Tide change

Most of our predictions are based on the assumption that liquidity will continue to be withdrawn until monetary and fiscal conditions reach and surpass their neutral level – whatever that means in a possibly unprecedented environment – at which point central banks and governments will learn how badly they have overshot their targets and begin the next easing cycle.

Market chatter is starting to turn to the overshoot even as inflation prints continue to surprise to the upside in mid-2022, which suggests most analysts are at least confident that the rules remain the same even if the state of play has changed.

I am not absolutely convinced this is correct. Central banks may be sticking to the old monetary policy norms but there are clear signs that governments are less willing to give up the popular option of fiscal stimulus. Confronted with the undoubtedly distressing impact of spiralling cost of living pressures, Australian state governments are using helicopter money to subsidise domestic power bills. The race to be the next prime minister of the UK is, in its early days, shaping up to be a battle over which prospective leader can promise the most expansive tax cuts.

It seems, in other words, that governments have not got the message about tightening. Once again, this is likely the consequence of the dismal state of public discourse. In markets, we know that the bottom line of today’s economic conditions is that some pain is coming. It might be in the short term, as wages continue to lag inflation and households feel the pinch of cost of living pressures. Or it might be more protracted, in the form of the dreaded wage-price spiral.

Unsurprisingly, this does not seem to be the focus of discussion in most public forums. Instead, we seem to be willing to blame national leaders for the global oil price, banks for not absorbing higher cost of funds or any of a range of implausible factors.

Personally, I cannot help feeling the unwillingness to acknowledge that things are not going to be pleasant stems at least in part from a tacit awareness of how inequitably the up and down sides of the past decade and a half have been distributed. “We’re all in this together” rings less true to a populace that has been consistently bombarded with clear evidence that some of us are more in it than others.

Still, for the time being I think it is relatively safe to assume that tightening will go on. No-one is yet storming the central banks demanding they abandon the basic principles of monetary policy to keep mortgages and the wider cost of living affordable, for one thing. It is a curious paradox that even as we increasingly disparage politicians’ ability to solve our problems, we seem more willing than ever to hold them directly responsible for causing those problems in the first place.

The most interesting question is what the longer-term impact of a more capital constrained world will be. We have already seen some early signs that the catch-all term “the global hunt for yield” is starting to go into retreat. The cryptocurrency crash might just reflect a Ponzi scheme that finally ran out of greater fools, but it does seem at least plausible that it did so because there was simply no more money willing to chase fantasy returns. Was this the direct consequence of the end of direct, personal stimulus in most of the developed world? It is a hard line to draw with any degree of certainty, but it does not seem implausible.

In the non-pyramid-scheme markets, I have been interested in the phenomenon of Japanese investors selling down foreign currency assets, including Australian dollars. There is of course a significant caveat here: the Japanese investor base has followed a similar path on numerous previous occasions and the near-term driver – profit taking on positive FX moves – has a well-established precedent.

Something different this time, however, is commentary about the Japanese selling to the effect that these investors are, for the first time in decades, finding appealing fixed-income allocation opportunities in their home market. If policy tightening has already reached the point at which yen yield is worth considering for outright-return investors, it is pretty clear that market dynamics are shifting significantly.

Such an evolution might at first glance seem to be a problem for the Australian capital market. There is no doubt local rates and credit markets have benefited substantially from global participation, and that this involvement has at least in part been driven by the hunt for yield.

The activity of investors motivated by global relative value initially helped create a market with arbitrage pricing that was of particular benefit to international supranational, sovereign and agency (SSA) names. But, over time, the bid diversified and brought demand benefits to issuers for which the Australian dollar is their sole or primary market – especially local sovereign and semi-government credits.

This maturity in turn created new relative value opportunities for SSAs and a range of credit products, as well as increasing the profile of the Australian dollar market as a whole. Arguably, international demand was the largest single cause of growth in Australian dollar credit issuance during the 2010s – albeit definitely not the only one.

If the global bid retreats to any significant, protracted extent one has to assume it will pose a challenge for the Australian dollar market, including to its depth of liquidity and the breadth of issuers to which it will appeal.

On the other hand, it is hard to imagine a more capital-constrained world will leave Australia marginalised. If anything, the tsunami of liquidity poured into global markets since the financial crisis has obscured Australia’s status as a global investment powerhouse, thanks to a domestic superannuation industry that had grown to A$3.4 trillion (US$2.4 trillion) in assets under management by the end of March 2022.

The scale of Australian retirement savings is well known but bears repeating. According to the Willis Towers Watson Global Pension Assets Study 2022, published in February, Australia’s superannuation pot is the world’s fifth largest in aggregate – well behind the US but in a group with the UK, Japan, Canada and the Netherlands – and its second largest as a proportion of national GDP, at 172 per cent.

If easy liquidity is not going to be an ongoing feature of global markets it is easy to imagine a restored primacy of real money taking its place. This could be a game changer for sustainable finance, among other things. Arguably the biggest challenge sustainable finance has faced has been the lack of genuine compulsion.

Ultimately, most businesses, projects and assets have been able to find capital even if they are lagging on environmental, social and governance standards. It is one thing to be forced to look to second-tier or noncore financiers but quite another to be contemplating complete lack of access to funds. Whether sustainability truly becomes core to capital allocation – and quickly enough to support a timely zero-carbon transition – remains to be seen, but for the first time in decades the foundational conditions may be in place.

The outlook is also unclear for the Australian market itself. It would be nice for local participants to assume that the draw factor of domestic capital will in and of itself protect and expand the Australian market ecosystem. But things could easily go another way, especially if the managers of the superannuation pool feel their funds have already and irrevocably outgrown the local market. Not so much a big fish in a small pond, in other words, as a fish that is already swimming in a global ocean.

To some extent this is inevitable: there is no way the ever-growing pot of local capital could be allocated domestically, let alone with any reasonable degree of diversification. But this does seem to be a moment for the Australian market to redouble its efforts to present a global face, as a place to find funding, to transact and to work. Hong Kong’s apparently declining status as a regional hub may also present an opportunity here, much as Singapore is likely best placed to take advantage of any serious migration.