It has been observed frequently, and correctly, that markets and the economy are only loosely correlated. Investment and economics are distinct disciplines. Nevertheless, it is also true to observe that a careful study of economics can be a very useful aid to investors looking for investable themes or making strategic and tactical asset allocation decisions.
In this edition of Investment Enews, we take a look at the Australian economic outlook as we head into the final quarter of calendar year 2018.
Where are we now?
The dislocation between markets and the economy is shown neatly by the present situation. Over the last few weeks, pundits have reveled in descriptions of the collapse in equities markets, both in the United States and here at home. Our own S&P/ASX 200 has dropped from 6,352 in August to around 5,700. It is worth noting that these levels are still massively down on the values seen immediately pre-global financial crisis, when markets were trading above 6,700. Investors in equities markets have genuinely experienced a lost decade.
On the other hand, as the infographic from the Reserve Bank of Australia (RBA) shows, the Australian economy is experiencing something of a Goldilocks moment. Economic growth is strong and the Australian economy is entering its 28th year of continuous growth. Unemployment is low and falling, despite improving participation numbers. Inflation – once the bete noir of the Australian economy – remains under control and the federal government is on the cusp of returning its budget to surplus.
That is not to say that there are no economic challenges. The cash rate remains at emergency levels and wages growth remains stubbornly low. What’s more, Australian household indebtedness is second only to that of Switzerland.
Taking all of that into account, however, and despite the fact that we seem as a nation congenitally unable to accept it, it is hard to deny that the Australian economy is enjoying some authentic economic sunshine. And that’s something worth noting.
Possible clouds ahead?
So what could upset this story? As always, there are a number of issues and risks facing the Australian economy. In considering their portfolios and investment decisions, it would be wise for investors to have regard to some of the broader economic themes that could affect market performance in the medium term. We have identified five key themes for investors to watch in the months ahead.
The Royal Commission has made public extraordinary misbehavior by some Australian banks and financial services organisations. There is now the temptation for regulators and legislators to over-react. In an over-regulated market, borrowers will find it both more difficult and more expensive to take out loans. This will reduce credit and history tells us that sharp reductions in credit generally lead to recessions and unemployment.
For that reason, it is critical that the lessons from the Royal Commission are learned and applied with care and precision. The cancer of misbehavior in financial markets must be excised with the scalpel, not the blowtorch. The early signs are positive. Both the Interim Report from the Royal Commissioner and commentary from regulators and legislators indicate that the key players are well aware of the stakes and are alert to the danger of the unintended consequences of potential regulatory over-reach.
As a relatively small and highly trade-exposed nation, it is in Australia’s economic interest that international trade be both free and fair. Recent ructions between the US and China have the potential to result in reduced demand for many of our key exports. To date, the US has placed tariffs on $250 billion worth of imports from China. A further $267 billion has been proposed on other imports. In retaliation, China has put tariffs on $100 billion of imports from the US. As we write, it would seem that there is a serious risk of a full-blown trade war.
Australia is both a close strategic ally of the US and highly dependent on the Chinese economy as a key purchaser of many of our major exports. For that reason, if a full-blown trade war broke out, whoever the eventual winner, Australia would lose. At present most modelling shows a real, but small, effect on the Australian economy both of current policies and likely future events. Further, it should be noted that many of the world’s other large trading economies are being spurred by the US/China dispute to expedite other trade deals to compensate.
Again, therefore, at present the fallout of this dispute is likely to be limited, but investors should remain watchful of developments.
An important feature of the 2018 financial year was the decoupling of key market interest rates from the RBA’s Official Cash Rate (OCR). Whilst the OCR remained stable at 1.50% p.a. across the financial year, key market reference rates, like the 30 day BBSW, increased markedly.
Source: ASX, RBA
While this might seem a bit esoteric to many investors, the effects are real and tangible. These reference rates are the basis of the cost that lenders pay for the funds that they on-lend to individuals and businesses across Australia. As the graph above shows, from 1 July 2017 until now the cost of funds for lenders increased by about 0.30% p.a. (and, in fact, peaked around 0.40% p.a. higher just prior to 30 June). Whatever the RBA decides to do with the OCR, lenders will inevitably pass these increased costs through to borrowers.
For borrowers, this means higher interest rates. For the RBA, its ability to influence monetary policy via interest rates has been diluted, at least temporarily.
Many of us are old enough to remember that high inflation was one of the most destructive forces in the pre-1990s global and domestic economies. For investors, high inflation eats away at the real value of portfolios and income and makes retirement planning almost impossible. It has now been almost three decades since then-Treasurer Paul Keating, famously declared that he had “broken the inflation stick.” And low inflation has become one of the world’s most enduring post-GFC phenomena.
Many reasons have been posited for persistent low inflation and many economists have argued that higher inflation would be, in fact, desirable in that it would drive wages growth and make it easier for the world to deal with high levels of government and household debt. It is just possible that they will get their wish.
Followers of our currency will have noted the substantial reduction in the Australian dollar throughout 2018 to where it now sits (at around US70c). It was not so long ago that our dollar was above parity, buying up to US$1.10 in 2011-2013.
One effect of the lower dollar is to make imports more expensive. Since imports both directly comprise part of the goods and services that Australians consume and are inputs in production, more expensive imports result in higher inflation in the “tradeables” component of overall inflation. In the words of the RBA:
“Tradable items are much more exposed to international competition. This includes many imported manufactured goods such as televisions and computers, as well as some food items and services such as international travel. The prices of these items should be less influenced by conditions in the Australian economy, and more affected by prices set on world markets and fluctuations in the exchange rate.”
Source: RBA: The Determinants of Non-Tradeable Inflation
The most recent CPI prints have non-tradeable inflation at the upper end of the RBA target range, held back only by tradeable inflation. If this is affected significantly by a declining exchange rate, we may see increased inflation (and upward pressure on the OCR) sooner than we think. This remains a ‘wait and see’ however. High inflation has been predicted many times over the last 10 years.
Over the last two years, US Government 10 Year Treasury Bond yields have increased dramatically on the back of rising interest rates, economic reform and increased central bank activity. Indeed, the US 10 Year yield went higher than the Australian equivalent for the first time since 1984! Some, such as noted fixed interest investor, Jeffrey Gundlach, are predicting that the trend will continue and yields will continue to rise.
There are a number of implications arising from this. For example, the increased yield reflects decreased demand for 10 year bonds, suggesting that investors are expecting interest rates to increase. What’s more, the 10 year yield is a key reference rate and interest rates on other loans and bonds tend to increase as 10 year yields rise. This is yet another signal that the times of cheap debt and easy money might be coming to an end. Given high levels of global indebtedness, economies across the world, including Australia, will be tested by the next phase of the post-GFC global economy.
So how should an investor respond to these issues and possibilities? The answer, surprisingly enough, is simple. Remember the basics. In times of market flux and volatility, remember the value of capital stable, income producing investments. Be wary of fixed rate assets – with inflationary and interest rate pressures rising, variable rate investments that can increase with markets are critical.
Finally, stay diversified. There is no telling how these issues will play out. The intelligent investor prepares his or her portfolio for a range of possible outcomes. Diversification remains one of investments’ true “free lunches”.
La Trobe Financial Services Pty Ltd ACN 006 479 527 Australian Credit Licence 392385.
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