Opportunities from QE3?

Chairman Bernanke and the FOMC have acted strongly in their announcement of “QE3” overnight.  An immediate share market rally is expected by many, some argue that it’s been already priced in.  A complex web of domestic and international influences should be considered by Australians in making their investment decisions.

Commentators vary in their response to the Fed’s announcement ranging from Goldman Sachs’ view that “further stimulus represents a clear signal that economic growth remains stalled” to UBS’ strategic view essentially ignoring QE3 and taking steps to position for a pullback in stock prices post-easing and as the fiscal cliff approaches toward the end of the year.

Karen Maley writing in the AFR said today:

Critics argue that QE3 will undoubtedly affect the prices of assets, such as shares and commodities, but will have no effect on US employment. The Fed is able to affect asset prices because when it buys US Treasuries and mortgage-backed securities, it effectively removes these assets from the market. That pushes up the price (and reduces the yield) on those ‘safe haven’ assets. (Incidentally, it also pushes up the price, and reduces the yield of other ‘safe haven’ assets, such as Australian government bonds, which boast a triple-A rating.)

But QE3 won’t encourage businesses to borrow more money to invest and hire new workers, because companies are worried about feeble demand for their products. And QE3 won’t encourage consumers to spend more, because they’re worried about their job prospects, and banks remain extremely reluctant to lend to debt-laden households.  By pushing up their cost of living, QE undermines the living standards for millions of low- and middle-income households. The wealthy – who own large share portfolios – get a benefit from rising equity markets, but most people end up worse off financially.

By targeting mortgage bonds in his latest round of QE3, Bernanke is clearly trying to spread the benefits of QE3 to the US middle classes – for whom their house is their important asset. But with an estimated one in seven US households underwater on their mortgages, and with a mountain of foreclosed houses yet to hit the market, it’s unlikely that a marginal reduction in US mortgage rates will provide much of a boost to home prices, or spur activity in the embattled housing sector.

Back in March 2012 we wrote about Investing in a QE World.  In that piece we explained what QE is and how it has been implemented by the major central banks.  Since that time we have observed the European ECB and Bank of England response.

The Economics editor of the Guardian reflected on 6 September 2012:

In one important respect, QE did the trick, because without it there is no telling what would have happened to the global economy in the winter of 2008-09. By the summer of 2009 there was clear evidence that the decline in output had bottomed out. Fears of a Great Depression 2 were scotched.

And yet, QE was supposed to be a temporary measure, with the process reversed once the global economy returned to normal. Far from that happening, central banks kept on buying bonds. The Bank of England is on its fourth round of QE; the Fed is about to embark on its third. Despite an unprecedented stimulus, the global economy is losing momentum

Is it all bad, though? Before answering this question, Australian investors need to consider the following six interlinked areas:-

1. The Australian dollar:  Our earlier post set out the critical issues for our dollar including commodity prices and demand from foreign sovereigns.  Devaluation of the US Dollar inflates the value of ours – this correlation must be watched closely mindful of the negative effects on Australian producers & exporters of a high dollar.
2. Commodities prices: (especially iron ore) but also metals including gold and silver – to a very large extent these are determined by demand for our commodities from China.   Slowing global demand for our commodities particularly iron ore and other mining exports will be the greatest influence on our domestic economy for the near future.  The recent price falls in the iron ore price and its partial recovery will be pivotal.   The speed with which change in this sector can occur is exemplified by Fortescue  this week which is now in a trading halt as the company approaches its banks to waive lending conditions.  Watch this space – China is key.
3. Shares: There will undoubtedly be winners in equity markets in Australia and overseas.  The challenge is in picking suitable stocks (or ETFs) which sit happily with your risk profile and your proposed holding time.  We all know a trade is different from an investment.  Our summary of the current position is: Expect market volatility between now and the start of 2013 as global issues dominate including further chapters in the European debt crisis, Arab political instability, US presidential elections and dealing with the “fiscal cliff”. Traders may wish to consider income producing stocks including global ETFs. Traders may wish to consider diversification into natural resources funds as a potential hedge against future inflation (see more on inflation below).  Longer term investors may prefer to remain prudent in the face of continued volatility  and uncertainty and stay out of stocks until the start of 2013.   US equities may appear more attractive than Australian shares if you can manage the currency issues.
4. Inflation:  How do you protect your investments against this?  Protecting yourself against future inflation is going to be an increasingly important consideration now.  There are a number of options to consider – ranging from investments in gold, hedged equities, commodities, inflation protected bonds and ETFs.   We consider these options at length and propose specific strategies suited to our clients’ investment profiles and needs.  This is a sophisticated and complex area and we do not make any general recommendations at this point in time.
5. House prices: Australian house prices continue to be considered overpriced by international and historical standards.  Overseas commentators remain negative about future capital growth in the Australian real estate sector.  Domestically, there are mixed messages coming from different markets across the country.  However, the overall trend is that things are tracking sideways, with risks to the downside.  This is no environment in which to recommend investment properties with enthusiasm.  Yet we continue to receive multiple calls weekly from property spruikers wanting to put our self funded retirees into residential real estate investments.  We are currently resisting this trend and do not recommend Australian residential investment to our SMSF clients generally at this time.   We mention house prices now as we are going into a new spring selling season, mindful that supply of housing stock is at record highs, the time it takes to sell a house is also very long in Melbourne and Sydney and the recent volume of mortgage transfers reported by government is at historic lows.  We would not be surprised to see a flat or negative selling season ahead.  This has an effect on the Australian banking sector and bank stocks in particular given the huge focus they have had on domestic mortgage lending over the past decade.  Their massive profitability has ridden the “house price increase” wave and all commentators seem to agree that this ride is over: see Gail Kelly’s recent comments here.
6. Australian interest rates: Expectations are that the RBA will lower interest rates again, and that the immediate future looks like a lower rate environment. This is a further blow to self funded retirees looking to live off their super pensions and those for whom a large part of their super is currently held in bank deposits. Lower returns on investments are the “new normal” and the only thing that will change these returns at this time is increased risk in investments – and that brings greater risk to the downside as well.  Speculative investment within super is not good if you want to rest easy at night.  It may prove good for the hip pocket but then again it may not go well at all.  That’s the risk. Lower rates are reflected in the Australian Bond yield curve, to which we have made reference before.  It continues to be in a negative yield curve – a negative portent for our economy generally.

We haven’t talked in this post about other economic indicators such as unemployment, GDP and PMI.  Neither have we mentioned industrial unrest, wages pressure, political issues such as funding for government spending programmes such as the NDIS, Gonski and the Dental Scheme which are looking like blowing a big hole in the Commonwealth Budget.  These issues are all bubbling away in Australia and whilst we have no doubt on the scale of relativities that we are indeed a fortunate country, there remain risks to our domestic economy which provide significant challenges ahead for us all.

The major message coming from the Fed today is that the US Central Bank is going to continue its active and open ended interventions for as long as it takes to improve the employment market in the USA.  There are big consequences for global trade in all this.

The Aussie Bond

What's all the discussion about bonds?  We know and love the iconic logo of the maker of our favourite "comfy undies" but there is a very different significance attaching to government bonds in Australia and around the world at the moment.

A government bond is issued by a national government and is denominated in the country`s own currency. Bonds issued by national governments in foreign currencies are normally referred to as sovereign bonds. The yield required by investors to loan funds to governments reflects inflation expectations and the likelihood that the debt will be repaid.

The Australian  bond yield looks like this today:

www.bloomberg.com.au 5/6/2012

This is called an inverted yield curve and is generally interpreted as a leading indicator of recessionary times. Orange line is yesterday, green is today.  This afternoon's rate cut by the RBA in the official cash rate of 25 bps is in line with the bond market's expectations with the expectation of more to come.


The 12 month chart for the Australian Government 10 year bond looks like this.



www.bloomberg.com.au 5/6/2012

Australia's Government Bond Yield for 10 Year Notes have declined since October 2011 which means it became less expensive for Australia to borrow money from investors. Historically, from 1969 until 2012, Australia Government Bond 10Y averaged 7.9%  reaching an all time high of 16.4% in May 1982 and a record low of 3.1% in May of 2012. 

The international picture for bonds can be seen here:


www.ritholtz.com 2/6/2012

This week US government bond prices reached all time lows. German and Swiss bonds currently can be bought with a negative interest rate.  Other than the obvious argument of "flight to safety", why would anyone want to buy sovereign debt with a negative return? John Mauldin writes here 

But even given the pessimism in Europe, why should Germany be able to sell €5 billion of two-year bonds at zero percent interest last week and see them trade this week at a slightly negative interest? Why would anyone buy a bond that is guaranteed to not even give you your money back? Is that a sign of severe potential deflation?
The answer is, not really. Buying German bonds, even at a slightly negative rate, is actually a cheap call option on the eurozone breaking up. A German bond that became a new Deutschemark-denominated bond would rise in value at least 40-50% almost overnight. If you are a pension fund, for instance, with a lot of sovereign debt from a variety of European peripheral countries and you think a break-up of the eurozone is possible, it is a way to hedge your investment portfolio.
Switzerland actually sold outright this week bonds that have a negative coupon. Again, not a sign of deflation but another call option, betting that the Swiss Central Bank will have to give up on its peg to the euro. That peg has got to be one of the biggest losing trades in central banking history, and the Swiss seem determined to lose even more money. If the euro goes to $1.15 or lower, that trade becomes an even more massive loser. At what point in the next year will the Swiss Central Bank decide it has endured all the pleasure it can stand in fighting the fall of the euro? If they abandoned the peg, the move in the Swissie (as traders call the Swiss franc) would be large and almost instantaneous. And the reward for investors outside of Switzerland buying Swiss bonds with a negative yield will be large. 

What about inflation?

We know PMI numbers are showing economic contraction.  We know we are living in deflationary times.  Australians are deleveraging fast - retail sales are down and we are paying back personal debt to the banks at very high rates.  Unemployment in the USA and Europe is at persistently high levels.  This leaves central governments around the world able to employ strategies such as Quantitative Easing without an immediate inflationary effect. Mauldin offers the theory that this is due to the slowdown in the velocity of money - for a fascinating explanation see here.  For those without the desire to read more deeply, it follows from his argument that low bond yields are here for a long time and will not change quickly.

He says the Fed "will be able to monetize more than you think without causing a repeat of the 1970s.  Eventually it will catch up to us, as there is no free lunch, but they are betting they will be able to reduce some of the actual inflation by cutting back on the money supply and raising rates.  But we are years off from that. So, yes, at some point inflation will be back".

The following chart shows the US Federal Reserve's holdings of US government bonds and the timing of such purchases, relative to each wave of quantiative easing:

Deutsche Bank

The significance of the above chart can be seen when reading, from Deutsche Bank:

In addition, central banks (Fed, ECB, BoE, BoJ) buying government bonds has lowered supply of risk-free bonds real money managers can buy (for example, the Fed currently holds 30% of all 5-10 year US Treasuries outstanding).

Bottom line: More demand for risk-free assets and less supply of risk-free assets combined with significant long-term risks to global growth imply that interest rates are likely to stay low for many more years.

and via FT Alphaville on 4 June 2012:

...from JP Morgan’s Flows and Liquidity team on Friday, we have five reasons, other than quantitative easing, why rates will stay down for the foreseeable future:

- Regulations such as Solvency II, pension fund regulations, Basel III

- It is not only regulations inducing financial institutions to buy bonds, demographics may also be playing a part

- Due to ultra low policy rates, retail investors replaced money market funds with bonds as savings vehicle

- G4 central bank QE

- An acceleration of the global savings glut since the Lehman crisis.

- The end of the equity culture

What does a long term low priced bond environment mean? 

Bottom line, for self funded retirees in Australia, it means that we are likely looking at a low yield investment environment over potentially quite a long time.  This is not great news.

Jeremy Warner wrote in the London Telegraph in June 2011 (not much has changed in Europe in 12 months!):

The traditional relationship, which has ruled with only a small number of aberrations since the late 1950s, is that bonds yield more than equities. This juxtaposition is underpinned by the idea that equities are able to grow their earnings at least in line with GDP, and therefore over time will offer a better rate of return than fixed income investment.
The man most credited with creating this relationship was George Ross Goobey, who back in the 50s headed the Imperial Tobacco pension fund. By advocating equity investment as an appropriate policy for pension funds, he brought about a revolution in investment thinking.
Pension funds developed a previously non-existent appetite for risk and switched wholesale from fixed income into shares. The "cult of equity" was born. Shares began to yield less than bonds to reflect their supposedly superior growth and inflation hedging characteristics.
But what happens when growth slows, society ages and risk appetite diminishes? Well as it happens, bonds have been outperforming equities for many years now, but it was only with the onset of the financial crisis that the cult of equity's fifty-year reign started to crumble.
Post the Lehman crisis, we saw an extreme reversal in the yield gap, followed, after the policy response and signs of a spluttering economic recovery, by an uneasy truce, when the two yields essentially tracked each other. But since June this year, the relationship has gone unambiguously back into the post Lehman danger zone.
It's still too early to say this is the new normal. We are once more in one of those periods of extreme risk aversion, with multiple uncertainties crowding in on investors. It's not surprising that there should be a dash for safe haven assets.
In a downturn, corporate profits will fall, dividends will get cut and insolvencies will rise. Bonds, by contrast, become the default security of choice. Money that would normally be spent on consumption or invested in productive assets gets hoarded instead, generally in cash or the nearest equivalent, government bonds.
As risk aversion grows, a vicious circle establishes itself of falling demand, employment, and economic activity. The more risk averse that companies and households become, the more they save. In Japan, they've had this phenomenon for twenty years now and still there is no end in sight to the deflationary funk.
The mood is infectious; having let rip with deficit spending in the immediate aftermath of the Lehman's collapse, governments too are losing their appetite for further risk and are reining in as fast as they reasonably can.
It's hard to be bullish about prospects for equities right now. Investors won't return until uncertainties over the US and eurozone economies are lifted, and that's going to require a level of political leadership which right now seems entirely absent on both sides of the Atlantic.
Extreme volatility and sideways trading look set to remain the order of the day for some while. That's not to say equities are not worth buying. Some businesses prosper, even in a depression. But we seem to be going back to the old, pre-war days, when equity was priced for risk.
Equity is becoming scarcer, and therefore more costly, just at a time when large swathes of the banking and corporate landscape, not to mention the economy as a whole, need most.

Interesting times continue.

Investing in a QE World

www.bbc.co.uk

We've written a lot about global macro issues lately.  The debt issues of Europe and the USA are enormous and ongoing.  They remain unresolved.  The statistics are staggering: the combined central banks of the world have "printed" so much money since the GFC that their balance sheets now constitute a third of global equity values: see

Bianco Research: www.arborresearch.com, 27 January 2012

We maintain Australian investors need a global context for their investment decisions.

What is QE?
Quantitative Easing ("QE") is an expanding of balance sheets via increasing bank reserves.  The purpose of QE, as explained by this Bank of England video,  is to increase bank reserves through purchases of fixed income securities in order to lower interest rates.  This makes fixed income securities relatively unattractive/overvalued and pushes investors out the risk curve.  This should increase buying for riskier assets such as stocks, pushing them higher in price.  Theoretically these higher prices should lead to a wealth effect and increased economic activity. see

Everybody (else) is doing it
The  major economies of the world are exercising monetary policy in order to stimulate economic activity as the first chart shows.

By contrast, the Australian economy is undergoing an unprecedented mining boom at the same time as other sectors of the economy are contracting.  We call this our "two-speed" or "patchwork" economy.  Some argue it's a manifestation of "dutch disease".  The Gillard Government's trade policy is premised on the following:

Non-mining businesses seeking to retain their employees and contractors will need to bid for them against extremely profitable mining-related businesses. And since the mining boom is not confined to Australia, overseas bidders have also entered the market for Australian expertise. Similarly, the prices of materials and equipment used in mining-related activities are being bid higher.
An independent, inflation-targeting Reserve Bank, confronted with these price pressures, would be obliged to consider raising interest rates to prevent inflation from rising above its 2-3 per cent band of tolerance. The blunt instrument of interest rates hurts non-mining businesses and regions of Australia, accentuating the patchwork economy.
A further natural economic consequence of the mining boom is a rising exchange rate, the Australian dollar having surpassed parity with the greenback in November 2010 for the first time since well before the currency was floated in 1983. A high Australian dollar has the desirable consequence of putting downward pressure on prices by lowering the cost in Australia of imported goods and services — taking some pressure off the Reserve Bank to lift interest rates. But a high Australian dollar is also damaging our import-competing and export industries, weakening their ability to compete for productive resources against mining-related industries. While this, too, has an anti-inflationary effect, it is more deeply embedding the patchwork economy.

What to do?
Where does all this money printing  leave the Australian investor?  Holding your deposits in cash eats away at their value longer term if inflation kicks in.  How does the SMSF Trustee determine the best course for achieving the returns required to fund retirement?

You could take the risk of riding the upward trajectory of the risk markets such as stocks.  The risk is described well here

Until a worldwide exit strategy can be articulated and understood, risk markets will rise and fall based on the perceptions and realities of central bank balance sheets.  As long as this is perceived to be a good thing, like perpetually rising home prices were perceived to be a good thing, risk markets will rise.
When/If these central banks go too far, as was eventually the case with home prices, expanding balance sheets will no longer be looked upon in a positive light.  Instead they will be viewed in the same light as CDOs backed by sub-prime mortgages were when home prices were falling.  The heads of these central banks will no longer be put on a pedestal but looked upon as eight Alan Greenspans that caused a financial crisis.
The tipping point between balance sheet expansion being bullish for risk assets versus bearish is impossible to know.

A new option for Australian investors
One new option is to consider a high interest cash exchange traded fund such as Beta Shares new offering, the Australian High Interest Cash ETF.

Characteristics of this product include:

• diversification of investment portfolio - the product as part of a cash or term deposit allocation aims to earn a higher rate of interest than the 30-day bank bill swap rate after fees and expenses
• suitability for cash flow for SMSF pension holders - monthly income payments may be made
• the ETF is backed by deposit with an Australian bank trading under new ASX AQUA rules
• investors buy and sell units in the ETF through a broker (and pay brokerage)
• as interest is earned each day on the deposit, the value of the ETF will rise, providing investors with liquidity, coming with the ability to sell at any time without penalty (in contrast to term deposits).

We note:

• the Government Guarantee on bank deposits for Australians is now limited to $250,000 per deposit with one bank/ADI (authorised deposit taking institution).  Participation in a cash ETF does not equate to a deposit for the purposes of the government guarantee.
• A Cash ETF provides the possibility for a spread of risk from one institution to many, exposing the investor to multi-party credit risk akin to the former Macquarie Bank Cash Management Trust product.  (Note: the current Macquarie CMA attracts single party credit risk). 
• the BetaShares Cash ETF currently only offers single bank risk (Westpac) though the PDS describes the possibility of deposits with other major Australian Banks: see here Accordingly, we recommend this is a product to watch, and once they and others offer diversification of credit risk we would recommend our clients to consider these products.

There are similar new products coming onto the market in Australia such as offerings from  iShares and Russell Investments.  You can read more about these products in The Age/SMH or call us to have a chat about your needs and risk appetite.  

Please note this is not financial advice and you should not rely on opinion/s expressed in this blog post.