Key statistics
Cash remains unchanged at 0.10%
RBA term funding facility remains open through to June 30, 2021
Unemployment in Australia is 5.80%
Inflation at 0.9% and wage growth at 1.4%
RBA has undertaken $51Billion of government bond purchases in 2020
Economic commentary
If the economic mantra of 2020 was ’Stimulus, Stimulus, Stimulus’, then 2021 appears to be ’More, More, More’.
A once in a century pandemic galvanised policy makers, both government and central bankers alike. Their mammoth and synchronised stimulatory response has, from an investment point of view, overshadowed the economic impact of COVID. Investment markets V-shaped recovery appears to be booked in, and with more stimulus in the funnel, may even turn into a tick.
Don’t be fooled into believing this investment market recovery is borne from strong economic fundamentals. It is as much, if not more, a function of government and central bank monetary and fiscal policy settings. COVID has exacerbated a breakdown in the correlation between asset prices and economic fundamentals, with some commentators warning we may be approaching a breaking point.
Source: Bloomberg, Macquarie Group
For investors, government stimulus and central bank policy settings dwarf other risk considerations in the near term. Around the world the scale of government stimuluses account for a significant percentage of GDPs. So, changes in government spending and tax setting have an enormous impact on markets.
Source. Bloomberg.
Government stimulus has been coordinated with and strongly supported by central banks.
As governments necessarily expanded spending to combat COVID related economic hardship, deficits blew out and government debt expanded. Government deficits are funded by issuance of government bonds. A government bond is simply a note of promise by the government to pay back the money it is borrowing, with interest. Government bonds are considered low risk by investors as governments can simply print extra money to pay back the loan.
The return an investor generates on their loan to the government is the yield (interest) on the bond. Ordinarily, the government’s cost of debt is set by investment demand for, and government supply of, government bonds. With a COVID induced glut in supply of government bonds, higher yields would be expected to induce investment demand for government bonds (increasing government debt funding costs).
Central banks, keen to support credit flow into the economy entered bond markets as an ‘investor’. By buying a vast quantity of government bonds, central banks artificially generated demand, avoiding a sharp rise in the price of government bonds (particularly those with near term maturities).
Central banks fund bond purchases with newly created money. That is, central banks ramp up the currency printers at the mint to buy bonds. Their investment in bonds becomes an asset on central bank balance sheets. This process of inventing money to buy government bonds is dubbed quantitative easing (QE). COVID has caused a substantial expansion of ‘assets’ on central bank balance sheets.
The below graph demonstrates the uptick in government bond assets on central bank balance sheets across leading developed markets.
Source: Bloomberg
QE supports credit flow to governments and the economy more broadly. A biproduct of QE is an inducement in risk taking (investment) by investors and businesses, supporting an economic recovery, if undertaken prudently.
However, there are several undesirable consequences from QE.
1. If we believe debt must be repaid (and we do), central banks are enabling governments to access unnaturally cheap debt today, at the expense of future spending.
2. Central bank investment crowds out investors, forcing them up the risk curve. This has led to a sharp increase in asset prices, often unsupported by underlying fundamentals.
3. Asset price rises drive inequality. Existing asset owners (those already wealthy) benefit from QE.
4. The more debt central banks fund, the more vulnerable the economy is to any subsequent change to interest rates.
5. The more debt absorbed by financial markets, the more probable and consequential a disorderly deleveraging (financial crisis) event will be in the future.
Central banks appear to be backing themselves into a corner. If you owe the bank $100 that’s your problem, if you owe the bank $100million that’s the bank’s problem - Government debt is now very much a problem for central banks!!
Investment commentary
Plan for upside, position for the downside. With so much stimulus flowing into markets, and with interest rates set to remain low, markets are buoyant. The cost of not investing is high but being ignorant of risks could be even costlier. There are a number of risks and three we would like to highlight:
1. Inflation.
Inflation is primarily a problem should it force central banks to raise interest rates. Presently, investment markets are pricing some assets as if interest rates will remain low forever. Should interest rates change, so will the valuation of these assets, and it will happen quickly.
US government stimulus spending might be one such catalyst. Former US Treasury Secretary and National Economic Council Chair, Larry Summers, lays this out succinctly in a recent Opinion piece for The Washington Post
• In 2009 (GFC), only 50% of US GDP shortfall was offset by fiscal stimulus.
• Biden’s $1.9trillion stimulus package, on top of the $900billion stimulus already flowing into financial markets, is worth about $150b a month. This is roughly 3x the US GDP output shortfall in 2021. This could conceivably light a rocket under the US economy.
In contrast to Summers, Paul Krugman (Nobel Laureate in economics), believes the composition of economic stimulus will not be sufficient to stimulate demand pull inflation. He argues that many stimulus cheques will be saved and state-based public spending initiatives may take years to fully flow through the economy.
Further, modest inflation is a positive thing for investors. Modest inflation assists with restoring resilience into the economy as it would, over time, moderate debt in real terms.
RBA Governor Philip Lowe has been transparent with his thinking. He will not worry about inflation until there is low unemployment. Low unemployment typically leads to wage pressure. Wage growth drives up the cost of producing goods and services. This is passed onto customers via higher prices… thus inflation.
Between 2005 to 2008, unemployment fell from 5 per cent to 4 per cent, and inflation soon followed. However, in 2018 when unemployment only lowered to 5 per cent, we saw little inflation. This has given cause for the RBA and market commentators to speculate that the level of unemployment required for wage growth to emerge is now at 4 per cent, or even lower. This represents a change from historic norms, where 5% unemployment was sufficient. This may provide investors some time before inflation risks materialise. But watch unemployment data like a hawk; with the unemployment rate now at 5.8% in Australia, and with a sharp uptick in job vacancy growth, the unemployment rate may drop surprisingly quickly.
As an aside, one reason the NAIRU (non-accelerating inflation rate of unemployment) may have lowered is in response to efficiencies in employment allocation. Employers and employees are matched more efficiently through digital marketplaces, and employees find themselves less geographically constrained. The timing and adoption of digital innovation and associated reduction in the NAIRU appears well correlated.
As the below graph suggests (courtesy of Janus Henderson), the next few months might be very telling on how much time we have before we should worry about inflation. Inflationary expectations have returned quickly.
2. Debt
A McKinsey study in 2010 stated that a debt to GDP ratio above 50% creates systemic financial risk. Debt is now greater than any time since the 1930’s (great depression) and well and truly at levels warranting concern. Household debt is again rising quickly - as interest rates went down, debt went up, and sharply. Servicing this debt will be a drag on economic growth and amplifies monetary policy decisions. A majority of household debt is flowing into residential property, an unproductive asset, further stifling innovation and productivity.
Source: RBA, ABS, SMH
Concerningly, should market participants decide it is appropriate to repay debt, history has shown periods of deleveraging can lead to financial instability. In the 42 instances of economic deleveraging since the great depression, 32 of those instances led to a financial crisis. Should an attempt be made to deleverage, there appears a greater than 70% chance of a financial crisis developing.
According to McKinsey, deleveraging typically comes in one of four ways:
1. Austerity – tightening the belt to spend less than earnings. I.e. credit growth needs to be lower than GDP
2. Default – large numbers of borrowers default on loans, leading to massive write-downs and potentially a liquidity crisis, like that seen in the GFC.
3. High inflation – Large debts can induce governments to print greater amounts of currency to service obligations. This can lead to high inflation, even hyperinflation (like in the Weimar republic), and this reduces the relative value of debt.
4. Growth – Growing out of debt through very rapid rises in real GDP. This requires a productivity boom, often because of a serious disruptive event, such as war and the ensuing peace dividend.
Not one of those options by itself would be pleasant. Governments and Central Banks need to ‘thread the needle’ in calibrating a combination of moderate inflation, gradual repayment, and sustainable GDP growth.
Finally, debt levels in the transparent western economies are concerning. We can only speculate at the scale of the problem hidden within the Chinese economy.
3. Inequality
One consequence of historically low interest rates is a boom in asset prices. This has driven rapid wealth gains for the wealthy. The top 1% now own 15x more assets than the bottom 50%. In the year 2000, the top 1% owned only 7x more assets than the bottom 50%.
Specific consequences of inequality are difficult to predict. However, the probability of social unrest and political turbulence rises with the increased likelihood of populist governments and/or populist agendas to tackle inequality. Already we are seeing a collective call for higher taxation.
In a bid to protect the most vulnerable from COVID, countries did what is necessary and borrowed against future income to avoid a disorderly economic crash. It is the next generation of workers who will be paying off this debt, the same group who find themselves priced out of assets (like housing), and who are likely to face the prospect of a decline in government services and/or increased taxation. This inequality may also lead to younger people becoming a more vocal political force. Or, inequality may be self-correcting if there is a significant drop in asset prices.
Portfolio positioning
Inflation protected income streams are now more valuable within portfolios. The equity risk pendulum has swung towards value stocks (with some merit), but growth exposures, particularly in price setting businesses, remain appropriate. Price setting businesses can pass on increased costs to consumers and businesses, and therefore are more immune to higher overheads.
Exuberantly priced assets, like Bitcoin or Tesla, should be avoided entirely.
Fixed income bond assets are a trickier asset class to invest in. This market segment requires very active management to roll down yield curves, take advantage of mispriced credit spreads and generally work hard to generate upside. Conventional diversification benefits of fixed income have all but disappeared. Floating rate credit is preferred over the medium to long term.
Listed infrastructure, although more volatile than credit and fixed income, provides less cyclical income risk than equities. Toll road, utilities and ports will still operate largely unchanged in an economic downturn, and regulated monopolies can pass on inflation related costs. Infrastructure yields tend to be more attractive than credit, and this asset class has attracted defensive investors who have being forced further up the risk curve given the demise of the fixed interest asset class.
Cash remains sensible for those with near term funding demands or those who are comfortable losing money in inflation adjusted real terms.