The true cost of a rate cut

Pressure now builds on leading stocks to pay high dividends ... but how can we get stimulus to small business and wider manufacturing?

Summary: The recent cut in interest rates signals the Australian dollar has further to fall. Meanwhile, the Chinese economy is slowing and Australian commodities will be depressed in price for a long time, but Chinese property investment is important to our economy. The interest rate cut will push up asset prices, and although the RBA wants business to invest, that investment will have to come from SMEs.

Key take-out: Many businesses are under-invested because of shareholder demand for high dividends. Lower rates will curb investment as big businesses need to satisfy demand for yield.

Key beneficiaries: General investors. Category: Economics and investment strategy.

When RBA Governor Glenn Stevens lowered interest rates this week he was sending some clear signals to the market. And it is important to understand these signals in preparing your investment strategies. 

The first and most important signal is the Australian dollar has a lot further to fall. The Reserve Bank set a target of US75 cents – I think it will fall below US70 cents and might even fall to the low 60s and below in 2016.

And the reason why this is likely to happen is that first and foremost the United States is the world’s strongest economy and, although it has delayed its interest rate rise, it is sucking in money so the US dollar will be firm in its strategy.

Secondly we have just been through the effects of the amazing China stimulus package which came after the global economic crash. And that stimulus package was all about fostering capital works that boosted demand for commodities which inevitably boosted the price and the rate of production. We in Australia were big winners.

China is now slowing. It is possible they will give their economy another sharp injection but if they do they risk a later collapse. It is more likely there will a long period of subdued growth in China. So the goods Australia produces are going to be depressed in price for a long time. It is true that in oil and iron ore the Saudis and BHP Billiton/Rio Tinto are flooding the market with product to push the price down and squeeze out high-cost producers such as shale oil in the US and damage Australian LNG. 

If either the Saudis or BHP Billiton/Rio Tinto decide enough is enough and curb their own production then we will see a recovery in oil and iron ore. The current recoveries are more linked to derivatives trading than fundamental change. The subdued nature of the Chinese demand will restrain the rises. 

In these circumstances normally the Australian economy would go into deep decline. What is holding it up is the massive Chinese investment in our property and if that falters then watch out. So far it has not faltered and I don’t know enough about the inner workings of the Chinese people to make a prediction but everyone should be aware of how important the Chinese property investment is to our economy.

Given the dramatic fall in the Australian terms of trade the Reserve Bank wants to take more of the pain on the dollar. You will remember last year we had special seminars on overseas investments and I have been writing commentaries on the subject for some time (see Surprising news from the international investing experts, November 26, 2014). I know many Eureka Report readers adjusted their portfolios and are grateful for the help we were able to give them. If you haven’t done it then I think the dollar is still overpriced. 

When Stevens announced the interest rate cut there was a rush into shares and make no mistake the lower interest rates will push up the price of assets including houses. What Stevens wants is for the government to take some steps to stop superannuation funds investing in property and curb negative gearing. I am not sure the government is going to take action because Prime Minister Tony Abbott has lost enormous political capital and will find it difficult to get controversial decisions through parliament. But watch this space. If you are planning to do negative gearing, to be safe, do it now. But I must warn: I have given that advice before and nothing has changed. 

The RBA wants business to invest. A great many businesses are currently under-invested because of the demands of shareholders for high dividends. Nowhere is this more apparent than in the banks. In a strange way the lowering of interest rates will actually curb business investment because it exacerbates the needs of big stocks to satisfy shareholder demand for yield. The investment will have to come in small- and medium-sized businesses. 

And big businesses are going to find it tough as the government sees shareholders have done well and it is time to make it more attractive for smaller businesses. I will write on this in more detail in a later commentary.

Domestically, what 2015 and beyond is going to be about is the scramble for the discretionary dollar. And those discretionary dollars are diminishing because salaries are not rising. Inflation is now low and the market believes that it will stay low. With inflation around or below 2% low interest rates actually carry a real rate of return which is not available in other countries, albeit a low rate of return. Finally, will inflation ever return? It's not going to happen in a hurry but I think eventually it will, because as the dollar falls we will get a dose of Dutch disease (the theory that non-mining industries suffer during or after a mining boom in an economy).

In the boom we sent much of our manufacturing and production offshore and that will come back to bite us. We have shut down our motor industry which, given modern plant, is very economic with the dollar around US65 cents. We will pay for that with higher car prices in the future. That will also apply to other asset classes too. In addition Australia, having exported its gas at a loss, will now be a high-cost gas country and that will put pressure on prices. Having said that the new technologies in the world are lowering the cost of production of goods and services and that is keeping a lid on inflation and that development is not about to go away.

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