But this time around, it will mainly affect unregulated non-bank lenders and private credit portfolios due to the fact that regulators have forced most sub-prime borrowers out of the banking system into the arms of non-banks after the last crisis.

Modest bump belies risk

It also signals a two-speed economy: while most firms are healthy, those that predicated their business models on the ongoing availability of cheap money, and the sustenance of very low interest rates, are slowly but surely getting asphyxiated.

The same dynamics are emerging in the household sector.

While banks are reporting only a modest bump in home loan arrears, our tracking of securitised home loans issued by non-banks has highlighted a striking increase in defaults to historically elevated levels.

These dynamics are only going to deteriorate over 2024 as the Reserve Bank of Australia struggles to reduce interest rates in the face of reaccelerating core inflation driven by intense cost pressures in the services sector, where the latter is fuelled by unsustainably strong wage growth that is itself an artefact of our tight labour market.

Australia’s 3.9 per cent unemployment remains below the RBA’s estimate of full employment, while the central bank’s target policy rate is about 65 to 115 basis points lower than peers such as Britain, Canada, New Zealand and the United States.

This column’s core forecast is for global stagflation: that is, core inflation above central bank targets coinciding with deteriorating economic growth. For all the stock jockeys’ talk of “soft landings”, this cycle is not remotely over.

Look across the Tasman

And the canary in the coal mine is the characteristically prescient New Zealand central bank, which began lifting interest rates in October 2021, way ahead of most of its developed world contemporaries.

New Zealand’s first-quarter inflation data, which was published during the week, revealed an increasingly familiar, and yet profoundly problematic, fissure: temporarily weakening goods price pressures coupled with accelerating services inflation, which is keeping overall core inflation at unpalatable levels.

With escalating oil prices and freight costs undermining future goods price disinflation, the outlook is very worrying indeed.

On our seasonal adjustment, New Zealand’s goods price inflation continued to slow to about 1.5 per cent in the first quarter, down from its 10 per cent pandemic peak. At the same time, much more persistent, and hence important, services inflation picked-up to circa 6.5 per cent.

This resulted in core or trimmed mean inflation expanding by a robust 0.8 per cent in the March quarter after a 0.7 per cent gain at the end of 2023.

The Reserve Bank of New Zealand’s preferred sector factor model pointed to similar dynamics, with inflation of 4.3 per cent in the first quarter more than double its 2 per cent target.

“The tension between weak goods prices and sticky services inflation is also echoed in the split of the sectoral factor model estimates, with lower core tradable annual inflation of 1.7 per cent contrasting sharply with still-high non-tradable inflation of 5.2 per cent,” Kieran Davies, Coolabah’s chief macro strategist, says.

“The NZ economy has contracted almost continuously since late 2022, while unemployment has lifted from 3.2 per cent to 4.0 per cent,” Davies adds.

“But unless the sectoral inflation estimates show something materially different, the RBNZ will find it hard to cut rates later this year.”

This echoes the challenge faced by many central banks. Market pricing for the first cuts from the US Federal Reserve has been pushed out from March to between September and October this year.

This has been triggered by reaccelerating US core inflation powered by stubborn core services price pressures, which are climbing at an unacceptably high 6.5 per cent annual pace.

Inflation cycle not over

When the Fed was hitting its 2 per cent target before the pandemic, core services inflation was running at about 3 per cent. Our analysis of the monthly inflation data in Australia hints at similar issues.

The US economy has failed to normalise because the unemployment rate of 3.8 per cent is too low, wage growth is strong, and fiscal policy is too stimulatory (with a gigantic budget deficit of 6-7 per cent of GDP).

This situation was exacerbated by the Fed foolishly deciding to ease financial conditions late last year via its “dovish pivot”, which crushed the global cost of both equity and debt capital.

The belated realisation that this inflation cycle is not over has forced the US 10-year government bond yield up from 3.8 per cent at the start of the year to almost 4.7 per cent, which has precipitated a 4.6 per cent capitulation in US equities prices from their high in March.

Yet the S&P 500 remains an extraordinary 22 per cent above its mark in October last year when the US 10-year government bond yield was at 5 per cent, which is where it may yet return. There therefore remains tremendous downside risk for asset prices previously buoyed by the presumption that financing costs were in structural decline.

This presents challenges for portfolios exposed to any cyclically sensitive sectors and/or riskier borrowers that have higher probabilities of defaulting on their debts in an environment characterised by elevated interest rates.

Aussie corporate defaults are concentrated among commercial real estate, residential property development, construction, retail and hospitality.

These sectors dominate the portfolios of non-bank lenders servicing sub-prime borrowers that struggle to obtain finance from conventional banks that have little appetite for lending money to individuals and entities that find it hard to service their debts.

The Australian Prudential Regulation Authority’s research has consistently shown that commercial real estate and residential development exposures are the most likely drivers of bank failures, as they were in the 1991 recession, and has strongly discouraged deposit-takers from accumulating credit concentrations in these areas.

Investors searching for yield appear not to have learnt these same lessons judging from historically very tight (or expensive) credit spreads on the riskiest debt securities.