July Market Commentary

15 Aug July Market Commentary

Generally some modest moves higher across the equities asset classes depicted below. The impact from the RBA cutting cash rates to 2.5% in early August has not yet shown up in longer dated term deposit rates, hence our risk free threshold remains at 4.4%. We do however expect that in coming weeks that term deposit rates will adjust lower, and will update you next month as to the effect this has on the valuation ranges outlined below.

We will start with a review of the regions we discussed last month, those being the United States and China, before moving to Europe and Australia where upcoming elections command our attention.

UNITED STATES

The labour market is one of two areas, along with inflation, monitored closely by the Federal Reserve as they contemplate moving interest rates up from zero, where they have been since late 2008. Long term readers will recall that in earlier notes we have focused on labour and also housing for signals of the strength of the economic recovery in the US. On the latter the recent data has been strong, though the improvements have come off a very low base, and in some instances, at least anecdotally, there are some troubling signs. Recently economist Robert Shiller noted that “the cities that bubbled in the past are bubbling again.”¹

Of greater note though is that the housing recovery is thus far not contributing to a recovery in employment. As the yellow line shows whilst the unemployment rate has come down, the red line shows that total employment in the US economy has been essentially flat since late 2010.

An optimistic outlook would require that not only those that have been discouraged from seeking work would resume their search for a job, but also those that are working part time involuntarily being able to find full time positions. Taken together, it seems unlikely that the Fed’s threshold of unemployment falling below 6.5% is met any time soon. Note that this does not preclude the gradual paring back of the bond purchase program; rather this threshold and an outlook for inflation exceeding 2.5% are criteria for considering moving interest rates above the current levels of between 0% to 0.25%.

Making the task that much harder, further sequestration spending cuts set to be enacted by the Federal Government have been predicted by the non-partisan Congressional Budget Office² to cost 1.6 million jobs by the end of 2014.

CHINA

Early signs are that the policy efforts from Beijing to gain more transparency over the shadow banking system in China, and to slow the rapid growth in this sector of the economy, are starting to take effect. A recently announced audit of debt, particularly in the potentially troublesome local government finance vehicles. This will provide a measure of clarity that hasn’t been available up to this point, and is being interpreted as the authorities seeking to prevent further rapid increases in credit, rather than enforcing any sharp contraction.

“Local government borrowings are ultimately China’s fiscal liability. Even under the most aggressive assumptions discussed in the marketplace, China’s total gross public sector debt, including local and central governments, is still not excessively high compared with that of most countries. Moreover, the Chinese government also owns vast amounts of assets. Therefore, the net debt situation is easily manageable, especially considering the country’s very high domestic savings rate.”³

Occasionally an article or presentation reminds us of the unprecedented scale of the transformation in the Chinese economy over the last several decades. Recently though this brief video prompts us to contemplate the scale of the transformation still to come. The New York Times⁴ provides some graphical context to accompany an article that discusses the 250 million people still to be urbanized in China.

EUROPE

Unfortunately, the scale of the problems that still confront Europe are also profound, notably including the condition of the labour market. The unemployment rate in the Euro Area stands at 12.1%, and but for a brief respite in 2011 this rate has climbed steadily in the years following the financial crisis. Of course some individual countries are much worse, notably Greece and Spain where the unemployment rate is 27.6% and 26.3% respectively and significantly worse when youth rates are considered.

The austerity policies once thought to be the only path to salvation for indebted nations are perhaps best represented by Ireland, which embraced the ‘take your medicine’ approach imposed by Brussels and is still suffering as a result of having done so. These two charts show the annual GDP growth rate has recently fallen below zero again, and that despite the genuine hardship inflicted on the Irish the level of debt compared to GDP has only increased. One suspects the Irish would be skeptical about OECD forecasts for debt to plateau from this point forward.

Chancellor Angela Merkel is expected to be returned at the September elections in Germany, and there is thinking that a widely held desire to see this happen, and more lately the traditional August holiday period, has led to a period of comparative calm in Europe. A widely read and respected commentator nonetheless highlights the ongoing issues still to be resolved, including joblessness, fatigue to ongoing austerity especially in the absence of improvements, along with even more fatigue to any prospect of further bailouts and private enterprises still struggling to access credit markets. He concludes as follows:

All of this adds up to a sad reality for Europe. Despite hopeful blips in an economic indicator here and there, too many countries lack both immediate growth and longer-term growth engines. As a result, debt overhangs will remain problematic. Owners of private capital that could be allocated to productive investment will remain hesitant. And societies will continue to lack the jobs and capital investment that are essential for durable prosperity and general well-being.⁵

Some valuations and prices in parts of Europe look historically cheap, though this is for good reason, and as a result we will continue to be interested observers rather than investors for the time being.

AUSTRALIA

The most recent Statement on Monetary Policy from the RBA provided a subdued interpretation of the short term outlook for the Australian economy. Whilst inflation will remain in check, modest employment growth is expected to lead to a slight increase in the unemployment rate, though this measure was steady at 5.7% for August. Not surprisingly, much of what occupies the RBA’s thinking is how our economy will manage the process of mining investment making a smaller contribution to our GDP.

Over the next few years a strong contribution to GDP is expected from the export of bulk commodities, mainly coal and iron ore. This will be helped in part by the lower Australian dollar but driven mainly by the large capital investment in recent years that has significantly increased capacity. Of course, prices for these commodities will be critical in determining the final contribution to GDP, and at least of late there has been some resilience in iron ore prices though coal prices have weakened.

The RBA also notes that as the investment phase comes to an end in the near future, the actual size of the impact on our GDP will not be as great as around half of the investment has been on imported capital goods. Activity in the mining sector is inherently difficult to forecast, as the outlook can change very quickly based on very large scale projects either going ahead or being postponed.

We finish with some observations from the economists at ANZ Bank⁶, who note that recent trends in the NSW economy are supportive of the transition away from the mining sector. Having underperformed the broader Australian economy for a decade given it has substantially more exposure to financial services, insurance, IT and media and telecommunications, the NSW economy is now leading other states in some respects. Economic activity has been above trend for the last year, and strong results have also been recorded in employment growth and the housing market. We will continue to watch this closely, however at this stage it provides an encouraging view of our ability to manage the transition required in our economy, extending to the outlook for companies that prosper when the domestic economy is resilient, notably including our major banks.

SOURCES:
1. Quoted in “Housing market heats up but not at boiling point yet” – J Schoen, cnbc.com. 30-Jul-13.
2. Eric Painin, CBO Says Sequester Part II Could Cost 1.6m Jobs. The Fiscal Times. 26-Jul-13.
3. BCA Research, “China: More Tightening On Local Government Debt?” 6-Aug-13.
4. Graham Roberts, “In China, a Staggering Migration” New York Times. 15-Jun-13.
5. Mohamed El-Erian, Europe’s Fake Normal. Project Syndicate. 5-Aug-13.
6. Warren Hogan, et al. NSW Recovery May Underpin The Transition From Mining Boom. ANZ Research. 7-Aug-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.