The Fed can’t win: in August market weakness was put down to the threat of the Fed raising interest rates in September, then weak markets in September were put down to the fact they didn’t! The media’s been full of quotes from economists criticising the Fed for not seizing the opportunity to lift rates for the first time in nine years, something the Fed itself has been telling us it wants to do all year. Some of those same economists would have been earlier campaigning for the Fed to leave rates untouched. It’s a bizarre situation when a central bank is harangued for not increasing interest rates. It brings to mind Harry Truman’s famous quote of “Find me a one-handed economist”, one who can’t say ‘on the other hand’. You can imagine how a conversation might go between two economists:
Right Hand: It’s ridiculous the Fed didn’t raise rates in September. Gosh darn, just look at unemployment: at 5.1% it’s the lowest it’s been since the last boom.
Left Hand: But that’s only because the participation rate is 62%, whereas in the last boom it was 66%, so the actual employment rate is 59% compared with 63% pre-GFC. When you’ve got CPI going up at only 0.2% year on year, you can’t afford to raise interest rates.
Right Hand: Come on, don’t you remember the Phillips Curve from university? When employment gets too low inflation goes crazy.
Left Hand: Oh come on, you know very well the Phillips Curve’s been tossed into the same bin as the Taylor Rule on bond yields. There’s just no wage pressure.
Right Hand: Then why are transport companies having to pay truck drivers a $50,000 sign on fee? And why are car sales hitting a record and house builders are the busiest since 2003?
And so it goes on, and on. The Fed has always said that while it wants to raise rates this year it will be guided by the data. This time around, while they acknowledged the U.S. economy is doing pretty well, they were concerned about economic weakness in the rest of the world (read China). The committee ended up voting ten to one to leave rates unchanged, which hardly suggests there’s a lot of quibbling, but a week after the meeting Chair Yellen said the committee still expects to be raising rates in 2015. While the now famous ‘dot points’ show the committee expects interest rates to rise more than 2% over the next two years, they’ve been consistently too high over the past few years and now the market is rating the chances of even a 2015 increase at less than 50%. On the other hand(!), the U.S.$ has been steadily rising over the past 18 months, which is estimated to have had the same effect as raising interest rates by 0.75%.
During September the yield on the S&P500 hit the same level as the yield on the 10 year U.S. bond: 2.2%. This has happened only twice in the last 55 years outside of crisis conditions, September 2011 and January 2015. Both times the share market performed well over the following six months (+25% and +6% respectively) as money chased the more immediate income. Nobody knows if it will happen again this time, since it depends on whether earnings are strong enough to pay the dividends, but the very low bond yield underpins our valuation of equities markets being cheap at the moment.
If you think those numbers should sound tempting to investors, here in Australia the trailing dividend yield (that is, the amount actually paid) on the share market has hit 5%, compared to the 10 year bond yield of 2.7%. That’s the biggest gap since the GFC, when it was only very slightly higher (see the chart below). That serves as another illustration of how cheap share markets are following the recent selloff.
Australia Equity and bond yields
Source: IRESS, Datastream, Deutsche Bank
Speaking of dividends, CommSec pointed out that over the next few weeks there will be about $20.7bn of dividends being distributed in Australia following the recent results season, which equates to about 1.4% of GDP. While that’s an impressive number, some of the other numbers from reporting season weren’t so impressive: from a sample of 143 companies they look at, revenue only went up by 0.4% while expenses rose 3.1%, which saw profits fall by 32% year on year much of which was from the resources sector.
During the month Australia’s GDP growth was released. The good news is that our record breaking run of growth continued for a 95th quarter. The bad news is that the 2% year on year growth is way below the 3.25% considered as ‘trend’ growth (see the chart below). We’ve said before the trend rate will inevitably have to be revised down in this low growth environment, but it’s something the government is very reluctant to do since it will wreak havoc with their pie in the sky budget forecasts.
Australian real GDP growth
The low GDP figure of course lifted expectations and hopes the Reserve Bank will cut rates again, but that only helps lift growth if people and, more particularly, firms are borrowing. The capex chart below shows firms are actually expecting to reduce capex and household debt levels remain at record levels.
Actual and expected capital expenditure
A country’s GDP growth is a product of how many workers there are and how much they produce. So there are only two ways for a country to increase its GDP: get more workers, or make the workers they have more productive – the latter being the hallmark of successful economic policy. The sad fact is that much of Australia’s enviable GDP growth over the past decade has come from population growth: productivity is going backwards. This is shown in the chart below.
Real Gross Domestic Product
One problem now is population growth is expected to decline, partly due to a slowing of migration. That is going to put pressure on governments to address productivity, but our sclerotic political environment has seen genuine, critical reform fall at the first of many partisan hurdles. We were treated to yet another demonstration of the appalling political state with our fifth Prime Minister in five years, to put that into some context, Italy has had four in the same period and Greece six. We can but hope that the new ministry finds the political courage and capital to undertake the reform that is required.
One pleasing point is the RBA said it is happy with the effects the APRA-led restrictions on housing investment are having on the housing market. That comes after the ABS announced that approvals for private units rose 32% in the year to the end of July and at the same time rental growth of 0.7% for the year was the slowest since records started in 1995. Melbourne’s rental yield is 3.1% (compared to 3.3% a year ago) and Sydney’s is 3.3% (compared to 3.8%). Take away all the costs of owning a property and the net yield is significantly less than what you can get from a risk free term deposit, meaning the only possible reason people could be investing in those properties is for capital gain, something that is also known as ‘the greater fool theory’.
The other feature of the month is ongoing turmoil in commodities markets. China’s industrial companies announced that profits in August fell by 9% compared with a year ago, which was the worst result in four years. That saw commodities get whacked, which just added to the fear generated by Glencore’s debt-induced death throes. Honestly, a company goes on a debt-funded $50bn buying spree during a raging resources boom – we’ve seen it all before and it was only ever going to end in tears.
The Eurozone still looks like it’s in recovery mode: industrial production rose 1.9% from last year – ok it’s not great, but at least it’s positive. Inflation is still dangerously low at 0.2% p.a., which would have the die-hard monetarists scratching their heads since between them the European Central Bank and the Bank of Japan continue to buy U.S.$125bn of bonds every month (mind you, the oil price falling another 6% helps). Even Britain, which at one stage was the odds on favourite to be the first to lift interest rates, voted to keep rates at the all-time low of 0.5% for the ninth year and maintain their ‘asset purchase’, or quantitative easing, program.
With markets having fallen another month, there is unquestionably value being restored to equities markets. We can’t tell you if the falls are over, but we can tell you that there is real value there.
The good stuff…
As a terrific illustration of the power of a disruptive business model, Airbnb released its 2015 summer travel report. In the summer of 2010, about 47,000 people stayed with an Airbnb host, compared to this summer, which saw the number rise to 17 million! That’s enough to give the hotel chains nightmares.