03 Dec October Market Commentary
The primary tool that the world’s central banks have at their disposal is to set short term interest rates, from which other investments are priced either directly or indirectly, using this cash rate as a reference. We often refer to it as a risk free rate of return, and from this it follows that when investors assume more risk they should be compensated for it with higher expected returns. In normal economic cycles central banks move interest rates to respond to the prevailing conditions, that is, when growth is sluggish they cut interest rates to lower the cost of funds and promote economic activity. Conversely, when an economy is in danger of growing too fast and potentially becoming unstable, an increase in rates is intended to have the effect of slowing economic activity. The latter course of action has famously been described as taking away the punchbowl, when the party is really getting started.
In the early years following the financial crisis it became apparent that the economic contraction was bigger than that expected of a recession in a normal cycle. Rather, excesses had been allowed to build up in many parts of the economy that would take a much longer time to unwind than a normal recovery. Using the United States as our initial example, where the crisis originated, we saw the Federal Reserve cut rates to effectively zero (really to a target range of between 0% and 0.25%) at the end of 2008, and they remain there today. When the economy was still not showing signs of responding to this unprecedented low level of rates, the Fed pursued extraordinary policy moves that saw them buy bonds. Rather than just manipulating the short term cash rate, by becoming a significant buyer of bonds they could also push prices down at longer maturities. This would help, amongst other things, to keep interest rates on mortgages low, which would provide support to borrowers, particularly those that were able to refinance on home values that had fallen substantially in many major cities.
The data on the US economy in recent times has been reasonably encouraging, such that the Fed has now stopped buying bonds, or ended the program known as quantitative easing, though for the time being interest rates are still at 0%. Which of course begs the question, when will the first rate increase be forthcoming? Just the anticipation of that move has led to volatility in a wide range of investment markets and we can expect a reasonable disruption when the move eventually comes, no matter how well signposted it may be. Prices in equity markets at least in one sense can be thought of as a function of supply and demand. We have also spoken in previous commentaries about the very low or non-existent returns on traditional safe investments like bonds and term deposits. An increase in rates to say 0.25% or 0.5% won’t change the actual return on term deposits by all that much, but it will represent a signal that is likely to influence demand for other investments like equities. In such an environment, any new investment dollar will be slightly less likely to head towards equities when rates are increasing towards normal long term neutral levels. This is likely to remove at least some of the demand that has supported equity prices for the last several years.
We therefore need to pay attention to the commentary coming from the Federal Reserve, and helpfully it and other central banks are much more transparent about their intentions than has been the case in decades past. There is certainly a range of opinions at the Fed, including some of whom vote on interest rate decisions and some who don’t. Despite this variety, with a focus on the most influential members we can derive more confidence about the likely policy course, and that means listening most closely to Chair Janet Yellen, her deputy Stanley Fischer and the head of the New York Fed William Dudley. On this basis, it seems likely that there won’t be any move on rates until around the middle of 2015, though if the economic data changes so will that prediction.
Perhaps the most important data in this regard is in relation to the labour market, and the somewhat imprecise judgment about how much slack may still exist, despite the headline unemployment rate falling most recently to 5.8%. We monitor a broad range of indicators in this area, and there are some that are not showing the same extent of recovery as the 5.8% number implies. These include the labour force participation rate, the level of long term unemployed, those that would like full time work but are only working part time, and the ratio of job openings to hires. However, the one that deserves the most attention relates to growth in wages, and there seems good reason to believe that the Fed won’t move on interest rates until there are signs of emerging inflation in wages. Presently that figure is running at around 2% to 2.25% or not much more than underlying price inflation, and expectations are that it would need to be more like 3% to 3.5% for the Fed to make the first move on interest rates.
On balance, those with the most influence at the Fed would seem to prefer to err on the side of allowing inflation to gradually increase, perhaps even a little beyond their 2% target, rather than hiking rates too early and finding that the perceived nascent economic strength wasn’t as self-sustaining as thought. Or as one Fed President put it1, they ought to see the whites of the eyes of inflation before moving on rates.
The path of extraordinary policy support that the US has just finished is one that the Europeans look set to embark upon in earnest, at least if European Central Bank President Mario Draghi gets his way, though that is by no means certain. If we look back to 2011, the ECB made two moves to increase rates from 0.25% to 0.75% before having to quickly reverse course as the economy weakened, eventually moving back to zero and in time beyond that to negative rates in 2014. Far from being at all close to seeing the whites of the eyes of inflation, Europe is staring down the prospect of outright deflation, which is an especially invidious phenomenon when debt levels remain so high. Across the Eurozone the unemployment rate is 11.5%, and there are significantly worse rates than that in specific countries and when the data focusing on youth unemployment is reviewed.
Making the task of stimulating the economy more difficult is the fact that the ideological divisions in Europe go well beyond the merely diverse opinions that we spoke of above. Lining up against Mario Draghi is Jens Weidmann, the head of Germany’s central bank, the Bundesbank. Recent reports suggest the relationship between these two is acrimonious, with seemingly no prospect of agreement on a policy consensus, at a time when a third economic recession and deflation are looming. A recent article laid out clearly some of the fears coming from Berlin and also the potential ramifications.2
“[Merkel’s] entourage is also deeply skeptical about Draghi’s plan to buy up asset-backed securities and covered bonds in the hope of encouraging commercial banks to lend. Most of all, politicians in Berlin worry that if this scheme doesn’t work, the ECB President will be tempted to launch full-blown government bond buying, or quantitative easing. This is a taboo in Germany and a step Merkel’s allies fear would play into the hands of the country’s new anti-Euro party, the Alternative for Germany. Losing the support of the euro zone’s biggest and most influential member state would be fatal for the ECB’s credibility, eroding confidence in its ability to work with governments to get the euro zone economy growing again.”
In short, the prospect of a disorderly break up in Europe which had largely been discounted in July 2012 after Draghi made his famous ‘whatever it takes’ speech, seems now to warrant further consideration and at least a higher probability than has been the case for more than two years. As we have said often, it is important to distinguish between the outlook for an economy and the investment markets, as there are many examples of where good long term returns can be still be found in otherwise moribund economies, providing valuation discipline is followed.
Next month we will provide the Quarterly Asset Allocation update, and after that in the final Monthly Commentary for 2014 we will shift the focus to Australia and China. We are awaiting information due out later this month about potential changes to the oversight and regulation of banks, and specifically the amount of capital that regulators will require them to hold against their lending. There has been much speculation about this in the financial media but it has been just that – speculation. We expect that increased capital ratios will be mandated, along with some form of standardised approach to modelling risk weights across residential and commercial lending.
In China, the most recent economic data was ahead of expectations with GDP growth coming in at 7.3% for Q3 2014. Disappointingly, this still lead to headlines about the rate of growth slowing, seeming to demand that the Chinese economy grow at 10% per annum in perpetuity. Jonathan Pain commented: “In 2015 we will see China report a growth rate with a six in front of the decimal point. But, as I have said countless times, this is perfectly acceptable, as by then it will be a $10 trillion economy. I continue to be impressed by the quality of the leadership in Beijing; the changing composition of the economy; the crusade against corruption and pollution and the liberalisation of the financial system. In view of all of the above, and given the compelling equity valuations, I see further stock market gains ahead.”3
1. Dennis Lockhart, “Thoughts on Liftoff” – Federal Reserve Bank of Atlanta. 11-Jul-2104.
2. N Barkin, E Taylor, P Taylor. “Mario Draghi’s German Problem.” Reuters. 23-Oct-14.
3. Jonathan Pain, “Shock and Awe from the BOJ.” The Pain Report. 4-Nov-14.
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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.