01 Apr February Market Commentary
Monthly Economic & Investment Market Commentary
A research paper(1) that was written more than a decade ago about the state of the Japanese economy provides an interesting framework for assessing current financial problems in Europe and the United States. The author analysed the Japanese economy using the CRIC cycle as a framework, an acronym derived from Crisis, Response, Improvement and Complacency. His conclusion was that in early 2001 Japan was about to enter its fourth CRIC cycle, as each time signs of improvement lead to complacency and to less impetus for the difficult reform required for sustainable growth.
Today, it is common to speak of Japan having experienced a lost decade, however we know the malaise started much earlier than 2001 and is likely to continue for many years to come. Our task is to think about the path that lies ahead for the major developed economies of the world over the next decade and in doing so we can perhaps estimate where each region is in terms of Crisis, Response, Improvement and Complacency.
The United States led the world into the Global Financial Crisis, and a significant cause of the crisis was deregulation within the banking sector.
Commercial banks that hold deposits and lend to households for mortgages and to businesses had been prevented from engaging in investment banking since the 1930s. However, in the mid 1990s these restrictions were removed and banks began to grow rapidly, both by acquisition and because restrictions on the amount of leverage they could undertake were also relaxed.
Around the same time, the process of securitisation meant that mortgages were bundled together and sold to investors as secure investments paying regular income, but this process also meant that banks were now removed from the risk of mortgage default. There were therefore powerful financial incentives to lend higher amounts to people with lower credit, and everyone was feeling good about themselves until home prices started to fall.
When home prices started to fall we had the beginning of the crisis, which led to major banks that needed staggering amounts of emergency funding, and we came to realise that just about no one understood the complexity or scale of some exotic financial derivatives, which operate in a mostly unregulated market. The then Treasury Secretary Hank Paulson, having stepped down as Chair of Goldman Sachs to accept the role, asked congress to approve the Troubled Asset Relief Program, which was a US$700 billion program to promote stability in financial markets, which were in absolute turmoil.
The central bank in the US, the Federal Reserve, took interest rates to 0% and has this month stated they expect to maintain these levels through late 2014. They have also expanded their balance sheet using quantitative easing programs, which injects more liquidity into the financial system by purchasing additional assets from banks. In short, there was an unprecedented policy response, and we are now a couple of years into seeing improvement in the US economy.
So now we need to ask the obvious question: are we heading towards the complacency phase of the cycle?
House prices are still falling but look to have stabilised, leading some to predict that a bottom may be in place or at least imminent. On average the fall in house prices has been 34% from their peak, though the regions that had the biggest bubbles have fallen much further: Las Vegas (-61.8%), Phoenix (-55.7%) and Miami (-51.3%), providing another example of just how destructive and permanent an impact buying over-priced assets can have on your wealth.
In addition to housing we have been following progress in the jobs market closely, as these are two of the most critical elements of any economic recovery. The chart below on the left shows just how severe the crisis was to working people in America; monthly job losses exceeded 700,000 through late 2008 and into early 2009, compared with current gains of slightly more than 200,000 per month.
There is improvement to be sure, but we are a long way from recovery, which is shown clearly by the chart on the right which we have included in a couple of earlier commentaries. The broader measure of unemployment remains around 15%, while headline unemployment also remains stubbornly high.
When we think about the next decade for the US economy we can’t help but focus on the major problems that they are yet to meaningfully address. In simple terms the US economy spends more than it collects in taxes, and has been doing so for decades, on the basis that it has been able to finance its deficits at very low rates. The annual interest rate on 10 year government bonds issued by the United States is 2%, and importantly the US Government issues its debt in US currency, an advantage that the troubled European economies don’t have.
Politicians seem unable to consider comprehensive policy reform that includes both spending and tax changes, or to be able to successfully shepherd any such policy changes through an increasingly polarised Congress.
We believe the US is well into their first CRIC cycle; however we don’t think it will be their last.
Turning now to Europe, where we have all seen the crisis play out in recent months. The roots of the crisis go back to the foundation of the common currency, and we have written in the past about the fundamental flaw of having economic unity without fiscal integration. The economies that are now in the most trouble were able to borrow large amounts at low rates of interest, and as a result accumulated more debts than their individual economies are able to sustain.
They sold large amounts of government debt to European banks that grew to the point where many bank’s balance sheets were bigger than the GDP of their home country. In a number of cases these banks were at least partially nationalised, examples including Dexia in Belgium, Fortis in Holland and RBS in the United Kingdom. At its core the problems that led to the crisis are not dissimilar to the United States, for a large part of Europe spending exceeds revenue.
The United Kingdom was among the first to implement a response to the crisis, which was to pursue a path of austerity as a means of repairing their economy.
However, rather than seeing an improvement phase we are actually seeing the UK economy contract significantly, with the hope being that the short term pain will lead to recovery in the medium to longer term.
Late last year and just recently we have seen a significant response to the crisis from the European Central Bank, via their Long Term Refinancing Operation (LTRO) which has provided more than €1 trillion to European banks for three years at 1% interest rates. The expectation now is that these banks will make similar investments to those that landed them in trouble in the first place, which is to buy European government bonds, profiting on the interest rate differential of around 3% to 5%. This allows the troubled nations to access additional bailout funds and also to rollover their existing debt and we have recently seen interest rates on government bonds come down in Europe.
So it would appear that Europe may be approaching the end of their initial response phase, and perhaps can look forward to some improvement ahead. Long term however, the region still has very significant problems. Unemployment rates, particularly youth unemployment rates, remain very high and will only be exacerbated by proposed budget austerity programs. The latest figures in Spain report nearly 23% unemployment, Greece is currently at 21% and Ireland and Portugal are both around 14%. These are rates synonymous with not just recession, but depression.
Most discussion now centres on the likely depth of the recession in Europe in 2012, and looking further ahead does not provide any additional comfort. Our current forecast for Europe shows negative earnings growth over the next 10 years, and this includes some assumptions that politicians and regulators will help rather than hinder the process of recovery.
We expect that the Europeans are going to face further CRIC cycles, that there will be additional crises, requiring even bolder policy responses to achieve fundamental reforms.
FEBRUARY TIPPING POINTS
There has actually been very little change in the index levels shown below from the end of January to the end of February, and we have not altered our targets, we did however increase the Financials exposure in Australian Equities. Also, within International Equities we will gradually sell down the ETFs domiciled in the developed world, as we see valuations as being much less compelling at current prices. New investors will buy into the Asia 50 and Emerging Markets ETFs, whilst longer term portfolios will gradually rotate into these from the Global 100, Global Consumer Staples and Global Healthcare.
1. Robert Feldman, Cobwebs and CRICs – Japan Economics. Morgan Stanley Dean Witter. 4-Apr-2001.
Reuben ZelwerB Acc, FFIN, CFP Director
About Reuben Zelwer
Reuben Zelwer established Adapt Wealth Management in 2011 to help time poor clients achieve financial freedom. For over 15 years, Reuben has helped professionals, executives, business owner and those approaching retirement make the most of their circumstances by making good financial decisions. Reuben’s professional practice is complemented by substantial voluntary work, which has included setting up financial literacy and savings programs in the local community.