Economists, like investment fund managers, are like lemmings. They don’t mind going over a cliff as long as everyone else goes too. Mind you, I have a certain sympathy for their position. But we do need to understand the inherent conservatism of the beast.
It’s hard to stand out from the pack. The fear is that if you stick your neck out, the first time you’re wrong (when others aren’t) it’ll get chopped off. And that would involve loss of business and livelihood. If, on the other hand, you’re part of a whole pack and wrong, you’re not a clean target. And we’re always suspicious of people who are right when the rest of the pack is wrong.
Hence the inherent conservatism of forecasters and of investment allocation. It’s much safer to be strategic rather than tactical. It’s always better to get an objective technique to take responsibility rather than making subjective judgments, even when that objective technique is imperfect. Hence my argument that modern portfolio theory, using historical variance/mean for risk/return, is a recipe for shutting the door after the horse has bolted – and then locking the door so that it can’t get in again. Everyone knows it doesn’t work, but we haven’t got a safe alternative so we use it anyway.
That doesn’t help us make good decisions.
Markets are cyclical. Market movements are not orderly or small. There are major shifts and we need to understand that.
I made an, admittedly aggressive, bet with some of my colleagues in April 2004 when cash rates were 5.25 per cent, up from 4.25 per cent in 2001, that they would reach 8.5 per cent this cycle. They’re now 7.25 per cent, after two more interest rate rises this year. It’s not our official BIS Shrapnel forecast of another half to 0.75 per cent, but there’s a possibility I might turn out to be right. I hope not. It depends on the sensitivity of consumption expenditure to rising interest rates.
The point is that through most of this time, our official forecasts were much more moderate – about a 1 per cent rise. And even so we had to wear criticism about “sensationalist forecasts” until they came through. Meanwhile, most forecasters were only looking at a maximum 0.25 per cent rise indefinitely into the future. It’s only in the last few months that some have got a little more aggressive and are looking at 0.5 per cent.
It doesn’t matter whether I turn out to be right or wrong about the 8.5 per cent. It is the emerging demand-inflationary pressure that would cause the RBA to raise interest rates significantly. My point is about the size of shifts and the inherent conservatism of forecasts, even ours.
This is not a gentle time for the Australian economy. Strong growth is being driven by strong business investment.
In a sense, we’re still living through the consequences of the 1980s boom and the 1990s bust. The 1980s strength was driven by investment so that the 1990s recession was characterised by excess capacity and excess labour. Not surprisingly, business focused on restoring profitability by cutting costs and cutting investment expenditure to levels that absorbed excess capacity. And once excess capacity was absorbed, we weren’t investing enough. Hence the emergence of capacity constraints, as the economy strengthened this decade, has underwritten strong growth in business investment.
Interestingly, governments (both Common wealth and State), too, were in cost-cutting mode. They weren’t investing enough. And that inadequate infrastructure investment has led to today’s bottlenecks and forced a round of strong government investment. It would be better if government investment were delayed so as not to crowd out the private sector, and to make government investment counter-cyclical rather than pro-cyclical, but much of it is now in the urgent basket.
Add to that the minerals boom and this extraordinary boom in minerals investment. No wonder the construction sector is bursting at the seams and construction costs are skyrocketing.
Only the residential sector is languishing under the weight of interest rate rises which are suppressing a much-needed upswing in construction. We’re not building enough to satisfy demand and there’s an escalating deficiency of residential stock. To me that means that residential construction is waiting in the wings and will drive growth in the first half of next decade.
Business and government investment is now providing the major stimulus to economic growth. That’s why the US downturn will have little impact on Australian growth. It also means that the current financial market shocks will, once absorbed, have little impact on the real side of the Australian economy.
Australia’s problem is inflation, not growth.
Again, it was capacity and labour constraints earlier this decade which led to the build-up of demand inflationary pressure. But it has been slow to be reflected in the CPI.
Why? The minerals boom, together with a widening of the differential between Australian and US interest rates, brought with it a rise in the Australian dollar which reduced the price of tradeables, including both imports and import-competing goods and services. Without the free ride on inflation coming from the rise in the dollar, interest rates would have risen much more sharply long before now.
Only now has underlying CPI inflation risen above 3 per cent, forcing an aggressive RBA response. And even now the strength of the $A is taking some of the heat out of the rise.
My concern is that the delay has allowed inflation to build momentum and could make it resistant to monetary policy. In this environment, rising interest rates have little impact on investment. To work, they have to hurt households, to induce them to reduce consumption expenditure, to reduce demand and put pressure on retailers’ margins.
But strong growth, strong employment growth and rising wages are boosting household disposable income. That, together with the likelihood of the promised tax cuts, will offset much of the impact of interest rate rises for many households. Consumer confidence will be a key. But the strength of investment and growth will make it difficult to have an impact on household spending. That’s why we think more interest rate rises will be required. The problem is that the higher interest rates are when sentiment turns, or external factors turn negative, or investment falls, the greater the risk.
How does this end?
This is a long game not a short game. We still don’t know how many more interest rate rises will be required to contain inflation. That depends on the ability to reduce consumption expenditure. It’s a game that needs to be played carefully to avoid a hard landing.
We may argue about the outcomes – they’ll become clearer as time progresses. The minerals boom will bust. Investment will decline. The $A will fall. We still don’t know whether there will be a soft landing at the end of this inflationary episode. Residential property will lead the next upswing.
But one thing we can be sure of is that this world won’t stay in a steady state. There will be major cyclical swings. And understanding them before they happen will be a key to good investment.
