Lowe errs for longer (on the side of caution)
A tale of two markets: a recap of October
The chart below depicts the performance of the Australian share market (as represented by the All Ordinaries Index) relative to that of the US market in October.
What we have seen is an incredible divergence in performance.
The underperformance of the US market is likely to have been driven by several factors including inertia around fiscal policy (with a second coronavirus relief package still ricocheting through congress), uncertainty around the election and the muted performance of the technology sector.
In contrast, the strong fiscal support measures announced by the Australian government have seen our market surge almost 6% higher this month. This has been driven by a recovery in bank shares over the period, which your portfolio has benefited from, as well as the continued strength of our technology sector (in contrast to the of the US).
Lowe errs for longer (on the side of caution)
Two key speeches have been delivered by the Reserve Bank of Australia’s (RBA) governors over the past fortnight. These speeches have shed more light on the future of monetary policy in Australia.
Governor Philip Lowe
Last Wednesday Governor Philip Lowe gave a speech titled “The Recovery from a Very Uneven Recession”.
The speech highlighted aspects of the downturn that readers are very much aware of, namely the disproportionate impact across the population (with small businesses and young people disproportionately affected). Strong economic policy, a solution to the health crisis and a return to spending by businesses and consumers all remain key to an economic recovery.
Governor Lowe also reiterated some of the unique features of the downturn. Focus was placed on the sharp rise in household savings and deleveraging (reduction of debt). This contrasts with the archetypical recession, where incomes typically fall, and households are forced to draw down their savings.
Therefore, the willingness of households and businesses to draw down on these financial buffers they have built remains key to the shape of a recovery. In our view, a sharp rise in spending will accelerate the recovery in economic activity and provides upside potential for inflation in the short-medium term.
Governor Lowe also reiterated the importance of the strong fiscal response we have seen to date and that the resulting increase in debt “is entirely manageable and affordable and…the right thing to do in the national interest”. Furthermore, the Reserve Bank is not in a hurry to raise interest rates.
Mostly importantly, the Reserve Bank is open to further intervention. Higher Australian government bond yields (relative to the rest of the world) and the resulting strength in the dollar are a clear negative for economic activity. The speech suggested a willingness to further intervene in government bond markets if necessary (particularly longer-term bonds), to help manage the exchange rate and government borrowing costs.
Assistant Governor Christopher Kent
Similarly, in a less publicised (but nonetheless significant) speech this week, Assistant Governor Christopher Kent explored the tools the RBA has at its disposal, and their effectiveness in a post-COVID world.
With this came an acknowledgement that “it’s not just the cash rate target that matters”. The Reserve Bank recognised that the new tools it has implemented post-COVID (targeting longer-term interest rates and providing cheap funding to banks) are effective in providing liquidity, monetary stimulus, and lower borrowing costs.
Furthermore, there was an acknowledgement that these tools “influence interest rates directly in a way that gives…greater control over a wider range of rates than previously”. This indicates they are likely to remain in the Reserve Bank’s arsenal longer-term and represents greater flexibility for the Reserve Bank to provide monetary stimulus in the future.
Have bond prices crested?
Readers of Investment Matters are aware that we are reluctant to call the “bottom” of markets, stock prices or otherwise. It would be folly to imply that such forecasts can be made accurately or reliably.
In particular, the calling of a bottom for interest rates has been a “widowmaker” of market pundits over the last decade.
We do, however, note that we have seen long term interest rates begin to rise from the crushing lows we saw towards the beginning of July (noting that these lows not only represented the lowest rates have been over the last two decades, but in all likelihood, the lowest we have seen in human civilisation).
In a free market, the interest rate investors demand to be paid on long term government debt typically reflect expectations around future inflation and economic growth.
And while we acknowledge central bank intervention has been a key influencing factor of these rates globally, the cresting of bond prices may reflect a recovery of confidence in the outlook for the global economy, as well as rising inflation expectations.
Your portfolio has been positioned with a view that the prospect of rising inflation and long-term yields has been under-priced.
Should we see this continue, we would expect to see a slow rotation into companies of a “value” style at the expense of those whose share prices have benefited from lower interest rates.