Australia and the US are both likely headed for a recession, but Australia's housing market is more vulnerable to higher interest rates, according to global bond giant Pimco.

Morningstar Investment Conference 2023

Pimco's Dan Hyman and Rob Mead spoke on recession risks at the 2023 Morningstar Investment Conference. Picture: Morningstar

Speaking at the Morningstar Investment Conference, Pimco's co-head of Asia Pacific portfolio management Robert Mead believes it is unlikely the Reserve Bank of Australia can navigate a soft landing for the Australian economy.

"If any households or businesses are somehow expecting that all they need to do is ride out a short-term storm in terms of higher interest rates and suddenly, miraculously, they're going to come down and miraculously we're going to get a soft landing, we think that's a fool's paradise," he said.

"As rates have gone higher and higher and higher, as consumers have been reluctant to stop spending, we think that miracle of a soft landing that the RBA has been hoping for will be a very, very difficult path to move down, and also that means that recession becomes our base case not only for the US but for Australia as well."

Debate over recession or soft landing


AustralianSuper chief investment officer Mark Delaney also believes a recession is likely, with the nation's largest super fund positioning its $280 billion portfolio for a downturn.

"Our view is a recession is most likely and we've positioned the portfolio for that, so we're short stocks and long bonds," Delaney told the Morningstar conference in Sydney.

"We think the destination [a recession] is far more likely than getting it right about the timing, so we will just have to live through the volatility until that occurs."

The world's second-largest asset manager Vanguard puts the probability of a recession in Australia at about 50% and in the US at 90%, its chief investment officer Greg Davis told the conference.

Yarra Capital Management head of Australian equities research Katie Hudson is among those who believe Australia can avoid a recession.

"Our central case is that we'll have a soft landing, we don't think we'll have a recession," Hudson says.

"There are definitely pockets of stress, we certainly wouldn't want to underestimate that," she adds.

"But our view would be it's more localised recessions rather than a broader recession for the Australian economy."

Daniel Hyman, Pimco's US-based head of agency mortgage portfolio management, says the firm's base case is that a modest recession is likely in the US although a deeper recession is possible.

"Our view is later in the year we are likely to tilt into recession and the Fed's going to be more accommodative, and we would expect further rate cuts in the US."

Australian housing market's challenges


Pimco believes the Australian housing market faces challenges and is more vulnerable to rate increases than the US, where it has "a pretty sanguine" outlook on housing.

While both countries have an undersupply of housing and affordability has declined, Mead notes Australian households are about twice as indebted as US households.

Most US homeowners are locked into 30-year, fixed-rate mortgages of 3% or less, which he says helps avoid mortgage stress.

Mead says 100% of Australian mortgages are essentially on floating rates, being on variable rates from the start or after fixed terms of up to five years.

"It just means we're much more vulnerable to monetary policy shifts and that transmission mechanism of monetary policy to the real economy is so much more powerful."

Australia still faces a fixed rate 'mortgage cliff', with about $350 billion of fixed rate mortgages to expire this year.

Mead says most of those mortgages will move from a rate like 2–2.5% to 5.5–6.5%.

"So that cliff is very, very powerful, it's something that the RBA knows all about and something that will definitely be a driver in terms of calibrating how tight monetary policy needs to be moving forward."

Mead says the resurgence in immigration post-COVID has turbocharged population growth, which combined with the structural undersupply of housing will likely support the market over the near term.

But the migration surge has also created challenges.

"The complication around immigration means that first of all we get some increased labour supply and hopefully a decrease in wage pressure, but simultaneously an increase in demand for housing, so really complicating the way monetary policy needs to work and operate."

Fund manager Perpetual's deputy head of equities Anthony Aboud is not worried about the housing impact on Australia's big four banks, although he notes growth will slow and net interest margin will likely decline.

"The banks are very well provisioned; they're obviously heavily leveraged to the Australian housing market.

"...In the absence of a housing collapse, the banks are going to be OK."

Hudson says the cyclical dynamics, which also apply to regional banks, and structural trends in the banking sector are challenging.

She says structural trends including increased competition mean mortgage return on equity is down to at or below the cost of capital.

"Where the pressure is being felt the most is actually in that non-bank part of the market.

"...That will prove to be a challenging part of the market and that's certainly the part of the market that small cap financials are exposed to."

Mead says the first real stresses will show up where the consumer makes discretionary spending decisions, rather than in the banks.

"Even if house prices can stay relatively sticky, the cost of servicing debt continuing to go up just means the first thing to crack will be that discretionary spending part of the consumer wallet."

Bonds reprice, unlike some asset classes


The complete repricing of interest rates means the bond asset class is much more defensive, Mead notes.

"Bonds are back. It basically means that bonds will now play a role in keeping every single other asset class honest. There's no free lunches to move into risky assets."

Mead says bonds also establish a hurdle to take additional risk, but instead of the hurdle starting at zero it now starts at 5, 6 or 7%.

"With this repricing in interest rates, not every asset class has repriced," he notes.

"You don't need to look far past Silicon Valley Bank to see what dangers there are if you don't mark to market.

"Surprisingly, even to this day, some asset classes have not marked. It's shocking in fact but it's the reality."

Hyman says for the first time in a long time, bonds are offering attractive, positive real rates of return.

But other asset classes that tend to perform well in recessions have not repriced.

"Starting valuations are quite cheap when you look at some of these high-quality spread assets that tend to do well even in recessions, so we see opportunities there to position defensively given our outlook, but it's not priced for it yet," Hyman says.

He says government-guaranteed securities tend to do better in recessions than corporate bonds tied to the business cycle, but that is also not priced into markets.

He also highlights opportunities where investors can bet on the strong US consumer with AAA-rated securitised credit, which are out-yielding A-rated corporates and are more defensive in a downturn.