Quantitative Easing will likely come to Australia

John Abernethy

Clime Asset Management

We remain positive for the outlook for Australia and expect its economic growth to exceed that of most other developed economies. This view is informed by observations of trade and expected population growth.

However, we believe that Australia will succumb to the pressures of international monetary policy, the deflationary cycle and the need to deal with excessive household debt.

We expect that Australia will adopt policies that have been used overseas and which now form the basis for the expression “Modern Monetary Theory” (MMT). This theory suggests that sovereign nations (those that issue their own currency) do not face financial budget constraints. Their fiscal or financial deficit can be funded by everyone else’s surpluses which can be created by printing currency.

MMT is confronting to conventional economic thinking. It has developed following the responses and mechanics of QE across Japan, Europe and the US in the wake of the GFC. The success of QE is not measured in economic growth but in the observation that it has neither created an economic catastrophe nor a massive inflationary surge. It has driven down bond yields so that highly indebted governments can trade on, or “kick the can down the road”.

The proponents of MMT argue that sovereign countries need not worry about fiscal deficits for they can be funded by creating monetary surpluses. This argument will continue to gather acceptance for as long as deflationary pressures persist. However, along with deflation has been slowing economic growth and this has now reached Australian shores.

Recently, the RBA reduced its economic growth forecast to 2.75% for 2019 from its previously forecast 3% while consumption growth, which makes up 60% of the economy, was reduced to 2% from 2.75%. In coming quarters, we expect that growth forecasts will be cut further.

Australia’s growth so far in 2019 has been supported by exports (as LNG exports come on stream) and direct government (public) expenditure. These sectors have offset the weakening residential building sector and soft business investment (particularly in working capital). Labour productivity has also been on the wane with a sluggish 0.4% growth reported in 2018 – well below the long run trend of 2.2% growth.

The development of LNG has been impressive, and Australia is now the largest supplier to world markets. Concurrently, iron ore prices have continued to hold at levels around $100 per tonne and, with LNG, have helped drive Australia’s trade account into a healthy surplus.

Outside resources or energy (and much like the US), Australia has abundant trade potential in services (especially tourism and education) with China. The table below gives an interesting insight into the opportunity with China and the emergence of tourism and beverages companies that are attracting the interest of the burgeoning inbound tourism sector.

Australia’s trade opportunity extends past China and a focus on Indian consumers must soon develop. The opportunity is enormous and the next table which focuses upon a very basic aspect of Indian development creates an interesting possibility for a closer trade relationship. It is worth remembering that Australia was once at the forefront of the development of the two-flush system.

However, these positive opportunities are currently being overwhelmed by the excessive level of household debt following the housing price bubble. Further, the Australian economy is being managed with a lack of co-ordination in economic management across monetary and fiscal policy. The political imperative to balance the Commonwealth budget will soon give way to economic reality.

Australia drifting toward Quantitative Easing

This leads us to speculate on what lies ahead for Australia’s monetary policy settings and the likely drift into some form of QE over the next two years.

First, we believe that at some point the RBA will move from cutting interest rates (aimed at protecting over-geared residential borrowers, many with negative equity) to a program of asset purchasing. This program will be introduced when it becomes apparent that extremely low cash and borrowing rates do little to stimulate economic activity or lift residential property values. Indeed, there is much overseas proof that lower rates can deflate an economy. Thus, the RBA will eventually conclude that it is better to buy the bad loan books (using QE) from the banks and deal with them outside the financial system. If readers believe this is far-fetched, then simply ask yourself why this is any different to the ECB buying Italian bonds, or the BoJ buying Japanese property securities?

Second, the driving down of long term bond yields will eventually create a significant financial problem that only QE can nullify. Thus, in many countries where bond yields have been compressed, it has become the norm for QE to continue even though it is no longer theoretically needed. This is because it is extremely difficult to reverse low bond yields once they are embedded in the financial system. The capital losses that would be felt across the financial system, particularly by banks, insurers and pension funds if long term yields rise would be catastrophic. At that point, QE becomes a perpetual band-aid.

Now that the RBA has succumbed to lowering interest rates in the face of local market and international pressure, it has set in motion a course that will naturally lead to QE at some point

Today, Australian long term bond yields have reached historic lows, with 10-year bonds yielding less than inflation. A further surge down in yields to, say, 1% would force the RBA to intervene.

Whether that is MMT or not does not matter. It is the consequences for financial markets and the effect on investment returns that will.

What does this mean for investors?

While unconventional monetary policy has been in existence for a decade: this is a relatively short period for observation in the history of the financial world. Thus, the winding up of QE and the lowering of interest rates has been a “one way affair” to this point. The flipside of the unwinding of excessive monetary stimulation has not been observed and can only be speculated upon.

However, we can predict, based on the observation of overseas central banks, that once the RBA starts on unconventional policy and supports the market for low interest rates, it will be present for a long time. The unwinding will be delayed for as long as possible.

Thus, we are likely to see and feel the effects of lower interest rates in Australia for quite a while and this will mean that returns from all investment assets will succumb to deflationary pressures.

In the early stages, there are capital gains made as yields crunch and this explains the returns from bonds and A-REITs over the last year. There will also be growing support for high yielding equities and hybrids. Passive investors will drift out of bank deposits into other higher yielding (but riskier) investments.

At some point, most of the value of income returns (present value) will be fully priced into markets and overall returns will begin to stagnate, or market prices will oscillate allowing returns for active asset managers to be generated.

The logical offset is to seek growth in emerging or developing economies and particularly by focusing on international companies that have products or services that are well respected and sought after. What upsets this logic is the current trade war that surely must be settled at some point.

Over the next few years, portfolios must be set to generate sustainable yield, above inflation, with an eye for capital maintenance.

A balanced approach with good diversity across asset classes is suggested with the allocation requiring a deep and comprehensive understanding of an individual’s circumstances.

Investors should be willing to accept lower returns and appreciate when these returns are exceeded, or when asset market declines are to be avoided.

We have little doubt that at some future point we will endure challenging times. These challenges also bring opportunity and it will be the enduring focus on the fundamental process, the diligence to complete the research and the patience to hold the spotlight on a long-term horizon that will build value over time.

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John Abernethy
Clime Asset Management

John has 35 years experience in funds management and corporate advisory services. Prior to establishing Clime, John’s roles included ten years at NRMA Investments as the head of equities. Clime is a management and advisory business for mainly SMSFs.

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