Toohey: Where Aussie house prices are headed

Since March last year, investors have keenly watched central banks for clues on fiscal and monetary policy as a potential guide on where markets are headed. It’s become a common past-time for investors around the world, our ears pricked for the latest announcement from the US Federal Reserve, the European Central Bank and – closer to home – the Reserve Bank of Australia.

In the latest edition of The Yarra Exchange, a regular podcast hosted by business journalist Malcolm Maiden, he interviews Yarra Capital Management's head of macro and strategy, Tim Toohey. One of Australia’s most respected economists, whose career includes a 15-year stint at Goldman Sachs, Toohey’s insights in the early stages of the market calamity that accompanied COVID proved very prescient.

As part of a broad-based macro discussion covering the US, Australia, and China, he’s quizzed on the RBA’s activity over the last 18 months, particularly the most recent announcement. He also touches on a more uniquely Australian past-time, property price predictions, giving his view on where residential property prices are headed in the next couple of years.

On the local stock market, Toohey reveals what he expects will happen once liquidity is eventually drawn out of the system.

“I'm not calling a broad-based equity market, massive drawdown, but it's going to get bumpy,” he says.

“I think we're going to see that coming through a bit more in 2022, even though the economic backdrop will look and feel pretty good. I think it gets a little bit bumpier for financial markets.”

Toohey warned early on that the virus’s spread – which was soon after declared a pandemic – was being drastically underestimated. He also recognised early on the likelihood of a V-shaped recovery, even as markets plummeted in the sharpest decline seen in decades.

In this interview, he also discusses:

• How the rapid response of central banks this time affected the outcome, in contrast to what happened in 2007-2008
• The US macro environment
• The “great resignation” phenomenon among workers in various developed markets
• Whether the US Federal Reserve got it wrong on inflation
• The danger of tapering stimulus too quickly.

The Yarra Exchange

Transcript

Mal Maiden: Hi, I'm Malcolm Maiden, and welcome to The Yarra Exchange, a podcast covering what's happening in the markets and the world of business generally brought to you by Yarra Capital Management.

My guest today is Tim Toohey, the head of macro and strategy at Yarra. Before that he was chief economist of Ellerston Capital’s Global Macro Team. And for 15 years before that until 2016, he was chief economist and head of macro strategy for Australia and New Zealand at Goldman Sachs, during which time he was rated Australia’s number one economist in the Greenwich Associates survey for 13 consecutive years from 2003-2016.

Tim, great to see you again.

Tim Toohey: Pleasure to be here, Mal.

Mal Maiden: We did the first-ever Yarra Exchange together in early February 2020. And as we all know, that was on the cusp of a momentous change and challenge for the world. COVID was expanding as we spoke, but its extent and its impact was unknown by April. However, you put out a note for Yarra that contained a key prediction. It said that consensus economic forecasts at the time were seriously underplaying what was happening. But you also predicted that the recovery would be much faster than people were expecting.

Tim Toohey: Look, we certainly took a bit of heat on that prediction at the time it was made, it wasn't a prediction that was made lightly and the financial press, I think I've had a bit of a run at the time, mainly I suspect because it was so counter to the consensus views and what policy setting views were at the time.

So, you know, there was no shortage of people from all disciplines out there suggesting a prolonged downturn was likely and that they were using. Let's just call it a very inventive use of letters of the alphabet to describe the outlook and…

Mal Maiden: And the markets had tanked. They had before you came out with the ‘V’.

Tim Toohey: Yeah, they certainly had, and it probably seems like an eternity ago now, but at the time it was a prolonged downturn, second only to the great depression. Sharp falls were expected in housing prices, as well as financial asset prices people were expecting. Or the core view was that the unemployment rate was going to 10-12% and we're going to see a surge of bankruptcies and suffice to say none of those things actually happened.

I think one of the interesting things about a crisis is that you can pretty reliably assume that policymakers will set a policy for the lessons learnt from the last crisis rather than the one you're currently facing. And the proximity to the GFC I think saw a willingness to deploy as much policy firepower as possible in as expedient a method as possible, despite the very, very different set of circumstances that we were facing. And the lack of distinction between the economic destruction that is typically unleashed in a debt-deflation cycle compared to something which was essentially a health inspired, mandated shutdown was the first hint I think that the cycle was not going to be an extended ‘U’ or, or even an ‘I’ shaped one as, as some sort of wags were suggesting.

The second clue was just obviously the size of the response. I mean, depending upon whether or not you want to include things like undrawn guarantees from central banks and governments, Australia ranked either number two or three on the planet in terms of its fiscal response. And I think that wasn't as well appreciated at the time and it easily eclipse the size of any other fiscal stimulus we had done in the post-war period.

Mal Maiden: How did it compare with the GFC, for example?

Tim Toohey: It was orders of magnitude bigger in terms of the timeframe it was delivered under. in the GFC we were looking at about a four to 5% of GDP stimulus that came through this one got close to nine. So it was, it was right up there as I remember it in terms of direct stimulus…

Mal Maiden: As I remember it, you were also saying in that piece that economies and corporations were in significantly better shape going into this than they were going into the global crisis. The global crisis was in fact in part an over gearing.

Tim Toohey: Very much so. I mean, the economy was, and households were in just a much better place. We hadn't taken on an enormous bout of leverage in the five to seven years leading into the event. It looked like we were moving into a traditional industrial cycle. There wasn't a whole series of financial excesses or economic excesses that needed to be worked off and you didn't have the hallmark of a debt-deflation cycle, where the banks would essentially stop lending. We had the opposite, we had the banks falling over themselves to do things that were brought into the policy relief mechanism that's done around via loan holidays and, and restructuring which was very different and very effective. And, of course, the RBA also cut interest rates to 10 basis points. They also went into the full quantitative easing immersion.

I think we had the core ingredients for the forecast and a recession caused by mandates, not financial successes. We had excess fiscal and monetary stimulus in the system, and we had these technological breakthroughs that dramatically altered the timeframes. So in essence, they were the core parts of why we thought we get a V-shaped type recovery.

There were some other things we thought would mitigate the blow. We tend to forget in Australia that Australians love to travel. We love to spend far more offshore than what foreigners coming here tend to spend. So the perverse aspect of shutting the borders is that we ended up um that becoming in some degree, a bit of a mitigating effect to the blow that other countries were seeing as well.

So I think they were in essence, the main reasons why we were calling the V-shape. And I think the other thing that we probably undercooked at the time though, you know, we didn't get everything exactly right. It was probably that we thought house prices are probably going to fall as much as people were suspecting. And by May, we changed that to the view that maybe house prices could actually go up somewhat.

Mal Maiden:

The thought process is that we're going down, down, down, look where they are now. Yeah. Is there a simple explanation?

Tim Toohey:

Well, I think a couple of things, very cheap financing helps. So you know, you can't discount the fact that we had 10 basis points for a mortgage rate and we, we saw a pretty competitive mortgage lending environment. In fact, the banks really flicked the switch on loan provision. If you look at a simple chart on low mortgage applications, it is actually quite frightening in level terms, how much credit was extended over the last 12 months.

Mal Maiden: But we're looking for some sort of universal reason maybe because this is happening all over the world.

Tim Toohey: Yeah. So, I think partly the money that was transferred from the government sector to the hassle take the help. I think the fact that you had the breakage of the linkage between economic downturn and leading to large increases in the unemployment rate.

So obviously what we saw in terms of JobKeeper in this country, but other forms in other countries was a big deal. So house price, declines, most strongly correlated with big shifts in the unemployment rate. And, you know, we just didn't get that this time around, which was again, a tick for the policy delivery through this event.

And I think the third one was, it was during periods of uncertainty, house prices or housing is one of the go-to assets. And once it started to build a bit of momentum, it certainly took off in that way, in that way. And there was a bit of a FOMO that got into it in the later phases.

Mal Maiden: I thought there would be a house price crash at the start of the pandemic because I think I probably thought everything was going to crash. That didn't happen. Not only didn't it happen, but government policy actually drove it higher at a time when demand was naturally falling because of Corona with immigration coming to a halt.

Tim Toohey: Yeah. So we had a, we had an open-ended program called HomeBuilder, which was designed around the view that housing activity was going to fall by about 30%...

Mal Maiden: And that it was so core to the Australian economy. It just had to be propped.

Tim Toohey: Oh yeah, there's an implicit guarantee in Australia that every tradie should have a new Hilux, so we must give a large stimulus to the building sector. But it came in three times, you know, in terms of the package, it came in three times the size of what it was planned for. So it was super excited, super successful from that perspective.

So that's induced a lot of new home supply cause you're building them. The question is, are there going to be the people to naturally come through from an underlying demand perspective? And that goes to your point about net migration. So, net migration essentially stopped with the pandemic and given that net migration is essentially one-third of the population growth. And they’re a very high concentration in terms of the demographic that comes through.

Look we do a bulk of work going through all that analysis and trying to figure out city-by-city, essentially person-by-person, pretty much or age-bracket-by-age-bracket, how many homes we need to build. And the bottom line is either building approvals needed to fall a lot further. And they've already fallen quite a lot from when we initially came up with that analysis, but I think they will still fall. Or we need to get the net migration numbers up pretty quickly, or we're going to be left with a very large housing over-supply through 2023.

And that's probably not something that's I think, again the penny really hasn't dropped, but it's just simple maths, right? It's a view of if you are building far too many homes than what ultimately there are people to put in them, then at some point, you're going to get an over-supply.

Mal Maiden: And it's been masked, I guess because super-low mortgage rates have pulled domestic demand forward and filled that gap during the pandemic, that hole of immigration.

Tim Toohey: Absolutely. You've artificially boosted first-time buyer affordability massively.

Mal Maiden: But you haven't created demand. You've just pulled it forward.

Tim Toohey: Exactly. And it wasn't actually just the HomeBuilder grant. It was also what the state governments were doing, they all had their own first home buyer grants, which they escalated. And as a lot of those policies lapse, together with high mortgage rates, it's going to be a little bit, I mean, I think people have this sort of rose-coloured view of what's going to happen with the housing market over the next couple of years.

Again, we’re not saying there's going to be a crash, but I do think when the fundamental backdrop is you have an oversupply and the cyclical view is you have a central bank that will eventually start to raise rates. Then it becomes a little bit more problematic.

Mal Maiden: House prices are going to go down, is that what you're saying?

Tim Toohey: I think in some parts of the country, yes, they will. You don't get house prices really going down in this country in a broad-based way unless you can build a narrative around why the unemployment rate’s going up and we don't really have that view.

So I wouldn't say that house prices are going to go down 20% or something. I just think that under the environment that we're probably likely to see, people are sort of overpaying at the moment because there's scarcity. And as we move into that next period, it's going to be excess.

Mal Maiden: Let's move forward to this year and look at how all this has worked out. Your V-shaped recovery has been happening at the same time, though it's coming out of a period of more extended lockdowns than expected. And you said in your V-shape prediction piece, that there were limits to how long lockdowns could run before they cause long-term structural damage. What's your feeling about that now as we hopefully leave the lockdowns behind?

Tim Toohey: Well, I think first of all, on the long-run structural damage element from the crisis, there, there were some things that looked as though they had permanently changed. And I think some of them have well-trodden on some of those would probably include the share of wallet that goes towards online retail for instance. And it might leave smaller retailers at some business risks in years ahead, is that process because as though it's a step-change rather than something that will mean revert and there are things that are a little bit less transparent, I think which, you know, my mind was really at.

And although we'll never really know what the cost is, we seem to wear the tag of the longest city with a lockdown globally with a sort of ironic badge of honour. But I do wonder whether we'll be picking up the economic price tag for the social damage down via, you know, depression, anxiety, eating disorders, diminished human capital via lack of on the job training. And of course, diminished human capital from a more challenging educational provision as well. And for years to come and that will have a real penalty that will never actually be fully calibrated. And the pandemic clearly has also changed the relationship of the way that people interact, I think that feels more permanent to me.

One of the defining aspects of what is a successful economy is trust in its institutions. There's plenty of research that shows that, and we’ve imported a little bit of the US craziness and social media has probably not helped in this regard as well, but we've done some collateral damage in that relationship, which I'm not sure we'll be able to turn back in a hurry.

And perhaps the combination of post-pandemic exhaustion and elevated asset prices has actually encouraged a surprising number of people to retire early. And we've seen this more in the US but it'll be interesting to see what happens here and that'll have an impact because it will tighten up the labour market more than what people will currently anticipate.

Mal Maiden: Is that tied up with what's being called the great resignation here and overseas. And are there other reasons for this wave of people moving away from jobs?

Tim Toohey: Definitely. Asset price growth has, I think without question been the surprise of the pandemic, which has actually brought forward the timeframe that people could really see themselves retiring. The baby boomers were always going to retire more aggressively over the next few years in any case. But I think no longer having attachment to the workplace has probably expedited it.

Mal Maiden: I think people who were COVID exposed at work are also getting away from it if they can.

Tim Toohey: Definitely. And I think that's going to be a real challenge over the next 12 or 18 months.

We've got a swing of demand towards services, but no one to actually deliver those services. So there's an implicit assumption from the policymakers, by the way that goods prices inflation, you know, driven by shortages and the demand surge we’re seeing will mitigate because we'll transition and services and service prices will be far more. But sort of by definition, if the volume of demand is going into another sector and the people aren’t there to deliver it, I'm pretty confident saying that service price inflation won't be as benign as people expect as well.

Mal Maiden: US president Joe Biden when asked about this issue, said, companies should just pay their workers more. And of course, wage inflation, which isn't particularly present in the Australian economy is what we're being told by our central bank is the trigger it would to push rates higher. And this all raises what I think you think is an absolutely crucial question. What's happening to inflation, how much of it is not transient, but structural or real. And what does it mean for what the central banks do to reverse from this period of extraordinarily low to zero rates and quantitative easing?

Tim Toohey: The Fed’s adopted a real change in the way it's going to operate monetary policy. So it's adopting average inflation targeting, you know, the policy of allowing, allowing inflation to run above its target for a period of time to make up for any period of undershooting. And that change has been echoed throughout the world, by other central banks in different forms, including our own.

So we had that big shift in the regime here as well, which was largely understated and underreported. So that's important in setting the scene because it's, we also learnt in September of last year that the Fed had completely altered the way it was going to recalibrate policy. And again, this got, I think very much under the radar of just about all analysts.

The second most important person that the fed through a policy wonk you know, the go hates the actually the economist said, look, there are so many different ways of measuring inflation expectations. We really care about it, but we've never really had a good way of getting to the bottom of it. So here's a really fancy model that we've built. And by the way, we're going to set policy on the basis of what this signal is telling us. So he put that out in September 2020, and almost to the day…

Mal Maiden: It's a, it's like an aggregated measure, isn't it? I mean it takes everybody's opinion and everybody's estimate and everybody's modelling and mergers.

Tim Toohey: It does. It tries to provide that sort of underlying signal from all those various 21 different measures of inflation expectations that are available via market measures, consumer measures, business measures, economists surveys et cetera, et cetera.

But again, they just didn't know which one of those ones to really look at and point to, because they can send different signals at different points in time. But the really important thing is he basically said: “we're going to use the signal to guide policy”.

And when he published it, it was actually on its lows and then started to move and…

Mal Maiden: Almost as they published, it started to move, I think?

Tim Toohey: That's right. And they were only going to update it quarterly. So we rebuilt the model ourselves and we're sort of following it in real-time. So for me, that was a really big deal.

And by January of 2021, it really started to move. By February the market had started to notice that we had a, I think, it was the primary catalyst for why we had the big sell-off in bonds in Feb. And the Fed started to shift its language a bit, and that sort of mattered.

As we sort of moved throughout the year the Fed also started to shift its whole narrative around transitory. So as you recall by March, April, may, we're really talking about transitory as being merely COVID related factors that would fall off the other side in the matter of a few months.

When we got to August, they weren't coming down and suddenly transitory wasn't a locked-in belief by the Fed, it was a thesis. By the time we got to October, by the way, we'd actually changed the definition again, or Powell had changed the definition of transitory to just something that doesn't come down at any time in the future, which, you know, he probably should pull out the Oxford dictionary or any dictionary because transitory it's time-dependent. It's, it's a matter of measured in time, not measured in levels.

So, you know, the general point here is that not only did they, they change it from a locked-in view to something that was a thesis to something that is you know, maybe is now semi-permanent they were prepared to change it on a dime.

And he's opened the door to the view that actually what we're now seeing is potentially a shift towards wage-based inflation. So, the interesting thing I think at the moment is how much of what we're seeing in terms of this transition towards wages was foreseeable. Should they have seen it earlier? And how much of this shift in inflation expectations, has it continued to evolve, or has it actually slowed down?

From my perspective, some of these things were identifiable not only just months earlier, but quarters earlier. Any economist worth his salt should be thinking about inflation in terms of unit labour costs and unit labour costs versus, you know, essentially how much does it cost per unit of labour to deliver a unit of production. It had surged pretty much three quarters before inflation even started to move and it's embedded in any serious inflation model as one of the key ingredients.

So they missed that. And that was, that was, that was a bit of a mystery. The other thing that was in the, it was in the producer surveys, we could see it within a lot of business surveys that input costs were surging, upstream, price pressures were clearly coming. And there were some more fundamental factors that I think are structural in nature that were yet to be embedded as core beliefs with inside policymakers views.

By definition, if you're going to diversify your supply chain away from say, let's call it China or the lowest cost producer, that's inflationary by definition. If you're going to move away from just-in-time inventory management to carry more inventory, that adds costs. By definition, if you're going to decarbonise the planet, which is a great idea and a good policy, and you're going to do a whole lot of investment, but for no boost in production, well, that is the virtual definition of long-run inflation.

So none of that's embedded in the current view, but you can obviously see labour market tightness and product market tightness that is putting a lot of pressure on the Fed to do something different. Over the past week or so we've seen my old boss, Bill Dudley at the New York Fed in his last guise come out and put out a very strong opinion piece, basically saying the Fed has got this wrong. You know, he's basically singing from the same hymn sheet that we've been singing from.

The point that I would make on this is that someone like Dudley, who is very much a, a person that would sing a similar tune to what the core people at the Fed would be talking to, is suddenly saying the Fed has got it wrong on inflation, they've got it wrong on transitory. And importantly, those inflation expectations are the things that matter. And it still looks like it's rising. It's exactly the view that we've been trying to push.

Mal Maiden: So are you saying, is Dudley saying, are the critics of the central bank saying they calling this wrong, they're signalling that they don't have to move as quickly as they really do?

Tim Toohey: I think they're signalling that the Fed was of a view that if inflation comes, that it's going to come gradually, it's going to take a long time for us to go for on average to get that inflation to overshoot versus how long it was undershooting for.

And what I think some of these commentators are suggesting, is the starting point is inflation is running at six. We never actually went below 2% on the core measures in the middle of a pandemic and the biggest economic contraction we'd seen for many decades. It never fell. So we're accelerating away on the other side, quite rapidly. The Fed now needs to recalibrate to get a little bit ahead of what the market is probably going to if they were serious about trying to think about controlling long-term inflation expectations and long-term risks.

Now, the Fed’s not going to do that. The only real options that they're going to do are taper faster, and that opens up the window to do maybe an additional rate hike other than the two that's priced in the back half of next year. And then it becomes a question of can the economic data hold together into 2023 to continue that process?

So I think the real issue here is if the Fed tapers faster; if we wake up in February and the RBA also says, you know what, we're going to taper much quicker as well. And we might talk about that in a moment. We’ve already seen Bank of Canada, just pull that trick, you know, basically, stop QE overnight. You know, the point here is if we taper much quicker, then we're going to be very much laser-focused on this idea of, is it the pace of tapering, or is it the level of balance sheets, central reserve balance sheets that matter for markets? And that's a really, really big issue.

I’m more in the camp it’s the rate of change. The central banks have pulled a very strong line, but a very strong line in there that it's actually the level. But I would challenge the professional economics community to try and replicate the research that they quote because it's one of the most obtuse pieces of research I've ever encountered. And frankly, I don't think there are many people out there that could replicate it. What I can see is what has been the path of shifts in the central bank balance sheets and the liquidity provision and the implication that's had on asset values and the economic cycle to date, so since say 2010. And that's instructive of what will happen if they taper too quickly.

Mal Maiden: If they taper too quickly if the inflation pressure is higher than the central banks and the markets are generally broadcasting, then the market is headed for a downtime. Aren't they? That's the bottom line?

Tim Toohey: So there are three things here, I guess. One is if the Fed tapers faster. Biden's got through his infrastructure package. So he's going to be issuing more stimulus, but issuing more debt. So there's more bond supply, less bond buying from the principal buyer in the market and more inflation than what the central bank is currently expected. That's a little problematic, particularly if you think that part of where we got to with asset prices is that the discount rate was effectively being distorted. And that goes to, why did we get into QE, to begin with, right? So we got in there to recapitalize the banks to ensure that credit creation could get outside the banking system and into the real economy.

Well, then the whole process migrated to no, we're actually about now trying to hold down the discount rate and generate wealth. And that's a much more…. let's say questionable motive and much harder to get out the other side of.

Mal Maiden: Well, they were trying to encourage people to move into riskier assets and they've certainly achieved that haven’t they Tim?

Tim Toohey: Well, they have. I mean, if you look at credit spreads, if you look at you know, what's happened with obviously growth parts of equity markets, if you look at the multiples that industrials will trade on you know, if you look at the whole developments around SPACs, crypto…

Mal Maiden: There’s some absolute rubbish out there, that's being highly valued. Let's face it.

Tim Toohey: Yeah, I would agree. And you can't put all of that on the Fed, but there is always going to be the danger of long-dated forward guidance. If you say, we're not going to do anything for multiple years. It provides to the decree of let's just say it might not look like in an aggregate at the time that's all happening, but under the surface, there are some things that would be clearly distortive. We'll only see them in real-time as yields rise, but there has to be something of a recalibration across some of those parts of the market. I'm not calling a broad-based equity market, massive drawdown, but it's going to get bumpy as we start to take that liquidity out.

I think we're going to see a bit of that coming through a bit more in 2022, even though the economic backdrop will look and feel pretty good. I think it gets a little bit bumpier for financial markets.

Mal Maiden: You mentioned that one of the less visible byproducts of this pandemic has been a decrease in people's trust in institutions. What about trust in the reserve banks and our reserve bank? Is there less trust in them and less faith that they can steer us through this extraordinary cycle back to more normal times?

Tim Toohey: That probably goes to whether QE was a good idea and have we done any reputational damage along the way? So can we continue to hold the faith?

I think the first point I would make is that when we came out the other side of the financial crisis, we were essentially at a corner solution. Or what economists like to call a corner solution. It's very hard to get out if you’re very close to being, if not, you were in a liquidity trap. So, something had to give, you had to find a new way to provide stimulus into the system. And there was a very, as we're were just chatting about a very real reason to do it because the banks were massively under-capitalized. So things changed.

Now if you're going to go down the path of quantitative easing, long forward guidance and providing yield curve control, that's fine, but you have to be consistent in the delivery of it. So we were late advocates. We went through the gears very fast of the different options of QE that you could possibly put into the system. And we put a relatively aggressive form of QE into the system over the past 18 months or so.

The reputational issues, look I don't want to be overly critical about the abandonment of the yield curve control here. But it was a little, I’d say, ungraceful in terms of its exit.

Mal Maiden: You're talking about the reserves failure to defend its pegging of the three-year bond yield to cash?

Tim Toohey: Most people probably don't care about this other than bond traders or people that actually have a position on, and it's not overly visible, but the point of QE is it provides stability of the instruments that you're dealing in. It provides a low reference rate and it takes out the volatility in those in those products. And given that the rationale for stepping away was essentially what was well, other interest rates had started to move, and then we had a CPI print, which was a little higher than what we're expecting. So we're just not going to honour our prior commitment to turn up at the bond auctions and buy and do what we said we'd do.

It wasn't as though they needed the crunch all the way back to 10 basis points, but thinly traded markets, unlimited capacity. They could have turned up at very little cost to them, really in terms of their balance sheet, defended their honour, effectively turned up on Tuesday, announced the rationale and policy change. And probably could even just put out a couple of hallmarks in the market about speeches around what their plans are.

The reason why I'm sounding a little critical on this is that if you think about all the assets that a central bank has on its balance sheet, its single biggest asset is its reputation. And, and when you look at quantitative easing and the research around it, yeah bond buying’s important, but in some ways, the bigger thing that's important is their ability and their commitment to hold the market to that forward guidance.

So what it's done for those just not turning up for a couple of days, it's essentially then opened the question about, well, what does it mean now for their tapering commitments? What does it mean about this 2024 as the kickoff?

And because the bill market is pricing model wise next year, they're clearly not believing the RBA at the moment. And that's a kind of a problem, right? When the markets are basically saying, yeah, okay: for me once or twice, you know, this that's essentially what's going on now. You do want your central bank to have credibility in the market. I'm not saying they’ve lost it. I just think it was a bit of a no brainer to turn up on those couple of days, buy a couple of bonds and not have this problem. So some of this is a little bit of their own doing.

Mal Maiden: Our Governor Phil Lowe is continuing to say, it's a steady as she goes. We don't see any reason for a rise in 2022, for example; he most recently said that. You clearly doubt that they can hold that long don't you, or do you think they will hold for 2022 at least?

Tim Toohey: Oh, no. The view even prior to the CPI print was that they would start hiking in the middle of 2023 after the CPI print. Okay. The first half of 2023, I think it's more likely. The principal reason why I don't have them hiking in 2022 is that if you're going to start the journey to higher interest rates, it helps if you have a fix on where the terminal rate should be going. And until we know what's going on with net migration there's not a lot of point doing that because we're going to have I think some issues around trying to figure out exactly what rate of population growth we're going to have, and also what sort of productivity growth we're going to have on the other side of this pandemic before starting that journey.

The other part of the story is it's actually true about wages. It's going to take a while for wages to build the momentum here, despite the fact in terms of measured wages, the wage price index, despite the fact that every business that we run into tells us that wages are clearly going up and it's been going up for a while. The way that we measure wages in this country or the way that the RBA chooses to look at the measure that matters, it's going to take a while. So they've got some time you know, you could potentially make the case under some surprising wage data that may be the backend of ‘22, but I think more likely it's 2023 still at this stage and principally because of the net migration component.

But let's not pretend that the inflation number, wasn't just a surprise, it was a massive surprise for the way the RBA had drawn their prior forecast relative to what they've just put through. So again, it probably wasn't well discussed or thought in the financial press. But if you look at their forecast that had for prior to what they updated, they were looking for inflation to go back down to 1.5% core inflation, 1.5% in the first half of next year.

They've essentially upgraded that by three-quarters of a per cent. Now that might not sound a lot, but that's a lot when the central bank is for less than 12 months out is having to shift its view around core inflation over that timeframe, that rarely if ever happens. So they missed it by a lot. They now have at the very end of their forecast profile at the end of 2023 core inflation getting to the mid part of their target band, two and a half, but let's just put it this way: if we had a 0.7 trim mean last quarter, if we get a 0.8 trim mean this quarter, we'll be at 2.5% at the end of this current calendar year.

And a 0.8 for the trim mean is not out of the question for this December quarter. There's plenty of things in there that could give it to you. So again, I don't want to be critical, but we recently had a speech from the Governor talking about why we're different and, in particular, why we're different looking at these factors that have contributed to inflation over the last year, and even in the most recent quarter and directly pointed to these are the factors that have helped lift up core inflation.

But the factors he was pointing to were fuel, housing costs, rates and all of those things were excluded from the trim mean. They were trimmed off the top, so the trim mean measure takes off the volatile mid-to-high measures at the top and the bottom 15% of the distribution at the bottom. So what I'm saying is that there was a much broader, generalized increase in inflation recorded recently than what he was pointing to. He was pointing to things that actually weren’t causing that pickup in the broader core measure. There were a lot of other factors that were driving it.

Mal Maiden: Can we move on to China? I know it's something that's of interest to you and of interest to everybody. Obviously, it's a difficult topic for the market because geopolitics are involved here. It's part of the inflation story, for example, because supply chains between China and the rest of the world have broken down partly for political reasons, as well as economic ones. But in a nutshell, China's economic growth has been slowing. It's become more adventurous militarily in the Asia Pacific region. It's more aggressively pushing back against critics, including Australia, which has been paying a price in cancelled trade deals. And at the same time, it's become more focused on internal demand cycles and less focused on the export trade cycle, which basically drove weaker prices for goods worldwide for a couple of decades. That was the Deng Xiaoping export model. It's now emphasizing internal demand, partly for political reasons, but partly for economic ones too. Now you put a piece out about this recently and you came up with what I think is a very interesting reason for the changes that we've been seeing in China.

Tim Toohey: I think most people have come to accept that this is China stepping somewhat back from the global trade model, as you sort of pointed out. And there are implications of that. We have seen already if you're looking at export prices out of China and into places like the US which one form of looking at downstream inflation pressures, there's clearly more inflation being imported into major economies from China already.

And part of it is what we're seeing with the supply shortages and all the rest of it. It looks fairly broad-based across a lot of categories. So there is, it feels like the models already changed from China being a disinflationary source to something that is at least not contributing to disinflationary forces, maybe it's inflationary at the moment, so that's of interest. But I think the interesting thing was clear they'd been stripping credit out of the system or putting it through a negative credit impulse all the way through the last 12 months.

And it's actually relatively aggressive how much credit they're trying to de-lever if you like, you want to call it in that sense. So we're talking about the pace of credit expansion relative to prior periods. And that looked quite restrictive and they had a real economic impact. We could see a lot of the data that we normally look at and trust: industrial production, electricity, all those sorts of things looking quite sick, but we also saw some super aggressive policies coming through that really caught people, blindsided people in that September quarter. Without question the restrictions on childcare providers, private education, and then, of course, everything related to residential property developers, Evergrande being front and centre there.

Mal Maiden: Essentially with their so-called three red lines, they're forcing balance sheet improvement on corporations that are definitely over-geared. But the big surprise is that it's forced one of the biggest property developers in the world Evergrande to go close to going under and they haven't stepped in.

Tim Toohey: No, and this is just it. I mean, in any prior downturn in the data that we've seen the Chinese response would be to step in and either cut rates, provide some more credit creation in the system or something else, you know, a new infrastructure package of something of that ilk. And they essentially did the opposite. They put these other policies in that were really quite draconian. Not huge parts of their economy, but in terms of residential property development or residential construction, a massive part of their economy. You know, up to 30%. And without that sort of government support coming in, it does leave the financing model of the developers vulnerable because it's very different from a system like in Australia where we think about, you know, a property developer will do a lot of presales. Yes. But in essence, you know, moms and dads are going to the bank and getting the finance so shifts in the policy rate matter a lot.

Over there, a lot of the financing for developers has been debt being issued in their own name and via investors putting up the money upfront. So it's a confidence based system. You need to be confident that the developer's going to be able to be there in the future. And also confident that house prices are going to continue to go up. So what we're seeing at the moment is we had a couple of months of house prices in decline. We've got a period where the developers are clearly not going to be building as much so you’re going to get the negative growth impulse, but it has the risk of obviously then spilling and breaking that confidence channel. And that's important.

But again, the question is why. And this is the thing I spent a month or so just pondering, as to why. And it sort of dawned on me that the only thing that made logical sense was that some data was starting to get released out of the census in China.

Now for essentially a command economy, a census is such an important ingredient. It's a foundation really. Because it's basically how they determine how they do everything, because the census is telling you not just where people live or how much they earn. It tells you a lot about their family structure and the like, and I think it would have been a massive shock when they got the initial data back. So most people, including the people in China that do the analysis, assumed that the birth rate would continue to hold at 1.7 times

Mal Maiden: Which is still contractionary.

Tim Toohey: Yeah. It's below the replacement rate. You might remember that in the prior 20 years, China's population growth is very strong and then supplemented by the huge net migration from the cities. So they really had a demographic tailwind. We all knew it was going to turn, but they were investing heavily in growth-focused or new productivity-focused industries. And there was a general belief that they'd probably get that vaguely right and would offset some of that contractionary population dynamic.

It's a really big difference though when the data came out and it was 1.3 and essentially what that means, it's feasible that by the time you get out to say, you know 2090, or something of that ilk, you’re looking a long way out but the population could halve. And it happens quite quickly and not only does it halve, but that also leaves you with a dangerous population pyramid, where it's so heavily weighted to the aged that would bring all sorts of issues to the fore. Everything from social stability, to tax collection and those sorts of things, which I think would be a real shock to a centrally planned economy.

Now, some of the implications of that is that happens actually relatively quickly, over the next 10-15 years. It is essentially, the decisions that we saw put through with childcare and education and even housing I believe it's all directed at trying to appease the cost of raising additional children in China. So it is an expensive thing.

And in China, you are kind of expected the own a house before you marry effectively. And the number of bedrooms that you have will ultimately determine how many children you're likely to stack in them, but it's also you’re then expected to pay for tuition and external private educators. And it becomes embedded in the system. It weighs directly on the birth rate. And what we don't know is whether the birth rate is even stable at 1.3. What if it’s 1.1? And in the time when they update in 10 years’ time? I mean that is a really challenging, super challenging development.

Now, obviously, you can point at countries like Japan and say, well, you know, their population is declining somewhat and they've done okay. Yeah. But they're doing it from a much wealthier position with a much bigger asset base. And by the way, the population drop off, doesn't look anywhere near as perilous as what China's looks like it could be facing.

So I think that is not something that's in the general discourse. It amazes me that people aren't discussing this because of that one number, I think it really changes everything the way we think about China. You can't look back at the last 30 years and say, okay, I understand what China's doing. And then extrapolate, because the fundamentals of what drove that growth is really changing.

And let's not also ignore the fact that they really not only had that demographic tailwind, the technological development that came partly from the west, partly from themselves, but they also had the ability to lever up the economy and they did it. They now have Western-style levels of leverage, in what is still a largely developing…. that makes it pretty tricky to generate. I just wonder where the growth is going to come from over the next 20 or 30 years?

Mal Maiden: Alright. Putting all these together, how far through what is obviously already a choppy transition is it going to continue to be choppy might be more than choppy from zero interest rate policy to something more normal. How far through that process do you think we are right now? How much more of a market correction to take it into account is going to be needed?

Tim Toohey: Calling how far in equity markets should correct over what timeframe is, is always a pretty dubious profession. Tombstones of lots of people are written with that one!

But if I had to chance my arm on it, I still think that when we get into the first part of next year, so let's call it a timeframe before Easter of next year, if you want to hit the calendar like that, I'd be pretty surprised if the inflation issue, the Fed recalibrating, speeding up tapering, some volatility kicking through markets well I think it’s a pretty good bet.

But at the same time, you can't be too bearish because we're talking about still better than a 4% global growth environment. Part of the reason we're seeing the inflation is because firms are passing it on, it's just something we just really haven't seen en masse, right?

For the last decade or so, the story has been consumers have ultimate transparency and firms have no pricing power. The pandemic has sort of, I'm not sure whether it's the smoke of the pandemic or whether it's something a bit more fundamental, but they're passing it on and they're being rewarded in equity markets for those that pass it on.

So, you know, it's interesting, it's a bit of a different dynamic, but those that miss, those that can’t pass it on I think are going to be penalized pretty hard. So you probably don't get as big of a correction on the inflation threat. If the firms are getting strong volume growth and then some pricing power because the operational leverage is still working in their favour.

Mal Maiden: You're actually seeing that dynamic at work in the US market right now where profits season is very strong and offsetting inflation and rate fears.

Tim Toohey: Definitely. If you look at the number of upgrades vs. downgrades that's true. And I think we can point to a host of companies.

It's also true here. We've seen some companies that haven't been able to pass it on, have been penalised pretty heavily in the last month or so. So I think other companies would be looking around and watching and they'll chance their arm to try and put through some price increases. I'm pretty confident in that, at some point the competitive pressures kick back in, but some of them I said are somewhat permanent, we’re probably not going to go to just-in-time inventory management. We're probably not going to be as aggressive in our sourcing of the material from dominant places on the planet.

So, you know, those things are going to permeate around, but there has to be something of a recalibration here if we're lifting the risk-free rate. And the risk-free rate has been a large component of what's caused some of the excess valuations and that has to be part of the story. If in the US we're removing some of the fiscal accommodation, tightening rates, and then you start, you know, if you're looking into 2023, where growth should be slower, then you'll have to pay… by the time you start getting into the middle part of 2022, we start to think about that a bit more.

Then I think that's also going to be a little bit more problematic. You know, you're not going to have as strong tailwinds and probably the cost structure has stepped up a notch. So it probably is a little bit harder from an earnings delivery point of view. So I think there is, as I say, it's been this sort of golden period for equity markets where you've had basically super cheap financing, super stimulative financial conditions, super stimulative fiscal delivery, and a household sector that is still sitting on a bank of savings that can help drive growth over the next 12 months. It's just then you’ll be beyond that m. You'll be on that. That is probably going to be a bit more of an issue.

Mal Maiden: And China Another big known unknown.

Tim Toohey: Yeah. And when will China actually choose to stimulate? And in what form? It seems as though their appetite is very, very limited. They don't want to see a re-acceleration in the house price model, but it's been a really big feature that's helped lift the wealth of the average Chinese person is that boom in housing. So it's a really delicate balance. You know, you've got to give them their due though. They have done a good job at managing a cycle, both on the way up and various bumps along the way.

I would give them the benefit of the doubt that there'll be able to navigate this to some degree. But the years of looking at China's growth with a seven handle, let alone an eight handle that they are long gone. It's just a question that we talking about two, three or four handles.

Mal Maiden: Wow, that low?

Tim Toohey: Well, it has to be, I think if you're talking about our contracting population growth, not using leverage to juice the economy and you are investing in certain areas, but can they actually get that right? China's got a great record of building things to order. We need to see whether they can show the innovation that… I'm not saying they haven't been able to innovate in the past, but the level of innovation that's going to be required, given those demographic challenges, it will be phenomenal.

Mal Maiden: That's fine. Great. Thank you so much. And I'm sure we'll talk again in the, not too distant future to see how all this has worked out.

Tim Toohey: Thanks, Mal. Pleasure to be here

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