Coolabah Capital Investments | Christopher Joye
Christopher Joye is a contributing editor who has previously worked at Goldman Sachs and the RBA. He is a portfolio manager with Coolabah Capital, which invests in fixed-income securities including those discussed in his column.
“With property prices on the turn and banks unlikely to pass on full rate cuts, it seems inevitable that the RBA will expand its monetary policy toolkit.”
House prices are climbing again in some areas with Melbourne home values up 0.1 per cent in June in what is the first capital gain the city has recorded since November 2017. According to CoreLogic, Sydney has also experienced its best monthly result (-0.1 per cent) since July 2017 while the overall five capital city index is similarly signalling the correction is coming to an end.
This confirms our April 2019 forecast that the housing downturn would end if the Reserve Bank of Australia cut rates and we retain our May projection that national prices will climb 5 to 10 per cent over the 12 months following the second RBA rate cut. The bottom line is that with more cuts coming, and APRA yet to reduce its 7 per cent serviceability test, the housing party is just getting started.
While the market is pricing a circa 70 cent probability that the cash rate is lowered a second time to just 1.0 per cent at the RBA’s July board meeting, a key question is what the banks will actually pass through. (I think the RBA could cut in either July or August.)
The big four in particular face tremendous pressures on their net interest margins and returns on equity via numerous headwinds, including: the inability to cut deposit rates below zero; a permanent increase in their regulatory and compliance costs; ongoing customer remediation payments; opportunistic class action litigation; a huge hike in the equity capital they are required to hold in their New Zealand subsidiaries; a new levy on their New Zealand deposits; intense competition from Chinese, Japanese and European banks in business lending, and from lightly regulated non-banks in residential finance; and, finally, the spectre of APRA eventually introducing a total loss absorbing capacity (TLAC) regime that could materially raise their funding costs.
(There is, of course, also Scott Morrison’s unprecedented big bank levy of 0.06 per cent annually on the value of their wholesale liabilities.)
Back in 2015 we argued that the steady-state returns on equity for the major banks should decline from their 16 to 18 per cent levels to around 10 to 12 per cent, which is about where they have landed today. The concern will be if these returns start shrinking below the banks’ cost of equity, which would imply they should be trading in share price terms at less than one times book value.
If it was difficult to make the economic case for banks to pass through more than 15 basis points of the RBA’s first 25 basis point cut, one would be hard pressed to imagine them passing along much more than 10 to 15 basis points in July or August.
After the generous “gimme” of near-full pass-through in June, the banks have to start behaving like profit maximisers and defend the sustainability of their business models, which frankly could rationalise pass-through of less than 10 basis points after the next RBA move.
It is, as a result, plausible that the RBA gets less than two-thirds of the lending rate reductions it would normally expect from a brace of standard cuts. This is not nearly enough to give it confidence that monetary policy will stimulate the economy toward its new full employment target, which is a jobless rate of less than 4.5 per cent (compared to today’s 5.2 per cent level).
That immediately introduces the need for a third cut, which may be why financial markets are pricing one in by the end of the year. The problem, of course, is that the RBA will get even less pass-through at that time, perhaps as little as 5 to 10 basis points.
Finally, there is the nontrivial complication that the US Federal Reserve is likely to slash its own cash rate, which will put upward pressure on the Aussie dollar and directly detract from the RBA’s attempts to stimulate the economy.
This presumably explains why RBA governor Phil Lowe is suddenly talking about the “limits of monetary policy” and expressing a desire to see fiscal policy furnish more support. The problem with this logic is that Scott Morrison and Josh Frydenberg were elected on the basis they would balance the books and deliver a string of surpluses. The only thing likely to stop them doing this is the threat of a full-blown recession.
When you think through this decision-making tree, all roads inevitably lead to the RBA sensibly expanding its monetary policy toolkit to target a wider range of interest rates than just the conventional overnight cash rate. This should include longer-term risk-free rates and the spreads over these benchmarks that determine bank funding costs and hence the practical savings and loan rates they set for depositors and borrowers. If the RBA wants to, it could quite easily link its wider interest rate targeting program to changes in both bank funding costs and the rates they charge customers. Whether we really need rate cuts is naturally a very different question. What we know is that the RBA has made an extremely vocal case that driving the economy towards full employment will deliver the community large welfare gains.
One could easily counter that these jobs will be in businesses experiencing artificially high rates of growth powered by unsustainably cheap money. Indeed, many of these firms might not exist in a normalised interest rate world, wherever that long-term cost of capital lies. In the meantime, we all need to focus on making money. A core objective of the RBA’s rate cuts is to force folks out of cash deposits into higher-risk investments, which appears to be working on the evidence available thus far.
And while investors may be worried about superficially low interest rates, if yields and credit spreads keep compressing, total returns can be very large indeed. Over the last 12 months, a portfolio of sevenyear AAA rated government bonds yielding, on average, only 2.1 per cent delivered a stunning total return of 11.4 per cent. This is because the expected return from these bonds collapsed from 2.4 per cent a year ago to 1.2 per cent today. The price of the bond has therefore jumped to reflect the fact investors are now happy to accept much lower yields. The point is that one can capture enormous returns from ostensibly low-yielding investments if the required yield drops sharply. The trick is to find those investments that still appear cheap in a world where most asset classes look heinously expensive.
One team that has proven especially adept at hunting out such bargains is the high-profile long-short duo Rob Luciano and Doug Tynan, of VGI Partners. I first met Rob and Doug when I profiled them for this column way back in 2011. Alongside the likes of AMB Capital’s Todd Bennett, superstar adviser Chris Garnaut and myself, Rob and Doug helped sergeant Harry Moffitt establish the Wanderers Education Program, which has raised millions of dollars to fund education scholarships for currently serving soldiers in the Special Air Services Regiment. This is the first time in the world that a private philanthropy has been set up to educate active (as opposed to retired) special forces soldiers.
While Rob can be as idiosyncratic (euphemistically put) as the next exceptional fund manager, I love the guy and admire his unparalleled intensity. This son of a piano player is almost as tough as one of his mentors, master water-boarder and Manikay Partners chairman Russell Aboud (trust me, I’ve experienced the latter’s torture many times).
Luciano’s protégé Tynan is no less impressive and the perfect foil for his curmudgeonly, yet also incredibly generous, boss. These guys go to extraordinary lengths on behalf of their investors, and some time ago sent their entire team to the US to be trained by former CIA interrogators.
(Full disclosure: my mother recently invested in VGI’s management company, which has almost tripled in value since it started trading)
The author is a portfolio manager with Coolabah Capital Investments, which invests in fixed-income securities including those discussed by this column.
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