Tuesday, June 7, 2022
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What’s the most important thing in today’s environment?

Alex ShevelevOne of the 19 “Most Important Things” for Oaktree Capital’s famed co-founder Howard Marks (from his excellent 2011 book) is to have a sense of where we stand. 

“I don’t think anybody can consistently know the economy, interest rates, currencies, and the direction of the markets better than anybody else,” Marks said in an interview three years ago. “So I swear off forecasting and one of the elements in Oaktree’s investment philosophy is that we do not base our investments on macro forecasts. That doesn’t mean we’re indifferent to the macro. Our approach is, rather than depend on forecasts of the future, we depend on reading the present.”

While we don’t talk much about macro forecasting at Forager, we do try to read the present. And there has been plenty to read recently. The ramifications of the war in Ukraine continue to be felt. Inflation is rising in many parts of the Australian economy. And interest rates are set to soar. 

The macroeconomic situation has changed faster than many expected and there are some serious threats to the spending power of Australian consumers. At the end of December, the oil price was $75 per barrel. It is now $100 per barrel, leading average petrol prices to be well over $2 per litre and up more than 30% during the quarter. The cost of labour and the increase in other commodity prices have also played a part in rising inflation, increasing the cost of living for Australians. 

For now, these pressures are actually being felt rather than turning up in official backwards-looking government statistics. Official underlying inflation in December was only 2.6%, while wages were showing a 2.3% increase. Reading the present, though, suggests that this will change dramatically over the next six months. 

This being an election year, the government had some money to spend to relieve consumer pain. In the budget delivered last month, the government halved the fuel excise for six months, increased the low-and-middle-income tax offset this year and handed out cash. This totalled $8.6 billion, or about 0.6% of household disposable income. That tax offset is set to end this financial year though, despite the government initially thinking about another extension. This will sap about the same amount from consumer pockets starting in July. 

But the other shoe is still to drop. 

Interest rate expectations have risen sharply over the last quarter such that by mid-2023, Australia could be seeing cash rates of 3% from the current historical low of near zero. This would see the standard variable rates of the cheapest major banks move to nearly 6% from 3% today. On the average $800,000 new mortgage in NSW, that would be an extra $16,000 of annual after-tax dollars to be funded from consumer pockets for the length of the loan. The banks have already adjusted the interest rate on fixed-rate mortgages for new borrowers, with Westpac hiking nine times in the last six months. 

Expert economists don’t agree. Then again, economic forecasting is often described as driving a car blindfolded while getting instructions from a passenger looking out the rear window. The Australian Financial Review’s recent survey suggests the median economist is expecting a cash rate of only 1.25% by mid-next year. And the public outcry about calamity in an interest rate environment unseen for a decade has grown louder. That might be right, but the very liquid market for government bonds is telling you that rates are going up quickly. That’s something well worth listening to.  

There is also a burning consumer hunger for long-overdue holidays. Tourism spend is 6% of discretionary income now, compared to 14% pre-COVID. That is $80 billion of annual spend that will flow towards tourism and won’t be spent elsewhere. 

As a result, many companies exposed to consumption of large-ticket items and domestic goods could suffer. Lower house prices, dragged down by higher interest rates, are unlikely to make consumers feel good about spending up. Already, household spending estimates show that furnishings and household equipment spending is down 5% on the prior year in January, but remains 9% higher than pre-pandemic levels. The next big purchase is much more likely to be an overseas holiday than a new sofa. 

Less than 5% of the Fund is invested in consumer-oriented businesses most affected by these pressures, and stock-specific factors should overcome macro risks. It helps that both Motorcycle Holdings (MTO) and Shaver Shop (SSG) start with low expectations and very low valuations. 

A further 3% is invested in fintech lenders Plenti (PLT) and Wisr (WZR), which would suffer from consumer strain. But high originations growth to high-credit quality borrowers, passing on higher interest rates to consumers, and growing revenue at a much faster pace than costs holds these businesses in good form for the coming challenges. 

At the moment, reading the present involves paying attention to higher inflation, interest rate expectations and changes in consumer spending patterns. We may well be standing on the edge of a spending cliff, and that’s not good news for retailers of large-ticket items and domestic goods.

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