economic commentary june 2013

Wednesday, 13 June 2013

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US and Developed Markets In the US, financial markets are still watching every word of communication from the Federal Reserve members for a clue as to the timing of withdrawal of QE. The USD (DXY index) gained 3.2% in the first three weeks of the month. The catalyst for this surge, in the first instance, was Wall Street Journal journalist Hilsenrath being rumoured to be writing an article about Fed withdrawal of QE. His perceived connection with Fed movements caused a violent move in the USDJPY through the 100.00 barrier, as well as other USD crosses.

Fed Chairman Bernanke also raised expectations of “tapering” with this one sentence – “if we see continued improvement and we have confidence that that’s going to be sustained, then we could in the next few meetings… take a step down in our pace of purchases”. Using the words “next few meetings” had the USD bulls jumping into action. There is a lot at stake as the phasing out of the Fed’s unconventional monetary policy comes into play. Firstly, whilst we all knew the punch bowl had to be withdrawn at some point, markets have become used to the “Fed put”. Good economic news will likely be negative now for bond and equity markets in the short term. Secondly, volatility is likely to increase in the bond market which will cause volatility to increase in other asset classes. Finally, in our view, there has been some gap between the prices of financial assets and fundamental economic conditions caused by QE. This gap will need to narrow one way or the other to get back to normal. The IMF [International Monetary Fund] said falling business investment and the Eurozone’s on-going recession, which have hampered German growth, meant the economy would grow by just 0.3% this year, compared with an April estimate of 0.6%. "The uncertainty, mainly surrounding prospects for the euro area and the on-going recession in the region, have led to declining German exports to the region as well as a sharp pull back in business investment," the IMF said in a report

In Europe, the monetary easing is coinciding with a relaxation in the pace of fiscal consolidation as the Commission extended the deadline to reach the 3% deficit target for a number of countries, including France and Spain. There was also good news for Italy as it officially exited the Excessive Deficit Procedure after successfully reducing its deficit below 3%. This more growth-friendly policy backdrop underpinned the better performance of the Eurozone inflation linked bonds relative to their peers. Italy was the best returning global inflation linked bond market (up 0.16% in US dollar hedged terms). The Irish nominal bond market also performed well and was the best performing Eurozone nominal bond market, as it remained on track to exit the EU/IMF programme at the end of the year


Australia The key development here was the Reserve Bank of Australia’s rate cut in early May. Official rates are

now below the levels reached during the GFC. The weakness in the Australian dollar should take some

pressure off sectors of the economy that struggled with the currency at its previous highs. However, at

around 95 US cents, our dollar is still at a very high level historically. Although May was a positive

month, markets were much weaker towards the end of the month. A big part of that weakness was due to

concerns about what the world’s major central banks might do. Bond investors had a difficult month.

Yields rose very sharply in all the major bond markets. While yields are still at very low levels

historically, their rise meant global investment-grade bonds had their worst monthly result since 2004.

Job Ads.

The recent fall in Job Ads post the March spike reflects similar corrections after spikes in 2001 and 2012. The trend however is not positive. This is a reflection on the falling demand for workers in the resource industry and the continued pressure on our domestic exporters. While the latter has seen some pressure come off as the A$ slips to around 95 cents to the USD this is still a very high by historic standards.


The AUD has always been a macro play on China in recent times. Our concerns on China and

bearishness on the AUD can be summarised by the continued credit growth of the scale experienced in

China and the amount required to continue the headline GDP growth is unsustainable; it has

historically always ended in tears (in different examples in other regions); This leads us to our

continued bearish view on the global demand and supply story for iron ore; and finally the “Fixed Asset

Investment” story in Australia is about to fall off a cliff.

The recent pull back and increased volatility of our stock market is a reflection of these concerns and

that the markets have discounted strong profit growth for the listed companies which is looking

increasingly unlikely given the slowdown in growth in China and the very modest levels of growth in

the other major economies.


Emerging Markets We still remain concerned about the on-going problems emerging from the stronger US dollar. Commodities remain under pressure and emerging markets are looking increasingly vulnerable, not helped of course by 'risk' events such as the riots in Turkey. At the heart of the problem is that yield spreads collapsed as savers chased nominal returns without thinking about a) sovereign risk or b) currency effects. Now either or both are coming into play, mixed together with the lagged 'sell the underperformers trade' as EM equity funds are redeemed. The problem for these markets is that local currency debt becomes unattractive to international investors as the currency declines, while foreign currency debt can suddenly become economically ruinous. Some would argue (rightly) that the cheap money that has flooded into EM has created some dangerous mis-allocation of capital as it always does and that we are due a period of 'discovery' as the cost of capital rises - just as we are seeing in Spain, Portugal, and Ireland etc. Cheap funding hides a multitude of economic sins. Those countries that need global capital - most obviously Turkey, South Africa and India - could find things rather less pleasant than they have become used to. Weak bond markets lead to weaker currency which triggers selling in bond (and equity) markets, which means weaker currency and so on. In short there remains a risk of the reversal of the beta trade that led to so much 'genius' in EM investment over the last 10 years

This rise in US Treasury yields was mirrored in global bond markets, particularly in emerging markets where investors perceive the positive impact of the Fed’s policy stimulus to have been strongest. The Mexican nominal and inflation linked bond markets were amongst the worst affected emerging markets, due to its close economic ties with the US and liquidity. Elsewhere, during the month, interest rates were lowered in Poland, Hungary, Israel and South Korea in an effort to spur growth. The RBA and ECB followed suit in lowering rates during May to support their economy and weaken their currencies.


Summary

We are quite concerned that share markets had run too far ahead of fundamentals – in particular, too far ahead of corporate profits. We still have those concerns even after the recent pull back of around 7%. We need to see decent profit growth from here to justify some of the gains that markets have made over the past 12 months which have put companies on unrealistically high price/earnings ratios.

We still believe future share market returns look considerably better than bonds, cash or residential property. However, investing in the right shares, and managing risk ( and market volatility,) really well, is extremely important.


Disclaimer

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economic commentary june 2013

Economy & Finance