Interest rates globally continue to rise with the Reserve Bank of Australia (RBA) increasing the cash rate by 0.50% to 1.85% on 2 August 2020. Just 5 months ago the cash rate was 0.1%. This is in line with actions taken by most central banks and notably, the US Federal Reserve and Canadian Reserve Bank that increased their equivalent cash rates in the last month by 0.75% and 1.0% respectively. The US Federal Reserve has now increased interest rates 1.50% in a 2 month period.

The back flip by central bankers on interest rates is staggering. Twelve (12) months ago, the Governor of the RBA said rates would not rise until 2023/24. Unfortunately, many property and equity investors took these comments into account when making investment decisions.

Why may you ask are equity markets now recovering?

Simply because equity markets trade on future (12month) earnings, and market analysts believe that the US Federal Reserve will limit the increases because significant rate rises will crash the US economy as they believe that inflation is coming under control and some commentators are now arguing that rates may even fall again.

The recent bounce in the equity markets is being talked of as a  “bear market rally” which means that the market will go up and then will fall below the last low, rather than a sustained recovery. Time will only tell on this analysis although there are some historical indicators that point to this being correct. The most telling indicator that a recession is coming (but not when it will occur) is because the Eurodollar and US treasury curves inverted in December 2021 for the Eurodollar futures curve and March 2022 for the 10 year US treasury. Like night follows day, if history repeats itself a yield curve inverting precedes a recession.

The US economy is already showing signs of recession with reported lay-offs (a leading indicator) in the mortgage and technology areas and the Purchasing Manufacturers Index (PMI), which is also a leading indicator, showing signs of a slow-down. Whereas, an unemployment figure is a lagging indicator. The continuing supply chain problems will take longer than expected to correct, e.g., a new car order depending on the type and model can take 18 months to deliver. Furthermore, the number of semi-conductors in new cars that was on average 1400 per car is under pressure because of the supply chain constraints caused by the Ukraine/Russian war.

On the positive side the US economy “changes gears” quickly because of less restrictive labour and bankruptcy laws as well as the weight of money looking for an investment home. The major pension and investment funds are drawing in millions of dollars every week that must be invested. The same occurs in Australia. Equally as important to the US economy is that it is now energy independent, so it is not hostage to the Middle East, as was the situation the 1980s.

Debt Levels – A drag on economic growth

We have been writing about global debt and the high levels being a drag on economic growth for many years now. Specifically, the unsustainable nature of the US National debt (USD30 trillion) and US budget deficit (USD3 trillion) which impacts all of us. With increasing interest rates, the debt serviceability cost increases, so the percentage of government taxation receipts that are used to pay interest payments increases. In the case of the USA with their GDP falling in the last 2 quarters, this mathematically increases the Debt/GDP ratio.

The US is fortunate that it has the world reserve currency as this allows it to fund the twin deficits; however, with the US confiscating Russian reserves held in US banks and at the US Federal Reserve all countries are considering the level of US treasuries they should hold. In particular, if China actively reduces its holding and decreases its purchases, then this will place further upward pressure on US interest rates as higher yields will be required to attract investors with flow on interest rate impacts to other OECD countries.

Fortunately, Australia went into the Covid crisis with effectively a balanced budget which allowed the Federal Government to respond with fiscal stimulus. High iron ore and coal prices being the main drivers of the higher than expected taxation receipts of the last couple of years. The budget deficit is now $1trillion which is manageable in terms of Debt/GDP ratios, so long as the new Labor government spending is at a rate less than increases in taxation receipts and it starts a program of paying down the debt.

So where to from here?

It will take time for the effects of interest rate increases to flow through into the wider economy, as folks and companies take stock of their financial position. We believe that central banks will pause on further interest rate increases for a couple of months as they monitor their impact on inflation and economic activity.

We continue to see having a diversified portfolio as critical to wealth management while in the short-term the building of cash balances is the best strategy, unless there are any major developments.