02 Feb 2020

Interest Rate Cuts are Coming

The big news of the week in Australia was the decision by the Reserve Bank of Australia (RBA) to hold interest rates steady yesterday, with the cash rate still sitting at 0.75%.

Throughout January, there was some speculation that the RBA would cut rates this week, bringing them to a new all-time low of just 0.50%, with fears of the economic contagion caused by the coronavirus outbreak one of the factors supporting a rate cut.

Some commentators even suggested the RBA should “shock the market” and cut rates by 0.50% or even 0.75%, bringing interest rates all the way to zero, in a clear sign that the central bank would do all it could to push the value of our currency lower, in the hope it would stimulate the economy.

Thankfully, saner heads have prevailed for now (and we really must stress the “for now” part), with stronger than expected employment data in late January and a pick-up in house prices enough to see the RBA stay put.

Make no mistake though, interest rate cuts are coming in 2020, with expectations (seen below in this chart from the ASX), suggesting the market has now fully priced in a rate cut by May of this year, with the potential for further easing seen in the second half of 2020.

 

ASX 30 Day Interbank Cash Rate Futures Implied Yield Curve
As at market close on 3rd February 2020

ASX 30 Day Interbank Cash Rate Futures Implied Yield Curve

Source: ASX. ASX disclaimer: This document provides general information and is indicative only. It is not investment advice and readers should seek their own professional advice in assessing the effects of the information in their circumstances. ASX limited and its related corporations accept no responsibility for errors or omissions, including negligence , or for any damage loss or claim arising from reliance on the information. Futures and options trading involves he potential for both profits and losses and only licensed brokers and advisors can advise on the risk.

Overall, the economy remains still too weak, seen recently in:

  1. Manufacturing, construction and service industry data, all of which indicate a continuing slowdown in the major sectors that power the economy
  2. Inflation data, which is still running at less than 2% per annum, which the RBA sees as “too low”
  3. Private sector credit growth, which is essentially in recessionary conditions

Commonwealth Bank’s Composite Output Managers Index, which happens to be highly correlated to demand in Australia, has also recently plunged to all-time lows (see chart below), with the latest fall in output the sharpest since the survey began in 2016.

 

Commonwealth Bank Flash Composite Output Index
sa, >50 = growth since previous month

Commonwealth Bank Flash Composite Output Index

Source: Commonweal Bank.

This is further evidence, if any were needed, on how soft the economy is right now, and why it’s likely to stay that way, if not weaken further still in the months and years ahead.

Property not out of the woods either!

Since last year’s Federal election, the mood in the property market has turned. Pessimism has been replaced by euphoria, with some commentators thinking that Australia will return to the years of +10% per annum property price gains all around the nation.

We aren’t so sure, with the gains seen over the last 6 months concentrated only at the higher end of the market. Furthermore, there are still plenty of investors realising losses in the property market, with 20% of Australians who sold a unit, and 10% of Australians who sold a house during the September quarter of 2019 selling at a loss.

This can be seen in the table below, which shows the percentage of sales that are loss generating. In some places the data is downright frightening, with over 35% of unit sales in Brisbane done at a loss, whilst in Perth and Darwin, its over 50%.

 

Proportion of total resales at a loss/gain, houses vs units, September 2019 quarter

Proportion of total resales at a loss/gain, houses vs units, September 2019 quarter

Given this backdrop, the key thing for investors to focus on is not what the RBA does or will do on a month-to-month basis, but what they’re likely to do with a 5- to 10-year view in mind.

When looked at it that way, there is little doubt that interest rates will go lower, and stay well below the real rate of inflation for many years, especially when (and in our view it’s still just a matter of when) the RBA also begins printing money.

Money in the bank is therefore going to be a guaranteed loser for years to come, helping fuel price gains for pink diamonds, as investors flee negative yielding bank accounts, preferring to invest in hard tangible assets.

The case for diamonds will also be boosted by the ongoing risk in property markets. Astute investors realise the best days of property price growth are behind us, and that they will need to look at alternative assets, including pink diamonds, for opportunities to generate wealth.

Lower Aussie Dollar another Driver for Diamonds

Australian pink diamond investors will have benefitted from the circa 5% decline in the value of the Australian dollar, which fell below USD 0.67 by the end of January 2020.

This decline is likely a prelude of what is to come, with there being significant potential for a much lower AUD in the years to come, especially if the coronavirus fears can’t be easily contained.

So far, the signs are not encouraging, with Chinese stocks falling 8% on Monday, whilst commodities like iron ore and oil sank by their daily limits. The risks from this virus are especially relevant for Australia, as it will put a major dent in the commodity income we generate from selling iron ore and coal, as well as through the major reduction we will see in tourism and education dollars generated in Australia.

Moving forward, further declines in the AUD will be a continued tailwind for Australian pink diamonds investors, as they stand to benefit from both a price rise in US dollars for the diamonds themselves, as well as a decline in the value of our currency.

As always, we hope you’ve enjoyed this week’s edition of “In the Loupe” and look forward to any questions or comments you may have.

 

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