– Special Edition

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Tuesday’s surprising rate rise by the RBA is likely to cause many more problems than the one it is “supposed” to fix.  Principally, this rate rise is designed to control inflation which simply isn’t a problem by any real measure we can find and can only be based on the RBA’s apparent blind faith in the Phillips curve.

Essentially, they believe that as the unemployment rate falls, inflation must rise and they place the tipping point at 5%.  This means that as the unemployment rate reaches the 5% level they feel compelled to raise interest rates in an attempt to increase it again.

In other words, the RBA believes it is an economic catastrophe for everyone to have a job.  Whilst we can find no evidence to support this Phillips curve theory and plenty to debunk it[1], the RBA remains fixated.  They believe that if everyone has a job, employers will be force to pay more to retain good staff, forcing up wages.  This means everyone will have more cash to spend and prices rise as a result, pushing up inflation.   So much so that Tuesday’s announcement also indicated more rate rises are on the way!

As an employer however, I can assure you that giving all my staff a pay rise tomorrow will result in a dollar for dollar reduction in profit at exactly the same time.  I.e. higher wages without productivity and profit increase means a corresponding reduction in profit (i.e. income) for shareholders/business owners.  If anyone owns a business where this doesn’t occur, please let me know your secret!

So whilst employees have more money to spend, employers have the exactly the same amount less to spend. It’s hard to see how this will increase overall inflation.  Granted, this may be a little simplistic but it’s far more representative of the actual result than the Phillips curve.

The bad news is this is bad news for the domestic economy which, as far as we can tell, is in OK shape at best and far from the inflation surging beast the RBA seems to think it will become.  Just as the 12 rate rises through to 2008 all but plunged us into a recession, the RBA’s latest rise and accompanying comments suggest we could be headed this way again.  Last time we were saved by the GFC, which provided the opportunity to reverse the damage virtually overnight, ultimately averting catastrophe.  This time however we are unlikely to be so lucky and besides, who wants to be wishing for GFC2 anyway?

So what does this mean for investors?

For the time being it means we continue to remain more defensive in our investment positions, ie large companies, solid sectors such as energy & resources which are less reliant on the domestic economy (don’t worry we can still make money!).  With the significant printing of more money about to get underway in the US we had been hoping to reposition portfolios to sectors most likely to benefit from these measures.  The move by the RBA however makes such a move more uncertain and hence we will remain cautious.

The net result is we expect global markets to outperform our local given the significantly better conditions.  Why? Globally any attempt to stimulate growth is being considered whilst domestically the RBA seems keen to reign in any signs of growth possible.

Meanwhile Joe Hockey seems intent on extracting every possible political advantage from bashing “the banks”.  Now whilst I have no particular love for the “Big 4” I do have a significant distaste for lies and fabrications as a means to a personal end by those who do, or at least should, know better.

The fact is, (emphasis on fact), the banks get the majority of their funding from sources other than the RBA, namely depositors and overseas lending markets.  The costs for both of these sources of funds continue to remain high and as a result the main cost to the banks, ie the cost of money, is increasing, even if the RBA doesn’t increase the cost of their funds.  This is easily seen in the profit results of these companies, all of which have shown decreasing interest margins.  The only real mistake they’ve made is to make these changes in line with RBA announcements, which reinforces the public myth.  The fact that they do is in fact evidence that competition is alive and well, as no one wants to move first.

So is this profit reasonable and where did it all come from?

CBA Results 2007-2010

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Looking in little deeper into CBA’s results over the last few years shows a fairly steady rise in profit punctuated by a drop in 2009 Interim results.  It doesn’t take much further delving to find the principal reason behind this drop and the corresponding resurgence is largely due to bad debt provisions.  In Westpac’s case this alone was $1.84 Billion.

During the “GFC period” CBA, along with their colleagues decided that it might be prudent to dramatically increase their provisions for bad debts in case the economy really did tank and all those highly leveraged homeowners started defaulting on their loans.  This directly impacts (ie reduces) the profit booked.

Now that that hasn’t happened anywhere near the extent provided for, they have reduced these provisions so we get a corresponding rebound in profit.  In reality however, some of this profit is from prior years and hence this should be considered in any analysis.

Besides, what would we have them do?  Imagine the local baker getting hammered by Hockey for increasing the price of bread by more than the cost of flour, even though wages and rents have doubled.  The fact is the price of money will (and should) be whatever they can get away with.  The only effective way to deal with this is more competition, however this can be a double edged sword.

If you think increasing competition in the banking sector is the silver bullet, you may want to take a quick look at the US where rampant competition has brought the banking and housing sectors to their knees, with the legal system and government also struggling to stay afloat.

The other big issue for the bank’s competition is their own cost of funding.  Second tier institutions such as Credit Unions already access wholesale funding at greater costs due to their lower credit ratings.  The RBA rate hikes don’t help the competition as the total cost of funds increases for these players.

During the GFC we were thanking our financial institutions for their calm and sensible practices and our regulators for ensuring adherence to standards.  The banks can claim at least as much credit as any politician for our safe economic passage through the GFC.  Their US and European cousins race to over-compete and chase profits above all else is primarily responsible for the issues now faced by credit markets.  You can’t posture about effective governance and more competition and then complain when these don’t deliver what you want.

In conclusion      

So by all means let’s look at ways to increase competition in the financial sector but in ways which help, not hinder and let’s start by addressing the real issue, the cost of funding.   Be prepared however, to find that it may not be broken and therefore should be left alone, even though you don’t like it.  The reality is someone does like it and is benefiting from it being this way, you just have to find a way to switch sides.  After all that’s the great thing about economics, there are always winners and losers and the playing field has a great way of self-leveling provided some good intentioned politician doesn’t get in the way.

So whilst we don’t agree with the RBA’s moves and I don’t like paying more on my loans either, this is all evidence the system is actually working reasonably well and doesn’t need significant, particularly uninformed populist interference.

Perhaps Westpac shouldn’t have acquired St George or CBA BankWest, but the demise of Wizard and RAMS along with Aussie’s move to broker rather than pure lender also had an impact.  All these were in some way related to the increase in funding costs of the “securitisation” market which had brought significant competition to the main banks.

This same securitisation was ultimately at the heart of the subprime crisis which sparked the GFC so it’s not without its problems; however there’s plenty of evidence to suggest that more balanced access to wholesale funding is the key to keeping the Banks honest with real competition.  The Banks meanwhile essentially benefited, either directly or implicitly from taxpayer guarantees and hence were able to gain some advantage and not just survive, but continue to prosper.  The answer may lie in a more level playing field for access to wholesale funding.

The good news(?) may be that with the Banks increasing rates a bit more it should mean the RBA will have to be more cautious about future official increases.  If it were up to me, I’d much rather rates set by the market, even one with limited competition.

 

 

[1] We’ll cover this to a future monthly article
[2] Source: ASX announcements

Matt Battye

Matt Battye

CEO, Financial Adviser

Analysing what can seem to be like complex issues, Matt is effective in using analogies to better explain scenarios and truths to the rest of us. This is what Matt enjoys – educating clients on the truths and debunking the commonly held (wrong) view.

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