Tuesday 11 November 2014 by Legacy

IMF and RBA reinforce ‘lower for longer’ and ‘USD bull run’ themes

IMF World Economic Outlook – global growth revised downwards

In October, the IMF released its World Economic Outlook, including revised global growth forecasts.

The main message is the global economy is taking longer than expected to recover. The IMF has reduced its forecast for 2015 global growth to 3.2%, with 3.1% expected from the U.S., 1.3% in the euro zone and 0.8% for Japan. China’s projected 7.1% growth would be the country’s lowest in 15 years. The disparity in growth rates among the big four economies, the U.S., China, Japan and the euro zone, is significant.

The IMF sharply cut its forecasts for the main euro zone economies, and assigned circa 40% chance to prospects of outright recession in the euro area as a whole according to Bloomberg. The chances of Japanese-style deflation were also put as high as 30% according to Bloomberg.

Closer to home, wholesale prices have fallen every month since April 2012 in China. The huge increase in spending on plant and equipment over many years is now leading to excess production capacity, falling prices and lower profit margins. China is obviously a major importer of raw materials, many of which are sourced from Australia, so a slowdown in 2015 world growth will have a direct negative impact on the Australian economy.

The IMF expects Australia to grow by 2.8% in 2014 and 2.9% in 2015, but still below its long-term average of around 3.25%.

If correct, this picture is one of low global interest rates for the foreseeable future and a relatively strong US economy, where the USD continues to appreciate.

RBA Minutes – Australian growth to remain subdued with larger uncertainty

On 7 November 2014, the RBA released the minutes of the monetary policy meeting.  Growth forecasts are 2-3% for 2015 (unchanged from the August statement) and 2.5-4.0% for 2016,a larger range than the 2.75-3.75% guidance from the August statement, suggesting increased uncertainty. The lower AUD is likely to be ‘a small boost to GDP in the near term’ but ‘the key forces shaping the forecasts remain as they were’.

CPI forecasts are lower in the near term following the removal of the carbon tax, but marginally higher beyond that as a result of the lower AUD at 2.5-3.5% in December 2015 (unchanged from the August statement) and 2.5-3.5% in December 2016 (nudged higher from 2.25-3.25% in the August statement). 

How to invest if you believe interest rates will be ‘lower for longer’ and the ‘USD bull run’ will continue

Both reports above reinforce the themes of global and Australian interest rates remaining ‘lower for longer’ and the ‘USD bull run’ with lower global growth reducing any impetus for rate rises and the outperformance of the US economy likely to see a continued strengthening in their currency.  Lower than trend growth in Australia and China is also expected to restrain local interest rates and the AUD.

So if you believe these themes will remain, here are some strategies to profit from these trends:

Buy bonds over cash/term deposits: Buy a diversified fixed income portfolio paying circa 6%. Do not just sit in cash and short term investments waiting for something to change.  You may be waiting a long time.  Lock in good returns as the opportunities present.   A diversified bond portfolio is paying roughly twice the return of cash.   This is a significant difference.  For example $1m at 3% is $30k, while $1m at 6% is $60k. With base rates so low, the additional return from credit margin is magnified. A diversified portfolio of high yield (high credit margin) bonds is also a way to increase these returns. Typically credit margins will tighten when interest rates do eventually rise, offsetting any price impact on fixed rate bonds. Names such as Qantas, Adani Abbot Point Coal Terminal and 360 Capital may suit in this regard. For more information please see “How to reduce bond reinvestment risk and increase returns”.

Protect against long-term inflation:  Inflation is forecasts to be lower in short term but higher longer term rising off the back of a falling AUD driving up import prices.  Consider inflation linked bonds which provide long term protection against inflation.   

Gain exposure to the USD:   The IMF, World Bank, OECD and most of the G20 central banks are forecasting the US economy to be growing faster than the G20 average for the next 2-3 years at least. The USD therefore should perform against AUD.

The simplest way to profit is to be “long USD”, that is have a direct exposure to US Dollars. You can do this through a US bank account (very low interest); US shares unhedged; or USD denominated corporate bonds. The latter strategy has been one our clients have been successfully using for some time with yields of 2-10% p.a. on top of the 7.7% rise in the USD in the last 12 months.  This is also a strong hedge against the likelihood of falling equity returns when the global economy is slow.

Invest in Australian corporates with an exposure to export earnings:  Some companies will do well in a falling AUD environment, despite the slower economy.  Sydney Airport for example benefits from increased tourism traffic and to a lesser extent Perth or Brisbane Airports. Universities such as ANU may benefit from an increase in high fee paying international students.  Similarly, exporters such as Mackay Sugar, Newcrest and Fortescue will also benefit from a lower AUD, although the falling commodity prices (in USD) may offset some of this benefit.