Markets this month felt just like a roller coaster ride: up and down all over the place and then you finish back where you started. After the ASX200 almost touched 6,000 in early April, it dropped 7% to the middle of May and it felt like everything else was in upheaval too. During May alone the ASX went down 3.5% and then ended square – that’s a 7% round trip. While there are people who would pay good money for that kind of experience, your average investor tends to prefer things a little less exciting. Frankly, it speaks volumes about not focusing on the short-term.
There’s been quite a lot going on in markets, and some of it is kind of a chicken and egg situation. What came first: European bond yields backing up because of the perception of a teeny tiny bit of inflation in the system on the back of growth numbers, which then caused the U.S.$ to drop; or was it the U.S.$ dropping because of the Fed talking it down which caused commodity prices to go up, causing inflationary expectations which then caused a spike in bond yields? Take your pick, but either way, the U.S.$ is stronger, bond yields are higher pretty much all over the world and commodity prices are up too (see the chart to the left which shows Australian, U.S. and UK bond yields rising in unison together with the oil price – source IRESS). Before we make too many presumptions about what’s going to happen to bond yields it’s worth remembering Japanese Government Bond yields, which have been on a seemingly interminable decline since 1990, have spiked by more than 50bp some eighteen times.
Australia: a rate cut and a budget
Here in Australia it was all happening this month: we got an interest rate cut and a federal budget. The RBA took another 0.25% off the cash rate to bring it to a record low of 2%. The board clearly sees problems in the outlook for growth, saying afterwards that it’s lowered its GDP forecast to 2.5% and may well need to cut again if things don’t pick up.
While people have jobs it’s hard to say things are bad, and our unemployment rate is still at only 6.2%. The catch is, it seems most of the positive news we keep getting is on the residential property front, where it feels like prices keep climbing and climbing. And they do, in Sydney and Melbourne, but there’s not much action elsewhere. Record low mortgage rates have resulted in record investor lending which is up more than 10% in the past year, almost double the lending growth for owner-occupiers, and building approvals were up 24% in the year to March. We’ve seen in the past what happens when an economy becomes too reliant on one sector for growth, especially when that sector requires a lot of debt to keep growing, so we shouldn’t be surprised that the banks and regulators are trying to rein things in. Before we get too worried about how this affects the stock market, it’s worth bearing in mind the correlation between GDP growth and the stock market (globally, not just Australia) is zero. Markets are always looking well ahead of the latest news and in the longer run are driven by value.
The Abbott government’s second budget was all about trying to steady the ship after last year’s disaster. The media’s had a field day on the budget deficit blowing out to double what was forecast only twelve months ago, and it’s tough not to be a bit cynical when claims of fiscal responsibility are based on fanciful forecasts like 7% revenue growth in two year’s time, but the overwhelming focus on balancing the budget is sadly misplaced. The fact is our 16% government debt to GDP is very low by international standards and we can support a much higher level.
The chart on the right shows private sector capital expenditure hit a five-and-a-half year low in the March quarter. We knew mining investment was going to have to slow from the heady days of the post-GFC China-inspired mining boom, and it’s down 14% in the last year. Likewise manufacturing is also down 9%. Rather than the Treasurer constantly imploring businesses to ‘have a go’, this is precisely the point of the economic cycle that we need governments to step in to the gap left by waning private expenditure and invest in economic infrastructure. When bond yields (the interest rate paid by a government looking to borrow money) are at record lows, there literally has never been a better time for the government to borrow to build ports, roads, power generation or any other projects that will show a long-term economic return.
This is where a benign autocracy, not beholden to a three year political process shaped by the preposterousness of weekly voter polls, would be a huge advantage. We may even have governments that resist basing long-term permanent tax changes on short-term temporary mining booms. Hmm, it’s nice to dream…
The U.S.: still asking when…
You have to presume when the Federal Reserve Chairman, Janet Yellen, remarked that equity market valuations are “generally quite high” she knew exactly what she was doing and the likely effect (you guessed it, U.S. equity markets dropped sharply). The reason she said it may have been tied to a later comment that she still expects to raise rates this year, but at a very gradual pace. The Fed continues to do everything it can to make sure no one can be surprised when they put interest rates up before the year’s out, and to reassure that when rates do start to go up it’s going to be very gradually; but it’s still odds on markets will react like it’s a bolt from the blue.
We’re now used to the U.S. reporting healthy economic data, such as the 5.4% unemployment rate being the lowest since 2008, or jobless claims hitting a 15 year low, or housing starts rising 20% to a seven year high. But as always there are some data that hint at underlying issues, such as the underemployment rate being 10.8%, or labour productivity recording its first back to back fall in more than 20 years, or first quarter GDP falling by 0.7%. It’s like Goldilocks has found the cold porridge: it’ll keep you going but it’s not too tasty.
Yes interest rates will go up by the end of the year, but everything points to what we’ve talked about before: growth is likely to stay pretty low for some time yet, so don’t expect a return to ‘normality’ in a hurry. In fact, it’s very likely what we consider to be ‘normal’ will have to continue to adapt to dramatically different circumstances. Why is that the case? A lot of it has to do with the fact that the developed world is in a liquidity trap: interest rates are really low but there’s not a big appetite among private companies and households to borrow. Having spent some 25 years building a mountain of debt the private sector is chipping away to deconstruct it. That doesn’t mean growth rates necessarily fall in a big hole, it just means they’ll be lower than during the debt build up phase.
China: loosening up
Even China can’t escape the gravitational pull of lower inflation. Producer prices have been dropping for about three years now and the CPI hit 1.5%. Transitioning the world’s second largest economy from one based on shipping to shopping was never going to be a smooth path, evident from the chart below, but since political expediency isn’t particularly high on the government’s agenda it is more likely to do what’s necessary. The government remains very conscious of the social contract it’s struck with the people: keep the economy in decent shape in return for acquiescent workers. That doesn’t mean, however, that it’s going to manage growth to appease its trading partners.
China GDP annual growth rate
Source: NBS of China
For the time being the government is sticking by its 7% GDP growth target notwithstanding some pretty ordinary industrial production data showing two-thirds of major industrial products recorded a decline in volumes over the past year – further evidence of that economic transition. To help things along the central bank cut official interest rates for the third time in six months during May and the government followed that up with an announcement loosening controls on local government financing vehicles, which have been stacked with debt built up during the post-GFC infrastructure investment boom. Throw in further reductions in the reserve requirements for local banks, meaning they have more money to lend out, and the government is showing it’s serious about keeping the economic wheels spinning. Still can’t see it underwriting a big bounce back in commodities prices though.
Europe: more green shoots and the ongoing melodrachma
Euro area GDP growth
Who’d have guessed it: the Eurozone recorded the highest growth of the major economic zones in the first quarter of the year, at 0.4%. Okay, so it’s not shooting the lights out and it’s off a small base, but it’s the best growth rate in about four years (see the chart above). After the miserable time they’ve had you celebrate the small things.
It may well be the central bank’s quantitative easing program is having a positive effect, if only on confidence. During the month the ECB announced it would be buying more than the usual €60bn during May and June to compensate for the very quiet July and August period when every self-respecting European is sitting on a beach somewhere. As we’ve seen time and time again, when the central banks open the QE spigots, asset prices tend to follow.
A reflection of the resurrected confidence of the Eurozone is the hardball stance they’re taking with Greece, as it tries to work out how it’s going to repay its un-repayable loans. It’s a good, old fashioned standoff and it’s hard to see how it’s going to end well for the Greeks. A few years ago the ECB and IMF couldn’t have afforded to risk a country defaulting and being kicked out of the Eurozone, but now it appears they’re more comfortable with it. You can bet there’s been an awful lot of work done behind the scenes to prepare for that eventuality.
Before we all get too sanguine that the road to recovery is there for the taking, the UK showed deflation is still lurking out there recording its first negative CPI reading since 1960. A little welcome to reality present for the re-elected government.
The good stuff
Despite some 50 years of economic isolation, Cuba’s medical system is world renowned. Part of that is medical research that punches way above its weight and the CimaVax lung cancer drug is a prime example. It helps the body produce anti-bodies and while it doesn’t cure or prevent cancer, it extends the life of victims with advanced cancer by four to six months without the side effects of chemotherapy.
An American cancer institute is going to start trials soon with the aim of obtaining FDA approval. It is hopeful the drug also has applications for other cancers, including breast, prostate and head and neck and that it could even potentially act like a vaccine. Let’s just hope the $1 price the Cuban government pays for each pill doesn’t go the same way so many other drugs do in the U.S.