It’s buyer be­ware as risk rises

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

Money Magazine Australia - - OUTLOOK - Hans Kun­nen

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

Newspapers in English

Newspapers from Australia

© PressReader. All rights reserved.