This past week, the Reserve Bank of Australia kept the official cash rate on hold after consecutive interest rate cuts to a record low 1 per cent. Futures markets are expecting a further cut at the next meeting to 0.75 per cent and further cuts early next year. Essentially, the market consensus is for an official cash rate in Australia of half a percent in 2020. A little over a decade ago when the cash rate was at 7.25 per cent, some Australians had mortgage rates with a nine handle. What a difference a decade makes, writes Cameron Black.
Australia is not alone. The last decade has seen central banks globally flood the market with extraordinary amounts of liquidity. During the GFC the Fed Funds Rate in the US sat between 0 and 0.25 per cent for an extended period of time, before taking a decade to rise to 2.25-2.5 per cent. However, the cycle has now reversed with the Federal Reserve cutting interest rates last week. The market is expecting interest rates to almost halve over the next year with 100 basis points of easing priced in.
In Europe the situation is similar, with the European Central Bank (ECB) essentially having had interest rates at zero for the past decade. Perhaps more instructive is the fact that many European sovereigns have negative yields. That means investors pay countries like Germany and France to take their money. Even Greece, which teetered on the verge of bankruptcy not too long ago, can issue long term debt at under 2.5 per cent. It’s worth keeping in mind that these are nominal interest rates – they don’t take into account inflation. When you consider the corrosive impact of inflation the returns of bondholders are even lower. UBS just announced that it will charge deposit holders -0.5 per cent for the privilege of having cash in the bank. Other major banks are likely to follow.
Closer to home, the Reserve Bank of New Zealand surprised markets by cutting interest rates by 0.5% in one go. There have only been three other times in its history that it has done this – after 9/11, during the GFC and following the Christchurch earthquake. In other words, during emergencies. The fact that it has felt the need to do so now says a lot about the predicament the world is in and gives an insight that property investors should heed.
One of the major factors that drives property prices is interest rates. One reason is lower mortgage repayments that effectively reduce the cost of property ownership and increase the borrowing power of existing and prospective property owners which raises prices. However, falling interest rates have another impact – they make the cash flows generated by the property relatively more valuable. When you can get seven per cent on cash in the bank, a four per cent rental yield isn’t all that attractive. When you can only get one per cent on cash in the bank, a four per cent rental yield is suddenly incredibly attractive. All else being equal, the owners of assets such as property benefit when interest rates are falling.
It’s also important to consider that we live in a world where capital is both mobile and global and that global events matter to local asset prices. The global interest rate situation could be compared to a ‘drowning’ effect, where weak economies are dragging down the strong. As interest rates fall to record low levels in major economies such as Europe, other countries are forced to reduce their interest rates as well or risk having their currency strengthens to levels that render their exports uncompetitive. Essentially, we have a global race to the bottom that is only picking up speed.
The other issue is how dependent markets have become on ultra-low interest rates and easy liquidity. The mere suggestion by central bankers that interest rates may rise results in sharp drops in stock prices, such as the so-called ‘taper tantrum’ in 2013 and the sharp correction in December 2018. Central bankers fret that the market uncertainty could result in reduced economic growth and ultimately bow down to market pressure. Markets react to positive economic news such as low unemployment negatively as it may mean the removal of stimulus, whilst negative economic news can send stocks skyrocketing. This perverse ‘good news is bad news and bad news is good news’ cycle also applies to property, where despite a weak economy property prices have surged on the back of cheap money over the last decade, albeit with a pullback recently.
Investors desperate for returns are forced to invest in assets they believe to be overpriced in a weak economy as cash effectively earns nothing. This process has been sustained without losses as interest rates decreased further but there is a natural limit to how far interest rates can fall as they approach zero. Other non-conventional monetary policies such as quantitative easing (QE) have been of questionable efficacy and are believed to exacerbate inequality through increasing asset prices whilst having a limited impact on the general economy. The question property investors must ask themselves is how much of a property’s value is attributable to easy money and should that easy money be withdrawn is that value likely to disappear.
Property investors can take solace that ultra-low interest rates are likely here to stay for the next decade. For the last 40 years interest rates have trended down globally, the reason for which is not fully understood by economists. Some attribute it to China’s integration into the global economy resulting in cheaper exports of goods and a savings glut that reduced the cost of capital. Others believe the huge technological innovation and digitisation of the economy has led to deep structural changes in the economy that have had profound impacts on the cost of capital.
The key factor in all of this is inflation. All major central banks have an inflation target – in Australia the RBA aims to keep inflation between two and three percent. When inflation is above the target band rates will rise, and when it is below rates will typically fall. Despite extraordinarily easy monetary policy and money printing on an industrial scale via quantitative easing, in almost all major economies inflation has been moribund – flying in the face of traditional economic wisdom. Low unemployment has also not driven up wages as would typically be expected. No one is expecting the re-emergence of inflationary pressures to return anytime soon and there is talk of a ‘new normal’ of ultra-low rates and low inflation.
The prospect of being stuck in this low rate trap for another decade no longer looks remote. Western countries are rapidly ageing, as is China. The demographic dividend that fuelled such remarkable growth by baby boomers is now going into reverse. In all major economies the ratio of workers to non-workers is decreasing markedly, as the burden of government debt and higher taxes to pay for all the costs that come with an ageing population weigh on the economic engines in the West. Populations are also shrinking as birth rates decline. Much of Australia’s economic good fortune has been driven by immigration. However, the reason why our economic expansion hasn’t felt so great to many Australians is that on a per capita basis we’re barely growing. Three per cent GDP growth is of little benefit if the population has expanded by three per cent.
There is one country for which this scenario has played out for several decades already – Japan. The median age in Japan is 46, a full 12 years higher than Australia. A third of Japan’s population over 60 years of age. Not only is its population ageing, but it is declining. In 2014 Japan’s population was 127 million. By 2050 the population is estimated to be 97 million. Japanese companies rationally expect their addressable market to decline reducing the business case to invest in capital and equipment. They also can’t raise prices as demand continues to fall each year. Rather than inflation, Japan has been beset by deflation – where prices of goods fall each year. Consumers hold off on purchases knowing that they will be cheaper next year further exacerbating the economic malaise.
Western Europe, the United States, China and Australia all face the same demographic trends as Japan. Our populations are rapidly ageing. The relative working age population is shrinking. A smaller proportion of workers will be forced to bear the brunt of an ageing population with huge medical expenses and retirement and pension provisions that defer spending ever further into the future. Markets are hooked on extraordinarily accommodative monetary policy and any attempt to take it away sends asset prices into a tail spin. Such low interest rates lead to investment in inefficient projects that otherwise would never get off the ground weakening long-term economic growth.
Property investment is a decades long endeavour. Understanding where interest rates are likely to be over the next decade is fundamental to property investing. Low interest rates typically lead to high asset prices. However, it is falling asset prices that higher property prices. Property investors must ask themselves how much more accommodative monetary policy can get – how much further can interest rates fall? They must also consider how comfortable they are acquiring assets at artificially high prices in a fundamentally weak economy. Finally, what happens if inflation does eventually return and interest rates ramp up? Even in this slow growth world one thing is for sure – investors can expect a bumpy ride.
Cameron Black is the managing director of Certainty Property.