Investing

It’s all about interest rates

Written by Paul Miron, Managing Director, Msquared Capital

From an economic standpoint, it certainly seems we are headed in the right direction. We are getting the upper hand in living with the virus, international borders are reopening, and Australia is once again welcoming tourists, students, and migrants. The RBA has modelled that unemployment is at 4.25% and heading to sub-4%, the lowest we have experienced for decades – with GDP growth forecasts recently revised upwards to 4.25%.

Despite the economy recovering strongly enough to support the tapering of fiscal and monetary policies, the prospect of this happening has sent the market into a tailspin due to fears of immediate interest rate increases and inflation getting out of control.

The size and extent of government stimulus combined with “free money” (0.1% p.a. official cash rate) have never been applied in our economy’s history. As a comparison, during the GFC the amount spent to stimulate the economy was 2% of the GDP whilst Covid-19 support equated to 7% of the  DP. Some forget these extraordinary measures are always intended to be temporary. The economy needs to stand independently without monetary and fiscal support from the government. Official interest rates need to be normalised, arguably between a range of 3.5% to 5% p.a., with a move to balanced budgets for the primary purpose of cushioning our economy against future Black Swan events. Smoothening the troughs and peaks of economic cycles to limit the pain of future recessions and crises should always be the primary mission of the Reserve Bank and Governments. Reserve banks predominately use the lever of interest rates against persistent inflation to enable full employment and financial stability.

The inconvenient truth is that there is increased uncertainty in the economic future. 

Has the magnitude of the stimuli injected globally by reserve bankers been too excessive? Or will the economic scars caused by Covid subside, with chain supply, transitionary inflation and loss of productivity returning to normal?

Thus, the question is – have we unleashed persistent inflation, which will require a more aggressive stance in increasing interest rates? If the answer is “Yes”, this would result in decreased asset prices across most asset classes, reduced real wealth for businesses and personal balance sheets, lower consumption and investing, hence lower economic growth, and the possibility of an economic recession (Keynesian Wealth effect).

An entire generation has never had to deal with the consequences of inflation, and I believe they are not financially, nor psychologically, prepared. Some economic historians reference the past 40 years as the “Goldilocks” period, primarily due to inflation having remained consistently low, allowing for a continual decrease in interest rates. Perhaps this period coincides with the productivity gains made due to globalisation and the subsequent fall in the prices of consumer goods via the movement of manufacturing to countries with much lower labour costs. As Nobel Prize winning economist, Arthur Lewis, concludes in his body of work, we may have indeed reached the “Lewis Turning Point” – the point where there are no further productivity gains made by using cheap overseas labour and manufacturing. Global trends such as “De-globalisation” further support Lewis’ theory and the notion of inflation being a more prevalent issue in the near future.

With the trend of cheaper consumer goods ending, will the pace of technological advances be enough to make up for slower productivity gains?

To find out how investors can invest confidently in such an uncertain world, visit Msquared Capital’s webpage here or click below to download the full report on interest rates.

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