October Market Commentary

October Market Commentary

Monthly Economic & Investment Market Commentary

October 2012

The seemingly interminable election campaign in the United States has at last concluded with quite a strong showing from the Democratic Party. President Obama has won a second term, Republicans have retained the House but with a slightly smaller majority, and perhaps most surprising was that the Democrats have gained ground in the Senate. In the post-election analysis the easy conclusion is that the US will face more of the same political gridlock, though we will examine this in more detail below.

Between now and the start of the new year, President Obama and the “lame duck” congress will face the task of finding agreement to avert the automatic spending cuts and tax increases we have come to know as the fiscal cliff. We should not lose sight of the fact that these automatic measures are only in place because legislators were unable to fulfil their primary function in the last Congress, so expectations for a resolution in the next seven weeks should not be especially high. However, the immediate reality for most American’s won’t change all that much in January, though the need for serious proposals to address their very real long term problems cannot be put off indefinitely.

There is a story, which may or may not be apocryphal, about a popular Irish politician who was travelling through Ireland as part of campaigning to become the Lord Mayor of Dublin in the mid-1800s. When he came across a work crew that was building roads, one of the labourers was so overcome by the politician’s presence that he offered effusive praise for his leadership and the change that he knew the politician would bring if elected. The politician offered a much needed dose of reality, saying “calm yourself, whether I win or whether I lose, you will still be breaking rocks.”

There are certainly more nuanced ways of saying it, but the truth is that for many Americans, and for that matter a lot of Greeks and Spanish and Portuguese as well, they will be doing the modern day equivalent of breaking rocks for many years to come.

In the aftermath of the financial crisis we spoke of a grand social experiment that would be played out over the ensuing years. On the one hand there were the austerity programs such as have been implemented in Europe, which were seen as necessary medicine for formerly profligate countries. Broadly speaking, the alternative was for governments and authorities to continue to provide short term support to their economies while their private sectors were in such poor shape. Critically, this latter plan also required not just this short term support but a long term plan to manage the accumulated government debt which would ultimately restore balance to the economy.


One can argue that it is as a result of the political gridlock in Washington as opposed to a conscious policy decision, nonetheless the United States has thus far largely pursued the latter path described above. To date, much of the heavy lifting in terms of providing that support has come from the Federal Reserve’s extraordinary monetary policy, for instance keeping interest rates at close to 0% and promising to do so well into any recovery, something that is certainly not found in the traditional central bank play book. In comparison to Europe, so far the results have been consistent with the so called muddle through scenario that we have spoken of for some time. The last GDP numbers in the US showed an economy that grew at an annual rate of 2%, though this was higher than expected due to a large gain in defense spending for the quarter. Correcting for this the annual growth rate is thought to be more like 1.3%.

As can be seen in the chart1, the economy has been consistently adding jobs, though at a rate that means a return to pre-crisis employment levels is still many years away. Most analysts say that the monthly figure needs to be greater than 200,000 jobs in order for the unemployment rate to reduce meaningfully. If and when that happens, the return of those job seekers who are currently discouraged from searching will make the task that much harder.

The real question about the future growth trajectory comes down to what is the policy prescription from this point onwards. The analogy between balancing the US economy and a household budget has flaws, though most people recognise that a sensible approach assume that both controlling spending and increasing revenue will be required, particularly given the size of the problem.

One of the things that we will be paying close attention to in the coming weeks are the delegates to any negotiations, and also several of President Obama‟s key appointments not the least of which being the appointment to Secretary of the Treasury. If again we see one side offer negotiators that will give no or little ground on meaningful tax reform and the other give no or little ground on meaningful entitlement reform, then the prospects for the elusive grand bargain would appear to be bleak.

We will monitor the situation closely, and will remain cautiously optimistic that the cliff acts as a catalyst. In the meantime we continue to think that over the long term companies that rely on the US economy are unlikely to provide good long term returns. This chart shows corporate profits as a per cent of GDP going back to the 1940s. Profit growth in recent years has largely come from cost reduction measures rather than top line revenue growth.

Many are suggesting that the gains to be extracted from controlling costs are just about exhausted, and that the long term problem continues to be a lack of demand from a deleveraging private sector, that is still struggling with high unemployment levels and a stable but still struggling housing market.


We finish this month’s note by sharing some excerpts from a speech2 by John Laker who is the Chairman of the Australian Prudential Regulation Authority, our banking supervisor. He spoke of the importance of stress tests conducted on financial systems around the world, and particularly the most recent results for such a test of the Australian banks. The intention is to “assess vulnerabilities and resilience in the face of “severe but plausible” shocks” and to forecast the likely impact on cash flows, profits and capital for the banks.

In the wake of the Global Financial Crisis there have been significant improvements to the resources and processes applied to stress testing the banks, and Laker acknowledges that in the past there were what he described as some “Pollyanna-ish” scenarios that were tested. This remains a particular challenge for the Australian banks where the economic environment has been relatively stable for the last several decades and today remains much more so than is the case in Europe or the United States.

The scenario that APRA applied was tougher than they did in 2010 and included these parameters:

  • a sharp (5 per cent) contraction in real GDP in the first year;
  • a rapid rise in the unemployment rate to a peak of 12 per cent;
  • a peak to trough fall in house prices of 35 per cent; and
  • a fall in commercial property prices of 40 per cent.

Whilst highlighting that this was in no way a forecast, Laker describes the projection as “deeper and more prolonged, with a weaker recovery and a longer period before return to growth. The rise in unemployment is higher and the impact on the housing market therefore more pronounced; there is a greater peak-to-trough fall in house prices.” The assumptions also included that local banks were cut off from overseas funding sources for six months, increasing their cost to source local funding. In essence, the scenario is thought to be comparable to the UK and US experience during the GFC.

Not surprisingly the banks would report significant losses driven by bad debts under these conditions, though only around a fifth of the expected losses were attributable to residential mortgages. In APRA’s view, and consistent with what we have said in the past, this is due to the structure of our domestic mortgage market and also tighter lending standards being applied in the last few years.

Concluding that the results were very positive, the speech highlighted that “none of the banks would have failed under the downturn macroeconomic scenario” and further that none would have breached minimum capital requirements under new international standards.

We conclude our Australian discussion with one last excerpt which directly addresses one of the most frequent criticisms of the Australian banks, namely their reliance on offshore funding. Laker says “the liquidity consequences of the freeze in global funding markets did not, in the stress test, prove to be systemically challenging.” Naturally these types of conditions mean subdued credit demand, and growth in domestic deposits was seen as largely offsetting outflows as a result of current wholesale funding maturing. All of the above outcomes are before any remedial actions by the banks themselves or any liquidity support from the Reserve Bank in addition to current arrangements.

In China the leadership transition is underway as we publish this commentary, and whilst we know the new leaders there is much anticipation to assess the composition of the new Standing Committee of Politburo. We will provide an update in the November commentary when more information is to hand, though we note for the time being the key announcements being reported from the opening speech of outgoing President Hu Jintao, which are to double both GDP and per capita income by 2020.


The table below shows our long term (10 year) expected returns from four asset classes; Australian shares (represented by All Ordinaries index), international shares (S&P 500), Emerging Markets (represented by the FTSE Emerging Markets Index) and listed property (ASX 200 Property). The four valuation ranges, represented by the different colours, are determined by comparing the return we forecast, to a risk free rate of return (Term Deposit rate).


1. Bespoke Investment Group. Getting Back to Even: Job Creation Under President Obama. 6-Oct-12.

2. John Laker, APRA. The Australian Banking System Under Stress – Again? 8-Nov-12.

DISCLAIMER: The information in this commentary has been provided for publication by Implemented Portfolios (ABN 36 141 881 147. AFSL Number 345143). The information has not been verified by Implemented Portfolios or Adapt Wealth Management Pty Ltd (ABN 76 821 231 362 Corporate Authorised Representative of CHPW Financial Pty Ltd AFSL 280201) but is believed to have come from reliable sources as noted in the acknowledgements. No Liability is accepted by Implemented Portfolios, or Adapt Wealth Management Pty Ltd, 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.