The Australian stock market had its best July in six years, rising an astonishing 6.3%, making it one of the best performing in the world and taking it to an 11 month high. Meanwhile the United States’s S&P500 hit an all-time high. At the same time global bond markets have rallied as well, with the yield on both the 10 year Australian and US bonds hitting an all-time low – just a reminder, when it comes to bonds, if the yield is a record low it means the price is a record high. There are two issues here: first, in the past equities and bond markets usually went in opposite directions, and second, given what was happening only a month ago, why on earth are markets so strong?
ASX200 11 month high – Australian 10 year bond yield all time low
There are all kinds of explanations put forward for the strength in markets, any one of which could be right, or maybe it’s a combination of all of them. And to go in to a detailed look at them would require a book, so let me touch on the basics.
The obvious argument is that with global bond yields being so low investors are turning to anything they can get their hands on, including equities, to try to generate some return. But global earnings growth has been anemic as best, in fact US earnings per share peaked in the September quarter of 2014 and have fallen by more than 20% since, so what’s all the excitement about? If you look at what’s driving stock markets it’s the very defensive stocks, for example the S&P500 utilities sector has risen 21% over the past year, well over double the next highest, which is technology at 9%. In Australia the utilities index is up 21% year on year, and property trusts are up 20%. In other words, the money is going into what are seen to be the safest areas.
That also means if EPS has fallen over those six quarters but over the same time the index has risen by 10% then the price to earnings (PE) ratio is getting a lot higher, which is associated with expensive markets and yet they keep going up. The thing is, in the past when inflation is very high PE’s got very low and vice versa. Also, the lower the bond yield you use for a discounted cash flow valuation of a share, the higher it will be worth.
And when one third of the world’s government bonds are paying a negative yield why on earth would you buy them? First, when institutions like insurance companies and fund managers have enormous sums to invest it has to go somewhere and the bond market is very big. Second, many of the world’s central banks are still buying billions of dollars’ worth of bonds, so there is pretty much a guaranteed market. Third, because the perception is that growth is likely to remain low for a long time, it is therefore unlikely that inflation, the mortal enemy of bond yields, will spike, meaning bond yields might continue to go down which in turn means their value goes up. In fact, anyone who was lucky enough to buy a 30 year Japanese Government Bond at the beginning of 2016 will have made a 30% capital gain by now!
When the world had a bit of a panic attack after last month’s Brexit vote central banks made it clear they would make sure markets didn’t collapse. That reassurance on its own could well have been enough to underwrite markets, which have benefited enormously from the massive amounts of liquidity the central banks have pumped in over the past five years. The Pavlovian response from markets was well illustrated by the reaction to the Bank of Japan indicating it would increase its stimulation and then not delivering as much as had been expected. Markets rode a roller coaster before deciding that between the bank’s ¥90tn per annum of QE and the government’s newly announced ¥28tn fiscal package there might just be enough.
US$ tail winds
After being weak for years on the back of post-GFC monetary easing, last year the US$ started climbing when it became clear the US Federal Reserve was intent on raising interest rates, and markets started going a bit pear shaped. Commodities prices fell, which led to concern that commodities-based companies would struggle to repay their debt, which sent shivers through the corporate debt markets. Things got ugly until in February the Fed said it wasn’t wedded to the idea of raising rates in a hurry and suddenly the US$ weakened off and markets bounced, plus the Chinese government reopened the credit spigots as well, which added to the reflationary push.
When the US$ started going down in February…
…Commodities prices started going up
A cursory glance at the U.S.$ chart above would have the sharp-eyed saying “hang on, the U.S.$ looks like it’s started going up again over the last couple of months”. And it has. But you’ll also notice a big part of that was the panic buying at the end of June post-Brexit and over the last few weeks it’s tumbled again – especially after the U.S.’s June quarter GDP came in at 1.2%, which was less than half what had been forecast. Overall, a falling U.S.$ is good news for the markets and the Fed leaving interest rates alone is good for a low U.S.$, and after that GDP number the odds of the Fed raising rates by the end of the year tumbled to 36%.
Exceptionally low inflation continues as a dominant theme in this low growth environment, and central banks continue to battle it using all the monetary policy instruments they can. We too are feeling the winds of disinflation here in Australia, with the June CPI coming in at 1% p.a., the lowest since June 1999. Given the A$ has also been stubbornly strong this year, markets are now rating the chances the Reserve Bank will lower interest rates to 1.5% by the end of the year at 79%, if only to try to lower the A$ and give our exports a helpful nudge.
The problem is, every country wants a low currency to help their exports.
What’s an A between friends?
There are 12 countries with a AAA credit rating from Standard & Poors, and at the moment Australia is one of them. But it might not be for much longer after the agency placed us on credit watch negative with an estimated one in three chance of being downgraded to AA due to persistent budget deficits that need to be funded by borrowing from overseas. It’s ironic that what got us the top notch rating was the flood of money that came from the resources boom, but that was also what set successive governments on the spendthrift path that has resulted in chronic budget deficits.
So far this year S&P has downgraded 16 countries’ debt and Moody’s has downgraded 24, so we’re far from alone. There are some who point to how badly the ratings agencies got things wrong in the lead up to the GFC and ask ‘who would pay attention to them anyway’? The thing is, when it comes to individual companies or countries the agencies have a very good track record, they generally get it right.
The other point is that the real effects of a downgrade may be very slight, if anything at all. Even Dr Luci Ellis, head of the Reserve Bank’s financial stability department, said that a downgrading of Australia’s AAA sovereign debt rating wouldn’t have much impact on the broader economy. Realistically, in this low interest rate world it’s unlikely Australia’s bond yield is going to rise very much. In fact the U.S. lost its AAA credit rating in August 2011 yet its 10 year bond yield fell from 2.56% to 1.45% over the next 10 months.
Some concern has been expressed that the big four Australian banks will most likely also suffer a credit downgrade if the government does, which may be right given the government guarantee on bank deposits. However, Deutsche Bank estimates the profit impact that would result from higher funding costs from the banks being downgraded from AA to A would be less than 2% spread over a few years.
Overall, Australia copping a credit rating downgrade would be a hit to the government’s credibility, but the blow out in the budget deficit has been a known issue for a long time and the institutions that fund our deficits (by buying our bonds) will have been aware of this long before S&P made its announcement. But in the current environment it’s hard to see it having much consequence on a day to day basis.
Political risk is getting risky
Over the past few years global markets have all but ignored political risk: from the Russian invasion of Ukraine, the Syrian civil war and the Middle East fallout, China’s brinkmanship in the South China Sea and, of course, multiple terror events – markets have ploughed on largely unperturbed. But June’s Brexit vote has resulted in a far more introspective mood across the media and markets about what the influence of an angry, disenfranchised working and middle class might be across the developed world and with at least four major elections over the next 14 months, the biggest of which of course is the United States in November, the increasing pulse of nationalism and agitation for a change in the status quo appears to be presenting a real possibility of significant change that could indeed have economic impacts.
As we wrote about previously, the markets have bounced back strongly after the post-Brexit panic attack. In the cool light of day you can ask how bad will it really be for the UK to leave the EU? After all, the UK is estimated to pay an average of about £18 million per day in net terms to the EU for the privilege of trade access. There are various countries a fraction of the size of the UK that are not part of the EU but which have negotiated favourable trade deals with the common market, and in fact already some countries have approached the UK with offers to strike a deal. It’s inconceivable that Mercedes would want to risk any UK market share, but likewise the EU will be wary of looking like it’s rewarding the UK for being a recalcitrant.
You can also ask why any country would want to tether itself to dysfunctional European economies like Italy and Greece. The irony of Italy plunging the EU into yet another existential crisis straight after Brexit by insisting its terribly undercapitalized banks should be entitled to a state bailout, appears to have been lost in the noise.
But there will be consequences. Trade deals and terms of access will have to be negotiated, which takes time. Economic growth in the UK will probably slow in the near term while companies pull back on investment until they are sure what’s going on. And if nationalism continues to rise across the continent it’s not inconceivable the EU will be put under further strain.
The big one however is the United States. After being given no chance of even winning the Republican candidacy, Nate Silver (who correctly called every U.S. state and district in the 2012 presidential election and only missed two states in the 2008) is now rating Trump as 50/50 or better to become President. This article is not about the merits or otherwise of Trump’s candidacy, but is simply to point out that should he be elected in November he has promised what would be some radical economic changes, particularly with respect to globalization.
Economists argue that over the past 30 years globalization has yielded wonderful benefits, including helping to reduce poverty across the planet by 90%. That may be true but for many U.S. blue collar factory workers they have gone the opposite way, losing relatively well paid factory jobs that were relocated to Mexico or Asia, and instead working in hospitality for the minimum wage of U.S.$7.25 per hour. When ‘the elites’ talk about the benefits of trade, displaced workers can point to cheaper TV’s and clothes, but the truth is the greatest benefits have accrued to the owners of the capital. Trump made his money from real estate, not manufacturing, so he can afford to be politically opportunistic by threatening to slap 45% tariffs on Chinese imports.
It is these considerations that are driving this election, and both candidates are sniffing the breeze and talking tough on things like the Trans Pacific Partnership, which took seven years to negotiate and includes 12 countries accounting for 40% of global GDP. As yet I haven’t heard it pointed out that, due to technological advancements, the alleged 30-50,000 U.S. factories that closed between 1993 and 2007 could today operate on a fraction of the labour force.
The simplistic argument of blaming the US’s working class problems on globalization and immigration makes sense to those feeling angry and dispossessed, a view that conveniently ignores the reality that not a lot of people want to do the jobs the immigrants do and they’re just not technically qualified to go back to a factory and run the robots that now assemble the widgets they used to. It may be likewise a simplistic view but much of the anger boils down to low incomes and all but non-existent income growth. Change might have to start with examining the sustainability of a $7.25 minimum wage.
Political risk can take a long time to play out, having to navigate a legislative process first. Perhaps it shouldn’t be all that surprising that in a time of such extraordinary economic circumstances that we should be contemplating extraordinary political events.