It’s buyer beware as risk rises

The search for yield here and in the US could end in tears

Trust me – I’m an economist. (OK, stop laughing!) October is not “hexed”. Yes, bad things happened in Octobers past (1987, 1997 and 2007) but as my statistician friends tell me, “correlation is not causation”.

October is not special – unless it’s your birthday or you’ve got dividends coming your way. Don’t go looking for trouble in October, it’s there all year round.

So what about October 2018? Fallout from the royal commission is likely to drain demand for banks. At the same time, rising offshore interest rates and tighter lending regulations are crimping bank margins. In addition, credit growth just isn’t what it used to be, so profit growth will be harder to find.

Thankfully (for some), the Reserve Bank will keep its cash rate on hold. This is keeping the banks and debt-burdened consumers in the game. A rate hike in Australia would crush consumer spending while a rate cut would add fuel to the fire of our household debt binge. Net result: no change to our cash rate for at least a year. Not so in the US.

Tax cuts, government spending and strong job growth have seen the US economy power ahead. Its sharemarket has followed. Tighter labour markets and firm demand have seen US inflation pick up. The US Federal Reserve is pushing against these trends and expects to lift its cash rate to 3.1% by the end of 2019. That suggests a further rate hike in 2018 and three or four during 2019.

If US 10-year bond yields rise at a similar pace to the Fed funds rate, US equity markets could come under pressure as investors become attracted to these new, higher yields. With US equity markets at or close to record highs and interest rates on the march upwards, it’s buyer beware. If US economic and corporate earnings growth can continue, then sharemarket valuations can be maintained. If not, a pullback is possible – or at least a pause in their upward climb. The low-interest-rate environment in Australia and the US has driven a search for yield. Investors have taken on more risk to improve returns. The growth of high-yielding US debt products, known as collateralised loan obligations (CLOs), has been substantial. CLOs contain collections of “low covenant” business loans.

Slower economic growth in the US could see a rise in defaults within CLOs and investor protections may be less than imagined. Investor protections within these instruments have improved over the years but they remain complex and require significant expertise to see what’s happening under the bonnet. Again, buyer beware. If this market implodes, we’ll all feel its impact one way or another.

The usual economic stats will pop up in Australia. While these don’t move markets on the day, they set the scene in which consumers and corporates operate. Retail spending, job growth and inflation are all due. Retail sales and job growth tell a story about consumer stocks while inflation figures will confirm the context for interest rate expectations.

Going overseas this month? Unless you hedged, your travel just became a little more expensive. Over 2018, the Australian dollar has fallen against the US dollar and on a trade-weighted basis. But there is a bright side to a softer dollar. The offshore earnings of Australian companies will get a boost; our exports, including tourism and international education, will become more competitive, giving the economy a shot in the arm and possibly a dose of imported inflation!

In summary, no change to Australian official interest rates but further pressure on banks to lift rates to protect their margins. The biggest concerns are US sharemarket valuations in the face of rising interest rates and developments in US debt markets. Our economy continues to tick over. This may be boring to some but it provides good ground for corporate earnings growth – the engine room of long-term sharemarket returns.

Hans Kunnen is the chief economist at Compass Economics. He is also the author of Borrow + Build, a primer on borrowing to invest in the Australian sharemarket.

A rate cut would crush spending; a rise would add fuel to the debt fire