While the Australian economy has been expected to be affected only tangentially by fiscal problems experienced elsewhere, at an investment level there are strong effects flowing through to our markets, according to Tim Farrelly.
Over the past year, I’ve described at length how high levels of government debt throughout much of the developed world will have several long-term impacts.
These include:
- Much lower than usual growth in the developed world;
- Low or moderate inflation in the countries with high government debt;
- Central banks in those countries maintaining low interest rates;
- Financial repression in those countries by means of negative real interest rates; and,
- High valuation multiples as investors chase yield.
Much of the discussion has focused on countries with high government debt.
For the most part, the Australian economy has been expected to be affected only tangentially by the fiscal problems experienced elsewhere.
While this should be largely the case at an economic level, at an investment level, there are strong effects flowing through to our markets.
These effects will be stronger and longer lasting than we have previously envisaged – and will impact most, if not all, investment markets.
Currency is the lynchpin
Artificially low interest rates – close to zero cash rates and negative real rates – are in place in much of Europe, the US, the UK and Japan.
These artificially low rates put upward pressure on the currencies of any country running traditional interest rate policies.
International money flows will be drawn to currencies paying the most attractive interest rates which in turn pushes those currencies up.
Exacerbating the money flows and the currency impact, is that most of the countries that are attempting conventional monetary policies are also safe havens as they have manageable level of sovereign debt (just).
The end result is that artificially low interest rates elsewhere result in an artificially high currency here – and it tends to act as a handbrake for Australia’s economic growth.
While manufacturing is often assumed to be just about non-existent in Australia, it actually makes up around 12% of the economy.
Throw in agriculture, tourism and the foreign component of the education industry and about 20% of the Australian economy is directly and powerfully affected by the level of the Australian dollar.
And that’s leaving out the resources sector.
So, an artificially high Australian dollar means artificially slower Australian economic growth.
Lower cash rates
Now turn to the role of the Central Bank – to keep inflation under control while maintaining full employment. For much of the past decade, the RBA has had its neutral cash rate setting at around 5.0% to 5.5%.
If the economy was growing too fast, causing inflationary pressures, rates were lifted above that level to slow things down.
Similarly, if the economy was slowing, rates were lowered below 5.0% to give the economy and employment a boost. This can be seen in Figure 1.
However, in an environment where there is a structural headwind – an artificially high dollar – the neutral level of interest rates will need to come down. In the old world, if five per cent cash rates were neutral, then today – thanks to the high dollar – five per cent cash rates represent tight monetary policy, a headwind for the economy.
The big question then is this: how much lower is the new neutral rate? No one really knows. Even the RBA will eventually determine it by trial and error.
But for now, we do have their best guess. In a speech in early December, Deputy RBA Governor Phillip Lowe stated that interest rates are 1.5 per cent lower today than they would have been before the financial crisis.
He cited two influences – the high dollar, as discussed above, and higher funding costs being experienced by the banks which translate to higher spreads above the cash rate to borrowers in the real economy.
Low rates for the long term
So it would appear that cash rates of around 3.5 per cent to 4.5 per cent are the ‘new normal’ for Australia. How long may this last?
It really depends on how long the Australian dollar is artificially high and how long bank funding costs remain elevated.
The answer to the first question appears to be “a long time” – at least five years and possibly 10 years or more, as discussed late last year in my article on financial repression.
Essentially, the argument is that it is in the best interests of those countries with high levels of sovereign debt to keep inflation modest and interest rates very low until their debt levels have been brought into line – and that will take decades.
And, until the interest rates normalise elsewhere, we are likely to have an artificially high currency here.
Similarly, high funding costs for the banks will probably remain in place for a few years yet.
Currently, they are restructuring their funding sources away from wholesale debt towards retail term deposits, which are considered to be more stable sources of funding under the new Basle III rules.
While that is going on, we will see the banks continuing to pay up for term deposits.
As they bring their balance sheets closer to their new target funding ratios, we expect they will reduce the premium they’ve been prepared to pay to attract depositors, and their overall level of funding costs should fall somewhat – but probably not back to pre-GFC levels.
In the meantime, wholesale funding costs have eased over the past six months, giving some relief.
Given that central banks are determined to keep the financial system intact, it seems unlikely that wholesale funding costs will go back to the elevated levels of the past few years, aside from the brief spikes that will accompany the inevitable crises that will be an ongoing feature of the economic landscape over the next decade.
The net result is we expect that the neutral level for the RBA will settle down at around 1 per cent below the old levels.
Impacts will be felt across all markets
All investment markets will be impacted – cash rates, term deposit rates, bond rates, the Australian dollar, share prices and property prices will all ultimately be affected by a long-term move to lower interest rates.
We’ll focus here on the Australian dollar, equity and property markets.
As discussed, the Australian dollar is likely to be artificially higher than would otherwise be the case. This – categorically – does not mean that the dollar won’t fall from these levels.
It just means that no matter what level it trades at, the price would probably be lower if not for low developed world interest rates.
For example, if the Australian currency falls over the next decade by around 18 per cent (1.8 per cent per annum) to US$0.85 in line with our forecasts, without low rates elsewhere, the value would probably be closer to US$0.80 or US$0.75.
The strong rally in the Australian equity market is in part due to the fall in term deposit rates that is having quite an impact on the spending power of many retirees.
High dividend yields compared to term deposit rates should continue to support prices of Australian equities and A-REITs.
If our central thesis – that we will see low interest rates for a long time – is correct, we should see structurally higher multiples on these assets.
As a result, farrelly’s has lifted its expected 2023 Australian forecast PE from 14.5 to 15.5.
In effect, this means that yields in 2023 will be about 0.4 per cent per annum lower than they would have been had interest rates been 1 per cent per annum higher. farrelly’s has changed its forecast yield on A-REITs from 6.7 per cent per annum to 5.9 per cent per annum – a full 0.8 per cent per annum lower, reflecting an expectation that most of the interest rate fall will be translated into higher prices.
These changes mean that expected returns for Australian equities are still attractive at around the 9.5 per cent per annum mark, despite the strong rally – however the forecast returns for A-REITs, while enhanced by the change in assumptions, remain unattractive compared to equities.
The risk to this view – which is a real risk – is that the US in particular reverts to more traditional monetary policy in the event of a strengthening economy and an unwillingness or inability to introduce the fiscal tightening required to begin to bring the deficit under control.
If this occurs, expect to see a rise in interest rates across the board and, probably, a commensurate fall in asset prices.
A strong recovery in the US economy may not be a positive for equities. In such a scenario, past cosy correlation relationships may break down.
Tim Farrelly’s is principal of specialist asset allocation research house, farrelly’s, available exclusively through PortfolioConstruction Forum.
