Understandably, investors are concerned about the short-to-medium outlook for the markets and the implications for their portfolios. Indeed, many fixed-income investors have voted with their feet, exiting fixed-income mutual funds around the world and adding to broad market volatility.
Before making any hasty decisions, however, we believe Australian investors should consider carefully the factors that are contributing to market volatility — globally and locally. They might find, as we do, that there are many positive factors and that the implications for portfolios — particularly for actively managed fixed-income portfolios — can be positive, too.
From an Australian investor’s perspective, the most important factors at play are the US Federal Reserve’s recent guidance about when and how it is likely to begin winding back its quantitative easing or QE programme (the main cause of volatility, particularly in fixed-income markets) and the end of the commodity boom (of particular concern to the Australian dollar and economy).
The markets’ adverse reaction to the Fed’s guidance on QE reflects the extent to which unusually accommodative policy settings have helped to prop up markets during the last few years of uncertainty (the current QE programme is the third initiated by the Fed since November 2008). That the Fed is now talking about removing the prop is, clearly, a short-term negative for markets.
On the positive side of the ledger, however, the Fed is discussing the “tapering” of QE because of the continuing signs of improvement it sees in the US economy. In other words, it is preparing to move an artificial prop so that economic fundamentals — ultimately the best and truest guide to market valuations — can reassert themselves as the markets’ main drivers.
This is good news for Australian investors and the economy. The liquidity created in the global financial system as a result of QE (which, in its latest iteration, consists of the Fed buying US$85 billion of bonds a month) has resulted in historically low bond yields in Australia and certain other countries as much of that liquidity looked for a home in relatively safe markets.
These capital flows — together with those generated by demand for Australian commodities — helped take the Australian dollar to historical highs. The removal of QE, therefore, will help investors (particularly those in or near retirement) by at least easing some of the downward pressure on the yields of their fixed-income holdings, while a more fairly-valued Australian dollar will help export industries compete.
More generally, continued improvement in the US economy would be positive for global trade and might help to underpin, to some extent, the Chinese economy and the country’s demand for commodities — all good for Australia. The unravelling of the commodities boom has further to go, however, and this leads us to the second factor of particular interest to Australian investors.
The Australian dollar has fallen sharply recently as the downturn in commodity prices has offset the effects of offshore investors’ demand for Commonwealth bonds. We think the currency will fall further as the commodities downturn continues, but that its relative weakness will not prevent the Reserve Bank of Australia from cutting interest rates further.
We believe this for three reasons.
First, the correction in the currency to date only partly closes the gap that had emerged in recent quarters between changes in commodity prices (and hence the terms of trade, or the amount of imports Australia can buy for a given amount of exports) and the real effective exchange rate (the Australian dollar’s inflation-adjusted value relative to a basket of trading-partner currencies).
We estimate that the Australian dollar has gone from being 20 per cent overvalued (given current commodity prices and interest rates) to being overvalued by about half as much. With commodity prices remaining under downward pressure as a result of increasing supply and China’s economic slowdown, and with more rate cuts in the pipeline, we think the Australian dollar has further to fall.
Second, we believe that the weaker currency will have little near-term impact on the Australian economy. This is partly because of the dominant impact of the mining downturn, which has still to work its way through the employment and regional housing markets, and spending. Leading indicators, such as job vacancies, point to challenging times ahead.
There will be some inflationary impact as the effects of a lower currency are passed through to higher domestic prices, but while some of the impact will be immediate (fuel prices and the cost of overseas holidays, for example) most of it will be felt over time.
This leads to our third point: how we expect the Reserve Bank to respond to an environment of higher inflation and slower growth.
We believe it will 'look through' the initial impact of the exchange rate on inflation, so that a higher consumer price index will not be a barrier to further rate cuts. Indeed, we are inclined to the view that we could see a cash rate of less than two per cent before the current easing cycle ends.
What are the implications of all this for Australian fixed-income investors?
We believe they can be summed up in one word: opportunity. Quite simply, market volatility — combined with the fact that the US and Australian central banks are taking divergent paths on monetary policy — is providing new and interesting opportunities for active fixed-income managers to take advantage of movements in interest rates and currencies to generate returns for clients.
Investors, in our view, should consider these opportunities before making any radical changes to their portfolios. As they do, they can reflect upon the fact that, for all the Fed’s talk of tapering its QE programme this year (assuming the US economy continues to meet its forecast) and ending it in the middle of next year, it is not actually tightening monetary policy.
According to the Fed, most of its officials expect official interest rates to start rising in 2015. In other words, monetary policy will remain accommodative for some time, meaning that fixed-income investors can investigate the opportunities opening up for them in the post-QE environment while continuing to take some assurance that policymakers, for now, are still on their side.
Ross Kent is chief executive officer of AllianceBernstein Australia