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 Australian Dollar

 

In the past 12 months Australian commodity export prices have reduced by around 30%.

At any other time in our history this would have meant a corresponding drop in the Australian Dollar.

Not this time.

This week the RBA has considered the level of the Australian dollar. RBA Governor Glenn Stevens said yesterday that the exchange rate has remained high "despite the observed decline in the terms of trade and the weaker global outlook". This is a significant shift.

Today's Financial Review reports that the "tech giants" being Apple, Google and Microsoft together have stored significant holdings of short term Australian treasury bills from their cash reserves. This follow's Monday's Reuters report that Shell has announced it is shifting $15 billion of its cash reserves out of European banks into US treasuries and US bank accounts "to avoid growing macroeconomic risk" in the words of Shell's CFO.

It is argued that upward pressure on the Australian Dollar has been supported by acquisition of Aussie dollars by foreign central banks (from Germany, Kazakhstan, Russia, the Czech Republic, Switzerland, Qatar, Kuwait and Abu Dhabi) looking for a AAA government bond paying a good yield.

Why would US companies be doing this? In the past, the US companies mostly sent their Australian profits to the US, where some of their reserves are held in US treasury bonds. But very low yields on US treasuries and the weakness of the US dollar led them to invest in Australian debt instead.

Last week in the Financial Times, Neil Hume reported that there were a number of reasons posited for the current strength in the Australian dollar. They can be summarised as:

1. The Safe Haven - or diversification away from US$ and also from Euro exposure, (particularly the latter according to Gerard Minack from Morgan Stanley)
2. Australia's AAA rating
3. Good GDP numbers
4. Relatively high interest rates (3.5%)

It's not only government debt that is being sought by offshore investors: the statistics are rapidly rising in relation to State and Territory government debt, corporate bonds and bank bills.

Last week RBA Governor Glenn Stevens gave a speech entitled "The Lucky Country". 

Stevens spoke about the Australian dollar in connection with China. He said if there were a serious slump in China, the Australian currency would “probably” fall, providing a much-needed boost to the domestic economy but he also noted in the case of a Eurozone break-up that another financial crisis might result in a larger flow of funds into Australian denominated assets:

“In that case our problem might be not being able to absorb that capital”

Australians will be watching closely. WIll our currency remain a "commodity currency" or is the current decoupling a permanent shift?

Australia's Debt Position - the whole picture

Household Debt

Daily in the mainstream media we are told "Australia's debt is very low by international standards".  In terms of government/sovereign debt, this is undoubtedly true and this is extremely important.

However, add in household debt and that of companies and financial institutions and a different picture emerges.  The following chart, from macromonitors.com using 2011 data tells a very interesting tale:

Leaving aside the corporate debt position, you can clearly see Australia's household debt position relative to the ten largest mature economies of the world is significantly larger.  Yes, our government debt levels are relatively low.  But put the picture together and then Alan Kohler's excellent piece in yesterday's Business Spectator starts to make real sense.

Kohler writes:

 The only thing that makes sense as a single cause of Australia’s misery is excessive debt.He makes the points:-

• Household debt has stayed at its historic highs of around 150% of disposable income for the past five years where other countries' households have deleveraged;
• Interest paid as a percentage of income has doubled in 20 years;
• the cost of land is among the highest in the world (in spite of Australia being so sparsely populated)
• restrictions on residential developments in cities combined with population growth have also contributed to extremely high prices for residential real estate
• reductions in mortgage rates don't counteract the psychological effect of the size of household debt.

So in the current political environment in Australia where "middle class welfare" such as the private health rebate is currently in issue, it makes sense to appreciate the pressure and stress created by these levels of personal indebtedness.

Kohler again:

And now there is widespread terror that house prices will eventually collapse and leave millions with no equity, as happened in the United States. As a result the savings rate has skyrocketed and consumers are on strike, putting money aside for Armageddon.

Debt is making everyone grumpy and hypersensitive. When ANZ put up its mortgage rate by just 6 basis points last week – 0.06 per cent for heaven’s sake! – there was national outrage and attacks in parliament

Our daily diet of gloomy news from Europe and the United States in relation to debt is ringing the warning bells in Australians' minds.  We know we are part of the global economy and there will be fallout for Australia from the current financial calamity unfolding in Greece and other nations of Europe such as Spain, Ireland, Italy and Portugal. We also see from afar the politicians' seeming inability to take bold political decisions and we watch distrustfully the involvement of the hedge funds and bondholders in the process of "voluntary haircuts".

So we need to listen when Kemal Dervis (former Turkish Economics Minister, Administrator of the UN Development Program and vice president of the World Bank, currently Vice President and Director of the Global Economy and Development Program at the Brookings Institution) writes on Project Syndicate:

Beyond the specific problems of the monetary union, there is also a global dimension to Europe’s challenges – the tension, emphasized by authors such as Dani Rodrik, and Jean Michel Severino and Olivier Ray, between national democratic politics and globalization. Trade, communication, and financial linkages have created a degree of interdependence among national economies, which, together with heightened vulnerability to financial-market swings, has restricted national policymakers’ freedom of action everywhere.

Perhaps the most dramatic sign of this tension came when Greece’s then-prime minister, George Papandreou, announced a referendum on the policy package proposed to allow Greece to stay in the eurozone. While one can debate the merits of referenda for decision-making, the heart of the problem was the very notion of holding a national debate for several weeks, given that markets move in hours or minutes. It took less than 24 hours for Papandreou’s proposal to collapse under the pressure of financial markets (and European leaders’ fear of them).

Around the world, the stock of financial assets has become so large, relative to national income flows, that financial-market movements can overwhelm most countries. Even the largest economies are vulnerable, particularly if they are highly dependent on debt finance. If, for some reason, financial markets and/or China’s central bank were suddenly to reject US Treasury bonds, interest rates would soar, sending the American economy into recession.
But being a creditor does not provide strong protection, either. If Americans’ appetite for Chinese exports suddenly collapsed because of a financial panic in the United States, China itself would find itself in serious economic trouble.

These interlinked threats are real, and they require much stronger global economic-policy cooperation. Citizens, however, want to understand what is going on, debate policies, and give their consent to the types of cooperation proposed. Thus, a more supra-national form of politics is needed to re-embed markets in democratic processes, as happened during the course of the twentieth century with national politics and national markets.

The scale of this challenge becomes apparent when one sees how difficult it is to coordinate economic policies even in the European Union, which has moved much further than any other group of countries in the direction of supra-national cooperation. Nonetheless, unless globalization can be slowed down or partly reversed, which is unlikely and undesirable in the long run, the kind of “politics beyond borders” for which Europe is groping will become a global necessity.

Indeed, the European crisis may be providing a mere foretaste of what will likely be the central political debate of the first half of the twenty-first century: how to resolve the tension between global markets and national politics.

Actuary analyses Australian Residential Housing market

Anthony Street (ex Macquarie Bank) presented this paper to the Institute of Actuaries in Australia at their biennial convention, 10-13 April 2011.

In my opinion it is the best statistical evidence showing why there is a property bubble in Australia.

I commend this paper to you: it is quite readable and Street does not have a vested interest in the field unlike almost all other commentators.

Presentation slides:

http://www.actuaries.asn.au/Library/events/Conventions/2011/HouseOrHome-Presentation.pdf

Audio:

http://www.actuaries.asn.au/Library/events/Conventions/2011/HouseOrHome-Audio.mp3

Paper:

http://www.actuaries.asn.au/Library/events/Conventions/2011/Con2011_Paper_Street.pdf    

The Carbon Tax - Aussies fear the cost

Flat prices/fear of declining house prices are affecting the political "sell"

The Labor Government is having a hard time convincing ordinary Australians of the need to price carbon now.

Business and the union moverment are vocal in their opposition (van Onselen calls them in "lockstep": http://www.theaustralian.com.au/business/opinion/carbon-tax-is-like-a-bad-smell-that-wont-go-away/story-e6frg9if-1226041792769

Rob Burgess in today's Business Spectator considers this is due to three main factors:

1. Australians are not spending - the retail sales figures show dismal results for the first quarter 2011;
2. Wage rises have been only in a few industry sectors, largely mining and resources, not retail, manufacturing, tourism, education and other struggling sectors; and
3. Household debt: the RBA's aggregate data shows a dramatic and continuing decline in [discretionary income] due namely, [to] the debt we took on via housing finance...over the past decade: http://www.businessspectator.com.au/bs.nsf/Article/house-prices-carbon-price-ACTU-Jeff-Lawrence-pd20110420-G3SEK?OpenDocument&emcontent_Burgess

Burgess reflects:

In the mortgage belt, the voters Julia Gillard needs to win over for the next election are increasingly aware that their houses are no longer appreciating as they used to, and in cities such as Perth and Brisbane they may well be depreciating. Equity withdrawal and the wealth effect that flowed from it are all but over.

In this environment, the immediate effect of upping the cost of everyday goods makes for difficult politics.

David Murray: "the relationship between house prices and incomes is uncomfortably high"

High Australian house prices have made our economy "vulnerable" to overseas events

Future Fund Chair, David Murray made some interesting comments yesterday at a Sky News panel which have been picked up in various papers today.

http://www.theaustralian.com.au/business/house-prices-seen-as-vulnerable-says-future-fund-chairman/story-e6frg8zx-1226022788109

Murray said that a rise in global interest rates would prompt Australian commodity prices to fall (cutting the income flowing into Australia) and would leave our economy exposed with high house prices.  He hoped:  "that won't happen and we can work it through," however, he observed: "But, by any normal set of measures, house prices in Australia are high."