Looking backwards to look fowards

As investors welcome in the 119^th Financial Year since Federation in January 1901, we take a snapshot at where things are at right now, with an eye on the past examining what was and with an intent to construct a view to the future.

Starting with the equities market. The ASX 200 starts the financial year at near record highs at 6618.7, despite the fact that there are some significant issues facing investors in the immediate future. The elephant in the room is the on and off again trade war with China. There is no doubt amongst financial commentators that a full-blown trade war with our largest (China) and third largest (United States) trading partners would bad for Australia. That said, if a trade deal is done between these two goliaths, Australia's export economy may still suffer, especially in Agriculture (Beef and Wine), Natural Gas and coal sectors.

ASX 200. Source Iress

Of course, we have issues domestically which will have a direct impact on markets. The banking sector, making up 30% of the ASX 200 is under the pump post the Royal Commission into Financial Services, with all of the top 4 looking to exit their funds management business units which will have a significant impact on earnings for all the banks over the next 18 months. In addition, with loan books heavily focussed on the domestic residential sector, the valuation outlook for residential housing is also under the microscope, with house prices falling nearly 8.3% in the past 12 months. This fall in value when combined with almost zero real wages growth has made housing affordability the lowest since federation. This puts the Banks in the uncomfortable position of funding an increasing number of people with negative equity in the homes, which if we have a spike in unemployment would lead to an increase in mortgage default.

Domestic Interest Rates

For the last 119 years, Australians have not seen such low levels of real interest rates. The impact of a sustained period of low rates will be a new economic experience for the most seasoned investor and as such the long-term implications of low interest rates will be difficult to judge. Japan is our "go to" observation point, with negative real interest rates being a reality for the last 15 years.

Source Bloomberg

How will these low rates impact the Australian economy over the next 12 months remains to be seen. As the only lever the RBA can really use to prop up the housing market, one must consider that the recent rate cut of 25bp from 1.25% to 1.00% will unlikely passed on fully to investors from the lenders. So, the impact for borrowers is if you are under mortgage stress now, things are not going to improve as we could expect the banks to keep between 3 and 5Bp of any move down in rates. For depositors the opposite is true where they can expect the full rate cut to be passed on reflecting lower rates for cash deposits. This affects large cash business like Woolworths and of course all retirees. The other hope the RBA has in reducing rates is to encourage commerce within the Australian economy, with SME’s along with big businesses willing and able to keep people employed. So, will rates go lower and if so will the change be passed on borrowers creating a lift for the economy? If the Japanese market is anything to go by, Japanese GDP growth has remained very subdued at circa 1% per annum for a very long time, which does not auger well for Australia.

Of course, the slide in rates in Australia, has coincided with a similar slide in rates in the United States. The yield curve in the US has inverted for the first time in 10 years, (longer term rates are lower than short term rates) which has historically been a warning bell on the health of the US economy. Comparing the short-term rates for both the US and Australia, with Aussie rates now lower than those in the US, there would seem to be significant downside risk for the Aussie dollar as the carry trade is unwound.

US rates are not the only impact on the Aussie dollar and with our major trading partners for our export driven economy being China and Japan, the adage that when the US sneezes Australia catches cold is no longer as relevant. Australia's' s largest export (excluding services) is iron ore, followed closely by Natural Gas and Metallurgical Coal, and with prices for these commodity's reaching all time highs, the impact of lower US interest rates is lessened.

Source Bloomberg

So, considering all of the above, where is the ASX 200, RBA Cash Rate and the Aussie dollar going to be in 12 months' time? Time will tell...