Forecasting 2021: search for yield to be dominant narrative

Christopher Joye

Coolabah Capital

In the AFR I write that after experiencing the mother of all “known unknowns” via this awful, one-in-100 year pandemic, you’d be brave to venture into the forecasting business in the 21st year of the 21st century. Excerpt enclosed:

Before we do, it’s worth asking what we learnt from 2020. For those in the prediction game, there were several lessons. The first is sheer creativity: we can always do a better job of harnessing our imagination to contemplate the unthinkable. Nobody anticipated a global pathogenic contagion in December 2019, and yet that is what we’ve grappled with.

In this vein, our central tail-risk offering is the possibility of a bona-fide military conflict between the US and our irritable trading partner up north. That probability has leapt from circa 10 per cent a decade ago to as high as 50 per cent in 2021 according to our internal estimates and those of our most accurate geo-political advisers.

The trigger could be a miscalculation in the South China Sea or the decision by the one-person-political-state to take Taiwan whilst it still can. Here the fear is that there may be some disruptive US military technology looming that will close the window on the ability of the Middle Kingdom to conquer Taiwan and defend that territory.

Unification with Taiwan is one of the “People’s Leader’s” defining aspirations for his termless tenure. And if there is one thing the world has learnt about the most powerful Chinese leader since Mao, it is that he should never be underestimated and constantly surprises with his preference for economic and information warfare, and coercion more generally, over diplomacy. So that disconcerting thought could make 2020 look relatively benign.

A second lesson has been the importance of divining the second-order policy “reaction function”, or the so-called “endogeneity” in the economic system, whereby governments continuously adjust in response to shocks, which then reflexively alters their ramifications.

Put more simply, shocks tend not to be as bad as initially feared precisely because public and private actors mitigate them. Extrapolating in a straight-line from the shock to consequences, and overlooking the profound influence of policy decisions, can be disastrous.

A final learning has been the propensity to underestimate the power of human ingenuity and adaptability, with the case study of effective COVID-19 vaccines being developed, approved and deployed in 2020 taking almost all experts, including the leading US immunologist Dr Anthony Fauci, by surprise, at least judging by their March and April predictions.

While I’ve touched on all three of these lessons before, they afford valuable context as we cast our minds forward to imagine the contours of 2021. In respect of my first offering—the risk of major power conflict—a key question remains whether the ascendant super-power up north will “error correct” in the way a Western, liberal-democratic lens might expect?

There are two obstructions here. The first is that autocracies tend not to have efficient informational feedback loops: evidence and/or perspectives that conflict with the position of the central authority are instinctively suppressed.

A second obstacle to peace is that conflict and struggle with capitalism are core imperatives of the Marxist-Leninist model. Western calculus is useless, indeed an intellectual handicap, when trying to predict socialist behaviours. One is left to conclude that while internal error-correction expressly against the authority—or voluntary adjustment by the authority itself—are possible, they remain lower probability, which is a depressing prospect.

Questions also linger about the tractability of vaccines. While we’ve posited since the COVID-19 crisis that vaccines would be approved and distributed this year, there are lurking left-tail contingencies. The most obvious is that there are hidden, systematic side-effects that render the most promising mRNA solutions from Moderna and Pfizer redundant. If such vulnerabilities were to emerge, they could be cataclysmic for markets. Although this is not our central case, it’s worthwhile bearing in mind.

It’s also not clear that even 95 per cent effective vaccines will present a panacea for opening borders—as is widely assumed—especially in zero-tolerance countries like Australia. If the premiers are prepared to lock-down entire states on the basis of a handful of infections, it is hard to see them allowing foreigners to come here (or Australians to return) without 14 day quarantines if there is a 5 to 6 per cent chance the vaccine does not work. This implies that borders will not be opened to other countries until those nations eliminate the virus: eradication, not mitigation, has become the Antipodean priority.

What about the probability distribution for Aussie housing in 2021? It’s firmly skewed to right-tail outcomes. In March we projected a modest 0 to 5 per cent drawdown over 6 months (we got a 2 per cent correction) followed by capital gains of at least 10 to 20 per cent.

Since prices started climbing again in September, conditions have strengthened as the Reserve Bank of Australia’s monetary stimulus grips. In December, it looks like Sydney and Melbourne home values will increase by a robust 0.7 to 1.0 per cent. We expect capital gains of 10 to 15 per cent nationally in 2021 (a forecast analysts have belatedly embraced after previously advising their clients that prices would plummet by 10 to 20 per cent).

While the RBA clings to the view that property price inflation will be modest because of weak population growth, the practical reality will be different. But this should not be a cause for concern: we’ve repeatedly stressed that prices today are only normalising back to their 2017 levels after the largest correction on record (exceeding 10 per cent) between 2017 and 2019.

Across bank balance-sheets, housing credit growth is well-below historical averages. And the RBA knows that if they do develop some financial stability anxieties, they can actively cool any ebullience through the application of constraints on lending via so-called “macro-prudential” tools.

Our core view is that in 2021 the Australian economy performs materially better than economists project with unprecedented public spending, a rebound in consumption, the recovery in housing, and the booming resources industry key drivers. This will also be welcome news for federal and state budgets, which will not be as bad as the treasurers expect.

Since March we’ve asserted that the jobless rate would stabilise between 6 and 7 per cent (miles below consensus forecasts), and in 2021 employment growth will positively surprise. It will not, however, be enough to generate the 4 per cent wages growth the RBA wants to get inflation back into its target band. To do that, they need to crush the jobless rate back into the crucial “4 point something” per cent zone, which will take time and additional stimulus.

Coupled with the fact that Australia’s AAA and AA rated government bond yields are the highest in the world—and still very attractive hedged into Yen, Euros or US dollars—this should motivate the RBA to extend its efforts to combat the increase in long-term interest rates and the Aussie dollar (without sparking a housing bubble) by applying downward pressure on 5 to 10 year government bond yields through further quantitative easing. It is currently the safest policy option available to the central bank.

Near-zero per cent global cash rates should make the “search for yield” (aka risk) one of the dominant narratives of 2021. We expect 5-year major bank hybrid spreads to test their post-GFC lows around 2.35 per cent above the quarterly bank bill swap rate, especially if NAB repays the $2 billion NABHA security in the first quarter.

We similarly think that 5-year major bank Tier 2 bond spreads will challenge their post-GFC troughs at circa 1.4 per cent above bank bills. As banks draw-down on more money via the RBA’s Term Funding Facility ahead of its June 2021 deadline, senior bank bonds should continue to disappear as an asset-class, which makes us constructive on new AAA rated residential mortgage-backed securities (RMBS) issued by banks (not non-banks). (We don’t like existing RMBS because of their elevated arrears care of repayment holidays.)

Yet investors need not chase risk to get superior returns. Sure, if you only want more yield, you must take more risk. But if you are searching for better returns, a safer option is capturing capital gains on more liquid and lower risk assets that are rendered when you exploit asset mispricings using intellectual edge.

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Christopher Joye
Portfolio Manager & Chief Investment Officer
Coolabah Capital

Chris co-founded Coolabah in 2011, which today runs $7 billion with a team of 33 executives focussed on generating credit alpha from mispricings across fixed-income markets. In 2019, Chris was selected as one of FE fundinfo’s Top 10 “Alpha...

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