Insights

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Yesterday, the Reserve Bank of Australia (RBA) board met and reduced the Australian cash rate by 25 basis points to 4.1%. At the same time, they released the Quarterly Statement of Monetary Policy, which provides a broad range of outlooks for various variables affecting the Australian economy. The release of this report, on a quarterly basis alongside the RBA meeting, serves a similar function to the Summary of Economic Projections released by the Federal Reserve.

The RBA’s initial message was that even with the reduction in monetary policy, the outlook remains restrictive. However, according to our own model, A Cash Rate of 4.1% is not restrictive, but modestly expansive. Our model is based on 35 years of data.

The Quarterly Statement indicated that the outlook for the Australian economy is for considerable expansion. After last year’s GDP growth of only 1.1%, which economists consider a soft landing, growth is projected to pick up, with a forecast of 2% for the year to June 2025. This is followed by 2.4% for the year to December 2025 Growth continues between 2.3% and 2.5% over the following years. Even in 2027, growth is expected to remain above 2%. This represents a promising future for the Australian economy. Interestingly, business investment is not expected to be the main driver of this growth. Business investment growth for the year to December was zero and is expected to remain at zero for the year to June, only growing by 1.4% by the end of 2025. It seems that growth will accelerate only after the economy picks up speed. Household consumption is also forecast to increase slightly from 0.7% last year to 2.6% this year.

The primary factor driving the anticipated growth is Public Demand, largely funded by "other people’s money". Public Demand (Government Spending) grew by 4.9% in the year to December 2024 and is expected to grow by 5.3% or more for the year to June 2025, with projections of 4.3% for December 2025 and 4% for 2026. This growth in public demand, largely financed through public borrowing, includes Federal and State Government spending, particularly on infrastructure projects. While this expansion will stimulate demand, it will be paid for later by taxpayers.

The unemployment rate, currently at 4%, is expected to rise slightly to 4.2% mid-year, where it is anticipated to remain. The RBA has indicated that this increase in unemployment will help reduce inflation, although not to the target of 2.5%. Inflation is projected to fall from a trimmed mean of 3.2% for the year to December 2024, to 2.7% by June 2025. However, inflation is expected to stabilise at this level, not reaching the 2.5% target.

This raises an interesting question: why does the RBA believe that inflation can fall to the lower end of the 2-3% range without unemployment reaching 4.6-4.7%, as suggested by historical data? We believe that the significant import boom in Australia, with imports rising by 6.2% for the year to December 2024, has played a role. Import growth is expected to slow in the coming years. We think that but year's surge in imported manufactured goods at low prices has created an illusion of sustainable low inflation at the same time as relatively low unemployment.

Our analysis suggests that such low inflation is unsustainable unless unemployment rises to 4.6% or higher. This issue may resurface in the coming quarters as the true challenges of reducing inflation are revealed. However, for now, we can say that the Australian economy appears to have bottomed out. We’ve had our soft landing with 1.1% growth in December 2024, and growth is now accelerating, even if it is being driven by public spending. By the end of 2025, growth is expected to reach 2.4%, and the economy is set to maintain above 2% growth for the next several years. This represents a strong recovery, and the Australian economy appears poised for a period of better performance in the coming years.

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The start of an easing cycle is upon us, but the path forward remains unclear, much like the post-pandemic economy. The debate now shifts from when the cycle commences to where the terminal rate for this cycle might land. Nonetheless, the first interest rate cut since November 2020 marks a definitive turning point for market sentiment and its impact on risk assets.

Rationale for the Cut

The RBA's decision for a 25bps cut reflects a view that inflation is sustainably moving back towards the Bank's 2-3% range. Three consecutive declines in quarterly core CPI from 4.0% to 3.2% in the December quarter afford some space for monetary easing.

In the February statement, the Board also highlighted some weakness in the demand side of the economy, with consumer and business sentiment subdued. Noting that "there has also been continued subdued growth in private demand and wage pressures have eased".

The Board was careful to point out that upside risk remains, suggesting that the labour market may be tighter than previously thought. So, while today’s policy decision recognises the progress on inflation, the Board remains cautious on prospects for further policy easing.

While Australia's economic stability presents minimal recession risk, the RBA must balance stimulus against potential overheating concerns from ongoing fiscal spending, as our economist Michael Knox points out in his recent piece.

What is priced in

Before today's announcement, futures implied a further 50bps interest rate cut, taking this cycle's terminal rate to 3.6% by December 2025. The RBA's forecast assumes three further cuts by June 2026 and a terminal rate of 3.4%. Given the uncertainties around the path of inflation, we think the RBA’s comments will unlikely alter the market outlook for interest rates.

Updated Economic Forecasts (Feb 2025)

Michael Knox is more cautious and believes there is limited scope for further rate cuts until unemployment rises from 4% to around 4.6%. The situation is complicated by fiscal policy. The Labor government has been expanding employment in sectors like the 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 further.

ASX performance following the first RBA rate cut (1996 – 2021)

The impact on investor sentiment is clear - historically, the ASX 200 has risen by an average of 4% in prior cycles since 1996 when the RBA proactively cut interest rates, excluding the periods of the Global Financial Crisis and the COVID-19 pandemic. As per prior cycles, we think this marks a definitive turning point for sentiment and is likely to support the positive underlying momentum in the equity market.

However, at a sector level, performance is mixed - Industrials, Healthcare, and Utilities generally outperform the ASX 200 in the three months following the first cut, while Financials, REITs, and Energy tend to lag.

Market implications

The multiples being paid by the market, particularly for interest rate-sensitive sectors, are high (ASX Industrials c22x vs the 10-year average of 19x), suggesting that some level of interest rate easing is already factored into prices. The prospect of two further rate cuts will help sentiment but is unlikely to create a step change in earnings forecasts. Every cycle is unique, so positioning is key for us, especially around industries and stocks that are best placed to benefit from this easing cycle.

Banks

A lift in front book volumes and more-buoyant mortgage demand needs stronger anticipation of lower product rates than a modest start to easing would bring at this stage. We still struggle to find value across the major banks (CBA – no major upside surprise supporting the price).

Consumption

Assuming a terminal rate of 3.60%, this equates to a savings of ~$300 a month for the average $666k loan size  (ABS housing finance). This is expected to provide a modest boost to household consumption but the full impact is unlikely to be felt until 2H FY26. We prefer consumer linked stocks tied to lower-valued products (UNI, LOV) over housing-linked exposures at this point in the cycle.

Best ideas

Universal Store, Lovisa, Webjet Group

Property/Housing

As borrowing capacity improves, the housing market could see increased activity in lower-priced segments, alleviating some affordability issues that persist and offset inflation that is still evident in the cost of building. Banks are likely to actively promote fixed-rate mortgages ahead of potential further cuts.

Best ideas

James Hardie, Qualitas, Maas group

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I was particularly interested last week by the comments from one of two U.S. economists I really like. These two economists are Jason Furman, who has emerged as a top figure on the Democratic side, and Kevin Hassett, a leading figure on the Republican side. When I have seen them both debate in person, Kevin Hassett usually seems to be enjoying the event more than Jason Furman. Maybe Hassett just has a sunnier temperament.

Kevin Hassett, served as Chair of the Council of Economic Advisers to the President Trump in his first Administration. In Trump's current administration, Hassett holds the position of Director of the National Economic Council. The National Economic Council is responsible for coordinating all major economic policy actions across the top departments. This is a significant role, far beyond just offering advice.

Hassett was discussing the strange movement in the U.S. payroll numbers published by the U.S. Department of Labor. Last week, the numbers came in one million lower than expected. In fact, it wasn't just one million lower for that month; it was one million lower for the previous four years. It appears that during the Biden administration, the U.S. Department of Labor had overestimated payroll numbers by a million workers per month for the entire period, and immediately after the Biden administration left office, those numbers were reduced by a million. I thought this was a particularly insightful observation, as it led me to update all my numbers for U.S. employment.

I decided to examine U.S. employment growth and its median and then compare it with Australia's figures. The data revealed that the median growth rate of employment in the U.S. is significantly lower than in Australia. The median growth rate of employment in the U.S. is specifically 1.65% per year. Including the most recent updates, the current year-on-year growth rate is now only 1.3%. In this case the Fed might cut monetary policy. Employment growth is an easy way to look at monetary policy, though it’s not my preferred model, which is based on unemployment, excess resources in the economy, and current inflation, as well as inflation expectations.

What these models show, both in the case of the Federal Reserve and the Reserve Bank of Australia (RBA)—is that the decision-making of central banks is not so much about where inflation is currently, but where they expect inflation to be in the future. This expectation is heavily influenced by the level of unemployment and, to some extent, expectations around that. However, in Australia, as I mentioned a couple of weeks ago, the problem is that unemployment isn't high enough to bring inflation to a low enough level to allow the RBA to reduce rates.

When we look at the U.S. case, employment growth is lower than the long-term median. In this case the Federal Reserve could consider cutting rates. My model, which explains 89.3% of the monthly variation in the federal funds rate since 1982, suggests that the equilibrium Fed Funds rate is 3.9%. This is lower than the current Federal Funds rate of 4.35%. This indicates that the Fed could cut rates anytime it wants to. However, what Jay Powell, the Chair of the Federal Reserve, said at the last meeting was that he thought monetary policy was in a satisfactory position for now. Still, our model suggests that a rate cut could happen soon, as future inflation is expected to be lower than current inflation.

The situation in Australia is different. The median employment growth rate in Australia is higher than in the U.S. The median in Australia stands at 2.1%. This is higher than the U.S. rate of 1.65%. Right now, Australia's rate of employment growth at 2.8% is higher than its long-term median. This is not the usual circumstance in which the RBA could be expected to cut rates. The reason for this is that employment is growing fast is due to the Government adding more workers to the public sector, particularly in the National Disability Scheme.

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When we run our model for Australia, it explains 89.4% of the monthly variation of the cash rate since 1992. This is when the Australian cash rate first came into existence. The model suggests that the equilibrium rate is 4.41%, which is slightly above the current Australian cash rate of 4.35%. Based on where future inflation is expected to go, and considering the current level of unemployment, it is highly unlikely that the RBA will cut rates in the near future.

I know that this view doesn't align with the consensus, but I'm comfortable with that, as I often do better when I’m not in line with the majority opinion. The problem is that, as I shared a couple of weeks ago, historical data on the relationship between unemployment and inflation in Australia shows that over the past decade, unemployment needs to reach 4.6% or higher for inflation to be sustained at a level of 2.5%. Australian headline Inflation is falling, and Treasurer Jim Chalmers has been influencing that, as we know from the subsidies on electricity.

However, the RBA's decision will be based on where it expects future inflation to be, and my expectation is that we won't reach the 2.5% target for some time. Consequently, the RBA is unlikely to cut rates at its next meeting.

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Last week, I discussed how Trump was using tariffs in economic policy. I explained that the administration aims to pass a significant, comprehensive bill: an omnibus bill, which includes the Reciprocal Trade Act; reduces the corporate tax rate to 15% and imposes a 10% revenue tariff by April. I also showed that, despite commentary to the contrary, this tariff revenue was not inflationary, contributing a maximum of 0.8% to the US Consumer Price Index (CPI).

However, this week what we've seen is that Trump has used tariffs not for economic purposes but rather for social policy, in attempting to address the social crisis in the United States. This social crisis helps explain much of how Trump was elected and why he now has substantial support.

This situation began in 2000 when China entered the World Trade Organization, which allowed its exports to enter the US market. At the time, tariffs were exceptionally low, around 1–2%.

Over the next decade, the US experienced deindustrialisation. 12 million American workers losing their jobs and never got them back. This created a significant social crisis in the US, contributing to a social collapse. This collapse led to a massive increase in drug dependency, particularly within the American working class. A key work on this issue was written by Nobel Prize winners, Sir Angus Deaton and his wife Anne Case in 2020, titled Deaths of Despair.

In the book, Deaton points out that the US overdose deathrate increased from under 20,000 before 2001 to 92,000 in 2020. Overdose deaths rose further to 108,000annually by 2024. Notably, young men are twice as likely to die from these drug overdoses as young women.

Peter Navarro, Senior Counsel Trade and Manufacturing in the Trump administration, made his career at Harvard researching American trade with China. He claims that 76,000 of those drug deaths are directly linked to fentanyl use. From a social policy perspective, Trump's recent actions, including threatening to impose a 25% tariff on Mexico and Canada within a month and introducing a 10% tariff on China, reflect a shift towards addressing the flow of fentanyl into the US. This is not simply a trade war but, as Navarro asserts, a "drug war" aimed at reducing the influx of fentanyl and fentanyl-laced drugs.

In response to these threats, Canada has pledged $1.3 billion to police its border, and Mexico has committed 10,000 troops to patrol its border. I would bet that no 25% tariffs will be imposed on Mexico and Canada in fact, I am highly confident of this. Fentanyl, which is involved in most drug-related deaths, primarily originates from Mexico and is produced with chemicals from China. The 10% tariff in China could be a precursor to a similar revenue tariff later in the year as part of the omnibus bill. Remember, Biden before he left office, already levied a 100% tariff on Imports of Chinese Electric Vehicles into the US.

Historically, during Trump's first term, Trump had a meeting with Chinese President Xi Jinping, who promised to reduce the flow of basic chemicals to Mexico that were used to produce fentanyl. However, in response to the latest 10% tariff, China has stated that "fentanyl is a US problem "and has declined to cooperate as it had promised in the past.

The key question now is whether US tariffs on China will harm Australian exports to China. Australia's Iron Ore Exports to China are valued at $84 billion annually. China's steel Industry is the largest in the world.

Will US Tariffs on China damage Chinese steel exports? When we examined Chinese exports of steel last year, we found that very little Chinese steel is exported to the US. According to US data, the majority of Chinese steel is exported to the Indo-Pacific, with Vietnam being the largest importer (at 9.96%), followed by South Korea (9.1%), Thailand (5.3%). the Philippines (5.2%), Indonesia (4.5%), Türkiye (4.4%), The UAE (4.0%) and India (3.2%). The amount of Chinese steel sent to the US is minuscule. Therefore, it is difficult to see how any US tariff on Chinese steel would have a significant impact on Australian exports to China.

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February Reporting Season 2025 has kicked off. The February reporting season offers a crucial window into corporate Australia's health, with company-specific performance taking precedence over macro considerations. While earnings and share prices have shown remarkable resilience since the August reporting period, the focus shifts to companies' ability to maintain margins and drive growth amid subdued trading conditions, particularly as earnings growth moderates in FY25.

With a modest earnings outlook companies have been forced to adapt to the softer trading environment. Our focus in February is on companies and sectors that continue to see margin resilience and positive earnings trends. Large caps is another area to monitor given historically high valuations and strong performance over the past 12 months. Last August demonstrated that high expectations and in-line results might not be enough. The recent swing in the AUD will also complicate FY25 earnings and those exposed to currency fluctuation could see earnings volatility around the result.

In The Month Ahead this month, we highlight three companies from our key results to watch: Pinnacle Investment Management (PNI), Superloop (SLC) and Lovisa (LOV).

Pinnacle Investment Management (PNI)

RESULT: 5 FEBRUARY 2025

We expect outperformance driven by performance fees

We expect a strong result from PNI, driven by a combination of higher FUM through the period and strong performance fee contribution. We expect PNI can outperform consensus expectations based on higher performance fees. Key numbers include underlying 1H25 NPAT (forecast +105% on pcp to A$61.9m); and affiliate profit share (forecast +82% on pcp to A$68.1m).

Core flows and leveraging Horizon 2 spend

Current momentum and the outlook for flows is always in focus. We expect confident commentary from PNI, in part supported by new affiliates (e.g. Lifecycle). Horizon 2 spend has ramped up in recent years (primary driven by Metrics) and the market will be looking for some commentary or evidence that returns are starting to materialise.

Cashed up and ready

PNI has ample ‘dry powder’ following an equity raise in Nov-24. Commentary on the early performance of recently acquired stakes and the pipeline will be in focus.

Superloop (SLC)

RESULT: 21 FEBRUARY 2025

FY25 outlook

SLC expects FY25 underlying EBITDA of $83–88 million. We estimate $35.8 million for 1H25 (41% of full-year earnings), slightly below market consensus of $38 million (as of Jan 17, 2025). Since guidance was set in Feb 2024, there’s potential upside. One-off $5.5 million expenses in 1H25 include legal fees from ABB’s failed takeover and costs for acquiring Optus/Uecomm fibre assets (finalising by Mar 2025). A Vostronet earnout will also impact cash flow. Despite this, we expect net debt to decline slightly.

NBN subscribers (organically and Origin originated)

We forecast SLC will deliver slightly fewer NBN net adds in 1H25 (+31k yoy to 354k) vs +33k yoy in 1H24. This is due to our assumption that SLC has prioritised the material Origin migration. This assumption could prove conservative. Origin is, by our maths, the largest single EBITDA driver in FY25. We expect Origin to have ~155k NBN subscribers at year end, noting some of the Origin labelled ‘subscribers’ include voice products which SLC does not provide. We also assume organic growth in Origin is relatively slow in 1H25 due to the migration from ABB onto SLC. This should hopefully re-accelerate above its historical ~4.5k monthly net adds in early 2H25, although this is not within SLC’s control.

Business

The business segment remains challenged (NBN/macro driven price erosion), but we should still see some growth and are optimistic competition should settle in the latter half of CY25. We await clarification on the industrial logic around the Optus fibre acquisition which is likely largely back-haul cost avoidance for Smart Commmunities, and also provides SLC with the ability to more efficiently bring to market new product innovations (revenue upside).

Lovisa (LOV)

RESULT: 24 FEBRUARY 2025

Double-digit growth in earnings to continue

We see Lovisa’s half year result as an opportunity for it to remind investors of the growth in earnings it continues to deliver. We forecast a double-digit increase in revenue and income, all organic, driven by ongoing network expansion and higher gross margins. Our EBIT forecast of $93.1m is largely in line with consensus and represents 14% growth on 1H24. We forecast LFL sales of +1%. We expect the store count to have risen to 939, a net increase of 39 over the half, including 12 since the AGM trading update. This is clearly below the rate of expansion achieved in recent periods but maintains the positive long-term trend. We forecast a further increase in the gross margin to 81.5%. Lovisa’s results have seen some wild share price reactions in the recent year. We don’t expect a repeat in February, but the combination of a high P/E and high growth forecasts is always a potent mix.

The pace of expansion is due to accelerate

The key theme in the result will be the sluggishness of recent store rollout activity. The net addition of 39 stores we forecast for 1H25 falls 26% short of 1H24 and 55% below 1H23. In fact, if our number is right (and we are in line with consensus), it will be the slowest half year for network expansion since 1H21. Investors are justified in asking what’s going on. A key reason, in our view, is the need for Lovisa to consolidate after an extended period of very rapid growth in the US. The other reason is more nuanced. Lovisa has entered a large number of brand-new markets in the past two years. Its modus operandi is to spend around 24-36 months in any new market to become familiar with customers, landlords, competitors and price points before proceeding to expand. If we’re right, this is the calm before the storm and the pace of growth is about to get a whole lot faster.

We think it gets better from here

We think 2H25 will be a better (relative) period than 1H25. We forecast 63 net new store openings in the second half, with LFL sales growth picking up to +3%, despite comps getting more difficult. Earnings are always weighted to the first half (Christmas, BFCM and all that) but the 61/39 skew we forecast for FY25 tilts more to the second half than in any year since FY22.

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In recent weeks, there has been much discussion about the inflationary effect of Trump tariffs. This is sparked by Donald J. Trump's proposal of a 10% revenue tariff. Interestingly, the idea of a 10% revenue tariff was first discussed during his first term. At that time, it was considered as a potential source of additional revenue to offset the Trump tax cuts enacted during his first term.

The challenge in passing finance bills in the U.S. lies in the legislative process. Finance bills can only be easily passed if they are reconciliation bills, meaning they have no effect on the budget balance. When a finance bill does not affect the budget balance, it requires only a simple majority in the U.S. Senate to pass. However, when a finance bill increases the budget deficit, it requires at least 60-votes in the Senate, making such bills much harder to pass.

During Trump's first term, the administration found that by reducing certain tax write offs or tax cuts for specific states, they could pass the overall tax bill without effecting the budget balance. This allowed significant tax cuts for individuals and a major corporate tax cut, reducing the U.S. corporate tax rate from 35% to 21%. Now, as Trump seeks to cut corporate taxes again—this time from 21% to 15%, matching the German corporate tax rate—he needs additional revenue to balance the bill. This is so he can pass it as a reconciliation bill, requiring only 51 Senate votes. This has led to renewed discussions about the 10% revenue tariff.

In contrast to the European Union, where a value-added tax (VAT) would be a straightforward solution, implementing a VAT in the U.S. is effectively impossible due to constitutional constraints. A VAT would require unanimous agreement from all states. This is impossible in practise. So, the idea of a 10% revenue tariff has resurfaced.

Critics, particularly within the Democratic Party, have argued that such a tariff would be highly inflationary. However, when questioned during confirmation hearings, Trump's Treasury secretary nominee, Scott Bessent, referencing optimal tariff theory, explained that a 10% revenue tariff would increase the U.S. dollar exchange rate by 4%. We note that this would result in a maximum inflationary effect of 6% only if 100% of domestic goods were imported. Given that only 13% of domestic goods are imported, the actual inflationary impact would be just 0.8% on the Consumer Price Index (CPI). This makes the tariff effectively inflation neutral.

This idea was discussed by a panel of distinguished economists at the American Economic Association Convention in January, including Jason Furman, Christy Romer, Ben Bernanke, and John Cochrane. Cochrane noted that historical instances of tariff increases, such as in the 1890s and 1930s, did not lead to inflation because monetary policy was tight. He argued that the inflationary impact of tariffs depends entirely on the Federal Reserve's monetary policy. If the Fed maintains a firm stance, there would be no inflationary effect.

Trump's current plan is to pass a comprehensive bill that includes the Reciprocal Trade Act, corporate tax cuts, and the 10% revenue tariff. Peter Navarro, in a CNBC interview on 21 January, estimated that the revenue tariff could generate between $US350and$US400 billion, offsetting the cost of the tax cuts and making the bill feasible as a reconciliation measure.

With the Republican Party holding enough Senate seats, the legislation could pass by the end of April. The inflationary impact of the tariff, estimated at 0.8%, can be easily managed through moderately tight monetary policy by the Federal Reserve.

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