Paul Zwi, Chairman, Portfolio Review Committee at Clime and David Walker, Head of Equities at StocksInValue Wednesday, 6 November 2013
In recent months The View has covered the US economy, government debt crisis and quantitative easing (QE) at length. As the relationship between growth, money printing and government debt evolves we will cover these topics further but today it is time to step sideways for a history lesson to see if a momentous but somewhat forgotten year in the history of the US bond market informs our analysis of where financial markets are headed.
1994. Nelson Mandela is inaugurated as South Africa’s first black president. US President Bill Clinton delivers his first State of the Union address. Email was in its infancy and most people downloaded primitive web pages using 56K modems. The Channel Tunnel between England and France opened.
The US bond market suffered a devastating crash which rippled around the world. How did this happen, what were its implications and could it happen today?
In the early 1990s bond yields were depressed by recession, falling inflation and a jobless recovery. The cycle turned aggressively in 1994 after economic recovery became entrenched in 1993. In his first State of the Union address President Clinton made a compelling argument for why the US economy had returned to life: “Auto sales are way up. Home sales are at a record high. Millions of Americans have refinanced their homes. And our economy produced 1.6 million private sector jobs in 1993, more than were created in the previous four years combined.”
Bond investors were not convinced and discounted the prospect US Federal Reserve Chairman Alan Greenspan would raise rates in the face of an improving economy. But the US Federal Reserve (the Fed) dramatically surprised the market when it raised the Fed Funds Rate from 3% to 6% starting in February 1994, while the Reserve Bank of Australia raised its cash rate in sympathy from 4.75% to 7.5% over four months from August 1994. This saw 10-year bond yields rise from 5.2% to 8% in the US and from 6.4% to 10.7% in Australia, where bonds generated a loss of 4.7% in 1994. Equity markets lost 8.2% in Australia and returned only 1.3% in the US.
Bond investors were crushed. Large firms suffered major losses, some small firms went to the wall, the losses revealed trading scandals at some firms, Mexico entered a financial crisis and Orange County, California, declared bankruptcy after losing money on a bond derivatives bet. Investors had been lulled into a false sense of security that rates would remain low. This was understandable given the Fed’s February rise was its first in six years. Until then the central bank’s prescription for the weak economy was a long period of low interest rates, designed to heal the banking system and the housing market.
The irony was the 1994 monetary tightening delivered against the Fed’s mandate of price stability and full employment. Treasury bonds took a beating but by 1995 the Fed could point to a lower unemployment rate – 5.5% vs 6.5% in early 1994 – and falling inflation. Losses by overleveraged bond investors would have seemed an acceptable price to pay.
So could the bond market crash of 1994 happen again? There are some similarities between then and now: a slow economic recovery, banks recovering from a financial crisis and several preceding years of historically low interest rates.
The transmission mechanism of QE is to drive bond yields below where they would otherwise be to depress lending rates for businesses and homeowners, increase their profits and disposable income, and thus boost hiring, investment and consumer spending. Therefore bonds become artificially overvalued. It is difficult to observe or deduce the exact extent of overvaluation but given US bond yields have been to historic lows, admittedly before a recent upturn, it is safe to conclude bonds are still very overvalued from a long-term perspective. This makes bonds vulnerable to changes in sentiment.
Securities and asset classes tend to stay overvalued until there is a catalyst, such as a rapid rise in interest rates in the case of bonds. A sudden plunge in the US unemployment rate below 6.5%, the Fed’s threshold for restoring its funds rate from near-zero, could be such a trigger. A 1994-style crash in bond markets can never be ruled out but would require an unexpected and rapid improvement in economic growth and employment. In 1994 the Fed hiked rates by three percentage points within a year, prompting the crash. We are a long way from this in 2013-14. The US economic recovery remains much slower than after previous recessions, including the early 1990s experience, and faces weak bank lending, a corporate sector still reluctant to invest, a housing sector very sensitive to higher bond yields, excessive government deficits and millions of workers who have left the labour market.
Communication of the Fed’s thinking on monetary policy, while still the subject of relentless criticism, is also more open and transparent. 19 years ago the Fed didn’t always even announce rate changes and Alan Greenspan was notorious for his delphic, inscrutable comments on Fed policy. Today the Fed telegraphs the evolution of its thinking through policy statements, speeches and minutes of meetings. From June 2004, after the end of the early 2000s recession, the Fed implemented 17 well-telegraphed rate increases, increasing the funds rate in quarter-point increments to 5.25%, without crashing the bond market. The central bank will attempt the same this time.
What is different from 1994 is the enormous weight of surplus liquidity from QE, which is being used to purchase government bonds on-market and is in addition to the near-zero Fed funds rate. As we saw in May, when global bonds and equities sold off sharply in response to the Fed’s first talk of tapering QE, the artificial manipulation of rates by central banks makes markets nervous and investors are uncomfortably long equities and credit. Complacency is probably widespread if past experience of other overvalued markets is anything to go by, but the current veneer of buoyant optimism is fragile and. Normally, long periods of overvaluation encourage a belief prices will remain high indefinitely.
Figure 1. How QE works
The world has never seen major central banks exit QE and investor fears are justified. The scale of the bond bull market since 1994 means the downside is greater than then. Currently the Fed supports strong asset markets because these support macroeconomic goals, but will it be as supportive when the unemployment rate approaches 6.5%? The damage to investors who have been feasting for years on cheap money could be far worse than in 1994. The key possibility to watch for is a disconnect, even a temporary one, between economic and asset market conditions.
The stage is set for substantial bond market volatility in response to even gradual Fed tapering. Given government bond yields, as an input to discount rates and required returns, are a component of every equity valuation, substantial equity market volatility is likely as well. An ongoing steady rally in equities is hard to justify in the absence of surging earnings. The strength of the economic recovery is the wildcard and the risk is a surge in job creation which meets the Fed’s unemployment target before the market is ready.
Figure 2. Dr Benanke comic Source: Eric G. Lewis
China’s Third Plenary Session: the Party’s Reform Agenda
A year after President Xi Jinping’s took over the leadership of China’s Communist Party, the forthcoming party congress is seen as an important test of commitment to economic reform.
China’s ruling Communist Party will hold its Third Plenary Session of the 18th Central Committee on the 9th to the 12th of November in Beijing. President Xi Jinping will be hosting the meeting, which gathers together 376 of the top party leaders.
During its five year term, the Central Committee holds a number of meetings (plenums) where it discusses and approves big policy decisions. While other plenums have dealt with ideology and propaganda, this one is expected to focus on economics.
Expectations for this year’s meeting are high, with the view that a new round of reforms could be in the offing. Key themes being spoken about include improvements to the market system (via a transformation of the role of government and corporate structures); reforms to the land system, financial sector, taxation and the management of state assets; and a new focus on social security.
If President Xi were to announce major reforms, it could boost short term confidence as well as long term economic prospects. However, commentators see two impediments to a sweeping reform package: the new leadership still needs more time to consolidate its power; and vested interest groups could block meaningful reforms.
Figure 3. President Xi showing he is a “man of the people” Source: Xinhua
China’s political leaders know the consequences of not reforming. They know that without tackling the tough issues, it is unlikely China can sustain economic growth and maintain social harmony. For three decades, the implicit contract has been strong economic growth leading to rising standards of living, in exchange for a Communist Party monopoly over political power. This has been a contract that has worked well, but is increasingly coming under threat. Apart from the politically contentious area of land reform, areas where there will be pressure to inject some innovative thinking include financial, fiscal and tax reform.
There will be discussions around allowing more foreign competition, the introduction of a deposit insurance scheme, the liberalisation of deposit rates, the widening of the currency trading bands, and the relaxation of cross-border financing. Fiscal and tax reforms could include moves to centralise pensions, public health and food administration, expand VAT and resource taxes, and develop local and municipal bond markets. There may even be plans to allow private and foreign capital into fundamental service sectors, including public utilities, telecommunication, railways, legal services, banking and financial industries, and introduce more competitive pricing for electricity, water and other utilities.
Positive recent data
A recently released report showed that a non-manufacturing Purchasing Managers’ Index rose to its highest level this year during October. The increase follows faster than expected growth in two manufacturing indexes last week.
Signs of sustained strength in the world’s second-largest economy may give President Xi and Premier Li Keqiang more confidence in tackling reforms. At the same time, excessive credit growth, rising local-government debt and weaker export momentum may cap a stronger recovery from a two-quarter slowdown.
China watchers estimate gross domestic product will rise 7.7% in the fourth quarter from a year earlier, a touch below the 7.8% growth in the September quarter. According to a Bloomberg survey of 52 economists, GDP will increase 7.6% during 2013. That is similar to the 7.7% figure for 2012, but well off the average growth of 10% experienced over the last 3 decades. But growth above 7% is of course off a massively expanded base-line, and will sustain hopes for continued elevated commodity prices.
Figure 4. China GDP annual growth rate Source: National Bureau of Statistics of China, Trading Economics
Both President Xi and Premier Li have indicated that the days of annual GDP expansion of 10% are over. The government will focus on policy changes to support more sustainable growth that will reduce inequality and reform market mechanisms.
The economy is entering a phase of “transformation” involving a slowdown in growth “from a high speed to a medium-to-high speed,” Li said in September. He has signalled that the government’s bottom line for expansion is 7%, the level needed to meet the target of doubling per capita income in the decade through to 2020.
As pointed out by well-known commentator Jim O’Neill, who famously coined the BRIC acronym, by the end of 2013 China’s GDP will be around $9 trillion, making its economy more than half the size of the US, 150% the size of Japan, and six times the size of Australia. China is in effect “creating another India every two years”.
Chinese steel production growth has re-accelerated this year to above 8%, helping to maintain the iron ore price higher than anticipated.
Figure 5. China steel production growth (YoY) Source: Datastream
Given the stated desire by many large Australian corporates to increase their foothold in China, the Third Plenary Session may usher in a widening window of opportunity, particularly for our financial services companies. No doubt, ANZ’s CEO Mike Smith and many other Australian business leaders will be watching developments with close attention.