Home / Active strategies: a remedy for uncertain times

by Katrina King, Director, Research & Strategy – Global Liquid Strategies (QIC)

In an environment where economists are divided over the future outlook for the Australian economy, institutional investors should consider increasing their portfolio’s weighting to active strategies where portfolios can be focused on opportunities to deliver strong returns over the next five years. 

That the spectrum of views on the economy is polarised is indisputable.  On one side are the “relative optimists” who believe that low interest rates and petrol prices will translate into higher spending because consumers are saving the extra dollars. Meanwhile the other group of “relative pessimists” believe that the nervous sentiment of consumers and investors is contributing to a deflationary view.

A recent survey of 15 Australian economists revealed that the most optimistic GDP growth forecasts for this year was three per cent contrasted with the most pessimistic at nearly two per cent.  Next year the equivalent predictions are 3.50 and 2.25 per cent respectively.

Yet the outlook for interest rates falls within a narrow band between 1.75-2 per cent for the second half of 2015, which is expected to eventually widen to 1.75-2.75 per cent by the second quarter 2016 as interest rate forecasts mirror the dispersed economic views

Separating the views of the different economists is their interpretation of the behaviour of consumers and private investors in the wake of lower interest rates. The “relative optimists” believe that the unusually low-interest regime will eventually have an impact, encouraging consumers to loosen their household wallets, which will lead in turn to higher private investment (Figure 1).

Meanwhile their opposite number point to the combined effect of the GFC, its aftermath and job insecurity that has created a more cautious consumer with changed spending patterns who is more likely to use the internet, or other means, to get a product or service for a cheaper price. Not even lower interest rates or petrol prices can reassure them that a more liberal approach to spending can be sustained.

Previously, the level of interest rates that we have today would have caused a large boom in borrowing, but this has not occurred. Changes in interest rates are not affecting decisions about spending and saving in the way they might once have done.

The pessimists take issue with the optimists via a belief that models are not adequately capturing fretful sentiment. The Reserve Bank of Australia consistently refers to a lack of “animal spirits”.  Low interest rates, low petrol prices are not necessarily translating into higher spending as people are saving the extra dollars available.

The optimists argue that the Australian economy can pick up speed to three per cent annualised growth, largely driven by a consumer who will surprise on the upside. Their model driven argument is that lower interest rates will push up house prices and the resulting wealth effect will motivate higher consumption. In the early 2000s when property prices were increasing strongly, many households used their newfound wealth to withdraw equity and enjoy higher levels of consumption.  But the latest home equity withdrawal figures show that this has not been happening since 2008.

Consumption is weaker than it otherwise would be. In turn, subdued consumption growth is feeding through to a more subdued business climate and weaker investment.

The optimists anticipate a stronger labour market based on improvements indicated in the latest job ads surveys. However a structural change in the economy, which is very slowly transitioning from mining to non-mining, is contributing to deflation.  The downside is the associated trend from high to low wages. Mining employees, such as truck drivers who earned $200,000 a year, are being replaced by employees in low-wage industries like retail and tourism which will bolster the low or cautious consumption trend.

Moreover, the predictions that the unemployment rate will peak near seven per cent in 2015, and stubbornly resisting falling during 2016, is quite a distance from the current 6.4 per cent level. If that is where we are headed, household caution is warranted.

As investment is low and more people are out of work, some optimists suggest that with interest rates currently on offer at an all-time low, government should borrow more to drive infrastructure investments. Until governments announce a policy change in this direction, we prefer to err on the side of caution.

A weaker AUD is another part of the optimists’ case and this is very reliant on US Federal Reserve policy.  Our modelling suggests that the US Federal Reserve remains on track to gradually raise rates from around the third quarter this year on the belief that unemployment is falling to its natural rate and that wages growth is thus set to accelerate. 

However, if the Fed decided not to look through what we anticipate is a temporary decline in inflation due to oil prices and therefore delay their hiking date, our simulations suggest that a Federal Reserve delay in lift off of one year would result in the AUD retracing to about US$0.83, constraining economic activity. A two per cent RBA cash rate may be the floor we reach domestically, but if the US Fed pushes out a US rate rise to 2016 – rather than September 2015 – the RBA cash rate may reach as low as 1.5 per cent.

One area where low interest rates do appear to be having the broadly expected effect is on asset prices: the equity market has been strong; property prices are again recording solid gains in many States; and bond prices have increased. However, for these increases in asset prices to boost the domestic economy, households and businesses need to respond by increasing their spending. While in the US there are now some signs that this is happening, on the whole the response of private spending to higher asset prices is Australia has been muted.

Investors face several choices to achieve better returns. They can increase their allocation to equities, although the experience of the GFC made many cautious towards this asset class. Another option is to increase the portfolio’s weighting to strategies which allow an overweight holding to alternatives and credit. 

However given the volatility and some instances of lower liquidity we have seen in fixed income markets recently, active management is key.  Further this environment is likely to see absolute return portfolios perform well. Their ability to profit from both rising and falling markets will be enhanced as volatility remains high.

 

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