A Bullock trumps the horse race

Posted by Gavin Chau

I wish you all the best of luck with your one day of profligate gambling! For the record, I drew “Breakup” and “Soulcombe” in the office sweepstakes and won $15…. net.

But what’s happening in the serious world of finance and investing?

Looking at the global economy, all the signs point to weakness. The US 10-2 treasury yield curve has pivoted from being inverted and is now pointing upwards as normal. While this sounds good, a yield curve inversion has been one of the most accurate predictors of recession in the US. This much-feared predictor has had a 100% accuracy rate of calling a recession within 6-24 months since 1955.

The yield curve inverts when investors expect interest rates to fall in the future because they expect economic growth to slow down, which leads to lower inflation, putting downward pressure on interest rates. In addition, banks borrow money in the short term and lend it out in the long term. The difference between the short-term and long-term interest rates is their profit. An inverted yield curve makes this unprofitable, typically leading to banks cutting back on lending, further slowing the economy. While it is difficult to measure, it could also be partially due to a self-fulfilling prophecy as investors prepare for a recession by selling assets.

We can see two distinct spikes in the Google searches on recession after the yield curve inverts. The first is when the yield curve first inverts, and the second is when the recession arrives – this happens after the yield curve pivots. Looking at the Google search results, we can see the second peak starting to form…. Despite all the talks of a soft landing by the Fed, when we look at the data, it appears that a US recession is all but baked in. While US inflation leads the way up, it also leads down, now sitting at 3.7%.

Moving to the second biggest economy in the world, China, while not in a technical recession, is extremely weak, having missed its 5.5% growth target. Inflation in China briefly dipped negative this year, and they have already responded by injecting $100b into their economy and cutting interest rates. Keeping the economy moving forward is especially important for China, as continued prosperity is a way to stave off the potential for social unrest. Interestingly there has been a flood of capital flight from China recently August saw a $42b forex outflow, followed by a further $75b in September. At the same time Australia saw a 400% increase in FIRB property purchases.

Onto the Eurozone, its economy contracted by 0.1% in the third quarter of 2023, growing worse than forecasted. It has now contracted in three of the last four quarters, putting it on the brink of recession as well. It now looks like a recession in 2023 is a distinct possibility. Inflation fell from 4.3% in September to 2.9% in October.

Where am I going with all this?

These three regions comprise roughly 55% of the global GDP, and there is a clear pattern of slowing growth and falling inflation as the world teeters on the brink of recession. Australia won’t be immune from this either. While we have seen retail sales increase, retail volumes have fallen for five consecutive quarters. This is more a reflection of inflation than increased demand – people are buying less stuff, but it is more expensive. Job ads are down 3% in October and the forward indicators of employment growth point to sharp slowdowns. While I don’t think we will go into recession, the path forward is becoming increasingly clear with slower growth and falling inflation.

This brings us back to today’s RBA decision. Did we really need another rate rise due to a small blip in inflation with all this in play? Furthermore, the main contributor to inflation is supply-driven, which interest rates won’t affect. The only good news is that the AUD is down, indicating that the market thinks we are finally done with rate rises this cycle. I guess it wasn’t overly surprising since the RBA has always overshot the mark in the past. It’s been hard to read Michele Bullock’s intentions as she is so new in the position, but whatever the outcome in the short term, the outcome of our macro thesis remains the same. While we are now almost certainly not going to see a rate cut until next year, the bounce in the housing market will be sharp when it happens.

Posted by Gavin Chau, on 7th Nov 2023