Rumours of the yield trade's demise are greatly exaggerated

In a wide ranging speech given overnight, Glenn Stevens, the Reserve Bank Governor, gave the clearest indication yet that he will not lift the Overnight Cash Rate for an extended period.  The historically low interest rates are justified on the grounds that the economy still has excess capacity and that inflation is likely to remain under control over the next couple of years.

The fact is that Australia has remained stuck in a nominal recession for over two years.  Nominal GDP growth has not risen above 4% pa in each of the past two financial years, the worst outcome since the early 1990s (see chart).  No wonder that consumer confidence remains in the doldrums, revenue growth is weak and animal spirits in the corporate sector are still dormant.

Mr Stevens continues to lament the absence of entrepreneurial risk taking.  While he acknowledges that firms are waiting for more evidence of stronger demand, he suggests that the stronger demand should come from them.  This strikes me as somewhat circular.

Recent communications from the RBA indicate that it is puzzled that non-mining investment remains weak when corporate cash balances are high, gearing is low and Tobin’s q ratio has been growing.  That is, the market value of assets has been growing faster than the replacement cost of assets.

But the value of assets has been rising precisely because companies – beset by persistently weak revenue conditions and weak nominal GDP growth – have been boosting profitability by pulling back rather than expanding.  Gone are the days of chasing the pipedream of double digit revenue growth.  CEOs are now focussed on trimming costs aggressively, restructuring, shedding non-performing assets and deferring or completely abandoning capital projects to cater to investors’ insatiable appetite for income.  Mr Stevens can implore companies to take on more risk but this will continue to fall on deaf years.  The prospect of persistently subdued top line growth suggests that a revival in the corporate sector’s animal spirits is a way off (see chart).

Mr Stevens acknowledges that corporate business models in Australia have effectively been responding to various headwinds – including a high exchange rate – by restructuring and lifting efficiency, and that this has led to a pick-up in growth of productivity.  Indeed, Australia’s productivity renaissance has been evident for a while now (see chart).

Mr Stevens continues to advise caution on the outlook for house prices: prices have risen considerably in Australia’s largest two cities for a while now, they have growing faster than incomes by a decent margin and mortgage lending to investors has registered double digit growth.  Further, the RBA Governor highlights that house prices go up AND down (his capitals, not mine). 

Rightly or wrongly, one of the lessons that the RBA has taken from the past decade is that central banks should no longer be passive actors during periods of asset price inflation, particularly when these episodes are associated with rapid growth in credit.

Mr Stevens faces the dilemma that animal spirits in investor housing is buoyant (which according to the RBA poses a growing systemic risk) while animal spirits remain dormant in the corporate sector.  As long as the RBA continues to under-estimate the power of monetary policy to revive the corporate sector’s animal spirits, the Australian economy will remain stuck in a nominal recession.

From a portfolio construction perspective, this means more of the same and bodes well for the yield trade.  For a number of years now, analysts have been upgrading the growth prospects for large cap, defensive, high yielding stocks relative to cyclical stocks (see chart). 

The tailwind from declining bad & doubtful debt charges will no longer boost bank sector earnings going forward.  Nonetheless, in an environment of low nominal GDP growth and subdued revenue conditions, analysts are unlikely to materially lift their earnings forecasts for cyclical stocks.  Australia’s under-capitalised banking system represents the key risk to the yield trade, but that is not actionable at a time when growth in business credit remains anaemic.