In May this year, Evidente wrote an article published in the Fairfax press which drew parallels between the Reserve Bank’s much anticipated recovery in capital spending by the non-mining sectors and Samuel Beckett's play Waiting for Godot, in which the two protagonists wait for Godot under a willow tree, where he said he would meet them.
By the end of the final act, Estragon and Vladimir's optimism and anticipation remain palpable, yet Godot's arrival is no more imminent than it was at the beginning of the play. Rarely has such patience been so unrewarding.
Seven months down the track and regrettably, the RBA still finds itself in the same predicament. That much is evident from the growing chorus of economists calling for easier policy, the increased frequency of the term ‘income recession’ to describe the state of the economy, the slide in prices for Australia’s key export commodities, iron ore and coal, and the fact that animal spirits remain dormant in the business and household sectors.
Mr Stevens highlights the fact that since the RBA started to ease three years ago, it has brought the cash rate down to its lowest level in his lifetime on a sustained basis, and he believes that borrowing costs do not represent an obstacle to the recovery. He re-iterated that it is now up to the corporate sector itself to regain the psychology of risk taking and invest in projects for future growth.
There a number of issues worth exploring in more detail here. First, economist and author of the Money Illusion blog, Scott Sumner, draws attention to the work of Milton Friedman who argued that low interest rates – whether measured in nominal or real terms – do not mean that policy is easy. Rather, low interest rates are an indication that money is tight. In other words, focus on the reason why interest rates are so low. In the case of Australia, it is because the economy has been stuck in a nominal recession for three years now (see chart below which depicts annualised growth in nominal GDP).
Second, Mr Stevens continues to under-estimate the power of monetary policy to revive the corporate sector’s animal spirits. From a capital budgeting perspective, the effects of the compounding effect of a lower risk free rate can be powerful. But arguably, the monetary policy transmission mechanism is more powerful via the impact on the other part of the discount rate, the expected equity risk premium (ERP). It is reasonable to think that the amplitude in the ERP is far larger and more important driver of changes to discount rate than shifts in the risk free rate. And monetary policy can also help to boost expectations of revenue growth and cash flows.
Indeed, the capital budgeting framework sheds light on why money remains tight. Greater uncertainty - reflected in a persistently high ERP - and expectations that revenue conditions remain subdued, are contributing to the corporate sector's reluctance to invest (and hire). The deterioration in labour market conditions is evident from the rising unemployment rate and the fact that unemployment expectations are 50% higher than three years ago, around the start of Australia’s nominal recession (see chart).
A positive narrative for a February rate cut
Mr Stevens has devoted most of the this year to developing the central bank’s own forward guidance that an extended period of interest rate stability represents the optimal policy setting. He has cited concerns around stoking a bubble in house prices and rapid growth in lending for investor housing as reasons for being prudent.
The central bank is clearly mindful that cutting further would exacerbate these concerns and also signal that the outlook had deteriorated materially, particularly at a time when consumer and business sentiment remains fragile. Thus Mr Stevens has started to lay the groundwork for what he describes as a positive narrative for abandoning the bank’s own forward guidance.
This foundation focusses on the prospect inflation pressures remain well contained and that inflation does not present a barrier to a lower cash rate. Low wages growth is suppressing unit labour costs – productivity adjusted wages – and the sharp pull back in the oil price will help to ameliorate the inflationary impact of dollar depreciation.
Mr Stevens is surprisingly upbeat about the prospects for global growth of the sharp fall in crude oil prices. While it is difficult to disentangle the supply and demand dynamics in real time, it is reasonable to think that lower global growth expectations have contributed to lower prices (along with a lift in expected production stemming from the North American supply boom). Although oil importing nations stand to benefit at the expense of oil exporters, it is difficult to assess the net effect on global growth of these shifts in expected demand and supply.
Given that the inflation outlook will form an integral part of the RBA’s positive narrative, the most likely timing of the next rate cut is February, a week following the release of what is likely to be a benign CPI print for the December quarter.
A change in mindset for portfolio construction
Economists and portfolio managers are no doubt re-assessing their portfolio construction in light of the prospect that the RBA might deliver more rate cuts in the new-year. But I believe that a better starting point is to acknowledge that money is, and has been, too tight for at least three years now and that this has contributed to Australia’s nominal recession.
This starting point can help to explain a number of patterns in the stock market and corporate landscape market in recent years: slow growth in nominal GDP, persistently weak revenue conditions, corporate restructuring, a trend towards greater corporate focus (thanks to the demerger wave), rising unemployment, investors’ growing appetite for dividends, and the strong and sustained performance of the yield trade.
Even with the prospect of another rate cut (or two) in 2015, my expectation is that the RBA will be the reluctant rate cutter, which will undermine the potency of policy to revive animal spirits. Against this backdrop, Australia will likely remain stuck in a nominal rut and the stock market trends that have prevailed for the past three years are likely to persist. Mr Stevens is discovering that being too patient comes at a very high price.