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Shane Oliver
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Shane Oliver is head of investment strategy at chief economist at AMP Capital.

Investment markets and key developments over the past week - 25 July 2014

Friday, July 25, 2014

by Shane Oliver

Share markets rose on mostly good economic data, continued solid earnings results in the US and an absence of additional bad news regarding either Ukraine or the Middle East. This saw Australian shares rise to their highest since June 2008. Bond yields rose but only slightly. Oil and metal prices rose too, but gold fell. The Australian dollar got a boost as Australian June quarter inflation data showing inflation at the top of the RBA’s target range was seen as curtailing the chance of another rate cut.

The July round of business conditions PMIs provided confidence that the global recovery is on track with the US manufacturing PMI remaining strong at 56.3, the Eurozone composite PMI rising to its equal highest reading for the recovery and China’s HSBC PMI rising to 52 its highest in 18 months. Japan’s manufacturing PMI disappointed though falling back to 50.8. The overall, impression is of continued solid global growth, but not so strong as to invite generalised inflation worries or rate hikes.

The Chinese share market was perhaps the most interesting over the last week with the continuing run of good economic news resulting in a technical break higher. We have seen a few false breaks in Chinese shares before so it’s premature to get too excited, but with China A shares amongst the world’s cheapest and economic indicators looking better, we continue to see significant medium term return potential from Chinese shares.

Victory for business friendly Joko Widodo in the Indonesian election is a great outcome for Indonesia, but he lacks the winning margin Modi attained in India and a challenge to the results by the defeated candidate former General Subianto Prabowo, will pro-long political uncertainty. So the outcome does not warrant the sort of re-rating of the Indonesian share market that Indian shares have seen. At least not yet.

RBA Governor Glenn Stevens provided a reminder of just how important the global policy response to the GFC was in heading off a re-run of the Great Depression. Thankfully policy makers had learned the lessons of the 1930s well and weren’t to be distracted by the disciples of Austrian economics who advocated a do nothing approach. Steven’s also rightly points out that the search for yield and risk taking is “the whole point” to quantitative easing. While this has yet to flow on to risk taking by US businesses, ie investment, with Governor Stevens suggesting this owes much to subdued confidence, I think there are enough indicators to provide confidence it will. This includes the rising trend in US durable goods orders and its strengthening jobs market.

Comments that Australian home owners with a mortgage will struggle if mortgage rates rise are a bit overblown. We heard similar warnings at the bottom of the last rate cycle in 2009 but didn’t see major problems through the 2009-10 tightening cycle. There are several reasons to expect the same when rates eventually start moving up again.

First, just as Australians have sped up principle repayments as rates have come down they will likely slow them as rates go up. In fact debt interest payments are at a ten year low.

Second, the household debt to income ratio has been basically flat since the GFC so it’s not the case that Australians have been rapidly taking on more debt.

Third, interest rates won’t rise unless household income is also on the rise and this will provide some offset to higher interest rates.

Finally, I agree that the rise in household debt ratios over the last twenty years has left households a lot more sensitive to higher interest rates. But this is not new and it explains why the peak in the cycle for interest rates has been trending down.

The RBA is well aware of the issue and knows that it doesn’t need to raise rates as much as in times past to have the same impact. So just as the 2010 cash rate peak of 4.75 per cent was below the 2008 peak of 7.25 per cent, the next peak will likely be lower again. Maybe around four per cent. At this stage it’s still a bit academic though as the first rate hike is still a way off. But for those home buyers looking for another opportunity to lock in low mortgage rates, the cut in five year fixed rate mortgages to below five per cent by major banks on the back of reduced borrowing costs and competitive pressure is good news.  

Major global economic events and implications

US data was mostly good. New home sales disappointed but existing home sales rose solidly, house prices continue to rise, the Markit manufacturing PMI remains strong, jobless claims fell to their lowest since early 2006 and core inflation remained benign at 1.9%. The US economy is on the mend, but the benign inflation result gives the Fed breathing space on interest rates.

Meanwhile, June quarter earnings remain solid. So far 45 per cent of S&P 500 companies have reported with 77 per cent beating on profits and 66 per cent beating on sales.

Eurozone July PMIs rose and beat expectations. Services conditions were particularly strong and pushed the composite PMI to its equal strongest for the recovery so far, a level consistent with 1.5 per cent annual growth.

The slight fall in Japan’s July PMI was disappointing. Meanwhile inflation data remains positive, even allowing for the impact of the sales tax hike.

The further rise in China’s HSBC manufacturing conditions PMI in July backs up the rise already reported in MNI’s business confidence indicator in telling us that growth has continued to improve. No hard landing here!

Australian economic events and implications

In Australia, the news that inflation has risen to three per cent caused some consternation that there might be a rate hike around the corner. But while inflation at the top of the target range makes it harder for the RBA to cut interest rates again - not that they wanted to anyway - it doesn’t point to a rate hike. First, the rise in the annual rate of inflation reflected strong inflation during the second half of last year, but it has since slowed. Second, outside of housing costs, much of the rise in inflation owes to government decisions. Higher interest rates won’t stop this. Third, inflation is set to fall with the removal of the carbon tax and continuing very low wages growth. Fourth, underlying inflation at 2.8 per cent is basically in line with the RBA’s forecast of 2.75 per cent. And finally, a rate hike will only push the $A even higher. So rates are likely to remain on hold.

Meanwhile, there was good news on the economy with the weekly Roy Morgan consumer confidence survey rising to pre-Budget levels and a rise in skilled vacancies in June. The former suggests the hit to confidence from the Budget has faded and the latter adds to evidence that forward looking labour market indicators are improving.

What to watch over the next week?

In the US, the focus will be on the Fed (Wednesday) which is expected to taper its monthly asset purchases by another $US10bn taking them to $US25bn a month, consistent with continued solid economic data. However, most interest will likely be on the tone of the Fed’s post meeting statement which is likely to acknowledge the improvement in the economy but leave the impression the first rate hike is still some time away. My best guess for the first rate hike remains mid next year, but this doesn’t mean financial markets won’t start to worry about it earlier. On the data front, expect a further gain in June pending home sales (Monday), another increase in house prices (Tuesday), little change in consumer confidence (also Tuesday), June quarter GDP data (Wednesday) to show growth bouncing back but only to a 2.9 per cent annualised pace, the July ISM (Friday) remaining solid at around 55.5 and July jobs data (Friday) showing a 225,000 gain in payrolls but unemployment unchanged at 6.1 per cent.

Eurozone economic confidence measures for July (Wednesday) are likely to remain consistent with continued gradual recovery and inflation (Thursday) is likely to have remained very low.

In Japan, June data for household spending (Tuesday) and industrial production (Wednesday) will be watched for signs of recovery after the April sales tax induced slump. Jobs data is likely to have remained solid.

In China, expect to see a further improvement in the official Chinese manufacturing PMI (Friday) for July. 

In Australia, expect to see flat building approvals after a strong rise in May and modest growth in credit (both Thursday). June quarter export prices (Thursday) will likely show a sharp fall reflecting the slump in the iron ore price. Data for new home sales, house prices, the manufacturing PMI and producer prices will also be released.

Outlook for markets

Shares remain vulnerable to a short term correction, with a potential Fed rates scare at some point being the most likely trigger, but we continue to see little evidence suggesting we are at or near a major market top. Valuations remain reasonable, particularly if low interest rates are allowed for, global earnings are continuing to improve on the back of gradually improving economic growth, monetary conditions are set to remain easy for some time and there is no sign of the euphoria that comes with major share market tops. In terms of the latter if anything there is still a lot of scepticism which is a long way from the sort of confidence that is normally seen when bull markets end. Given all this, any short term dip in shares should be seen as a buying opportunity as the broad trend is likely to remain up. Our year-end target for the ASX 200 remains 5800.

Bond yields are likely to resume their gradual rising trend over the next six months led by increasing evidence that US growth is picking up pace. This combined with low yields is likely to mean pretty soft returns from government bonds. Cash and bank deposits continue to offer poor returns.

While the carry trade from ultra-easy money in the US, Europe and Japan risks pushing the $A higher, the combination of soft commodity prices, an increasing likelihood that the Fed will start raising interest rates ahead of the RBA and relatively high costs in Australia are expected to see the broad trend in the $A remain down.

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The power of compound interest - an investor's best friend

Thursday, July 17, 2014

by Shane Oliver

Key points

  • Compound interest is an investor’s best friend. 
  • The higher the return, the greater the investment contribution and the longer the time period the more it works. 
  • To reap maximum advantage from it, ensure an adequate exposure to growth assets, contribute early and often to your investment portfolio and find a way to avoid being thrown off by the investment cycle. 


I reckon the first wonder of the investment world is the power of compound interest. My good friend Dr Don Stammer even goes so far to refer to it as the “magic” of compound interest because it almost is magical. Compound interest can be the worst nightmare of a borrower as interest gets charged on interest if it is not regularly serviced. But it’s the best friend of investors. Unfortunately for a variety of reasons some miss out on it. 

Compound interest – what is it? 

But what is it and why is it so powerful? Compound interest is simply the concept of earning interest on interest. Or more broadly, getting a return on past returns. In other words any interest or return earned in one period is added to the original investment so that it all earns interest or a return in the next period. And so on. Its best demonstrated by some examples. 

  • Suppose an investor invests $500 at the start of each year for 20 years and receives a 3 per cent annual return. See Case A in the next table. After 20 years the investment will have increased to $13,838, for a total outlay (or $ Flow in the table) of $10,000. Nice, but hardly exciting as the return was only low at 3 per cent pa. 
  • But if the investor put the same flow of money in an asset returning 7 per cent a year, after 20 years it will have grown to $21,933. See Case B. Not bad given the same total outlay of $10,000. And in year 20, annual investment earnings are now $1435, more than three and a half times the investment earnings in the same year in Case A of $403. 
  • Finally, if the whole process was kicked off by a $2000 investment at the start of the first year, with $500 each year thereafter and still earning 7 per cent per annum then after 20 years it will have grown to $27,737. Case C. By year 20 in this case the annual investment earnings will have increased to $1815. 

These examples have been kept relatively simple in order to illustrate how compounding works. Obviously all sorts of complications can affect the final outcome including inflation (which would boost the results as the table uses relatively low returns for both the low and high risk asset), allowance for the more frequent compounding which actually occurs in investment markets as opposed to annual compounding in the table (which would also boost the final outcome) and the timing of the return from the high growth asset through time in that it won’t be a steady 7 per cent year after year.

However, the power of compound interest is clear. From these examples, it is evident that it has three key drivers:

  • The rate of return – the higher the better. 
  • The contribution – the bigger the better because it means there is more for returns to compound on. The $2000 upfront contribution in Case C boosted the outcome after 20 years by an extra $5804 compared to Case B. Not bad for just an extra $1500 investment. 
  • Time – the longer the better because it means the longer the compounding process of earning returns on returns has to run. Time will also help smooth out any year to year volatility in returns. After 40 years the investment strategy in Case A will have grown to $38,832 but Case B will have grown to $106,805 and Case C will have grown to $129,267.

Compound interest in practice

This all sounds fine in theory, but does it really work in practice? It’s well-known that growth assets like shares and property provide higher returns than defensive assets like cash and bonds over long periods of time. This is because their growth potential results in higher returns over long periods of time which compensates for their higher volatility compared to more stable and less risky assets. 

The next chart is my favourite demonstration of the power of compound interest in action for investors. It shows the value of $1 invested in 1900 in Australian cash, bonds and shares with earnings on each asset reinvested along the way. Since 1900 cash has returned 4.8 per cent per annum, bonds have returned 6 per cent pa and shares returned 11.9 per cent pa.

Shares are clearly more volatile than cash and bonds. The arrows in the chart show periodic, often long bear markets in shares. However, the compounding effect of their higher returns over time results in much higher wealth accumulation from them. Although the return from shares is only double that of bonds, over 114 years the $1 invested in 1900 will have grown to $398,420 today, whereas the $1 investment in bonds will only be worth $750 and that in cash just $204.

Now of course, investors don’t (usually) have 114 years. But the next chart shows rolling 20 year returns from Australian shares, bonds and cash and it’s evident that shares have invariably outperformed cash and bonds over such a period.

Note that while the return gap between shares on the one hand and bonds and cash on the other has narrowed over the last 20 years this reflects the relatively high interest rates and bond yields of 20-30 years ago, which provided a springboard to relatively high returns from such assets. With bond yields and interest rates now very low such bond and cash returns are very unlikely to be repeated in the decade or so ahead.

Some issues

What about property? Over long periods of time Australian residential property has generated similar total returns (ie capital growth plus income) for Australian investors as Australian equities. For example since 1926 Australian residential property has returned 11.1 per cent pa, which is similar to the 11.5 per cent pa return from shares over the same period.

What about fees? Fees on managed investment products will clearly reduce returns over time, but less so for cash and fixed income products and for equities the fee impact will be offset by the impact of franking credits in the case of Australian shares (which amount to around 1.3 per cent pa) and which has not been allowed for in the last two charts.

Are these returns sustainable going forward? This is really a separate topic, but the historical returns from the three assets likely all exaggerate their future medium term return potential. Cash rates and bank term deposit rates are likely to hover around 3-4 per cent, current ten year bond yields around 3.4 per cent suggest pretty low bond returns for the decade ahead (in fact just 3.4 per cent for an investor who buys a ten year bond and holds it to maturity). And the Australian equity return may be closer to 9 per cent pa, reflecting a dividend yield around 4.5 per cent and capital growth of around 4.5 per cent. But for shares this sort of return is still not bad and leaves in place significant potential for investors to reap rewards from the power of compounding over the long term.

Why investors often miss out

But if the power of compound interest is so obvious, what can cause investors to miss out. There are several reasons:

  • First investors may be too conservative in their investment strategy, opting for lower returning defensive assets like cash or bank term deposits. This may avoid short term volatility but won’t build wealth over the long term if that’s the objective.
  • Second, they leave it too late to start contributing to an investment portfolio or don’t contribute much initially. This makes it more difficult to catch up in later life and leaves investors more at the whim of financial market fluctuations during the catch up phase. Fortunately the Australian superannuation system forces Australian’s to start early in life, albeit the contribution rate is too low.
  • Third, they can adopt the right strategy to benefit from compound interest over the long term only to get thrown off during a bout of market volatility. This usually occurs after a steep slump in investment markets and sees the investor switch to cash only to return, if at all, after the market has already had a good recovery.
  • Finally, some investors have been sucked in over the years by promises of a “free lunch”, eg the 10 per cent pa yield funds that were floating around prior to the GFC which then ran into trouble once the GFC hit and proved to be more risky than equities.

Implications for investors

There are several implications for investors looking to take advantage of the power of compound interest.

First, if you can take a long term approach, focus on growth assets like shares and property with a long term track record.

Second, start contributing to your investment portfolio as much as you can as early as possible.

Third, find a way to manage cyclical swings. For example, invest a bit of time in understanding that the investment cycle is a normal part of investment markets and partly explains why growth assets have a higher return in the first place. Or invest in funds that undertake dynamic asset allocation to help manage the investment cycle. Or both.

Finally, if an investment sounds too good to be true – implying some sort of free lunch – and/or you can’t understand it, then stay away.


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Investment markets and recent key developments

Friday, July 11, 2014

by Shane Oliver

Share markets retreated over the last week on worries that problems at some European banks might spark a return of its debt crisis and nervousness about a possible correction in the US. Most share markets fell, including in Australia and China. Share market nervousness saw bonds rally, except in peripheral Eurozone countries where Portuguese bank problems weighed. Commodity prices were little changed but interestingly the oil price continued to drift down as worries about Iraq abated and Libyan and Saudi supplies rose. The $A saw a brief bounce higher, but it was short lived.

It seems there is always something to worry about. Just as investors were getting a little less concerned about oil supply disruptions from Iraq, along comes a scare about problems at European banks. A week ago Austria’s Erste Bank issued a profit downgrade and then the parent company of Portugal’s largest bank Banco Espirito Santo delayed a debt payment.

Investors fear this may be a sign of problems at other Eurozone banks, which might require public support leading to renewed budget blowouts. So far there is no evidence of this but the slow recovery in Europe does present risks as does the ECB’s bank stress tests this year.

It’s certainly worth keeping an eye on, but several considerations suggest we won’t see a return to the dim dark days of the Eurozone crisis. First, the problems at both Erste Bank and Banco Espirito Santo look to be partly specific to those organisations, eg issues in its Romanian and Hungarian businesses for Erste and a troubled parent and exposure to dodgy Angolan loans for Espirito Santo. Second, the backstop support for Eurozone banks is now huge compared to the situation three or four years ago, eg the ECB’s commitment to supply cheap funding to banks.

Third, the rally in Eurozone banks had arguably gotten ahead of itself. Eurozone banks are down 13 per cent from their high in April this year, but from the Eurozone crisis lows in 2011-12 to their April high they rallied 122 per cent, nearly double the 68 per cent gain in Eurozone shares generally. So a correction was inevitable.

Results from the Indonesian election may take a week or two to be finalised, but most exit polls suggest a win by Joko Widodo, who is the most market friendly and reform oriented of the two candidates, so if he has won it would be a positive for the Indonesian economy and assets. However, it would appear likely to be only a narrow win, so a strong reform mandate may be lacking, unlike in the case of the recent Indian elections.

The first Budget of the new Modi led Indian Government was a bit of a non-event in terms of announcing dramatic reforms. But it did present a sensible fiscal strategy in terms of reducing the deficit and focussing on productive spending. The Budget should be seen as just a start with significant reform still on the way in India.

The debacle in Canberra regarding the passage of the Budget and associated policy changes through the Senate is depressing, particularly given the optimism that had come with the demise of minority government last September. There is a risk that it starts to act as a broader drag on confidence in the economy.

That said, it would be dangerous to read too much into it at this stage. So far the Australian share market and the $A are rightly ignoring it. And if it results in a softening in some of the harsher measures in the Budget (perhaps funded by a “delay” in the paid parental leave scheme) then it could have a positive impact on confidence.

Major global economic events and implications

US data continues to point to stronger US growth. Job openings are at their highest since 2007, consumer credit continues to rise, weekly mortgage applications rose, jobless claims fell and a private survey of June retail sales pointed to solid gains.

Meanwhile, the minutes from the Fed’s last meeting offered little that was new with the Fed on track to end quantitative easing in October and nothing to change the view that the first rate hike is unlikely till around mid-next year. There was some discussion about whether investors had become too complacent on interest rates, but Janet Yellen’s recent comments suggest she was not that concerned. Finally, the June quarter profit reporting season kicked off with a solid result from Alcoa auguring well.

Japanese data was mostly okay with the June Economy Watchers outlook survey remaining solid, bank lending trending up, a rise in tertiary activity and higher consumer confidence but a sharp fall in machine orders.

Chinese import and export growth were a little weaker than expected in June, but continue to pick up consistent with better growth. On top of this inflation remains low, posing no constraint to further easing in China.

The divergence in the state of Asian economies was highlighted in the past week with Malaysia raising interest rates for the first time in three years citing strong growth and inflation risks, whereas the Bank of Korea left rates on hold but with a clear easing bias after revising its growth forecasts down. Korea seems to be more of a special case though with the ferry accident earlier this year having a negative impact on spending.

Australian economic events and implications

Australian data was rather messy. Consumer confidence rose in July but only slightly and is yet to fully recover its Budget related slide, but against this business confidence is running slightly above average. Employment also rose by more than expected in June but jobs growth is still not enough to bring unemployment down, with it bouncing back to the top of the 5.8 to six per cent range it has been in for the last nine months.

The good news though is that leading employment indicators such as ANZ job ads and the hiring component of the NAB survey are pointing to stronger jobs growth ahead. There was also good news for the construction sector with the AIG’s construction PMI rising strongly in June. While housing finance slipped in May adding to evidence of a welcome moderation in momentum in the home buying market, it remains at a high level.

With interest rates set to remain low and on hold probably into next year and the Budget likely to be softened to get it though the Senate, its likely that consumer confidence will gradually improve over the months ahead.
According to Australian Property Monitors capital city rental growth over the year to the June quarter ranged between -6.6 per cent (in Perth) and +5.6 per cent (in Melbourne. The point though is that with dwelling prices up around 10 per cent over the same period rental yields are continuing to fall.

What to watch over the next week?

In the US, a key focus will be Fed Chair Janet Yellen’s Congressional testimony starting Tuesday. It’s unlikely she will waver much from the message following the June Fed meeting which was basically that the economy is improving allowing continued tapering but that monetary tightening is still a considerable time away given slack in the economy.

She may elaborate a bit on the risks around inflation and rates and the Fed’s exit strategy. On the data front, expect a 0.6 per cent gain in June retail sales, a 0.3 per cent rise in June industrial production (Wednesday), a further rise in the NAHB homebuilders conditions index (Wednesday)  and gains in housing starts and permits (Thursday). Producer price inflation data will also be released.

The US June quarter earnings reporting season will start to hot up. The consensus is for earnings growth of 6 per cent year on year and sales growth of 3 per cent. Given the downgrade from 8 per cent three months ago and a high level of negative profit warnings it’s likely that earnings growth will come in stronger than this.

Chinese activity data released Wednesday is expected to confirm a pick-up in growth, after the slowdown in the March quarter. June quarter GDP growth is expected to grow 1.8 per cent quarter on quarter (after 1.4 per cent QOQ) in the March quarter, leaving annual growth at 7.4 per cent. June industrial production is expected to pick up to nine per cent year on year, with growth in retail sales expected to remain unchanged at 12.5 per cent.
In Australia, the minutes from the last RBA Board meeting (Tuesday) are likely to express a more dovish bias than seen in the post meeting statement consistent with the more dovish tone seen in the previous minutes and in

Governor Steven’s recent speech. Data for dwelling starts (Wednesday) will likely show a further rise.

Outlook for markets

Could shares have a correction? Yes. As always there is no shortage of possible triggers with Eurozone bank issues back in focus and the potential for a Fed rates scare as the US economy continues to hot up. Are we at a major share market top? No. Valuations are not stretched, particularly if low interest rates are allowed for, global earnings are continuing to improve on the back of gradually improving economic growth, global and Australian monetary conditions are set to remain easy for some time and there is no sign of the euphoria that comes with major share market tops.

In terms of the latter if anything there is still a lot of scepticism – as evident in headlines about capital markets being out of step with reality (Financial Times) and markets being so high that the air is thin (Wall Street Journal) – which is a long way from the sort of confidence that is normally seen when bull markets come to an end. Given all, this any short term dip in shares should be seen as a buying opportunity. Our year-end target for the ASX 200 remains 5800.

Bond yields are likely to resume their gradual rising trend led by increasing evidence that US growth is picking up pace. This combined with low yields is likely to mean pretty soft returns from government bonds. Cash and bank deposits continue to offer poor returns.

While the continuing carry trade from ultra easy money in the US, Europe and Japan risks pushing the $A higher in the near term (potentially up to $US0.97), the combination of soft commodity prices, an increasing likelihood that the Fed will start raising interest rates ahead of the RBA and relatively high costs in Australia are expected to see the broad trend in the $A remain down. RBA jawboning is already making a bit of a comeback.


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Abenomics: good for Japan, good for investors and good for Australia

Thursday, July 10, 2014

by Shane Oliver

Key points

  • Japan’s economy appears to be weathering the April sales tax hike well and Abenomics looks to be working. 
  • Third arrow supply side reforms are very positive. 
  • The success of Abenomics augurs well for Japanese shares, which are now cheap. It’s also positive for Australia as Japan is our second largest export market. 

It’s now over 18 months since Japan embarked on a program designed to reinvigorate its economy under Prime Minister Shinzo Abe, which has become known as “Abenomics”. Growth has rebounded, deflation has given way to inflation and Japanese shares are up around 70 per cent. But is Abenomics working or are we just seeing another cyclical bounce? And what does it mean for investors?

Three arrows

Since the Japanese bubble economy burst at the end of the 1980s, it has wallowed with sub-par growth, six recessions, chronic deflation and a secular bear market in shares and property. Many reasons have been given: a failure to realise how serious the problem was; a conservative approach to policy making; a focus by the dominant Liberal Democratic Party on protecting special interests; revolving door political leadership with 16 prime ministers since 1990; and a declining population. Regardless of the drivers, Shinzo Abe and the LDP were elected with a mandate to fix up Japan in December 2012 and with voters giving him control of the upper house of the Diet, Japan’s parliament, in July 2013.

Abe is both an economic rationalist and a Japanese nationalist. A key motivation is likely his desire to see Japan’s regional standing strengthened in the face of China’s rise and North Korean threats. He has acted very decisively. His policy response has been characterised by “Three Arrows”: fiscal stimulus, monetary stimulus and supply side economic reforms. All with the aim of boosting inflation to two per cent per annum (pa) and real economic growth to two per cent pa.

Given Japan’s large public debt, any fiscal stimulus has to be modest and supply side reforms always take time so the initial focus has been on monetary stimulus. On this front, the approach has been very aggressive with the Bank of Japan announcing a two per cent inflation target in January last year, Abe appointing ultra dove Haruhiko Kuroda as central bank governor and the BoJ announcing a massive quantitative easing program (pumping cash into the economy by purchasing $US75bn/month of assets using printed money) in April last year. Adjusted for the size of the economy this was more than double the size of the Fed’s then quantitative easing program and with the latter being reduced now swamps it. The program has seen the Yen fall by 21 per cent. 

The initial response has been positive with the economy growing three per cent over the year to the March quarter and inflation (ex the impact of an April 1 sales tax hike) running at 2.2 per cent. But concerns remain: that the sales tax hike from five per cent to eight per cent will drive a slide back into recession as the last sales tax hike in 1997 arguably did; that boosting inflation has only led to a fall in real wages; that the BoJ’s success in achieving sustained inflation will depend on the Yen continuing to fall; that Japan’s poor fiscal position dooms it long term; and that the Government has not delivered enough in terms of the third arrow reforms. Let’s look at each of these in turn.

Japan weathering the sales tax hike well

A return to recession as followed the 1997 sales tax hike is unlikely because unlike in 1997 Japan now has quantitative easing, unemployment is falling, property prices are rising, bank lending is rising, banks now have small non-performing loans and business confidence has been rising.

A range of indicators have bounced back solidly from their recent sales tax related fall:

  • The Economy Watchers outlook index is up strongly;

  • The outlook components of the BoJ’s Tankan survey are strong and business investment plans have improved;
  • The unemployment rate has fallen to 3.5 per cent, its lowest since 1997, and the ratio of job vacancies to applicants is at its highest since 1992.

  • While overall household spending remains weak after the tax hike, retail sales rose solidly in May.

The overall impression is that the Japanese economy has weathered the sales tax hike reasonably well and that a re- run of the 1997 experience is unlikely.

Ending deflation is key

Rising real wages, when inflation was negative, didn’t exactly help Japan. Rather, deflation was the much bigger problem because it zaps spending – why spend or invest today when you know it will be cheaper tomorrow? The key was to first end deflation and institute an inflationary mindset and Japan has done this with the introduction of a two per cent inflation target for the BoJ and backing this up with unprecedented monetary printing. Inflationary expectations are now starting to rise in response and with the labour market stating to look tight wages growth is likely to pick up. Large firms already seem to be starting to put through faster wage increases.

More domestic focus going forward

The decline in the Yen was clearly important in initially driving inflation higher. Our assessment is that a further decline in the Yen is likely - as the BoJ’s huge money printing program, which likely won’t be increased but will be extended beyond its two year timeframe, and the Fed’s taper means that the supply of Yen is rising relative to the supply of US dollars. However, with an inflationary mentality starting to become more entrenched a falling Yen won’t be as important in driving Japanese inflation going forward. In fact this is evident in a breakdown in the negative correlation between the Japanese shares and the Yen recently.

Japan’s fiscal problems bad, but not that bad

Japan’s public debt looks horrible with gross public debt of 244 per cent of GDP (compared to just 31 per cent in Australia!). However, it’s not nearly as bad as it looks. First, its gross public debt of 244 per cent of GDP falls back to 137 per cent once assets such as Japan’s foreign exchange reserves are allowed for. Second, Japan borrows from itself, with public borrowing being a mirror image of private sector savings. Thirdly, various reforms over the last decade will limit growth in pension and health spending. Fourthly, tax as a share of GDP is low by OECD standards in Japan and there is plenty of scope to further increase the sales tax rate from eight per cent. Finally, while some fret that rising bond yields will blow out Japan’s interest bill this won’t be a problem if the back up in yields reflects stronger growth & inflation as it will mean higher tax revenue.

Third arrow reforms are being understated

A critique of Abe seems to be that he has been lax in delivering “third arrow” reforms. But several points are worth noting. First, it was always second order. Japan’s problem is

a lack of demand not supply, as evident in falling prices. And supply side reforms often make things worse before they get better. So it was right to first focus on reflation.

Second, Japan’s third arrow reforms may seem more like a “thousand needles” but they are adding up. A range of reforms have been announced in recent months, eg easing visa requirements, cuts to rice subsidies and eased factory regulations. On top of this the Government has released its “New Growth Strategy” which includes a range of measures including a plan to cut the corporate tax rate from currently 36 per cent to in the 20-30 per cent range, measures to boost female workforce participation and measures to allow more foreign workers in certain sectors. These are all far reaching and while one “big bang” reform should not be expected the gradualist “thousand needle” approach is very positive. For example, the cut to Japan's corporate tax rate could boost Japanese earnings per share by between 10 to 30 percentage points over the next 4 years.

Finally, Abe’s huge popularity, stable Government, control of both Diet houses and fading resistance to reform – eg farmers, who have been strong resisters of allowing a more efficient agricultural sector, now have an average age of 70 – means the reforms have a strong chance of success.

Good reason for optimism on Japan

Japan will not grow as fast as China as it is already a rich country and the success of Abenomics should not be judged mechanically by the two per cent inflation and growth targets (as they are just lights on a hill). But when assessed broadly there are good reasons to believe Japan is throwing off the malaise of stop start growth and deflation seen over the last 20 years: the BoJ is doing all the right thinks to entrench inflation, the longer term reforms it is introducing are broad based and Abe appears to have the support required to deliver.

Implications for investors

There are two major implications for investors. First, a reinvigorated Japan is positive for Japanese shares. After a 57 per cent gain last year, Japanese shares had become overbought and due for a correction, which is what we have seen this year with a 15 per cent fall into April. Having worked off the excess, Japanese shares are now attractive again. While the boost to Japan’s economy and share market last year was driven more by monetary easing, economic reform looks likely to be a major driver over the longer term.

Second, Japan is still the world’s third largest economy, so stronger more sustainable growth in Japan is positive for the global economy at a time when Europe is gradually recovering and the pace of growth in the US is picking up. This in turn is positive for global shares generally.

Japan and Australia

Japan takes 16 per cent of Australia's exports and is our second largest export market, so a continuing exit from deflation and stronger growth in Japan is positive for Australia. This also comes at a time when a free trade deal with Japan is being signed. While the trade deal does not change the near term growth outlook for either country, its benefits will accrue over time. The main beneficiaries are beef and dairy farmers, service industries (such as finance) and consumers as tariffs on imported cars, household and electronic goods from Japan fall to zero.

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Investment markets and key developments over the past week

Friday, June 20, 2014

by Shane Oliver

Global share markets generally rebounded over the last week as a dovish Fed and solid economic data offset continuing uncertainty regarding Iraq and Ukraine. Australian shares also had a good week but Chinese shares were dragged down by worries about new share IPOs. Bond yields were flat to down helped by indications that the Fed sees lower long term interest rates, but yields backed up a bit in Spain and Italy. While oil was little changed, gold and metal prices had a bit of a rise. The $A was essentially unchanged.

The message from the Fed’s latest meeting was supportive of both bonds and equities. While our concern for some time has been that there will be some sort of inflation/Fed rates scare this year – much like last year’s taper scare – at this stage it still seems a while off. While the Fed is more confident on the growth and unemployment outlook, it doesn’t look to be too fussed by the recent rise in CPI inflation because its preferred measure of inflation is running somewhat lower and the CPI may have been boosted by noise and it would clearly like to see broader measures of spare capacity in the labour market improve. As a result, Janet Yellen continues to point out that below normal levels for the Fed Funds rate may be warranted even after inflation and unemployment have returned to target. What’s more the Fed meeting participants revised down their median long run Fed Funds rate level by 0.25% to 3.75%. So understandably both bonds and equities rallied.

However, it’s not necessarily all smooth sailing. Fed meeting participants did creep up their interest rate expectations for 2015 and 2016 and as Janet Yellen points out the key will be what happens to the data going forward. Our view remains that the first Fed rate hike is still 9-12 months away, but we are likely to see more focus on this in the months ahead particularly if US economic data remains solid. With US (and global) bond yields a lot lower than they were at the start of the year there is a bit of complacency on this front. So a US inflation/rates scare could still be a source of market volatility in the months ahead.

Ukraine and Iraq are clearly bubbling away as risks but not posing major threats, at least not yet. The conflict in Iraq is still building with the US committing military advisers and considering air strikes, but our assessment remains that it will have to get a lot worse before it becomes a major threat. The conflict is currently in the north of Iraq but 2.1 million barrels per day of its 2.3 mbd of oil exports comes from the south, OPEC has sufficient spare capacity to meet any shortfall from Iraq and US shale oil production means that the US is less affected than in times past. Historically the oil price needs to double within 12 months and right now we are a long way from that.

Major global economic events and implications

US economic data provided more evidence that growth has bounced back after the first quarter soft patch, with a solid gain in May industrial production, strong readings for the New York and Philadelphia regional manufacturing conditions surveys, a decline in jobless claims, another rise in the Conference Board’s leading index and an increase in the NAHB home builders’ conditions index. Housing starts fell in May but this was after a very strong gain in April and permits to build standalone homes rose strongly. One concern though was a stronger than expected gain in CPI inflation with both core and headline inflation running around 2% on a year ended basis and around a 3% annual rate over the last three months. While at this stage the Fed is not too concerned as its preferred inflation measure is a bit weaker, the risk of a mini-inflation/Fed rates scare in the next six months is worth keeping an eye on.

Chinese house prices down, but another sign that growth is stabilising. Chinese house prices fell an average 0.1% in May, their first decline in over two years. However, so far the property downturn is little different to those seen around 2008 and 2011 and it should also be remembered that this is what the Government has been hoping to achieve. Meanwhile, a second consecutive gain in the MNI business indicator in June adds to confidence that growth in China has bottomed and that the various mini stimulus measures of the last few months are getting traction. Meanwhile, Premier Li indicated that “smart and targeted regulation” will ensure that the 7.5% growth target for this year will be met.

Australian economic events and implications

It was a light week on the economic news front in Australia with a marginal rise in new vehicle sales and the Westpac leading index and the minutes from the RBA’s last meeting confirming its rates on hold stance. The minutes did express a degree of uncertainty as to whether low interest rates would be enough to offset declining mining investment and fiscal consolidation but this should be interpreted as supporting the case for rates to remain on hold at current low levels rather than signalling new dovish leanings on the part of the Bank. Meanwhile, comments by RBA Assistant Governor Kent regarding spare capacity in the labour market and falling unit labour costs highlights the RBA’s comfort in the benign outlook for inflation.

Australia’s population rose another 1.7% last year to 23.3 million, which is above its long term average rate of population growth highlighting that this remains a strong force for growth in Australia. This is both via a rising labour force and rising demand, particularly in terms of the demand for housing. Australia’s strong population growth stands in contrast to parts of Europe and Japan where populations are flat or falling.

What to watch over the next week?

Globally, its PMI day again on Monday with June business conditions PMIs set to be released in China, the Eurozone and the US and the news is likely to be reasonable. The further increase in the June MNI business indicator in China points to a further slight rise in the flash HSBC PMI, the Eurozone PMI’s are expected to stay around the 52-53 level with some possibility of a boost from the ECB’s latest easing measures and the Markit PMI in the US is expected to remain around 56.

In addition in the US, expect to see further gains in existing home sales (Monday), new home sales and house prices (all Tuesday), a slight rise in consumer confidence (Tuesday), solid underlying durable goods orders (Wednesday) and a rise in the Fed’s preferred inflation indicator (ie the core private consumption deflator) to 1.6% year on year for May (Thursday). March quarter GDP growth (Wednesday) is expected to be revised down further to -1.8% annualised, but this should be seen as old news given the improvement seen in a range of indicators in recent months.

Japanese data to be released Friday will be watched for a bounce back in consumer spending after the tax related slump in April and for continued strength in the jobs market. National inflation is expected to have increased to 3.7% year on year but this has also been affected by the sales tax hike.

In Australia it will be a light week on the data front with only data for skilled job vacancies (Wednesday) and overall job vacancies (Thursday) due for release. Both will be watched closely for Budget related impacts.

Outlook for markets

Shares remain vulnerable to a mid-year correction, just as we have seen in each of the last four years now. Iraq, Ukraine and the risk of an inflation/Fed rate hike scare in the US at some point are all risks. However, in the absence of a global monetary shock as we saw in each of mid 2010, 2011 and 2013 and with shares having been in a bit of a stealth correction through the first part of this year, any pull back may well be mild. In any case the broad trend in shares is likely to remain up. Share market fundamentals remain favourable with reasonable valuations, global earnings improving on the back of rising economic growth and monetary conditions set to remain easy for some time. So any dip should be seen as a buying opportunity. Our year-end target for the ASX 200 remains 5800.

Bond yields are likely resuming their gradual rising trend as its becoming increasingly clear that US inflation has bottomed and this combined with low yields is likely to mean pretty soft returns from government bonds. Cash and bank deposits continue to offer poor returns.

While the boost to the carry trade from the ECB and continued dovishness from the Fed risk pushing the $A higher in the short term the combination of soft commodity prices and relatively high costs in Australia are expected to see the broad trend in the $A remain down over the medium term. RBA jawboning is likely to return if the $A goes up too much further.

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The bond rally, secular stagnation and now Iraq

Thursday, June 19, 2014

by Shane Oliver

The global bond rally so far this year can be explained by a combination of soft growth, dovish central banks, short covering and increasing belief in “secular stagnation”.

It’s likely that the rally has gone too far and that sooner or later the focus will shift to when the Fed will start to raise interest rates. This could cause a resumption of the gradual rising trend in bond yields and volatility in shares.

Nevertheless, history tells us that it’s only when rates reach onerous levels that they become a lasting threat to share markets and ultimately to economic growth. And that seems a long while a way yet.

Iraq is a worry but as with numerous other geopolitical threats it’s unlikely to be enough to derail global growth.


A big surprise this year has been the renewed rally in government bonds – both globally and in Australia. Since December 31 last year, 10-year bond yields have fallen from 3.03% to currently 2.65% in the US, from 4.24% to 3.74% in Australia and from 1.93% to 1.4% in Germany. The big question for investors is whether the renewed decline in bond yields is telling us the global economy is in trouble, whether it’s an adjustment to lower long term interest rates in what some call an environment of “secular stagnation” or whether it’s just an overshoot that has now seen bond investors become a bit too complacent again with the rising trend in yields set to reverse.

Our bias is more the latter. As often with major market moves it’s the US that sets the direction and on this front it seems a Fed rate hike is gradually starting to appear on the horizon and debate will increasingly start to hot up as to whether it’s closer than we think.

What’s driven the bond rally?

Numerous lists have been put together on drivers of the bond rally this year. The reasons fall into four groups:

  • The global growth soft patch at the start of the year and various growth threatening geopolitical risks – the US economy contracted in the March quarter, growth disappointed in Europe, Japan was consumed by worries about the impact of the April 1 sales tax hike, Chinese growth slowed and emerging country growth generally disappointed. On top of this, geopolitical risk has remained with first the crisis in Ukraine and now Iraq. So one might be forgiven for thinking: here we go again with another year of global growth disappointment.
  • Dovish central banks – deflation fears and further easing in Europe, an easing bias in Japan and dovish comments from Fed Chair Yellen to the effect rate hikes are a still a considerable period away have reduced fears the world was closer to serious monetary tightening.
  • Short covering – last year bond rates rose leading to poor returns from bond funds such that by the start of this year traders were short bonds and some pension funds may have been under pressure to rebalance towards bonds as share weights had increased. News of growth disappointment and dovish central banks may have simply been the trigger to unleash this.
  • A growing pricing in of lower long term central bank rates – in response to talk of a period of “secular stagnation” that has been gaining increased airplay lately. It basically says that as a result of a combination of factors including slowing labour force growth, slowing productivity growth (as a result of less investment and a lower payoff from recent innovation), slower credit growth (in response to tougher regulation and high private sector debt ratios) and rising inequality (reducing the spending power of low and middle income earners) will result in a slower trend of economic growth. This in turn will mean lower real interest rates over the long term, a bit like Japan’s experience over the last two decades.

The reality is that each of these factors has probably played a role. And not just globally, but also in Australia where the decline in global yields has flowed though to a fall in Australian bond yields particularly as a combination of lower March quarter inflation, the Federal Budget’s impact on confidence and a bounce back in the Australian dollar have pushed out expectations for the first rate RBA rate hike.

But is it sustainable?

My concern is that the bond rally has gone too far:

Firstly, while the global economy started the year on a soft noter, abstracting from normal volatility, leading indicators point to a pick-up in global growth.

Stronger growth after the first quarter soft patch is particularly noticeable in the US:

  • business conditions indicators (often called PMI’s) are at levels consistent with solid growth;
  • business investment looks to be strengthening;
  • consumer spending has picked up;
  • housing related indicators are continuing to trend higher;
  • bank lending growth is trending higher; and
  • the level of employment has finally regained its pre 2008-09 recession high.

Secondly, while central banks in Japan, Europe, Australia and China will likely maintain a dovish or on hold tone for some time to come, the Fed is likely to start shifting its rhetoric in the direction of an eventual rate hike:

  • if current trends continue, unemployment will have fallen to 5.5% by mid next year, which is often seen as full employment; and
  • while inflation and wages growth remain low, both appear to have bottomed and with the core CPI (ie inflation ex food and energy) already at 2%, it’s likely that the Fed’s preferred measure of inflation, the core private consumption deflator, will reach 2% by year end. In other words inflation will soon be back at the Fed’s target.

This is still consistent with the first Fed rate hike being 9-12 months away, but as we get closer the Fed is likely to start warning of it and markets will start trying to anticipate.

Third, investor positioning regularly sets markets up for corrections that reverse the primary trend for a while. But short trader positions in bonds have been cut and more broadly the strong inflow into bond funds seen through the GFC and its aftermath have yet to be fully reversed. In other words the great rotation from bonds to shares may still be ahead of us.

Finally, while the secular stagnation story has some merit, it is worth noting that the US economic recovery to date has more in common with the sort of cyclical recovery seen after a debt crisis rather than the stagnation scenario experienced by Japan over the last twenty years. What’s more, America’s quick fiscal and monetary stimulus and bank recapitalization stands in contrast to Japan’s failure to move quickly on these fronts, so there is less risk of the US following Japan.

More broadly, the secular stagnation concept reminds me of the talk of new eras or permanently strong growth that were popular after the run of strong conditions around the end of last century. In other words, it looks a bit like a reflection of the classic behavioural finance tendency to extrapolate recent and current conditions into the future, in this case rationalise a more severe than normal cycle and turn into something more permanent. In other words just an ex-post rationalisation of the bond rally.

All of these considerations suggest that the bond rally might have gone a bit too far.

What about Iraq?

Just when we were getting used to the crisis in Ukraine and starting to see the risks as acceptable, Iraq has popped back into the headlines. In the low inflation era since the 1980s globally, oil supply shocks have been more of a concern to growth than inflation. There are two main concerns regarding Iraq: the loss of Iraqi oil exports which amounts to around 2.3 million barrels a day (compared to global production of about 91.7 mbd) and the threat of wider (Sunni v Shia) Middle East conflict dragging in the US and its allies (again).

However, it is worth bearing in mind that we have seen it all before: OPEC looks to have enough spare capacity of around 3 mbd to meet any short fall from Iraq; the Iraqi conflict is in the north of the country, but most of its oil exports (2.1 mbd) come from the south; US shale oil has reduced the threat to the US, which is likely to mean only a limited US intervention (eg air strikes as opposed to full on ground forces); and many Middle East conflicts seem to flare up regularly only to settle down again without turning into a broader conflict. So for these reasons, whilst Iraq could get worse before it gets better causing share market volatility along the way, it’s hard to see it disrupting the broader global economic recovery and uptrend in share markets. Since the early 1970s it’s clear that it’s not the level of the oil price that poses a risk to global growth but its rate of change. Severe hits to growth have required a doubling in the oil price in the space of 12 months. And right now we are a long way from that. See the next chart that shows the relationship between the oil price and US growth.

Concluding comments

Bonds have had a surprise rally this year. However this is likely overdone and with US growth picking up it’s only a matter of time before debate about the start of Fed tightening hots up causing a resumption of the rising trend in bond yields. However, while this could contribute to a correction in shares, it’s unlikely to be the end of the bull market in shares as even when US interest rates do start to rise we are still going to be a long way from tight monetary conditions.

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Europe continues to reflate

Thursday, June 12, 2014

by Shane Oliver

Europe has been getting its act together and the latest ECB stimulus measures add to confidence that its recovery will pick up pace. This is good for global growth.

The ECB’s actions provide a reminder global monetary conditions remain very easy which is supportive of relatively high yield assets and growth assets generally.

One risk is that the boost to the search for yield will delay further falls in the value of the $A.


Since the high point of the Eurozone crisis in 2012, Europe has been steadily fading from the headlines as the risk of a break up in the Euro diminished and troubled peripheral countries started to get their public finances under control.

Quite clearly the combination of various bailouts, Eurozone leaders focusing on “more Europe, not less” and the efforts of the European Central Bank President Mario Draghi to “do whatever it takes to preserve the Euro” backed up by various monetary programs have been successful. This is all evident in a collapse in bond yields in peripheral countries and a return to economic growth across Europe. However, Europe has hit the headlines again with the ECB providing another significant round of monetary stimulus. This note looks at what it means for Europe, global growth and for investors.

Eurozone recovery

Signs abound that the Eurozone has left the crisis behind.

Thanks to austerity programs and more recently a return to economic growth, budget deficits are coming under control in the main crisis countries, viz, Italy, Spain, Portugal, Ireland and Greece. Spain is a laggard, but the average Budget deficit in these countries will be around 4% of GDP this year, down from 10% plus a few years ago. Greece, Italy and Portugal are on track to run primary budget surpluses (ie the budget excluding interest payments) this year. See the next chart.

The decline in budget deficits in the crisis countries is set to see average gross public debt levels peak this year.

Economic restructuring is starting to bear fruit. One guide is unit labour costs as it reflects both productivity growth and labour costs, so is a guide to competitiveness particularly across countries with a common currency as is the case in the Eurozone. Italy (and France) have been the laggards on the economic reform front with rising unit labour costs, but Spain and Portugal have made significant progress in reducing costs, particularly relative to Germany. See the next chart.

Reflecting the return of investor confidence, particularly once it became clear the ECB was not going to allow a break up in the Euro (and so bond holders would get paid back in Euro’s & not devalued new liras, pesos, etc), bond yields in the crisis countries have collapsed to precrisis levels or below. In fact Spanish and Italian 10 year bond yields have fallen to record or near record lows.

Finally, confidence and business conditions have improved across the Eurozone and this has seen a return to growth. While the next chart has a lot of lines on it the key is that confidence is moving up across the Eurozone including in the crisis countries. In fact, the improvement in Greek confidence levels is quite astounding given where it was a couple of years ago.

The ECB moves again

However, E+urope is not completely out of the woods yet.

While confidence and business conditions have picked up nicely, growth remains gradual (at just 0.9% over the year to the March quarter), unemployment has only fallen slightly from its peak of 12% to now 11.7%, inflation is just 0.5% year on year, money supply is growing at just 0.8% year on year and bank lending contracted 1.8% over the year to April. This has led to concerns that the Eurozone might be sliding into a Japanese type scenario of low growth and deflation.

To head off this risk the ECB has unveiled another round of monetary stimulus. While much anticipated, as the ECB had been foreshadowing a move for some time, it did not disappoint. The key measures deployed include cutting its key interest rate to just 0.15%, cutting the rate of interest banks receive on excess deposits at the ECB to -0.10%, an extension of guidance as to how long rates will remain low, an extension of the commitment to supply unlimited short term funds to banks at the 0.15% interest rate, a new long term lending program to banks (called Targeted Long Term Refinancing Operations or TLTRO), an end to the sterilisation of the bonds held in its existing bond buying program (which it calls SMP) and preparation for a program to purchase asset backed securities (which would amount to a US style quantitative easing program). The highlight was probably the TLTRO program which is effectively a “funding for lending” program that will allow banks to borrow to fund their non-mortgage lending at just 0.25% interest for four years.

The latest ECB move is not as momentous as its efforts in 2011 and 2012 (the first LTRO, “whatever it takes” and the Outright Monetary Transactions program that backed it up) that ended the Eurozone crisis. It would also have been better to see a US style quantitative easing program straight away and there are doubts about how successful each of the measures announced by the ECB will individually be.

But the ECB has more than met market expectations as reflected in the 2.3% rally in Eurozone shares and the collapse in bond yields in Spain, Italy and Greece since the announcement. What’s more the scatter gun approach of deploying virtually everything at once adds to confidence that the whole should be worth more than the sum of the parts in terms of its impact on the economy. The ECBs broad based approach also adds to its own credibility and confidence that it is determined to get the economy on to a stronger path.

And the clear impression is that while interest rates have hit bottom it stands ready to do more if needed and this is likely to involve the purchase of private sector asset backed securities. Finally, there are signs that the wind down in bank lending in Europe that has occurred in the run-up to this year’s review of the quality of the banks’ assets and stress tests of their capital, has run its course. If so the ECB’s measures aimed partly at boosting bank lending have a good chance of succeeding.

Implications for Eurozone & global recoveries

The bottom line is that the ECB’s measures – and commitment to do more if needed – add to confidence that the Eurozone economic recovery will pick up pace over the year ahead and that deflation will be avoided. This in turn is good for global growth and since Europe is China’s biggest single export destination, also good news for China, which in turn of course is good news for Australia.

What it means for investors

There are several implications for investors.

First, the determination of the ECB to put Europe on to a stronger growth footing and the easier monetary environment in Europe is positive for Eurozone equities, which remain relatively cheap. The chart below shows a composite valuation measure for European shares that indicates they are still about 2 standard deviations (or about 20%) undervalued.

Second, ECB actions are likely to maintain downwards pressure on peripheral country bond yields, but given they are historically low, particularly so given the still high debt levels in such countries, this trade is becoming risky.

Third, the ECBs actions provide further support for the global “carry trade” that involves borrowing cheaply in low yield countries like Europe and putting the proceeds into higher yielding countries and assets. As a result, the chase for yield looks like it has further to run. This is supportive of corporate debt and high dividend paying shares.

Fourth, and related to this, the reinvigoration of the carry trade risks delaying the next leg down in the value of the Australian dollar, as global demand for high yielding investments like those in Australia remains strong. Japanese interest in Australian bonds appears to be returning and Europe is likely to be a source of funding for carry trades. In the short term this could work against the  downwards pressure on the $A coming from the weaker terms of trade and the need to rebalance the Australian economy.

Finally, the ECB’s latest monetary easing also provides a reminder that the global monetary policy back drop remains very supportive for growth assets like shares generally.

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The structural challenges facing Australia

Friday, June 06, 2014

by Shane Oliver

Australia faces three key structural challenges: the end of the commodity price boom is leading to slower growth in national income; this is putting pressure on the budget; & it’s all occurring when productivity growth has slowed.

To get growth in economic activity and in material living standards back onto a strong sustainable path will require more serious economic reform, including getting the budget under control, tax reform, more privatisation, more infrastructure spending and reduced regulation.

This will likely be necessary to ensure strong sustained performances from Australian asset classes.


During the past few years Australia has had a tough time in achieving economic reform. The first attempt in a decade at serious tax reform got bogged down with debate around the poorly designed Resource Super Profit Tax in 2010 leading to the less than optimal mining tax, the attempt to put a price on carbon pollution looks like it will soon be terminated and getting the budget back under control is proving very difficult. The saga over the budget in particular has been depressing with the 2013 Budget showing a run of deficits worse than those associated with the 1990s recession despite having the biggest boom in our history. And the community reaction to the latest Budget seems to have had the effect of refocusing the debate from the broad based need to reform the economy and get the budget back into surplus to a focus on equality. In other words rather than focusing on growing the national pie, the focus is back to how to divide it up.

The problems Australia faces are trivial compared to those seen in many other countries with more rapidly aging populations and far bigger public debt burdens. Talk of a budget emergency is over the top. But we do need to take our fiscal challenges seriously or else we could end up in the sort of mess several other countries have run into, where when luck ran out and things turned sour the IMF got called in and the choice became cut back or no bailout from the IMF. We are a long way from that but so too was Ireland in 2006 when its net debt to GDP ratio was the same as Australia's today but its boom turned to bust, house prices tumbled, banks had to be bailed out, public debt ballooned and lenders dried up necessitating IMF support.

After the biggest resources boom in our history, Australia’s public finances should be in far better shape. Norway is a good example. Realising that its North Sea oil reserves would not last forever it has been running big budget surpluses and putting the money into a sovereign wealth fund for use when the boom is over. As a result Norway’s net public debt is negative, ie it is owed way more than it owes.

I am optimistic we will get Australia and its fiscal finances back into shape, but we need to see much better from all in Canberra than we have seen lately for this to occur.

The challenges

The structural challenges facing Australia are simple:

  • The biggest boom in our history is now fading as lower commodity prices drive lower growth in national income.
  • This has seen the boost to the budget from the resources boom go into reverse at a time when we have spent and continue to spend the proceeds whilst the demands on health and pension spending are set to accelerate from the ageing population. At the same time we are embarking on several major expenditure items at once – the National Disability Insurance Scheme, the Gonski education reforms and the new Paid Parental Leave scheme. All of these are desirable, but they are not really all affordable. The NDIS in particular could turn out to be very expensive over time.
  • This is all occurring at a time when the boost to productivity growth from the economic reforms of the 1980s and 1990s that lasted into early last decade has faded. This is particularly evident in multifactor productivity (that looks at growth in output per unit of labour and capital), which has gone backwards over the last decade. This didn’t matter when national income was growing strongly through the commodity boom, but with it now slowing it matters a lot if we want to keep growing our living standards.

What to do – restart the reform agenda

To get back on track, Australia needs to do several things.

Put the Budget on to a sustainable path towards surplus. To not do so will leave us with little fiscal flexibility come the next downturn and leave us vulnerable should our luck turn against us resulting in extraordinary demands being placed on the Federal Government as occurred in Ireland.

The Government’s Budget puts us in the right direction. To minimise the negative impact on confidence and to gain Senate passage some of the harsher aspects of the Budget are likely to require softening.

Reform the tax system. This is a big one. Put simply the current tax system suffers from a number of problems.

  • It’s too complex – with over 120 taxes but just 10 of them raising 90% of the revenue.
  • There is a heavy reliance on income tax (raising around 50% of revenue) as opposed to sales tax (raising nearly 30% of revenue) and this did not change with the GST.
  • As a result, following the Budget Australia’s effective top marginal tax rate at 49% will be 15th highest globally and the highest in our region, viz NZ 33%, Singapore 20% and Hong Kong 15%. Sydney can forget about becoming a world financial centre – as why would individuals locate here and lose half their extra income? The end result is a disincentive for extra effort, increased demand for tax minimisation strategies and less incentive to save.
  • The numerous taxes along with the GST exemptions for fresh food, health and education result in various distortions in the economic system.

Ideally, from an economic perspective the GST needs to be broadened and its rate increased and the proceeds used to fund the removal of numerous nuisance taxes and reduced income tax.* Tax reform should occur with the aim of not increasing the overall tax burden on the economy. Once allowance is made for compulsory superannuation contributions in Australia and social security levies in other countries, the tax burden in Australia is already around the OECD country average. Taking it higher would only reduce incentive and Australia’s long-term growth potential, as various high tax European countries have found.

Embark on another round of privatisation. Private operators can invariably run businesses better than governments and the proceeds from asset sales can be used to pay down debt and/or recycle into new infrastructure spending. Privatisation of infrastructure assets also provides investment opportunities for Australian superannuation funds. The Federal and Victorian Governments went down this path significantly in the 1990s and there are still significant utility assets in other states that can be privatised.

Boost infrastructure spending. This is essential if we are to boost productivity and income levels. The Federal/state agreement to privatise assets and use the proceeds to invest in infrastructure is a move in the right direction. Queensland has announced a move down this path, but it won’t start till after next year’s election.

Reduce regulation. Excessive regulation is slowing business and investment. The Federal Government looks to be taking this on.

Reduce remaining protection. Industry protection has been substantially reduced but remains significant with various protection measures remaining such as bans on book imports, restrictions on pharmacies and the licensing arrangements of doctors and lawyers. The Government has at least made a start on this front by not chasing various failing businesses lately with blank cheques.

Get our education system producing better outcomes. As various studies have shown our education system is lagging other OECD countries in some areas. But as the debate around the Gonski reforms highlights, fixing it probably requires more funding, a solution to which likely involves greater deregulation, greater private sector involvement and higher fees.

Of course there is much more, but these are the main areas needed to be looked at to boost productivity growth.

What does it mean for investors?

Economic policies can have a significant long-term impact on growth and hence asset market returns. Australian shares outperformed global shares significantly last decade. A lot of this owed to the resources boom and our absence of tech stocks which meant the Australian market largely missed the tech wreck. But the boost to productivity and profitability from the economic reforms of the 1980s and 1990s also helped.

Since 2009 though, the relative performance of Australian shares has slipped. While several key global share markets have made new highs including the US share market and just recently global shares generally, the Australian share market remains 20% below its November 2007 high.

Why the recent underperformance? A combination of factors have played a role including tighter monetary policy, the strong $A, weakness in China, and the fact Australian shares reached a much higher high in 2007. It’s also worth noting that if the reinvestment of dividends is allowed for then Australian shares are above their 2007 high. But the lack of recent growth enhancing reforms and the productivity growth slowdown have likely also played a role in the relative underperformance of Australian shares in recent years.

Concluding comments

Don’t get me wrong. I am not bearish on Australia. The economy can rebalance as the mining investment boom continues to fade – as it has been doing over the last year.

But if we want strong sustainable economic growth that underpins a relatively strong performance from Australian asset classes we do need to seriously reinvigorate the economic reform process in Australia. Getting lost in endless debate about how to divide up the national cake or denial about the need to get the budget under control will only take us back to the poor economic performance of the 1970s.

* As with the introduction of the GST, pensioners and low income earners can & should be compensated for any broadening and increase in the GST.

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Australia’s March quarter GDP growth

Thursday, June 05, 2014

by Shane Oliver

Australia’s March quarter GDP growth was an impressive 1.1% quarter on quarter or 3.5% year on year. So much for sub-trend growth, at least in the March qtr.

However, this was all due to a 1.4 percentage point contribution to growth from net exports, as mining investment is surging following recent new mine completions and capital goods imports are weak partly reflecting the slowdown in mining investment.
Consumer spending rose 0.5% and dwelling investment surged a strong 4.7% quarter on quarter as the housing recovery has started to come through. But consumer spending and housing investment were more than offset by weak business investment, a fall in public sector investment and detraction from inventories to result in Gross National Spending falling by 0.3% quarter on quarter.
While the March qtr GDP data shows the economy weathering the end of the mining investment boom well, helped by strength in housing investment, consumer spending and a stronger trade performance, growth will not be sustained at this pace for the next few quarters:

  • Mining export volume growth will slow down after the initial surge from new mine completions;
  • Consumer spending is likely to slow on the back of the Budget’s short term hit to confidence; and
  • The further decline in the iron ore price will weigh on national income.

So growth in the current quarter is likely to slow back to around 0.5% quarter on quarter. In other words it’s too early to break out the champagne!
Meanwhile, it’s worth noting that the household saving rate remains solid at 9.7% providing a solid buffer for consumers.
Labour productivity growth over the last year was also a solid 2.2% which when combined with soft wages growth is resulting in weak real unit labour costs which adds to confidence that inflation will remain benign.
Overall, it’s hard to see the strong March quarter GDP outcome having much if any impact on the RBA’s thinking on interest rates as growth at this pace won’t be sustained. As a result, we continue to see the RBA leaving interest rates on hold for a while yet.

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Investment markets and key developments over the past week

Saturday, May 31, 2014

by Shane Oliver

Investment markets and key developments over the past week

Share markets mostly rose over the past week helped by relief at the conclusion of the European and Ukrainian elections, mostly good economic data and more signs that easing is on the way in Europe. Signs that non-mining and housing investment are starting to offset the slump in mining investment also helped support the Australian share market. Despite this bond yields fell again as expectations for future interest rate levels are getting revised down. Commodity prices, including the iron ore price, were mostly lower but the $A rose a bit as the latest business investment data saw investment plans for the year ahead revised up. It’s hard to see the rise in the $A being sustained given the fall in the iron ore price and the risk that RBA interest rate hikes will be pushed into 2015.

The win by various Euroskeptic parties in the European Parliament (EP) elections is unlikely to have much impact. Sure they got 30% or so of the vote, but it represents a protest vote as voters know that its national elections that matter, Euroskeptic parties tend to represent the extreme left and right and don't vote together and its well short of a majority anyway. The increase in support for the extreme right in France and extreme left in Greece may concern governments in those countries but they know it’s a protest vote and governing parties did well in Germany and Italy. So it’s hard to see any real change in policy direction in Europe.

The victory of Boris Poroshenko in Ukraine without the need for a run-off election is also a good outcome. While conflict remains in the east he is someone who can work with both Russia and the west.

Policy fine tuning announcements in China continue to mount up, adding to confidence that growth will be supported around 7.5% for this year. These amount to various spending measures (on shanty towns, railways, etc) and monetary easings. They’ve also been underlined by Premier Li stating that downside risks should be taken seriously and that policies should be fine-tuned appropriately, so more easing measures are likely.

In Australia, APRA announced draft qualitative guidelines aimed at encouraging lenders to appropriately manage high-risk mortgages. This is very different to the quantitative restrictions on high loan to valuation ratio mortgages seen in New Zealand and reflects Australian regulators’ scepticism about the distortions such approaches result in. But quite clearly APRA does not want to see any deterioration in lending standards. To the extent this has an impact it is likely to add to the loss of momentum already seen in house prices this year and provide further room for the RBA to keep interest rates low.

Major global economic events and implications

US economic data was mostly good. The bad news was that March quarter growth was revised to -1% annualised. However, this reflects a bunch of temporary factors including the impact of adverse weather on construction activity which will reverse. More importantly, forward looking indicators continue to improve with solid durable goods orders, continuing gains in home prices and house sales, a rise in consumer confidence, a strong rise in the Markit services conditions index and a fall in jobless claims. So the US economy remains on track to expand strongly this quarter.

Eurozone data was a bit more mixed, with sentiment readings up across the board in May, but money supply growth remaining weak and bank lending still down on a year ago. Meanwhile, ECB officials continue to reinforce expectations for a combination of ECB easing measures to be announced at its meeting next week.

Japanese data showed the expected fall back in household spending and industrial production in April associated with the sales tax hike and the related surge in inflation. My inclination remains that with the underlying economy and policy stimulus both stronger than was the case around the time of the 1997 sales tax hike, the impact on growth is just temporary and Abenomics will continue to work. It is notable that the unemployment rate at a low 3.6% and the rising trend in the ratio of job vacancies to applicants have both been unaffected by the tax hike, adding to confidence that its effect is temporary.

Australian economic events and implications

Australian data was actually pretty good, relative to fears. Sure mining investment fell another 8.7% in the March quarter and business intentions point to a further 15 to 20% fall over the financial year ahead. But against this the latest capital spending plans point to a less negative outlook for 2014-15 than previously foreshadowed with mining investment set to fall more slowly and investment in other industries now looking like it will see a solid rise. On top of this residential investment rose 6.8% in the March quarter, a further rise in new home sales in April points to more to come and credit growth continued its modest acceleration in April.

The bottom line is that the rebalancing away from mining investment as a source of growth is starting to occur. The problem though is that it’s still tentative, so it’s critical that the blow to confidence from the Budget proves temporary. It’s obvious the Government will have to compromise to get aspects of its Budget through the Senate and this may lead to some softening of the harsher measures. Something else might have to give though given the need to see the budget still heading towards surplus, and paid parental leave is a logical candidate.

What to watch over the next week?

In the US, expect the ISM manufacturing and services conditions indexes (due Monday and Wednesday respectively) to have remained around solid readings of 55 and May payroll employment (Friday) to show a gain of 220,000. The ISM and payroll reports are likely to confirm that growth is picking up after the first quarter slump.

In Europe, the focus will be on the ECB (Thursday) which is expected to finally act on its easing bias again and announce more monetary stimulus. This is likely to take the form of interest rate cuts but there is some chance it will also include a form of quantitative easing.

In Australia, it will be a busy week. The RBA (Tuesday) is certain to leave interest rates on hold for the ninth month in a row as it has previously indicated is likely to be appropriate for some time yet. Since the last meeting, the Budget has clearly had a negative impact on confidence and consumer spending too according to various anecdotes, but it’s unclear how long this will last and the stimulatory effect of record low rates is still working through the economy. At the same time inflation remains benign and tentative signs of cooling in the housing market and APRA's qualitative crackdown on high-risk mortgages means the Reserve has plenty of scope to continue with low rates.

On the data front, March quarter GDP growth (Wednesday) is expected to show that growth remains below trend with soft business investment but support from dwelling construction, consumer spending and trade likely to see GDP up 0.5% quarter on quarter, or 2.8% year on year. Expect to see a further slowing in house price growth but a 3% bounce in building approvals (both Monday), a slight setback in April retail sales (Tuesday) after 11 months of gains and a continuing trade surplus (Thursday). The AIG's business conditions PMIs for May will provide a good indication of the impact of the Budget on business confidence.

Outlook for markets

Shares remain vulnerable to a mid-year correction, just as we have seen in each of the last four years now. However, with shares having been in a bit of a stealth correction all year, any pull back may well be mild and in any case the broad trend in shares is expected to remain up. Share market fundamentals remain favourable with reasonable valuations, global earnings improving on the back of rising economic growth and monetary conditions set to remain easy for some time. So any dip should be seen as a buying opportunity. Our year-end target for the ASX 200 remains 5800.

Bond yields are likely to resume their gradual rising trend as it becomes clear that US inflation has bottomed and this combined with low yields is likely to mean pretty soft returns from government bonds. Cash and bank deposits continue to offer poor returns.

With $A short positions now largely unwound, it’s likely that the broad downtrend in the $A is resuming. Commodity prices including the iron ore price remain relatively soft, RBA interest rate hikes are getting pushed out and the $A is likely to revert to levels that offset Australia’s relatively high cost base.

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