Following today’s big market announcements, here’s a rapid fire Q&A with First Sentier Investors’ Richard Rauch, Investment Director of Fixed Income & Multi-Asset Solutions.
Why did the RBA cut the cash rate today? Why now?
The RBA reduced the official cash rate by 25 basis points, from 0.75% to another all-time low of 0.50% amid the coronavirus crisis. This cut was fairly well telegraphed in the lead up to the meeting with the market fully priced for the move (i.e. the probability of the cut was already at more than 100% in money market futures). Market pricing had changed quite quickly – only a week ago, futures markets were suggesting the probability of a cut at the March meeting was only around 5%. Governor Philip Lowe has desperately wanted to keep the Reserve Bank’s precious remaining powder dry and has been managing the market’s expectations accordingly.
Therefore, today’s move appears to have been made reluctantly by the RBA, perhaps as part of a globally coordinated move to ease monetary policy settings to help support the global economy in the face of weakness arising from the ‘COVID-19’ outbreak. The Bank of Japan yesterday foreshadowed more quantitative easing, Christine Lagarde said the European Central Bank is ready to take “appropriate and targeted measures”, and during an unscheduled statement on Friday last week, Chair of the US Federal Reserve Jerome Powell said the central bank will “use our tools and act as appropriate to support the economy.”
There’s a conference call scheduled this evening (Tuesday morning US time), led by US Treasury Secretary Steven Mnuchin and Powell along with representatives of the G-7 countries to help coordinate a response to the virus. The RBA is simply doing its part by kicking off this global easing. Given markets have moved to aggressively price in rate cuts in the US, the RBA appears to want to get in front of this. Local policy makers are also likely concerned about the Australian dollar, whose recent falls have been helpful for exporters. Over time a lower dollar might also benefit some recently challenged sectors, such as education and tourism.
Will cash rates go any lower in Australia? What else can the RBA do?
Central banks around the world including the RBA have been pressuring governments to pursue more aggressive fiscal stimulus measures (e.g. tax cuts, expanded government spending, loans to struggling business sectors, etc). With central banks running out of ammunition as interest rates move closer to zero, the task of smoothing out the economic cycle is increasingly falling on governments who may or may not have the capacity to step up. In the case of Australia, we believe there is certainly financial capacity although perhaps not the political will to expand government spending.
In terms of further RBA action, officials have publicly stated that they do not want to embark on negative cash rates. They have suggested 0.25% is the practical floor for cash rates and the bar to begin a quantitative easing (‘QE’) program is materially high – not a smooth continuum from rate cuts to QE. So market expectations are now for a further 25 basis point rate cut in April, May or June, bringing us to the effective floor and beginning to ramp up expectations of future QE in Australia.
How effective will today’s move be?
In terms of effectiveness, we believe the cash rate moving from 0.75% to 0.50% is unlikely to move the needle on the Australian economy meaningfully. Is doing something better than doing nothing? Time will tell.
With so much uncertainty around both the health impact of the coronavirus and the economic consequences, the actions might at least temporarily lift sentiment. Given the role of confidence on both economies and markets, a small boost could be all we need to navigate these hopefully temporarily uncertain times. While that’s the bull case, there is a much more dire bear case which could see a recession in Australia and overseas, regardless of what the RBA and the government do.
How has the coronavirus outbreak impacted the ‘real economy’?
Clearly, the economic impact as a result of COVID-19 will not be positive. GDP growth is going to be lower than it otherwise would have been. This primarily reflects a slowdown in activity, which started in China and is now expanding around the world in concert with the spread of the virus. The real question is what will the recovery look like? We are only beginning to receive hard data on how big the slowdown has been so far in 2020, and it’s not pretty. China just reported its lowest purchasing managers’ index (PMI) figures on record for January, at 35.7; anything below 50 indicates a contraction. Although there is evidence of factories re-starting in China, this appears to be happening unevenly and with reduced capacity, which makes the prospect of a “V” shaped recovery – one where a sharp slowdown is followed by an equally sharp recovery – increasingly unlikely.
What makes this situation different to other market-moving shocks such as a natural disaster is the uncertainty around both the spread of the virus itself and then the ongoing economic impact. Typically bad news is digested immediately and then investors ‘look through’ to the potential recovery. This is what was happening in Australia following the recent bushfire crisis. Unfortunately, a steady stream of negative COVID-19 related news may continue for an extended period of time, and we may not know the full extent of the global economic impact until much later. Given the lagged impact of economic data releases, it can often be six months into a recession that investors realise they are in one. Many economists in Australia are already warning of a possible technical recession (two consecutive quarters of negative economic growth) – which would be the first in Australia in 29 years. In the meantime, we are closely watching leading indicators such as manufacturing surveys to gauge how much the slowdown in China is impacting the Australian economy.
Should investors be panicked?
We believe panic should be reserved for day-traders and speculators, not investors. In our view, astute investors typically follow a pre-set strategic asset allocation; while dynamic shifts can be made to take advantage of opportunities, large swings between growth vs. defensive asset classes are unusual. In our experience, emotionally-driven investment decisions are generally poor ones.
Should investors be selling (or buying) risk assets such as equities or credit?
This really depends on people’s individual circumstances, investment objectives and risk tolerance. Those considering selling down a particular asset class based on short-term market movements might have had too much risk in their portfolio to begin with based on their risk tolerance and/or time horizon. Alternatively some could have too much cash and might have missed out on some phenomenal returns from risk assets in recent years.
We run some multi-asset portfolios that are goals or objective-based and although they are managed in a highly dynamic manner, these portfolios tend to only hold cash for liquidity purposes. This is because real (after inflation) cash rates are negative and might contribute to investors failing to achieve their objectives over the medium to long term.
While perfectly timing market peaks and troughs is notoriously challenging, we do aim to exploit market mis-pricing in actively managed portfolios. Many institutions and individuals have structural cash allocations precisely for this reason: to take advantage of attractive opportunities. The reduced liquidity and increasing level of transaction costs in some assets such as corporate credit makes price discovery challenging during a market correction. While we do see some value emerging in some pockets, we believe it’s premature to be ‘pounding the table’ on any specific market dislocations at present.
Did fixed income markets foreshadow this?
There’s an old saying in markets, “When equity people see flowers they think weddings, but when bond people see flowers they think funerals.” This gallows-humour-meets-dad-joke is a good reminder, however, that fixed income markets almost always foreshadow trouble on the horizon sooner than stock markets. The main reason is that fixed income investors are obsessively focused on the key macroeconomic drivers of bond yields – GDP growth, inflation, central bank policy, etc. On the other hand, stock analysts are typically concentrated on researching an individual company inside and out, not focusing on the macroeconomic cycle. It’s worth pointing out that bellwether US 10-year Treasury yields started responding by moving lower immediately after the New Year in January, ultimately moving from around 1.92% at the end of 2019 to an all-time low today (last quoted at 1.14%). Further, parts of the US yield curve have sharply inverted (a typical ominous sign of a looming economic slowdown). The yields on short term bonds (1 and 3 month) are now higher than the yield on 10-year Treasuries.
How have we positioned portfolios as events have unfolded?
Positioning has been varied by asset class and client mandate, although in general a degree of market volatility is typically favourable for active managers. In diversified fixed income portfolios, we have held overweight duration positions in most major rates markets as the crisis has unfolded. These strategies have supported performance outcomes relative to benchmarks.
We have also seen credit market spreads widen in sympathy with equities although have observed that investors have typically been selling higher quality, more liquid names and therefore we have not seen the full extent of the moves across the market. We expect pricing to catch up over the coming weeks and will then be in a position to reassess relative value. For portfolios with a higher percentage in riskier assets such as multi-asset and emerging markets debt there has been an overall de-risking, albeit in a measured way. For instance, exposure to various Asian equity markets has been lowered in our multi-asset strategies. These portfolios subsequently implemented protection strategies in case of a sustained drawdown in equities. These strategies have ranged from simple out-of-the-money put options to a protective collar and extended across US, European and Australian equities.
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