It will soon be time for the RBA to cut

Hello again, we are recording this outlook for the December quarter of 2024 before the conclusion of the September quarter, a couple of weeks ahead of our normal schedule.

Last quarter, the key points we made were the time of P/E expansion in the equity market was likely over as we move from the “hope” phase to the early stages of a “mid-cycle” phase. We suggested the handover would likely be volatile for equities and in conjunction with what would be heightened focus on US politics and likely some choppier US economic data it was time to look for a pause in the equity rally and in particular look for the equity market to broaden out from its narrow Tech focused leadership, and that it was time to rotate from equities and buy some bonds and look for some bear steeper trades.

Review of the quarter

So how did we go? Well, the S&P 500 shed a full PE point by mid-August, using 12mth forward consensus numbers, and has since moved back to around early June levels. Measures of volatility spiked, and it does appear that the general thesis that the two-year long P/E expansion phase for US equity markets has likely concluded is playing out. Importantly small caps are finally showing signs of outperforming large caps in the US, helping to facilitate the broadening out in the equity market. The Russell 2000 has outperformed the S&P500 by ~5% this quarter. In terms of bonds, global bond returns rose ~6% in the quarter and the US yield curve steepened a decent 24bps. Our more constructive view on the A$ also found some support during the quarter with the A$ up 3.8% in the month of Aug. So, if you were unhedged, Global bonds appear to have beaten Global equities by about 150 bps in the quarter.

Of course, the main event of the quarter was the huge spike in volatility that followed the July payrolls report in the US and a modest rate rise and FX intervention in Japan. The sharp unwind of carry trade positions saw the VIX spike to 39 on the 5th of August, the highest level since October 2020.

Of the 2 events it was the US payrolls report that likely mattered more because, as many will now know, it triggered the Sahm Rule – defined as when the three-month moving average of US unemployment rate rises 0.5% above the minimum unemployment rate of the past 12 months a recession follows.

It hard to argue with the rule in terms of its historical record, but even the person whom the rule is named after is unsure whether this time is different. The reason why it could be different is that the rise in the unemployment rate has come via a rise in the supply of labour via immigration rather than layoffs. Interestingly, we covered off on this exact same topic in last quarter’s video in the context of the Australian labour market and Australia’s rising unemployment rate.

One needs to be careful between the distinction between causality and correlation when in comes to the Sahm rule. Just because the unemployment rate rose doesn’t mean the preconditions that generate recessions are all in place.

Typically, recessions occur due to one of more of the following reasons:

Firstly, clear policy error. While a case can be made that the Fed could have eased in July, it is clear they discussed easing and post recent data they have expressed a greater degree of urgency to act now to forestall a larger than desired easing of the labour market. As such, if the Fed does follow through and act in a timely manner, there is no clear policy error at this point.

Secondly, a breakdown in credit provision. Credit was already tight heading into the August market correction, using the Fed’s Loan Officers Survey as a guide. There are risks that large a financial institution falls into trouble as the carry trade unwinds, but there is no evidence that a systemic threat to markets has been breached. In fact, it’s actually quite likely that credit availability becomes less tight as we move forward into the rate easing cycle.

Thirdly, expectation shocks: This is the main mechanism that turns economic downswings into recessionary shocks. It’s important to note that levels of US business and consumer sentiment are closer to 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 when expectations are already subdued and as such a sharp retracement in activity growth is also less likely.

Occasionally a recession can be triggered by a large exogenous shock. 

Oil price shocks, large scale geopolitical conflict or idiosyncratic events such as the recent pandemic are all examples. Indeed, oil prices, yield curves, and sentiment surveys are typically the key variables in “recession probability models” used by economists, so it’s worth noting that oil prices are nowhere near recession inducing levels. In fact, it’s the 12-month change that matter most and on that metric oil prices are 8% lower over the year. The risk period for oil prices was 2021 and 2022, not now – albeit we are all watching events in the Middle East closely. In terms of the yield curve, well 2s/10s in the US were over 100bps negative in mid-2023 – today it is negative 12 basis points. We’re well on track to move into positive space in coming months as the Fed moves into this easing cycle.

In other words, the Sahm rule may have been triggered but the supportive evidence for a recession is imminent is just not in place.

An aggressive or gradual Fed easing cycle?

The reality is US economic activity data has on balance been only modestly disappointing in recent weeks. Yet the good news on moderating inflation pressures has continued.

What is clear, however, is that Jay Powell has a much greater sense of urgency to ease rates in 2024 than what was detectable only weeks earlier. And it all comes back to a shifting sense on what is happening in the labour market. The one key Jackson Hole quote from Powell was: “We will do everything we can to support a strong labor market”. It sounds a lot like what the ECB said a couple of years ago.

When it comes to both the Fed’s Jackson Hole and ECB Sintra conferences its always worth looking at what conference papers get top billing and this time the key paper was referenced by Powell and I think it tells an important message.

The Paper suggests that when job vacancies are greater than the number of unemployed in the US, wage pressures are more acute and the inflationary impacts of supply shocks get “super charged”. That’s the world that we had been in since COVID-19, but now the number of job vacancies exactly matches the number unemployed.

But the Paper also suggests that once vacancies move below the number unemployed – a situation that we are almost certainly now moving into – it becomes economically costly to attempt to reduce inflation any further.

To me at least, the message is pretty clear. Jay Powell has taken this research on board and, given that he is now confident inflation will be around target in the next 12 months, there is a real urgency to get policy back to a neutral setting or even an expansionary setting as soon as possible. The consensus is that the Fed will start with a 25 bps easing. Yet as I said last quarter, I still think it’s more likely that they choose to ease by 50 bps, and look to ease 100 bps before the end of the year.

What about the RBA?

This forward looking and more aggressive Fed contrasts with the RBA, that insists that it is not giving forward guidance but nevertheless insists that it won’t be easing in the next six months.

We agree with the RBA’s new Deputy Governor that policy making under uncertainty requires a healthy degree of humility. Where we disagree with the RBA’s current view is in their belief that there is symmetry in potential outcomes for the savings rate. The RBA shows the vastly different economic outcomes of a rising or falling saving rate at this juncture. And they state that they simply don’t know what will happen with the saving rate, so it’s better to do nothing on the policy front until they find out.

In the Deputy Governor’s own words, in situations where there is asymmetry of potential outcomes, the Bank should take a more activist or forward-looking approach to interest rates. It is precisely because of this asymmetry why we continue to suggest that the RBA should take a forward-looking activist position and commence its easing cycle in December 2024.

In short, we think there is not a symmetric risk to the saving rate looking into 2025 and this will have big implications for the generating a weaker economic growth outlook, a weaker employment outlook and less inflation. The starting point is a saving rate that is already close to zero, banks are not facilitating mass access to liquidity for households to consume prior wealth gains, the superannuation system remains in a state of net inflow and the recent rapid rise in the SG levy in addition to a further rise in 2025 essentially guarantees the saving rate will rise rather than fall in the period ahead.

In concert with the observations that the buffer of liquid excess savings in the post-COVID period has now been completely depleted, and a clear trend rise in the unemployment rate, it is likely that a bout a precautionary saving ensues in the months ahead. We you add the policy choice to rapidly slow population growth from 1 Jan 2025 via cutting student numbers, the risk to the economic growth outlook is far from symmetric.

It’s clear from the RBA’s current guidance that there are no rate cuts on the horizon until mid-2025 – if you look at their forecasts – but a lot can change between now and the end of 2024. A shift in the RBA’s perceptions of the directional risk to the saving rate would be one of the key steps in the RBA returning to a pre-emptive central bank and open the door to a late 2024 rate cut.

Previewing the Dec 2024 Qtr

So, what are the investment conclusions when looking into the December quarter?

The first is that a far more aggressive Fed and a backward-looking RBA suggest that the A$ is set to continue to gap higher in coming weeks. If you want to stay long global equities, then consider your hedging options.

From our perspective, the weakness in the US labour market is just getting started. We will have several more months of weaker payroll reports before the year is out, hence keeping some volatility across risk assets. It’s possible with Powell that he’s suggesting a Put on the labour market and that bad news is good news for the equity market in that sense. However, until the US election is run and won – and at this stage for all the Democrat momentum it still looks like it’s a very close race – that equity markets will remain volatile and bonds will be well bid.

A post-election rally is certainly possible and may well be worth positioning for later in the year, but for now we are happy with the relative and risk-adjusted performance of bonds and we will stick with our steepener trades for a while yet.

All the best for the quarter ahead and see you again in a few months’ time.