The “surprise” decision by the Reserve Bank of Australia to cut interest rates this week has mixed implications for the overall equity market outlook. But it does re-affirm two key themes I have been emphasising for the past year – go for yield and companies with offshore earnings exposure.
One the one hand, the RBA’s decision to cut rates reflects a downbeat outlook for the economy. As the Bank stated in its post-decision policy statement, it now expects the economy to grow at a below-trend pace for longer – and as a result, the unemployment rate will likely move higher still. That’s not great news for company earnings overall, which still remain under downward pressure.
The collapse in iron ore prices and still fairly subdued economic indicators led the Bank to ditch its earlier view that the economy would pick up to at least a trend pace of growth by the second half of this year. That now won’t happen until at least 2016.
The good news, however, is that the RBA has demonstrated it’s not prepared to just sit idly by while the economy remains in a rut. With wage and price pressures under control – and new “macro-prudential” controls to hopefully contain excessive investor activity in the housing sector – the Bank felt it could do what it can to help the economy by cutting rates further.
Of course, no-one should imagine one rate cut – or even two – will suddenly turn the economy’s economic fortunes around. Mining investment is still likely to be cut back savagely in coming quarters, and households are not showing a great desire to spend up despite rising house prices and today’s already low interest rates. State and Federal Government face their own budget challenges, and strong fiscal stimulus is unlikely.
But where a rate cut could possibly help is by kick starting a self-reinforcing cycle of improved business and consumer confidence. Part of the economy’s currently plight reflects the fact that business are waiting on consumers to spend before hiring more workers – while households are waiting for stronger employment conditions before they spend. It’s a Catch-22. Lower rates might provide a circuit-breaker.
The other result of lower interest rates is that is even more likely we’ll see further broad based weakness in the Australian dollar. Again, let there be no dispute: the RBA has joined the global currency wars – and is not about to allow the economy to be a casualty of that battle. Indeed, despite its notable decline in recent months, the RBA kicked the $A further this week by noting it still remains above fundamental fair-value.
A much weaker currency is an important price signal which should help the economy re-balance to other non-mining trade exposed sectors like manufacturing, tourism and education.
Note the RBA would likely not have bothered to change interest rates after more than a year of leaving them steady if it felt it only needed to cut once. History shows there’s usually at least one more to follow – so the base case must be that another rate cut is likely in either March or April.
And if the economy remains sluggish, the RBA has not opened the door to potentially even lower rates of less than 2 per cent. After all, the RBA has said if the outlook – based on unchanged interest rates – is one of persistent below trend economic growth and rising unemployment, it feels obliged to do what it can by lowering interest rates. So if it looks likely that growth will remain below trend into 2016, we can expect further rate cuts in the second half of this year.
Given this outlook, the financial sector is in a no lose position. Either the economy strengthens – which is good for credit growth – or lower rates are likely, which encourages an even greater “yield chase” toward the banking sector. Could CBA crack $100 soon? Quite possibly.
There are also investment opportunities among the many companies with offshore exposure – such as CSL or James Hardie – not to mention those that will gain for the likely influx of tourists and students.
More broadly, the Australian market’s overall dividend yield still appears attractive given the steady decline in interest rates. Despite the fact that the overall economy and corporate earnings could remain sluggish for some time, therefore, market valuations may well be re-rated further.
Here’s the bottom line: with inflation low in both Australia and globally, central banks can afford to be generous. It’s hard to be negative on risk markets against that backdrop.
