Financial markets over August gave us another reminder that for all the commentary we hear about geopolitical risk it often has very little effect on markets. As concerning and distressing as the problems in Ukraine, Gaza and the Islamic State are, they have had about the same influence as recent issues in China and Japan, Syria, or the Arab Spring. What matters to markets is company earnings.
Even the oil price, which is usually a barometer of global risk, has gone down 12% since its highs in late June.
NYMEX West Texas Intermediary Oil Price
Markets anxiously watched the annual conference at Jackson Hole for further guidance about changes to the current extraordinary monetary policy settings. The closest to a surprise came from Mario Draghi who confirmed the ECB may resort to ‘unconventional instruments’ in the fight against inflation.
For Australia, August marks the full year company reporting season. Deutsche Bank described it as a bit disappointing with only 43% of companies beating forecasts, compared to an average 52% and pointing out that we start FY15 with the second lowest growth forecast for the past 20 years at 6%. Still, given July’s 4.4% rise it was hardly surprising that the market would take a breather.
Market forecast EPS growth in July for the coming year
Source: IBES, Datastream, Deutsche Bank
During the month business confidence was reported as hitting an 11 year high, which is kind of difficult to reconcile with unemployment hitting a 12 year high. And the iron ore price continues to wreak havoc with Australia’s biggest export earner (see chart below). The price has now fallen by more than 50% from the peak it hit during the Chinese post-GFC infrastructure boom.
China import Iron Ore Fines 62% FE spot, US Dollars per Dry Metric Ton
Source: The Steel Index via the IMF
A strong US second quarter reporting season was followed up with a bunch of data that continued to suggest the economy is in pretty good shape: consumer confidence hit its highest since 2007, housing construction is up 22% over the year, manufacturing activity hit a four year high and inflation is just low enough at 1.9% for the Fed not to have to slam the brakes on yet. Happy days, except that there are more Fed governors calling for an end to the Zero Interest Rate Policy. When rates are as low as they are, even a 1% cash rate sounds scary! For investors, it pays to be wary when things start to look about as good as they can get.
By contrast, Europe looks like a mess! The bogey man of deflation is alive and well, with inflation reported at 0.3% for the 18 member Eurozone – remember deflation is every bit as bad for central banks as inflation because it can take root and slows spending, like Japan. Second quarter GDP for the area came in at 0.0% – with Italy in its third recession since 2008 and even Germany looking soft at 0.5%. The ironic thing is, with the ECB having stepped up its jawboning efforts, talking about using QE and all but daring markets to ‘watch this space’, the worse the data the better the markets like it on the basis that it will simply force the ECB to actually do something.
The UK still looks the most likely candidate to raise rates, with GDP coming in at 3.2% annually and unemployment at a 6 year low of 6.4%. It’s an interesting comparison to Australia, with similar stats but vastly different cash rates. The UK’s 0% rate is the lowest in some 500 years, ours is the lowest in 50 years, but is still at 2.5%. And yet the BOE hosed down rate talk saying that it’s concerned about the low level of wage growth, at 1.25%. By contrast, Australia’s wage growth came in at the lowest in 17 years but was still 2.6% p.a.
Rate of change of quarterly wage growth in Australia
Janet Yellen has avoided pinning Fed policy to only one or two specific data points, but has instead been talking about a ‘dashboard’ of indicators that they will monitor as a guide to when interest rates should be raised. One of those indicators is presumed to be wage costs, which have a strong link to inflationary pressures and interest rates. Deutsche Bank is particularly concerned that those pressures are building.
Business sector unit labor costs vs Fed funds target rate
Source: FRB, BLS, Haver Analytics, DB Global Markets Research
Number of unemployed workers per job opening
Source: BLS, JOLTS, DB Global Markets Research
Paying a government to look after your money
The yield on German government bonds has fallen to almost unimaginable levels. In fact, the yield on the two year Bund is -0.03%: you have to pay the government to sit on your money! To lock your Euros away for five years earns you a return of 0.17%.
German five year bond yield
By contrast, the yield on an Australian five year government bond is 2.81%, or some 16 times higher.
Why is this given Australia still enjoys a AAA rating? The ECB has all but assured the market that it will not allow a sovereign default. It’s too big to fail writ large.
One upshot of this was reflected in a story we were told last week, where a wealthy German family reportedly paid ‘about 15% too much’ for a Sydney CBD building. They were approaching it as a permanent holding and the yield of c.3% was a whole lot better than what they could get back home.
It is indeed one of the ways this extraordinary period of monetary policy works. Financial repression, or negative real interest rates, forces investors to take on more risk in search of income. So share and property prices go up. The longer-term distortions this creates will only be fully understood in hindsight.