Much has been written about the central banks and their policies during the COVID
pandemic, and the errors made (the benefit of hindsight is great, isn’t it?). Australian
investors have been treated to unending speculation as to the fate of Dr Phil Lowe as his
verbal messaging and policies during and since the pandemic came into sharp focus.
Investors will have to weigh whether a new era under Michelle Bullock will be meaningfully
different; and what this will mean for the economy and the prices of various assets in the PLE
(post-Lowe era).
A famous bon mot asserts: “nothing fails like success.” Whether by luck or good judgment –
or likely a combination of the two – the twenty-five years before COVID were a central
banker’s dream. Able to reduce interest rates, investors became accustomed steadily and
cyclically to lower lows and lower highs; and as risk-free returns declined as measured by
Government bond yields) those same investors were being incentivised (perhaps unwittingly)
to take more risk to achieve more substantial returns. Result: asset price inflation in the riskier
asset classes of bonds and property due to a well-behaved bond market, courtesy of no
consumer price inflation. The GFC was a rude interruption to the party, but with no rise in
CPI, the flood of cash righted the ship and – after a significant interruption – the party
continued.
COVID
With a flood of cash from all sorts of fiscal stimulus plus the RBA printing money, perhaps the
central bank settings of the past would work their magic again?
Doubtless, the severe impact of COVID warranted an economic response, and in Australia’s
case it was large, swift, and may have been overkill. Large cash payments to keep individuals
and businesses afloat during the many lockdowns (particularly in Victoria) in concert with a
flood of cash from RBA via bond buying, and a near-zero cash rate, led to two things
happening; employment and activity recovered more quickly than many had anticipated, and
inflation rose with free cash splashed everywhere. While some central banks, notably in NZ
and the UK moved to reduce super-easy monetary conditions, Phil Lowe doubled down and
pronounced rates would stay at zero for three years. Borrowing increased, house prices
spiked and those with savings and who desired less risk were forced to risk capital further in
shares and property or buy bonds or deposits at paltry rates of between 0.1% and 2%.
So what (now)?
With the emergence of much higher consumer inflation and very strong employment growth,
policy settings had to change. Twelve successive rate rises took the RBA rate from 0.1% to
4.1% in a stunningly short time. Those with savings rejoiced and those with large mortgages
reached for their calculators.
The AUD and the local share market (and bonds)
Share prices in Hong Kong and China sit at levels 30% lower than mid-2021 and the AUD is
around 12% lower than during that year. Meanwhile, locally, the share market is near all-time
highs. Fixed rate longer dated bond prices have fallen by up to 25% in two-years, creating
amazing opportunities for “yield to maturity” investors: investment grade corporate bonds
that scarcely yielded 2% two years ago are now at 6.5%.
Central banks can change quickly, but investors….
When the penny dropped in mid-2022, the RBA moved rates with great haste. Like a soccer
team that’s 3-0 down with fifteen minutes remaining, it was an all-offense strategy. While the
rises were rapid-fire and loan rates adjusted quickly, the behaviours of investors often don’t
change so fast.
Rental yields versus bond yields
While bond yields tripled, the rental returns on main city housing stock rose also – in a far
more muted fashion from a little over 2% to around 3.2%, while yields on units were close to
5%. All in all, this seems insufficient when investors are carrying far more risk in these assets
(as deleveraging continues) than in capital guaranteed bonds. It follows that investors must
believe in price gains to make up the difference in returns or are so in love with the taxbreaks
associated with negative gearing that they feel the risk is worth taking. Granted, nighon
full employment and resumption of immigration is keeping rental yields buoyant, but if
the mean return on $1m of capital city property is 4% (minus expenses) and borrowings are
now at or near 7% (and possibly higher for investment properties), further adjustment seems
likely in the prices of these properties.
Eg 1. Don’t fight the central bank(s) – another old saying
While investors have been seeing adjustments in bond prices due to the rises in official cash
rates, this is likely to stabilise as we near the anticipated highs of this rate cycle. Corporate
bonds at 6-8% are giving investors returns well over the RBA target inflation rate and well
over the market anticipation for inflation over the next five years, which are both under 3%
Eg 2. Don’t fight the central bank(s) – the “Bernanke Put”
A few Fed Governors ago, Ben Bernanke’s name was associated with the phrase “The
Bernanke Put”. What this meant was that it was okay to take risk with your capital and buy all
sorts of high return options including shares, mortgages, derivatives because the central
bank would come to your rescue in times of trouble in one (or both) of two ways: by cutting
interest rates hard or by buying troubled assets in the event of a meltdown. But, these
options are severely reduced while consumer inflation remains a problem.
Conclusions
1. Corporate bonds and private debt are attractively priced for investors – those worried
about further tightenings should consider floating rate bonds
2. Shares and property have not yet significantly adjusted given moves in rates, and the
local share market may be susceptible with China now deflating
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