Licensee Economic Update – Feb 2014
A combination of softer than expected economic data from the US and China plus renewed pressure in emerging markets from the impact of the US Taper has led to renewed volatility in global financial markets since the start of the year. In addition, mixed earnings reports from US companies have contributed to the markets’ nervousness. Interestingly equity markets fell and bonds rallied in a reversal of the pattern of performance seen in previous months.
However, despite the volatility the situation is probably not as grim as the markets seem to fear. Latest US data has been distorted by exceptionally poor weather and the figures from China are consistent with the slowdown most commentators have been expecting for 2014.
As for emerging markets falling – some clearly have significant problems to deal with while others are in much better shape. The media tends to make this one homogenous heading which is not an accurate picture. In fact it would be premature to extrapolate the current difficulties into global contagion and downturn. Indeed, for the counter intuitive or counter cyclical investor, emerging markets are trading at a 30% discount to historical value and ‘may’ appear opportune to invest for the long term. The key phrase is long term because of the unknown timing of value being reflected in share price movement. To help us understand emerging markets better, Snapshot has focussed commentary on the sector in this edition.
In other news, the World Bank raised its global growth forecasts slightly from 3.0% to 3.2% for 2014 and the Reserve Bank of Australia left interest rates on hold and indicated this might persist for some time.
Figure 1: January saw volatility return to global markets
(VIX is the volatility index)
There were some data surprises during the month in Australia and this has carried into recent weeks. Most notable was the increase in the NAB business conditions index and the December quarter CPI reading. A variety of factors including some weather-induced increases in fruit and vegetable prices and faster than expected pass-through of the impact of the $A depreciation helped push the headline CPI up by 0.8% in the December quarter to 2.7% for the quarter as a whole. The underlying inflation rate was 2.6% for the year, just above the middle of the Reserve Bank’s target range. The NAB business conditions index rose to its highest level in more than two a half years in December, although business confidence was roughly unchanged. Components of the index showed improvements in sales and profits in the wholesale, transport and services sectors and some improvement in the employment index. However as usual there were mixed messages with some of the forward indicators within the survey casting doubt on whether the improvement will be maintained.
Given the stronger readings on these two key indicators of growth and inflation, combined with further reports of higher house prices and continued improvement in construction activity, it came as no surprise that the Reserve Bank Board decided to keep interest rates unchanged at its February meeting. One of the most interesting lines in the Reserve Bank’s media release announcing the decision was the reference to a likely period of stability in interest rates.
It makes sense that the Reserve Bank would keep interest rates where they are for a sustained period of time while they assess the impact of competing forces on the Australian economy in 2014. Although the housing sector appears to be responding in the way the Bank wants, consolidation of the Federal Budget will provide significant fiscal drag on the economy in the coming year.
Figure 2: The latest NAB combined with higher than expected inflation helps rule out further rate cuts
In other news, employment fell by 22,600 in December with a small increase in part-time employment being more than offset by a substantial decline in full-time employment. The unemployment rate remained steady at 5.8%, reflecting a decline in the participation rate from 64.8% to 64.6%.
Finally, it was interesting to see the $A kick up in reaction to the news of no more rate cuts. To many experts this seems a little misguided. One key driver of the $A in 2014 will be what happens to the US dollar and by extension the US economy. As long as the US economy continues to grow in 2014 and the Federal Reserve completes the Taper then it is realistic to expect the US dollar to appreciate further and assuming so, we will see a lower $A/US$ as a result. Domestic interest rates have much less to do with it.
Although growth has been solid, some of the more recent economic data from the United States has not been as good as the markets had hoped. For example, the January ISM (a manufacturing index) released a few days ago came in 10% lower to the previous month. A number of components within the index fell and the index commented that unusually adverse weather conditions had influenced the results. Even so, the figures shocked the market, with the S&P 500 falling sharply on the news. Part of the markets’ surprise at this result was because the ISM was so much weaker than the other partial indicators of manufacturing activity had been suggesting.
Figure 3: The latest ISM reading shocked the markets, but may be a one-off
The December employment report was also weaker than expected – again due to weather conditions. Although payroll employment posted a gain of only 74,000 in December, well below the consensus expectation of 197,000, the unemployment rate still declined from 7.0% to 6.7%. This reflected a further decline in the participation rate to 62.8%. Weather conditions may also have affected the pace of new housing starts in December which were nearly 10% lower than in November and new home sales which fell 7% in the month. In short the freezing weather pattern has had a dramatic impact on economic data.
Despite this conundrum in the USA, real GDP growth reached 3.2% in the fourth quarter of 2013, which was higher than had been expected and was received very favourably by the markets. Retail sales also rose slightly more than expected in December and consumer confidence had an encouraging rise in January. Latest readings show both producer and consumer price inflation remained subdued. The Congressional Budget Office released updated projections for the US budget including a downward revision to the deficit (US$ 5.4 billion) in 2014. Uncommon news from America.
Finally, we should remember that the Federal Reserve has been quite clear about its flexible approach to the Taper. Although the Reserve reduced its bond buying program by another US$ 10 billion a month in January and indicated that markets should not expect it to moderate the Taper to accommodate difficulties faced by other nations, It also said it may choose to do if the US economy were to slow in a meaningful fashion. It would appear one way or the other, financial markets will either get the growth they want to see, or the prospect of growth via the actions of Reserve. This should help underpin risk assets through 2014.
Turning to what is termed ‘the emerging markets’ where there has been considerable volatility in recent times, we are seeing another chapter in the drawn-out process of getting over the Global Financial Crisis. A number of emerging market countries coped with the sharp fall in export income in the GFC by boosting domestic demand through higher government spending. At the same time, having learnt some hard lessons from the Asian Crisis of the late 90s, these countries had taken to issuing government debt denominated in their own currencies rather than in foreign currencies.
Global investors were attracted to the high yields and appreciating currencies of this debt at a time when the Federal Reserve was pushing US interest rates to zero and actively depreciating the US dollar. Consequently foreign investors wound up holding much larger shares of emerging market debt in their portfolios than envisaged. Once the Reserve started the Taper and the US dollar started to appreciate against the emerging market currencies, these positions no longer seemed as attractive and were unwound leading to volatility in prices.
Despite aggressively moving into the sector through 2012 early 2013, global investors have been aggressively reallocating money away from emerging market assets. For example, in January more than US$7 billion of Exchange Traded Fund holdings (effectively index positions) in emerging markets were liquidated. This in part explains the reason for falling share prices.
Some countries are now better placed to handle these pressures than others. Those countries with large budget and current account deficits and low credibility of economic policy are finding their exchange rates vulnerable to sustained international selling. The risk then becomes that currency depreciation feeds into rising inflation which has to be met with tighter monetary policy. That in turn undermines prospects for economic growth which is necessary to support the valuations of the assets purchased by foreign investors. Furthermore, lessons from past crises around the world suggest that aggressive interest rate responses to currency depreciation can threaten the stability of banking systems and lead to much greater economic downturns.
In terms of countries being affected, The massive depreciations of the Argentinian and Venezuelan currencies stand out and dwarf the experience of the other nations. Nevertheless, many of the other Emerging Countries are experiencing significant depreciations which have been met with interest rate increases, especially in India, Indonesia, Brazil and Turkey.
The key question for global investors is whether these problems will remain specific to their countries of origin or whether they spill over into a general global contagion. The latter could happen either through trade channels, banking system exposures or financial market sentiment. However most analysis to date suggests that although the emerging market nations now account for over just over 40% of global GDP, the exposure of the developed market countries through trade channels and banking systems are not really large enough to be cause for concern.
The biggest potential risk could well lurk in adverse financial market sentiment snowballing around the world. At this stage, economist consensus suggests it would be premature to expect this to happen as a base case forecast. Further credible policy action from the most prominent troubled emerging market countries would contribute to easing financial market concerns.
Not surprisingly, the chances of a smooth resolution of these problems would be enhanced most by the US economy picking up and growing in line with consensus expectations rather than continuing the pattern seen over the past month or so. Better growth in the US and Europe, combined with stability in China, would provide a positive tailwind to help the emerging markets balance their growth from domestic to export driven demand and relieve some of the pressure on their currencies at the same time. This of course is where the counter cyclical investors thrive.
Given no one can predict markets accurately and timing markets is a financial health hazard, the only question in portfolios would therefore be is the risk of Emerging Markets offering upside with modest diversification from major economies. The risk return equation implies the risk is higher than last year due to the current outlook – but time and patience in investing is generally rewarded.This has been prepared by Paragem Pty Ltd [AFSL 297276] and is intended to be a general overview of the subject matter. It is not intended to be comprehensive and should not be relied upon as such. We have not taken into account the individual objectives or circumstances of any person. Legal, financial and other professional advice should be sought prior to applying the information contained in the above. Advice is required before any content can be applied at personal level. No responsibility is accepted by Paragem or its officers.