15 May April Market Commentary
The relativities between the major asset classes depicted below is largely unchanged, notwithstanding that some strength in Australian Equities has pushed the valuation just into the bottom end of our Fair Value range. In International Equities the stark outlook between Fully Priced Developed Markets where we see low growth, compared with Cheap Emerging Markets continues to inform our positions.
Political and Economic Commentary
As we write in early May, the Australian equity market for 2013 has very much been a tale of the “haves” and the “have nots”. Overall the ASX200 index has provided a very respectable return of slightly more than 10% during this period, though as you would be aware the financial sector and the major banks in particular, have been very strong producing a capital return of just over 20%. Given these numbers it stands to reason that the other parts of our equity market have had a tougher time of it, the Resources sector has declined by 8% and the new addition to your portfolio the Small Ords index has dropped a little over 3%. The Small Ords ETF provides exposure to a more diverse range of sectors, including consumer discretionary and industrials which account for nearly 45% of the exposure.
The Australian share market is slightly behind the S&P500 index in the United States which is at record highs and has added 11.4% during 2013. In Europe, the French and German indices are showing more modest returns of 6.0% and 6.5% respectively, however all the major markets are well and truly in the shade of Japan. Japan‟s Nikkei 225 has gained 37% this year, and slightly more than double that since its 2012 low in early June. The Nikkei has been spurred on recently by a change of government and a more aggressive monetary policy approach from the Bank of Japan, which is attempting to turn around two decades of deflation in the Japanese economy.
Many of you will have seen us present on the importance of avoiding bubbles, in which we use the example of Japanese equities to illustrate the long term damage that bubbles can have on your portfolio. Despite this rise of 77% since June 2012, the Nikkei still remains 62% lower than the high point reached in December 1989. As we have communicated many times, the importance of avoiding these asset bubbles cannot be overstated. The Japanese investor who bought at the peak has a little more than one third of their capital today, after 23 years.
In early May, the Reserve Bank has taken interest rates to below 3%, the level that was reached in April 2009 when responding to the global financial crisis. In broad terms most central banks around the world have a dual mandate, which means that their use of monetary policy is meant to promote two things; full employment and price stability. When these two objectives are at or close to the desired level, that is when almost everyone who wants a job is able to find one and when inflation is controlled and within the target range of 2% to 3%, then we can expect monetary policy to be neutral. Now, there is a lot of nuance involved in interpreting the statements and speeches of central bankers, but prior to the financial crisis it was generally accepted that a neutral range for interest rates was between 4.5% and 5.0%.
As we all know Australia was able to weather the financial crisis much better than most other major developed economies in the world. This was in no small part due to the fact that we entered the crisis with comparatively very low levels of government debt and also because our interest rates were in fact higher than the neutral range. The RBA was actually increasing interest rates in early 2008, with two moves for a combined 0.5% increase passed in February and March taking the official cash rate to
7.25%. This rate persisted until the September meeting where a 0.25% increase was passed, which would be followed by rates more than halving over the three remaining monthly meetings of 2008 and the first meeting of 2009. In total, the central banks response to the crisis saw rates cut by 4%, from 7.25% in August 2008 to 3.25% in February 2009.
As we wrote after the crisis, the RBA was well aware that their use of monetary policy to provide support was likely to be effective as the vast majority of mortgage debt in Australia was in variable rate loans. This is in contrast to the United States where most mortgages are at fixed rates set at a margin above long term government bonds. The result was that Australian mortgagees felt relief almost immediately in the form of reduced mortgage payments. That said, our economic recovery has been held back by the household sector choosing to use a portion of these savings to reduce their debt, though this of course will benefit the economy in the long run.
This same notion of a “balance sheet recession” was evident in the United States, where households had more to do to repair their balance sheets, not least because their house prices collapsed in many major metropolitan cities. The difficulty of the recovery was also compounded by high levels of unemployment, such that the Federal Reserve, commencing from a lower starting point, quickly took interest rates down to between 0% and 0.25% where they remain today. Finding however that the economy was still not responding to this support, the US central bank went beyond 0% interest rates to the extraordinary measures we know as quantitative easing. This involves the Federal Reserve increasing the monetary base and buying assets, initially toxic mortgage assets from troubled banks and more recently bonds from the US Treasury. As a large scale buyer of bonds, the Fed is keeping long term interest rates low, and seeking to encourage the revival of both private consumption and business investment.
Whilst those of us that have been fortunate enough to travel overseas in the last little while have enjoyed the increased spending power of the Australian dollar, it has been a hindrance for many sectors of our economy. The fact that our government debt is among one of only a handful of countries to be rated as AAA by all three of the major ratings agencies, along with our comparatively high interest rates has meant a lot of international money has been pouring into Australia.
All of these factors have combined to influence where the RBA now sees their neutral stance on interest rates. So while the cash rate is now below the level that represented the emergency response to the global financial crisis, it is because we are in a much different global environment where the United States and much of Europe is likely to keep rates at or close to zero for some time to come. The RBA is seeking to strike the right balance between both elements of the “two speed economy” using what has often been called the blunt instrument of interest rates.
In the most recent accompanying statement RBA Governor Glenn Stevens had the following to say:
Growth in Australia was close to trend in 2012 overall, but was a bit below trend in the second half of the year, and this appears to have continued into 2013. Employment has continued to grow but more
slowly than the labour force, so that the rate of unemployment has increased a little, though it remains relatively low.
With the peak in the level of resources sector investment likely to occur this year, there is scope for other areas of demand to grow more strongly over the next couple of years. There has been a strengthening in consumption and a modest firming in dwelling investment, and prospects are for some increase in business investment outside the resources sector over the next year. Exports of raw materials are increasing as increased capacity comes on stream.
These developments, some of which have been assisted by the reductions in interest rates that began 18 months ago, will all be helpful in sustaining growth.(1)
Leaving interest rates and monetary policy, we turn briefly to the United States and to fiscal policy, which covers how the government taxes and spends. Even a cursory discussion on the dysfunction in the US government would easily fill more than these four pages, so let it suffice to say that an inability to reach any sort of agreement on fiscal policy, led to automatic spending cuts that are known as sequestration. These are spending cuts that are applied across the full range of government services, from Meals on Wheels programs to the Smithsonian Museums, but also to thousands of staff being furloughed from government paid or supported employment.
The employment and GDP results for the early part of 2013 have been relatively strong, within the context of this tepid recovery, though many predict that the full impact of these sequestration cuts is yet to be felt. It is telling that both the current Federal Reserve Chair and his expected successor have described “fiscal policy at the local, state and federal levels as a powerful headwind slowing the economy’s return to full employment.”(2) The same article notes that whilst recovery was boosted by stimulus programs immediately after the crisis, since then “fiscal policy has been contractionary, reducing aggregate demand and restraining growth.”(2)
With a medium to longer term view, we continue to see economic growth in the “muddle through” range of between 2% and 3%, though given the peaks in both company earnings and share market indices we are happy to direct our international equities investments elsewhere until better value appears.
1. Glenn Stevens, Statement: Monetary Policy Decision. RBA. 7-May-13.
2. Laura Tyson, America‟s Sequestered Recovery. Project Syndicate. 25-Feb-13.
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.