Broadly speaking, higher interest rates will have a negative impact on domestic demand growth. But just how much of an impact is the real question.
Increasingly, the market is pricing in a hard-landing scenario because of Reserve Bank of Australia (RBA) over-tightening. But we do not think that a hard landing is likely in 2008. Over the next year or so, domestic demand growth will slow but still remain at or above trend.
Growth will be good, just not as good as what we have seen in 2007. The labour market is strong, with leading indicators presaging further solid employment growth. Also, significant housing shortages will boost house prices and spending growth.
While interest rates are at their highest level since the mid-1990s, we do not believe rates are too high. With GDP growth running at a little over 4%, and core inflation running at 3.5%, rates between 7.5% to 8% are broadly appropriate.
We also need to understand that the RBA is tightening because growth is good. The reason is the strong boost to the economy coming from terms of trade expansion. Strong Chinese growth has boosted commodity prices, which in turn has added to domestic income growth and spending. The RBA's view is that commodity prices could continue to rise even if world growth slows abruptly. But if this forecast does not materialise, growth could slow quite sharply in 2009/10.
In terms of sectors, we think that there are downside risks to resources stocks from slowing world growth and falling commodity prices.
We like consumer stocks because of their solid earnings growth outlook in 2008. While consumer stocks are leveraged to commodity prices, the exposure is less direct than for mining stocks. Specifically, it will take some time before lower commodity prices feed through to jobs, income and spending growth.
We are slightly positive on banks; we like their defensiveness in a slowing global growth environment. But we are also wary of higher credit costs from the United States credit crunch.
The bulk of the current account deficit in recent years has been financed by bank borrowings from abroad. With access to offshore funds now restricted by the seizure of US securitised lending markets, banks will now find it harder to obtain funds.
Chief Australia Economist,
The Australian equity market is being increasingly influenced by the rise in inflation and interest rates. The underlying rate of inflation is pushing well above the Reserve Bank of Australia's target band of 2% to 3%.
The RBA has responded by lifting the official cash rate by 75 basis points (bp) to 7.0% since last August. We expect rates to rise by 25bp in both March and May.
With monetary policy moving to more restrictive levels, the economic and interest rate sensitive sectors are most affected – housing, consumer discretionary and financials. However, the sharp decline in the financial sector also reflects an interaction with the lagged impact of the credit crunch.
Companies which have used a greater degree of leverage in their business models are heavily exposed to rising interest rates (i.e.; parts of the listed property trust sector, infrastructure and second-tier financials). With inflation moving higher, higher price-to-earnings (P/E) and growth stocks are vulnerable to P/E de-rating.
The energy and materials sectors reflect more positive commodity prices and expectations that global growth may improve into 2009 on US Federal Reserve easing. The relative out-performance of telecoms and health care reflects their defensive qualities.
Overall, we would hold our tilt to global resource names and add to our positions in financials, particularly banks and diversified financials from around mid-2008.
MLC investment strategist,
National Australia Bank
The short answer is badly. The Australian share market has been one of the best performing developed markets in the world over recent years. Australia's miners have clearly been big winners from booming commodity markets as a result of China's insatiable demand for raw materials.
Booming commodity markets have boosted Australia's terms of trade and national income. The domestic economy has accelerated over the past year in contrast to developments in the United States and elsewhere.
However, for the first time in some years, a range of factors seem to be conspiring against Australian equities. Years of sustained economic growth have given rise to capacity constraints, most notably in the labour market where unemployment has fallen to multi-decade lows.
Household debt levels continue to increase at rates well in excess of growth in either the economy or household income. The boom in Australian house prices looks far scarier on several measures than the US property bubble.
Inflationary pressures have built to the extent that underlying inflation is now expected to stay above the Reserve Bank of Australia's target range for an uncomfortably long period of time. The RBA has made its intentions perfectly clear. Either the economy soon begins to slow significantly, or the bank will make it do so by hiking rates further. The end result is weaker domestic demand, slower credit growth and weaker earnings for those sectors most exposed to the domestic economy. The only unknown is how high rates need to go in order to achieve the bank's desired outcome.
Despite some aggressive monetary policy action from the US Federal Reserve and other central banks, global financial conditions have not improved significantly. Credit market conditions are still difficult, and share markets are still vulnerable.
It is likely that global growth will slow considerably further, and that the US economy is already in recession. In addition, Chinese authorities are continuing to take steps to slow their economy from its breakneck speed of recent years. As a result, the global backdrop which has been so favourable for Australia may not look as rosy over the next year or two.
The good news is that markets have begun to factor in the likelihood that earnings growth in Australia could weaken considerably, or decline outright. Valuations have improved. Opportunities have emerged, and will continue to emerge over the coming months.
Global asset management,
Recent economic data has highlighted that after 17 years of uninterrupted growth, the Australian economy is capacity constrained with rising inflationary pressures. The Reserve Bank of Australia's recent Monetary Policy Statement leaves the market in no doubt about its intention – to significantly slow the economy so as to bring inflation back within the 2% to 3% target range. The RBA's desire to generate a significant slowdown will pose a major threat to earnings of those stocks and sectors leveraged to the domestic, rather than international, economy.
In a period of sharply slowing economic and earnings growth, most sectors exposed to the domestic economy will be negatively impacted to some degree. One of the sectors most leveraged to the fallout from the RBA's policy of high rates will be consumer discretionary, which includes retailers, other consumer services and media.
With household gearing at record levels, consumers are particularly vulnerable to the trend in higher rates. It's this part of the economy that the RBA is looking to "make room" for the booming mining and related construction and infrastructure sectors of the economy. Higher rates, combined with a tightening in credit conditions, will also negatively impact financially engineered sectors such as listed property trusts and a range of non-bank financiers.
While higher rates are normally seen as a negative for the building and construction sectors, the nation-wide under-building of housing, along with the infrastructure requirement for an economy reaching capacity, points to a more positive outlook for companies exposed to these trends.
Notwithstanding the prospect of increasing unemployment and the deterioration in credit markets, the banking sector remains well positioned given the impairment of the non-bank lending business model which has significantly improved the medium-term outlook for the sector.
Sectors such as consumer staples and health care are well positioned to see out the risk of a sharp slowdown in the Australian economy given less cyclical earnings, along with bulk commodity producers which are benefiting from still robust demand and tight supply.