Interest Rates in 2024

I have been writing for the Eureka Report for some 18 years and have enjoyed every discourse with the wonderful group of people who make up the Eureka family.

This will be my last correspondence with you, so rather than try to pick the trends in the Middle Eastern and European wars, I am going to concentrate on two companies – BHP and Qantas – and a truly remarkable but dangerous interest rate event set to take place next July – just eight months away.

BHP

BHP have made some fundamental decisions in the last 12 months which will govern their future for the next decade. They plan to take advantage of electrification via copper and nickel and have excellent new resources. Both those thrusts are likely to take them into greater secondary processing which will involve considerable capital. Their best copper operation is in South Australia, but they may need to spend the money in other countries because of proposed Australian industrial relations laws.

They have also chosen not to go into lithium which may be right or wrong, but it would represent a new minerals investment and the company already has one very new materials expansion via Canadian potash. One new major product is enough.

 But where BHP is taking a controversial step is that the major industry that it is involved in – iron ore – is undergoing a very large revolution which will see more higher grade magnetite ore mined and converted to pig iron either in China or Australia.

 This revolution is taking place because companies want to reduce the usage of coal. For what it is worth I think that magnetite projects that require the proposed coal replacement, hydrogen, to be extracted from water are extremely high risk because the costs are too great.

There needs to be a better way of obtaining hydrogen to produce pig iron from magnetite. And it looks like goethite iron ore which contains hydrogen molecules may be the added substance that will enable magnetite to be converted to pig iron using some gas but no coal. This revolution has many steps to go but BHP is not taking part and is staying with hematite which will be wonderful for profits in the short term. But given the magnetite expansion by Rio Tinto, Fortescue and Hancock this is a high-risk decision. And it is not being discussed at any length by the market.

Qantas

In the case of Qantas, I believe that their financial model is simply inappropriate for an airline. The airline business historically can encounter severe fluctuations and so airlines need to be well financed with strong equity capital. Qantas has assets of about $20 billion in the books, but it has equity capital of only $10 million. And it is buying back shares! 

Qantas's “capital” comes from airfares paid in advance and advance money received from the frequent flyer programs which total $8.5 million. That structure produces great returns(and executive rewards) when the business is going strong as it is now. Cashflow is in the vicinity of $5 million.

Without making any prediction whatsoever let’s imagine that we have a Ukraine, Middle East and Taiwan wars. The Qantas business would be slashed, and it will go into loss.

It has a $10-billion line of credit from the Commonwealth Bank but I am not sure if that money would be available in the case of a world airline slump.

Qantas is too valuable to be running on a model like that and the market has woken up which is why the shares have fallen so sharply. The first task of the new chairman is to change the financial model.

Stage three tax cuts

Finally, it is highly likely that the stage three tax cuts will come into play in July 2024. This represents an enormous $21 billion stimulation in 2024-25 which will really boost the economy. If in mid-2024 the Reserve Bank is still struggling with inflation (and the 5 per cent wage rises being demanded in many places around the country are clear danger signs) then the Reserve Bank will have to raise interest rates substantially to keep the economy under control. Few are discussing this at the moment, but this will be a major discussion point in 2024. As it is higher house prices, strong labour demand and lingering inflation rates will tempt the Reserve Bank to lift rates in November but that's nothing to the stimulation coming in July when the tax cuts are due to be implemented.

Remember a tax cut reversal is difficult given they have been legislated and endorsed by the ALP government. 

For your own personal calculations, there are three major prongs to the tax cuts:

• Marginal tax rates for those earning between $45,000 to $120,000 are cut by 2.5 per cent to 30 per cent;
• The marginal rate for those earning $120,000 to $180,000 cut by 7 per cent to 30 per cent; and
• The threshold for the top 45 per cent marginal rate is lifted by $20,000 to $200,000.

Following the stage three tax cuts, 94 per cent of people will have a maximum 30 per cent tax rate. Middle-income Australia will rejoice and will spend up big at about the same time as the current wage push hits the road. In your portfolio be aware that interest rates could rise sharply unless there is a substantial world downturn.

At the opening, I used the word “dangerous" when describing the interest rate outlook. If prior to the tax cuts, the economy is sailing along reasonably well and inflation is sticky, then the rate rise could possibly reach one per cent. For those under mortgage stress, this would absorb the money from the tax cuts, and more – hit the housing market. I am not making that forecast. Rather, it's an alert to factor it into your strategies as 2024 proceeds.