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

Posted On:Jul 09th, 2014     Posted In:Rss-feed-oliver    Posted By:Provision Wealth

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%. But is Abenomics working or are we just seeing another cyclical bounce? And what does it mean

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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%. But is Abenomics working or are we just seeing another cyclical bounce? And what does it mean for investors?

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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 2% pa and real economic growth to 2% 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 2% 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%.

The initial response has been positive with the economy growing 3% over the year to the March quarter and inflation (ex the impact of an April 1 sales tax hike) running at 2.2%. But concerns remain: that the sales tax hike from 5% to 8% 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.

Source: Bloomberg, AMP Capital

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

  • The Economy Watchers outlook index is up strongly;


Source: Bloomberg, AMP Capital

  • 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%, its lowest since 1997, and the ratio of job vacancies to applicants is at its highest since 1992.


Source: Bloomberg, AMP Capital

  • 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 rerun 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 2% 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% of GDP (compared to just 31% in Australia!). However, it’s not nearly as bad as it looks. First, its gross public debt of 244% of GDP falls back to 137% 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 8%. 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% to in the 20-30% 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 – e.g. 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 2% 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% gain last year, Japanese shares had become overbought and due for a correction, which is what we have seen this year with a 15% 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% 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.

Dr Shane Oliver
Head of Investment Strategy and Chief Economist
AMP Capital

Important note: While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) makes no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This article has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this article, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This article is solely for the use of the party to whom it is provided.

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Share market risks

Posted On:Jun 26th, 2014     Posted In:Rss-feed-oliver    Posted By:Provision Wealth

As we approach mid-year it’s worth reviewing the outlook for shares particularly with numerous warnings of corrections and crashes. Our view for this year has been that share market gains would be positive, but more constrained than seen in the last two years, and that volatility would increase – including the likelihood of a 10-15% correction along the wPhase 1

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As we approach mid-year it’s worth reviewing the outlook for shares particularly with numerous warnings of corrections and crashes. Our view for this year has been that share market gains would be positive, but more constrained than seen in the last two years, and that volatility would increase – including the likelihood of a 10-15% correction along the wPhase 1 is driven by an unwindingay. In the event gains in shares have been more constrained, with global shares (in local currency terms) up 4.5% year to date and Australian shares up 1.5%. However, volatility has been relatively low.

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Most concerns regarding the share market outlook relate to US shares. It invariably sets the direction for global share markets including Australia’s but many contend that at record highs it is overvalued and at risk of a crash.

Common concerns about US shares

There seem to be three commonly expressed concerns regarding US shares: record highs, valuations and complacency. Looking at each of these in turn: US shares are at record highs. Does this mean they are due for a bust? The following chart shows the US S&P 500 since 1990. It broke out to record highs last year and is now up 190% from its Global Financial Crisis (GFC) low in 2009.


Source: Bloomberg, AMP Capital

However, just because US shares are at a record high does not mean a crash is on the way. The breakout seen last year came after a 13 year secular bear market, which saw US shares stuck in a huge range. Our assessment is that US shares have entered a new secular bull market helped by a range of factors including an energy boom, a manufacturing renaissance and a return to better health for US debt measures. And as can be seen in the chart the surge in the share market has been supported by a surge in profits to record levels.

Are US shares way overvalued? Proponents of this view typically cite the following:

  • the ratio of share prices to the 10-year moving average of earnings (Shiller PE) is well above its long-term average;

  • the overvaluation is even worse if allowance is made for higher than average profit margins; and

  • the ratio of the market value of US listed company capital to its replacement cost (called Tobin’s Q) is well above its long-term average implying share prices have been pushed beyond levels justified by their asset base.

To be sure, these are valid concerns but while such valuation measures are useful they need to be treated with caution.

  • While the Shiller PE (next chart) at 23 times is well above its long-term average since 1881 of 16, the equilibrium PE has likely risen since the 1800s. During the last 100 years, shares have become easier and cheaper to trade and it’s become easier to assemble a well diversified portfolio, all of which has likely seen the equilibrium PE rise. On this basis, it’s noteworthy that the Shiller PE is only marginally above its long-term rising trend suggesting US shares are not particularly overvalued.


Source: AMP Capital

  • In a world of very low inflation, interest rates and bond yields, earnings yields on shares should be lower & price to earnings multiples higher than longer-term averages.

  • Although US profit margins are high, they have been high for a long time and attempts to forecast their return to some long-run average have failed. It’s debatable what the normal level should be and with falling capital prices and with a global supply of cheap labour it’s hard to know what will cause profit margins to fall.

  • Finally, there is reason to be sceptical of Tobin’s Q as it does not allow for a world where corporate capital is increasingly dominated by intellectual capital as opposed to physical capital.

Is the decline in volatility a major concern? The next chart shows the VIX index, which is a guide to expected volatility in the US share market implied by options.


Source: Bloomberg, AMP Capital

It is clearly very low and is consistent with the US share market having traded in a relatively narrow rising trend since mid-2012. There hasn’t been a 10% or more correction in US shares since mid-2012. In many ways this is a good thing. It is far better than the extreme volatility seen through the GFC and its aftermath and worrying about it is perhaps a bit like worrying that there is nothing to worry about! The concern, though, is that periods of low volatility can lead to a false sense of investor security and excessive risk taking, eg using high levels of gearing to buy overvalued assets.

However, the low level of volatility is arguably a rational reaction to the more stable macro-economic environment seen in more recent times. It is doubtful that risk taking has reached the extremes seen at previous major market tops and, as the 2004-07 period showed, volatility can remain at very low levels for a long time before it runs its course.

Broad cycle view

More generally, our view remains it’s too early in the investment cycle to expect a new bear market or crash. The normal play out for a cyclical bull market is as follows.

  • Phase 1 is driven by an unwinding of very cheap valuations helped by easy monetary conditions as smart investors start to snap up undervalued shares as investor sentiment moves from pessimism to scepticism.

  • Phase 2 is driven by strengthening profits. This is the part of the cycle where optimism starts to creep in.

  • Phase 3 sees euphoria with investors pushing cash flows into shares to extremes. The combination of tight monetary conditions, overvaluation and investor euphoria then sets the scene for a new bear market.

Our assessment remains that we are still in Phase 2. We still don’t see the signs of euphoria that become evident in Phase 3 as precursors to a new bear market. 

  • Price to earnings ratios based on forward earnings are around or below their averages seen during the low inflation era seen since the early 1990s.


Source: Thomson Reuters; AMP Capital

The gap between earnings yields and bond yields, a proxy for the excess return shares offer, remains above pre-GFC norms. This is reflected in our preferred valuation indicators, which show markets slightly cheap. 


Source: Bloomberg, AMP Capital

  • Global economic indicators have been gradually heading higher, which should be supportive of earnings growth. US growth is rebounding from its March quarter soft patch, Japan seems to be weathering its April sales tax hike pretty well, European growth remains slow but atleast it is continuing and Chinese growth appears to have bottomed after slowing earlier this year with various ministimulus measures helping.

    In Australia, a likely softening of some of the measures in the Federal Budget to allow it to pass through the Senate combined with continuing low interest rates, strong housing construction activity and strong resource export volumes should see the economy back on track by year end.

  • Global and Australian monetary policy remains easy and is likely to remain so for some time yet.

  • Finally, there is no sign of the investor exuberance usually seen at major market tops. Various surveys show that investor scepticism towards shares remains high. The mountain of money that built up in bond funds in the US has yet to fully reverse. In Australia, investors still prefer bank deposits over shares and the share of cash in the superannuation system remains double pre-GFC levels.

Concluding comments

None of this rules out a short term correction in shares and a return to more volatility. Numerous possible triggers for a correction exist including: a continued run of stronger US economic data raising concerns about an earlier Fed rate hike; risks around Ukraine and Iraq; maybe a return of worries about Europe on the back of European Central Bank bank stress tests and independence referendums later this year in Scotland and (possibly) Catalonia. And in Australia, we need to see confidence levels pick up. However, we still seem a fair way from a major market top in shares. As such, the cyclical bull market in shares likely has further to go. Our year-end target for the ASX 200 remains 5800.

Dr Shane Oliver
Head of Investment Strategy and Chief Economist
AMP Capital

Important note: While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) makes no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This article has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this article, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This article is solely for the use of the party to whom it is provided.

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The bond rally, secular stagnation & now Iraq

Posted On:Jun 18th, 2014     Posted In:Rss-feed-oliver    Posted By:Provision Wealth

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

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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.

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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.

Source: Bloomberg, AMP Capital

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.

 

Source: Bloomberg, AMP Capital

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.

Source: ICI, AMP Capital

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 recapitalisation 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.

 

Source: Bloomberg, AMP Capital

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.

Dr Shane Oliver
Head of Investment Strategy and Chief Economist
AMP Capital

Important note: While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) makes no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This article has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this article, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This article is solely for the use of the party to whom it is provided.

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Europe continues to reflate

Posted On:Jun 12th, 2014     Posted In:Rss-feed-oliver    Posted By:Provision Wealth

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

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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.

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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.


Source: IMF; AMP Capital

  • 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


Source: OECD; AMP Capital

  • 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.


Source: Global Financial Data; AMP Capital

  • 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.


Source: Bloomberg, AMP Capital

ECB moves again

However, Europe 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.

Source: Bloomberg, AMP Capital

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.

Dr Shane Oliver
Head of Investment Strategy and Chief Economist
AMP Capital

Important note: While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) makes no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This article has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this article, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This article is solely for the use of the party to whom it is provided.

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The structural challenges facing Australia.

Posted On:Jun 05th, 2014     Posted In:Rss-feed-oliver    Posted By:Provision Wealth

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

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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.

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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.


Source: IMF, AMP Capital

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.


Source: ABS, AMP Capital

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


Source: Bloomberg, AMP Capital

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.

Dr Shane Oliver
Head of Investment Strategy and Chief Economist
AMP Capital

 

Important note: While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) makes no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This article has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this article, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This article is solely for the use of the party to whom it is provided.

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India getting back on track

Posted On:May 21st, 2014     Posted In:Rss-feed-oliver    Posted By:Provision Wealth

The overwhelming victory by the reform oriented BJP led alliance in India’s recent election, has boosted hopes that the Indian economy will get India’s growth story back on track. In the clearest election outcome since 1984, the BJP led alliance won 336 of 543 parliamentary seats giving it a clear majority, with the BJP alone getting a majority of 282

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The overwhelming victory by the reform oriented BJP led alliance in India’s recent election, has boosted hopes that the Indian economy will get India’s growth story back on track. In the clearest election outcome since 1984, the BJP led alliance won 336 of 543 parliamentary seats giving it a clear majority, with the BJP alone getting a majority of 282 seats. The BJP led by Narendra Modi has received a clear mandate to push through with its reform program.

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The Indian share market has, not surprisingly, taken this very positively having risen 3.5% since the election and being up 15% year to date, making it one of the world’s strongest share markets this year as investors moved to position for a BJP win. But has it gone too far in the short term? What does the change of Government mean over the long term? And what does it mean for commodities and Australian exports?

India's growth potential is very high…

India’s growth potential is well known. Its population is still growing rapidly, unlike say China’s. By 2050 its population will likely exceed that of China. It has a highly educated workforce which has helped fuel growth in its services sector. Its urbanisation rate is low and has the potential to rise much further. Similarly its starting point of low per capita income (about one third of China’s) also means plenty of potential. And being a relatively closed economy it’s not as vulnerable as say Brazil to slower growth in China.

Source: AMP Capital

Through much of last decade this potential started to be unleashed as a result of economic reforms of the 1990s that de-regulated the economy and opened it up to investment. As a result the Indian economy performed spectacularly well, with growth averaging nearly 9% per annum over the five years to 2007 and increasing confidence that it was following in China’s footsteps.

…but yet to be fully realised

However, starting late last decade it seemed the wheels started to fall of the Indian economy. As can be seen in the next chart, for the last five years inflation has pushed higher while growth has slowed leading to a significant deterioration in the growth/inflation trade-off.

Source: Bloomberg, AMP Capital

At the same time, the budget has remained in chronic deficit and is currently 5% of GDP and the current account has also remained in deficit.

Essentially the supply side of the economy did not keep pace with demand resulting in rising inflation and trade imbalances. Perhaps the biggest problem was that the Indian Government, run by the Congress Party, for various reasons failed to continue with the reform agenda in a meaningful way. As a result, privatisation has been slow, protection of domestic industries has been high, its labour market lacks flexibility and business is mired in red tape. It takes more than twice as long to start a business in India than it does in China. Compared to China, India also saves less and invests less in infrastructure.

As a result of its poor recent performance along with its dependence on foreign capital, India only a few months ago was being described as being one of the “Fragile Five” countries along with Turkey, Brazil, South Africa and Indonesia in terms of their vulnerability to the end of quantitative easing in the US.

Another round of reforms

However, the resounding BJP victory means that the reform process will likely get underway again. Narendra Modi’s pro-development track record in Gujarat state where he has been Chief Minister for the last decade has been impressive, resulting in 10% pa growth over the last five years. The BJP and Modi ran their campaign with a pro-business and pro-reform policy agenda, which they now have a mandate to deliver upon. Based in large part on the BJP’s economic agenda, key reforms are likely to include:

  • cutting subsidies and price controls;

  • implementing the GST;

  • increasing infrastructure spending over current spending;

  • reducing the budget deficit;

  • faster privatisation;

  • commencing a high speed rail network;

  • boosting urbanisation and low cost housing;

  • cutting read tape;

  • simplifying labour laws; and

  • support for inflation targeting by the central bank.

The BJP led alliance found support from all social classes and regions (with the exception of Muslims) indicating that the electorate is supportive of the reform agenda. These reforms should help to boost India’s average growth rate back up to around 8% pa in the years ahead. That there are some signs of slowing inflation and a stabilisation/revival in growth indicators may mean that the task may be a bit easier in that at least some of the hard work in getting inflation down has already been undertaken by the Reserve Bank of India.

Short term challenges

Of course, Modi and the BJP alliance will face a number of short term challenges worth keeping an eye on:

  • First, the BJP alliance does not have a majority in the upper house and support from the states will be required. There are potentially ways around the upper house though using joint sessions, although this will take time. And un-cooperative states will be under pressure as they will lose out to states that go down the reform path.

  • Second, there’s a lot to fix.

  • Third, past experience with economic reforms indicates that economic conditions can get worse before they get better.

  • Finally, there are some concerns that the BJP’s victory will fuel tensions with Muslims. A counter though is that at the end of the day Modi and the BJP are pro-development and pragmatic.

Implications for the world & Australia

A reformed India combined with its large and strongly growing population will put it back on the path to (again) becoming the world’s biggest economy – probably by the end of the current century (but after China gets there first).

Source: Angus Madison (2001, 2005), AMP Capital

Like China, India will become an increasingly important driver of global economic growth, it will add to commodity demand and its abundant cheap labour and cost advantages will see India play an ever increasing role in world trade adding to downwards pressure on global inflation. In terms of commodity demand, the following table highlights the potential. India’s per capita consumption of commodities is a long way behind that of China, let alone developed countries.

Source: Bank Credit Analyst, AMP Capital

India has a long way to go though. Its per capita real GDP is about where China’s was in 2000 and its commodity demand is only around 15% of that of China. So, it’s a long way from being able to fill any gap in commodity demand should China have a short term setback. However, its long term demand for commodities will be large and over time this will provide a strong source of growth for Australian exports. India is now Australia’s 4th largest export market, having risen rapidly from 7th largest in 2007 and 15th in 2001.

What about the Indian share market?

On most metrics the Indian share market is expensive. Its price to earnings ratio and its price to book value ratio is above that in other emerging countries and the world average and its dividend yield is far lower.

Source: MSCI, AMP Capital

A higher return on equity does provide some support for richer valuations, but having risen so rapidly this year to record highs and relative to other markets Indian shares are at risk of a short term set back. This could be triggered by short term uncertainties or setbacks regarding the reform process.

However, with the election ushering in a business friendly reform Government, which should be very positive for long term Indian growth, any short term set back should be seen as a buying opportunity. Over the long term Indian shares are likely to be relative outperformers globally.

Dr Shane Oliver
Head of Investment Strategy and Chief Economist
AMP Capital

 

Important note: While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) makes no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This article has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this article, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This article is solely for the use of the party to whom it is provided.

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