So here we are, official interest rates are now at 1% with a further 25bps cut possible in August which would take the cash rate to 0.75%. While there has been much speculation in the media about the flow on effects for both the property market and consumer spending, it would be prudent to ask the question (as indeed Governor Lowe did) as to how much stimulus this really brings to the table. Even assuming that the full extent of the cuts are passed on by the major banks (not happening), the actual impact this will have on a consumers propensity to spend remains somewhat unclear. What this does to asset prices is however another story altogether.
Last week we touched on the problem of the aging demographics and the follow through implications of this factor in asset valuations and prices in developed countries. We suggested that, with an aging population and in a low interest rate environment, investors are left with very little choice but to move up the risk curve towards assets which end up trading at a premium for an extended period of time. For us, this was brought into the limelight in an article in the Australian Financial Review this week. This article looked at the impact of the rate cuts on platforms such as Netwealth and Hub24. While the article takes a rather cynical view of the revenue models of the platforms themselves, what was interesting is the real-world illustration of how a low cash-rate is effectively penalising savers or holders of cash. It suggests that the net return of investors holding cash on these accounts is -6bps. In a country with an aging demographic, this certainly creates problems for those of us looking to generate a safe income to live off.
Whatever your views on the decision, as investors our job is to take the emotion out of our analysis and to be pragmatic when making allocation choices. After all, in this game there is always a winner (sometimes this isn’t necessarily the collective but that is the way it has always been). Hence it is vital that we rethink or review our current situation. We would posit that, whatever might be the actual impact upon the real economy, the low interest rate environment bodes well for the equities story in this country and for Australian investors with global equity exposure. With regards to domestic equity exposure, what the rate cut illustrates to us is two things:
This is not to say that we don’t see any significant headwinds in the future. What we are suggesting is that, given the low inflation and low interest rate environment, there remains very little choice but to allocate towards risk assets with the expectation that regulators and governments will continue to act as cheerleaders for the markets. Indeed, looking at the past behaviour of governments gives us a pretty good indication as to how they might react in future. To misquote the Bank of International Settlements: where inflation used to be the key indicator for which regulators and governments watched, now it has been replaced by financial asset cycles. Fiscal measures, rather than being countercyclical, have been increasingly procyclical; expanding budget deficits in times of contractions and failing to consolidate when the opposite is the case. Though they were using this within the context of determining the right sort of fiscal policy measures. Another interpretation (and rather more adept) is that governments around the world have become rather sophisticated when it comes to kicking the perennial can down the road; supporting markets at all costs (i.e. spending in times of contractions and not bothering to reign it in during periods of expansion). The classic case in point is of course the Tweeter-in-Chief’s obsession with using the S&P Index as his litmus test for economic performance.
So what does this mean for investors from a risk management perspective? As we have previously stated, risk management becomes exceptionally complicated when we don’t have a benchmark or risk-free rate of return to use (after all, the cash rate or government bond yields are zero bound). Given this to be the case, we would suggest a radically different thought process and one that hinges on paradigms (and shifts thereof) in the Kuhn sense of the word. If we can accept that, under the current environment of relatively low growth and low inflation, regulators who watch the same things will use the same tools that they always have - expecting different results - then we can develop a fair idea of how markets might react over a given period of time (i.e. correlations between equities and interest rates or, god forbid and if things get dreary enough, QE). In other words, we can afford to take on more risk in the portfolio than would otherwise be the case with the prospect that at least some of the downside will be worn by the public's wallet (privatised returns at public risk). This being the case, we would suggest a significant component of ones portfolio remain invested in equities (despite sluggish growth predictions) and moving towards high-yield credit alternatives which has been a big thematic in the past few years. After all, if the cost of capital is zero as previously stated it is quite hard for companies to go bankrupt or be unable to service debt obligations (they would simply refinance in a worst case scenario). However, the caveat is that we also have to be more constant in our ability to watch changes in big picture themes that might derail the process. An example of this is inflation coming back while growth rates are still bearish (you have yourself an interesting environment in this context). But as the old saying goes, ‘you can’t fight the Fed’ or, in this case, the RBA.
Markets & Commentary
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TAMIM Asset Management provides general information to help you understand our investment approach. Any financial information we provide is not advice, has not considered your personal circumstances and may not be suitable for you.