22 November 2023
The May edition of The Monitor runs through seven events indicating an increasingly fragile market.
The two rules for the Monitor are:
- Don’t take anything for granted and
- Review, Re-assess and Recalibrate.
The two events that triggered the last edition was the increase in the US overnight cash range by 0.5% to 2%-2.25% (now 2.25% to 2.5%) in the September Federal Open Markets Committee (FOMC) and our shifting of our Caution Meter from 50% Alert Caution to 60% Extreme Caution.
In this edition, we want to introduce you to the third of our analytical guides which normally is largely related to investments. That analytical guide is “There is no free lunch”.
Our Break with Tradition
Traditionally, we use 3 questions to help guide readers to deeper insights. The questions we use are:
- What are those you can trust up to?
- What changes in the United States will impact Australian Interest rates in the short-term?
- What are those you can’t trust up to?
The 7 events that triggered this issue of the Monitor are multi-lateral and profound, so we need only rely on the events to provide valuable insights.
The 7 events are so transformational that the insights they provide allow us this luxury.
The Triggering Events
The events that have triggered this May Day edition of the Baillie Capital Stable Monitor are as follows.
The table below provides the inflation data of the Australian Bureau of Statistics on a quarter by quarter comparison, year on year comparison to the 31st March 2019 and year on year comparison to the 31st December 2018.
The history of Australian Inflation data over the last 60 years has shown that wage inflation and expectations of inflation are the 2 most influential factors of the recognized variables that contribute to inflation.
It is a commonly held belief that Whitlam’s Labor Government and the 1973 OPEC oil crisis ignited Australia’s 2 decades of high inflation. Our research finds different.
The foundation of inflation for the 2 decades starting 1970 and ending in 1990 was the equalisation of female wages for equal valued work introduced by the Commonwealth Conciliation and Arbitration Commission in 1969.
The consumer price index in the first of those decades was just under 10%, followed by 8.5% for the second decade of 1980 to 1990.
In the November quarterly report in 2018, the RBA re-tabled its concerns about the persistent low levels of real wage increases. This is causal to the above data set. The prevalence of the inflation mindsets fashioned from 1970 to 1990 experiences is increasingly declining.
The average inflation rate for the last 25 years has been 2.6% and so less and less people have experienced the economic distortions of mid-to-high inflation.
In turn, this should increase the confidence that the threat of inflation is not what it was, and nor is this likely to change for some years into the future.
The relevance of Inflation is it disguises permanent losses of capital where real returns after tax did not protect the purchasing power of investible capital.
As announced on the 5th of June, overnight cash rates are at 1.25%..
Central Bankers from different countries have slightly different briefs that all coalesce around Financial Stability. Australia has an inflation target range of 2% to 3% and full employment of 4.75% as its Central Bank policy objectives.
The graphs below show the year on year change in the 18-month market pricing for 30-day cash interest rates.
The change of the direction illustrates that the level of volatility is significantly more dynamic than historic models and economic beliefs indicate. We now face a market that has said that from September this year to September next year, the overnight cash rate will be 1% or less.
Whilst neutral interest rates are optimal for financial stability, Hyman Minsky’s 1973 thesis shows that human nature will force Central Banks to either be accommodative or restrictive as evidence becomes available.
Our RBA wants to provide discipline for monetary policy decision making to provide an appropriate anchor for private sector expectations.
Debt is allocated to the 4 sectors of Government, Households, Non-financial Corporations, Financial Corporations (mainly banks, superannuation funds and insurers).
This raw data has many drawbacks, with two easily identifiable. First, looking at liabilities in isolation to assets produces an incomplete picture. Second, the aggregate debt involves some double-counting. Households have lent money to banks, who have lent money to Corporations and Government.
Despite the drawbacks in data many credible experts question whether the sustainability and robustness in the earnings component of economic growth is compromised by this growth. They have concluded that debt at a certain level is an inhibitor to an economy rather than having neutral impact or being an accelerator.
Is the global economy heading towards a “Minsky Moment”?
We do not profess to know, but we do recognise that the global economy is much more fragile than it was a year ago and that fragility is increasing.
Global debt as a percentage of GDP has increased by 50% over the last 20 years.
There are no simple mechanisms for reducing the current sources of fragility and based on historic precedent the US Central Bank would need to reduce US interest rates down to minus 2.5% to combat a recession.
Baillie’s conclusion is that Event 3 makes Capital Stability much more valuable but increasingly harder to achieve and maintain.
Both political parties have declared policies that will lead to a fiscal surplus for the 4 year forward estimate period for Australian Government budgets. The estimate for 2018/2019 fiscal position of minus 0.8 % of GDP may be pessimistic. This puts Australia into a very strong position to continue its 27 Year period of non-recessionary economic experience. However, the per capita position paints a bleaker picture and the RBA’s having to adjust its end of year inflation estimate by 0.5% in just over six months shows how cloudy rather than clear, the skies are.
Our fiscal position gives us a get out of Jail card and protects our exchange rate which in turn curbs inflationary pressures.
Our February trade surplus was revised upwards to $5.140 billion and the first announcement of the March data shows a $4.949 billion surplus. This is $7.3 billion more than for the same two months a year ago.
This shows we can well afford all our imported trinkets without damaging our exchange rate and in fact we are exporting inflation.
ASIC has stipulated to the Federal Court that ASIC has evidence of 261,987 cases of breaching responsible lending laws from 2011 to 2015 by one of the big “four” banks. Both the RBA and APRA are very aware that the current 7.25% default rate used for responsible lending analysis assessments has outlived its applicability and needs to be reduced.
On 2 May, the US Federal Open Markets Committee kept the range of overnight rates unchanged at 2.25% to 2.5% despite the U3 unemployment rate shrinking to 3.6% and the U6 unemployment rate staying constant at 7.3%. The personal consumption expenditure measure of inflation in the US moved further down from the 2% target. This has been nominated as the causal element of why Jeremy Powell left interest rates unchanged.
Where to From Here
It is very comforting that the IMF has re-enforced how strong our banking system is despite our Banks sins.
We applaud the perspicacity of Dr Lowe who identified that the issues unearthed by the Royal Commission of Banks was the fault of Bank Management – not the Regulators.
We have confidence that the same insight will be applied to the $64 question for the Australian economy, which is: what will be the flow-through impact on consumer spending as a result of the fall in residential property prices? We are certain the Reserve Bank of Australia would love to know accurately what the possibilities or probabilities and plausibility’s of this question are.
We assess the balance of probabilities being that inflation will shrink more than it would have done if the house price contraction impact hadn’t occurred. The March quarter inflation data, the year to date and the change in the year to date data corroborate this.
We identified the negative of inflation in its capacity to cause a permanent loss of capital. Many self-interested parties believed that if a little bit of inflation is healthy because it is a proxy for robustness of economic growth.
We see that the combination of globalisation, technology and demographics will cause continued disinflation and probable deflation leaving the advocates of the healthy view of inflation sorely disappointed.
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*The views and opinions expressed in this article are those of the author and do not necessarily reflect the views and opinions of Reach Markets.
**There is only one mandatory reminder appropriate for any edition of the Baillie Capital Stable Monitor. You need to be reminded that this Monitor is designed as a reliable source of data and provider of insights to capital qualified Wholesale Investors. The Corporation Act definitions establish the boundaries for the Professional, Expert and Sophisticated Investors that qualify.