• RBA Deputy Governor Guy Debelle gave a speech in Sydney called “Risk and Return in a Low Rate Environment”.
• He discussed the outlook for interest rates amid a backdrop of reduced monetary stimulus by global central banks.
• Debelle said the risks posed to stock valuations from the prospect of rising interest rates have not been fully priced by markets.
• He also expressed caution about the underlying exposure to low-volatility trades faced by large institutional investors.

A key questions for global markets in 2018 is how long will the current “Goldilocks” economic conditions last?

It was a term coined to describe the combination of steady growth with low inflation.

And it’s good backdrop for stocks, because the earnings outlook benefits from economic growth without the threat to valuations posed by rising interest rates.

It was one of the themes addressed by RBA deputy governor Guy Debelle, in a speech today called “Risk and Return in a Low Rate Environment”.

And Debelle issued a word of warning about the mis-pricing of stock valuations and risks posed by a increased volatility, if and when rates start to rise.

Debelle summarised the crux of his speech as follows:

One of the main points I would like to make is that the low interest rate structure underpins many asset prices.

That is, asset prices which might look expensive are more reasonably priced given that the rate structure currently is at historically low levels.

So in my view, a fundamental question that you need to think about as an investor is: will the current rate structure remain at these levels, or will it return to the higher levels we have seen in the past?

Debelle considered the outlook for interest rates within the backdrop of the gradual withdrawal of liquidity by global central banks.

Years of monetary stimulus have helped to underpin an extended period of low volatility and steadily rising stock prices, but Debelle isn’t convinced markets have correctly priced in the prospect of changes to the current paradigm.

He conceded that calculating the exact impact of demand and supply dynamics for government bond issuance is difficult.

Nevertheless, “in 2018, there is going to be a net supply of sovereign debt to the market from the G3 economies for the first time since 2014”.

The world’s major central banks are steadily scaling back their asset purchases. And while that process will be gradual, it’s happening at the same time as the US is ramping up its issuance of government bonds to finance expansionary fiscal policy.

“If the global recovery continues to play out as currently anticipated, one would expect that the monetary stimulus will unwind, which would see at least the short-end of yield curves rise,” Debelle said.

So what does that mean for global equity markets?

The evidence suggests that stocks often perform quite well as interest rates rise, because conditions are reflective of a strong economy, and – importantly — an improved corporate earnings outlook.

But stock jitters typically occur when there’s a catalyst for interest rates to rise faster than markets anticipate.

A case in point was the market meltdown in early February — the first serious market shock-wave since 2016 — when a rise in US wage growth data suggested that inflation was rising faster than expected.

Debelle said that while central banks attempt to provide certainty by offering forward guidance about rates, there are many occasions where that forward guidance doesn’t come to pass.

“In my view, it is more important for the market to have a clear understanding about the central bank’s reaction function.”

If that’s clear, then it adds an extra layer of certainty in the event that market conditions change.

And when it comes to current stock valuations, Debelle issued a word of warning.

“Equity prices embody a view of the future that robust growth can continue without generating a material increase in inflation,” Debelle said.

“Again, there is little priced in for the risk that this may not turn out to be true.”

“Such a repricing does not necessarily mean a major derailing of the global recovery — indeed it is a consequence of the recovery — but it may have a dampening effect.”

If in fact it isn’t true, then share valuations could be further impacted by jitters stemming from the accompanying rise in volatility.

Last year’s investment landscape was defined by record low levels of volatility, and investors booked in easy gains by executing trades based around a low-vol strategy.

But the central narrative around February’s stock sell-off was an over-positioning towards trades based on low-volatility which had to be unwound when volatility spiked.

According to Debelle, “the recent episode was primarily confined to the retail market”.

However, “the large institutional positions that are predicated on a continuation of the low volatility regime remain in place”.

With the US expected to raise interest rates four times this year — starting with this Wednesday’s rates announcement — Debelle’s concluding remarks show that his view towards rising volatility is decidedly cautious.

“I have expected that volatility would move higher structurally in the past and this has turned out to be wrong,” Debelle said.

“But I think there is a higher probability of being proven correct this time.”

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