Rates and Planet Heat Up

US rate rises

The much anticipated first US interest rate increase since 2006 should be good for investors due to the healthier US economy it implies.  US overnight cash rates were near zero for the past seven years and are now 0.25-0.5% p.a.  This is still extremely low and stimulatory so they’re likely to gradually rise over coming years towards a neutral setting of about 2-2.5%, if nothing stems recovery.

Stock markets have responded positively, largely happy that interest rate uncertainty is over.  Subsequent rate rises might bring lower returns from shares once we approach neutral settings and beyond.  Future rises will slowly edge rates up as the US economy is judged able to cope with progress back towards neutral levels.  The next rise might be in March and US rates could rise to 1% this time next year, if their economy remains robust.

This modest upward adjustment is recognition that the emergency conditions of the GFC are now past.  It should not be enough to upset the US recovery, so equities remain attractive for now as the US is keen to minimise market volatility and maintain its recovery.  Improved US interest rates should add a little extra support for the US currency and aid commodity prices that are often priced on the US$.  Some downward pressure can be expected for interest-rate-sensitive US utilities, banks and real estate investment trusts (REITs).

Meanwhile in Australia, our rates are expected to stay low next year and our A$ could fall further as the US rises.  Our business conditions are slow as we transition from a mining dependence and slowly broaden our economic base with a focus on innovation.  Consequently we expect a slow year on the ASX.  If bad debts grow, then bank stocks may find their extraordinary post GFC performance harder to replicate.  Energy stocks have been pushed down over the past year and may be due for reprieve.

While government debt is relatively low (though rising), Australia’s huge personal debt has built up over the 17 year housing price boom since 1998.  House prices tracked slightly down after the 1990 recession, then slipped sideways for 8 years till 1998 before the current house price boom began.  There are now signs that boom has peaked but a gradual transition to a new innovative recovery for Australia seems most likely.

Changing our economy will not be fast and while innovation can facilitate more start-ups, policy is lacking to avoid losing such business just as they are about to reach ‘pay-off’.  New tech Australian company ‘Atlassian’ is instructive in this – nurtured in Australia with some Government support, it needed to move to the UK for tax reasons and recently listed on the US NASDAQ exchange for capital reasons.  So again, we missed the pay-off.

There is perhaps a 30% chance of recession in Australia – jobs related to mining revenue are being cut, house prices have possibly peaked and we’ll soon lose 40,000 car manufacturing jobs.  We’re affected by China’s slowing commodity demand and many hope India might fill the breach.  But India may not yet be ready and recent urging for Australians to innovate will take some time to bear fruit.  Meanwhile, our chance of a recession rises if mining and automobile woes are amplified by a housing bust.

But back to rising US rates, it will cause re-pricing of everything that’s benchmarked against them.  Stock markets benefit when money is cheap to borrow, and rate rises have historically caused stocks to fall initially then rise 6-12 months later because of the improved economy that triggered the rate rise.  The rate rise was widely anticipated since April, so the falling stock market since then was probably in anticipation.

Rates are rising now to return to neutrality.  But when rates rise in a tightening phase (beyond neutral), the later rises in that cycle begin to really squeeze credit availability, causing ‘bear’ market pressure.  However, the gentle, prolonged rising cycle now expected as the US moves back towards a neutral position is unlikely to bring any bear market pressure.

Climate/Energy Update

In Paris, almost 200 countries made greenhouse gas reduction promises and if they’re all met, our planet will become 2.7-3.5°C warmer than mid 18th Century levels.  If we want to keep the warming to a more bearable 1.5°C, scientists say we’ll need to rely on risky, untested geo-engineering sinks to soak up the greenhouse emissions that are already in the atmosphere and locking us into 1°C warmer.  Countries may not keep their promises but on the other hand, peer pressure for more urgent climate mitigation may increase.

Fossil fuel use will keep declining and renewables will get cheaper.  To underline national innovation and encourage investment opportunities in renewables, Australia desperately needs a credible climate mitigation strategy.  Meanwhile, investors are reading where the world is headed and are starting to move their money ahead of Government action.  While juggling our own investment decisions, let’s hope for greater urgency and perhaps Paris may prove to have been a tipping point.