In 2020, the Reserve Bank of Australia could initiate a plan to reignite our economy.
The effect of this plan will likely have big consequences for the stock market.
It could ignite a surge in the ASX that would take stock prices way higher than anybody expects.
Westpac’s respected chief economist Bill Evans expects this to happen in the second half of 2020.
Though it could come sooner.
I cannot think of a more important story for Australian investors in 2020.
The plan the RBA is considering is not a new plan, though.
In fact, it goes all the way back to the eve of the First World War...
The year is 1914…
London is the richest and most powerful city on the planet.
The British Empire is at its peak. The first era of globalised trade is at its zenith.
Then, on 28 June, the Archduke Franz Ferdinand is assassinated in Sarajevo.
But it barely causes a ripple in London markets.
Indeed, British investors are more vexed over UK policy towards Ireland.
It’s not until a month later, when Austria gives Serbia an ultimatum, that markets go into a state of panic.
Investors begin to flee to cash…
European stock markets begin closing to halt the panic selling…
Gold gets hoarded…
By 31 July, UK regulators close down the London Stock Exchange (LSE) — the largest securities exchange in the world.
The British public now know the situation is grave.
The LSE had never closed before — except for holidays.
New York follows.
London is the banker to world trade.
The world’s first global financial crisis now hits — and threatens to send the British credit system into complete meltdown.
Money market rates double.
Britain declares war on Germany on 4 August.
You know how this story ends.
But I tell it because there’s a little-known fact from this period of history that most investors are likely oblivious to.
And understanding this aspect of the 1914 crisis gives you direct insight into what could be in store for Australia in 2020.
As you’re about to learn, you can use this knowledge to your great advantage…
Because if I’m right, the ASX could massively inflate on this fact alone.
In July 1914, markets weren’t prepared for a continental war.
The implications became huge as the reality and gravity of the situation dawned.
Credit began to contract…
Foreign banks based in London began calling in loans.
That meant their clients had to pay back their loans in an instant — or default.
But that wasn’t the worst of it...
Foreign debtors to London couldn’t access sterling finance to settle their accounts in the UK.
That began to stress UK financial institutions that were relying on their clients to pay up.
German and Austrian clients owed an estimated £70 million (the equivalent of billions today).
The most crucial aspect of this was that the British banks became vulnerable.
Depositors began to withdraw cash and gold in nervousness — draining liquidity away from the banking sector.
Many of the banks held securities on the London Stock Exchange but couldn’t sell them to raise cash to help them in the cash crunch. The exchange was closed.
And now loans (their assets) were becoming stressed because their clients couldn’t roll over their financing.
The money market froze as war loomed all over Europe.
London banks — in the financial capital of the world at the time — were in danger of bank runs and going broke. And all on the eve of a major conflict.
A small London bank called the National Penny Bank failed on 1 August that same year.
The fear in the British government began to escalate.
Why am I telling you this?
And what does it have to do with the ASX in 2020?
Because of precisely HOW the Bank of England — the UK’s central bank — resolved the crisis.
Ben Bernanke would echo this very move 94 years later in 2008.
And the Reserve Bank of Australia looks likely it will do the exact same thing here in 2020…
Banks in peril are a disaster for any economy, at any time.
This is because they create the money supply that finances all our transactions and spending.
A major credit contraction will nosedive the economy.
That’s what Britain faced in 1914 (and the USA in 2008).
In 1914, the British banks held vast holdings of ‘discount bills’ that were either in default or heading there.
This threatened their solvency.
The Bank of England, with British government backing, stepped into the market and bought the troubled assets off the UK financial firms and the British banks.
It did this using the power of money creation that all central banks have.
They can create (or destroy) as much money as they want.
In 1914, the Bank of England flooded the financial system with liquidity in an audacious move on an unprecedented scale at that time.
For all intents and purposes, it was an operation to reflate a fast ailing economy.
The Bank of England’s purchases were equivalent to 65% of central government spending or 5.3% of GDP.
This is very similar to what the Fed did in 2008, too.
And here’s the rub: It worked!
The English financial system stabilised…and the entire crisis was resolved in about six months. If only it avoided the Great War.
Now, we don’t have a financial crisis on our hands in Australia…
But we do have a credit contraction stifling the economy.
Australian credit is at a 2.5% annual growth rate currently — the slowest pace in nine years.
This is why the consumer economy is so flat.
The Reserve Bank of Australia is perfectly aware that it must do everything it can to get this growing again.
The RBA also keeps missing its growth and inflation targets.
It really only has one tool left in the kit…
It’s the same one the Bank of England used in 1914.
What did the Bank of England do exactly?
Maybe you’ve already guessed…
The Bank of England ran a ‘quantitative easing’ (QE) program — except nobody called it that then.
This same policy, or at least a variant of it, is now highly likely from the Reserve Bank of Australia this coming year.
You’re going to start hearing a lot about this in 2020.
The time to prepare is now.
The American QE programs fooled many investors when they ran.
Those who didn’t understand the banking system expected inflation — even hyperinflation — and bought gold and hard assets as a result.
The inflation never came. It was never going to.
Even legendary financial observer Jim Grant admitted this year in a profile:
‘“What I missed in 2011 was the technical fact that the dollar bills that the Fed was creating effortlessly were not in circulation in the broad economy… but were locked up in the reserve accounts of the banks at the Federal Reserve system… They did not make their way into the broad economy to finance the next inflation,” he explains.’
He wasn’t alone.
For years I’ve been delving into why many intelligent people were wrong-footed on this issue…
But let’s get the origin of the term ‘QE’ out of the way first.
It came from an article on monetary policy in Japan in 1994.
A financial analyst called Richard Werner was urging the Bank of Japan to use its powers of credit creation to kick Japan out of its large recession at the time.
He was looking for a term (in Japanese) that inferred something different from the standard central bank policy of interest rate reductions, plus — and here’s the most important bit — a way to increase money circulating in the real economy.
The English translation of his policy proposal came out as ‘quantitative easing’.
Werner proposed that the Bank of Japan buy the troubled loans off Japanese banks.
That’s right — just like the Bank of England did in the UK in 1914.
This would allow Japanese banks to begin lending again.
This term, and the policy, appeared in a 1995 article in Japan’s largest business paper.
See it for yourself:
Source: University of Southampton
Now, this is where we come to a confusing fork in the story…
In 2001, the Japanese central bank adopted the term quantitative easing, but not the same policy recommendations Werner put down.
This ‘official’ Japanese kind of QE is now known to be useless.
I mean, just look at the Japanese economy and stock market…it’s gone nowhere for two decades.
In 2008, Ben Bernanke at the US Federal Reserve got much closer to Werner’s original proposal (though not all the way).
This is a major part of why the US stock market roared back up after the low point in 2009 — until today.
This is important to understand when it comes to judging the upside and the risks on the ASX in 2020.
You’ll often hear QE dubbed as an ‘unorthodox’ or ‘unconventional’ policy in the financial press.
It’s nothing of the sort.
Central banks have been buying and selling assets for as long as they’ve been around.
Which brings us to today…
Australia is inching closer to some version of QE every day.
I believe 2020 is the year it initiates its ‘Operation Reflation’.
And if I’m right, it gives you an amazing opportunity.
Mainstream economics and the media constantly reiterate that interest rates are the dominant tool for ‘monetary policy’.
This is based on theory only.
Here are the facts…
Interest rates follow growth, not lead it.
The most important variable in the economy is NOT interest rates.
What matters is the amount of credit creation.
This is why observing the Big Four Aussie banks is so important.
It’s the banking system — and not the RBA or government — that creates 96% of the Australian money supply.
Banks don’t lend deposits. They create credit from nothing.
We get a rising housing market if this credit goes into housing.
We get a rising economy if this credit goes into productive business.
And we get inflation if it goes into consumption.
Philip Lowe, the Governor of the Reserve Bank, addressed the issue of QE in a speech in November 2019.
He declared QE unlikely in Australia and, if it were to happen, would involve the RBA buying government bonds in the secondary market.
This is, as of now, the equivalent of the official Japanese version of QE, and not similar to what the Bank of England did in 1914 or what Werner called for in 1994.
This version of QE is unlikely to have much effect on the Australian economy, except to pin down interest rates. This hits the return retirees can get from term deposits even harder than the way things are now. The market appears to be pricing in QE coming to Australia, despite Lowe’s public reservations.
The ASX rose in value by $33 billion, or 1.6%, on 16 December as QE became even more likely.
That was the market’s best trading day since May!
As I said above, Westpac’s respected chief economist Bill Evans expects QE by the second half of 2020.
Here’s why the RBA’s hand may be forced here. The current policy rate is 0.75%.
That leaves the RBA two rate cuts before it’s pointless to go lower.
It may already be pointless now.
The banks are unlikely to pass on any further rate cuts from the RBA in a meaningful way.
Their margins and earnings are under already pressure. Lower interest rates would drag these down even further.
Bank chiefs work for their shareholders and not the Reserve Bank.
That’s a big problem for the RBA. Monetary policy is useless without passing through to the household sector via lower mortgage rates.
Rate cuts have little room to work further.
As far as I can see, QE is the one way left they can get things moving...
The men and women at the RBA are the true princes of the ASX.
They hold the monetary levers.
Pressure is likely to bear down on the RBA to not only introduce QE, but also in a different way to what Lowe guided last month.
The RBA needs to alter its QE guidance away from government bonds to directly helping the Australian banks.
There are two major reasons to suggest this. One is practical.
There is a relatively small pool of Australian government bonds available.
Australian banks must hold these as part of their liquidity and regulatory needs.
The RBA buying any of these would shrink the number of bonds available even further.
The second is more important…
Australian consumption is flat.
The RBA, in the absence of strong wage growth, needs to stimulate this.
The RBA could use QE to help the banks lower their cost of funding and…here’s why you care for the markets…get mortgage rates lower to drive up consumer sentiment and spending power.
This could lower mortgage rates further while protecting the bank interest margins and therefore profits and stock prices.
What I’m saying is that the RBA doesn’t WANT to do this.
But it’s going to HAVE to do it.
The federal government has staked its political legitimacy on delivering a federal ‘surplus’ in the budget.
PM Scott Morrison and Treasurer Josh Frydenberg also dare not risk Australia’s triple-A rating (this keeps borrowing costs low all over the country).
But the consumer economy is weak. Australians are paying down debt instead of spending because of weak wages and high debts.
My bet is the market will be hunting for the RBA to launch QE in 2020 — and price it by lifting stocks higher.
But that’s not all…
The property market is now recovering.
This could allow the big banks to regain some earnings growth in the near future.
This possibility, alongside Australia’s strong resources sector, makes me bullish for the Australian market for the first half of 2020.
Of course, a wild card event could change that.
But as it stands right now, the RBA looks like it will keep interest rates very low for a long time.
This alone could drive up stocks as investors look for income via dividends.
The Australian market yields a healthy 4% currently.
That’s an outlier in global markets. It’s below half that in the US for the S&P 500.
For NAB, WBC and ANZ, the yields are even higher, at over 6%.
Since September, I’ve tracked the travails of the Aussie banks over their compensation payments, money laundering transgressions, and new capital rules from the Reserve Bank of New Zealand.
I believe most of these issues are now priced in.
The banks make up 20% of the index. They need to lift for the market to push substantially higher from here.
QE could help make that happen.
This gives us a potentially great entry point to ride any climb higher in the Aussie market as the pressure for QE and government stimulus builds.
The question is entry into WHAT?
Well, the obvious thing to do would be to buy the Big Four banks directly.
You could do that. Ahead of the RBA’s Operation Reflate could be an ideal time to do so.
But I believe there’s a much better, simpler and potentially more lucrative way to play this situation…
The latest GDP figures show Australia is growing at a 1.7% annual clip. That keeps Australia’s domestic economy grinding along in a ‘per capita’ recession.
But one thing can’t be denied. Our export sector is booming. It’s at a record high!
Here’s what most people don’t know when it comes to how Australian growth is reported. There are two ways of reading GDP.
One is the ‘nominal’ GDP rate…and the other is the ‘real’ rate.
The real rate purports to strip out the effects of inflation to arrive at the genuine growth in the economy.
However,as Reuters reported in early 2019:
‘Australia’s export earnings are booming as resource prices surge but a statistical quirk means tens of billions of dollars go missing from main measures of growth, making the economy seem weaker than it actually is.’
What appears to happen is the higher prices for Australia’s commodity exports — iron ore, LNG, gold, etc. — are written off as inflation and taken out of the ‘real’ GDP figures.
This figure is what attracts attention in the mainstream press. But part of that ‘missing’ cash is pouring out of natural resource stocks on the ASX.
Fortescue Metals Group Limited [ASX:FMG], for example, is up 150% in 2019.
BHP Group Limited [ASX:BHP] paid a record high dividend this year and had its biggest profit in five years.
Rio Tinto Limited [ASX:RIO] also declared a ‘surprise’ US$1.45 billion special dividend in August 2019, thanks to the booming iron ore price.
Even Perth property prices have finally stopped their slide after five down years.
This is not to say all is hunky-dory in the Australian economy.
But major resource stocks like BHP, Rio Tinto and Woodside make up big numbers on the ASX and — this is a key point — they serve the international market too.
The share market couldn’t care less about what a bunch of statisticians say are Australia’s GDP figures.
Investors can see the profits and dividends flowing into the related companies.
One reason that iron ore prices — and Australian exports in general — have held up, despite the US/China trade war, is that they are disproportionally used in the Chinese domestic economy and not its export sector.
And that looks to be in very reasonable shape…
Chinese behemoth Alibaba Group Holding Limited [NYSE:BABA] is a good proxy to measure the Chinese consumer.
Its recent Singles Day sales event on 11 November 2019 smashed its previous sales record.
The stock has now gone into a new high for 2019. See for yourself:
China is not currently sending signals of distress, with iron ore around US$95 a tonne and Australian commodity imports showing strength.
The windfall from the current iron ore price is likely to show up in the revenue of the Aussie federal government.
The Treasury has used conservative estimates of iron ore at US$55 for its projections.
If the current high price of iron ore endures well into 2020, then it actually gives the government some hope of stimulating the economy and protects the promise of delivering a ‘surplus’ at the same time.
BOTTOM LINE: There’s scope for the entire Aussie index to lift over 9,000 points (it’s currently at around 6,800).
Here’s why I say that…
Researchers in 2018 did a comprehensive study on the effect QE had on UK and US stock markets after they used the same policy.
Here is what the findings stated: ‘…unconventional policy measures adopted caused increases in equity prices of at least 30%.’
However, I’d be reluctant to go too aggressive at the moment.
There isn’t a heap of momentum or strength outside the top stocks on the ASX.
You can see the small-cap index topped out in July 2019 and appears to be going sideways currently:
My suggestion is that you should stick with where the current strength lies — the top 50.
The recent battering in bank stocks has suppressed the index.
I think this gives us a compelling entry point for any rally in the first half of 2020.
Of course, the risk with this strategy is that my read of the market is wrong and stocks weaken from here.
It’s possible that the banks fail to rally, QE never happens and the iron ore price weakens substantially.
That would drag down the ASX because it’s so dependent on these factors.
However, I believe pressure on the RBA and the government to stimulate the economy will soon force them to act and lift the ASX higher in the short term.
The recovering property market adds another kick.
Over in the US, we also have Donald Trump entering an election year and running huge deficits.
My assessment is that the markets are still building towards a peak but have not yet reached a level of unacceptable risk.
Therefore, my recommendation is to position for further upside in Australian stocks in the first half of next year (with the usual volatility along the way).
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The prospect of QE alone could inflate the ASX in early 2020. I recommend you take advantage of this favourable trend while it’s there.
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