This quarterly edition from Snowgum Financial Services provides you with a ten minute summary of matters to do with investing, economics and markets. We explore monetary policy limitations, fiscal policy necessities and debunk the problematic rise of Modern Monetary Theory (MMT).
Key Stats
Unemployment remains at 5.2%, not low enough to stimulate inflation.
The Australian economy has added 830,000 jobs in the past three years. Growth in the working age population kept pace, as has labour market participation (now at a record high).
RBA cash rate dropped to 1.25% in June and again in July to 1%.
Globally, interest rates are tending to ease. The ten-year US treasury bond rate has dropped from 2.86% to 2.03% in the last 12 months. The US yield curve is inverted, meaning investors receive lower interest rates for fixing their capital for longer periods of time. Rates however start to increase as maturity approaches the ten-year mark.
Australian economic growth was at 1.8%p.a. (RBA June 5, 2019)
Inflation is benign at 1.3%p.a. (RBA June 5, 2019)
Wage growth is slightly improved at 2.3%p.a. (RBA June 5, 2019)
Economic update
In this update, we’ve focussed on Australia and broken the economic commentary into a discussion on two macro-economic levers - monetary (cash rate setting) and fiscal (government budget management) policy.
Monetary policy
The Reserve Bank of Australia (RBA) cut the cash rate on 4 June to 1.25% and then 2 July to 1% (a record low). Market commentators interpret this as a signal of challenging economic conditions. Business and consumer confidence continued to slide downwards over the last quarter.
In a post GFC quirk, global markets are more sensitive to monetary policy than actual economic data. Philip Lowe (RBA governor) has publicly mused that
“there are investors who think the outlook is sufficiently weak that they expect central banks right around the world to cut rates, but they are not worried about corporate profits or credit… I don’t really understand that”.
It is head-scratching to see the increase in negative economic sentiment pushing investment markets to new heights”. - Philip Lowe
Why is this happening?
A rate reduction punishes conservative investors. The increased movement of money into the corporate investment markets simply reflects the opportunity cost of maintaining capital in defensive investments like cash. Those in, or approaching retirement, find themselves with no alternative but to take on more investment risk to meet funding needs. With the past four years of cash rates of 2% or less, and with what appears to be years more of benign cash rates, depositors (those with cash/term deposits) are starting to see the value of their capital eroded vs. inflation.
Even the most patient and conservative investor must be feeling the inexorable pull towards higher returning (and riskier) assets. With each successive rate reduction, more money is forced to move out of defensive investments into already fully valued growth assets, further increasing valuations.
Towards the end of a bull market, it is often individual and retail investors who are late to the game. Our concern is that Federal Banks, with their blinkered pursuit of inflation targets, are sweeping less sophisticated investors into risky assets.
Interest rates are now so low that they may be ineffective at stimulating further business and consumer investment. We even think that further rate reductions may have the potential to negatively impact capital allocation decisions. Our thinking:
A reduction in interest rates signals economic weakness, dampening business sentiment
If business sentiment is dampened and the cost of production reduces due to lower debt servicing costs, in a competitive market, prices will lower (negative inflation)
With record low interest rates, further rate reductions have minimal impact on the cost of capital and a business’ capital spending decisions.
Private consumers remain ‘maxed out’ with record high private debt levels and record low savings ratios. Interest rate reductions are cashflow band-aids for highly leveraged borrowers.
Interest rate reductions make existing investments more valuable. This has the potential to dampen investor appetite to invest further capital to generate additional returns.
Economics traditionally contends that lower interest rates stimulate employment. By stimulating employment, the natural limit of employment is approached, at which point the labour market attains greater bargaining power to push up wages. The resulting wage growth leads to expanding buying power and to (recently elusive) inflation. This inverse relationship of wage growth to interest rates is known as the Phillips curve. The Phillips curve relationship has historically been proven to be effective over short time frames, three years or less. It is not a long-term solution; a further weakness of monetary policy.
The logic underpinning the Phillips curve relationship relies upon businesses increasing their investment in infrastructure and labour as the cost of capital decreases. As debt is already so cheap, will further reductions in the cost of capital make any difference to a business? We think no or only at the margins. The short-term relationship predicted by the Phillips Curve appears to diminish as the gap between interest rates and inflation diminishes.
Given the breakdown in ability of Monetary policy to stimulate business investment, we see no reason why the RBA should consider further reducing rates once they’ve hit inflationary lows – but that does not mean they won’t, as has been demonstrated internationally.
With that reasoning, where do we forecast interest rates are going? - No idea.
“There are two kinds of forecasters: those who don’t know, and those who don’t know they don’t know.” [John Kenneth Galbraith]
– Then there’s the rest of us; we know we don’t know.
Of 25 leading economists surveyed by the AFR, the majority of them expect rates to be cut at least one more time before 2019 is out. More here.
Fiscal Policy
Australian federal politics saw the return of a Liberal/National coalition, whose proposed tax cuts should provide timely stimulatory economic relief.
Domestic equity grew and property markets stabilised in May and June. Private debt levels remain at record highs and metropolitan property prices are largely and fundamentally unaffordable for the next generation of owner-occupiers. Australians are continuing to have great difficulty saving, with the savings ratio at record lows. With these factors in mind, residential property, particularly in major cities, doesn’t appear to be heading for a period of sustained growth.
Economic growth is traditionally driven by consumption growth and export growth. These two segments contribution to growth have shrunk, and Australia’s economic growth has become reliant on expanding government spending and growth of the working-age population (immigration).
Source: ABS, Deloitte Access Economics
The above graph shows the changing factors producing economic growth, as well as the reduction in business investment we alluded to in the monetary policy discussion above.
Thanks to record infrastructure spending and the previous decades of somewhat sensible budgetary management (from both sides of politics), Australia is in a fortunate fiscal position to do what many other nations cannot; invest in infrastructure projects that are stimulatory, improve productivity and, where appropriate, allow capital to be recycled upon project completion.
On a simplistic basis, if GDP growth = workforce growth + productivity growth, and infrastructure spending improves productivity, then the other significant driver of Australia’s continued economic growth has been immigration. Australia’s growth in its working age population has added close to 1% per annum to the GDP over the last decade. Australia has been an outlier in this regard amongst developed country peers, as the graph below demonstrates.
Monetary policy (cash rate control), as discussed in the previous section, is limited in its effectiveness from here on. It is now fiscal policy that must be relied upon to do the economic heavy lifting.
In summary, Australia finds itself increasingly relying upon infrastructure investment and immigration to sustain economic growth. More than any time in the previous generation, we are reliant on our politicians to do the heavy lifting…
*PM Scott Morrison (our heavy lifter?) celebrating election victory at the Sharks game.
Investment Outlook
With so much volatility at play, geopolitical risks mounting, trade tensions increasing, and uncertainty of how effective monetary policy can be, it is little wonder that investors are nervous and uncertain about allocating capital. However, in uncertain times like this, it is still best to remain focussed on the long term.
A bear market is painful but exiting a bull market too early can be far more painful. If you accept that markets tend to rise over the longer term, then investors should continue to allocate capital sensibly into well managed and structurally appropriate businesses.
The above graph (courtesy of Morningstar) shows that there have been eight market downturns since 1926, the most severe one being the Great Depression. Morningstar comment:
More recently, during the “lost decade,” [in the US] two consecutive downturns with little to no expansion discouraged U.S. investors. However, the market has returned 133.0% since the current expansion started in March 2012, and, based on previous expansionary episodes, there is still ample potential for future growth. [Morningstar]
We may be closer to the end of the bull market than the start, but predicting the peak and getting it wrong, as is likely, is more costly than sensibly investing throughout the whole of a cycle.
The rise of nonsense
As we become more reliant on politicians to deliver the policy agenda required to navigate more challenging economic conditions, we are, unfortunately, seeing a rise in unqualified and ego-centric self-promoters, as the key decision makers. In a democratic society, the joke is on us for putting them there.
This recent article in the SMH will pander to the inner pessimist in us all. https://www.smh.com.au/business/banking-and-finance/how-phonies-and-self-promoters-came-to-rule-the-world-20190521-p51pm4.html
Modern Monetary Theory
In line with this section on nonsense, an economic theory called Modern Monetary Theory (MMT) has grown in prominence. Particularly popular with far left-leaning politicians Alexandria Ocasio-Cortez and Bernie Sanders in the US.
MMT proposes that currency issuing nations control the flow of money into the economy via fiscal settings. By running fiscal deficits (taxing less than you spend) you are essentially borrowing foreign money to fund a deficit incurred in your own currency. As the currency is something that you as the government create, you can always pay back those claims. There is no limit to how much debt you accumulate, so long as it doesn’t result in excessive inflation, which is primarily addressed by taking money out of the economy through taxation.
Therefore, according to MMT, Japan and the US, currency issuing nations with mounting federal debt, are simply exercising an agenda to inject foreign money into their economy, with no material downside. As the economy grows, should inflation rise they can simply increase tax revenues to pull money out of the economy.
MMT proposes that government central banks facilitate the fiscal policy settings by controlling bond issuance to fund government deficits. Under MMT, interest rate control by the central banks is focussed on attracting investors to continue to meet deficit funding requirements. Central banks under an MMT model lose their capacity to target inflation objectives.
We see two key flaws in MMT;
Although central banks set interest rates on government bonds to attract investors, there are no obligations on investors to invest in a government bond. Compounding debt obligations further deteriorate a nation’s servicing capacity resulting in a growing supply of government bonds that will eventually exhaust investor demand. Interest rates must rise to try and stimulate investor demand. This crowds out private investment, negatively impacting economic growth. Additionally, higher interest rates flow through to existing debt servicing obligations as they reach maturity and are reset. Whilst this is occurring, a slowing economy (partly resultant from a crowding out of investment) requires more fiscal support. This requires the government to accelerate bond issuance activities, and a cycle arises that leads to one of the following:
At some point, the government will fail to attract investors to buy bonds and default on existing debt obligations or
Be forced to drastically scale back government services or drastically raise taxation. Both will result in a rapid deterioration in living standards.
The currency will crash on a sovereign debt default or living standards will rapidly deteriorate... or both.
2. The mechanism to control inflation appears to have inverted in MMT. That is, it relies upon government policy flexibly adjusting taxation to control the flow of money into the economy. This puts an unusual amount of faith in politicians to deliver and pass difficult taxation policy quickly.
Our thoughts on ‘the Donald’s’ chance of galvanising legislators is summed up by the look on Apple CEO Tim Cook’s face.
By Matt Vickers