Remember just a few months ago when one big broking house was calling oil prices to fall to $20 while, at the same time, another was forecasting $200? There is nothing new in attention-seeking forecasts – it’s a bit like a girl wearing “killer” heels or a young man driving “that” sports car!
Those of us who invest for a living (rather than just talk about it) need some basis in fact. And fact is thin on the ground in commodity price forecasting. Until the start of the 2014-15 financial year (FY15), all we seemed to have to be really worried about was the slide in iron ore prices.
A deliberate over-supply by the three big guys was to blame – or so we thought/think. Oil prices came on the radar in July 2014, but the OPEC decision not to take action to halt the slide in September 2014 sent shivers down our collective spine.
Whether we look at the US-relevant price (WTI, or West Texas Intermediate) in Chart 1 (click to enlarge) or the “world price” in Brent, oil prices all but halved in the second half of calendar 2014. No one should need charts to know what that did to the ASX 200 – and the energy stocks, in particular.
Closeness of correspondence
What is interesting to me in Chart 1 is the closeness of the correspondence between oil prices (Brent, in particular) and our Aussie dollar (note my manipulation of the vertical scales) until the end of January 2015. http://www.professionalplanner.com.a...-1-300x150.jpg
Since the beginning of February 2015, the close relationship between oil prices and the Aussie has broken down. But, hang on, the RBA made its first rate cut on the first Tuesday of February, after 17 months with rates on hold! Perhaps the gap between Brent and the Aussie at the end of Chart 1 is a measure of the impact of that rate cut. So what about the next (and the next) rate cut?
Readers might recall that I derive my market and sector forecasts from broker forecasts of dividends and earnings, as collected by Thomson Reuters. From Chart 2 (click to enlarge) it can be seen that my 12-month-ahead capital gains forecasts for the energy sector took a beating – but with a lag after oil prices started their sharp decline. http://www.professionalplanner.com.a...-2-300x150.jpg
Note that each point on the horizontal axis denotes a new forecast origin for a new, overlapping 12-month forecast horizon.
On the left is a forecast of around 15 per cent for July 1, 2014 to June 30, 2015. On the right is a forecast of around 30 per cent for the 12 months from April 1, 2015 to March 31, 2016 – which in part is accounted for by the overshoot in late 2014. We expect this 30 per cent forecast to start to fall as the data settle down over coming months.
Since I have my own methods for converting broker forecasts of dividends and earnings (as discussed in a report available from my website) it is not easy to say how much of my expected future capital is due to the changes in broker forecasts and how much is due to my methods.
Stable period
But what we can say is that, after a stable period of projected gains that started well before July 2014, the forecasts fell from more than 15 per cent to nearly 20 per cent in a few months, only to bounce back to nearly 30 per cent. Perhaps an over-reaction in late 2014 as the bears came out of hibernation and then headed back into their caves for the northern winter?
The fall in the energy sector forecasts was the main contributor to the decline in my ASX 200 forecasts. Now that energy forecasts are “back in the high life”, my end-of-year forecast of 5900 for calendar 2015 is starting to look far too conservative – but we currently have fair value at 5750 (as at April 1, 2015).
Markets fluctuate.
So while 6000 is on the cards for a number of short periods in the near future – or perhaps even before you receive this issue, owing to production lead times – it now looks like 6000 will well and truly “stick” before the end of calendar 2015.
And then the November 1, 2007, all-time peak of 6829 will then be just a hop, skip and a jump away.
Our current forecast for the high during the rest of calendar 2015 is 6500, but to finish the year at around 6150!
France 40 has demonstrated a shooting star in april (see #27, please) and DAX monthly seems to be in an descending trend (#29).
I'm let my France 40 Short Order (#4, 5'046.6) still into the market.
FXcube
Address to the Anika Foundation Luncheon Supported by Australian Business Economists and Macquarie Bank
Sydney – 22 July 2015
Thank you for coming out once again to support the Anika Foundation.[1] As a result of your generosity in past years, the Foundation is continuing to expand its activities, as you have heard from earlier presentations.
The very efficient logistics for today were again provided by The Australian Business Economists. I also thank Macquarie Group for its financial support of today's event.
I will organise today's remarks under four headings:
Negotiating turbulence
Accepting adjustment
Maintaining stability
Securing prosperity.
Negotiating Turbulence
Until recently, we were living, at a global level, through a period of remarkably low volatility and skinny pricing for risk. There was bound to be some set of events with the potential to change that.
Once again, some of them have been in Europe. After some months, difficult discussions between the Greek Government and its European partners reached an impasse and Greece was, as a result, unable to make a scheduled repayment to the IMF. The ensuing few weeks, during which the Greek authorities had no choice but to curtail access to the banking system, have been extremely difficult and surely quite damaging for the Greek economy.
There has been progress towards a solution in recent days, though a huge amount of work remains ahead to put the Greek economy, and the whole European project, onto a stable footing.
To date, though, the financial spillovers from the Greek situation have not been large. Spreads to German sovereign yields observed for debt issued by the governments of Spain, Portugal and Italy remain quite contained. At this stage, we do not see a market response that signals serious doubts about the ability of those countries to remain in the euro area. There could be little doubt about the willingness of their European partners and European institutions to support these countries in the event that market conditions took a serious turn for the worse – as they might have done, and still might, had/if ‘Grexit’ occurred. The likely direct economic spillovers to the rest of Europe also seem fairly contained, since Greece is quite a small economy.
Of course, things remain fluid. An unexpected turn of events – of which there have been many over time – could change the assessment above. Broader financial and economic impacts might be longer in coming and harder to predict. There are also important geo-strategic elements to the situation, which is one reason why nations outside Europe are taking such an interest. For our part, all we can do is watch and see what eventuates.
Meanwhile, and of arguably greater relevance in our part of the world, China's economy and financial system are going through a period of adjustment and uncertainty.
Recently there have been some quite spectacular developments in the equity market. A rapid run-up in share prices – which more than doubled in the space of a year, far beyond any plausible prospective improvement in company earnings – turned to a slump in mid June to early July. Share prices remain well above their level of a year ago, but the speculative nature of the run-up, and the part played by an increase in leverage, has understandably made everyone a little nervous. The Chinese authorities have acted forcefully with some very wide-ranging interventions to stabilise the situation.
The effect this will have on the Chinese economy is not clear, but may prove to be relatively small. Share prices have stabilised in recent days and authorities have been making financial conditions more accommodative. Households' direct exposure to equity prices is relatively small, notwithstanding their large share of turnover. In addition, the rise in share prices was probably too short-lived for there to have been much in the way of positive wealth effects on spending. Other leveraged entities, such as banks and brokers, have shown little obvious sign of stress resulting from the developments in equity markets.
It seems, on the basis of information available at present, that developments in the Chinese property markets and the broader financial sector are likely to be more important for the outlook. The economy had been showing signs of slowing, of course, in the first part of this year. But policies have been responding to this, and some of the recent economic data suggest they have been having a positive effect.
Lastly on the international front, the likelihood still seems to be that US interest rates will begin to rise before the end of this year. This change, when it comes, will have been very well telegraphed. That being said, long-term yields in the United States and elsewhere are still very low, and risk premia compressed, albeit not so much as they were. Some turbulence may well occur as a result not of the first increase in US rates, but of investors trying to assess how soon subsequent increases might occur. But sooner or later we have to see a start to the process of adjusting these financial prices and I would expect Australian financial markets to be able to take all that in their stride.
Accepting Adjustment
The Australian economy has been growing, but at a pace a bit below what we have traditionally thought of as average, as it adjusts to some pretty large changes in circumstances.
The story of the phases of the ‘mining boom’ is well known. Commodity prices rose massively and have since declined (though some prices remain pretty high compared with longer-run history). Investment spending followed suit – first it rose by about 5 to 6 percentage points of GDP, and now it is on its way back down. Finally, shipments of resources picked up, as the new capacity created by the investment became available. As an aside, unlike the situation posited some years ago in the United States, and notwithstanding the growth of services, the physical weight of Australia's GDP has probably increased over the past decade. For iron ore and coal, annual tonnages being shipped from Australian mines have increased by more than half a billion tonnes since 2004.
Growth in domestic demand, in contrast, is fairly subdued. Over the latest year for which we have data (to March 2015), final domestic spending rose by a bit under 1 per cent, as the fall in resources sector capital spending accelerated. Capital spending by other businesses has been weak too, while public demand was roughly unchanged over that year.
The weakness in those areas is juxtaposed, as you know, with changing household behaviour. After a lengthy period during which consumer spending growth ran ahead of income growth, and leverage (measured as the ratio of debt to income) almost trebled, households changed course some time ago. To be sure, the rate of saving from current income has declined a little over the past couple of years, which is what is expected at a time of very low interest rates and positive wealth effects resulting from rising asset values. But it remains significantly higher than it was a decade ago. The types of saving rates we see now are more likely to be ‘normal’ than those of a decade ago.
Moreover, while some households (such as first home buyers or, perhaps increasingly the same thing, first home investors) are taking on more leverage, many others are reducing it. They are taking advantage of lower borrowing costs to repay mortgage debt ahead of the schedule in their debt contracts. Despite the lowest interest rates that any current borrower has ever seen, the pace of lending to households remains moderate.
This is not a credit crunch – lenders are willing to lend and competition to do so is strong. Indeed, the prudential supervisor has been minded recently to issue some timely warnings about the need to maintain sound lending standards. Rather, the story is that households are being more prudent about debt and are holding more liquid assets. One measure of this is the size of ‘offset account’ balances – bank deposits held to offset mortgage debt. These now amount to about $90 billion. When the housing credit data are adjusted for the increase in offset account balances, the rate of growth over the past year is put at about 6 per cent, as opposed to over 7 per cent as published.
This may mean that the effect of easy monetary policy is to be somewhat lessened, at least for a time. Taking a medium-term perspective, though, the general strengthening of the balance sheet among many formerly more-indebted households has to be seen as a good thing.
In the interim, the somewhat more restrained attitude to debt and spending by households, combined with a similar attitude by the government sector, has meant that there has not been quite enough domestic demand to achieve full employment, in the face of the fall in business investment. That is why we have felt that, on balance, a somewhat lower exchange rate was likely to be a part of the necessary adjustment. That adjustment seems to be occurring, with relatively little disruption, and is having an expansionary effect. Growth in services trade for example is picking up. The ‘net export contribution’ of services trade over the past year, of around ½ percentage point of GDP, is about the same as the contribution from iron ore exports over that period.
It is worth noting that business conditions as measured in surveys have tended to improve overall, outside the mining sector, over the past year or so. At the same time, the state of the labour market, while still somewhat subdued, appears to be better than we had expected three or six months ago. Employment growth has picked up noticeably, and hours worked have also increased. The rate of unemployment is unchanged from a year ago, whereas we had been thinking it might be a little higher than this by now, since growth in real GDP has been, according to the available statistics, below trend.
Candidate explanations for this better-than-expected set of labour market outcomes include the following:
Perhaps there is statistical noise in the labour force data or maybe future observations or revisions will paint a different picture. It is worth noting here that recent information on Australian population growth suggests that the absolute growth of employment will be revised down somewhat, though this should not significantly affect labour market ratios like the unemployment rate or the employment-to-population ratio.
Perhaps output growth has been higher than the GDP data suggest, in which case upward revisions to those data would probably occur over time.
Perhaps below-trend output growth and trend employment growth can be reconciled in the form of the slower-than-expected growth of wages.
Perhaps trend output growth is lower than the 3 per cent or 3¼ per cent we have assumed for many years. That is, perhaps the growth we have seen is in fact closer to trend growth than we thought.
Some or all of the above possibilities may be at work. Time will tell which ones, but a few observations may be worthwhile at this point.
First, the economy is making the adjustments required, even if it is a bit slower than we would ideally have liked.
Second, if the slow growth of wages has in fact been a significant saver of jobs, that would appear to indicate a degree of labour market flexibility in operation.
Third, to the extent that the data are hinting that our assumptions about trend growth may need to be revisited, that will be worth some discussion. It need not be the case that per capita growth would be any lower, if the lower growth simply reflects slower population growth. So there may be few implications for living standards as measured by income per head. But if there are assumptions about absolute growth rates embedded in business or fiscal strategies, or retirement income plans, they would need to be re-examined.
I suspect this will turn out to be an important discussion: what is Australia's potential economic growth rate, per head, and why? And what do we want it to be? And, of course, what do we need to do to achieve our desired outcome? I return to that theme – securing prosperity – shortly.
But first, a few words about stability.
Maintaining Stability
One of the features of much regular discussion of macroeconomic policy, and monetary policy in particular, is that people tend to adopt a rather short time-frame. Everyone watches high-frequency data and adjusts expectations about what policy should or will do accordingly. Policymakers are expected to respond to events and to deviations of economic performance from what had been anticipated. The number of surveys and obscure indicators seen as conveying information has continued to grow, as has the number of commentators to talk about them.
To some extent this is perhaps a natural outworking of richer, more complex societies possessing more information and analytical resources, the 24/7 operation of financial markets and a competitive media searching for content. And to a point, it is perfectly reasonable to expect policy to be adjusted in response to relevant information about how things in the economy are tracking relative to policy objectives.
The risk, however, is that this process can lead to a mindset in which policymakers end up responding to quite short-term phenomena, using instruments that take quite some time to have their full effect, including effects that might actually turn out to be adverse. This is relevant to our situation. A period of somewhat disappointing, even if hardly disastrous, economic growth outcomes, and inflation that has been well contained, has seen interest rates decline to very low levels. The question of whether they might be reduced further remains, as I have said before, on the table.
But in answering that question, it is not quite good enough simply to say that evidence of continuing softness should necessarily result in further cuts in rates, without considering the longer-term risks involved. Monetary policy works partly by prompting risk-taking behaviour. In some ways that is good: in some respects, there has not been enough risk-taking behaviour. But the risk-taking behaviour most responsive to monetary policy is of the financial type. To a point, that is probably a pre-requisite for the ‘real economy’ risk-taking that we most want. But beyond a certain point, it can be dangerous.
Deciding when such a point has been reached is, unavoidably, a highly judgemental process. And that is after the event, let alone beforehand. My judgement would be that policy settings that fostered a return to the sort of upward trend in household leverage we saw up to 2006 would have a high likelihood, some time down the track, of being judged to have gone too far. That is not the case at present, given the current rates of credit growth and so on. But the point is simply that in meeting the challenge of securing growth in the near term, the stability of future economic performance can't be dismissed as a consideration. A balance has to be found. I note that the Board's post-meeting statements routinely refer to seeking a stance of policy that will ‘most effectively foster sustainable growth and inflation consistent with the target’ (emphasis added). The adjective ‘sustainable’ is used deliberately and financial sustainability is very definitely one of the things we have in mind.
Securing Prosperity
The transition in growth is not perfectly smooth, but our economy has, in my judgement, coped remarkably well through a lengthy period of very large shocks in a difficult world. Despite the doom and gloom and fulminations over the airwaves, in newspapers and in cyberspace, business confidence has risen in recent months. One day last week as I was preparing these remarks, newspapers carried stories that personal insolvencies are the lowest for more than a decade. On the same day we could read that income inequality in Australia, as measured in the most detailed survey available, has not, in fact, increased, contrary to the impression so often given. Perhaps we might be allowed to conclude that we have been meeting some of our challenges, thus far, with outcomes that, while not perfect, are not too bad.
So there are reasons to feel more confidence in our future than we often seem to. The question to be asking is how we build on the broadly successful record we have in order to secure prosperity in the future.
In this context, it is likely that questions about potential growth, in per head terms, will become even more prominent. This is partly because of the well-known implications of the lower terms of trade for income per head (i.e. it grows more slowly than output per head). It is partly about demographics, also a well-known issue. Ageing will lower the proportion of people working and hence, other things equal, output and income per head in the country.
We all know these things at an intellectual level. But unless we think our wants, including for publicly provided services, will grow more slowly, which I doubt, the very practical imperative will increasingly be to secure sources of growth. And it is increasingly clear to people that the kind of sustained growth in mind here won't be the result of the manipulation of interest rates or year-to-year government fiscal settings. Demand management policies play an important role, but they have their limitations.
Raising the economy's potential isn't just some esoteric concern for economists, or at least it shouldn't be. Our collective ability to deliver social policy outcomes, to enjoy the benefits of a ‘good society’, or at a more basic level to provide public services and even to defend ourselves, ultimately rests on a productive economy. Many problems, including distributional ones, are easier to deal with if per capita incomes are rising steadily, less so if they are stagnant.
Let's be clear that this is not ‘growth at any price’. Wealthy countries tend to have cleaner air, cleaner water, better health and education systems, and more demanding standards for environmental protection, employee safety and leave entitlements. They can afford to devote resources to such things because their business sector is so productive. They tend also to have higher wages – not because they decree wages shall be high but because well-educated, skilled workforces working with a lot of capital and modern technology are more productive. The poorest peoples usually have far less in the way of such things. If we care about wellbeing in the broadest sense, we should care about things that affect potential output per head.
Our citizens certainly care about the results. They don't frame the question as being about per capita real GDP or productivity per hour and they care about more than just ‘narrow’ outcomes for economic statistics. Many would be concerned to reduce our environmental footprint. They would not wish to sacrifice civilising aspects of our society and culture, including many that result from government intervention. But nor will they accept a future in which they are marginalised in the global village because of unwillingness to adapt or to invest, or because of a failure to foster a growth economy.
There is a lot of talk at present about ‘reform’. I would suggest that the case for ‘reform’ needs to be presented as a positive narrative for economic growth. We all know that competitive markets, investment in education, skills and infrastructure, and adaptability, are key parts of that growth narrative.
These reforms matter because of the gains to incomes resulting from better allocative efficiency. But they also, ideally, would support entrepreneurship and innovation – ‘risk-taking’ by another name and of the kind we want. Measuring ‘entrepreneurship’ is not straightforward and various studies have somewhat differing results. At the risk of oversimplifying, one might say that Australians hold our own in the entrepreneurship stakes, but since we don't generally score at the top in such surveys, there must be scope to improve. That too can be part of the growth narrative – the narrative of how we build on the success enjoyed to date and secure an even more prosperous future.
Conclusion
Thank you again for your attention, and for your support of the Anika Foundation. I hope to see you again in another year for a new round of challenges.
Profile
Standard and Poor's 500 Index is a capitalization-weighted index of 500 stocks. The index is designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries. The index was developed with a base level of 10 for the 1941-43 base period.
Look up the word “bond” in any dictionary and you’ll find two basic elements: first, the amount of money borrowed, or “principal”, to be paid back at a later date; and second, the interest rate, or fee, charged on that borrowed money. Until recently. In Europe today, many borrowers need not worry about the latter. That’s because bonds issued by countries from Germany to Finland are coming with “negative” interest rates, a fact that’s turning the term “fixed income” into somewhat of a misnomer. In other words, lenders are actually paying borrowers for the privilege of lending them money, and are therefore guaranteed a loss if they hold the paper to maturity. Now that’s a foolish investment, something fixed income investors would avoid like the plague, right? Wrong. Many are lining up to buy.
Why would they do such a thing? Because none of them plan to hold onto this paper until maturity. In other words, some investors expect rates will fall even further, and if they do, prices of existing bonds will rise and investors can sell them at a profit before they mature. They’re particularly willing to take such a risk because they suddenly have a very large and very eager buyer: the European Central Bank. Just this month, the Mario Draghi-led institution began “quantitative easing” – a promise to purchase 60 billion euros in sovereign bonds per month in its bid to fight deflation and boost lending. Having such a large buyer mopping up bonds will theoretically create a supply shortage, another potential source of higher bond prices. ”Investors are getting used to fixed income valuations at absurd levels,” says Michael O’Sullivan, Credit Suisse Chief Investment Officer for the U.K. and EEMEA in the Private Banking and Wealth Management Division. “They expect rates to become even more negative.”
Investors have other reasons to stay in European bond markets. One is a currency play. Investors are buying negative-yield Swiss bonds, for example, because they expect the franc to continue appreciating against the euro. So while they’ll take a loss from the negative yield, they expect gains from a stronger franc to outweigh those losses. Another one: some institutional investors have no choice but to buy the bonds. Many pension funds, for example, are obligated to keep a percentage of their holdings in European sovereign bonds, no matter the return.
The result is a scenario that can only be described as bizarre. According to O’Sullivan, more than 25 percent of the world’s government bonds currently have negative yields. In Europe, about 1.44 trillion euros of sovereign debt currently sits in sub-zero yield territory, according to Bloomberg. It’s not just the paper of countries like Germany, where the yield on the 2-year bund is -0.23 percent and the government sold five-year bonds at a negative yield for the first time ever in February. Peripheral countries in the euro zone are trading at record low yields, too; take Spain’s five-year bond, which currently yields 0.52 percent, or Italy’s 10-year bond at 1.33 percent. Even corporate paper issued by European corporations such as Nestle has hit record lows.
How long will this last? It’s hard to say. The current fixed income environment is truly uncharted territory; there aren’t any historical precedents. For now, the ECB seems fine with the way the bond market is behaving. Since the announcement of its inauguration, the QE program has held the euro down – all-in, it has depreciated 20 percent over the past year to 1.09 euros per dollar. Draghi isn’t complaining: Fueling economic growth is, after all, the main objective of the ECB’s QE program, and a weaker euro is good for exporters and should help to keep deflation at bay.
Yields should, in theory, turn positive if the European economic recovery continues to gain strength and investors become more willing to dump safer assets like bonds for riskier assets such as equities. And the economy is already looking better. Consumer confidence, retail sales and auto sales have been improving, for example, as low oil prices fuel increased spending. Corporate outlays are also growing as loans to the private sector have been on the rise since late last year. Of course, if the economy does stay on its current course, investing in bonds with negative yields will no longer be such a great idea, as a rising yield environment will punish holders of lower-rate bonds. In light of this possibility, Credit Suisse is currently underweight fixed income. “We think it’s overvalued,” says O’Sullivan.
