Since the lows of February this year global financial markets have rebounded sharply and the Australian equities market posted its seventh straight weekly rise. Whilst that makes us all feel better about our portfolio balances, it would be nicer if that rebound was because of a resurgence in corporate profitability and confidence in the outlook for earnings growth. Alas, much of it has to do with central bank monetary policy, which, in the absence of governments being prepared to step up to the plate with fiscal policy, remains front and centre in the battle to sustain economic activity.
It’s the central banks, stupid
This is getting a bit repetitive. Pretty much every month we write about how markets remain fixated on what central banks are doing, and it will stay that way while governments remain either too scared, powerless or unwilling to undertake any fiscal policy stimulation. The prospects of that changing appear remote: the U.S. is in an election year so President Obama is already seen as a lame duck; the European Union can’t get governments to do anything either by agreement or force and even here in Australia what passes for fiscal debate results in zero reform.
So, let’s have a look at what a few of those central banks have been up to this past month.
Glenn’s new record
Australia’s -0.2% inflation reading in late April, combined with a healthy dose of angst about a stubbornly high currency, prompted the Reserve Bank of Australia (RBA) to lower its benchmark interest rate by 0.25% to a record low of 1.75% – see the chart below.
Australian cash rates at a record low
Source: www.tradingeconomics.com; RBA
The short-term effects were immediate: the ASX200 jumped almost 100 points in two days and the A$ started a fall that may yet have more to go – see the chart below.
A$ vs. U.S.$
Immediately the market began speculating there would be another rate cut to come, seizing on the RBA having reduced its 2016 inflation forecast from equal to its long-term target rate of 2-3% down to only 1-2%, which perhaps overlooks the fact it had also kept its GDP growth and unemployment forecasts unchanged. Once the minutes of the May meeting were released it became clearer the board was not in fact flagging further imminent rate cuts; yes they’re keeping a close eye on the CPI and they’re conscious the low inflation numbers may not be entirely due to temporary influences like weak commodity prices but could be partly because wages growth has been soft, which means there’s less money chasing up prices in general, but as always there are countervailing arguments to consider, like unexpectedly strong first quarter GDP growth and the risk of a runaway housing market.
The RBA is nowhere near as desperately keen as the U.S.’s Federal Reserve to keep markets on side, reveling instead in the fact that global markets don’t hang on its every word. In the end markets have calmed down a bit, lowering the likelihood of a June rate cut to about 20%, keeping August at 50/50 and the October odds are a near certainty.
Once again the RBA Governor, Glenn Stevens, who retires in September, urged governments to do more to help their economies rather than leaving all the heavy lifting to the central banks. With such low inflation rates the yield on the Australian 10 year bond has fallen to a new all time low of 2.25% (see the chart below) a pretty low hurdle rate of return for some showcase infrastructure projects.
Australian 10 year bond – at an all time low
Interestingly, in comments that resonate with our observations last month that deflation may not be the bogeyman it’s made out to be, a former RBA Governor Bernie Fraser, who is credited as having been the architect of the RBA’s 2-3% inflation target, was quoted in the press as saying he wouldn’t be in the “slightest bit” concerned about letting inflation undershoot the target rate for a lengthy period of time. It’s highly unusual for a former governor to comment on current policy, so you can only presume Mr Fraser was feeling particularly moved and he too suggested the focus should now be on government-led stimulus rather than monetary policy
Janet and her flip flops
Last month we wrote about how the U.S. Federal Reserve had tried to calm markets by saying that, having raised rates at the end of 2015, they weren’t in any real hurry to keep going. It worked: markets calmed down and the 2016 bear market reversed itself.
This month we can report the opposite: not only is Governor Janet Yellen talking up the prospects of a rate hike some time around the middle of the year, but so too are various members of her merry band of deputies. To ordinary people this looks like a classic case of cognitive dissonance, but these are not ordinary people, they’re economists.
The Fed has told us time and again whether they raise rates depends on the data, and as we know, if you torture data hard enough it will admit to anything. So while the CPI was reported as only 1.1% p.a., core CPI, which leaves out the more volatile food and energy prices, was 2.1%; and despite S&P500 companies reporting the biggest quarterly decline in earnings since the GFC to make it four negative quarters on the trot, unemployment is super low at close to 5%; and although 40% of the new jobs created since the GFC are so low paying they’re barely above the poverty line, wages look like they’re edging up (see the chart below).
U.S. unemployment is staying low while wages are trending up
All that adds up to the Fed being able to justify anything. So when you consider that the board would presumably love to give itself a bit more interest rate wriggle room, you can understand how they would be itching to raise. After Governor Yellen spoke last Friday, the markets are factoring in a 32% likelihood that rates will go up after the Fed’s June meeting, compared to only 4% two weeks ago and the odds rates will go up by July rose to 58%.
The Bank of Japan just can’t win
For a long time now Japan has been like an ongoing economic experiment. The latest phase of that started when Prime Minister Abe set out his blueprint for growth, since dubbed Abenomics. A quick bit of background: economic growth is determined by two things, how many workers a country has and how productive those workers are. It’s a simple and irrefutable equation. As is well known, the Japanese government and its central bank are fighting a demographic tide, which is really hard. Interestingly though, while GDP growth is relatively low, GDP per capita has been strong. The Bank of Japan (BOJ) has been one of the most aggressive central banks in the world, undertaking a quantitative easing (QE) program that, as a proportion of its economy, is multiples of its peers – see the chart below.
The Bank of Japan’s balance sheet
They’ve tried everything: normal QE, where the central bank buys bonds off the banking sector and credits the banks with funds to lend out; they’ve had 0% interest rates for years and shocked markets by going to negative rates in January of this year, and kind of bizarrely, the BOJ has been buying A$38bn worth shares in Japanese companies per year (through ETF’s), to the point where Bloomberg estimates the BOJ is now a top 10 shareholder in 200 of the Nikkei’s 225 companies (incredibly, it’s understood Governor Kuroda wants to more than double the spend, which could see it become the number 1 shareholder in about 40 companies by the end of 2017). While that’s been good for the Japanese share market, frustratingly for the BOJ inflation and growth remain below target, and worse, the Yen has been rising against the U.S.$ – see the chart below – in fact the Yen has given up almost one third of the hard won losses against the U.S.$ since the introduction of Abenomics.
The number of U.S. cents that can be purchased with 1 Yen
You’d be forgiven for wondering how that could be possible, but as we’ve pointed out many times, there is an undeclared currency war going on. For every cent the Yen rises, Japan’s exports are less competitive, undermining economic growth. Japan’s finance minister said they are prepared to intervene in foreign exchange markets if they have to, but that would risk retaliation by major trading partners. What else can they do?
It is suggested there is another thing the BOJ can try: what has come to be called ‘helicopter money’. This is where the central bank effectively creates money which is then distributed by the government through either tax cuts or public spending. So rather than waiting for the banking system to inject money into the economy through lending like ‘normal’ QE, money is put directly in to the economy.
The idea is that it creates inflation and stimulates growth. The problem is, it’s not clear whether it’s controllable.
Is monetary policy working?
Whether or not the radical monetary policy programs employed by central banks to promote growth have worked is hotly debated. The fact is, we’ll never know. We can’t undo what’s been done and the reality is economies across the world did recover from the post-GFC slump. Whether that would have happened without QE can only be a matter of conjecture.
The problem is, however, monetary policy is a very blunt instrument. All it can do is try to control the price of money, which in turn tries to encourage people to borrow or save more. Low interest rates, such as we have now, are normally trying to get people to borrow, which is effectively just drawing forward consumption from tomorrow to today.
When economies across the world, from the U.S., to Europe, to China, to Australia, are already facing high debt levels, be it government or household debt, it’s tough to see where the extra demand for debt is going to come from. Households are showing a preference for saving – as shown in the chart below.
U.S. households’ preference for saving vs. spending
Source: Deutsche Bank
It could well be that we just have to reduce the debt pile before we see global economic growth experience the same debt-fuelled trajectory we did from 1980-2007. Which fits neatly in to the low growth scenario we’ve been talking about for some time.
So what should you do?
The correction we saw in markets at the beginning of this year saw redemptions of equity and bond funds, especially in the U.S., spike up to levels not seen since the GFC. Investors reacted with an almost visceral response to volatility, despite the correction being no more than what is experienced on average every second year.
I suspect that’s because the shadow of the GFC still looms large in every investor’s mind. There seems to be a perception that nothing’s really been fixed since the GFC so it could all just happen again. As a matter of fact, a lot has changed: banks right across the world have been recapitalized and regulations have been strengthened. Given the media’s self interest in focusing on the negatives, we tend not to read or hear much about those positive changes. Essentially, when the alternative to being invested in financial markets is bank interest rates of about 2%, on anything resembling a long-term view it’s a no-brainer.
I heard an interview with a 50 year veteran of financial markets who observed that we’ve been in a bull market for about seven years and he’s never seen a bull market end in a state of visceral fear, they always end in euphoria. Right now, we’re a long way from euphoria.