ANNA HONG: Three risk factors for recession

Cash rates are now close to neutral, but several factors mean recession is still a possibility. ANNA HONG explains

THIS month’s rates decision turned out as expected with 90% of economists predicting the Reserve Bank’s 50-point hike.

The RBA has said the neutral rate is likely to be 2.5% “plus a bit”, so at a cash rate of 2.35% we are getting close.

The question now is whether this cycle of aggressive rate hikes will lead to the desired soft landing or a recession.

The pace of the rate hikes makes recession a clear and present danger when we consider these extra three uncertainties:

1. Impact of fuel excise ending

The December quarter will start with holiday blues.

The fuel excise holiday ends on October 1, meaning we’ll be paying an extra 22c per litre for the drive home after the school holiday break.
This will nudge unleaded petrol towards $2, further increasing cost-of-living pressures.

2. Impact of rate hikes are slow to flow through to mortgages repayments

There is an average three-month lag between an RBA rate hike and the full impact on loan repayments for a variable-rate borrower, says Australia’s biggest mortgage lender, Commonwealth Bank (see graph below).

So borrowers have only experienced the first round of rate hikes from May.

The second 0.5% from June is flowing through about now.

That leaves 1.5% in rate rises from July, August, September to come.

The full impact of locked-in rate increases will come through in December — just as we start our Christmas shopping.

Much has been written about the fixed-rate cliff in 2023, but it appears variable-rate borrowers are also sliding down a steep hill with the pace of rate rises.

Fixed and variable-rate borrowers are in the same boat come 2023.

Without understanding the full force of hikes already passed on, the Reserve Bank is at risk of over-tightening.

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3. Supply shocks are hard to forecast

Central banks around the world failed to forecast the inflation impact due to Covid supply shocks.

This task will get harder for central banks as we head into 2023. The desire for countries to lift growth by boosting production will clash with economic nationalism.

This struggle highlights the fragility of the lean manufacturing strategies brought on by globalisation in the last few decades.

If supply shocks ease, the RBA may have already over-tightened. But if the rebuild of supply chains fail, expect more rate pain ahead.

Mixed with the pace of rate hikes, these three factors raise the prospect of a recession.

The Reserve Bank is keenly aware of that. Governor Phil Lowe describes the desired soft landing as a narrow path “clouded in uncertainty, not least because of global developments”.

What does this mean for fixed interest investors?

With 3-year Australian government bonds at 3.3%, the potential for upside gains is higher than the downside risks.

That gives balanced portfolios the opportunity to rotate into defensiveness at good levels.

About Anna Hong and Pendal’s Income and Fixed Interest team

Anna Hong is an assistant portfolio manager with Pendal’s Income and Fixed Interest team.

Pendal’s Income and Fixed Interest boutique is one of the most experienced and well-regarded fixed income teams in Australia. In 2020 the team won the Australian Fixed Interest category in the Zenith awards.

With the goal of building the most defensive line of funds in Australia, the team oversees A$22 billion invested across income, composite, pure alpha, global and Australian government strategies.

Find out more about Pendal’s fixed interest strategies here

About Pendal Group

Pendal is an independent, global investment management business focused on delivering superior investment returns for our clients through active management.

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