Analysing Inflation Part 1: How Rising Inflation and Cash Rates Affect the Finance Sector

The rising inflation rate’s effects continue to ripple through Australian businesses and households. Accelerating prices are placing pressure on all corners of the economy, prompting the RBA to implement increases to the cash rate and the interest rate on Exchange Settlement balances.

The RBA Board has highlighted an expectation to adjust the size and timing of their continued cash rate increases based on uncertain global developments. They will need to continue to hike interest rates to curb inflation, while minimising a potential recession’s effects. The main trends the Board pays close attention to include:

• Consumer Price Index (CPI – Household inflation)
• Labour market tightness
• Money velocity
• Business confidence
• Consumer sentiment
• Household stress indicators

This trend can be good news for financial lending institutions, as the cash rate is projected to continue rising over the next five years. Passing on these rate hikes to household borrowers will boost potential interest earnings for financial institutions and gradually stabilise the economy.

Financial services labour environment

Skills shortages continue to cut into professional services labour availabilities. The big four consulting firms are looking for workers for over 4,000 vacancies, as they wait for the disrupted visa application processes to be hastened.

Many large companies in the finance sector are in a position to raise wages in line with or above inflation as a means to attract highly skilled employment. However, small-to-medium enterprises are seldom in the same position. Smaller businesses often do not have their larger counterparts’ cashflow reserves, and many will have to choose between raising wage expenses or remaining a viable company.

For other ways to attract high-skilled professionals, consider the following:

• Can you offer stronger employee perks and benefits to create a better culture?
• Can you develop partnerships with other local businesses for employee discounts?
• Can offering a better work-life balance compared with competitors, through volunteering initiatives and reasonable workload expectations, enhance your firm’s attractiveness?

Changing trends in finance

Following the volatile financial environment, lending institutions, investment banks and consumers are all taking less risks. However, some consumers are taking out riskier personal loans to keep up with their increasing cost of living.

Lending institutions are noticing the rising cost of living’s downstream effects. Many parties are refinancing, hunting a competitive fixed rate as opposed to the riskier variable options based on unknown future increases. As the value of the dollar decreases with rising inflation, the relative price of existing long-term debts is falling. Therefore, many parties are attempting to renegotiate fixed long-term loan agreements.

From a borrower’s perspective, rapidly increasing expenses in other aspects of running a business, including wage and input costs, are currently heavily overshadowing the relief they feel at their existing debts falling in value.

Small-to-medium businesses (SMBs) can currently rarely afford to take on large debts. Business growth plans are suffering due to the rising cost of mortgages, business loans and personal loans. As a result, cashflows will decline, as consumers tighten their purse strings and purchase goods and services more selectively. Several factors are exacerbating this trend. For example, the house construction crisis involved builders risking taking money up front, but they can now no longer afford to complete builds due to inflation.

In addition, the Buy Now Pay Later (BNPL) sector is feeling inflation’s effects. Major players in this sector rely on consumer spending and late payments. However, as households restrict their spending in the face of rising inflation rates and interest repayments in other aspects of their life, the BNPL Australian-listed companies may see less cash flow. This trend also means that more late payers will not be able to repay late fee charges at all.

However, rising interest rates will support insurance firms. Not only are investment revenue streams often largely dependent on bond yields, but their premium revenue will also improve, as demand for insurance tends to climb alongside interest rates.

The new era of financial strategy

As IT, property and wage expenses continue pressuring our largest companies, many major banks such as NAB and CBA have abandoned their cost-cutting targets. Rising interest rates will boost profitability throughout 2022-23, as banks attempt to earn more interest from larger amounts of more expensive financing. However, the major banks’ interest rate margins will likely decrease further in the following few years. These decreases coupled with increasing loan defaults will cut into profits. Lending institutions need to increase their bad debt provisions to prepare for an upcoming spike in mortgage stress.

SMBs in the finance sector may have to increase fees to service loans contracts of their own. Additionally, to purchase property, equipment or other assets, consumers and businesses will need to take out larger loans to afford the assets.

Not all businesses will be able to absorb this inflation, and most will have to increase their costs to stay open, particularly SMBs. This trend is clearly apparent in the café and restaurant industries, and will flow downstream to the institutions needed to finance operations around the economy.

Financial assets: winners and losers

Are you worried about your investment strategies? Historically, rising inflation, subsequent cash rate hikes and heightened economic volatility have broadly benefited a variety of financial vehicle types, while hindering many others.

 Read Part 2 of our Inflation Series analysing the effects of inflation on the Construction & Manufacturing industries.