A Rate Cut Weakening the Aussie Dollar Would be Counterproductive

Remember a few weeks ago when US stocks broke out to new all-time highs?

Now we know the reason.

On Friday, data released in the US showed the economy growing much slower than expected. Wall Street thought growth for the three months to 30 June would come in at an annualised rate of 2.6%.

Instead, actual growth was just 1.2%, while first quarter growth numbers were revised down to 0.8% from an initial estimate of 1.1%.

That makes it three consecutive quarters of sub-2% economic growth for the US economy. And the stock market breaks out to new all-time highs just ahead of this news. The market knew what was coming.

That is, growth is weak enough to keep the Fed on hold (and maybe even ease again), but not weak enough to send the economy into recession. Not yet, anyway.

That’s just the way the market likes it. Hence the break out to new all-time highs.

If you think this is crazy, you’re not alone. As the Financial Review reported on Friday:

Sharemarkets are at record highs, yet professional investors around the world are scared.

So scared that in July a record proportion of them put money into investments that hedged against the risk of a potential crash, according to Bank of America-Merrill Lynch’s latest fund manager survey. That sounds entirely reasonable – there’s a lot to be worried about, after all.

Yes, there is a lot to be worried about. But when isn’t there?

One thing you absolutely must learn about the market is that it isn’t there to satisfy your views on what should happen. It’s your job to make sense of it.

Even the professionals can’t make sense of it so, as the article above suggests, they’re insuring against a potential crash.

But do stock market crashes happen when everyone (or at least a lot of players) thinks one is inevitable?

No, they don’t. At the very least, it’s a low probability outcome. Betting on a low probability outcome is not usually a profitable exercise, unless you do so via the options market (for example), where the payoff for being right is huge, but the cost of being wrong is low.

And thinking about the market ‘mood’, the present seems very different to what it was like in late 2007, when we were on the precipice of a monumental crisis.

I remember that time clearly. I was on a flight to the Gold Coast to give a seminar. I was reading an essay by former Morgan Stanley Chief Economist, Stephen Roach. In it, he pointed out the huge and destabilising imbalances that were building in the global economy.

I had been worried about the market for some time, and said so in my presentation. I told people the market was overvalued and vulnerable, advising them to avoid the banks. I remember one lady coming up to me after saying she had pretty much all her money in ANZ.

My talk had her slightly concerned. But most attendees were after tips. Not many were really interested in a cautious or bearish message.

This was in November 2007 from memory. Hindsight told us that the market had already peaked. But there weren’t a bunch of nervous Nellies around back in late 2007. In fact, apart from a fringe bunch of analysts who thought things were about to go pear-shaped, most people thought the market would only head higher.

Today, the mood is very different. Despite being eight years ago, the 2008 credit crunch is very much on peoples’ minds. The fear of another 50–60–70% crash just won’t go away.

And while not impossible, I don’t think such an outcome is likely while there is continued angst about it. The market simply doesn’t act the way most people expect it to.

That’s why you’re better off going with the flow. Don’t fight the market. Try to understand and profit from it even when you don’t agree with it.

Despite the bad news on the pace of US economic expansion, the Dow Jones index only fell slightly, while the S&P 500 finished marginally higher on Friday.

The big mover was the US dollar index, which fell 1.31%. That reflects the likelihood that the next supposed Fed rate hike won’t happen anytime soon.

Dollar weakness is bullish for gold, and the yellow metal surged around US$20 an ounce in Friday’s trade. Is the gold correction and buying opportunity I’ve been talking about over?

I don’t know, of course. But what is clear is that investors ARE buying the dip in gold. Prices don’t have to fall too much before buying support comes in. That is certainly bullish from a longer term perspective.

And what does all this mean for Australia?

Well, with the Fed again on the back foot, it’s making our currency undesirably stronger. After Friday’s trading session, it’s back up to 76 US cents. That’s not something the RBA wants.

And given they meet tomorrow to decide on whether to lower interests rates again, the dollar’s strength could have important implications.

Having said that, cutting interest rates just to weaken the dollar would be a dumb and counterproductive move. The last few rate cuts have had no bearing on the dollar. China’s latest growth pulse is having a much greater effect on the value of our currency; all the RBA has to do is wait for that growth pulse to fade, as it inevitably will.

Rate cuts simply encourage a greater amount of debt accumulation, which pushes up house prices even further and increases the long term risks to financial stability.

Another rate cut tomorrow would be grossly irresponsible. Especially given we’re not even remotely in a global economic emergency situation. What happens when the proverbial really hits the fan? We’ll be in the trenches holding a gun without ammunition, watching the enemy come towards us in their thousands.

So my guess is that the RBA will hold off for at least another month. But who knows what they’re thinking? Central bankers and their economic models are cut from a different cloth from the man (or woman) on the street…who tend to get on with things armed only with common sense.

If only central bankers had more of that…

Regards,

Greg Canavan,
For Markets and Money


Greg Canavan is a Contributing Editor at Markets & Money and Head of Research at Port Phillip Publishing. He advocates a counter-intuitive investment philosophy based on the old adage that ‘ignorance is bliss’. Greg says that investing in the ‘Information Age’ means you now have all the information you need. But is it really useful? Much of it is noise, and serves to confuse rather than inform investors. And, through the process of confirmation bias, you tend to sift the information that you agree with. As a result, you reinforce your biases. This gives you the impression that you know what is going on. But really, you don’t know. No one does. The world is far too complex to understand. When you accept this, your newfound ignorance becomes a formidable investment weapon. That’s because you’re not a slave to your emotions and biases. Greg puts this philosophy into action as the Editor of Crisis & Opportunity. He sees opportunities in crises. To find the opportunities, he uses a process called the ‘Fusion Method’, which combines charting analysis with more conventional valuation analysis. Charting is important because it contains no opinions or emotions. Combine that with traditional stock analysis, and you have a robust stock selection strategy. With Greg’s help, you can implement a long-term wealth-building strategy into your financial planning, be better prepared for the financial challenges ahead, and stop making the same mistakes that most private investors do every time they buy a stock. To find out more about Greg’s investing style and his financial worldview, take out a free subscription to Markets & Money here. And to discover more about Greg’s ‘ignorance is bliss’ investment strategy and the Fusion Method of investing, take out a 30-day trial to his value investing service Crisis & Opportunity here. Official websites and financial e-letters Greg writes for:

 


Leave a Reply

Your email address will not be published. Required fields are marked *

Markets & Money