Monthly Roundup
After the worst start in umpteen years for global markets we’re now seeing a snap back – as is so often the case. The reasons for that remain as mysterious as those for the fall.
A handy rebound
Bloomberg published the chart below on March 23, listing all the markets that had rallied by more than 10% from their lows, which were generally mid-February:
Markets Rebound
Source: Bloomberg
Given a picture speaks a thousand words, here are a few of those impressive moves:
Why the rebound? Take your pick: the US Federal Reserve indicated it wasn’t going to rush to raising interest rates again; China’s 13th five year plan targeted GDP growth of 6.5% p.a. and introduced another infrastructure program; the oil price stopped falling; all of the above.
The little Aussie battler
Even a cursory glance at the chart above would lead one to ask: what’s going on with the Australian market? One of the headwinds has been the remarkable rebound in the A$, which has bounced 12% from its January lows – see the chart below.
A$ vs. US$
Source: IRESS
So what’s behind that? When it comes to currencies there are normally countless moving parts that make up the full picture. To start with, the US Federal Reserve’s comments that it was in no hurry to raise interest rates took a lot of upward pressure off the US$ (which made the US stock markets very happy). At the same time Australia’s fourth quarter GDP came out at a surprisingly strong 3%, which had currency traders punting that at best the Reserve Bank won’t be cutting interest rates again soon and at worst could go to a tightening bias. Also, the combination of China’s announcement of a targeted 6.5% GDP growth for the next five years, which was higher than most had expected, plus Premier Li Keqiang outlining pledges to spend 800 billion yuan ($A164bn) on railway construction and 1.65 trillion yuan ($A339bn) on building roads saw a rally across commodities (see the charts below), which in turn fed through to the A$.
Source: www.quandl.com
Whether the rally in iron ore prices is sustainable is another question. Even BHP, which you’d have thought would be the main cheerleader for a sustained rally, talked the prospects down. As we’ve pointed out before, last year China produced some 820m tons of steel; during their post war industrialization period neither the US, Japan nor the Soviet Union produced more than 200m tons in any one year. So the Chinese know they have a massive over supply issue and the government has indicated it is going to shut down unprofitable mills, which will reduce iron ore demand.
Meanwhile, all those mine expansions from the Pilbara, Brazil and Chile are continuing to drive supply higher and higher – see the chart below. So the medium term outlook for iron ore doesn’t seem good, which should take pressure off the A$ because it will put pressure on the Australian economy.
Changes in iron ore supply vs. demand
Source: Macquarie
The other source of upward pressure on the A$ is central bank shenanigans: competitive monetary policy moves designed to stimulate an economy partly by keeping exchange rates low…
NIRP – the new black
The post-GFC world was introduced to the acronym, ZIRP, which was the Zero Interest Rate Policy: keeping cash rates at close to 0% in an effort to stimulate the economy through increased bank lending. At the time it was such a radical idea that many misguided economists declared it would debase fiat currencies and cause a hyperinflationary breakout reminiscent of the Weimar Republic of the 1930s. That, of course, didn’t happen, and instead the world continues to battle with disinflation and people are still very happy to accept cold, hard cash.
Last month the Bank of Japan joined the European Central Bank in setting its interest rates at below zero, thus the new acronym: NIRP, or Negative Interest Rate Policy. This of course set off a debate amongst commentators as to the wisdom of resorting to something that had not long ago been inconceivable and the doomsayers once again trotted out how it will lead to disaster.
But the BOJ and ECB are not the only central banks to have resorted to NIRP; Sweden, Denmark and Switzerland have also done the same. Does it make any sense? As extraordinary as it sounds, there is a good argument to say it’s just a logical extension of the existing monetary policy regime. Interest rates are essentially the price of money and are used to manipulate the demand for investing in interest-bearing assets and borrowing money. The difficult part for conventional thinking is to get past the concept of the price for something being negative, but obviously in theory it can happen.
How does it work? During Quantitative Easing (QE) the central banks have been buying different kinds of bonds off the banks in exchange for crediting the banks with funds. The idea being that the banks would take those extra funds and lend them out to rev up economic activity. But instead the banks kept the money deposited with the central banks which had been paying them interest on it, saying they couldn’t find any borrowers. Originally that interest rate had started out at, say, 1% p.a. – money for jam for the banks. Now, however, the central banks are saying “we’re serious, we want you to lend this money out”, so they’re now paying a negative rate on those funds. In other words, it’s now costing the banks to leave the money sitting doing nothing. The problem is, when debt levels amongst companies and households are already high there’s just not a lot of demand to borrow more. That’s why critics argue monetary policy is ‘pushing on a string’ and the central banks are pleading with governments to do some of the heavy lifting through fiscal policy.
The extraordinary upshot is that now some 30-40% of the world’s government bonds, representing almost a quarter of the world’s GDP, are trading with a negative yield – you pay the government to look after your money. This is illustrated in the chart below, where the red blocks represent bonds that pay a yield below 0%.
Government bond yields
Source: Bloomberg Finance LP. DB Global Markets Research
Back to the A$: RBA Governor Glenn Stevens complained during the month that those pesky central banks that keep cutting rates makes his job much more difficult because it keeps placing upward pressure on our dollar.
European shares on sale
Those who read our quarterly GMAP updates will know that we have been overweight European shares compared with US for some time. Why is that? We always try to be overweight those asset classes that offer the best relative value.
The chart below, from AMP Capital, shows how cheap European shares are compared with US at the moment, with the gap between them the highest it’s been in at least 36 years.
Cyclically adjusted price to earnings ratios
Over the past five years the Vanguard S&P 500 index fund (VFIAX) has returned 11.43% p.a. whereas the Vanguard European index fund (VEURX) has delivered a relatively paltry 1.92% p.a. That earnings differential has never been greater.
As a result though, US shares now appear pretty expensive and consequently the expected future returns are commensurately lower. Our asset allocation consultant, farelly’s, has the following 10 year annualised forecast returns:
Mean reversion is one of the immutable long-term laws of financial markets, but it doesn’t operate on a schedule. It could take a long time for the relationship to reverse, but the important thing to remember is that it doesn’t necessarily require good news out of Europe, just less bad.
Bank bashers
Not long ago a UK hedge fund research group, called Variant Perception, captured some pretty alarming headlines by forecasting that Australian bank shares could drop by 80% when the “Australian housing bubble bursts”. They forecast mortgage default rates of 20%, in line with what Ireland experienced as a result of the GFC, or twice as bad as the US experienced, which would of course be really bad news for the banks. However, to put that extraordinary forecast into some context, Australian default rates are currently amongst the lowest in the world at 0.5%.
That report, which garnered a conspicuous amount of media attention (including a spot on 60 Minutes and front page articles in the Financial Review and SMH) for the hedge fund that short sold Australian bank shares, duly saw the banks get whacked the day it came out. Bear in mind short selling means they sold shares they don’t own, something you do if you are confident a share price is going to fall, but which can be very painful if the shares go the wrong way because there is no limit to how much money you can lose. A high profile media campaign like that would certainly have helped their own book.
On top of that a couple of weeks ago ANZ announced an increase in its impaired loan provision from $800m to $900m, largely due to exposure to mining and commodity-related companies, and once again the banks got walloped, with media headlines talking about the resources correction coming home to roost.
How do these stack up? Given bank share prices have fallen between 20-30% over the past year are they still a disaster waiting to happen?
Looking at the impaired loan provisions first, there is no doubt the banks have enjoyed an earnings tailwind over the past few years with the decline in bad and doubtful debts. They have now reached a cyclical low so it’s very likely we’ll see a rise from the current levels. With regard to exposure to the resources industry ANZ’s loan book has the highest exposure at 2.2% of its loan book, while CBA has 2.1%, Westpac has 1.4% and NAB has 1.2%. It appears at this stage the provisions are for specific companies rather than across the board for the sector. Whilst there may well be exposure to other resources-related sectors, it is something APRA has been monitoring for its risk parameters. It’s also worth remembering the loan impairment provisions are, at this stage, only that: provisions.
Further, over the last year the banks increased their collective capital by about $40bn, which not surprisingly coincided with their share price weakness. APRA has indicated their capitalisation ratios are now in the top quartile globally, which is what they were targeting.
With regard to the Australian housing market, there are some mining areas that were indeed disasters waiting to happen. When you hear reports of mining towns in the middle of nowhere seeing house prices tripling inside two years and rents higher than capital cities during a time of historically high resources prices, it spells trouble. In Moronbah a real estate agent recently sold a couple of houses for 80% less than what they’d been bought for only four years earlier. That was a bubble, but it was isolated.
Australian housing has long been a target of hedge funds, who point to high debt to income levels as well as the high rate of price appreciation over the past 30 years. In fact, one commentator refers to shorting the Australian banks on the basis of a housing bubble as the ‘widow maker’ among hedge funds. We are not property experts by any stretch, but would offer a a few observations. Recently Merrill Lynch did some analysis of Australian house price appreciation and found that adjusted for the rise in household income and the decline in interest rates, the price increase over the past 30 years is bang in line with projections. In other words, if interest rates go down and your income goes up, you’re going to be able to afford to pay more for a house. That certainly doesn’t mean they’re cheap, but nor do they appear bubble-like.
Also, APRA came down hard on the banks last year, forcing them to lower the risk in their residential loan books by restricting lending to investors and increasing the servicing requirements across all borrowers. The banks have an average loan to valuation ratio across their books of about 60%, which leaves a lot of room for prices to fall before they are in big trouble, and those loans with an LVR above 80% are normally insured. New loans written over the past two years represent something like 4% of the banks’ total loan book and Westpac reported that 74% of its borrowers are ahead of schedule on repayments. One analyst calculated that if the Commonwealth Bank suffered a 10% default rate (which is 20 times higher than current levels), it would report about a $1.4bn loss, which is around 10% of one year’s profits.
We’re not advocating to buy property, nor are we advocating to buy bank shares. What we are saying though is that from time to time markets overdo things, particularly when the media gets involved and as always a healthy dose of skepticism is warranted when it comes to media headlines. It’s always worth remembering, for most people no news is good news, but for the media, good news is no news.
