The Rate Debate

Ep 40: The winners and losers

• Darren Langer • Episode 40

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The RBA has paused on hiking rates (for now) creating some big winners and losers. 

This month Darren is joined by special guest Roy Keenan, Co-Head of Fixed Income, to identify the potential warning signs for lenders, discuss whether Australia's banks will remain "unquestionably strong", and examine which companies in the consumer sector will stand to win or lose.

Darren and Roy discuss this and more in episode 40 of The Rate Debate.

Speaker 1:

Hello and welcome to the raid debate. I'm Darren Lange, co-head of Fixing Home at Yarra Capital, and joining me today is my co-head of Fixing Home, roy Keenan. Hello everyone. Well, it's the first Tuesday of July and that means the RBA has just met and, roy, no change today. I thought it was interesting. We just did an analysis of the statement and pretty much 75% of the statement was similar or the same as last time, but we get a different result. What were you thinking about it?

Speaker 2:

Oh look. I think it's a good outcome for Australians. I think they've made the right decision. It gives them time to assess the impacts. They've obviously painted a pretty narrow pathway to a soft landing, which I tend to think is going to be really hard to pull off, given the last couple of tightening. So I think it's the wise decision. Let's sit back, watch what, how the data plays out, and let the previous tightnings take shape.

Speaker 1:

Yeah, i thought it was interesting A couple of things that they sort of markets talked about leading into this was the fact that basically the CPI, the core CPI, had been relatively sticky, and I think the RBA has referred to that a few times outside of the meetings, but there was no mention of the stickiness of core inflation. And this time they also specifically mentioned the monthly CPI, where previously they've been a little bit reticent about talking about that, given it's fairly new, but it was a pretty adamant thing that we see inflation have come off in the monthly CPI. I'm not quite sure why this month was a bit different for that, but they were the two main sort of things that I saw. Either one wasn't in the statement and the other one was, but made a big deal of for a change.

Speaker 2:

Yeah, and I think that's right, darren, and I think the other thing that I sort of pick up on is that this not a lot of. I think they're now displaying not a lot of confidence about the outlook for growth, and I think they're probably getting to the stage where they're getting finely balanced between what their outlook for is inflation and also making sure that we don't head into recession, which I think is really important.

Speaker 1:

Yeah, it seems to be the most common thing between both statements is the fact that they've again tied sort of future rate hikes or pauses, as maybe the case, basically to growth and inflation. So again we're back to data dependency, which probably makes sense at this stage of the cycle. I think it's pretty hard. Their forecasting's been pretty bad to start with, but I think when you're at this point of the statement it's very so cycle It's very hard to be have exact forecasting knowledge and being data dependent probably makes a lot of sense And I think we're seeing that generally with central banks around the world at the moment.

Speaker 2:

Yeah, totally agree.

Speaker 1:

So for this month, since we've got somebody who is obviously an expert more on credit but has also been around in markets as long as what I have, we thought we'd probably have a look at maybe some of the impacts that higher interest rates are causing on the economy. One of the things we hear in the news quite a bit, roy, is that increased rates generally hurt companies. Banks seem to be doing pretty well out of it. It doesn't seem to have any real big impact on banking sector, but are you starting to see any cracks starting to appear in corporate sector, and where in particular?

Speaker 2:

Look, i think there's no doubt that if you think about what the speed of the rate rises, that we've seen the actual sectors, there's going to be winners and losers And in some ways we were on the right side of this in our thinking that we always thought inflation was going to come pretty hard. We obviously didn't factor in Ukraine, but we had sort of this defensive mindset. So we're sort of it's pretty obvious, but we had a, you know, we had definitely a view that we wanted to avoid the consumer, even more so now that if we think that central banks tighten more aggressively than what was required, which we think you know for myself, i think the last two tightnings has sort of pushed that, you know, consumer on the edge of that cliff that everyone's talking about. And so from a consumer point of view, you know there will be winners and losers. Even the consumer sector And I think that's what's going to be really interesting about the market going forward Doesn't matter if it's credit equities, you know there is definitely going to be some sectors of the consumer market are going to do well, but there's going to be other parts of the of the consumer that is going to, you know, experience a significant decline in sales.

Speaker 2:

And look, you know we want to see so obviously very closely and you know there's no doubt the beginning of 2023, january, february, march was a pretty buoyant period, yeah, especially for Mel Bernies that have been locked up for the last couple of summers due to COVID. You know we definitely saw some really strong numbers there. But it's very evident in the data that we're looking and that we're receiving from companies that the second quarter of 2023, particularly the latter part of the quarter, we've seen a significant drop in sales and the consumer starting to whine back their spending. And it's obvious because obviously the amount of increase in interest rates has meant that their interest burden on mortgages has just risen alarmingly in such a short period of time.

Speaker 1:

There's been some relatively, i guess, strong numbers still coming through from sales, but a lot of it is really just the inflation component that's coming through. The actual volume of sales appears to be dropping and you're starting to see more and more news articles from some of the bigger consumer companies, like JB Hi-Fi and things like that, where they're not quite as happy as what they were. I mean, are there any sectors where you think there's sort of a benefit to higher interest rates rather than losers?

Speaker 2:

Yeah, look, i think there's obviously the mining sector. Obviously hard to get credit exposed to the mining sector, but there have obviously been very big beneficiaries of higher volumes, higher commodity prices, but also the services sector that support the mining sector. Obviously, the rail and the movement of these goods is also an area that we think is going to hold up very well. Also, insurance insurance is going to be is one sector we're quite happy to add in this environment and probably fits our defensive mindset in that premiums arising Yes, the cost of goods and repair and replacement has risen. but also, as we know, insurance companies have been a bit more defensive in their investments style and managing the money that they have on balance sheet. Obviously, as rates rise, the returns from those investments also adds to their profit margin and we think insurance sector is probably one sector we want to have a little bit more exposure to. So it's going to avoid the consumer and try and pick the winners.

Speaker 1:

Yeah, i was going to say with the insurers. They get a double benefit that they're finally earning a bit of income on their assets, but they're also able to put through premium increases due to inflation. So they're probably doing better than a lot of people out of this environment and although they've struggled for some years. But yeah.

Speaker 2:

And a pretty captive audience. Yeah, that's true.

Speaker 1:

It's hard to avoid insurance. I guess we talk about the banks a lot and one of the fears with the banking system is obviously the heavily exposed to mortgages. We have seen a rears start to pick up, but we haven't really seen a rears pick up to a point where we'd start to worry about it. Where do you think the worrying signs are going to come for lenders in the next couple of months?

Speaker 2:

Yeah, look at the analysis that we do. It doesn't matter if it's on a major bank, a regional bank, an R&BS structure. We always look at the downside risk and one of the things that even yes, you're right, there's no doubt The historical, as we've seen in the rears is not going to. They're starting to rise, there's no doubt, but obviously we think the worst is still ahead, right, but you look at the sort of capacity for banks to actually absorb those losses or work with the customers to actually find outcomes.

Speaker 2:

I don't think I've ever seen bank balance sheets in better shape to handle that change. Now, particularly major banks, they're running somewhere close to nearly 20% 19.5 total capital. When you look at their break up their mortgage book and think about how much exposure and what can go wrong, even if you write off their high risk loans and I'm talking about writing the lines off, not in getting any recovery in the sale of the asset, any of the mortgages with a dynamic LVR of above 80%, it's sort of only a $3.2 billion hit to their actual balance sheet which, as we know, their current impact per half for the CBA is around five and a half billion. So things need to go terribly, terribly wrong for banks to start to wear significant losses is in their mortgage book And that's the way it should be, because they're the highest quality lenders, right? So that's where we get a lot of comfort and very, given our defensive mindset, we're very happy to be there.

Speaker 1:

Yeah, i guess some of the other really comforting things. you know it's never comforting with people and losing their homes and things like that, but employment's still relatively strong And even if it weakens, like the RBA expects it to, we're sort of going back to what we probably were in the mid 2000s to mid 2010s So sort of you know more around that four and a half to 5% level of unemployment, which is not great, but it's also not dire. And I guess the other thing is we actually are starting to see house prices pick up, something that seems to be more a supply demand factor. but I'm not expecting a really big rebound in prices And I don't think anybody really is. but you know, just the mere fact that even if houses go sideways for the next couple of years, it's probably means that if they do see a bit of force selling in the market, it's not too bad an outcome in terms of recoveries for housing.

Speaker 2:

No, that's correct, And you know the amount of immigration, people coming into the countries at record levels and, as we know, if the building industry at the moment it's hard to have a lot of confidence about builders and therefore we know the supply of housing, you know, is going to take a while to pick up. So we sort of see that in that sort of deficit and that's going to be supportive of prices. So that's why I don't see a lot of downside risk. I mean, there's obviously I think there's going to be other segments of the market that we're monitoring very closely.

Speaker 2:

There's obviously lenders out there that you know providing consumer finance, personal loans, car loans and you know there's no doubt that you know we're going to see that area of the market is going to be where we see higher rears and probably coming through a lot quicker, especially given that you know, as we know, darren, that the fixed rate mortgage market that people borrowed from the central bank at, you know all the banks were able to lend out at sub 2% for three years, with that cliff starting to take place and it's going to play out over the next nine months. So we sort of see that sort of higher risk lending is probably where you're going to see the first signs of significant rears arising. That being said, the market is probably for those types of credits. the market's already at price that risk of higher rears and most of those companies have pretty well capitalized balance sheets. So, once again, you know you mentioned earlier unemployment's the key. Long as we keep people employed, you know banks will and lenders will be able to work with their customers to get through this.

Speaker 1:

Yeah, i think it's been interesting. The last few days in the press there's been a few fairly negative articles on rising rears in non-bank lending. We know from ourselves that those sort of lenders generally go for the. When I say more risky borrowers, more risky than what the bank banks do, they're not really risky borrowers per se, but you know, even the rears, though that we're seeing in the non-banking space is still not what I would call terrifyingly high. Yes, they've increased, but there's still nowhere near a level that we would say is distressed in any way, shape or form, and still significantly below the 1990s experience, when there was probably a small amount of mortgage stress around at the time. What are your feeling around some of those non-bank lenders? Are their business models still sound or are they going to struggle from here? I?

Speaker 2:

think it depends on which name you look at. You know we, obviously, without naming names, we obviously look at. You know quite a few companies that are in that space. As I say, though, the credit spread has moved out significantly but you know even some of the regional banks and some of the more high risk. You know I'll pick out a deal recently Deudo Bank raise some sub-debt with a yield, a remarkable yield, of just over 9%, and you know, when we look at that balance sheet, they have nearly yes, they are lending to higher risk SMEs, but at the end of the day, they still have 19% capital on their balance sheet, and in this sort of economic environment, it's hard to see how they're going to grow and reduce that capital.

Speaker 2:

So there is a lot of buffers in the system and I think that's what gives us a lot of confidence. And for me to add and I'm sort of almost waiting for the moment to change our mindset from being defensive to adding risk I just want to see more visibility on that sort of pathway that the RBA is going to be at close to finishing And that we can somehow get that soft landing that we're all hoping for.

Speaker 1:

It's hard to believe that a 9% yield compared to what we were saying to you is good. It sounds pretty impressive, and I think that's the main thing you sort of say is that there is some compensation for risk now, where two years ago risk was basically being priced for free, and I think that's one of the more healthy things that we're actually seeing, not just in credit markets but in interest rate markets in general.

Speaker 2:

Yeah, it's a key word and I think bonds, credit, lost their defensiveness in some way while probably over the last five years, and what's happened with inflation coming on And it's returned credit and traditional fixed income bonds and semis It's returned that defensiveness to them and you need something to go horribly wrong before you start to talk about negative returns, particularly in floating rate credit that we sort of focus on.

Speaker 1:

Yeah, i still worry that the RBA keeps going, that they're going to cause that horribly horrible outcome to happen. But so far around this month at least they seem to be holding the powder dry a bit. But yeah, i think that's really the key. I think a soft landing now is going to be really difficult and I think we're probably going to still see a more normal business cycle over the next couple of years. But I think where the central banks globally start to pause on interest rates now rather than continue to go at the rate they've been going, is going to really depend or really have a big outcome on what happens in the next couple of years.

Speaker 2:

Yeah, totally agree. I think it's. From my perspective, it's an opportunity this type of market and I think it's given me today, compared to two years ago, where I can find value and generate alpha in the credit space. It's an exciting time for us.

Speaker 1:

Not to mention we actually get paid income.

Speaker 2:

Correct.

Speaker 1:

You and I have both been around for a very long time, probably longer than most of our listeners. Has there been anything different about this rate cycle? I mean, we've probably seen what three, four full rate cycles over our careers. I mean, has there been something about this one that you think is a little bit different to previous ones?

Speaker 2:

Look, i think there's a couple of things and I think, first of all, from a credit point of view. Normally when you head into this type of cycle, it's a period where balance sheets are at their worst And what's really confusing? you sort of look at this sort of clock of where you go. You want to be buying credit here, not buying here and selling there, and sort of. From my perspective, this is quite a unique period because when central banks are raising rates around the world, like they have generally, balance sheets are at their worst and you'd be starting to get worried about credit. It's quite the contrary this time, and in some ways it's because this tightening cycle has come straight on the back of the pandemic, where we know that the government of Australia threw a hell of a lot of money at the economy And there was a lot of companies that were true beneficiaries of that and they were able to pay down their D-Levver And in some ways, post the pandemic, they haven't really had the chance to actually return that money excess money to shareholders or all regear the balance sheet for acquisitions or vice versa, but also companies that probably weren't the beneficiaries of the pandemic right, because they were so scared of what potentially could happen. At the start of the pandemic they repaid their balance sheets by raising equity. So we have this sort of Nevada period where we're actually getting balance sheets around in this period. Yes, the outlook doesn't look great in some aspects, but we actually have balance sheets in really good shape and we're getting paid to take that sort of risk, which is sort of one of the.

Speaker 2:

You know, i'm sort of getting half itchy about adding risk, you know, and in some ways I just want to see that the RBA stop. So from my perspective, you know, that is something that's not normal. Normal I'd be at the moment I'd be pretty worried during a rate tightening cycle that balance sheets won't be able to cope with the, especially the amount of rate rises in such a shorter period of time that we're seeing. I think the other thing that being different this time is the lack of consistency from the RBA, and I know you've touched that over the many episodes on the rate debate. You know, i think that's been totally confusing this time for me And I think probably the last thing that is probably a bit different about this cycle is that I'm sort of getting the feeling that a lot of participants in the market sort of have this sort of feeling that we're going to go back to an interest You know the RBA, fed is going to come back in, risk you, whether it be the equity markets or credit markets and they're going to return back to a low interest rate environment.

Speaker 2:

I just sort of think that we're sort of almost at the sort of prepassists of sort of a new regime And we have to be thinking about who's going to be the beneficiaries and what's the sort of next five to 10 years look like. And I think that's potentially the winners of the baby boomers. But we know that the sort of the mid ground, the sort of 25 to 45 year olds or 50 year olds, are definitely going to be in that sort of bracket where they're going to really sort of stage. The cycle is going to set them back for years. So so how do you invest and sort of pick those winners and losers? I think it's going to be really important on how you add returns in your portfolios.

Speaker 1:

Yeah, i think one of the things that is probably a common element of previous rate hiking cycles is there's been more the banking system that's been the issue in 2009. You know, we had probably the biggest banking collapses of our entire careers, but even the cycles of the 80s and 90s were characterized by problems in banking systems, just not quite as systemic as what they were.

Speaker 1:

This time It's really the bonds and the bell groups, And you know we had a lot of corporate collapses back in the late 80s, early 90s, Yeah, which a lot came from irresponsible lending to a quite a direct, to a degree where this time around, it really seems to be focused very much on the consumer but also governments. I think if we look around the world, we call it a risk-free asset, but there probably are governments around the world that you would no longer call really risk-free. I mean, they are probably at risk And that's something we haven't probably seen before. We probably had a bit of an element just after the GFC, with Europe getting itself into problems, but we haven't really seen, you know, a significant sovereign problem, and that seems to me that we haven't really learned a lot of lessons. There's just really been we transferred all the risks from the banks to world governments.

Speaker 1:

But you know, whether that plays out that way, it depends. But I think you're right, we need to stop having the situation where central banks protect everybody from their bad mistakes and that eventually somebody has to sort of at least stand up and say you know, i made a mistake and I'm going to wear it. But whether that be equity markets or bond markets or wherever that happens, whether that comes to fruition, whether central banks can step back and let markets behave themselves how they should, i don't know, but it'll be interesting to see.

Speaker 2:

Yeah, we continually ask ourselves as a team. You know what can go wrong, what are we missing, or you know what could actually change the outlook in the near term. And you know, i think that you know. You touched on, you know, government debt And you know, obviously, when we look at Australia and the states, and yes, we've increased our borrowing dramatically, but we're still in, you know, good shape compared to a lot of other countries And, as we've just seen, you know, obviously the budget surface is heading towards 20 billion. So I can't stay there, but it just shows that we, in some ways, we do have a bit of firepower to actually throw at the economy if we do from a fiscal stance.

Speaker 1:

Well, that's it for this month. Thank you for joining us, Roy.

Speaker 2:

Thank you, Darren. It's been truly exciting and I can't wait to come back on another day.

Speaker 1:

Tune in next month when we'll be joined by Phil Serrano, our head of credit, to help deliver our latest thoughts on the RBA's August rate decision and provide an update on what's happening in markets. If you ever want to suggest topics to us, we can be contacted at theratedebate at yaracemcom.

Speaker 2:

The rate debate podcast content may contain general advice. Before acting on anything in this podcast, you should consider your own objectives, financial situation or needs and seek the advice of an appropriately qualified financial advisor.