Monthly Economic & Investment Market Commentary February 2017

17 Feb Monthly Economic & Investment Market Commentary February 2017

By almost any measure the first few weeks of President Trump’s term have been truly staggering. However, the natural desire to seek to make sense of the unprecedented events that have characterised the incoming administration should likely be resisted. For as best we can tell, the normal tools with which we would attempt to do so are obsolete in such an endeavour. Deductive reasoning, evidenced based assessments and conclusions drawn from consideration of diverse opinions will likely not be remembered as the hallmarks of this occupant of the Oval Office. In just one example, the President reportedly rang his (now former) National Security Adviser at 3am to query whether it was a strong currency or a weak currency that was preferred, presumably with a view to making the American economy great again. One wonders whether those on the President’s Council of Economic Advisers feel slighted at not fielding a question from their own area of expertise, even at that hour of the morning.

So, what does this mean for investment markets and the global economy? Two points come to mind initially; firstly, the importance of acknowledging that a few weeks or months is not an adequate period from which to draw definitive long term conclusions, and the second is that presidents and prime ministers have much less impact on an economy than for which they are given credit. The latter point applying both in terms of praise when times are good and criticism during times of struggle. At this point, it should be said that one area that hasn’t staggered since the election in November or Inauguration Day in January has been the world’s share markets. In a little more than three months the S&P500 index in the United States is around 8% higher and the Dow Jones pushed through 20,000 for the first time. In Australia the ASX200 is up by nearly 12%, led by our two biggest sectors Resources and Financials which are both about 15% higher. In Japan the share market is up about 18% and in continental Europe it is about 9% as opposed to the United Kingdom where there is still a gain, but a more modest 5%.

Importantly the increase in bond yields looks to have stabilised following the quite sharp upward moves since the US election. The consensus behind this move was that President Trump’s policies would be a catalyst for a reflationary surge from tax cuts, increased spending on defence and infrastructure and significant reductions in regulations that would spur increased business investment. We were cautious about signing on to this way of thinking as we thought the reality of governing was unlikely to match the campaign promises, especially in the short term. The mere act of signing an executive order as statement of intent has thus far not proven to be as effective as one suspects the new President may have thought was going to be the case.

We remain of the view that interest rates are still in the ‘lower for longer’ regime, though no longer in the ‘very low’ territory of the middle of last year. This view has very important connotations across not just the defensive investments in your portfolio, but as a key input to the valuations that are appropriate to the risky asset classes such as Listed Property and Australian and International Equities. Janet Yellen has been a steady hand as Chair of the Federal Reserve and has just testified before Congress that with continued progress towards full employment and price stability that “afurther adjustment of the federal funds rate would likely be appropriate.”³ The market’s interpretation of this language is that there will be two or three further increases taking US rates to somewhere between 1.0% and 1.5% by this time next year. The consensus assumption is that the Reserve Bank of Australia will hold at 1.5% until well into the back half of 2017, or possibly even early 2018. Our currency has been buoyant of late, adding 5c against the US dollar in 2017, though we would expect this to start to unwind as interest rates move up in the United States in coming months.

AUSTRALIA

A recent speech⁴ by Dr. David Gruen tells a compelling story about the resilience of the Australian economy. Dr. Gruen has held senior economic roles over more than 30 years at the Reserve Bank, the Treasury and now the Department of Prime Minister and Cabinet. He begins by referring back to mid-2014 when he responded to a high profile economist’s prediction that Australia faced a ‘hard landing’. The expectation was that the impact of the coming significant decline in mining related investment would not be able to absorbed by the economy and would assuredly lead to a recession, absent some profound productivity enhancing policy reform. At the time Dr. Gruen said “myview of the transition was cautiously optimistic, or as I put it: ‘so far, so good’.” His current assessment is that the intervening period has been kind to the cautiously optimistic stance.

We are now in the latter stages of making the adjustment referred to above, indeed RBA Governor Philip Lowe recently put us at 90% of the way through the fall in mining investment. This has acted as a headwind to our economy for many years now, though this was an unavoidable follow on from the truly extraordinary scale of the boom, from which we all benefited.

Lowe goes further in declaring the end of another headwind with the adjustment in our terms of trade now deemed complete. The terms of trade is the ratio between the prices we received for our exports compared with those we pay for our imports, and it helped sustain our incomes when the financial crisis was impacting other countries around the world. In conjunction with monetary policy that kept our currency relatively high, we enjoyed the benefits of cheaper prices for imported goods and cheaper international travel. The impact of the terms of trade on Gross National Income per capita can be seen in this chart⁴ in purple. What is also apparent and just as important is the fact that labour productivity (in orange) has remained steady through each phase of the mining boom.

The economic reforms put in place in past decades have instilled in the Australian economy a greater degree of flexibility than those who predicted recession seem to have allowed for in their analysis. Ross Gittins pondered how the predictions of hard landings and recession by high profile economists seem to have got it wrong, and concluded: “Ithink they underestimated the extent to which the micro-economic reforms of the 1980s and ’90s,combined with the improved ‘frameworks’ for the conduct of macro-economic management, have made the economy more flexible – better able to roll with punches from economic shocks; less inflation-prone and unemployment-prone – and hence easier to keep growing at a reasonably stable pace. In particular, they underestimated the way the moves to a floating exchange rate, an independent central bank and decentralised wage-fixing would help us cope with our periodic commodity booms. In their enthusiasm to urge more micro reforms on us, they failed to realise how much we’dbenefited from those we’dalready made.”⁵

The current phase of this transition in our economy has meant a period of several years with weak wages growth, as this chart⁴ clearly shows. Importantly though much of this this has occurred during a period of low interest rates and low inflation, which has helped to mitigate the impact on households and in the broader economy. That the impact has been mitigated does not however mask that there are soft patches that we expect will start to improve. Typically these are measures such as retail sales which require a robust household sector that is experiencing job security and benefiting again from wages growth.

The Australian economy has not been in technical recession since mid-1991, a period which coincides with the steady but cyclical growth in earnings depicted above. The cautiously optimistic view from here is that we can start to look forward to that trend asserting itself again in our economy. “Withan end to the trend decline in the terms of trade now in prospect, positive real income growth should return – with its rate of growth again strongly influenced by the rate of labour productivity growth.”⁴

SOURCES:

1. Lowy Institute, “In-conversationwith Michael Morrell, former Acting Director of the CIA.” 14-Feb-2017.
2. Deborah Snow, “Ex-CIAman gives Turnbull advice on how to handle Trump” – SMH. 14-Feb-2017.
3. Janet Yellen, “SemiannualMonetary Policy Report to the Congress” Federal Reserve. 14-Feb-2017.
4. David Gruen, “Howhas Australia Responded to the Terms of Trade Decline?” – dpmc.gov.au. 2-Feb-2017.
5. Ross Gittins, “Nowthe economy’s transition phase is ending, wages can start rising” smh.com.au. 11-Feb-2017.

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.