More dangerous rate cuts to come

The RBA move might be useful for some ... but it threatens confidence.

Summary: Interest rate cuts over the last few years have had a negative impact on the economy. Growth should be booming in consumer spending, housing and non-mining investment, but it is not, as confidence remains weak. This week’s rate cut, as with earlier cuts, could actually harm confidence and there is no certainty it will lift consumer spending.

Key take-out: Stocks in the consumer discretionary space are perhaps most at risk in this scenario. Property is probably the only clear winner from the RBA’s action.

Key beneficiaries: General investors. Category: Economy.

The RBA’s decision to cut rate by 25 basis points to 2.25% is a dangerous move. Not so much because 0.25% will make much difference to the real economy one way or the other.

An interest rate cut of this magnitude won’t affect things one bit… even if there are more cuts to come. Readers may recall my view through 2014 that the best bet was to expect another cut and I reiterate that forecast now.

How many more cuts? It’s a guess. I realise that’s a bit vague but under the circumstances but that is the best that can be done. That the RBA – or someone else in government – felt the apparent need to leak the result before the actual board meeting, shows that there are few analytical tools open to economists in forecasting the next move. This is a fact also borne out by the large number of economists caught unawares by the move. Indeed it was only late last year that economists were expecting the next move to be up! For our purposes then, continue to expect the next move to be down – timing uncertain.

The unfortunate thing is that rate cuts – just over the last few years – have actually had a disastrous impact on the economy. That’s not how it normally goes, but don’t forget rates were already very low when the RBA started easing again.

Consider this: The single largest component of the Australian economy is consumer spending. Consumers alone account for about 55% of the Australian economy. Housing is another 5% and then non-mining investment represents about another 8% or so. Now the question economists and policy makers need to be asking (but clearly are not) is this…Why is it that with interest rates at their lowest in a generation, growth in each of those sectors is around trend? Indeed most economists wouldn’t even allow that growth is at trend – “below trend” is the consensus view.

This is the critical question. Because in each instance there are no structural headwinds, no glut of investment, debt servicing is low, indeed most Australians don’t even hold any debt. So on paper, growth should be booming in each sector. For my mind, the only sensible answer is that confidence remains weak.

That being the case, it isn’t clear that easing rates again from already exceptionally low levels will do anything to lift confidence. As with past rate cuts, it could actually harm confidence. At the same time, we can’t be certain that further rate cuts will do anything extra to lift consumer spending or non-mining investment.

Taken in isolation I would be more certain that the RBA’s rate cuts would actually see confidence, spending and investment dip over the next quarter or two, and plans to hire would be put on hold. This is what we have seen consistently since 2011. So it would be harmful.

The issue is complicated this time around by the extraordinary slump in crude prices that we’ve seen, which of course is hugely stimulatory. On paper and if fully passed on to petrol prices, the crude slump could be equivalent to six rate cuts (see Oil price fall: Worth six rate cuts, December 8, 2014).

Uncertainty is extreme, but I think it is clear that we are closer to a downturn as a result of the RBA’s actions that at any time since the GFC. This is not due to any deterioration in Australia’s underlying fundamentals I might add, which remain very strong. Instead it’s because of the impact the RBA’s rate cuts will have on confidence. Rate cuts are unlikely to lift confidence – the best we can hope for is that the negative influence of the RBA is outweighed by the fall in petrol prices.

Stocks in the consumer discretionary space are perhaps most at risk in this scenario. Less exposed are stocks in the A-REITs, banking and construction sectors. Existing house price inflation is very supportive here and while that momentum may moderate if confidence dips, domestic investors tend to rely less on the rhetoric and actions of policymakers.

International investors, however, will likely remain cautious to the extent that policymakers are still advocating for a weaker currency. The prospect of currency losses remains a very real risk, which suggests that the RBA’s actions will encourage the continued underperformance of the domestic market, notwithstanding the recent rebound. Naturally events in the commodity space will take precedence though. Already some of our major miners have rallied hard as commodities recover and international investors would be on that trade.

Property, of course, is probably the only clear winner from the RBA’s action. The likelihood of increased regulation has risen markedly following the RBA’s actions – yet even so, property will remain a very attractive investment through 2015 – and I see little at this point that could change that.

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