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Sherwood Comment 30th November 2017 – Why the RBA should remain on hold in 2018.
In this morning’s AFR former RBA board member Warwick McKibbin stated that the RBA should start raising the target cash rate to reduce exchange rate volatility and to prevent a more volatile economic reaction that could occur if we paused for another year. This followed similar calls from the OECD yesterday who stated that the RBA board should increase rates to curb risky debt. Two primary risks in the next three years
The two greatest risks to the Australian economy in 2018-2020 are a housing downturn and economic dislocation from a moderating China. Both are higher risks in 2018 than they were this year, so I think a stable cash rate at 1.5% is absolutely the prudent things to do, especially when Australian core inflation is expected to get back within the RBA’s target band until 2020. Housing is already slowing, so why accelerate the trend?
In relation to housing, recent data has indicated that household sector credit growth is around nominal GDP (circa +6%), house prices are no longer rising, auction clearance rates have fallen and housing approvals have moderated. So Australian housing is already slowing on its own volition and I see absolutely no upside to the Australian economy in front running housing and China risks with policy tightening.
Not only would higher domestic interest rates cause a further weakening in domestic consumer spending as household increase their precautionary when asset prices decline and wages growth is low (and lets not forget that the a large portion of the retail sector is been displaced by new entrants), but this would also have flow-on effects to investment (business usually only invest if consumer spending growth is rising, and vice-versa) and exports through the exchange rate (at a time when our largest trading partner is moderating its growth and transitioning away from its commodity-intensive investment fuelled growth). The changing play book
When thinking about monetary policy and inflation, times have clearly changed, and the last thing we should be doing is using the last decade’s play book with inflation dynamics around the world having evolved. With the six D’s (higher debt, weaker demographics, increasingly disruptive technology, declining equality, increased deregulation and threatened duopolies) the global economy has recorded much lower inflation over the past decade despite record high stimulus. We have had ten years of highly stimulatory economic policy including negative interest rates, zero interest rates and USD15 trillion of QE programs, yet since 2008 the US Fed has hit its +2% inflation target in only 4 of the subsequent 105 months – which is four times more than their peers in Europe and Japan. Quite clearly, inflation dynamics and the relationship between unemployment, wages growth and inflation has changed, which indicates that this cycle is not typical. The RBA have managed risks very well
While I have been critical of other regional central banks for their egregiously generous policy settings, I think the RBA has played a very strong hand in the past decade. We performed solidly during the GFC as previous tightening’s meant the RBA had policy stimulus to unleash, the exchange rate fell and the Government stimulated the economy. Then in 2011, we faced the largest mining investment unwind in 150 years and previous unwinds have all ended in recession and double digit unemployment, but six years later we have had no recession and Australian growth in the September will be around 3% (which is high relative to other OECD countries) and unemployment is gradually declining towards 5%. Hence, despite high risks, our policy settings have been very well managed and the Australian economy continued to expand. Some central banks are behind the policy curve, but not the RBA
There is a list of central banks whose policy settings need to be tightened such as the US and Europe, but the time for Australia to be at the head of that list is not now, though it could be at end-2018 if the economy transitions as we expect. An on-hold target Cash Rate is appropriate not only because we have major growth risks ahead, but also because the housing boom is already deflating, inflation is entrenched low and below the target, and we have macro prudential tools which have already curbed lending to riskier types of borrowers. Australian rates are expected to remain on hold for 2018
As a former economist at the RBA, I can safely say that there is a real art to central banking, particularly around turning points in policy settings and the art is about ‘timing’ policy changes and ‘judging’ when the risk dynamics have changed from weaker growth to higher inflation and I feel that despite solid GDP growth and falling unemployment, we are still a considerable way from that point. Implications for investors
Australian investors need to recognise that the investment landscape has changed and examine their investment portfolio to ensure that they asset allocation is appropriate for the changes underway around the world and at home. Investors need to place their funds in markets which have superior growth potential, have more attractive valuations and which are earlier-cycle and then determine how to diversify risk as bonds may not do it this cycle. The golden rule for investors over the past four decades has been to reduce duration exposure before the central bank hikes rates and have greater risk exposure in shares. However, during the US Fed’s recent hiking cycle, US bonds yields have fallen and shares have risen despite Fed policy. I would guess that if the RBA hiked rates unexpectantly in 1H2018 we could see a similar result as hiking rates when inflation is below the +2% to +3% target would most likely quash domestic inflationary expectations (as it has in the US) and would increase concerns about policy mistakes and spark increased flows in safe havens. However, rates-on-hold for 2018 remains my base case. Perpetual’s Diversified Real Return Fund is purpose built for this environment given it doesn’t use a strategic asset allocation framework (which is based on historic correlations) with no minimum holdings in any asset class (bonds, equities or others). Every asset in our Fund is included to meet the investment objective of inflation plus 5+% over rolling five-year periods with moderate risk. The Fund has a modest exposure to Australian shares and a much higher exposure to global shares where we believe the opportunities are better and valuations are cheaper.
Originally published by Matt Sherwood. Head of Investment Strategy, Multi Assets. Perpetual