11 Jul June Market Commentary
Monthly Economic & Investment Market Commentary
We are now five years on from the announcement by investment bank Bear Stearns that redemptions on two of its hedge funds were frozen, and that there was “very little value”(1) remaining for investors. Shares in Bear Stearns fell almost 99% from the record high in January 2007 to the sale price of $2 when Merrill Lynch took over the failed company in March 2008. The problems in those two hedge funds, which invested in mortgage securities, mark the start of what we now know as the GFC – the Global Financial Crisis. At the time we were assured that these were isolated problems and there was no contagion risk to the broader economy or other investment markets; assurances we now know were wildly inaccurate.
Five years on and the world is still trying to deal with the fallout from these problems, and much as we wish it were otherwise, it would appear likely we will still be writing about this topic for many years to come. The process of restoring balance in the world is extraordinarily complex, but one which ultimately comes down to Jonathan Pain’s succinct summation, which we have shared with you previously:
- Submerging nations will spend less and save more;
- Emerging nations will spend more and save less
- Yes, it is as simple as that.
A government has the power to levy taxes to fund spending programs, and so intuitively it follows that when a country needs to reduce its indebtedness, it should spend less and increase taxes. Proponents of austerity programs have been insisting on this approach, though it must be said in several notable cases there is a much greater emphasis placed on spending cuts than on tax increases.
One of the first to accept austerity measures were the Irish, and so we start our regional review with a look at the current state of the Irish economy.
Ireland was known as the Celtic Tiger for more than a decade heading in to the crisis in 2008. The Irish economy was held out as an example of all the benefits that could flow from embracing European integration, and enjoyed very strong growth as the chart above shows.
Unfortunately much of the growth was illusory, and based on what was subsequently shown to be increasingly reckless lending by a handful of banks. The sharp contraction that started in 2008, and from which they are yet to recover, shows up clearly in the chart above.
Over the ensuing years a range of measures were enacted, which led to the Irish government taking on increasing debt as a result, and in turn requiring their own bailout from Europe. However, the Europeans demanded austerity measures from the Irish before making rescue funds available.
In their Medium Term Fiscal Statement(2) released late last year, the Irish Government speaks of these measures serving to “arrest the rise in the debt/GDP ratio” which is expected to peak at more than 120% of GDP next year.
The Irish people have already felt the painful impact of several years of budget austerity measures, it has been reported that they consume 12% less now than they did in 2007. Unfortunately, they face many more years of spending less and saving more before balance in their economy is restored.
Facing such a contractionary domestic environment, it stands to reason that the Irish are looking towards exports to drive their recovery. The problem is more than 40% of Ireland‟s exports are to the United States and the United Kingdom, two more countries where there will be less spending and more saving.
Government debt in the United States is now more than 100% of GDP, unemployment remains high and economic growth is positive but anemic. We include below the chart that we have shown several times previously, which shows the depth and duration of the job losses in the United States since the financial crisis. Whilst the unemployment rate has dropped in recent years from 10% to just above 8%, a significant portion of this reduction is attributable to people giving up the search for a job.
“If the same percentage of adults were in the workforce today as when Barack Obama took office, the unemployment rate would be 11.1 percent. If the percentage was where it was when George W. Bush took office, the unemployment rate would be 13.1 percent.”(3)
A significant portion of the unemployed are now long-term unemployed, who face increasingly dim prospects and the cessation of their unemployment benefits.
Middle class Americans funded their consumption for many years by withdrawing what they thought was equity in their home. The chart(4) above shows the rate at which equity was being withdrawn prior to the crisis, which in dollar terms exceeded US$200 billion per quarter.
In stark contrast the withdrawal rate has now gone negative to the tune of more than $100 billion in the first quarter of 2012. In net terms there is now therefore US$300 billion less being spent in the US economy.
The other part of the equation is saving more, and the personal savings rate has increased and mortgage debt has declined by US$885 billion over the last four years. Whilst households have begun their deleveraging process, there remains a mammoth task ahead for the US Federal Government where total debt is now approaching US$16 trillion.
ASIA AND EMERGING MARKETS
Historically we have tended to focus on China in this part of the discussion, though it is worth pointing out that the international equities class is well diversified within this region. These include China, South Korea and Taiwan, as well as Brazil, Russia, India, Malaysia and Mexico. In these countries the ‘spend more and save less’ theme continues to unfold.
It can be difficult to convey the enormous potential of these emerging market economies, so we will turn again to our macroeconomist Jonathan Pain, and borrow from his latest commentary:
We need to remind ourselves as we are mesmerised, if not horrified, by the events in the submerging nations that they comprise less than 10% of the world‟s population. In fact if you combine the populations of Greece, Portugal and Ireland they are less than the municipality of Chongqing. And while on the subject of demographics, it is important to remember that for the past decade, and for the next decade at least, average annual rural to urban migration in China has been, and will continue to be, around 20 million. This means that between now and 2030 China will expand its urban population by roughly the equivalent of the population of the United States.(5)
The rate of GDP growth in China is slowing, and this has been partly as a result of the global financial crisis, but also as a matter of deliberate policy from the Chinese. The chart shows that Chinese GDP has risen from US$350 billion in 1990 to nearly US$6 trillion in a little over two decades. So a slower rate of growth, but an enviable rate nonetheless, for what is now the second largest economy in the world, should be expected.
In Australia we also enjoy the flexibility of relatively low debt; relative to the rest of the world at least, though our government debt has increased from around 10% of GDP in 2008, to just under 23% in 2012.
We are of course not immune to the problems in the global economy, though our long held view has been that we have the capacity to address them in a much more effective manner than the submerging economies that we spoke of earlier.
Unlike the United States, the United Kingdom, Japan and Europe where interest rates are at or close to 0%, our Reserve Bank has the scope to reduce interest rates and has shown recently they are willing to do so. Australian mortgagees benefit from this almost immediately, as most if not all of these cuts are passed on relatively quickly. Our banks have also reduced their reliance on offshore funding sources, reducing a vulnerability that was revealed during the financial crisis.
With regard to the resources sector, we have certainly seen commodity prices moderate and more recently we have seen management at the major miners prudently consider the rate at which planned expansion projects should proceed. In the long term we are confident that the major Australian mining companies will continue to see demand for their exports, not the least because 7% to 8% annual growth in a US$6 trillion Chinese economy will still represent significant commodity demand in the future. It is however likely to be a more volatile growth path than we anticipate from the financial sector.
We expect that the two themes we discuss above – submerging economies will spend less and save more, and emerging economies will spend more and save less – will dominate investment markets for the rest of this decade and likely well beyond.
1. Reuters. A dozen key dates in the demise of Bear Stearns. 17-Mar-08.
2. Department of Finance. Medium Term Fiscal Outlook. Ireland. Nov-11.
3. Ezra Klein. The incredible shrinking labor force. Washington Post. 5-Apr-12.
4. Bill McBride. Q1 2012: Mortgage Equity Withdrawal strongly negative. Calculated Risk. 9-Jul-12.
5. Jonathan Pain. Make Up or Break Up, The Pain Report. 28-Jun-12.
Reuben ZelwerB Acc, FFIN, CFP Director DISCLAIMER: The information in this commentary has not been verified by Adapt Wealth but is believed to have come from reliable sources as noted in the acknowledgements. No Liability is accepted by Adapt Wealth Management, its Directors, officers, employees or contractors for any inaccurate or incorrect information. The information is a broad commentary and there is no intention that a client should act on the information without seeking professional assistance from their own advisers (legal, tax, accounting, financial Planning) for suitability in respect of their unique circumstances.
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.