Strategy commentary cont'd: Coolabah’s global long duration strategy, known as the Pacific Coolabah Global Active Credit Fund, returned 0.83% in June before fees, outperforming the benchmark by about 0.13%. Since it was launched in October 2023, the Pacific Coolabah Global Active Credit Fund has returned 10.43% gross compared to the Bloomberg Global Aggregate Corporate Index’s 8.09% (or alpha of about 2.34%). This strategy is not currently available in Australia.

There were echoes of this dissimilitude in the equity market reactions. Whereas stocks rose in the US (S&P500 up 3.47% and Nasdaq up 6.18%) and Australia (0.85%), they declined in Europe (Eurostoxx 50 (sx5e) down 1.80%), the UK (FTSE100 down 1.34%), and New Zealand (NZX50 down 1.26%).

The cross-currents in markets appeared to hurt Bitcoin, which lost 11% in June, while the price of oil bounced almost 6%.

With the June month numbers in, we can now look back to assess performance across the 2024 financial year. Coolabah’s two best performing strategies were the A+ rated, zero duration, and daily liquidity Long-Short Credit Fund and Long-Short Opportunities Fund, which both returned between 11.9% and 12.1% net of fees. These two strategies carry current gross annual running yields of 7.4% (or 8.6% pa in NZD) and 8.4% pa. The USD and NZD versions of the Long-Short Credit Fund returned 13.2% and 13.1% respectively.

Next cab off the rank was the A+ rated, zero duration, and daily liquidity Floating-Rate High Yield Fund, which returned 11.4% to 11.7% after fees and has a current gross annual running yield of 8.1%.

In the long duration or fixed-rate bond space, Coolabah’s A+ rated, daily liquidity, and 5.1 year duration Active Composite Bond Fund, which is also an ETF trading under the ticker FIXD, returned 8.2% net compared to the Composite Bond Index’s 3.7%, providing an excess return of 4.5% after fees. FIXD has a current gross running yield of 6.5% pa (in NZD the yield is 7.6% pa).

In the cash enhanced sector, Coolabah’s A+ rated, daily liquidity and zero duration Short Term Income Fund, which is also an ETF trading under the ticker FRNS, returned 6.7% to 6.8% net (the USD and NZD versions returned 7.4% and 7.9% net). FRNS has a current gross running yield of 5.6% pa (in NZD the yield is 6.8% pa).

The risk of a sovereign debt crisis is back

The financial market volatility induced by the political dramas in France highlight that we are likely moving into a new regime where the risk of sovereign debt crises comes back into frame.

Strategy commentary cont'd: This is a clear extension of the fiscal dominance problems repeatedly outlined by Coolabah. That is, a situation whereby the inflation crisis, which started in 2020, is prolonged by the political propensity to spend vast amounts of public money in the name of myopically buying votes.

It is being exacerbated by politically compromised central banks that are once again making the same mistakes they made in 2020 and 2021. They are predicating interest rate decisions on uber-rubbery forecasts that consistently underestimate the inflation pulse due to a lack of data dependency and not fully accounting for fiscal policy, which is pouring fuel on the flames.

The ascendancy of the French far-right in the European parliamentary elections, and subsequent polling suggesting that centrist President Emmanuel Macron will lose control over domestic policy at the snap election in a few weeks, has global investors who tenuously bankroll the country’s gargantuan budget deficits worried.

In 2023, France recorded a fiscal deficit worth an incredible 5.5% of GDP, which is materially above the EU maximum limit of 3%. The deficit is forecast to be similarly chunky this year, which will push France’s public debt to 114% of GDP in 2025, almost double the EU limit.

With popular political movements on the right and left significantly outpolling Macron’s Renaissance party and proposing policy measures that would plunge the budget into deeper deficits, investors have dramatically jacked-up the required returns on French government bonds, known as OATs.

The spread between a 10-year OAT and the European risk-free benchmark, which is the 10-year German government bond yield, has leapt from 46 basis points to 79 basis points this month, which is the toughest risk premium recorded since 2017.

In fact, French government bond spreads were even higher than those that prevailed during the global financial crisis and have only been bested once since 1995 by the extreme risk premium that gripped during the 2011-12 crisis when investors fretted that the eurozone was going to collapse.

This is precisely the sort of shock this column has repeatedly warned about: profligate and inflationary political spending forcing bond markets to lift the interest rates on ostensibly risk-free government bonds which, in turn, increase the discount rates on all assets, including equities.

At the height of the French turmoil this month, the French domestic sharemarket benchmark, the CAC 40, slumped by more than 7%. Conditions have since stabilised, thanks to efforts by Macron’s rivals to assuage market anxieties by promising to act responsibly.

It remains an open question whether this is simply a stay of execution: while investors were happy to buy new French government bonds issued during the week, and therefore continue to fund the burgeoning budget deficits, OAT spreads over German government bonds have not compressed materially.

In our own portfolios, we had taken profits on our US and European exposures many months ago simply because local Australian spreads appeared relatively more attractive. The higher cost of capital demanded by Antipodean investors also meant that there was a paucity of new bond issuance, or supply, from overseas firms, which were tapping the cheaper finance available in the US and Europe. Recent ructions have once again recalibrated this calculus.

Similar thematics around reckless fiscal largesse are playing out with state government budgets. The spread on a 10-year Victorian government bond over the risk-free Commonwealth bond benchmark has leapt from a 16 basis point nadir in 2021 to as high as 92 basis points in 2024.

This is because the quantum of state government debt that domestic investors are being asked to underwrite has exploded from less than $50 billion per year before the pandemic to what will likely be north of $120 billion in the next financial year.

Strategy commentary cont'd: In September 2021, Coolabah revealed for the first time a deep liquidity hole on Aussie bank balance sheets that would necessitate an enormous increase in their holdings of Commonwealth and state government bonds.

The shortfall was estimated to be north of $200 billion, depending on the assumptions one made. We predicted that banks would focus on buying higher-yielding state government bonds because of the superior return on equity offered on these assets, all else being equal.

Since that time, unprecedented bank balance sheet buying of state government debt has been evidenced over and over again via record book-builds. The share of the market owned by banks jumped from 42% in December 2021 to a record 55% by the end of 2023.

From 2020 to 2023, banks bought $154 billion of state government bonds, or 60% of the total supply. Accordingly, a big chunk of the liquidity hole that we identified in 2021 has now been cauterised.

Indeed, we estimate that the banking system now only has between $10 billion and $50 billion of Commonwealth and state government bonds left to buy to meet its targets by the end of 2024. This means that banks no longer need to hoover up the extraordinary quantities of bonds they have accumulated in recent years.

The dissipation of this demand is a key reason why state bond spreads to Commonwealth bonds have gapped to more than 70 basis points. The states will now be forced to compete with the much more attractive spreads on the major banks’ similarly rated senior ranking bonds.

The challenge here is that where an AA-rated, five-year CBA senior bond pays an 85 basis point risk premium above the quarterly bank bill swap rate, AA-rated Victorian government bonds provide a far less attractive 30 basis point spread. (Heaven help Victoria if its rating is downgraded to below the big banks.)

Both securities are implicitly government guaranteed. The key difference is that the banks are much more rational and predictable debt issuers. To get really excited about state government bonds, they would ideally need to be paying spreads that are similar to the major banks’ bonds.

And while the big four banks collectively issue similar quantities of debt to the states each year, they are spreading this supply across many different global markets, such as the US, UK, Europe and Japan.

The states have been reluctant to issue debt in anything other than Aussie dollars because they know they would have to pay another 20-30 basis points in extra annual interest if they were to go offshore. But it is not clear who is actually going to buy all the states’ bonds: offshore demand has been declining for more than a decade, while pension and investment funds only account for 13% of the securities outstanding.

The budgets released by Victoria, Queensland, NSW, and South Australia disclosed a predictably disappointing deterioration in their deficits that was explained by discretionary political spending. Consequently, debt issuance in the next financial year was upgraded in all states, except for NSW, which was able to allegedly reduce its funding task from $24.5 billion to $22.3 billion.

The concern is that NSW tried to pull the same trick last year: it shocked the market by announcing a modest $23 billion funding task for the 2024 year, only to surprise investors by issuing a 50% larger quantum worth $34.5 billion. One thing savvy NSW Treasurer Daniel Mookhey can be congratulated on is his prudent decision to cease funnelling future taxpayer revenues into risky financial markets by de facto debt-funding a NSW investment vehicle, paradoxically known as the Debt Retirement Fund, while bleeding budget deficits.

Both the federal and state governments have developed a nasty appetite for squirrelling away taxpayer money into dubious investment vehicles at a time when they are racking up record debt.

Strategy commentary cont'd: Rather than gambling on the bet that these investments will offer superior returns to the interest rates paid by taxpayers on their ever-expanding debts, they would be much better off simply repaying unnecessary liabilities, especially considering that the cost of new debt is multiples of what they were paying when the deficits started to balloon during the pandemic.

The RBA should hike in August

Underlying inflation continues to track above the RBA’s forecast profile, suggesting that the board should raise rates in August.

Headline inflation came in above market expectations for the third month in a row in May, up 4.1% over the past year.

More importantly, measures of underlying inflation - for which there are no consensus forecasts - point to persistent above-target inflation.

The monthly CPI proxy for the quarterly trimmed mean CPI - which is the RBA's preferred measure of underlying inflation - is the ex-volatile items/holiday travel CPI. This series rose by 0.3% in the month to be 4.1% higher than a year ago.

Similarly, annual trimmed mean inflation to 4.4% in May, its highest level since November (note that the ABS does not publish the monthly movement in the trimmed mean CPI, which is why it is approximated by the ex-volatile items/travel CPI).

The monthly proxy now points to the trimmed mean CPI increasing by 1.0-1.1% in Q2, with an assumption for the June outcome having little impact on the Q2 estimate (the Q2 result was previously estimated as a quarterly increase of 0.9-1.0% based on conservative assumptions for May and June).

Governor Bullock said in her recent press conference that the board had again considered raising rates in June, with policy-makers alert to higher-than-expected inflation in April and recent upward revisions to consumer spending.

If realised, a 1.0-1.1% increase in the trimmed mean CPI would be above the RBA’s 0.8% forecast, representing the third upside surprise to inflation in the past four quarters.

Politically a hike would be extremely difficult and it would also be presentationally awkward given a couple of the RBA's peers have started to cut rates and others plan to ease policy if inflation improves further.

However, it seems that underlying inflation is proving more persistent than the board had assumed, with the RBA failing to benefit from the persistent goods deflation seen in some other advanced economies and with services inflation still tracking in the 4s.

The governor understandably wants to avoid triggering a recession (or at least a negative quarter of GDP growth given the media frenzy that would ensue), but it still seems that policy is not tight enough to bring inflation back to the 2.5% target by 2026, bringing home how her predecessor should have followed the example of other countries and raised rates sooner and by more in total.

The board might still decide to keep rates on hold, but that strategy would risk inflation staying high for longer, with the RBA not meeting the inflation half of its dual mandate.

Deputy Governor Hauser gives his first formal speech on the economy tomorrow night and might try to guide market expectations, although he may hold back if the governor does not want to publicly commit the board ahead of the Q2 CPI on 31 July and the policy meeting on 5-6 August.

For its part, the market now puts the odds of a rate rise in August at about 35%, up from around 10% yesterday.

Strategy commentary cont'd:

Market forecasts for inflation

Underlying inflation is tracking above the RBA’s forecast profile

Policy rules point to central banks diverging on rates

A simple policy rule points to a slow and shallow easing cycle in the US, gradual rate cuts in the euro area, and risks around the RBA's conscious decision to raise rates by less than other countries in order to lock in the employment gains of the past few years.

CCI uses a version of the Taylor rule to assess the risks around central bank forecasts for the policy interest rate in the US, euro area, and Australia.

A Taylor rule estimates policy rates based on central bank forecasts for underlying inflation and inflation relative to their respective inflation targets and estimated NAIRUs.

Strategy commentary cont'd: The rule’s estimates are anchored by estimated neutral policy rate in each country, which is where policy rates will end up if central banks successfully return inflation to target and bring demand back into line with supply in each economy.

• In the US, the rule still suggests that the Fed will be slow to cut rates, starting around Q4 2024/Q1 2025, with fewer cuts in total over the next few years than assumed by Fed policy-makers because the neutral rate looks to be higher than pre-pandemic levels.
• In the euro area, the ECB started cutting rates this month and the rule suggests the ECB will continue to slowly ease policy as inflation improves, similar to the market-based profile for interest rates that underpins ECB staff forecasts.
• Australia remains a different story, with the rule still suggesting that the RBA should have raised the cash rate more in the near term.

The divergence in Australia is the result of the RBA board purposefully deciding to raise rates by less than other countries, accepting a slower return to the inflation target in order to retain as much of the gains in employment over recent years as possible.

The risk to this strategy is that interest rates stay high for longer to contain inflation and/or inflation takes longer to sustainably return to the RBA’s 2.5% target.

A modified Taylor rule points to divergence in policy rates across countries

Strategy commentary cont'd:

Goods and services prices inflation are both above the RBA target

A more resilient consumer and excess savings

The most important feature of yesterday’s national accounts was that consumer spending looks more resilient than first thought.

Originally, spending showed few signs of life, barely growing over the course of last year (although at the margin the ABS was classifying some government-subsidised spending as public expenditure).

Now, the ABS estimates spending grew by 1% over 2023, picking up to 1.3% in the year to Q1, similar to what prevailed immediately prior to the pandemic, but less than the 2.5% average of the ten years prior to COVID.

The revision was driven by better data on household spending overseas, where the ABS started surveying Australians again on what they spent while travelling.

Although household income has passed its worst point, it has been weak over the past year and a half after returning to a more normal level following a surge during the pandemic on massive government handouts, which begs the question of how consumers funded this extra spending.

The answer lies in the household balance sheet, with the household saving rate revised lower and our estimate of household net cash flow – which equals saving less investment in physical assets, mainly housing – turning flat to slightly negative since late 2022.

Household net cash flow, or “net lending”, equals the net acquisition of financial assets by households less their net incurrence of financial liabilities, so for it to turn slightly negative means that households are not only tapping the excess savings accumulated during the pandemic – which were the product of government handouts and saving by households during lockdowns – by saving at a slower rate than the pre-pandemic trend, they have reduced their net financial wealth slightly by selling some financial assets and/or increasing their debt.

(A negative cash flow for households is not unprecedented – it was common for households during the 1990s and 2000s, when Australian households rapidly geared up and/or sold some of their financial assets.)

This raises the question of why households would save at a slower rate and likely slightly ran down their net financial assets recently.

Comparing Australia with other countries, it looks like households are following the lead of the US and euro area by running down their more substantial excess savings, which peaked at about 13% of GDP and where our preliminary estimate for Q1 is 8% of GDP.

In this way, the excess savings are smoothing spending during the recent period of extreme COVID-driven volatility in income and wealth, supporting expenditure until income recovers.

Strategy commentary cont'd: That strategy seems to have worked for most households in that income should soon be boosted by July’s income tax cuts and with total household wealth growing strongly on capital gains from a sharp recovery in house prices.

For the RBA, the revision to spending challenges its main downside risk to the outlook, which was that a stressed consumer would place downward pressure on inflation.

Consumer spending has been revised up

Revised consumer spending is growing close to its pre-COVID trend

Strategy commentary cont'd:

Consumers are tapping still-substantial excess savings