Make Sure You Get The Message

This story features MONADELPHOUS GROUP LIMITED. For more info SHARE ANALYSIS: MND

This story was first published two days ago in the form of an email sent to registered FNArena readers.

By Rudi Filapek-Vandyck, editor FNArena

Currency and bond traders have switched to a “no more RBA rate hike” view with the latter all but completely pricing out a possible further hike at the Reserve Bank’s meeting in May. Meanwhile, economists are cutting GDP growth forecasts for 2008/2009 and some, like Joshua Williamson at TD Securities, now expect the RBA will soon start lowering official interest rates, possibly as early as in the final quarter of the current calendar year. Some overseas currency experts are warning for a potentially significant downward correction for the Australian dollar if prices for commodities would fall in the second half of this year.

However, all of the above is in contradiction to the message RBA governor Glenn Stevens has been trying to get across since November last year to Australian homeowners, business leaders, politicians and investors and that is that underlying inflationary pressures in Australia are likely to remain strong -possibly too strong- for at least another 18 months.

This week’s release of the minutes of the RBA board meeting in March has revealed a slightly softer stance, but whether this indicates the RBA has now all but given up on the need for further tigthening seems, on all accounts, a bit far fetched. It certainly does not correspond with the fact that Stevens used his speech to the Australian Treasury in Canberra last week to point out that the March quarter CPI figures to be released at the end of April are likely to reveal inflation in Australia will have risen to 4%.

This begs the question: are investors and commentators missing the key message the RBA is trying to transmit or are they pre-empting a pending shift in monetary policy?

Usually inflation is a problem when an economy is booming as strong demand for products and labour pushes up overall prices and central banks therefore apply the brakes by raising interest rates to keep overall growth under control and inflation contained. This time around, however, virtually everyone agrees the Australian economy is already past its peak, yet the Reserve Bank maintains inflation warrants close and continuous attention and may even remain above its 2-3% comfort zone until 2010.

At 7.25% official interest rates in Australia already are at their highest level since December 1994. Every week now the Sunday newspapers are carrying stories about how families throughout Australia are finding it harder to cope with increasing mortgage stress, while both consumers and businesses are feeling the pain of banks increasing lending costs by more than the last 25 basis points hike by the RBA because of increased wholesale funding costs. How come the RBA is not so convinced that slower economic growth will automatically tame the inflation monster?

It all starts with the Commodities Super Cycle, or more precisely: with what preceded it; a structural underinvestment in infrastructure both by mining companies as well as the successive federal governments in Australia throughout the nineties. As a result, world consumers now have to spend more on bulk commodities such as coal and iron ore, but both the government and the private sector are now playing catch up and the result is a massive pipeline of projects and investments into the coming years.

While this explains the ongoing strong earnings outlook for companies such as Leighton Holdings ((LEI)) and Monadelphous ((MND)), this also explains why unemployment has fallen to 4% and why some economists believe it is likely to fall even further in the coming months. Most of these projects will go ahead no matter what, and the RBA certainly is fully aware of the overall impact of this on the Australian economy while being virtually immune to any interest rate increases – effectively the only weapon at the central bank’s disposal.

The Commodities Super Cycle is also apparent through much higher prices for all basic materials from copper to gold to uranium, oil and gas. This has pushed up Australia’s terms of trade (and effectively the overall wealth of the country) and the Australian currency. The stronger Australian dollar should have made imports much cheaper but it is already widely reported that retailers have simply increased their profit margins instead of passing on the benefits to their customers. This is likely to change now that Australian consumers have become more cautious in their discretionary purchases. Lower prices at retailers and less spending by Australian consumers are two important factors to mitigate some of the inflationary pressures elsewhere. The key question is, of course, will this be enough?

Consider also that there is another catch up development occurring throughout Australia, and one that is an equally important contributor to the CPI and, similar to most business and government investments, immune to anything the RBA can possibly do: housing rents. Economists at BIS Shrapnel have built up a solid reputation by analysing and forecasting the housing and property sectors in Australia. BIS Shrapnel believes Australian renters are about to receive the shock of their lives, especially for those who are renting a house or apartment in Sydney or Melbourne where average rents are forecast to rise by more than 10% and by circa 8% respectively in each of the next five years. That is 10% per annum, or an increase by more than 50% by 2012, if you happen to live and rent in Sydney. And there is little anyone can do about this.

The main reasons for the ongoing rent increases are an extended period of stable rents (house owners didn’t mind as long as capital appreciation was a sure bet) and the fact that relative availability has now fallen to extreem levels (Australia is structurally building too few houses, with NSW the worst in the past years). So after nearly a decade of no or only minimal increases, rents have started to move higher over the past year as structural undersupply of housing pushed total vacancy rates in all of Australia’s major cities to 1%-something. In Sydney, where the situation is worst, vacancy rates already fell below 1% last year – and they have continued falling. Of course, any smart investor will have guessed that such situation will eventually lure back new investors in the property markets as yields will increase considerably while demand will remain strong, but it’ll take time before building activity will pick up significantly and even more time before vacancy rates will see some relief. Meanwhile, rents will go up substantially. This will not only eat into consumers spending budgets, it will also push up inflation and keep the RBA on official alert.

BIS Shrapnel suggests rising rents can already be held responsible for the RBA hiking interest rates to 7.25% as without last year’s increases in rent Australia’s CPI would probably only have risen to just above 3% (instead of the 3.6% in last year’s December quarter), which would have left the RBA with more flexibility and possibly official interest rates at 7% instead of the current 7.25% (with ongoing upward bias).

For those who believe BIS Shrapnel’s forecast is too high, other property specialists are forecasting rent increases throughout NSW of 16% in the coming year.

On top of all this come persistently higher petrol prices. Only weeks ago market consensus was that crude oil prices would average around US$82 per barrel this calendar year. These forecasts have crept up considerably with more and more specialists now anticipating crude oil might fall back temporarily in the short term, but it is likely to remain above US$100 per barrel throughout the rest of the year. Again, this will have an upward impact on Australia’s CPI reading, and there’s nothing the RBA can do about it. The same goes for higher agricultural product prices. If current forecasts for “agflation” are correct, this would simply mean another upward CPI contributor that is effectively outside the reach of the RBA.

Another positive contribution will be delivered by the banks as financial services and insurance are a relatively important part of the current CPI calculation in Australia. The banks have been increasing costs for all sorts of loans by more than the official interest rate increases, and are expected to continue doing so as the global liquidity crisis pushes up their own wholesale funding costs.

What all these factors have in common is that there’s little the RBA can do about it, and they all reduce household budgets. Now you also know why the RBA does not want to see the Australian dollar back at US$0.80 anytime soon, as that would give inflation another unwelcome kick through higher import prices.

In November last year the RBA suggested global economic growth was likely to disappoint this year and next, but the message was completely overlooked by investors and commentators at the time. As a result, they all fell over each other when global growth indeed turned sharper than expected lower into the new calendar year.

This time around I believe the RBA wants Australia to be prepared for interest rates at elevated levels for much longer than would normally be the case. Interest rates in Australia are possibly on hold for the time being, but only because the global financial system is going through its most severe crisis in at least many decades – apart from this the bias is still to the upside (as proven by Stevens’ speech in Canberra last week).

Were this to change at any time in the foreseeable future, this would indicate time has arrived to really get worried as it would mean things have unexpectedly turned nasty and a home grown recession has become a genuine possibility.

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