The higher for longer narrative gains traction as US consumer data holds steady and markets hit all time highs. The late cycle AI heated market rally may be cause for concern, but the more urgent risk for investors is an economy with falling yields and sticky inflation. The rate summit has been found, but how do investors coordinate investment strategy along a historical plateau?
We have reached the summit of the rate cycle, but it is not the resounding victory and decisive end to the inflationary era we had all expected. The interest rate trajectory and commentary has dominated markets the past two years, leaving investors dumbfounded as to exit options or pivot strategies. After two years of widespread capital destruction the market has distilled some confidence, moving from a state of panic to a rate environment with a known summit. But, how far and how wide stretches the top of the mountain? As the economy tiptoes along the peak of this new range the market has yet to fully grasp its surroundings, surveying the plausibility that we are in ‘higher for longer’ territory.
An unknown landscape where the neutral rate of interest is held substantially higher than the normal historical range of 2-3%. This would be a more restrictive rate path held constant at the current rate level for the foreseeable future, to maintain a real rate of interest that is better equipped to contain the risks of persistent inflation. Unfortunately, market function is derived from the interpretation of directional moves in rates, more precisely up or down data signals. Therefore, consensus views often struggle to accurately quantify market outcomes when a rate environment is held constant. This market tendency can explain the overplayed bias of investor behaviour preferencing a cutting phase in early 2024. Our view is that the policy switch from the 2010’s QE excess to the rapid QT over the past two years has not resolved the structural imbalances to liquidity levels, and these generational capital distortions cannot not be repaired with the ‘flick of a switch’ from near term policy stances. At or near peak interest rate levels need to be held along a lengthy plateau to correct the permanent damage of overrun QE policy.
For investors intending to beat the market in 2024, the rate summit and ‘lengthening plateau’ effect will undoubtedly group investment performance along the conveyor belt of tentative Central Bank thought. As the market reaction to this historical rate cycle phenomenon is yet to play out, nevertheless investor outlook looks buoyed by the improved sentiment in corporate activity and transactions being viewed as deliverable in a higher neutral rate environment. As investors we are positioned to identify peaks and troughs, it is likely that the sideways rate path movement will add significant dispersion to decision making and volatility to markets. An effective investment strategy in 2024 will outperform benchmarks independent of near-term monetary policy decisions. In this distinct generational market phenomena, commodities are a superior asset differentiator to escape any negative impacts of monetary discussions, as their price operates in an inverse relationship to rates. Therefore, to beat the market in 2024, consideration should be applied to long run commodity positions that offer a two-tail benefit of attractive early phase spot prices and also the best protection from late cycle credit risk.
The global economy has continued to surprise through the tightening cycle, particularly the durability of the consumer and the relative strength of retail spending that has been undeterred by record rate rises. A widespread consumer trend that formed in the US and has certainly been carried into the domestic market, as Australian shoppers push ASX listed retailers JB Hi-Fi (ASX:JBH) and (ASX:LOV) to all-time highs. Despite the seemingly resistant consumer data, there are growing doubts if this trend can continue as the local savings rate declines at a rapid rate quarter on quarter, extinguishing the safety net of savings amassed during Covid. Australians are consuming more than they earn and save at an alarming rate, with nearly half of the population (45%) having less than $1,000 in savings. A savings rate comparison to the recent quarter of 1.1% with the peak savings rate of 24% of disposable income during the height of Covid uncertainty in June 2020 quarter, the deterioration of household budgets in Australia is cause for growing concern.
The rundown of household savings paired with a longer interest rate plateau will likely be the economic catalyst to force a consumer slowdown from Q4 FY ’24, followed by falling revenues in consumer discretionary income by September. A niche of the retail market that will maintain outperformance in an inflationary environment is the non-discretionary consumer sector, as a lack of consumer choice will continue pushing shoppers into absorbing higher prices, some key players include: Coles group (ASX:COL), Metcash Ltd (ASX:MTS) and Bubs Australia (ASX:BUB). The negative outlook for the Australian consumer is unlikely to have any significant impact on the housing market as a tight labour market and record net migration continue to support demand levels in an already under supplied market. The remarkable turnaround of digital property group REA (ASX:REA) up 90% since June ‘22 now trading at a record high of $180 demonstrates the upbeat sentiment in domestic property, primarily driven from investors chasing rental growth that outstrips inflation.
The robust employment data from both the US and the local labour market has been the perplexing employment story mystifying economists as job force participation defies expectations to remain the steadying data guidance for a plausible ‘soft landing’. If the labour force participation significantly deteriorates in the second half of 2024, it will have compounding impacts to not only the Australian consumer, but also property and the overall market outlook. However, for now the unemployment rate is holding steady and it will be the most critical guidance in determining Australia’s economic position during the second half of ‘24. Regardless of labour market outcomes, private credit markets look attractive this year with consumers spending more than they save, corporate activity returning and capital expenditure beginning to normalise under the backdrop of stabilising rate levels.
The levelling out of the rate cycle creates a support level for lenders outside of the ‘Big 4’, Virgin Money UK (ASX:VUK) and Credit Corp Group Ltd (ASX:CCP) have both rallied over 40% since November. Once the interest rate plateau duration becomes known or better understood these lenders will be trading on a clearer path to improved margins and continue their outperformance. Zip Co Ltd (ASX:Z1P) a fallen star from the pandemic era fetched over $12 per share at its peak, has collapsed dramatically due to margin squeezes from increasing rates, high levels of competition and the threat of bad debts pushing the price to a low of $0.26 in October ‘23. Z1P has since surged nearly 400% in the last 6 months. A defined rate path would be a huge tailwind for Z1P as it addresses internal compliance and better quantifies the quality of debt issuance. The non-banking financials are becoming more attractive under a peaked rate environment, with consumers that need credit and corporates engaging with funding options for the next business cycle. Pepper Money Ltd. (ASX:PPM) is a quality exposure to the retail mortgage space, a sector with strong fundamentals, offering a 5% dividend and trading at a 30% discount to its listing price. Judo Capital Holdings Ltd (ASX:JDO) focuses on SMEs that are outside the lending mandates of the ‘Big 4’, a gap in the market with huge upside as capital investment and corporate activity gain momentum later in the year. Judo is down 43% since its listing in late 2021 and is certainly a stock to watch as the rate hold signals a return of corporate confidence. There are growing opportunities in the private credit and non-bank lender space, especially as the ‘Big 4’ are forecast to underperform this decade, discerning the lending practices and quality of debts is critical in this sector.
The anticipated policy pivot has encouraged a highly concentrated equity rally in quality tech and market leaders, but it has been slow to extend through to small caps and commodity-based stocks. Over the past month commodity spot prices, particularly gold and crude have seen considerable movement, but this appreciation has not yet carried through to resource-based equities. Woodside (ASX:WDS) an energy-based heavyweight is a clear reference of this disparity with a disappointing performance for the opening months of 2024. When global Indices are at all-time highs resource and energy stocks are lagging significantly, despite their market weightings, relative valuation discount, elevated geopolitical tensions and supply risks. The market divergence is seen at an even greater level in the small cap commodity space. As the broader small cap sector has been under pressure for a number of years and continued to lack the surge of demand seen in the wider global equity relief rally from October last year. The trading environment in the new year signalled a market of falling yields and sticky inflation, igniting a capital push into ‘quality leaders’ that has distorted valuations to record highs. Investors need to consider the growing risks of top-heavy indices that are being viewed as safer alternative options for growth. When their viability as a growth strategy hinges on exponential expected revenue growth. The future share price performance of large cap leaders at current valuations is precariously tied to the market’s adaptive expectations of inflation prints. Once the plateau of higher for longer has been clearly defined conditions will become considerably more favourable for mid and small caps, with their relative valuation discount offering significantly more upside for investors.
A forward-looking investment approach to overcome the ‘plateau predicament’ acknowledges that although the duration of higher neutral rates is unknown, we are considered to be in a late-stage credit cycle. Therefore, an impending commodity growth cycle will very likely precede the arrival of a new credit cycle. Australian based investors must utilise the inverse relationship of rates and commodity prices, for it is the most dynamic response to navigate rate uncertainty in our local market, given the dominant representation from ASX miners and energy producers.
Due consideration to ASX positions that produce a diverse range of critical minerals offers exposure to considerable long run upside. As a mix of future facing commodities will effectively structure a balanced portfolio that is prepared to counter persistent inflation. The uplift in business confidence and the long awaited Chinese fiscal stimulus are positive tailwinds for raw materials and commodity inputs that should lead to a sizable demand driven push from industry. Commodity cycles are always demand led market shifts and the legislated drive from governments to decarbonise economies, at the very least puts a demand floor on critical minerals in a market with already extremely tight supply levels. The compelling need for net zero and the growing urgency to transition, will accelerate demand levels at speeds never experienced in modern based trade. The accelerating demand dynamic outpacing production capacity will commence the green transition in an environment of record low supply, establishing a dual sided disequation that fundamentally supports the green based commodity thesis. It is a structural and multi-generational requirement for all countries that will likely drive Australia into its next mining boom. A long run ‘green boom’ may seem ambitious, nevertheless the cyclical factors indicate market stabilisation and return of corporate activity are fundamental signals that commodities will pick up in the near term as industry momentum builds.
The magnitude of late cycle credit risks are incredibly difficult to dissect as the record QT and the historical ‘lengthening plateau’ effect disguise excess liquidity yet to be absorbed into the economic system. Commodity exposure is the best path forward along a plateauing rate environment, because they offer attractive entry prices that are less correlated with monetary decisions and position a portfolio for the cycle ahead. The ASX offers a great selection of green miners and transitioning energy stocks; a bias toward copper, gas, lithium and battery metals on current spot prices demonstrates great upside. Aeris Resources Ltd (ASX:AIS) is a strong small cap copper producer that struggled under the elevated recession risk reaching a multi-year low of $0.082 in February has since more than doubled its share price, timing new resource discoveries with improving macroeconomic conditions. A retail favourite during the pandemic boom Chalice Mining Ltd (ASX:CHN) has dropped over 90% in less than 3 years as the company’s production feasibility report assumed much stronger commodity prices. The Perth based miner is still years away from market production highlighting a clear market overreaction to softer current commodity prices, Chalice has a sizable discovery of critical metals that offer long run share growth. A cobalt miner stirring interest in the famous mining region of Broken Hill is Cobalt Blue Holdings Ltd (ASX:COB) trading near its 52 week low with a current market cap of $58m is significantly below 2022 highs. Arafura Rare Earths Ltd (ASX:ARU) recently announced massive Commonwealth funded support for its rare earth Nolans project in the Northern Territory of US$533m, a debt package that exceeds its current market cap and ensures Australia’s first rare earths processing facility can be delivered. The change to commodity-based demand offers a unique opportunity to enter at attractive valuations in positions that will outperform yield based strategies along a flat interest rate environment.
The world is aggressively tilting toward divergent rate paths, as the Fed and the Eurozone appear to more openly lean towards an easing trajectory whilst the BoJ considers a long awaited lift to rates, dissolving nearly 15 years of QE policy. The RBA, now split between conflicting foreign policy, has been slow to indicate their policy position and will likely be one of the last major Central Banks to signal a directional shift. The equity market has made a distinct momentum shift from distressed sales to demanding quality market leaders that perform under the uncertainty of differing late cycle rate conditions. The end of the RBA’s tightening cycle has dissipated market panic, but the delayed pivot to easing has stirred confusion on the length and shape of the downward rate curve. Will the speed of growing regional rate divergence impact volatility and the global macro-outlook? The two primary economic health signals on the demand side are a negative savings rate and an outperforming labour market that is expected to retreat under the extended weight of restrictive credit territory. These negatively skewed consumer signals will be embedded by an RBA that cannot confidently justify rate cuts until late 2024, indicating a weak Australian consumer outlook for later in the year. The persistent uncertainty in financial markets will continue alongside the lengthening plateau effect, coupling market volatility with indeterminate monetary policy. Investors that proactively navigate the duration risk associated with any future policy pivot will structure portfolios that perform independent of ‘deanchoring’ inflationary expectations. To beat the market in 2024 investors must be rate summit conscious, policy plateau concerned and actively considering the curve of an easing pathway. An investment bias toward businesses that provide quality cash generation and stable dividend distributions with a mix of forward-facing commodities will balance the investment unknowns of prolonged sideways monetary decisions.
