To QE or not to QE: That is the question...
While there has been growing discussion on the possibility of Quantitative Easing (QE) in Australia, we believe recent domestic developments have broadly argued against the likelihood that the Reserve Bank of Australia (RBA) will need to embark on a QE program in the near future.
While growth remains sluggish and inflation below target, there are tentative signs that the recent trilogy of rate cuts, APRA easing, and personal income tax cuts are stabilising consumer spending and sentiment around the housing outlook.
Indeed, the most recent reporting season suggested selective areas of improving consumer demand, such as technology, autos, electronics and leisure. In contrast, the dominance of capital management suggested corporates perceived fewer investment opportunities ahead.
Of course, this does not preclude the RBA taking the cash rate toward zero amid a currency war, to avoid the Aussie dollar unhelpfully rising as other global central banks cut rates further (and further into negative territory) as global manufacturing and trade hits the skids on the back of the recent trade war escalation.
Australia may also benefit should China unleash more aggressive domestic easing, a further catalyst to avoiding the need for QE.
RBA's QE would probably look like the Fed's
If the RBA were to embark on an unconventional policy path, we believe it is more likely to resemble policies followed by the US Federal Reserve (US Fed) and Bank of England (BoE), rather than the ECB.
Like the US Fed and BoE, the RBA is more likely to focus on lowering the policy rate toward zero (but not going negative), using open-mouth operations to provide explicit forward guidance on the likelihood of low rates for an extended period, as well as purchasing government securities to inject liquidity and lower the longer-term risk free rate.
Of course, with much of Australia’s borrowing occurring at the shorter-to-mid part of the lending curve (in contrast to the US, where much of the borrowing occurs at longer-term rates), the RBA may focus its bond purchases to a shorter duration than overseas programs.
In contrast to the ECB, we would not expect to see the RBA shifting rates negative, nor engaging in policies to support credit creation, as there are no obvious potential problems in bank funding or the credit channels to which this type of policy is targeted.
Significant implications for markets
The prospect of an extended period of very low or near-zero risk-free interest rates can potentially have significant impacts on the investment environment.
This flows from the key catalysts driving such a scenario, in particular low growth and low inflation. The more we think inflation is going to stay low, the more we should as investors be contemplating that we are ‘mid-cycle’ rather than end-cycle.
Structurally lower interest rates also provide greater valuation support for equity markets, but can also significantly tilt demand toward (scarce) growth sectors, or those sectors with defensive income characteristics, ie, the recent history of out-performance for growth (over value) and yield generally is likely to continue to be well supported by a near-zero interest rate environment.
It also means valuations on already low-yielding sovereign bonds may not be as expensive as they first appear.
Further, an extended period of near-zero rates, low growth and low inflation, and where economies tend to ‘muddle through’ rather than cycle from one extreme (recession) to another (overheated) likely increases the potential benefits of both manager selection and the advantage of harvesting the illiquidity premia often found in alternative assets.
Of course, to the extent that inflation may eventually re-emerge, it potentially increases the risk that at some point, everyone is on the wrong side of the boat, and tries to quickly move to the other side, a scenario that rarely ends well.
What can investors do
While we may appear to be on the cusp of an extended period of near-zero rates that fundamentally alters the investment environment, there is always a degree of uncertainty about the outlook.
As such, portfolio diversification is always key, and alternative assets such as private equity where investors get paid for illiquidity become relatively more attractive asset classes.
Similarly, private credit markets are worth considering, where a reasonable amount of risk can be deployed to receive regular income at yields well above persistent low risk-free rates.
Within more traditional asset classes, active management directed at regions and sectors that have strong underlying long-term thematics may become a more important consideration when building portfolios.
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Scott has more than 20 years’ experience in global financial markets and investment banking, providing extensive economics research and investment strategy across equity and fixed income markets.