Economic and Market Commentary

February 2023 Update from the Australia Trade Floor

Adam Bowe explains why we think it’ll be a challenging year ahead for Australia, with interest rates about as restrictive as households have ever experienced.

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Text on screen: Hugh Holden, Account Manager

Holden: Hello and welcome to our first trade floor video for 2023. I'm joined by portfolio manager, Adam Bowe. And Adam, we've picked up where we left off at the end of last year

with the Reserve Bank raising interest rates by another 25 basis points to 3.35%. That was largely expected by markets. And in fact, bonds have had a strong start to this year as central banks around the world seem to be getting, I guess, closer to pausing their hiking cycles. So what's our view for Australian interest rates?

Text on screen: Adam Bowe, Portfolio Manager

Bowe: So I think, as you said, for most developed markets, central banks, we do think we're getting closer to the levels where they can hold interest rates at restrictive levels rather than getting them all the way there. So as you mentioned, despite interest rate increases by the RBA, the Fed, Bank of England, ECB, Bank of Canada, just about most of them, bond returns have been pretty reasonable to start the year. And that's because for bond returns the painful period is market pricing in the expectation of interest rates increasing, which was last year, not when they're actually delivered like we've seen this year.

For Australia, we haven't changed our view on where we think they need to get interest rates to which is a peak cash rate of between three and a half and 4% roughly.

That view hasn't really changed. And I think importantly, the important question is why that is so much lower than offshore. That’s a percent, maybe a little bit more lower than other parts around the world. And there's a couple of important reasons for that.

The main one in Australia is when we look at economies and try and estimate where interest rates need to get to to be restrictive we look at the weakest balance sheet, the most levered weakest balance sheet. In Australia that's households. Household debt to GDP in Australia is up around 120%. It's one of the most levered household balance sheets on the planet. Compared to the US it's about 40% more debt relative to GDP. You can just think of that in terms of your own household balance sheet. If you went to bed, woke up in the morning, had 40% more debt, the level of interest rates you could manage your mortgage at would be much lower.

And that's the key reason in Australia. So it's not that we don't think they need to be restrictive, we think that will be very restrictive. Our estimates suggest that a cash rate of between three and a half percent to 4% in Australia will be just about as restrictive as households have experienced here. So a challenging year ahead for Aussie households.

Holden: And I guess that leads onto the other big question at the moment which is recession risk. And in our recent cyclical outlook, our base case now is for recession, at least in the US and Europe, a mild recession. So what's the view there for Australia and what does it mean for portfolios?

Bowe: For Australia there's two key reasons why the probability  of recession is probably a little lower. First is just the RBA's reaction over the last 12-18 months. They started the hiking cycle a little later. They slowed down the pace of the hikes a little earlier.

It's too early to say whether that was the best decision to take, but it could end up being a longer period of high inflation and sluggish growth which will be painful.

But in any event, it probably means the probability of a technical recession in a period of two quarters of negative growth is probably a little lower here because of their reaction function. The second reason is that importantly for the region, we've got China opening back up and late last year they abandoned their COVID zero policy. We're not expecting

that growth improvement. We think growth improvement there will go from somewhere around 3% this year to 5 to 6%. We're not expecting that to be particularly commodity intensive, but it's still a big part of the region going from a headwind for growth to a tailwind this year. So for those two reasons, Australia’s recession probability are probably a little bit more finely balanced.

But to be honest, I think you just need to step back from that and leave that debate for the economists. The punch line is most of the developed markets, including Australia, were expecting recession conditions or near recession conditions. And the punch line for investors is that's a really good market for bonds. So when we look at that global bond market for core bonds in Australia, starting carry of between four and 5% and a macro environment that looks like a recession or near recession, that's the punch line.

It's a much more constructive environment for bonds that we've seen in many years.

Holden: Well, well said Adam. Thank you and thanks for joining us. If you do want any more information, please visit our website at

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