13th October 2021
Market Update
“My favourite things in life don’t cost any money. It’s really clear that the most precious resource we all have is time.” Steve Jobs
As we have mentioned in prior editions of the weekly, inflation will be a major influence on interest rates going forwards and the AUD has now come in to play as factor in this context with a weaker AUD possibly leading to a bump to inflation.
With domestic developments in the past month largely as anticipated, there were no significant new observations on the economy. In short, GDP is expected to have “declined materially” in the September quarter, but this set back is believed “temporary”, with the economy “expected to be back around its pre-Delta path in the second half of next year”. Despite this recovery, the RBA remains cautious on the outlook for wages and hence committed to “not increasing the cash rate until actual inflation is sustainably within the 2-3 per cent target range”.
The RBA’s Financial Stability Review released this week stated that globally, financial systems have remained resilient – despite the ongoing effects of the COVID-19 pandemic – and are supporting economic recoveries. Aided by expansionary fiscal and monetary policies, output has rebounded in most economies, particularly those with a more progressed vaccination rollout. Improved economic conditions have seen increased earnings for businesses and households, strengthening balance sheets and debt repayment capacities. As a result, banks’ loan losses have been much lower than was expected early in the pandemic. Many banks have therefore been able to reduce the provisions they were holding against future loan losses. This has boosted banks’ profits and improved their capital positions, which in turn has allowed regulators to remove restrictions on capital distributions.
In Australia, the fall in output and hours worked in the September quarter demonstrated that the economic risk from the pandemic persists. However, the Australian financial system is highly resilient – with rapid progress in vaccinations, it is expected that output will rebound as the economy gradually reopens, reducing the risk to the financial system. But with most of the global population yet to be vaccinated and infections widespread, there is a risk that new highly infectious or even vaccine-resistant variants could emerge, making the outlook for the economy and the financial system highly uncertain.
Internationally, financial stability risks are particularly elevated in those EMEs where the recovery in output from large falls has been less complete and where low vaccination rates leave them susceptible to increased COVID-19 cases. Financial stability risks are particularly prevalent in countries with pre-existing macroeconomic and financial imbalances, such as Brazil, Turkey and South Africa. With interest rates projected to begin to rise in advanced economies as spare capacity declines, EMEs will face the prospect of capital outflows and exchange rate depreciations if they do not raise their domestic interest rates but raising rates would further delay the recovery. Some have already tightened monetary policy in response to rising inflation, delaying the rebound in incomes.
In China, authorities remain focused on lowering elevated financial system vulnerabilities. Policymakers face the challenge of addressing those vulnerabilities without triggering widespread stress and sharply lowering economic growth, while also focusing on their broader policy and social objectives. A prominent example of the trade-off between lowering vulnerabilities and economic growth is the liquidity crisis facing large real estate company Evergrande. Authorities may have to choose between imposing market discipline and intervening to avoid a disorderly resolution that could trigger stress in the financial sector or real estate industry that has been a significant contributor to growth in recent decades.
One concern is that expansionary financial conditions are underpinning rising asset prices and risk-taking. This implies a moral hazard where risk-taking is rewarded, risk is mispriced, and investors become complacent.
While rises in asset prices have been underpinned by low interest rates and expected investment earnings, some asset prices appear high given the pandemic still presents a risk to economic activity. Furthermore, price falls could be widespread if interest rates were to increase sharply due to unexpected inflation or rising risk premiums. Sharp price falls could cause greatest harm to the financial system for assets where leverage is common, notably residential and commercial property. But even for other assets, sharp price falls could result in market dysfunction or illiquidity, as occurred in government debt markets in early 2020.
The chart below shows the almost unstoppable momentum of the national, but more specifically Sydney, property market. If you couple this with little to no wages growth, it’s clear that the one constant is low-interest rates. The concern is that people may overextend themselves when it comes to borrowing, something APRA as addressed by increasing serviceability rates.
Just for some fun below is an example of a coupon with the face of President George Washington. This is exactly where the term coupon came from. This coupon would be “clipped” when due and the bearer would receive the amount of interest due – $6.25 – as per the one below.
Here’s another example…. with the coupons attached below the bond.
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