RBA minutes point to 40 bps rate hike

The RBA is set to hike interest rates over the next year, underscoring concerns it may be too soon to jump heavily back into the sharemarket.

The RBA is set to hike interets rates over the next year, underscoring concerns it may be too soon to jump heavily back into the sharemarket. Picture: Joel Carrett/AAP Image

The Reserve Bank is expected to rapidly increase interest rates for the next 12 months, underscoring concerns that it may be too soon to wade heavily back into the sharemarket.

But the local bourse may keep doing better than the US market, thanks to a 10 per cent fall in the Australian dollar over the past year, exposure to companies that benefit from higher inflation and interest rates and a relative lack of large growth stocks with their sensitivity to rising rates.

Minutes of the RBA’s May board meeting appeared to back Westpac’s call for a 40 basis point hike in the cash rate to 0.75 per cent next month, but the money market was almost priced for that outcome before the minutes were released, with a further move up to 3.3 per cent expected by mid-2023.

A 15 basis point hike this month was “not the preferred option” as “policy was very stimulatory” and it was “highly probable that further rate rises would be required”, the RBA said on Tuesday.

A small rate hike would be “inconsistent with the historical practice of changing the cash rate in increments of at least 25 basis points”, not that history should matter with rates near record lows.

Struggling housing borrowers may be forgiven for thinking smaller rate hikes are warranted since the economy became geared to record low rates during Covid. The Reserve Bank said repeatedly that rates were unlikely to rise until at least 2024.

The minutes did warn that some households had incurred more debt and many had never experienced rising interest rates, and house prices could also be more sensitive to rising rates than assumed, lowering household wealth and consumption.

But the RBA also saw the potential for consumer spending in Australia to be stronger than forecast given that households in aggregate had not begun to draw down on the savings accumulated during the pandemic and the high household saving rate could normalise quicker than assumed.

Another source of domestic uncertainty related to the behaviour of prices and labour costs at low levels of unemployment.

“The extent to which the reopening of the international border would alleviate acute areas of labour shortages was also uncertain, given that the border reopening would also add to demand.”

Westpac’s Bill Evans said the RBA minutes highlighted the importance of the bank’s liaison surveys for assessing inflation challenges. Pricing power, labour shortages and rising labour costs all supported the rate hike decision in May, and a 40 basis point hike was “likely to be seen by the board as the best policy”.

“Information from the bank’s liaison program indicated that upstream price pressures were increasingly being passed on to final consumer prices of many goods, as supply chain pressures persisted and demand remained strong,” the minutes said.

“Members noted it was possible that firms’ price-setting behaviours were undergoing a change from the pre-pandemic period, with businesses becoming more confident that raising prices would not … reduce demand or erode their competitive position.”

Labour costs were “rising at a faster pace and that this was likely to continue”.

“Liaison indicated that many firms were having difficulty hiring workers with the right skills.

“Given the tight labour market and increase in job mobility, more firms were having to pay higher wages to attract and retain staff. The outlook for broader measures of labour costs had also been revised up … as firms turned to bonuses, allowances and other measures to attract workers.”

Mr Evans said the case for a 40 basis point hike at the June meeting “remained open without any real argument against it, although the RBA said that because it meets monthly it would have the opportunity to review the setting of interest rates again within a relatively short period of time”.

Another argument supporting a 40 basis point hike next month was the RBA’s description of the actions of other central banks in the minutes.

“Several central banks in advanced economies had indicated that they were seeking to return policy rates to a neutral setting quickly and may increase policy rates further thereafter,” the minutes said.

It came as Macquarie Equities said the valuations of the ASX industrials sector still wasn’t cheap and with interest rate hikes only just getting going the impact on earnings was yet to be seen.

“With the drawdown in global equities, we review a range of valuation metrics to assess if it’s time to buy the dip,” said Macquarie equity strategist, Matthew Brooks. “The short answer is no, it’s probably not.”

Mr Brooks’ model portfolio remains overweight resources and defensives.

“We think high market valuation levels limit upside risk for equities, especially given central bank hikes will pressure growth and valuations,” he said.

The equity risk premium – the historical gap between earnings from shares and the risk-free rate (the 10-year bond yield) was 1.4 standard deviations below average, and warns of a rise – implying lower share prices – due to US quantitative tightening.

“A shrinking Fed balance sheet may also push up real yields, a trend that has been pressuring PE ratios in 2022,” Mr Brooks said.

Based on real yields, he estimates the All Industrials price-earnings ratio is 10 per cent too high, with more than 20 per cent downside for telecoms and tech.

“Even though US stocks have de-rated, valuations are still higher today than they were before the 20 per cent correction in 4Q18 – the last time we had hikes and QT in a downturn,” he added.

“We still prefer stocks with high free cashflow, including resources, which are on a PE of 8.6 times, or less than half the 19.1x PE for All Industrials.”

Mr Brooks also noted that 28 of 37 central banks hiked rates in the last three months, the highest share since at least 1992, giving a “headwind to growth over the next year”.

The RBA and Fed are “early in their tightening cycles and are likely to hike at a faster pace over coming months to try and bring inflation under control”.

“We are yet to see the EPS downgrade cycle that comes from central bank hikes,” Mr Brooks warned.

“There is also the risk the Fed hikes the US into a recession in 2023/24, and in this scenario, we caution the All Industrials PE in recessions since 1960 was about 11 times versus 18.2 times in the 2020 Covid recession.

“Valuations alone don’t drive equity markets, but when valuations are high, central banks are tightening and the cycle is slowing, it’s hard to have a bullish view on equities.”