10 Oct 2019

Prepare for Zero as RBA cuts rates below 1%

Last week was a momentous one for the Australian economy, with the Reserve Bank of Australia cutting interest rates below 1% for the first time in history.

The move, which was widely anticipated by market participants, is a further blow to savers and those living on fixed incomes via term deposits, who have seen interest rates fall from over 7% before the Global Financial Crisis (GFC) hit a decade ago.

On a more positive note, the rate cut will no doubt provide some relief for heavily indebted mortgage holders, with research suggesting Australian household debt to income ratios are now over 190%, their highest level ever, with the vast majority of this debt housing related.

In terms of what happens next, it is almost certain that there will be more rate cuts to come. Market expectations are that the next rate cut will come in February 2020, bringing the cash rate down to just 0.50%.

This can be seen in the chart below from the ASX, which shows interest rate expectations between now and the end of 2020, though we’d note there are many that think the next cut will occur on Melbourne Cup Day, which is less than a month away.

 

ASX 30 Day Interbank Cash Rate Futures Implied Yield Curve
As at market close on 8th October 2019

Cash Rate

From our perspective it’s not so important guessing which month rates will fall next, but rather how low they will go. To that end, it seems inevitable now that they will fall all the way to zero – meaning you’ll earn literally nothing on the money you keep in the bank, with your real wealth declining once you take inflation into account.

This line of thinking is supported by the RBA itself (even if they aren’t yet saying they’ll cut rates another three times) with the latest monetary policy statement from the bank including commentary that they are: “prepared to ease monetary policy further if needed to support sustainable growth in the economy, full employment and the achievement of the inflation target over time.”

The RBA have also noted the risk in terms of the outlook for the global economy, stating that “While the outlook for the global economy remains reasonable, the risks are tilted to the downside” whilst they’ve also noted that the Australian economy only “expanded by 1.4 per cent over the year to the June quarter, which was a weaker-than-expected outcome.”

None of this is good news, and the concerns from the RBA echo comments they made earlier in the year when they also noted that; “it’s possible we end up at the zero lower bound” and that they “are prepared to do unconventional things if the circumstances warranted it,” though they also stated that they “hope we can avoid that”.

That’s an important line for investors to consider. In saying that they hope they can avoid doing unconventional things (which basically means printing money), they are telling investors loud and clear that something is wrong in the economy, and in financial markets.

You don’t cut rates to zero if things are going well. You don’t print money if everything is OK.

As investors we have a choice in terms of how we respond to these interest rate cuts. It is no surprise to us that customers of Australian Diamond Portfolio are taking decisive action in light of the financial market environment we find ourselves in and are protecting and building wealth through pink coloured diamonds.

Another Warning Sign for Investors

It’s not just ultra-low interest rates and the threat of money printing that should have investors concerned and looking at the benefits of alternative hard assets like pink diamonds.

Equity markets are also flashing red in terms of warning signals, with some indicators suggesting that a more than 50% decline in the years ahead would not be unexpected.

Activity in the market with companies looking to list on the stock exchange is another warning signal. We first alluded to this a couple of weeks ago when we discussed the now infamous WeWork initial public offering (IPO). Note that an IPO is the issuance of shares to investors that takes place when a company lists on a stock exchange.

The WeWork IPO has since been cancelled, with early stage investors who were hoping they could cash in on a USD $45 billion valuation now reassessing their financial futures, with the company fast running out of cash.

WeWork was not a one-off, but rather a high-profile example of a much wider problem, as the chart below highlights. As you can see, as 2019 comes to a close, roughly 80% of all companies that are listing are not making any money.

 

Profitless IPOs

Profitless IPOs

Source: Professor Jay Ritter, www.stansberryresearch.com

Listing companies on the stock exchange that are unprofitable is great for early stage investors and founders, who can cash out of their holdings, but it’s not great for the retail investing public who often end up the holding the bag and seeing their portfolios hit hard in any subsequent market correction.

As the chart makes clear, this kind of level has only been seen once before, which was back in 2001 right before the NASDAQ bubble burst, with technology stocks crashing by almost 80% in that wash out. The aftermath of the 2001 ‘tech-wreck’ as it is now known was also the birth of a huge bull market in tangible alternative assets.

Whilst we can’t be certain what the future will hold, most astute investors know that history has a way of repeating itself and is arguably our best guide to the future.

When I see charts like this, and I see central banks cutting interest rates, I for one am happy that a meaningful portion of my own wealth is tied up in hard assets, including coloured diamonds.

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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