By John Abernethy, Chief Investment Officer at Clime Asset Management Wednesday, 5 February 2014
The ramifications of the reduction in the quantitative easing program (QE3) by the US Federal Reserve (Fed) are now playing havoc in currency, equity and bond markets. A particularly negative result has emerged for developing economies such as Argentina, Brazil, South Africa and Turkey. Each of these economies have experienced capital outflows, declining currencies and a requirement to lift short term interest rates. This has resulted in a whiff of recession and a risk for those European banks that are heavily exposed to these economies.
In January, the Fed proposed that the rate tapering indicated by the lowering of its monthly purchases of financial assets to $65 billion from the $75 billion per month announced in December 2013. Remember that QE3 originally involved the Fed purchasing both US government bonds and mortgages from the open market in 2013 at the rate of $85 billion per month. This resulted in the Fed injecting substantial liquidity into the US economy in an attempt to create growth and consumption. However, much of this liquidity has merely been dispersed into speculative asset trading across the world.
We can now see that the $1 trillion of liquidity created by the Fed had its most dangerous effects in developing economies. These economies historically struggled for foreign capital which flowed freely from QE3 at historically low interest rates. This money or liquidity was sourced cheaply and was attracted to assets that appeared to show high returns through higher interest rates. It was so cheap and so easy to obtain that it was effectively gambled across asset markets with little concern for either risk or the pricing of risk. In the main, the gamblers are investment banks, hedge funds and some pension funds.
For the last year, our funds management team have repeatedly expressed concerns with the mispricing of investment assets. From the Australian equity market perspective, we observed that our equity market was also a recipient of the QE3 liquidity. Whilst there is always a steady flow of long term superannuation money into our equity market, this investment flow is challenged when “hot” money adds to the normal buying and bids up the price of assets. Our funds management team has and continues to position client accounts with high levels of liquidity so that a market correction in equity prices becomes an opportunity rather than a reason for fear.
Every cycle comes to an end and a return to normality in markets will eventually occur. However, the recent history of QE3 and the massive QE undertaken in Japan and soon to be undertaken in Europe, suggests that “normal” may not occur across world markets for quite a while longer.
We should note January, but that’s all we should do
The direction of US equity markets in January has often been a good predictor of the market direction for the rest of the year. In 62 of the last 85 years this has been the case. So 73% of the time it is predictive and 27% of the time it has not been. The S&P 500 index fell by 3.5% in January and is now down by 5% since 1 January. Last Friday’s US manufacturing survey was certainly a negative for market sentiment that was already in correction mode.
It is worth noting that January is when most major US companies report audited results, allowing the market to formulate and fine-tune their forecasts of 12 month earnings and price to earnings ratios. Today, as we have mentioned in recent months, the US equity market is trading at high forward multiples of earnings due to the liquidity effects of QE3.
Up until the recent capital flight from developing economies, the US equity market had achieved a remarkable recovery from the depths of the GFC. History suggests it is due for a pullback and it is most likely to be the result of some sort of financial crisis. These crises are regular events when you reflect on the last 40 years.
Figure 1. S&P 500 (in US dollars) Source: Bank of Japan, Capital Economics, Thomson Datastream
A scan across the major world equity markets sees large corrections everywhere. The standout has been Japan which has declined 12% from its recent peak. The UK and German markets have declined by about 4% and the Hong Kong market by over 5%.
Of more interest to Australian investors is the trajectory and outlook for the domestic equity market. Our analysis suggests that fair value for the Australian market is about 5200 as at June 2014 based on current earnings expectations. This valuation is derived from return on equity modelling and the expected level of retained earnings across the market.
Therefore, the current index level of about 5100 to 5200 suggests that short term market performance is unlikely and investors need to focus on stock selection and remain patient. Any correction in market prices will present opportunities for those with cash to invest.
Noteworthy is that the current index level of 5100 has been seen many times over the last 8 years. Consider the observations of past 5000 to 5100 levels (also visually represented in Figure 2):
- 12 August 2013 (6 months ago)
- 11 March 2013 (10 months ago)
- 14 February 2011 (3 years ago)
- 12 April 2010 (3.8 years ago)
- 11 August 2008 (5.5 years ago)
- 25 September 2006 (7.5 years ago)
- 27 March 2006 (7.9 years ago)
Figure 2. ASX 200 has crossed the price 5100 many times Source: Thomson Reuters
Remarkably, if the Australian equity market remains at 5100 points through to the end of March (and that is fair value) then it will have produced no capital gain for index investors in 8 years. Given that result, one would question why anyone would default their superannuation investments into an index-based style?
The rolling one year performance of the Australian equity market is becoming sober again after the dramatic 20% lift from mid 2012 to late 2013. The rolling year equity return (including dividends) to the end of January is about 8%. This market return is poor when you consider that the $A has depreciated by 15%, interest rate settings are at historic lows and the fiscal deficit is approaching a moderately low 3% of GDP. All of these macroeconomic events are highly supportive of the economy, corporate profits and therefore the performance of equities. Alas, despite these tremendous tail-winds, the Australian equity market is faltering. Indeed, it is the headwinds of a slowing in the resources capital investment cycle that is suffocating the economic outlook.
On reflection, the 2012 lift in the $A was a false reading of Australia’s prosperity. It was actually an indication of the immense economic problems in the US, Europe and Japan plus the rapid growth of China rather than an endorsement of our own prospects. Our leaders failed to acknowledge this, and nor did they seize the opportunity to claim excess resource revenues, drive productivity or borrow at historically low rates. The manic personal quest for leadership, without a vision or a sense of reality, has left Australia in a fairly difficult situation and so the equity market is appropriately priced. In our view, it needs to pull back towards 4800 points for real value to appear.
RBA keeps rates unchanged, signals end of easing cycle
As expected, the Reserve Bank of Australia (RBA) kept the official rate unchanged at 2.5% at its meeting on Tuesday. While not a surprise, the accompanying language has proved to have somewhat more of a market impact. Following its usual review of major international and domestic conditions, the RBA’s commentary was unusually explicit in stating that “on present indications, the most prudent course is likely to be a period of stability in interest rates”.
The RBA has maintained its somewhat sanguine view of domestic prospects. Although it acknowledges that inflation in the December quarter was higher than expected, this is explained away as being in part because of a faster than anticipated pass-through of the lower exchange rate. “The AUD has declined further, which, if sustained, will assist in achieving balanced growth in the economy,” the statement said. Since the announcement, the Australian dollar has frustratingly added US$0.02 to US$0.89.
Looking ahead, the RBA expects growth to remain below trend for some time yet and unemployment to rise further before it peaks. Beyond the short term, growth is expected to strengthen, helped by continued low interest rates and the lower exchange rate. Inflation is expected to be consistent with the 2–3% target over the next two years.
So if rate cuts are off the table, when is the next rate increase? It will of course depend on the way in which the economy performs over the next few quarters, but the likelihood is it will be in the latter part of the year – closer to the start of 2015 that to the beginning of 2014. We could see rates unchanged right through the course of calendar 2014.
Figure 3. Australian cash rate Source: ABS, RBA
Greece is coming back to haunt Germany
If anything, Europe appears to be returning to financial upheaval as reports emanate from Europe that Greece may be seeking a third bailout. With the German election passed, it is suggested that Germany will relent and allow 10 billion euros in support to flow. This bailout is required because Greece is simply not recovering and the household sector has suffered a massive decline in wealth.
The numbers are truly amazing. Greek household income has declined by over 40% in the last three years. Since the GFC commenced in 2008, household assets have declined by 17% whilst liabilities have increased by 23%. Meanwhile unemployment stands at a staggering 27.8%.
However, the household debt issues are not unique to Greece. The following table shows that household debt as a percentage of income remains at historic high levels. These average rates are clearly affected by high levels of unemployment that drives income down.
Figure 4. Household debt (% of disposable income) Source: Capital Economics, Thomson Datastream
By comparison, it is interesting to note that Australia’s household debt to income ratio stands steadily at about 150%. This is approximately the same as in 2007. This level of debt supports the high relative prices of residential property and so our biggest risk remains an economic slowdown that creates unemployment.
Some charts about Japan to contemplate
We have noted in past Views that Japan’s QE program is truly massive. The amount of Japanese currency printing approximates that of the US in 2013 and yet the economy is a quarter of the size.
The following chart shows the huge expansion of Japan’s monetary base which will double over 18 months.
Figure 5. Monetary base of Japan (Yen trillion) Source: Bank of Japan, Bloomberg, Capital Economics, Thomson Datastream
The next chart shows the deterioration in Japan’s economic position. For over forty years, Japan had not had a trade deficit in goods and services. This changed in 2011. The deterioration in the trade balance then resulted in the current account moving into deficit. Suddenly, Japan was no longer generating foreign exchange to meet its foreign debt.
A stagnating economy, an ageing population, deflation and massive increases in government debt meant that Japan could not afford to expose itself to foreign capital. The only possible economic response was to print Yen.
Figure 6. Japan’s current account balance (Yen billion, seasonally adjusted) Source: Capital Economics, Thomson Datastream
Printing Yen has resulted in a massive devaluation of the currency. As the following chart reveals, the substantial rally in the Japanese sharemarket looks to have merely reflected that devaluation. This is not genuine wealth creation for anyone – other than some Japanese equity investors. The equity rally that was built on speculative capital flows created from QE has now hit a brick wall and Japan remains a long way from normality.
Figure 7. Nikkei 225 & Yen/US$ Source: Bloomberg, Capital Economics