Investment Matters

Reserved and reactive

It has been a quieter time leading up to profit reporting season, which begins in August.

There has been little in the way of news as the 'moment of truth' for companies rapidly approaches.

The market’s focus this week was therefore on the Reserve Bank of Australia ‘s (RBA) meeting on Tuesday.

Governor Lowe’s speech highlighted the present reality: we have seen a rapid recovery in the economy, which has exceeded the forecasts of many.

As a result, the RBA signalled it will be gradually peeling back an aspect of the support it has provided over the past 18 months: slowly rolling off its purchase of government bonds (which pinned 3-year rates lower). However, policy overall remains highly accommodative.

Much of the market’s focus was on forward guidance by the bank: its framework for formulating policy and the path ahead.

Governor Lowe reinforced that the RBA is following the neo-central bank policy of today: an ‘outcomes based’ approach rather than a ‘forecast based’ approach.

In short, the RBA is on the back foot: itwants to see higher employment, wages growth and higher inflation before it begins to raise short term interest rates.

Specifically looking to see:

  • Consumer price inflation above 2%
  • Inflation sustained at this level
  • Wage inflation, which it believes will need to be at 3% to sustain inflation within its 2-3% target range.

The bank does not expect to see this achieved until 2024 but re-iterated any action would be based on data, not a prescribed date.

We note that wage growth has been incredibly difficult to achieve, particularly over the past decade, as seen below.

Wage growth has slumped over the past decade

Wage growth slump

Source: ABS

This is unlikely to be assisted by a reopening of borders and the resulting increase in the supply of labour.

Market commentators have opined that it is clear the RBA is prepared for an extended period of low rates. While opinions are divided, it may be some time yet before we see these targets achieved and rates rise.

All of this sends a clear message to savers: expect returns to b e eroded in the near future!

Tough times ahead for savers

As discussed in No more “Goldilocks” returns in bonds, bonds currently provide investors little in the way of return. Many fixed-income investments (such as term deposits and bonds) struggle to provide a return above inflation (and in many cases – are returning less).

Simplifying the RBA’s message: it is determined to achieve higher levels of inflation and committing to keeping interest rates low until this is achieved. 

The outlook for investors receiving fixed interest therefore looking less and less promising: rising inflation will eat away at already anaemic returns.

We have long positioned clients’ exposures accordingly: with little exposure to fixed interest, securities that provide an exposure to inflation and an income portfolio that is short in duration.

Implications

An erosion of real returns for income investors may not be the only side effect of this policy.

We have already seen the residential housing market go ’gangbusters’ over the last twelve months, with prices rising by an average 12.1% across capital cities. (Source: Corelogic)

Australian housing: lending goes gangbusters

Lending goes gangbusters

Above: Australian residential loan commitments (value excludes refinancing)
Source: Macquarie

This is beginning to concern the RBA: which has signalled it may implement macro-prudential policies if needed (broadly: policies to restrict bank lending)  and is looking at bank lending standards closely.

While the RBA is focused on this aspect of the economy, side effects may not be confined to the housing sector.

Shares are increasingly looking expensive (we are therefore holding higher levels of cash).

We are also wary that the recent accumulation of household savings and ultra-accommodative policy may spill over to other areas of the economy beyond housing. In our view, this increases the risk of unexpected inflation.