14 Oct Monthly Economic & Investment Market Commentary September 2016
“Global growthsolid at trend rates”1 is a headline to which followers of the world economy have become unaccustomed in recent years, yet there it was in the Financial Times. The article referenced an update from the Research Director at the International Monetary Fund given at the joint meetings of the IMF and the World Bank held recently in Washington DC. We should hasten to add though that there are really two underlying components here – one encouraging and one frustrating. The encouragement comes from the assessment that global growth is now moving sideways rather than continuing to slow and this is important because investment markets look for inflexion points. The assessment that needs to be made is not a simple determination of good or bad, but rather identifying when conditions are getting better or worse. For now it is too early to say definitively that things are getting better, but not getting worse or going sideways will suffice. That said, we should expect some residual frustration from the historically weak growth rates before we see a return to long term higher trend rates.
“There hasbeen a marked recovery in global growth since the low points were reached at the end of last year. At that time, the nowcast models identified activity growth at 2.5 per cent. This was more than one percentage point below trend and fears of an imminent global recession were rife. Whether a recession would have occurred without policy changes is anyone’s guess, but the necessary policy changes were forthcoming in many of the major economies, notably in China and the US. Both of these economies responded to treatment, especially China, and global growth recovered to 4 per cent by July, when it seemed that the world economy might actually break upwards above trend. So far, this has not happened, but earlier fears of global recession now look seriously misplaced.”1
Since our last commentary there has been a significant development in the process by which the United Kingdom will leave the European Union. Speaking at her recent party conference, newly installed Prime Minister Theresa May backed up the proclamation she made upon moving into Downing Street, Brexit most assuredly does mean Brexit. As it stands now the PM has said that the paperwork will be lodged with the EU by March 2017 at which point the formal negotiations will commence. The treaty that contemplates a member state leaving allows for a period of two years for that exit to be negotiated. If in that time no agreement has been reached then membership ends automatically unless there is mutual agreement between the exiting member state and the European Council to extend negotiations. In appeasing her base at the party conference by putting a firm deadline on starting the exit process some have argued that the Prime Minister has given up a crucial bargaining chip.
As the shock of the outcome has dissipated in the months since it was made, there is a need to be wary about discounting the true consequences of the decision. At the very least it must be acknowledged that the nature of the Brexit is unknown at this stage, though with recent developments it appears more likely that a so called hard Brexit is the more likely outcome. “So at one extreme, ‘hard’ Brexit could involve the UK refusing to compromise on issues like the free movement of people, leaving the EU single market and trading with the EU as if it were any other country outside Europe, based on World Trade Organization rules. This would mean – at least in the short term before a trade deal was done – the UK and EU would probably apply tariffs and other trade restrictions on each other. At the other end of the scale, a ‘soft’ Brexit might involve some form of membership of the European Union single market, in return for a degree of free movement [of people].”2
In the short term the sharp decline in the UK currency has provided temporary relief in that it significantly improves international competitiveness of UK exporters while existing trade deals remain in place. It also encourages other sectors like inbound tourism as Britain is now a much cheaper destination for international travel.
Ultimately however the lower currency will have a deleterious impact on the British citizens, and may mask the need for fundamental economic reforms.
“Theimplications of a realistic view of the UK economy [are] that, even without the looming shock of Brexit, the economy suffers from big weaknesses relative to the European economies that many Brexiters despise. Some argue that a real depreciation of sterling is mainly what is needed. If sustained, the post-referendum devaluation should indeed help, though it means a fall in real incomes and wealth. Yet devaluation alone will not cure UK weaknesses.”3 We are mindful that an investment market does not move in lockstep with the underlying economy, though we will shortly adjust the International Equities passive model holdings so that we can assess and manage the UK exposure discretely as opposed to the broad exposure we have now in the Europe and Far East ETF (IVE) that holds companies in the UK, Europe and Japan in a single security. We will communicate these changes to you in the near future, as we will any subsequent decision to adjust the UK exposure in its own right.
One of the key areas we have been focused on in our assessment of the Chinese economy is the level of debt in the corporate sector and the progress of ongoing reforms to the State Owned Enterprises (SOEs). In response to the global financial crisis the Chinese authorities undertook a very large scale stimulus program centred on infrastructure investment which played a large role in assisting the world economy to recover, and of course that was particularly important to the Australian economy. These stimulus programs saw the accumulation of significant debt both in local government finance vehicles and in the SOEs. One critical attribute of this debt is that the vast majority is issued in the local currency and is mostly owed to the domestic banks. That means there is a viable solution to dealing with it, and indeed we have already seen a successful first program in recent years. Local governments have been able to raise money in a burgeoning municipal debt market, which means their debts have been rolled over into a much more transparent market and at lower rates. There is now a further move to deal with the debt held in the SOEs which would see the introduction of a debt-for-equity swap along with policy encouragement for securitising debt, for potential mergers between companies, and importantly provisions for bankruptcies where appropriate. Comments from officials announcing the programme sought to allay some of the trepidation by emphasising that the swap would be “market-oriented” and targeted to companies with a viable outlook.
“Now is the time for China to push for far-reaching reforms. Bank’s balance sheets still have a relatively low volume of non-performing loans (and high provisioning). The costs of potential losses on corporate loans … are manageable. Furthermore, the government maintains high buffers: debt is relatively low, and foreign-exchange reserves are relatively high. The question is whether China will manage to deleverage enough before these buffers are exhausted. Given its record of economic success and the government’s strong commitment to an ambitious reform agenda, China can rise to the challenge. But it must start now.”4
We continue to expect that China will be an important allocation within the International Equities exposure in your portfolio and we will continue to monitor these reform developments closely.
At the outset of this commentary we spoke of thinking in terms of better and worse as opposed to good and bad. Here we present a 30 year chart that shows the Reserve Bank’s index of commodity prices and also the Terms of Trade (the ratio of export prices to import prices). Whilst it is also too soon in this context to speak unequivocally of things getting better from here, it can clearly be seen that there has been a recent pick-up in commodity prices and a flattening in the terms of trade.
At the very least this will provide a short term fillip to our economy and allow the bank to pause on further rate cuts, preserving capacity for policy support should it be required in the future. It will also be very welcome news for the Treasurer as he continues the process of restoring fiscal balance in our Federal Budget. There remains much work to be done in managing the transition and balance within our economy, but equally we believe there is a case for continued cautious optimism about the outlook for Australia.
- Gavyn Davies, “Global growth solid at trend rates” – Financial Times (ft.com). 10-Oct-16.
- UK Politics, “Brexit: what are the options?” – BBC.com. 10-Oct-16.
- Martin Wolf, “Economic ills of the UK extend beyond Brexit” – Financial Times (ft.com). 29-Sep-16.
- David Lipton, “China’s Corporate-Debt Challenge” – Project Syndicate. 18-Auug-16.
NOTE: It is important to note that each portfolio is managed to its own mandate, which can mean that activity mentioned above is not reflected in your own portfolio. This may be because it is more beneficial to your portfolios after tax performance to complete the trading at a different time, or may be due to individual customisation that you have requested. This flexibility is an integral part of the investment process. If you would like to discuss the tailoring of your portfolio please contact your Adviser.
DISCLAIMER: The information in this commentary has been provided for publication by Implemented Portfolios (ABN 76 821 231 362. AFSL Number 345143). The information has not been verified by Adapt Wealth Management (ABN 76 821 231 362 Corporate Authorised Representative of Paragem Pty Ltd AFSL 297276) 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.