KEY STATS
Cash rate remains unchanged at 0.10%
RBA bond buying program tapered to $4b per week, down from $5b per week.
Unemployment rate surprised on the low side at 5.1%.
Underemployment decreased to 7.4%.
Inflation rate sits at 1.1% in Australia.
ECONOMIC UPDATE
Threading the needle
Central banks and governments have done very little to slow the supply of stimulus, “At a time when economic activity contracted more and faster than at any time since the Great Depression in the 1930s, household disposable income actually increased”[1]
The speed of the economic recovery has surprised everyone. Sustaining emergency stimulus, now the emergency has passed for most sectors, risks distorting markets.
Economic dependence on stimulus might prove to be as problematic as too little stimulus. Policy makers are threading the needle trying to stabilise stimulus risks and find the right balance.
If investor risk and credit appetites are allowed to continue to grow to emergency stimulus settings, any future simultaneous removal of Quantitative Easing (QE), and modest increase of interest rates, would be extraordinarily disruptive and potentially be a catalyst for investment market upheaval.
Economists were split over whether stimulus measures should be tapered or sustained in the lead up to the most recent RBA meeting. Although no immediate change to interest rates is warranted, we would like to see a stronger change in rhetoric around the time frame of interest rate settings.
The RBA announced a gentle reduction in their bond buying program at their July meeting. This is unlikely to have much of an impact. However, should central banks quicken the wind down of bond buying programs (QE), the magnitude of government bond issuance would necessitate a rise in bond yields to attract sufficient investment. A return to real yields in government bonds would see a movement of capital away from riskier asset classes, lowering some financial system risks.
The longer private borrowers and governments are allowed to ratchet up ‘no consequence’ debt, the more consequential a future change to the price of that debt.
China, whose recovery is ahead of the rest of the world, is actively stifling asset speculation and credit growth to curb financial system risks. The Bank of Canada and the Reserve Bank of New Zealand are increasingly concerned about market distortions, particularly in the housing sector. A recent business conditions report from New Zealand was so positive that the largest four banks in NZ all expect interest rates to rise in November this year. In the US, Kevin Warsh and Larry Summers, as well as a number of US State Reserve policy setters, all have growing concerns that stimulus settings are too loose.
Financial system risks, we believe, will increasingly outweigh the benefits of loose settings, particularly QE and bond buying programs. One such possible risk is ballooning private debt, much of it directed into housing. High levels of debt are likely to stall productivity growth, dampen future consumption demand, and undermine the very thing central banks are trying to achieve. Macro-prudential[2] intervention targeted at housing debt might actually sustain longer term economic growth.
Inflation – headache or head fake?
The hot topic for investors is inflation. Is it transitory or more sustained? – We are not sure.
What is known:
Inflation numbers are presently high, reflective of year-on-year base effects. Base effects are the price jumps associated with a comparison to 12 months prior when demand fell off a cliff at the height of the global COVID lockdown crisis.
Money velocity has collapsed. Money velocity measures how many times new money supply makes its way through the economy.
Labour mobility is constrained.
Unemployment is at, or below, pre-pandemic levels.
Supply chain bottlenecks, notably high freight costs and supply shortages in raw inputs, are driving prices higher.
Known unknowns:
Will a return of labour mobility (through vaccine rollout) alleviate employment market pressures?
Is the rate of ‘full employment’ at or below 4%? (5% was the old benchmark)
Are supply chain bottlenecks associated with a temporary resumption in economic activity and a one-off surge in pent-up demand?
Although a bit early to call, supply chain challenges appear to be resolving. Recent data indicates a potential flattening of consumption demand in the US. Raw material price rises and pent-up consumer demand, both of which are inflationary, show signs of stabilising. This aligns with the view of major central banks that inflationary drivers are temporary.
Labour market dynamics are painting a different picture. Central banks, particularly the RBA, have been vocal in their view that wage pressure won’t emerge until 2024. Recent data does not appear to support this view. Forward indicators, like job vacancies, signal continued employment strength.
In Australia, job vacancies are up nearly 25% from February, with approximately 362,500 vacancies and 701,000 unemployed persons[3]. This is the highest number of job vacancies ever recorded in Australia. Underemployment is lower, and the participation rate higher, than pre-pandemic levels. If only 40% of advertised jobs were filled, the unemployment rate could be as low as 4.1%, less than what has been traditionally regarded as full employment. Employment markets are booming!! The same is true of the US.
It also remains unclear if the ‘full employment rate’ is as low as 4%. COVID was a catalyst for rapid changes to industry norms and the employment skills demanded by employers. It has also increased international labour market friction. It is possible that full employment, being the unemployment rate where remaining jobseekers are mismatched to employment vacancies, is higher than expected and won’t fall until international travel reopens - We penned some thoughts on this in more detail here.
Although some inflation drivers appear temporary, employment strength does not. Keep both eyes on wage growth, should that pop a little higher, and it could do so late this year, bond yields will jump, and the generous stimulus setting will have to be constrained.
Rotation of Risk
While employment growth looks strong, and pent-up consumer demand is flowing through the economy, who isn’t ‘joining the party’? To the chagrin of RBA governor Phillip Lowe, it appears to be businesses.
“If we are to build the capital stock that is needed for a more productive economy and a durable expansion, a further lift in business investment is required,” Lowe said.
Businesses, scarred by the GFC (as demonstrated by non-performing bank assets), have delivered continuous declines (excl. mining) in business investment, as a share of GDP.
This may, in part, reflect cost effective technology investment that is less capital intensive. However, the focus on efficiency has also translated into an unwillingness to pay higher wages.
Consumers who avoided the severe impacts of the GFC, have suffered slowly through a lack of real wage growth. Low wage growth stifles consumption growth. Without consumption growth, businesses lack confidence to invest further in their business, and this includes hiring more staff. This stagnating cycle is one that central banks are keen to break, hence the ever-lower interest rates, and recently, the printing of money.
To date, it has not worked. The printing of money (corelating to the expansion of domestic bonds in the RBA Assets graph) has only served to diminish the velocity of money.
Money velocity has gradually fallen from 3-3.5 to below 1. Where once a dollar created would be spent and passed on to 3 other businesses (through product and service exchange), it is now used less than once.
If money is being created that isn’t being used, where is it going?
It is being horded. Consumers are becoming asset speculators or savers.
Money velocity below 1, we believe, is a signal that further QE increases financial system risk faster than the associated economic benefit.
Further evidence that consumers, not businesses, are monetising QE programs is the meteoric rise in private debt.
The RBA is not too concerned. Their view, perhaps rightly, is that owner-occupiers are the consumers of debt, and that owner-occupiers are not speculators and so do not create financial system risk.
Housing credit growth is vastly higher than wage growth. That is not sustainable and will stall future economic growth.
Debt is being extended to owner-occupiers that defy traditional definitions of responsible lending. 17% of borrowers are borrowing greater than 10x household income[4]. Traditionally red flags are raised at debt-to-income ratios greater than 6x family income.
Concerningly, we are seeing a growing number of mature prospective clients exploring investment markets for the first time since the GFC, having previously preferred the safety and predictability of cash and term deposits.
The rapid decline in savings income has forced these investors to take risks. Taking risks doesn’t necessarily translate into economic growth.
Inducing, or almost forcing, those who can least afford it, at a time when it is least attractive, to take such investment risks, is a growing moral hazard of the current monetary settings.
Moral hazards are rising at both ends of the curve. Not only are the less affluent elderly taking expensive risks to help fund their retirements, the young are probably borrowing too much.
INVESTMENT UPDATE
“Interest rates are the gravity of markets” – Warren Buffett.
When interest rates are low, the discount rate used to calculate forward looking income is low. Income discounted by a lower rate will increase the relative value of a future income stream. This valuation methodology becomes particularly distorted when future income is expected to grow. Income generating assets, particularly those with the ‘promise’ of future and distant income, are very highly valued (some are saying unsustainably).
Unfortunately, nearly all asset classes are highly valued with respect to their historic benchmarks. We believe this moderates the scope for prospective future returns. However, the prospect of not investing is more unattractive given low cash rates (nearly 0%).
A variety of market commentators are expressing concerns about the current investment outlook. Many also expect the economic recovery to continue for years and that inflationary pressures are temporary.
Accepting it is impossible to predict the timing of significant market events and interest rate settings, economic commentary can distract from making actual investment decisions. More money has been lost being sitting out of a bull market to avoid a bubble than has been lost in the actual bubble. With little choice but to invest, but being conscious that risks are elevated, our view is that investing requires more nuance. Hard and fast box ticking asset allocation models are increasingly dangerous.
One easy decision is to avoid fanciful segments of the market. Non-value generating assets like non-industrial commodities, Bitcoin, unprofitable technology business, speculative investment vehicles and even some residential property markets. These asset segments either do not generate income (Gold, Bitcoin, Spec-Tech) or are fully valued, like residential property and some commodity businesses.
Traditional risk mitigation recommends incorporating bonds / fixed interest assets alongside equities to make a blended portfolio. Present macro-economic conditions make this risk management strategy precarious.
Fixed interest safe havens, like government bonds or semi-government bonds, are trading on an effective multiple of 75x earnings and often delivering negative real returns (when adjusted for inflation). So where do investors search for a defensive investment?
The hunt for a good defence.
With traditional defensive investments, like cash and fixed interest, delivering negative real returns, where does the investor look?
Floating rate credit – Credit is a loan to businesses, preferably in liquid secondary markets (like US corporate loans). Floating rate credit means you are the banker lending to a business who agrees to pay you a return that floats above a reference rate. This ensures changes in interest rate settings do not have a material impact on the relative value of the income stream. The loan to the business is typically used to allow that business to;
expand production of their business or service;
allow a bank (like a wholesale funder) to meet credit demand;
bridge a demand gap like in the case of a loan to Boeing etc.;
re-structure capital management within a business;
Credit risk management is more effective when diversification of credit risk is in the 100’s to 1,000’s of positions. The predominate downside risk in this investment space is a broad-based deterioration in the creditworthiness of businesses, leading to default. Capital remains far better protected than an equivalent equity position in that business.
Listed Infrastructure – Listed infrastructure comprises listed businesses like toll roads, ports, utility providers and airports. These are essential inputs to the function of day-to-day economic life. Infrastructure businesses can be monopolistic and if so, typically regulated to generate a prescribed return. Infrastructure assets are not immune from market risk and will decline over the short term in a rising rate environment. They are also impacted by declines in utilisation associated with a broad downturn in economic activity. However, with the ability to pass on higher costs to consumers, and diversified exposure to economic activity, infrastructure businesses are better placed than many to weather inflation shocks and rising interest rates.
Currency – Currency is a poor ‘defensive investment’, but does provide some diversifying protection. Unhedged positions in an economic/market decline will see the AUD depreciate, offsetting some of the downside in the international positions.
Private Markets – unlisted markets offer improved risk/return opportunities. The downside of investing via private markets is a lack of liquidity. Often, when taking a private equity position, you may have to commit capital for 5-6 years before you again gain access to this investment capital.
Cash – There is no better defensive substitute for cash in the short term.
None of the above ‘defensive’ positions (except cash and investment grade credit) are truly defensive in a traditional sense. This reflects the downward pressure on yields associated with central bank liquidity and policy settings. Central banks have ostensibly killed the traditional defensive investment when they began printing money to buy asset at artificially low prices.
A defensive offence
The best performing businesses and assets over the last few years have tended to be some of the least profitable and most speculative. An investor using past returns to predict future returns would be taking, in our view, an unhealthy risk. An investment portfolio full of Bitcoin, Tesla, ‘meme stocks’ and other leveraged and opaque investments may continue to outperform for a period, but at some unknown point in time, it is reasonable to expect a ‘reckoning’.
Should interest rates rise, it will be the most future and hypothetical incomes that decline the most. Businesses that generate profit in the present are, somewhat ironically, relatively more attractively priced. We favour businesses that are ‘price setter’s’. A price setting business can pass on higher costs to customers without worrying about a material loss in customers. These tend to be better businesses and attractive should inflation materialise.
Please feel free to reach out if you would like to discuss any of the above information in more detail.
Regards,
Matt Vickers
[1] Ellis, L (2021). Lessons and Lasting Effects of the Pandemic | Speeches | RBA
[2] Macroprudential measures refers to regulatory intervention into financial system operations. This would be things like APRA limiting the banks’ ability to lend more than 6 times household income, or limit investment loans to 10% of new issuance.
[3] Australian Bureau of Statistics - Job Vacancies, Australia, May 2021 | Australian Bureau of Statistics (abs.gov.au)
[4] RBA Financial Stability Fact Sheet - Financial Stability (rba.gov.au)