical factors worth highlighting
The simple driver of the jubilation was that inflation was low enough for interest rate expectations to move from further rises to the expectation of a cut between November 2024 and February 2025.
The ABS update shows the all-important Trimmed Mean CPI rose 0.8% for the quarter versus expectations of 1.0%. If a gap of only 0.2% doesn’t sound impressive enough, it may with some context.
First, let’s explain the Trimmed Mean.
The ABS measures movements in the prices of thousands of items in the economy and puts them in 87 CPI Expenditure Classes. The overall CPI is the movement in all of these 87 classes, weighted loosely by how much we, as a nation spend on each.
However, the nature of some of these items means that economists, the stock market, and ABS statisticians are more likely to look at various combinations than the overall number. For instance, some items, such as fuel, fruit and produce pricing, are inherently volatile and often removed.
We also break down the categories into Tradeable and Non-tradeable categories to show how changes in prices of goods and services from overseas differ from domestic-driven price growth. The Services sub-category of inflation is often used to understand the impact of wage growth on prices, as Services generally have higher shares of labour costs.
The critical sub-category for monetary policy is the Trimmed Mean. To calculate it, all 87 expenditure classes are sorted from lowest to highest in terms of seasonally- adjusted quarterly percentage change. The Trimmed Mean is calculated using a weighted average of percentage change from the middle 70 per cent of the distribution.
So, the Trimmed mean removes the largest and smallest price rises and is considered more representative of the trend in price growth.
Trend in the Trimmed Mean
The following chart shows long-run inflation along with the RBA’s target band for inflation (red lines on chart). The RBA considers “returning” inflation to this band a critical component of monetary policy and hence needs to be confident that current settings are likely to see CPI return to such a level.
Figure 1 – Q2 CPI data suggests the disinflation trend broadly remains on track
Source : ABS, Macrobond, UBS
The chart shows that Trimmed Mean inflation (y/y) has decreased in each of the last six quarters. The quarterly data in blue at the bottom of the chart shows that it has returned to a generally downward trend after spiking higher in the last quarter.
A range of technical factors, including the disappearance of the high level of inflation in Q3 last year and some Federal Budget-led changes, mean that the next quarter’s Trimmed Mean will be even closer to the RBA in three month’s time.
Why did the markets respond so definitively? Critical insight
The RBA has historically stopped hiking before the CPI has slowed materially and cut before inflation has returned to within the target band
This insight, the CPI result, and economic softening, as we see in the following chart of firm forward orders, will combine to force the RBA to cut in the next nine months.
Figure 2 – Forward orders are weakening and have historically been a good predictor of economic growth
Source : Macquarie Equities
Some market commentators say that a Goldilocks (not too hot and not too cold) scenario is emerging. Lower inflation will be combined with domestic demand supported by federal tax cuts, federal and state electricity rebates, and State-sponsored infrastructure investment and construction.
We agree with the core principle of government and infrastructure demand strength but remain concerned about the household sector. Tax cuts and interest rate reductions over the following year are more likely to be saved than spent. Where not saved, it is likely required to simply catch up on purchases foregone due to high supermarket and service prices.
The lack of real wage growth and high debt take years to recover from, not weeks. Therefore, we remain focused on the type of stocks that benefit from overall economic growth, not per capita or individual outcomes that are usually associated with growth in discretionary spending.
Can inflation, and hence interest rates, fall rapidly?
For this to occur in an environment where the economy has not contracted significantly, services inflation and non-tradeable inflation would have to fall considerably.
We are sceptical that Service inflation will fall. The charts below highlight two reasons. First, wage growth of at least 4 per cent is likely to continue. At four per cent growth, real wages have yet to recover any ground lost to inflation in the past three years.
The second reason is that since COVID, there is evidence that services have pricing power that is not perfectly explained by increases in wages. In fact, it appears that Services inflation is both leading and in excess of wage growth.
With changes in consumption patterns, less spending on goods and more on services, shortages in some areas, and the increasing concentration of service providers, pricing power is likely to emerge.
Within such a context, services inflation, which remains above the RBA target range, is likely to remain so for a considerable period.
Figure 3 – Services inflation remains elevated. Wages growth or pricing power?
Source : ABS, Macrobond, UBS
Non-tradeable inflation, closely aligned to Services inflation, has remained high in Australia for the better part of 20 years. Increasing land and regulatory costs remain a factor in the concentration of firms across a range of industries. None of these inflationary forces has yet to be tackled, let alone resolved. The long experience in price growth of education, childcare, building costs, and now rising rent costs augur poorly for non-tradeable inflation being less than 3 percent per annum soon.
Figure 4 – Non-tradeable inflation has rarely been within the 2 to 3 per cent RBA range
Source : ABS, Macrobond, UBS
Summary
The market responded positively this week to an encouraging reduction in inflation in Australia. The direction and scale of the response can be readily understood – moving from the risk of higher interest rates to the opportunity of lower rates is a positive for Australian companies.
The lower risk outlook may also prompt the market to move towards smaller companies and away from the exceptionally overpriced bank stocks that our clients are avoiding.
Extrapolating the opportunity for lower interest rates, to suppose that Australian households will return to high levels of spending is, as yet, a bridge too far.
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.