When a particular stock or group of stocks that you’d avoided for very good reasons is falling, it feels really good not to be exposed and you can bathe in that warm, fuzzy feeling that sticking with quality investments is always the best strategy. But then sometimes that group can bounce back hard, and even though you know it’s still relatively poor quality, it’s tough to watch. So it has been with the Australian resources sector, which has been a great place not to invest for a while now, but over the past few months has rebounded 40% from its lows – see the chart below.
S&P ASX200 Resources Index
All over the world, stock markets have rallied, and the MSCI All Countries World Index is up 14% from its recent lows. But a lot of that has been a junk rally.
Why the bounce?
Not so long ago investors were panicking about all the things that were going wrong with the world: Chinese growth faltering, the threat of US interest rate rises, the risk of a deflationary spiral, the risks of emerging market debt defaults. Many of these concerns were reflected in the rising US$, which put pressure on commodities prices and emerging market economies that hold a lot of US$-denominated debt.
So what changed? You can mount a good argument that the turnaround was from central banks once again riding to the rescue and, as always, the most important of those is the US’s Federal Reserve, which changed its tune in the middle of February saying it sees no need to keep raising interest rates right now, apparently because of global economic risks. Being less inclined to raise rates is commonly referred to as being more dovish, as opposed to hawks who advocate raising rates.
That was a big change from the last 18 months during which the Fed constantly prepared the markets for a rise in US rates, a process that saw the US$ strengthen significantly (money flows toward currencies that are likely to increase interest rates). You can see this in the chart below:
US$ Trade Weighted Index
Source: US Federal Reserve
We’ve also seen a strong rally in commodities prices since the start of the year, with oil bouncing 70% and iron ore 40%. While no doubt China’s promise of increased infrastructure spending has helped, the chart below shows there is a clear relationship between changes in the US$ and changes in commodities prices.
Changes in the US$ vs. changes in commodity prices
Source: Brandywine Global
The big question of course, is how sustainable is this? The world got a taste of what happens with a strong US$, which it didn’t like at all, but other countries are still determined to weaken their respective currencies to help their own economies.
Much will depend on the economic data we see from the US and whether that prompts the Fed to shift once again to a more hawkish tone. On the one hand, initial jobless claims in the US hit the lowest level since 1973 – good – but some 40% of the jobs created in this recovery are in the low paying sectors like food service and hospitality – not so good. Also, first quarter GDP growth came in at the lousy annualised rate of 0.5% – again not so good. Overall, it’s no surprise the markets are rating the chances of a June rate increase in the US at about 25%. Which means the US$ stays soft for now, which begs the question…
Will the A$ stay strong?
The headlines were very excited about Australia reporting its first quarter of deflation in seven years, with the CPI falling by 0.2% to an annualised rate of 1.3%. Predictably, the excitable forex traders sold the A$ on speculation the Reserve Bank is more likely to cut interest rates in the face of a lack of inflation. But just remember, last month Australia reported better than expected GDP growth which had forex markets speculating the opposite. It’s like they need to be medicated.
The Reserve Bank is facing a tough set of circumstances in which to set interest rate policy. As well as that surprisingly strong GDP figure at some point the inflationary effects of a rising oil price will come through, which of course mitigates in favour of interest rates going up. On the other hand, it looks like the Australian construction sector is slowing appreciably, with activity dropping to a 13 month low and rental yields in Sydney and Melbourne hitting a 10 year low (which is why we don’t need as much construction).
Also, Australia’s terms of trade, which measures how strong export prices are compared to imports prices, have fallen to a 10 year low – see the chart below. The higher a country’s terms of trade the stronger is its underlying economy – demand for its exports is strong, just like Australia’s during the mining boom. Although the chart doesn’t seem to be right up to date, it certainly paints a picture of how dramatic the rise in Australia’s terms of trade was, and how far they would need to fall to return to the long-term average.
Terms of Trade *
Is deflation necessarily bad?
Some economists point to things like a declining terms of trade or a rising US$ as increasing deflationary risks, which is an environment of steadily declining prices. We’ve talked about deflation many times and explained that central bankers are every bit as fearful of deflation as they are about inflation, because once expectations of falling prices becomes entrenched in an economy it makes it harder for consumers to justify making a purchase today and for companies to justify investing.
The classic example used to illustrate the perils of deflation is Japan and its ‘lost decades’ from the late 1980’s to the mid 2000’s. But a very interesting paper from our asset allocation consultant, farelly’s, casts the Japanese experience in a different light.
farelly’s points out that since 1990 Japan has slipped in and out of deflation and recorded very little economic growth. However, over almost that entire time Japan’s unemployment rate was below that of the US, UK and Europe. Likewise, real wage growth over the period of 0.2% per annum was not that far off the US’s at 0.4% per annum. So from a household’s perspective the Japanese experience could be considered to be better on the whole, as they were more likely to have a job and benefited from lower prices.
What about for companies? Interestingly, during Japan’s high growth phase from 1960-90, real economic growth averaged 5-6% per annum, but real earnings growth for companies was flat! Then when the Japanese bubble popped in the 1990’s earnings growth crashed by two thirds as companies struggled to adapt to the new environment. However, once they got the swing of it Japanese companies doubled real earnings growth between 2000-16.
In other words a low growth, deflationary environment looks like it doesn’t have to be bad for either consumers or companies.
Things that make you go hmmm
In 2001 the Argentinian government defaulted on more than US$80 billion worth of government bonds, which probably shouldn’t have shocked anyone too much given it was the eighth time they’d done that since gaining independence 200 years ago. Bearing in mind a bond is a debt owed by the government to the bondholder, you’d think that would naturally make anyone think twice before lending to them again.
Well, apparently the thirst for yield is enough to give people a short memory. Last month Argentina issued US$16.5 billion worth of new government bonds, making it the biggest single tranche issued by any emerging market economy in history.
Despite being rated as junk debt by credit-rating firms with a big chunk of the proceeds going to pay off old debts, and notwithstanding Argentina’s economy is forecast to shrink this year in the face of 35% inflation, the issue was oversubscribed more then four-fold! Such strong demand meant the government was able to shave the yield on the bonds back to 7.5% per annum on the 10 year bonds.
I guess when the world has US$6.9tn worth of bonds trading on a negative yield, throwing a little cash at a 7.5% return is marginally easier to rationalise.