hole 2808 Economic Update

The past week was all about the Federal Reserve’s Jackson Hole symposium. The market waited patiently for a revelation from the symposium only to be told once again that inflation remains too high, that rates will likely have to remain at an elevated level longer and finally that rates may have to keep rising. Well, the Federal Reserve team did not need to attend a “symposium” to conclude the obvious! The US still has extremely low (beyond full employment) unemployment levels and still has wages growth well above historical averages so we are not going to see inflation falling anytime soon. Oh, and I am sorry, but the US economy will not contract sharply while unemployment is at such low current levels. The economic bears need to be able to explain why unemployment is so low before they leap to other conclusions.

Sections of the market were hoping that the Federal Reserve was trotting off to the symposium to consider something new such as:

  • Raising the inflation target from the current 2%;
  • Declaring that the new neutral rate of interest – r* or r star – is now much higher than it was pre-pandemic;
  • Concluding that until the Federal Government applies fiscal restraint the Federal Reserve is fighting inflation with one hand tied behind its back;
  • Discussing and then releasing analysis that the shift to renewables that is increasing energy costs will mean that inflation is now permanently on a higher plain;
  • Some sort of chat about how rebuilding global supply chains so that they are not as reliant on China will mean higher global prices for many finished goods.

Our view remains that the Federal Reserve will remain on hold until it sees PCE core inflation rising again and this is increasingly likely as the strong labour market may propel growth higher over the next 12 months. Wages growth in the US is still at a high level not consistent with falling inflation. The fear must be that once the “transitory price” factors are depleted then a new round of inflation – embedded – will begin.

Credit is trust given financial form. Economic life depends on creditors believing that borrowers will pay interest on loans and return principal when it is due. Credit analysis without any bias is essential to achieving this outcome. Since the Basel capital adequacy requirements were first introduced after the 1990-92 recession Australia has seen residential property prices only increase. In fact, residential property has outperformed all other asset classes. This is not the intuitive outcome expected given the fact that the Basel reforms were based on a belief that residential property was a low risk asset. Outside of the family home residential real estate is no longer a low risk asset. The playing field for residential real estate has changed:

  • After a 30-year hiatus inflation has returned. This is important because it will mean that even if asset prices do begin to fall the RBA will not be able to ride to the rescue like Tonto and his sidekick the Lone Ranger.
  • Australia has not had a recession since 1992. Rising unemployment will force the mortgage belt to be a seller of their excess real estate.
  • All levels of government – local, state and federal – are looking at ways to tax the property gains made by investors over the past 30 years to fund their spending programs. In Victoria investments in real estate were targeted at the last budget. When commentators call for tax reform in response to the Intergenerational Report conclusion that the ageing population will require a huge investment in health and care facilities, they will and should be looking at reducing the tax incentives for residential real estate investment and improving the tax incentives, principally through a lower company tax rate, for investment in future production.
  • Various levels of government are now preparing the groundwork to roll out a Soviet-style housing plan not seen since Whitlam in the 1970s. Cries of a housing crisis then a rental crisis are being used to justify some pretty scary stuff such as:
    • The Victorian government taking the planning decisions off the local councils and proposing that no property owner can oppose a development that contains some degree of social housing;
    • Billions of dollars in federal government “social housing” building programs that will create ghettos in our capital cities and be used to move unskilled labour into marginal electorates.
  • This narrative of a housing crisis or rental crisis spread by both the federal and state governments does not add up when the same federal government has massively increased net immigration to 400,000 per annum. Where are the Greens complaining that this will increase our CO2 output or the unions that this will put downward pressure on real wages? There is only a deafening silence!

If residential real estate values fall then Australia faces a “balance sheet” recession. That much is obvious. It will take a long time for households to pay down their residential real estate-backed debts. What no one has realised is that, given the risk being taken by households and the rise in the inflation rate (interest rates then too), the returns from investing in residential real estate will not be sufficient even if property prices just remain stable for too long. When the tide goes out there are going to be a lot of naked Australians left stranded on the beach. Just like in the US in 2007-8 we will then see in Australia a financial crisis driven by our exposure to residential-backed mortgages. Australia’s household debt to income ratio is simply not sustainable if growth falters, house prices don’t keep increasing or inflation and interest rates increase. Let’s all hope Australia remains lucky because we are now a long way from being good at managing our economy.


Arculus Funds Management is an Australian asset manager of both public and private mandates.

They manage two retail public unit funds for DDH Graham:

  • The Arculus Preferred Income Fund, formerly the DDH Preferred Income Fund.
  • The Arculus Fixed Income Fund, formerly the GCI Australian Capital Stable Fund
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