Transcript Five questions for the CIO June 2019

Matthew Bolton (MB): Welcome to Five questions for the CIO. I'm Matthew Bolton and I'm an analyst working with our Chief Investment Officer, John Pearce, in our investments team.

Hi John. Since the last interview, a lot has happened both globally and domestically. In Australia, we’ve had an election and an interest rate cut. Are you surprised by the strength of the share markets in regards to the recent developments?

John Pearce (JP): I am a bit surprised, Matt. But maybe I shouldn't be, because it's all about the banks, and the banks are about 30% of the market. It's a huge component. Let's discuss what's happened with the banks. Leading into the election, there was a lot of pessimism. A Labor victory was expected and Labor had policies around franking credits, capital gains tax and negative gearing. That was potentially going to be negative for the housing market, which in turn would hurt the banks.

The Coalition victory really took everyone by surprise. The day after the election, look what happened to bank share prices—in a single day, you've seen these massive companies increase in valuation by 7%-8%.

Since the election, we've had more fuel to the fire. We've had APRA relax some of the lending standards, we've had a cut in interest rates and there's anecdotal evidence of more buyers coming into the housing market.

Another interesting graph here, look at the clearance rates in auctions—we see a tick up there, and typically this heralds an increase in house prices.

A word of caution there, though. I'm not expecting a V-shaped recovery in house prices. The owner/occupiers, I can see them coming back into the market but residential housing is still expensive relative to other asset classes, such as shares. If you look at yields of sub-2% (if you take into account cost), that compares to share market yields of around 5% to 6%. So I'm not expecting a V-shaped recovery, but I could be wrong.

MB: Now back to the recent interest rate cut. The RBA governor, Philip Lowe, is generally believed to be a reluctant interest rate cutter, so I'm concluding that there are ominous signs for the Australian economy. Do you agree?

JP: Let's have a look at why they cut rates. It's always three key variables. Firstly, inflation. The RBA is targeting around 2% to 3%—currently, we're undershooting that target. On unemployment, the RBA would like to see the unemployment rate around 4.5%—we're currently overshooting that. On economic growth, the RBA forecasts economic growth of around 3.25%—we're currently undershooting that.

So we're not in a dire situation—unemployment at these levels is not a dire situation—but they're just heading in the wrong direction and I believe that this is really the RBA taking out a bit of insurance, getting ahead of the game.

What's interesting is where we are in the market cycle now. Members would recall this graph that I often put up depicting the relationship between the Reserve Bank policy, economic growth and asset prices. We see the cycle—the economy starts overheating, central banks tighten liquidity, asset prices fall, economies slow down and then the cycle begins again.

In June last year, we put up this graph and I suggested that the US was at the 12 o'clock point, where the Federal Reserve was actually tightening and Australia was just about to embark on this tightening cycle.

So where are we today? Well, it turns out we’ve actually missed a few steps. The Reserve Bank has actually eased rates. In hindsight, it appears that I was terribly wrong about where we are.

Now in my defence, as late as November last year, governor Phil Lowe actually mentioned to the market that on the balance of probabilities, the next move in rates was going to be up, not down, so there's some vindication for my position in June. But we are where we are.

And a couple of things. Firstly, you tend not to see rate cuts come in ones, so I'd expect to see another one. I'd also expect to see more pressure on the Government to loosen up the purse strings in terms of fiscal policy. Once again, easier fiscal policy and looser monetary policy—it's typically good for the share market.

MB: Now turning to global developments, talk of trade wars have dominated the news headlines but recently, this has broadened from tariff hikes to the banning of technology transfers. Does this herald the start of an economic cold war between China and America?

JP: It seems that way, Matt. If you look at what we mean by an ‘economic cold war’, well, unlike a military war—which is fought with tanks and rockets—an economic cold war is where you have a freezing of relationships and you're weaponising other things such as trade, information-sharing and access to markets. And that's what we're seeing.

If you look at the language that's being deployed by the leaders, Trump recently effectively banned American technology companies from supplying product to Huawei. Huawei is a Chinese technology company and it's actually a global powerhouse. And the language that Trump uses, he refers to Huawei as ‘dangerous’ and invokes references to ‘military’ and ‘security’, etc. These are pretty provocative words.

Then we have Xi Jinping standing in front of a rare earths factory referring to the ‘Long March’ and talking about the ‘Red Army’.

Any student of Chinese history will actually understand the significance of talking about the Long March. I won't get into that, but rare earth—China manufactures about 70% of rare earths at the moment and these are really important minerals that are used for components (electronic gadgets). So this is Xi Jinping saying ‘look, we can fight fire with fire and we're in for the long haul’.

The tariff war—really, that was not always about tariffs, it’s about technological superiority. ‘Superpower’ status is not going to be determined by who's got the most rockets, in the future&mdashit's actually who's going to be technologically superior, who's going to have the advantage in artificial intelligence and in quantum computing. It's self-evident that there are philosophical differences between the US and China that are not going to be resolved. The best I think we can hope for is a long, drawn out, uneasy truce.

MB:What are the implications for investment markets and the global economy?

JP: Global share markets are actually quite strong but we shouldn't kid ourselves. It's not because of any sort of optimism about the global economy, it’s very much a reflex reaction to the massive rally in bond yields. Consider this—Australian 10-year bond yields are now at 1.43%. Many decades ago when I was studying economics, I would have thought that would have been impossible. We've now got $12 trillion in government bonds around the world trading at negative yields. It’s incredible. So clearly, shares in relation to bonds look far more attractive, and that's what's supporting the share market.

In terms of the global economy, how this all plays out is going to take a long time because of the interconnectedness of supply chains. America has got the technical advantage at the moment, and clearly a lot of componentry that's required is American-made, but we can't get away from the fact that China is the world's manufacturer. So decoupling these two is going to be extremely complex.

I can see a situation sometime in the future where we have two technology ecosystems. One where the US is at the centre and the other where China is at the centre. That might arguably be good for national security but it's hard to see how it's going to be good for the global economy.

MB: And given it's only a couple of weeks until the end of June, let's finish with a comment on what returns our members can expect to record for this financial year.

JP: There's still two weeks to go, so anything can happen. But barring any major catastrophe, I think most of our members can look forward to a solid but certainly not spectacular year.

If you look at our Balanced option—the default investment option for our accumulation members—at close of business last Friday it was recording around 6%. As I said, solid, but hardly spectacular.

Then there's quite a range. Our best performing option is actually Listed Property. That's interesting because two years ago, Listed Property was actually our worst performing option—it had a -3% return. There are still a lot of concerns around the Amazon threat to retail, etc. but Listed Property has really benefitted from strong demand for office and industrial, particularly in the context of lower interest rates. There's also a lesson to be learned here—we did see quite a lot of members switching out of Listed Property when the returns were so poor, and obviously they're missing out on the good returns this year.

At the bottom is the Cash option—once again, not overly surprising in a stronger market.

Our Cash option is as close to a risk-free option as you could get. The Cash option is designed for those who want to preserve capital, not grow capital, so it's not surprising to see low returns.

It's human nature to focus on one-year returns, because we send statements out at the end of each financial year. But we always counsel our members to look at the long term.

MB: Thanks, John. If you have any questions for John, or feedback for us, please email us at superinformed@unisuper.com.au. Thank you for watching.

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