The Stock Market Doesn’t Like It

 

Here’s a tip. Whenever I make an argument for a certain outcome, bet against it.

Yesterday, I made the case for why interest rates would be on hold in Australia for some time. Soon after, the RBA released the minutes to its July board meeting, when it left rates on hold.

According to The Australian:

The Reserve Bank may have laid the foundation for higher interest rates by revealing its thoughts on how high rates will need to go when it starts to unwind its GFC-linked stimulus.

In a discussion that will send a shiver through the highly leveraged residential property markets of Sydney and Melbourne, minutes of the July 4 board meeting said RBA economists estimated that the official cash rate — currently at a record low 1.5 per cent — would need to rise to about 3.5 per cent to be considered “neutral” once the economy reaches its ­potential growth rate.

The RBA thinks things are picking up, but not so much that they want to raise rates just yet. As I mentioned yesterday, the main concern is around household consumption:

Although recent indicators suggested that consumption growth had increased in the June quarter, members noted that there were still risks to consumption growth should household income growth remain subdued, particularly given the high levels of household debt.’

Whatever the concerns, the minutes have definitely increased the probability of an interest rate rise this year.

The opinion of the market was mixed, though. The dollar continued to move higher on the news. It was recently trading at 79.19 US cents. The Aussie dollar is clearly building in a rate rise this year.

RBA causes stocks to plummet

On the other hand, the stock market didn’t like the sound of it at all. Stocks fell sharply yesterday, especially after the release of the RBA’s minutes.

The banks were the big losers. The explanation is that the sell-off was due to concern about the soon to be released rules around the banks’ capital levels.

But the RBA’s intentions on interest rates would have weighed heavily.

That just goes to show you what a bind the RBA is in. In a healthy economy, banks should do well from a stronger economy and rising interest rates. The steepening of the yield curve that comes with that is good for bank profits.

But in this case, the market also has an eye on the huge amount of household debt in the economy, most of which sits on the big banks’ balance sheets.

Rising interest rates — even just one or two raises — have much more of an impact on a highly leveraged economy like Australia’s. Instead of looking at the higher profits that rising rates might bring to the banks, the market has one eye on the possibility of rising bad debts, which will instead weigh on profits.

The other thing I picked up from the minutes is that the RBA is clearly influenced by the shift to tighter monetary policy in other areas of the world.

Do you remember last week I wrote a fair bit about the natural, or neutral rate of interest? One of the US Federal Reserve governors mentioned it in a speech a month ago, in discussing how much US interest rate might rise.

Well, the RBA is in on the act now too. From the minutes:

Members discussed the neutral real interest rate and its decline over the preceding decade. The neutral real interest rate is the interest rate at which output growth is at potential and inflation is stable. Members noted that it is not possible to measure the neutral real interest rate directly, but that it can be inferred from the behaviour of other variables.

Members discussed the Bank’s work estimating the neutral real interest rate for Australia. The various estimates suggested that the rate had been broadly stable until around 2007, but had since fallen by around 150 basis points to around 1 per cent. This equated to a neutral nominal cash rate of around 3½ per cent, given that medium-term inflation expectations were well anchored around 2½ per cent, although there is significant uncertainty around this estimate.

In other words, the RBA is telling the market in this statement that interest rates are accommodative until the official rate hits 3.5%.

Maybe it is, I don’t know. But if you forced me to guess, I would say if the RBA hikes the official rate by 25 basis points eight times over the next few years, it would bring about a recession.

I mentioned last week that the Fed — ever since the Second World War, anyway — has brought about recession by raising interest rates too far.

I don’t know whether the RBA’s record is as good (or bad), but the Aussie economy usually follows the US into recession. Could it be that the US will raise rates too much, the RBA will raise rate too much, and the world fall into recession in a couple of years’ time?

I’m just putting it out there. But all this talk about a neutral rate, even though they admit that they really have no idea what the neutral rate is, is a little worrying.

It’s worrying the market too. As you can see in the chart below, the ASX 200 is now at risk of breaking down to new multi-month lows. I don’t think this is going to usher in a new bear market or anything. But it means the correction from the May highs could be a little deeper than expected.


Source: BigCharts
[Click to enlarge]

But what would I know? Anything can happen. Soon the minutes will be forgotten and other events will overtake and dominate the markets’ thinking.

As I mentioned yesterday, anything that sheds light on inflation or the health of the consumer will be the key to interest rates in Australia.

Regards,

Greg Canavan,
Editor, Money Morning


Greg Canavan is a Feature Editor at Money Morning and Head of Research at Port Phillip Publishing.

He likes to promote a seemingly weird investment philosophy based on the old adage that ‘ignorance is bliss’.

That is, investing in the Information Age means you have all the information you need at your fingertips. But how useful is this information? Much of it is noise and serves to confuse, rather than inform, investors.

And, through the process of confirmation bias, you tend to read what you already agree with. As a result, you often only think you know that you know what is going on. But, the fact is, you really don’t know. No one does. The world is far too complex to understand.

When you accept this, your newfound ignorance becomes a formidable investment weapon. That’s because you’re not a slave to your emotions and biases.

Greg puts this philosophy into action as the Editor of Crisis & Opportunity. As the name suggests, Greg sees opportunity in a crisis. To find the opportunities, he uses a process called the ‘Fusion Method’, which combines traditional valuation techniques with charting analysis.

Read correctly, a chart contains all the information you need. It contains no opinions or emotion. Combine that with traditional stock analysis and you have a robust stock-selection strategy.

With Greg’s help, you can implement a long-term wealth-building strategy into your financial planning, be better prepared for the financial challenges ahead, and stop making the basic, costly mistakes that most private investors do every time they buy a stock.

To find out more about Greg’s investing style and his financial worldview, take out a free subscription to Money Morning here.

And to discover more about Greg’s ‘ignorance is bliss’ investment strategy and the Fusion Method of investing, take out a 30-day trial to his value investing service Crisis & Opportunity here.

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