Insights

Today, I want to discuss the challenges the Reserve Bank of Australia (RBA) faces in cutting rates. To do this, I’ll explore our model of Australian short-term interest rates, and how its components interact. A key focus will be the relationship between inflation and unemployment, and how this relationship makes it particularly difficult for the RBA to now lower rates.

Our model of the Australian cash rate is robust, explaining just under 90% of the monthly variation in the cash rate since the 1990s, when the cash rate was first introduced. The model’s components include core inflation (not headline inflation), unemployment, and inflation expectations.

Interestingly, statistical tests show that unemployment is even more important than inflation when it comes to predicting what the RBA will do with the cash rate. This is because of the strong, leading relationship between Australian unemployment and core inflation.

To illustrate this, I’ve used data from the past ten years up until December, which shows the relationship between unemployment and inflation in Australia. The data reveals a Phillips curve, where inflation tends to fall as unemployment rises. This relationship begins to work appears almost immediately, though there is a slight delay of about 3 to 4 months before its full effect is felt.

We look at the data from 2014 to the end of 2024. When unemployment is around 4%—which is where it has been for the past few months—we can predict that core inflation should be around 3.7%. Currently, core inflation is 3.5%, which aligns closely with what we would expect given the unemployment rate. This suggests that the current level of inflation is consistent with current unemployment levels.

Unemployment vs Inflation

2014 to 2024

However, the RBA’s target inflation rate is between 2 and 3%, with a specific target of 2.5%. To achieve this target, unemployment would need to rise from its current level of 4% to around 4.6% or 4.7%. Historical data, such as from 2021, shows that with an unemployment rate of around 4.6%, inflation can be brought down to 2.5%. Therefore, to reduce inflation to the RBA’s target, the unemployment rate would need to increase slightly—though not drastically. If unemployment were allowed to rise to around 4.6%, it would create enough excess capacity in the economy to put downward pressure on inflation, which would take about 3 to 4 months to materialise.

If the RBA were able to allow this rise in unemployment, inflation would decrease to around 2.5%, and the RBA could cut rates. Current rates are at 4.35%, and under this scenario, we could expect them to drop to the low 3.0% range perhaps even lower. This would represent a fall of around 100 basis points from current levels.

Unfortunately, the situation is complicated by fiscal policy. The current Treasurer, Jim Chalmers, has been expanding employment in sectors like the National Disability Insurance Scheme (NDIS) and other areas of the public service. This fiscal stimulus is preventing unemployment from rising to the level needed for inflation to fall. As a result, unemployment remains stuck at around 4%, and inflation remains too high for the RBA to cut rates.

In terms of job vacancies and other labour market indicators, we would have expected unemployment to rise higher by now. However, Treasurer Chalmers is committed to keeping unemployment low ahead of the election, which is why we find ourselves in this position.

The government’s fiscal policy, aimed at maintaining a low unemployment rate, is preventing the necessary adjustment to bring inflation down.

If I input the current levels of inflation, unemployment, and inflation expectations into our model, the estimated cash rate should be 4.45%. This is 10 basis points higher than the current cash rate of 4.35%.

The Australian Government seems intent on maintaining the unemployment rate at 4% ahead of the election. If it does so, Inflation will remain too high for the RBA to cut rates.

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Following the release of the Aged Care Taskforce report earlier this year, the federal government has recommended a number of changes to the cost of residential aged care, some will commence from the beginning of 2025 and the remainder expected to commence from 1 July 2025.

Over the next 40 years, the number of people over 65 is expected to at least double and the number of people over 85 expected to triple. A significant amount needs to be invested in the Aged Care sector, by both government and private sector, to be able to manage the growing numbers of older people needing care and support in their later years.

From 1 January 2025:

• Increasing the refundable accommodation deposit (RAD) maximum amount without approval from $550,000 to $750,000. This amount will be indexed annually.

From 1 July 2025:

• Introduce a RAD retention amount of 2% pa to a maximum of 10% over 5 years.
• Removing the annual fee caps and increasing the lifetime fee caps to $130,000 or 4 years, whichever occurs first.
• Introducing a means-tested hotelling supplement of $12.55 per day which is to be indexed.
• Removing the means tested fee and replacing it with a means tested non-clinical care contribution (NCCC). The daily maximum is $101.16 which is to be indexed.

From 2029/30:

• The government is looking to commence a phase out RAD altogether by 2035. A commission will be established to independently review the sector in readiness.

Grandfathering arrangements will protect anyone who enters care prior to 1 July 2025 under the “no worse off” principle to ensure they do not pay more for their care.

Comparison of current and new aged care costs

Current aged care fees

The Basic Daily fee continues to be paid by all residents without change.

The Hotelling Supplement is paid by residents as a contribution towards their living costs. It is a means tested payment calculated at 7.8% of assets greater than $238k or 50% of income over $95,400 (or a combination of both). The Hotelling Supplement is capped at $12.55 per day (indexed).

The Non-Clinical Care Contribution (NCCC) replaces the current means tested fee. The NCCC is a contribution towards the cost of non-clinical care services which will be capped at $101.16 per day (indexed). It is a means tested fee calculated at 7.8% of assets over $501,981 or 50% of income over $131,279 (or a combination of both).

The lifetime cap for the NCCC is increasing to $130,000 or 4 years, whichever occurs first, indexed twice per year. There is no longer an annual cap.

Any contributions made under the home support program prior to entering residential aged care will count towards the NCCC cap.

Who will likely pay more from 1 July 2025?

It is expected that at least 50% of people entering care will pay more for their care each year.

The below chart illustrates the expected changes for regular care costs (excluding accommodation costs and retention amounts) for individuals based on specific asset levels:

Should you enter residential aged care before 1 July 2025?

It depends. For some people, if they have an ACAT assessment and are eligible to enter residential aged care, then it would be best to seek advice from your Morgans Adviser on both the current and future cost as well as cash flow and cost funding advice.

Contact your Morgans adviser today to schedule an aged care advice appointment. Our expert team will be able to simplify the aged care system, guide you through Government subsidies, analyse payment options, create 5-year cash flow projections, and model the benefits of home concessions and future asset values for your beneficiaries.

Australian’s life expectancies are increasing over time. We can now expect to live longer - on average 5 to 7 years longer - than our parents or grandparents did.

The problem is that as we live longer, we also need to support ourselves for longer in retirement. This is compounded by the fact that, according to the Australian Bureau of Statistics (ABS), we are retiring earlier these days with the average age of retirement reported to be 56.9 years. Interestingly, the average age people intend to retire is 65.4 years.

According to the ABS’s May 2024 report:

• There were 4.2 million retirees
• The average age at retirement (of all retirees) was 56.9 years
• 130,000 people retired in 2022, with an average age of 64.8 years
• The average age people intend to retire is 65.4 years
• Pension was the main source of income for most retirees

In their Media Release supporting their 2024 retirement report, ABS’s head of labour statistics, Bjorn Jarvis, said: “While the average age people intend to retire has risen over time, it hasn’t changed much in the last 10 years. This average has been between 65.0 and 65.6 years for close to a decade, since 2014-15. On average, men intend to retire slightly later than women, but this gap is closing. In 2022-23, there was around half a year difference between men and women, compared to a year difference a decade ago.”

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Income at retirement

According to the ABS retirement report, a government pension or allowance was still the main source of personal income at retirement for 43% of retirees. This was followed by Superannuation, an annuity or private pension at 27%.

Factors influencing retirement

In 2022-23, the most common factors influencing older workers’ decision to retire was still financial security (36%) and personal health or physical abilities (22%). Around one in eight retirees (14%) said reaching the eligibility age for an age (or service) pension was a key factor.

Retirement planning

According to the ABS, 710,000 people intend to retire in the next 5 years, with 226,000 in the next 2 years. Will you be one of these people? If so, do you have the confidence your retirement plans will be enough to support you in retirement? Your Morgans adviser can review your retirement position and recommend strategies that will help you stay on track so that your retirement, when it happens, is an enjoyable stage of life. Already retired? We can help there too.

Contact your Morgans adviser today to schedule an appointment to discuss your retirement plans.

The year 2024 will arguably be known as the ‘cost of living crisis’ year. So many Australians are feeling the pain of this high inflation environment, particularly with everyday consumer items and mortgage stress. Unfortunately, our Chief Economist, Michael Knox, is not expecting an interest rate cut by the Reserve Bank of Australia until mid-2025.

As we enter production of this edition of Your Wealth, the proposed $3 million super tax – or Div 296 as it is known - faces an uncertain future. Will it be tabled in February when Parliament resumes? If an early election is called, it could effectively be off the table until after the election.

We hope it gets shelved completely. We have always viewed this as bad policy; in fact, the worst policy that has ever been proposed for superannuation.

This latest publication will cover Australian retirement intentions, the new Aged Care Act 2024, Trump's trade negotiations policy, expected to reduce tariffs, contribution strategies for older generations, and understanding the benefits of the Legacy Pension Amnesty which is now law.

Morgans clients receive exclusive insights such as access to our latest Your Wealth publication. Contact us today to begin your journey with Morgans.

Investment Watch is a quarterly publication produced by Morgans that delves into key insights for equity and economic strategy.

This latest publication covers

Economics – Recession fears behind us
Fixed Interest Opportunities – Alternative Income Strategies for 2025
Asset Allocation – Stay invested but reduce concentration risk
Equity Strategy – Diversification is key
Banks - Does current strength crimp medium-term returns?
Resources and Energy – Short-term headwinds remain
Industrials - Becoming more streamlined
Travel - Demand trends still solid
Consumer Discretionary - Rewards in time
Healthcare - Watching US policy direction
Infrastructure - Rising cost of capital but resilient operations
Property - Macro dominating but peak rates are on approach

At the start of 2024 investors faced a complex global landscape marked by inflation concerns, geopolitical tensions, and economic uncertainties. Yet, despite these challenges, global equity markets demonstrated remarkable resilience, finishing the year up an impressive 29% - a powerful reminder that long-term investors should stay focused on fundamental growth and not be deterred by short-term market volatility.

The global economic outlook for 2025 looks promising, driven by a confluence of positive factors. Central banks are proactively reducing interest rates, creating a favourable economic climate, while companies are strategically leveraging innovation and cost control to drive earnings growth.

Still, we remind investors to remain vigilant against a series of macro-economic risks that are likely to make for a bumpy ride, and as always, some asset classes will outperform others. That is why this extended version of Investment Watch includes our key themes and picks for 2025 and our best ideas. As always, speak to your adviser about asset classes and stocks that suit your investment goals.

High interest rates and cost-of-living pressures have been challenging and disruptive for so many of our clients, so from all the staff and management we appreciate your ongoing support as a valued client of our business. We wish you and your family a safe and happy festive season, and we look forward to sharing with you what we hope will be a prosperous 2025.

Morgans clients receive exclusive insights such as access to our latest Investment Watch publication. Contact us today to begin your journey with Morgans.

And just like that, we’re into December. It’s been a whirlwind year for Australian and global markets and we at Morgans have been busy expanding our depth and range of services to help you achieve your financial goals. This edition of the Month Ahead presents ideas from three areas of focus for Morgans: domestic equities, ETFs and global equities. We take a look at the opportunities presented by Light & Wonder, the Firetrail Australian Small Companies Fund and Eli Lilly.

Wishing you a very happy Christmas and a prosperous New Year.

Light & Wonder (ASX: LNW)

Light & Wonder is a Las Vegas-based global games company focused on content and digital markets. It generates revenue through the sale and leasing of land-based gaming machines, alongside free-to-play digital and online casino content. Its primary listing is on NASDAQ with a dual listing on the ASX. In March 2022, Light & Wonder rebranded from its former holding company, Scientific Games and has since pursued market share growth with revamped management and a new board. Since the rebranding, management has reduced leverage from 8x to 3x in under two years and set a 2025 earnings target that seems achievable to us given its growth trajectory. The strongest performance in the recent third quarter results came from global outright machine sales which rose 50% year-on-year, driven by strong European shipments.

In October, litigation ruling was handed down with Aristocrat Leisure over proprietary math models used in "Dragon Train." This led to the game's withdrawal and the dismissal of its designer. While significant, the game represents just one of Light & Wonder’s approximately 130 annual titles and would have contributed less than 5% to earnings. A revised version is in development and expected by mid-2025 which we see as a significant upcoming catalyst. While litigation remains an overhang, we think the share price decline is overdone. Negative sentiment around the injunction and upcoming legal catalysts will linger, but it shouldn’t detract from the company’s strong fundamentals. Light & Wonder has a solid track record of delivering and in our opinion has the potential to be a multi-year compounder. It boasts top-tier game developers, including much of the team behind Aristocrat's standout growth in the 2010s.

Light & Wonder is busy buying back stock as it believes the share price undervalues the business. We agree and regard the discount to Aristocrat on which Light & Wonder trades as unwarranted.

Firetrail Australian Small Companies Fund Active ETF (ASX: FSML)

The Firetrail Australian Small Companies Fund Active ETF provides Australian retail investors access to a high conviction portfolio of Firetrail’s best ideas in domestic small caps, boasting a long track record of 12% p.a. outperformance net of fees. Managed by a highly experienced team led by Patrick Hodgens, Matthew Fist, and Eleanor Swanson, the fund benefits from their extensive industry knowledge and proven track record. The team's significant equity ownership in the firm ensures their interests are closely aligned with those of the investors and reflects a strong commitment to achieving long-term performance.

FSML debuted on ASX last month, providing investors with one of the first active ETFs in Australian small caps. FSML provides investors with a simple, accessible, liquid and transparent means of gaining access to a higher performance, diversified small cap manager – a sector of the market we at Morgans are particularly bullish on.

The fund's investment process is designed to identify undervalued opportunities within the Australian small-cap market. By employing a bottom-up approach and utilising a proprietary quality scorecard, the team rigorously assesses potential investments based on management quality, business sustainability, and financial transparency. This structured process results in a concentrated strategy, typically holding between 20-50 stocks, ensuring that only high-quality companies are selected, enhancing the likelihood of strong returns for investors.

Performance-wise, the fund has consistently and handsomely outperformed its benchmark, the S&P/ASX Small Ordinaries Accumulation Index. This impressive track record is further supported by the fund's strong risk management practices and the team's disciplined approach to portfolio construction, making it a solid option for investors looking to diversify their portfolios beyond the mostly fully valued ASX large caps.

Eli Lilly (NYSE: LLY)

“When health is lost, the only thing you want is to get better”. That’s the slogan of US pharmaceutical giant Eli Lilly, a company thrust into the limelight over the past year as chronic weight management drug Zepbound, along with type 2 diabetes medication Mounjaro, which shares the same chemical backbone, have gained ‘blockbuster’ status (more than a billion dollars in sales) in short order, propelling shares to all-time highs back in September. Since that time, however, shares have fallen more than 15%, with the majority of loss recorded in this month alone.

So, what has happened and does this represent a good time to ‘buy the dip”? We think so and here’s why. First, while 3Q results reported on 30 October 2024 disappointed on lower sales of both Zepbound and Mounjaro, it was not due weak demand, but inadequate supply. Actually, a good problem to have (if you have a problem), but trying to balance the supply/demand equation has proven to be easier said than done. Although LLY continues to invest in manufacturing infrastructure, it will take time to adequately scale to consistently deliver its obesity and diabetes care medications. As such, it is not uncommon for inventory levels to ebb and flow and quarterly results to be a tad bit lumpy. But there appears to be no fundamental cause for concern.

Second, while LLY currently enjoys a duology in the diabetes/weight loss realm with Danish pharmaceutical company Novo Nordisk (NVO), there are numerous other companies nipping at their heels. That said, the total addressable market is massive (pun intended!), with the latest projections surpassing US$100bn by 2030 (just two years ago it was cUS$25bn). In addition, the list of other diseases/disorders potentially amenable to treatment by these drugs keeps growing and runs the gamut from cancer and cardiovascular to neurological and even infections. So this expanding market is certainly big enough to support numerous players and is not a winner-take-all opportunity.

Third, while Zepbound and Mounjaro represent c40% of total sales and showcase LLY’s expertise in cardiometabolic health, it also has key franchises in cancer, immunology, neurodegeneration and pain, along with a deep R&D pipeline of more than 70 drug candidates (70% in mid/late-stage trials). Notably, Alzheimer’s Disease drug Kisunla (Donanemab) gained FDA approval last July and eczema injection Ebglyss was greenlighted last September, each targeting markets well over US$60bn. In addition, LLY is leading the pack in developing the first weight-loss drug pill, orforglipron, with late-stage data expected Apr-25. All concrete catalysts seemingly overlooked.

Finally, the recent Biden Administration proposal to allow Medicare/Medicaid coverage for the cost of weight-loss drugs could turn out to be an early Christmas gift, as it would expand access to more than 7 million Americans who currently are only covered (if at all) for conditions like diabetes and heart disease, but not for obesity alone. And while the future of the policy will be in the hands of President-elect Donald Trump's administration, to be enacted in 2026, it is likely to be a political landmine, one that the incoming administration is doubtful to denote, despite the added costs (CBO estimates that Medicare coverage of anti-obesity drugs would increase federal spending by US$35bn over 8 years), given it would be seen as taking away important health benefits. Given the above, the share sell-off appears unwarranted and an opportunity to ‘buy the dip’ in a company that make medicines that give people a chance at health.

Morgans clients receive exclusive insights such as access to the latest stock and sector coverage featured in the Month Ahead. Contact us today to begin your journey with Morgans.