The economy is awful and that’s great news for investors
Here at home, the economy is sputtering. Growth is slowing, inflation is on the mat, unemployment is ticking higher.
The situation has deteriorated to such an extent that it’s even jolted the Reserve Bank into action after three years of nothing.
It cut rates three weeks ago and now the betting is on that we could see another cut as early as next week.
Many economists are tipping three cuts this year. And yet, at every turn, investors appear to be overjoyed, clamouring over one another to pile into the stock market.
After taking a thumping late last year, when the global outlook appeared relatively benign, optimistic even, the local market this year has been on a tear, notching up one of the strongest performances in the world with an 18 per cent gain.
And things will only get better as the news gets worse.
Growth slowdown fires up stocks
Last week, our stock market galloped to an 11-year high and finally is within striking distance of cracking the record, from October 2007 just before the global economy tanked.
Compare that with Wall Street. Before the crash a decade ago, the Dow Jones Industrial Average peaked at around 14,000 points. On Friday, it closed at 26,719 points, more than double its pre-crash peak.
For most of the past decade, Australia has outpaced America’s economy. The resources boom saw us power through the worst of the global financial crisis as almost every major developed economy plunged into recession.
Why then, the relatively poor stock market performance? Shouldn’t the market reflect what’s happening in the economy?
In days past, stock investors positioned themselves for where they saw the economy six, or even 12 months, ahead.
Not any longer.
These days, traders and investors pretty much care about just one thing; interest rates. The lower they go, the better the market performs. And generally speaking, rates only fall in times of trouble, when the economy needs a boost.
One reason for this apparent mismatch is that there is so much investment cash out there looking for a home, when interest rates fall, it quickly migrates to stocks.
There’s another factor at work too. The global economy now is so overloaded with debt that, were interest rates ever to rise, there would be a massive spate of defaults that once again could threaten the banking system.
That’s why Wall Street tanked late last year as the US Federal Reserve persisted with its plan to “normalise” interest rates, to push them higher. December was its worst month since the Great Depression in the 1930s.
Global debt now stands at more than $US250 trillion ($360 trillion), more than three times its level 20 years ago, much of it backed by property.
Having painted themselves into a corner by issuing so much debt and printing so much cash, central banks, including our own Reserve Bank, are now so frightened about the potentially catastrophic impact of a downturn in either stock or property markets, that they are prepared to do almost anything to avoid it.
Market values must be maintained.
It’s a great strategy for anyone who owns a home or has a share portfolio. For those who don’t, it’s a recipe for disaster — or at the very least a widening of inequality and the wealth gap.
Why the RBA will cut again… and again
Reserve Bank governor Philip Lowe won’t have a bar of it. There’s nothing wrong with the economy, really. The RBA isn’t cutting rates because things are deteriorating. Not at all.
It’s cutting rates because the Non-Accelerating Inflation Rate of Unemployment has slipped. Ah, of course.
Where we once imagined the NAIRU at 5 per cent unemployment — the point considered “full employment” because anything under that saw labour shortages, wage breakouts and rampant inflation — it’s now closer to 4.5 per cent, maybe even lower.
That’s an oblique way of saying we’re in uncharted waters and the only way to navigate through is to throw caution to the wind.
The real reason for the RBA rate cuts is the dramatic fall in housing prices and the prospect that unemployment may spike, particularly if the escalating trade dispute between the US and China further crimps Chinese economic growth.
Should more people end up out of work, as the graph below from investment bank UBS indicates, there would be a rise in mortgage delinquencies and an acceleration of the housing price slump.
If there are two more cuts in coming months, that will take the official cash rate to 0.75 per cent. And at that point, we officially will have joined the race to the bottom.
Of course, quite a few countries already have reached the bottom and gone even further.
America spent years at zero per cent. Germany and other parts of Europe have seen interest rates at well below zero. Japan, however, is the world leader in negative rates, as this chart below shows.
All up, there’s around $US10 trillion worth of debt priced at an interest rate below zero.
What is quantitative easing?
Why would anyone lend money, deposit cash or buy a bond that guaranteed you’d lose money? Primarily because they think rates could go even lower. And many banks are forced to hold government-issued bonds, even ones that lose money, for liquidity reasons.
Once considered radical policy, it’s now becoming the norm and involves various strategies such as quantitative easing (printing money), ZIRP (zero interest rate policy) and NIRP (negative interest rate policy).
Our monetary mandarins, having explicitly raised the possibility of exploring such actions late last year, this week ruled them out, instead wisely urging governments to start spending big on infrastructure.
Rate cut goes nowhere — what now?
The disappointment must be palpable. When the RBA cut rates three weeks ago, its primary goal was to sink the Aussie dollar, to make our exports more competitive and to give a leg up to local industry.
It worked… for a while. But by the end of last week, the local currency had climbed back above US69c.
That’s the problem with rate cuts and currency manipulation — it only works when you go it alone or you’re in the minority. When everyone is doing it, it has no effect at all.
Shortly after our rate cut, US President Donald Trump’s demands for one at home grew louder as he openly discussed sacking Fed chair Jerome Powell if he doesn’t get his way.
European Central Bank chief Mario Draghi also has abandoned any plans to push rates higher, eliciting an attack from Mr Trump who, bizarrely for a leader engaged in the same strategy, accused him of trying to manipulate the Euro.
Mr Trump is threatening retaliation, possibly through trade sanctions. None of this bodes well for the global economy.
Perhaps it’s time to get into the stock market. It’s a great strategy, until it isn’t.