Licensee Economic Update – September 2013
This report has been delayed pending the Australian Federal election – which has completed and markets now await evidence of consumer and economic confidence lifting as a result of the change in government. In the broader world economies, data released in August painted a picture of improving growth in most of the developed nations overseas with the US and Europe posting stronger than expected figures.
Problems with inflation and current account deficits in some of the emerging market nations attracted more attention last month as the effects of the Fed scaling back its QE program start to be felt outside the US. The Australian economy continues to soften, although many believe the new government will clear the field for improvements in business and consumer confidence. Certainly noises from business leaders prior to the election indicated this. The Reserve Bank left the cash rate unchanged at 2.5% at its Board Meeting on 3 September, but made it clear that further depreciation of the $A would help the economy. Developments in the civil war in Syria have become a concern for financial markets, with the US and UK administrations discussing potential military action against the Assad regime. The more muted performance of equity markets in August and the spike in volatility reflect this.
The outflows from bond mutual funds and Exchange Traded Funds [ETF’s] in the United States are accelerating as investors come to grips with the bottom of the interest rate cycle and imminent changes to the Federal Reserve’s bond-buying program. Reports suggest that a whopping US$30 billion left these funds in the first three weeks of August, more than double the amount withdrawn in the whole of July. Views remain mixed on how much further bond yields might rise around the world, but as long as the economic growth figures are good and inflation remains under control, then bond yields will be under pressure to rise and equity markets are likely to outperform bonds.
Figure 1: Volatility spiked in August but Australian shares performed….again
Despite the uncertainty of an election, consumer confidence rose 3.5% in August. The Reserve Bank’s successive cut in the cash rate over the past year and a half seems to have contributed to this improvement since its low point in 2011. Figure 2 compares consumer confidence (red line, left hand scale) with the official cash rate (blue line, right hand scale). Note that the cash rate has been inverted in this chart to show more clearly the relationship between monetary policy and consumer confidence. The Reserve Bank lifts the cash rate (blue line goes down in the chart) in periods of stronger consumer confidence, which then eventually falls. Conversely, as the Reserve Bank cuts the cash rate (blue line goes up in the chart) so consumer confidence rises again, but with a lag of several months.
Figure 2: Falling interest rates boost consumer confidence – a feeling of cash in pocket
It is interesting to compare how consumer confidence rebounded sharply as the Reserve Bank cut the cash rate from over 7% to 3% in the GFC with the more muted response of consumer confidence to the phase of interest-rate cuts starting in late 2011. Although the cash rate is now lower than it was in the GFC, consumer confidence is still well below its previous peak. One would assume this reflects, a general perception that the economy is in a more difficult position now that the “China boom” is perceived to be over, with implications for job security and prospects. Forecasts from politicians and Treasury of rising unemployment have added to these worries.
The poor state of the Federal budget and politicising of this may also be contributing to caution on the part of consumers. The figures contained in Treasury’s Pre-Election Economic and Fiscal Outlook report confirmed the pessimistic forecasts of the budget deficit presented by the government a few weeks before the election. Households realise they will have to shoulder part of the burden of repairing the budget through a combination of higher taxes and lower benefits and are adjusting their behaviour accordingly.
One brighter spot in Australia’s data came from a report of further increases in house prices in the June quarter. This surge was noted in the last report and many believe it will continue with assistance from borrowing within the DIY superannuation market. Perth and Darwin led the way with increases of
3.4% and 2.9% respectively, while prices in Sydney and Melbourne rose 2.7% and 2.4% respectively. Hobart was the only capital city to record a fall in prices (-1%). In short what we are seeing is the established housing market being one of the main beneficiaries of lower interest rates at the moment.
The Reserve Bank left the cash rate unchanged at 2.5% at its Board Meeting on 3 September, but made it clear that further depreciation of the $A would help the economy. Financial markets and commentators still expect the RBA to cut the cash rate again at least once and perhaps twice in coming months. In its latest Statement of Monetary Policy, the RBA slightly lowered its forecast for real GDP growth this year and next, but left its inflation forecast unchanged. The RBA continues to expect inflation to be well-behaved and not at risk from the weaker dollar or higher wages.
Key statistics on the US economy showed further good news. For example:
- real GDP growth rose at an 2.5% annual rate in the second quarter, which was slightly higher than expected;
- the manufacturing index rose in August and most of the sub-components of the index were over a level which separates economic expansion from contraction – this is very encouraging;
- banks’ lending standards have been relaxed further for both businesses and households and the demand for loans from commercial and industrial firms is increasing;
- the US trade deficit fell 22.4% in June driven by an increase in exports and a decline in imports;
- a number of US firms reported good second-quarter earnings results;
- retail sales rose 0.2% in July, which was a little less than expected;
- inflation remains under control with the CPI 2% higher than a year ago;
- consumer confidence rose again in August.
Debate about when the Federal Reserve will begin scaling back its program of Quantitative Easing [QE] in bond purchases continues to preoccupy the financial markets. The President of the Federal Reserve Bank of Chicago cited “good improvement in the labour market” as justification for starting the wind back of QE in September. The President of the Federal Reserve Bank of Dallas effectively told financial market participants that that they are just going to have to live with the end of QE and that they cannot expect the Federal Reserve to be there for them for ever. The general expectation now is that the Reserve will start to scale back its bond purchases, in a process dubbed the “Taper”, in September.
The emerging market nations have been in the headlines recently with comments suggesting these markets are especially at risk from the effects of the above Taper. In light of this focus, ‘Snapshot’ is explaining this subject under its own heading this month and excluding China which has minimal change.
Where all the noise is coming from is that QE provided a steady source of cheap funds with which investors could purchase high yielding bonds from around the world. Purchasing bonds denominated in currencies other than the US dollar was particularly attractive because a key objective of the easing programme was to depreciate the value of the US dollar. High yielding bonds issued by emerging market governments proved attractive opportunities for these investors. However, now that the Fed has flagged phasing out QE, these investments are starting to look less attractive.
For example, just as QE pushed the US dollar down, so unwinding QE has started to push the US dollar up and the currencies of the emerging market nations down. This will erode the capital gains made on these investments, leading many investors to exit their trades to realise these gains. Depreciating currencies also contribute to inflationary pressures in the emerging nations, which further undermines the attractiveness of their bonds.
The impact of all this varies from one emerging market nation to another. The countries which are most at risk are those with large current account deficits and relatively high inflation rates. This includes Venezuela, Argentina, Brazil, India and Indonesia. These countries have experienced sharp falls in their exchange rates in recent months. The authorities need to tighten monetary policy in order to protect their currencies and mitigate inflationary pressures. This will in turn damage their domestic growth prospects. Not surprisingly, these nations are urging the US Fed to consider their plight when QE is unwound. The Reserve has quite reasonably pointed out that its mandate is to run monetary policy for the United States, not the rest of the world.
However it is very important to note not all the emerging market nations are suffering these problems. Korea and Taiwan are doing particularly well with low inflation and interest rates, current account surpluses and stable exchange rates. Within Latin America, Mexico and Chile are in much stronger positions than Brazil, Argentina and Venezuela. Malaysia and Thailand have relatively low inflation and interest rate structures, but have seen some downward pressure on the currencies recently.
Figure 3: Inflation is a problem for some emerging market nations, – but not all of them
Overall, the MSCI emerging equity market index does not look like it is going to be posting strong gains relative to develop all equities in a hurry. However, within the emerging market block some countries will continue to do better than others. It would be premature to extrapolate what we are seeing in selected countries into a repeat of the emerging markets crises seen in the early 1980’s and late 1990’s.
Furthermore, the latest figures from China have been better than expected. For example:
- exports rose 5% in the year to July, a noticeably stronger result than for the month of June;
- industrial output rose nearly 10% in the year to July, ahead of economists’ expectations;
- retail sales grew a bit more than 13% in July;
- inflation remained at 2.7% in the year to July
Data from Europe showed further improvement in growth in the region albeit steady and of a low base. GDP growth rose 0.3% in the second quarter of 2013, led by improvements in France and Germany. The Eurozone manufacturing index rose in July, the first time the index has been above 50 since 2011 (readings of 50 indicate that an economy is growing rather than contracting). Unemployment in Spain and Portugal fell the most in two years, though as figure 4 shows unemployment rates are still painfully high. Industrial production in Germany rose in June by the most in nearly two years and other measures of activity in the German economy also surprised on the upside in July and August. This better data for Europe comes at a timely moment when the Eurozone needs some positive momentum to help offset any adverse effects of the scaling back of monetary policy stimulus in the United States.
Figure 4: European unemployment rates outside Germany are painfully high
All in all, this month has been an encouraging staging ground for long term investment growth.
The challenge for many investors has been reducing their Bond exposures versus remaining diversified and exposed across asset classes irrespective of volatility and outlook.
In many respects, long term holdings overcome these timing issues. So it’s very much an issue of being active to add value and possibly reduce volatility –or remaining diversified and focussing on the long term with a view to achieving a similar outcome.
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.