June Market Commentary

08 Jul June Market Commentary

[titled_box title=”Financial markets over the past month” variation=”black”]Lower index levels mean slightly increased forecast returns, though the relativities between the asset classes depicted below remain unchanged.[/titled_box]

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Political and Economic Commentary

We start the June Monthly Commentary with a quick review of the numbers for the financial year just ended, but will move quickly on to looking forward to the two issues that are exerting the most influence on financial markets. The first of which is the likely behaviour of the central bank in the United States as they seek to normalise monetary policy, and the second is a discussion centred on the Chinese Financial System.

The index returns¹ for the financial year ranged from very strong to relatively weak depending on where we look, starting at home we know the banks had a very strong year with the Financials (excluding property trusts) sector adding 31%. However, the mining sector had a tougher time of it declining by 9.3% led down by the Materials sector (-10.2%), compared with the Energy sector which was moderately positive (+5.1%). Japan benefited from anticipation of the successful implementation of Prime Minister Abe’s proposed reforms and added 52% for the financial year, and other developed markets also posted good if less spectacular annual gains, including the United States (+17.9%), Germany (+24%) and France (17.0%). In Asia the Shanghai Composite was off 11.1% and South Korea’s main Sharemarket index closed essentially unchanged for the year.

Before moving on we should pause to note that very often, particularly over short time periods, there can be a detachment between share market performance and the underlying strength of a country’s economy. One of the main reasons we forecast over a ten year period is that the further out we look the more important are fundamentals like income and growth in earnings. Over time periods of as short as a year the impact of sentiment can be dominant and is incredibly difficult to forecast accurately, however its influence diminishes and hence the reliability of forecasts improve over longer periods.

UNITED STATES

For the benefit primarily of our newer readers, providing some context to recent developments is an important starting point to the discussion on monetary policy in the United States. We are talking here of the policy implemented by central banks with regard to interest rates, as opposed to fiscal policy which is administered by government and concerns polices that determine taxation and expenditure. Lower interest rates, meaning cheaper money, stimulates an economy by reducing borrowing costs for investment – ideally in building the productive capacity of an economy and to satisfy increasing demand for goods and services. Alternatively, when an economy is thought to be expanding too rapidly, that is, in an unsustainable fashion, increasing the cost of funds by raising interest rates takes money out of the economy and slows economic activity.

The circumstances that lead eventually to the Global Financial Crisis (GFC) are many and varied, but are due at least in part to consumption that was fuelled by increases in borrowing, in many cases predicated on rising home values. When property prices actually started to fall it triggered defaults by many borrowers which were not isolated to the banks that issued the loans. A process known as securitisation saw banks bundle up loans and sell them as conservative investment products to investors including pension funds and municipal authorities, with the blessing of the major ratings agencies. Removing the direct link from the issuing bank to the borrower saw a diminution of credit assessment standards, with growth in loan issuance trumping what should have been prudent loan underwriting criteria. A good summation of this activity can be found in the acronym NINJA Loans – which referred to loans that were made to borrowers with No Income, No Job or Assets.

In response to the crisis the central bank in the United States, the Federal Reserve, took interest rates from 5.25% in September 2007 down eventually to a range of between 0% and 0.25% in just over twelve months. However, not even such a dramatic cut in rates was sufficient to support the economy which was struggling to deal with what became the deepest crisis since the Depression. From late 2008 and into early 2009 the US economy was losing around 700,000 to 800,000 jobs per month² and households were truly in dire straits as the value of their homes dropped precipitously, and as it started to become apparent that a very long and painful period of repairing family balance sheets lay ahead.

When the economy continued to struggle to emerge from the depths of the crisis, the Federal Reserve in a sense went beyond the zero lower bound of interest rates and implemented the range of extraordinary policies to provide additional liquidity support we know as Quantitative Easing (QE). Now that we are more than five years on from the onset of the GFC, the US economy is continuing to recover, though at a pace that is frustratingly slow to many. The same measure of employment mentioned above has averaged around 175,000 jobs added per month for the last twelve months, and house prices have actually recorded strong gains of just over 12%³ for the year to April.

All of which brings us to the most recent statement of the Fed committee that sets interest rates: “The Committee is prepared to increase or reduce the pace of its purchases to maintain appropriate policy accommodation as the outlook for the labor market or inflation changes.”⁴ For those not accustomed to interpreting the nuanced words of central bankers, Chairman Bernanke was kind enough to put this another way: “To use the analogy of driving an automobile, any slowing in the pace of purchases will be akin to letting up a bit on the gas pedal as the car picks up speed, not to beginning to apply the brakes.”⁵

This is the sum total of what has been a primary catalyst for the volatility that has surfaced again in recent weeks in financial markets. To those such as ourselves who are able to lift their eyes and take a view beyond a day, a week, a quarter or even a year, this is an entirely expected and obvious move from the Fed. Whilst it is disruptive in the short term, one positive aspect of the volatility is that it has provided us the opportunity to get established in positions where we have been waiting for better entry prices.

CHINA

Also exerting a strong influence on investment markets was news of some disruption to credit markets in China. To be sure this is a very complex area, and one that is challenging to analyse due to the rapid growth and transformation in the Chinese economy and the financial system. The relationships between the government, the central bank, the commercial banks and the array of local government finance vehicles serves both to simplify and to obfuscate attempts at such analysis. In the first sense, we know that where directives are made from Beijing that these directives will be followed, but we also know that these directives very often give consideration to criteria other than those which a commercial bank would normally be expected to consider.

First, let us disavow any sinister connotations that we may have about the term shadow banking, as quite simply every economy in the world has a shadow banking system. The term refers simply to credit related activities that occur outside the regular banking system, and in an Australian context would include finance companies, money market and other investment funds. In China this sector includes similar entities as well as local government finance vehicles and trust companies which serve as intermediaries between banks and investors.

A recent paper⁵ from the Brookings Institution, a Washington D.C. based think tank, provides a comprehensive review of the Chinese financial system. The authors preface their discussion of the challenges that lay ahead for the Chinese with an acknowledgement of the success of the transformation to date. “China’s financial system has managed for several decades to perform well enough to support the very rapid economic growth of that nation. One can argue about whether alternative approaches would have worked better, but, at a minimum, it represents a real accomplishment to have avoided acting as an anchor preventing the impressive growth that China has achieved.”

In the late 1970s and early 1980s the People’s Bank of China (PBOC) started to change from conducting both central and commercial bank functions, when four new commercial banks were created the Bank of China, the Agricultural Bank of China, the China Construction Bank, and the Industrial and Commercial Bank of China. It is worth nothing that these banks are holdings in one or both of the Exchange Traded Funds, the Asia 50 and the Emerging Markets ETFs, that comprise our International Equities exposure. Combined, these four banks represent 2.2% of the 25.7% target exposure to International Equities in the most growth oriented No. 5 program, and proportionately less in other programs.

The recent concerns relate to growth in the size of shadow banking and also the extent that this rapid growth will lead to an increase in the level of non-performing loans. Estimates of the size vary widely and at the higher end of the range amount to 57% of China’s GDP.⁶ For comparative purposes shadow banking assets globally are estimated at 111% of global GDP and 152% in the United States, 168% in the Euro area and 370% in the United Kingdom.

Turning then to the issue of non-performing loans, we have a relevant example from the Asian currency crisis in 1997 of a spike in the rate of default, and importantly also the response from the Chinese. At the time the banks were undercapitalised and had only small provisions against losses, and in response the Chinese started a process that saw US$33 billion in capital injections as well as a program to resolve the underperforming loans. Reforms have continued since that time and will of course keep evolving as the Chinese economy grows. Chinese banks work in a tightly regulated environment which means they have very stable net interest margins of about 3%, and these have been consistent before, during and after the financial crisis. In Australia the major banks net interest margins range from 2.1% to 2.7%.

The People’s Bank of China manages the Reserve Requirement Ratio to provide stability and capital adequacy, and this currently means that 20% of banks assets are held at the central bank. The rise in shadow banking is being addressed and the authorities are taking steps to ensure that these lending activities are brought back onto bank balance sheets, that capital requirement are being imposed on the trust companies and disclosures and risk awareness is improved for investors.

Our stance on the Chinese economy and financial system has long been an acknowledgment of the challenges, but this has been and continues to be accompanied by an expectation that the Chinese have both the capacity and the intent to address these challenges.

SOURCES:
1. IRESS. Price index returns from 30-6-12 to 30-6-13.
2. Thomson Reuters – United States, Employment, Overall, Nonfarm payroll, total, SA, Absolute Change
3. Thomson Reuters – House Prices, S&P Case-Shiller, Composite-20
4. Federal Reserve, FOMC Statement – June 19, 2013
5. Transcript of Chairman Bernanke’s Press Conference – June 19, 2013
6. Federal Reserve Bank of San Francisco – Asia Focus. Shadow Banking in China. April 2013.

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.