Will Goldilocks Burn Her Tongue?
03 Jun 2021
With regards to the economy, the desired balance is the maximum level of employment without causing inflation. Strong economic growth ensures that more of the economy’s resources are utilised. Human labour is one of the major resources and when the economy is strong, jobs are plentiful and unemployment is low. However, if the economy gets too hot, inflation ignites, with the range of problems that causes. Historically this is what happens and economists expect it to continue to be the case.
For investors, the current focus is on:
- Positives of strong earnings (profits, rent/low vacancy) which are generated in a strong economy; versus
- Concerns higher inflation will eventually lead to higher interest rates and the negative impact this would have on asset prices.
Many people look at the past to formulate expectations for the future. However, the impact of interest rates on asset prices is so important that the last 40 years are an extreme case, not the norm. As interest rates are effectively zero, we must assume that they will either stay low (no help from falling rates) or rise (massive headwind for asset values). For decades we have had gale force wind pushing up the prices of several asset classes and those days are over.
Interest rates have fallen from the highest ever to the lowest ever over 40 years. Australia did not even increase rates at any time between the GFC and the Coronavirus recession.
Short term interest rates impact the residential property market, but it is longer term bonds such as the 10-year government bond yield that drive financial markets. We have enjoyed a Goldilocks period where we had lower and lower inflation and Goldilocks could sleep well on the bed that was just right, without fearing higher inflation.
The reason for this was globablisation (tariffs came down and we bought our goods from where they were cheapest which also had an impact on the ability to push up wages) and technology, in that we could do things we could never have done before. Those smartphones made retailing a much more competitive market. Gone are the days when you can just push up prices, knowing most people are not going to bother calling every ad in the Yellow Pages and drive around town looking for the best price. With a smartphone you have everything at your fingertips and delivery as well.
This has enabled interest rates to stay low, which has been very beneficial for asset prices – residential property in particular, as most people buy with debt. Analysts at the RBA found that almost all of the increase in property prices between 2013 and 2017 was due to lower interest rates. Supply and demand, immigration and all the other list of explanations had minimal impact.
So what happens if interest rates stop dropping or at some stage start to increase? Given that rates are about as low as they can go, the only options are staying low or rising. While, global investors are very aware of this, people buying homes have little understanding. They think the past is the best guess at what you can expect in the future. The past for them is an endless period of falling interest rates and a boom in prices unmatched in human history. It is like arriving on the hottest April day in Melbourne’s history and choosing your wardrobe for the month accordingly.
The world economy looks like it is going to come out of the Covid downturn booming. If inflation stays low as the Central Banks keep telling us it will (their past predictions would not give you much confidence in their ability to predict anything) and growth accelerates, profits will rise and we could see further strength in financial markets and a hot property market. However, if inflation starts to rise and does not disappear, even small interest rate increases will ensure that party is over. Mama, Papa and Baby Bear will return home and they will not be happy.
So how do you deal with a situation that has polar opposite outcomes?