Why China holds the rates keys

The Reserve Bank of Australia recently updated its Chart Book (November 2013), and this document provides investors with plenty of charts to review to help understand the current interest rate market and its outlook.

Unfortunately for savers, the charts paint a very daunting picture. Interest rates paid by banks to depositors seems set to stay low in 2014. Indeed, unless there is a sharp increase in the economic growth of the developed world, which I regard as unlikely, then deposit rates seems destined to stay low into 2015.

To begin, let’s review the cash rate settings of the major central banks (the G3). The central banks of the US (the Fed), Europe (ECB) and Japan (BOJ) have co-ordinated their actions and moved their cash rates to below 0.5%. Recently, the ECB cut cash rates to 0.25% as it flagged the risk of deflation. A general fall in the level of prices, as experienced for many years in Japan, is an economic scenario that the ECB wishes to avoid at all costs.

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It is now the fifth anniversary of low cash rate settings, and these policies are not expected to change anytime soon. Indeed, both the Fed and the ECB have forward guided the market to expect these low cash rates to be maintained into 2015.

These low cash rate settings are reflected in the Australian economy. Obviously if the G3, representing 50% of world GDP, hold rates down then rates everywhere will track down as well. For a while Australia held rates relatively high and offered a real rate of return to overseas investors. This resulted in the $A moving above parity, and this throttled our manufacturing base. More recently the RBA has followed international practice by lowering cash rates and bringing real rates to zero. Unfortunately, I suspect that is where they will stay until there is a break in offshore settings.

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Up until six months ago the long-term bond yields of the major economies had relentlessly followed the cash rates down. To some extent this “rally in bonds” was caused by the massive QE programs undertaken in the US and Japan. This is where the central banks buy bonds in the open market, utilising printed money.

Over in Europe the ECB has created a policy of “unlimited” financing for distressed banks. This means that European banks can borrow for a nominal cost and redeploy those funds in European bonds. It is clear that many European banks are continually borrowing for a short period and buying long-dated “junk” European periphery government bonds. This explains the observation that Spanish and Italian 10-year bonds currently yield the same as Australian 10-year bonds; i.e. about 4.1% per annum.

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Just as the major bond markets corrected in May in response to Fed chairman Ben Bernanke’s whisper of QE tapering, Australian bonds did too. The yield that touched 2.8% in mid-2012 has moved higher in 2013. The decision by the Australian Treasury to not tap those historically low interest rates with a massive international bond raising will no doubt be questioned when inflation does return to the world.

In any case, there are reports that the Australian government is contemplating a 20-year bond issue in coming months at rates of about 4.5% per annum.

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The above observations brings us back to the Australian interest rate market. Readers will no doubt be aware that term deposit rates have crunched over the last year and sit 2% below the rates that were offered on six-month and one-year deposits offered 18 months ago. This is causing immense stress to elderly retirees, who are seeking a reasonable yield to support their pensions but do not wish to take undue capital risk to achieve it.

On the flipside is the benefits flowing to borrowers, who are paying a “generational” low cost for mortgage debt. However, just as retirees need more capital to maintain income due to lower interest rates; borrowers will be forced to borrow more to buy a house. Clearly, in many respects, the so called benefits of low interest rates are illusory for they benefit neither borrowers nor savers.

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Conclusions for income securities

The above provides a disturbing snapshot of the world economic and investment landscape. The developed world is enveloped in a slow growth period that has as its features:

1. Massive government debt (excluding Australia);
2. High unemployment;
3. Near zero cash rate settings;
4. Quantitative easing (QE) on a grand scale;
5. An ageing population; and
6. A distressed younger generation who perceive an “entitled” older class.

Despite the euphoria being exhibited in world equity markets, I would suggest that this pricing phenomena is explained by unique economic policies and unique economic circumstances. Frankly, the equity market is being perverted by monetary policy settings that seem destined to remain in place for longer than any reasonable observer would expect.

Indeed, the intransigence of central bankers and their stubborn maintenance of monetary policy settings means that we will be presented with more of the same until there is a break in the inflation/growth cycle.

This later point is really the crux of the matter for income-based investors and I can best explain it from an Australian perspective from the following chart.

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Despite well documented economic theory concerning money printing, the world economy has not been confronted with inflation. The reasons for this are many but, in my view, two stand out.  

First, the end of the “US Industrial Century” featured the advent of massive technological advancements, which drove down both the costs of production and the need for labour in the production of goods.

Second, and importantly now, the advent of the “Chinese Industrial Century” has delivered another sweeping decline in the cost of production. The Western World has succumbed to the need of lower costs and transferred too much industrial production to China and other developing economies. Low labour rates and improved manufacturing quality have cruelled the developed world’s industrial base.

Thus, from an Australian perspective, this plays out as declining import prices drive down overall inflation readings. The large increases in the locally provided cost of living (health care, power and education) is offset by lower consumable prices from China. Therefore, inflation is not the 4% that confronts retirees but the 2% that is measured by the RBA.

I believe that this painful period for retirees will eventually come to an end, but it is not on the horizon in 2014. The thing that I particularly monitor is the revaluation of the Chinese currency and the level of Chinese inflation.

Right now, the Western World is frantically trying to conjure up inflation as a means of reflating economies. They will not be successful until China revalues its currency and exports inflation.

In the meantime, I am holding my income portfolio as presented but I do not expect any significant capital gains from this point on.

John Abernethy is the Chief Investment Officer at Clime Asset Management, one of Australia’s top performing equity fund managers. To find out more about Clime Asset Management, visit their website at www.clime.com.au.

Clime Income Portfolio Statistics

Return since June 30, 2013: 10.53%

Returns since Inception (April 24, 2012): 38.86%

Average Yield: 7.28%

Start Value: $150,754.88

Current Value: $166,636.73

Dividends accrued since June 30, 2013: $4,394.92