Thursday, 18th Jul 2013
A recent holiday to the USA and the United Kingdom stimulated one thought in my mind – how insignificant Australia has become, once again.
For a brief period as the world emerged from the GFC, it was clear that Australia had managed its way through the world recession, albeit with some luck. At that time and from afar, Australia appeared a dynamic economy that was well positioned in the Asian growth region. Our massive resource base would see Australia generate foreign income surpluses that could cleverly be reinvested across other industries to create an economy that would stand unique in a low growth world.
Well regulated, high education standards, a burgeoning albeit small population, democratically governed, with strong laws, an open media and a massive savings base for retirement. These are all positive features of our society and our economy. So much so that everyone wants to live here – however from afar, it becomes clear that our leaders either do not care or cannot envision what we will become or look like in 10 or 20 years’ time. Rather, they run Australia based on the preeminent desire of winning the next election.
These thoughts came to me in New York as my emails informed me that Australia had recycled its Prime Minister and extended an election campaign that had lacked any serious economic debate. In particular, Australia seems totally devoid of a stated economic policy or plan that is credible, sensible and designed in or for Australia’s best interests. It was interesting to observe that the rolling of the Australian Prime Minister hardly rated a mention on US television – but why would it? Johnny Depp’s new movie “The Lone Ranger” was opening at the box office.
The notion of an economic policy that is in Australia’s best interests is important to understand in the context of the effects of the unrelenting quantitative easing (QE) program (or is it now a saga?) of the US. Ben Bernanke and the US Federal Reserve’s QE program has literally been turned into a TV serial that is re-run multiple times on any day, over weeks, months and now years. It is also now watched by hundreds of millions of people all round the world who wake up each day for the overnight highlights and gossip. The US business programs are full of it and so too are the news services whose only other focus seems to be the criminal activities of American footballers. Unbelievably, 1% of all current professional footballers in the US have been charged with criminal offences; two were arrested in one day on charges of attempted murder.
Let’s be blunt about QE – the USA does not give an economic damn as to the effects of its policies on the rest of the world. Indeed, their concern starts and ends with the obsessive fascination with stock indices (the Dow Jones, S&P 500 and the Nasdaq) based on the perverse view that the US economy lives or dies on stock prices. A casual viewing of CNBC and Fox on a few occasions exposed this obsession at the time of a threatened market meltdown in June. Highly paid executives of major investment banks and fund managers paraded on TV telling everyone that what Bernanke had said was not what he meant. Then guess what – Bernanke came on and said that what he said was not what he meant! Then the Federal Reserve released minutes to the effect that Bernanke should have been clearer in his communication even though his comments came after the meeting evidenced by the minutes. The stock indices had fallen sharply from record highs, but have since recovered as QE survives for a while longer. In doing so, the Federal Reserve balance sheet has been propelled larger and is now 4 times its size of 2008, a new record!
Figure 1. Central Bank Balance Sheets (2008-100) Sources: Central Banks, Thomson Datastream
Frankly, the US is no longer the “home of the brave”. The unrelenting money printing and the propping up of Wall Street will go down in history as the economic disgrace of this era. Whilst QE and the financial support of banks was needed in 2008 to stabilise the financial system and avoid a depression, its continuation at the rate of $1 trillion per annum is economic abuse.
Amidst a number of unintended consequences, one result of QE has been the emerging irrelevance of Australia, lazily basking in the false economic sunshine of a highly inflated currency. Throughout this recent period our government, our bureaucracy and our Reserve Bank have failed to recognise the falseness of markets. Our currency and our bond yields were just fanciful, but those in control of Australia apparently had no idea that this was the case. In a few years’ time it will become more apparent that the Australian government should have issued immense amounts of bonds at low interest rates and at an inflated currency point to raise the foreign capital needed to fund our future infrastructure needs. In just the last 6 weeks, our long term bond yields have risen by 1% and the $A fallen by 15%.
We have missed a golden opportunity due to the idiotic political obsession with balanced budgets and the naïve belief in free trade with a world that manipulates currencies in our face. In our view, the lack of an ability to understand the world economic situation has led Australia towards a possible recession and therefore taken us back to relative insignificance.
Continuing weak retail sales growth in the US in the June quarter suggests that the US economy has re-entered a slow growth period. Despite this weakness, the benefits of some legislated fiscal adjustments will see the US fiscal situation improve. This financial year, ending September, the deficit will decline to $760 billion. At the end of June (i.e. some 9 months), the deficit is running $400 billion below the previous corresponding period.
This led to the US’s AA+ credit-rating outlook being upgraded to stable from negative by Standard & Poor’s based on receding fiscal risks, less than two years after it stripped the world’s largest economy of its top ranking.
The forecast US deficit equates to about 4% of GDP. By way of comparison, if Australia had a similar deficit, it would equate to $65 billion. In fact, we are nowhere near this level. Meanwhile the declining US deficit stimulated Christine Lagarde, the head of the IMF, to suggest that the US should not dramatically reduce its deficit until world economic growth improves. She should realise that the US will do whatever and whenever it wants. Hi ho Tonto!
As noted above, Ben Bernanke has reversed his statement that QE will taper off in the December quarter should the US economy and employment in particular continue to improve.
Figure 2. Payroll Employment (Millions) Sources: Thomson Datastream, Capital Economics
The above chart (Figure 2) shows that employment has improved rapidly in the last 2 years, but a longer view shows that employment numbers are barely higher than they were at the turn of the century. There have been 14 long years of virtually nil employment growth in the US.
We should not forget that the Federal Reserve wields another policy tool with its benchmark interest rate, reduced to close to zero in December 2008.
Figure 3. Official Interest Rates Source: Thomson Datastream
At this point, it appears that the Fed won’t consider raising this key rate until unemployment falls to 6.5% and for as long as long-term inflation expectations don’t exceed 2.5%. Indeed, the Fed is actually targeting inflation of 2%, which they currently claim is only running at 1.5%. It is interesting to note that the yield on US 5 year bonds have risen from 0.8% in early May to 1.4% now. They therefore still yield less than inflation.
The US ten year bond has fallen in price as yields have risen to 2.5%. Historic pricing and long term averages suggests that when QE finishes, the yield will rise further to above 3.5% and maybe 4%.
Figure 4. 10-year Government Bond Yields Source: Bloomberg
In the corporate world, we are now getting a glimpse of how tough trading conditions in the US have become. Whilst the major US banks (Goldman Sachs, JP Morgan, Wells Fargo and Citigroup) are reporting substantial lifts in June quarter profits, the broader corporate sector does not share the banks’ ability to write back provisions. In particular, it should be noted that whilst JP Morgan produced strong profit growth it still could only achieve a 13% ROE in the quarter. At the same time, in the real (ie non-financial) world, it was some concern to note that UPS, the world’s largest delivery company, sharply downgraded market expectations for its June quarter earnings.
Across the S&P 500 market, companies have generally led broking analysts to lower earnings forecasts. Six months ago, analysts expected June quarter earnings to grow by 8%. Today the projections are for just 2.6% growth over the June quarter in 2012. The US indices are at record highs but it is hardly due to rapid earnings growth. Rather it is QE and low interest rate settings that are holding the markets together. No wonder there was panic when Bernanke mis-stated what he said!
The IMF once again has lowered its forecast for world economic growth in 2013 to 3.1%, citing a slowdown in emerging economies and ongoing worries in Europe. It also lowered its outlook for 2014 to 3.8%, down from its previous guess of a 4% expansion.
The IMF cut its growth outlook for Italy and now forecasts a 1.8% contraction in 2013. This stimulated activity with the ratings agencies who got busy and downgraded Italy (Standard and Poor’s) to BBB or two notches above junk. Meanwhile Fitch got motivated to downgrade France to AA- but with a “stable” outlook citing the country’s uncertain economic outlook and the need for structural reform.
Over in Portugal the bond market retreated rapidly and yields rose (10 year to 7.2%) as two ministers resigned and there was growing public unrest concerning the demands related to European bailout programs. Now Portugal has formally requested a renegotiation of the austerity terms.
Somehow in Spain the government managed to issue 15 year bonds at 5.15% despite the economy continuing with its 6th year of economic decline. Whilst in Greece another 3 billion euros of aid was delivered, countenanced by Germany, which appears keen to keep things under control until September when Chancellor Merkel seeks re-election. It is not clear how Greece can continue to service its debt. Its ten year bonds currently yield 11% for those brave enough to own them.
The following table (Figure 5) outlines the growth outlook for Europe and the poor recent performance of most European economies. It also shows just how small the peripheral European countries are. However, the poor economic performance of France, Italy and Spain remains a real concern given their relative sizes in a world context.
Figure 5. Real GDP Sources: Thomson Datastream, Capital Economics
China’s annual economic growth slowed to 7.5% in the June quarter of 2013, from the 7.7% reported in the March quarter. However, what is more significant are Chinese trade statistics which in June showed that exports fell 3.1% in June from a year earlier. China’s trade surplus with the US slipped to $17.49 billion in June from $19.35 billion in May.
Figure 6. Trade Surplus ($bn, 12m sum) Sources: CEIC, Thomson Datastream, Markit, Capital Economics
Overall, total Chinese international trade declined in the June quarter, reflecting the economic weakness of Europe and some emerging economies. The charts below (figures 7, 8)show that inward and outbound trade are highly correlated. So if demand for Chinese exports declines, then so does its demand for imports.
Figure 7. Merchandise Trade ($bn, seas. adj.) Sources: CEIC, Capital Economics
The downturn in economic activity indicated by trade with China suggests that the recent IMF economic growth forecasts are merely reflecting a slowdown that is now both pronounced and obvious.
Figure 8. Exports by Destination ($bn, seas. adj.) Sources: CEIC, Thomson Datastream, Markit, Capital Economics