What happens if the RBA lowers interest rates?

The ASX 30 Day Interbank Cash Rate Futures Implied Yield Curve is forecasting two cash rate decreases of 0.25 percent in 2019.

The call for rate cuts seems to have picked up velocity after “celebrity” economist Shane Oliver (the one with the terrible dyed blonde hair) started making noises about the need for rate cuts. As the sage of Omaha once said, “economic forecasters exist to make astrologers look good”.

Christopher Joye, portfolio manager with Coolabah Capital Investments, has been one of the very few commentators to have been highly critical of the Reserve Bank of Australia’s insane policies. A quote from Coolabah’s web site:

Needless to say, the RBA is doing its best to once again irresponsibly inflate the hazards to which prudent investors are subject. It is quite staggering that with a 5.5 per cent jobless rate, which is a sliver above full-employment, and headline inflation within the RBA’s target band, that the central bank nonetheless deems it appropriate to impose a negative real cash rate on savers.

Other more sensible central banks around the world understand that if you keep rates too-low-for-too-long you inevitably blow asset price bubbles, an observation that has been completely lost on a myopic and immensely arrogant Martin Place, which is preternaturally incapable of admitting it is wrong.

Oh no, the rate cuts in 2016 had nothing to do with the “surprising” and striking re-acceleration in national house price growth back to double-digit rates in the months that followed. No, that was all about housing supply. Seriously Phil, bite the bullet brother.

I couldn’t agree more.

The RBA is now so addicted to the drug of inflated house prices that it is seriously contemplating rate cuts to an already artificially low rate when there is no recession and employment is as good as it has been in this country for at least 50 years! And this is all because people might feel a little poorer because their houses in Sydney and Melbourne have decreased in value by perhaps 10 percent or so, after a run up of 60-70 percent in recent years! It’s patently absurd.

Then the RBA Governor, Philip Lowe (a real life version of Nassim Taleb’s “Dr. John” character), had the audacity to call on employers to lift wages. They need to lift wages because many people in Sydney and Melbourne cannot afford to buy a house and are being hit with sky high energy prices – both of which are a direct result of government policy! 

The problem is, employers are not responsible for the breathtaking incompetence of government and they are already struggling under the burden of Australia’s already high average weekly ordinary time earnings (AWOTE), so dream on Phil – it’s not going to happen. (And if the jingoistic Bill Shorten wants to lift the minimum wage, go ahead, business will simply employ less people.)

At this point, the attempt to micro-manage the economy through the blunt instrument of interest rates is neither necessary nor ultimately effective. And let’s please remember that the majority of Australians own their own home or rent, those with a mortgage are in a minority (but are always pandered to by self-serving politicians and their factotum public servants).

The RBA has already lost significant control over interest rates. Approximately half of Australian bank funding is sourced from offshore (largely the US) and is thereby beholden to the rates that fund providers in those offshore debt markets require. A relative of mine who is a banker, told me on the weekend that if the RBA does cut rates, the banks are unlikely to pass on any more than 10-15 basis points (if they can even manage that). 

The cheapest funding source for Australian banks is domestic household deposits. These deposits finance approximately one third of the banks’ total funding needs. Most of this money comes from self-funded retirees and high net worth individuals (not always mutually exclusive groups). As pointed out by Coolabah Capital Investments, after tax, the return on these deposits is negative, i.e. below inflation.

Now, if the RBA cuts rates and banks choose to reduce rates on household deposits (i.e. term deposits) at the same time that a federal Labor government is in power (and has taken away the refunds on excess franking credits*), bank depositors will be forced to move part of this money out of the banks and into alternative (higher yielding) investments. Banks will then replace deposit funding with more costly funding sources such as hybrids and offshore funding, which in turn could result in independent bank rate rises. The exact opposite of what the nutcases at the RBA are trying to achieve.

This of course will all take time to play out, but it will happen if the RBA and the Labor party are stupid enough to do what we are supposing they will do.

Another casualty will be the Australian dollar. If the RBA actually makes two 25 basis point cuts, there is no way the Australian dollar will stay in the 70s against the US dollar. In recent times, backing the US dollar against the Australian dollar has been like shooting fish in a barrel.

Australia is a large net importer of manufactured goods and petroleum and this will result in price inflation on these goods, once again hitting the average person in the hip pocket.

With friends like the RBA and the Australian Labor Party, who needs enemies?

* Does anyone actually think that a Labor government will responsibly utilise the billions they think they are going to save from the abolition of refunding excess franking credits? And to all those younger people with self-funded retiree parents or grandparents who are thinking that all of this won’t affect them – like a thief in the night, the Labor Party is about to steal a good part of your inheritance.

Paying for alpha and getting beta (or worse)

Overall 2018 was a poor year for the performance of Australian fund managers, with some experiencing truly appalling results.

Charlie Aitkin’s Gobal High Conviction Fund lost 23.8% for the year which to me is an unforgivable performance given that the fund has the ability to go long and short and therefore should theoretically make (or at least protect) money in any environment. The Gobal High Conviction Fund now has a negative return since its inception.

In the Switzer Super Report of 27 April 2017, Charlie Aitkin wrote:

If you are going to charge active fees, which are higher than passive fees, then my view is your after fee returns have to be significantly better than what passive delivers.

I couldn’t agree more, so maybe it’s time to give up the game or return fees to investors? 

Steve Johnson’s Forager Australian Shares Fund lost 19.4% and they held (by their own admission) 25-35 percent of their portfolio in cash for the year, which makes the result truly horrendous.

The L1 Capital Long Short Fund had lost 21.9% to 30 November 2018. Very ugly indeed.

According to the Sydney Morning Herald (SMH) of 24 January 2019, Caledonia Investment’s main fund lost more than 15.6 per cent, while a secondary fund which is almost entirely invested in Zillow, Grubhub and The Stars is down 27.6 per cent. 

The SMH went on to state that Zillow shares have dropped 44 per cent in the last six months, while food delivery app Grubhub is down 15 per cent and Canadian gaming outfit The Stars is down 49 per cent. 

The SMH also stated that Caledonia has 75 percent of its funds invested in the three abovementioned companies. This is sheer hubris.

Caledonia wrote to their investors stating that: 

It bears repeating that we are not macro investors and we try not to let speculation enter our thinking.

To my way of thinking, placing 75 percent of your funds in only three companies is speculating on a truly epic level and Caledonia is now seeing the end result of that.

All of these funds charge high fees and all of their investors would have performed far better had they just invested in a low cost index fund such as those offered by Vanguard or iShares (Blackrock), or alternatively picked one of the old (low cost) listed investment companies such as Argo, AFIC or Milton and gotten far superior returns while sleeping well at night.

What all of these high fee active managers seem to have lost sight of is the first rule of money management, which is to protect the money you already have. This can sometimes mean being very defensive. It can be as simple as running a well-diversified portfolio where no investment represents an excessive percentage of the fund, keeping a reasonable level of cash (when markets are at high levels as they clearly were in 2018) and putting protection in place through the use of index put options (rather than shorting which requires far more skill). All of the abovementioned funds will have failed on at least one or two of these three points.

The Australian Government’s Future Fund now has a policy of favouring index funds over active managers and they are to be applauded for that. The Future Fund very significantly outperformed the above mentioned high fee funds over 2018 and has a very sound record since its inception. This is incredibly impressive given the vast amount of money managed by the Future Fund and the fact that its employees earn far less than your average private sector fund manager.

A lot of investors who chase higher than benchmark returns are really giving up birds in the hand for birds in the bush. In addition, it’s hubris on the part of investors to believe that they can pick active fund managers who are going to outperform over time – this is truly a fool’s game. But as I’ve said before, there is no shortage of fools in this country and nothing that I write (or anyone else writes) will change that (they make more of them every day).

Footnote: One of the outstandingly positive performances from an active manager in 2018 was John Hempton’s Bronte Capital. Bronte’s Amalthea Fund returned 20.8 percent in 2018. However, since its inception, Amalthea has only outperformed its benchmark (MSCI ACWI) by 0.8 percent per annum (14.1 versus 13.3 percent), which shows that even the best of them struggle to materially outperform a passive index.

All quoted performance figures are from the fund managers’ own web sites (apart from Caledonia Investments which was sourced from the Sydney Morning Herald).

How is Charlie Aitkin doing at Aitkin Investment Management?

Back in 2016 I wrote an article on this site regarding Aitkin Investment Management (which you can read here).

I mentioned a few things in that article which (for me) I thought were red flags. I won’t repeat all of that again - you can read the original article for yourself. 

So, how is Aitkin Investment Management (AIM) doing? Well, not that great. The chart below from AIM shows the performance of the Global High Conviction Fund.

However, what is more worrying is the following table from AIM showing recent performance:

The calendar year performance of -12.6% is rather shocking against a backdrop of the ASX S&P200 return of +9.44% (as I write this) and the US S&P500 return of +10.56%. It means AIM has underperformed this year by 22-23%, which is a terrible result on any measure.  

Please don’t get me wrong, it’s quite ok to underperform an index, but to underperform by a large double digit amount can only indicate that stock selection has been very poor.

Charlie Aitkin made the following statement in the Switzer Super Report on 13 April 2017:

As you know I am broadly cautious on all things USA, but particularly the US Dollar and US equities. This year I am far more bullish on China, feeling Chinese economic growth is running ahead of bearish expectations.

Aitkin also stated (in the same article) that:

I warned that the “Trump trade” was in trouble and it clearly is.

But it wasn’t! Both of these statements were totally incorrect.

US equities have vastly outperformed Chinese equities since Aitkin made these comments. What’s even worse is that the Australian dollar has also dramatically depreciated against the US dollar. Those of us holding US dollar investments (or even just US dollars) are making sound returns on the depreciating Australian dollar (alone). The decision by Aitkin to be cautious on “all things USA” and instead buy Hong Kong listed stocks has cost his investors dearly.

On 21 April 2016 in the Switzer Super Report, Aitkin had the following to say about Telstra:

All in all I believe the worst is behind TLS on all fronts and, for the first time, my fund now owns TLS shares. I think they are now cheap and have dividend certainty. I also think they will outperform the ASX200 on a total return basis from this point.

Put it this way, if over the next 18 months the TLS share price did recover to $6.00, the capital gain would be +10% and 18 month dividend yield 8.8%ff. Add on the value of franking credits and there is the potential for a +20% total return in TLS over the next 18 months, if I am right and the recovery continues.

Of course, it all needs monitoring as we progress but I think this is a major turning point for TLS and I’ve put my fund’s money where my mouth is.

Once again, Aitkin was completely wrong. Telstra was trading at around $5.42 when the above statement was made and what did you get if you took his advice? You got around 42% of your capital incinerated. To be fair, I own Telstra as well, but I bought them at a much lower price than was being advocated by Aitkin back in 2016 (I still made a mistake though).

To try and be a bit balanced here, Aitkin has made some good calls. His advice to buy Washington H. Soul Pattinson (the Berkshire Hathaway of Australia) was great advice. He wrote a very good article about the company in the Switzer Super Report and we are now seeing the share price of Soul Pattinson (SOL.AX) starting to reflect its true value as one of the most outstanding companies on the ASX.

But in many ways, this is my point, so many “professional” fund managers in Australia are totally hit and miss with their stock picks. Because of this, there is no way I would pay their 1.5% fee for assets under management, plus the performance fees of 15% or so. You can see (above) from AIM’s own data that anyone holding a MSCI World Index ETF will have easily outperformed AIM’s Global High Conviction Fund. 

In Australia, when a new high fee fund manager sets up business, you can almost put money on the fact that they will have a few good years early on and then regress to below benchmark (index) performance. As I’ve said on this site previously, the fee structure of these funds basically guarantees below benchmark performance over the long-term because the stock picking skills of the individuals running them are not good enough to overcome the drag of the fees involved. Someone as eminent as Warren Buffett has commented on this at length and people don’t listen to him, it’s just staggering that investors don’t get this.

So, we will continue to watch the performance of AIM and hope for the sake of his investors that Charlie can reverse his form slump and not drop too many more catches (he loves his cricket metaphors).