Licensee Economic Update – May 2013
Overall the month of May saw most asset classes retreat from the extraordinary run of the past 11 months, resulting in more long term returns becoming the norm. There’s an old adage known as “Sell in May and Go Away” and although this expression is more of a mysterious tale, once again it proved to be the case for the month. The index’s below show how most asset classes performed and highlight the difficulty of diversification in such a short time frame. The key message is to remain focussed on the long term outcome and not get distracted by events that no one can control or predict.
The wobbles that all financial markets started to experience were mainly driven by concerns about when the United States will start winding back its Quantitative Easing (QE) programme. This programme has no known outcome because of the level of debt and the unknown beyond the easing programme – hence uncertainty and volatility. The actual wind back is most likely to be a gradual shift rather than a dramatic change of policy and it has become known by economists as the “taper”. – as in a gradual tapering effect.
Although we experienced a poor month, in some respects financial markets may be jumping the gun on the above QE issue. As highlighted in previous editions, the US economy continues to improve, but not at a pace that would suggest the ‘taper’ is imminent. Growth in Europe remains sluggish and the authorities have taken steps to provide more support from both fiscal and monetary policy. The latest data for China continues to show economic activity at the more moderate pace seen in recent months.
Both equity and bond markets struggled in May and the $A continued with its slide towards US$ 0.95. Some commentators believe the A$ will now move towards its long term trading pattern against the US$ This is somewhere between 0.65c 0.85c and if it proves to be an accurate view, international investments purchased at the higher rate will lead to increased portfolio returns for long term investors. The price of gold also continued its recent dip.
However it is worrying for all that the Australian economy has slowed further and the federal budget last month highlighted the need for an extended period of fiscal restraint, which will inevitably act as an additional drag on growth. The Reserve Bank did not cut interest rates at its June Board meeting, but the odds favour further cuts in coming months.
Figure 1 summarises the returns for selected markets in May- Volatility spiked.
The main issue for the markets in May once again came from the United States. Where markets were disturbed after reported comments from Federal Reserve officials suggesting the Reserve may start easing back its liquidity policy as soon as June/July 2013. This issue accelerated in May, causing a further sell-off in assets across the board. Not just risk assets, but also bonds were sold.
How justified are financial markets in worrying about the Reserve tapering the programme any time soon? As flagged last month, much depends on the speed with which the US economy improves. In particular, how soon will the unemployment rate get to the Reserve’s target of 6.5% with inflation remaining under 2.5%?
Simple projections suggest this may be achieved by mid-2014. However, the risks are probably skewed towards this taking longer to achieve rather than sooner.
On the one hand, the US economy is recovering – although the data is still very mixed. For example, while consumer confidence improved in May to the highest levels seen in five years, a leading manufacturing survey fell back into contraction territory. Sales of both new and existing homes rose in April a bit more than expected but new construction starts fell 16.5% in April.
Economists opine the labour market story may not be as simple as it seems. A key feature of the decline in the unemployment rate has been the contribution of
the people who have left the workforce rather than keep looking for a job and thus be counted among the unemployed. Economists call this a fall in the participation rate. The impact of this is shown in Chart 2.
Figure 2: The improvement in unemployment may not be as good as it looks……
Without the lower participation rate, the US unemployment rate would be much higher than it is today. The Federal Reserve is well aware of this and has also made it clear that they will be flexible in how they handle it.
Furthermore, the start of the taper – whenever that is – does not necessarily mean they will start selling bonds and raising interest rates. The Reserve has bought so many bonds under the Quantitative Easing programme that it may never be able to sell them without risking massive disruption to the financial markets. A more likely scenario is that they will simply hold the bonds to maturity. As for interest rates, it may still be 2015 before we see moves to lift US rates off the zero floor.
On the whole, this seems like a fairly benign and pragmatic approach from the Federal Reserve. Compared with the usual obtuse central bank double-speak we see, Bernanke has been pretty clear about what they are doing. It may be that the markets have been looking for a trigger to take profits on some positions which have been held for some time and delivered great value. All this may take a while longer to play out before we see a resumption of preferences for growth-oriented assets.
The latest data on the Australian economy show an economy slowing down. For example, the first quarter GDP statistics were weaker than expected with the economy growing around 2.5%, which is below the 3% trend rate of growth. Consumer confidence fell 7% in May, which was the biggest monthly decline since December 2011. Job vacancies fell 2.4% in May after falling 1.7% in April to what the ANZ described as “the lowest level so far in this cycle”. Household surveys also showed more people are concerned about losing their jobs.
The Federal budget probably contributed to the decline in consumer sentiment. The message presented by the government and Treasury about the budget has deteriorated sharply over the past few months. Businesses and households know they will be the ones paying for it to be fixed and that this will mean a drag on growth for some time yet. In addition, the risks to Treasury’s forecasts are such that the fiscal situation may get worse before it gets better.
Commentators point to some irony in the fact that the Treasurer, having pilloried the Europeans for their fiscal tightening, has bequeathed Australia the need for the same medicine – albeit on a smaller scale. The government’s other legacy of a less competitive and less flexible labour market will only impede the process of adjustment, while the Europeans have learnt the lesson about labour market reforms. A corollary of the likely slower growth path for Australia is that interest rates should be lower than they otherwise would have been.
Notwithstanding the softer data, the Board of the Reserve Bank decided to leave interest rates unchanged at its meeting in early June. In a statement released after the meeting, the Bank noted the slower pace of growth and that inflation remains under control, while the effects of past interest rate cuts are showing up in household behaviour. The lower $A was mentioned as a factor contributing to easier financial conditions which did not justify an immediate rate cut. However, the Bank noted scope for further rate cuts in future if necessary.
The contrast between the US and Australian economies shows up very clearly in the exchange rate. Figure 3 compares the $A/US$ exchange rate (red line) with the US unemployment rate minus the Australian unemployment rate (blue line). This differential between unemployment rates is a simple measure of the relative pace of growth of the two economies. It is also a shorthand way of looking at the relative momentum of monetary policy between the two countries (assuming inflation is not an issue).
Figure 3: As Australia slows and the US speeds up, so the $A/US$ will likely fall
As the chart shows, the difference between the two unemployment rates is a useful leading indicator of the broad path of the exchange rate. The chart suggests there is already sufficient relative momentum between the two economies for the $A to decline to around US$0.90, which is a level flagged by many commentators. It also suggests the path of currency depreciation will extend well into next year – or, in other words, that the current depreciation of the $A is indeed a major turn rather than just a bout of short run volatility
Meanwhile in Europe, the German economy expanded a mere 0.1% in the first quarter of 2013, this is less than had been expected. Growth in the Eurozone as a whole fell 0.2% in the first quarter, after falling 0.6% in Quarter 4 2012. This was the sixth consecutive quarterly contraction. The European authorities eased some of the fiscal adjustment pressure on several nations by giving them extra time to meet their budget deficit obligations.
The news out of China in May continues to suggest the economy is moving sideways rather than accelerating. This included:
- Exports rising 14.7% in the year to April while imports rose +16.8%;
- CPI rising 2.4% in the year to April, driven by higher food prices;
- Premier Li said the government will not enact further fiscal stimulus measures as long as unemployment remains acceptable; price stability is more important than boosting growth.
Finally out of interest more than anything else, we thought we would look at the impact of volatility on active investment managers. One of the consequences of the central bank liquidity programme in recent years has been the so-called “chase for yield” which has seen money flowing into higher yielding assets pushing those yields down across the board. This has provided some very attractive returns for managers that are described as long-only bond and equity managers.
Figure 4: Greater volatility means different opportunities for active managers
The spike in volatility associated with the GFC stands out very clearly in the chart, as does its subsequent decline. The increase in volatility in the last six months or so is also noticeable and this partly explains the improved performance by managers using investment styles known as selected absolute return strategies.
Regardless of how soon the Federal Reserve begins to modify its easing programme, it is reasonable to expect increased volatility of this kind to be a feature of the financial markets in coming years. This will provide a different set of challenges for active investment managers, both long only and absolute return.
Absolute return managers best placed to exploit what is termed cross-sectional volatility should do well, while long only managers who are best placed to exploit opportunities across the full spectrum of their markets should also do well.
This has been prepared by Paragem Pty Ltd [AFSL 297276] and is intended to be a general overview of the subject matter. The document 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 this document. Advice is required before any content can be applied at personal level. No responsibility is accepted by Paragem or its officers.