Licensee Economic Update – June 2013
The 2012/13 financial year proved to be very good for equities and selected bond markets, but not so for gold or the Australian dollar. This is an important observation as many economists were forecasting a strong gold market from July last year whereas it’s proven to be anything but. Once again a timely reminder that markets don’t always follow economic logic and that diversification is the most assured way of capturing erratic movements between the asset classes. A year ago investors were worried about Greece and the Eurozone as well as possible recessions in the US and China. As these fears faded, so equity markets and corporate debt rallied strongly with better than expected returns.
However, following this strong rally, in recent months statements from the US Federal Reserve (FED) about ending the Quantitative Easing (QE) program “sooner” than expected has prompted profit-taking on a number of very successful positions which have been funded by cheap US dollars. Assets which have been offering very attractive yields, ranging from Australian bank stocks to high yield global debt, have been sold down sharply – explaining much of the recent retracement in Australian shares. In addition, the change in Fed policy is a contributor to the resurgence of the US dollar (making the Australian dollar weaker) which is a negative influence on commodity prices including gold. The good news is that Australian exporting can breathe more easily following a long draining
period with the A$ sitting at record peaks against many currencies.
Compared with a year ago, the US economy and the situation in Europe have clearly improved. However, the pace of growth in China, despite being good against the rest of the world, remains an ongoing source of concern and the Australian economy has continued to slow down as it feeds off this.
In Australia, the big news was mainly political with the return of Kevin Rudd to the Prime Ministership. For the moment, the only real implication of this for the markets is an increased uncertainty about the timing and result of the Federal election. Media outlets suggest an early to middle October election and business awaits this announcement with a need for policy certainty.
National accounts figures showed that the economy grew 0.6% in the first quarter of 2013 and 2.5% over the same period a year ago. Consumer spending was the strongest component of the figures. The unemployment rate remained unchanged at 5.5% in May.
At its Board Meeting in early July, the Reserve Bank elected to leave the cash rate unchanged at 2.75%. The Bank noted that growth is running a bit below trend, that inflation pressures remain subdued and that the dollar had depreciated substantially in recent months. The markets had generally expected no cut in the cash rate at this meeting but the tone of the commentary in the press release accompanying the decision suggests room for another rate cut if necessary.
Figure 1 summarises the returns for selected markets in 2012/13. Most equity markets had a very successful year, posting returns 20% or more including dividends. Emerging markets could not match this and achieved a return not much better than some of the bond indices. Among bonds, high yield stood out as the best performer for the year. The price of gold tumbled by a bit over 23% and the Australian dollar fell against the US dollar by nearly 11%.
Figure 1: 2012/13 was a big year for equity markets
In June 2012 few might have expected such an outcome. The three big issues investors were grappling with at that time were:
- 1. Would Greece exit the Eurozone and bring the whole system down?
- 2. Would the US economy have a double-dip recession?
- 3. Would China have a hard landing?
As we now know, the correct answer to each of these questions was no – these outcomes did not happen. The Eurozone did not fall apart, the US economy performed better than expected and China did not experience a hard landing. Investors who correctly identified the answers to these questions in mid-2012 then had a simple asset allocation decision to make: buy equities and high yield corporate paper.
In mid-2012 the precise details of exactly how strong growth would be in the US or China, or anywhere else for that matter, did not really matter. The simple fact that things would not turn out badly meant that the excessive risk premium built into markets would have to unwind and would thereby provide significant opportunities for profits.
What was not being talked about a year ago was the likelihood of the Fed easing back on quantitative easing any time soon. This question has caught the market out in the last few months and led to the significant declines seen in the price of gold and the Australian dollar.
It is this change in policy stance by the Federal Reserve which contributes to the unknown and leads to major questions for global investors as we enter the new financial year.
- How soon will the Fed start scaling back its purchases of bonds?
- When will the Fed stop its bond buying programme altogether?
- When will the Fed start lifting interest rates?
- Will the US economy be able to withstand these changes in policy?
Unfortunately, the answers to these questions may not be as straightforward as for the questions of a year ago. On the one hand, the Fed has been pretty clear about how it will try to manage the transition to the post QE-world. The catch with this however is that the pace of transition depends upon the pace of improvement in the US economy and in particular how quickly the unemployment rate declines to 7% and below.
This puts the focus of investors’ attention squarely back on the traditional analysis of the economic data coming out of the US each month. Reading these particular tea leaves is no easier now than it ever has been. However, the Fed has made it pretty clear that the end of QE does not mean the start of interest-rate increases. The Fed has suggested that interest rates will not start to rise before 2015 and it seems reasonable for investors to take this at face value.
The Fed knows that it is embarking upon the process of transitioning the global financial markets from one regime to another. That is, from an environment of abnormally easy monetary policy to environment of more normal monetary policy. These transitions are difficult enough at the best of times, but prematurely raising interest rates, which would have a significant adverse effect on global bond markets, would be the wrong thing to do. Investors do not want to see a repeat of the experience of 1994 when both bonds and equities suffered in the face of rising interest rates.
The Fed, the Office of Economic co-Operation and Development (OECD) and the International monetary fund (IMF) are all forecasting improved growth for the US without inflationary pressure in the coming year.
If this comes to pass, then we will see the bond buying programme being phased out over the next twelve months, hopefully without scaring investors out of both bonds and equities. Nevertheless, a characteristic feature of the transition period between regimes is increased volatility in global financial markets. This is what we are seeing at the moment as global investors take profits on existing positions and work out how to set their portfolios for the future.
If investors conclude that US and global growth will hold up over the coming 12 months despite the winding back of the QE program, Fund Manager consensus suggests it is likely that equities will continue to outperform bonds. In such instance, the current bout of volatility will be seen as profit-taking and portfolio repositioning rather than the end of the equity market rally.
In the United States the latest data shows a moderate pace of economic expansion. A survey of economic conditions across the Federal Reserve districts referred to as the “Beige Book” – showed economic conditions continuing to improve throughout most of the country. However, some regions reported slower activity as a result of the automatic tightening of the federal budget due to the ‘sequester’. (this is an across the board, automatic cut to government spending – commencing 1st March. )
One positive aspect of the sequester is that the US budget deficit is improving faster than previously expected. The Congressional Budget Office has reduced its forecast of the budget deficit and S&P ratings maintained its AA plus rating on US sovereign bonds after lifting its credit outlook from negative to stable.
The ISM purchasing managers index (PMI) rose in June marginally above in May. This result was slightly better than had been expected by the market and put the index back in positive growth territory. The regional PMI’s were mixed with a decline in the Chicago index but increases elsewhere. A range of other partial indicators released in June presented a positive story about the economy, including:
- consumer confidence increased in June;
- existing home sales rose 4.2% in May to their highest level since 2009;
- prices of existing homes rose 15.4% over a year ago;
- the consumer price index rose 0.1% in May and 1.4% over a year ago;
- housing starts rose 6.8% in May and are now more than 28% higher than a year ago;
Overall, these figures show the US economy continuing to improve, led by the household sector through consumer spending and housing activity, with inflationary pressures still very much under control.
Figure 2: A significant fall for the $A – with many of the view that more is likely to come
In Europe, political instability emerged again in both Greece and Portugal. In Greece, the government’s decision to close the national broadcasting service in order to save money prompted opposition in both the streets and the Parliament. Nevertheless, the governing coalition was able to remain intact and avoid the need for an election. In Portugal, senior ministerial resignations weakened the government’s push for austerity and reform.
These events disrupted the European equity and bond markets, especially towards the end of June, but statements from the European Central Bank (ECB) that they would continue to provide liquidity and support for the European economies for as long as is necessary helped stabilise the markets. The ECB has reduced its forecast for Eurozone GDP growth in 2013 to -0.6% (previously -0.5%) and it still sees Eurozone growth turning positive by the end of 2013 but stands ready to take action if necessary.
There was little in the way of good news out of China in June. The closely-watched HSBC PMI declined further to a nine month low in June. The indicator sits just below 50, which suggests the economy is contracting. The big problem confronting the authorities in China at the moment is how to rein in the proliferation of lending which has been supporting speculative activity in the property sector. Much of this lending has come from sources outside the state-owned banking system over the past few years. There are concerns that the credit quality of the Chinese financial system has been impaired by these so-called “shadow banking” activities and that they need to be brought under control before China suffers a serious financial market collapse.
In June, the authorities lifted short-term interest rates significantly in order to address this problem but soon had to reverse this in order to alleviate concerns in the markets. Overall, China still faces significant challenges in working out not only how to redirect its economic growth from exports to domestic spending but also how to finance that increased domestic spending.
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 above. Advice is required before any content can be applied at personal level. No responsibility is accepted by Paragem or its officers.