At the time of writing, 23 December, the past month has been a reminder of two important things all investors should keep in mind. First, volatility works both ways. We saw a bunch of sharp falls and some neck-wrenching rises across almost all markets – equities, bonds and commodities. That just happens from time to time.
Second, the media and most market commentators do their best to try to sound like they know what’s going on – but they don’t. Behavioural economics identifies the craving for certainty as a basic human trait; we want to know what’s going on and why. The media panders to that and always tries to sound authoritative. So back in June, when oil prices were hitting $110 per barrel, Reuters, Bloomberg, CNN and CNBC ran headlines blaming falling stock markets on rising oil prices. Last week, those same news organizations ran headlines saying the exact opposite! In other words, they’re guessing.
We suspect the correction in equities markets in the US had more to do with the fact that the S&P500 had experienced eight consecutive weekly rises and as we approach the end of the year a lot of money managers will be itchy to lock in some of those gains. But that’s just a guess too.
Australia reported a disappointing September quarter GDP number of 0.3%, about half of what was expected. What had the economists in a bit of a spin (and spurred more of those dramatic newspaper headlines) was that Gross Domestic Income has fallen for two quarters in a row – a ‘technical income recession’. The chart below shows that the rate of growth is well below the average of the past 30 years.
Australian Real GDP growth (seasonally-adjusted)
There is, of course, a lot of consternation about the end of the mining boom and what that means for Australian economic growth. Well, it’s likely to mean it’s going to struggle. A rising population has helped us maintain growth over the past decade, but productivity, which measures how much we can produce from the same amount of inputs and is a key indicator of how an economy improves over time, has been offsetting the benefits of more people contributing. In fact, multi-factor productivity, which measures both labour and capital, is lower now than it was in 1999 – see the chart below. The grim national accounts plus a four year low on sentiment and a 12 year high in unemployment saw a number of economists jump on the rate cut band wagon. The Reserve Bank has been on hold at 2.5% cash rates now for 18 months, but there’s a growing view that we could see them cut to 2%. We posted a great article by Tim Farrelly on interest rates last week.
Australian productivity – annual growth
We also saw the release of the long-awaited Murray Inquiry into the financial services sector. Again, looking through the sensationalism of newspaper headlines, it was interesting to see the messages an experienced banking insider was sending. Essentially, Australian banks are not as secure as we would like to think and he reckons they need to raise their tier one capital. That’s the money the banks store on their balance sheet to safeguard against the effects of things going pear shaped. The more money the banks have to keep sitting around for a bad day, the less they can lend out and the harder it is to generate high returns on equity. Since the GFC banks have been able to significantly reduce the capital they keep on hand against residential mortgages, which has been a boon for bank earnings and their shareholders, but you just have to remember what happened in the US and Japan to realise that houses sometimes aren’t so safe after all. From an investor’s point of view, what will matter is whether the higher capital requirements will reduce the return the banks make on their capital, which could translate into lower share prices and possibly even lower dividends.
The US continues to produce strong data. Although headline inflation saw the biggest drop in six years thanks to the falling oil price, it was a good reminder of why the Fed pays more attention to so-called ‘core inflation’, which excludes things like energy costs because they can whipsaw around violently, and which went up by 0.1%, to be up 1.7% over the year. Quite amazingly, there are more US job openings now than during the 2004-07 ‘bubble’ period and small business optimism is back to almost eight year highs. Not surprisingly, and again in stark contrast to Australia, US consumer sentiment is recovering well – see the chart below. An interesting anecdote of how the US is getting on with life compared to Australia: I heard an American psychologist present at a conference recently and he had run a count on how many times the expression ‘GFC’ was mentioned in a Friday edition of the AFR compared to the Wall Street Journal. The result: 48 to 2. His conclusion, we’re really struggling to let this thing go.
US Consumer Sentiment
Source: TradingEconomics.com, Thomson Reuters/University of Michigan
The only problem with such good news is that you have to wonder how much of it is already priced in to the US market, which has more than tripled from its GFC lows. The market is still happily convincing itself the Fed will hold off from raising interest rates, but that too won’t last forever. Rates don’t need to go back to historical averages, but when they’ve been basically zero for so long, even a small increase is proportionally significant and all that good news builds the pressure on the Fed, as shown in the chart below.
US long-term interest rates are disconnected from Fed expectations
Source: Bloomberg, Deutsche Bank
The other interesting development this month was that Russia raised its interest rates from 10.5% to 17% in one hit in an effort to protect its currency – an effort that failed miserably. The chart below of the Rouble vs. the US$ is possibly the best illustration of the effects of soft power. President Putin is coming under enormous pressure entirely due to economics, thanks to US sanctions and the oil price, rather than sabre-rattling.
Source: Trading Economics
Meanwhile Greece, that other emblem of all that’s wrong with Europe, has been forced to call an early general election, which the left-wing, anti-austerity party Syriza could quite possibly win. Amongst some of their rather extreme promises is that they would reject the EU’s bailout conditions, which would effectively force them to leave the Euro Zone. The Greek share market collapsed by more than 20% in three days!
Emerging markets took a real hit this month, largely because of a resurgent US$ and the leverage that some of the oil-producing EM countries have to a falling oil price, two things that are completely out of their control. They will certainly be hoping that Santa brings a new year rally.