Imminent Fed rate rise is just the start
Summary: The US has the world on a steady trajectory to a higher interest rate environment; while, in Canberra, the challenge is to separate the wheat from the chaff in the Budget countdown. |
Key take-out: The Australian equity market is going to become less yield conscious and more interested in growth. |
Key beneficiaries: General investors. Category: Economy, shares. |
Tonight the US Federal Reserve will make its interest rate deliberation. And it is almost London to a brick that the Fed rate will go up by a quarter of a per cent (if it doesn't happen, it will next time around).
As nearly certain is the fact that all over the media there will be articles and commentaries about the historic new trend. But that's nothing new.
We have known that the Federal Reserve would increase its interest rates this month for some time, but the avalanche of words and visual commentaries is likely to put a smoke screen under more important events taking place in the US.
Donald Trump came to power with the solemn promise to slash US unemployment and boost employment. As we have discussed previously, he has some dramatic tax and other financial proposals aimed at achieving that goal. But on latest estimates those proposals won't hit the deck until August. Meanwhile, before Trump is ready to act, the US labour market is going gangbusters. US unemployment is down to recent historic lows but, more significantly, the number of excess potential workers classified as 'want a job now, but not in the labour force' has reached its lowest level in 8.5 years – currently as a share of the labour market it is 3.5 per cent.
That is not far above the low of 3.1 per cent achieved in 2007 just before the global financial crisis. And the position would have been even more buoyant but for a spike in February of people aged 65-69 who suddenly re-joined the workforce. They obviously need ‘retirement money' and there are now jobs.
Macquarie estimates that in the light of the ageing American population, to maintain the current employment rate all that is required is the generation of just 45,000 new jobs per month.
Currently, the US is generating 200,000 jobs per month and of course Trump expects to increase that further. Suddenly we have a bottom line that older readers will recognise very well – the US will have a supply shortage of labour later this year but, more importantly, throughout 2018. And we all know what that means – wage rises, inflation and, consequently, the level of growth being projected (and that will be required to fund the large tax cuts) becomes in real danger. The US doesn't have the labour to supply the demand that the Trump measures are aimed at triggering. That means American interest rates are going to rise quite a lot in the next two years. And that is going to have an effect across the globe. As inflation and interest rates rise, a lot of US shares will be re-rated. Growth in a labour-short environment will be the key to share prices.
As you know I am always nervous about projecting currencies but if I am right about the basic trends, then the US dollar should rise and higher interest rates will infect Europe as we head into the new environment.
Australia's response
In Australia the Reserve Bank will resist the higher rate trend as long as it can because it wants to stimulate the Australian economy. For a time this will work and I know a number of bankers who are joyfully looking forward to this over the next year. They hope they will be able to keep their deposit rates down because the Reserve Bank is not lifting official interest rates, but then they will blame the US and global interest rates for lifting the mortgage rate. And even better, the Reserve Bank is encouraging them to lift the rate on investor loans. There will be a lot of fuss but the banks will try to lift their margins in the confusion and, if they succeed, that will be good for shareholders.
Longer term the Reserve Bank will have to recognise a higher global rate environment in the local market. So, step by step we are moving to a higher interest rate environment, but it will certainly not happen overnight.
I think over time the local equity market is going to become less yield conscious and, like the US, more interested in growth. After all, growth is what shares are traditionally about. The provision of very high yields is a relatively recent phenomena.
As I have explained in previous commentaries, highly leveraged companies that didn't take their opportunity to lock in long term rates will suffer. And bank term depositors will, over time, get relief from very low rates but the banks will try to extend the suffering of their depositors as long as possible.
Pre-budget stirrings
But here in Australia there is also stirrings on a series of other fronts that you may need to take into account in some of your longer strategies. The Government is at least looking at negative gearing – it probably won't touch it – but it is also looking at allowing first home buyers to access their superannuation. If either of these strategies is introduced on their own it will be a disaster – negative gearing curbs will cut dwelling prices and first home buyers accessing superannuation will boost them.
They must be done together but politically that looks too hard. Yet by freezing young people out of the housing market we are creating a huge long-term retirement cost. Nevertheless, for the first time I can see that state politicians (they restrict supply to boost prices) and federal politicians plus the Reserve Bank are concerned about Sydney and Melbourne house prices. Very, very nervously I predict we may get a Sydney/Melbourne boom cooling off.
Currently those couples in the $400,000 to $800,000 asset bracket and receiving the government pension are being encouraged not to downsize their homes because if they do then any extra cash they receive will substantially cut their pension. It looks like that is going to change.
Remember that at the moment Treasurer Scott Morrison is floating all sorts of ideas through the media to test reactions. For investors, it is a way of gauging what is on his mind – but be careful. He is canvassing ideas. Not until the final week, or even the last few days, before the budget can you believe the leaks that you are reading – until then they are not about real events, just speculation to test the water.
Batteries
And on the lighter side this week I logged on to a commentary about batteries in South Australia. Immediately flashing up on my screen was an advertisement for a Tesla battery. As I described last week, I had been the subject of an online advertisement auction which would have taken place in a fraction of a second – and Tesla won.
I don't think I will buy a battery but I actually got a quote from them and found that a battery that would store electricity to help us through any blackouts would cost about $16,000. I checked with True Value Solar and they have a battery package that comes to about $15,000 – on the surface, without further checking, which looked about the same.
It is a lot of money to protect yourself against a blackout. The True Value Solar battery comes from Redflow, which lost $6 million in its latest report. That made me nervous.
But the real fascination is to realise that your eyeballs have been the subject of an online advertisement auction, and the threat that represents to conventional media.