Friday, June 28th, 2019
To develop a view on the outlook for investment markets over the coming year, we must commence by reviewing both the performance of major assets markets, and the driving forces creating headwind over the last 18 months.
It has been a highly volatile period affected by shifts in monetary policy and this seems likely to continue for the foreseeable future.
First, there was the poor 2018 calendar year where returns across most (trading) asset markets were negative and drove balanced returns towards zero. It was notable that defensive assets (bonds and fixed income debt) generated no return whilst listed growth assets declined. However, away from listed markets, unlisted direct property and mortgage backed securities maintained steady income returns.
The table below highlights the particularly bad returns from both oil prices and European (particularly German) equities. The latter is significant because the feeble DAX Index return of -18% was generated as German ten-year bond yields dived down from 0.6% to 0.2% through 2018. Over the first half of 2019 German yields have fallen to negative 0.2% but the German equity market has rebounded strongly.
When we review the first half of 2019, we see a different return profile with an equity market recovery and lower bond yields pushing 3-month, 1 year and 3 year “balanced returns” back over 8% per annum.
Over recent months, there has been heightened volatility in offshore equity markets as the China-US trade war escalated. The resultant weak AUD has pushed the 12 month rolling international equity return from 1% (in local currency) to over 8% in AUD (unhedged).
Another feature has been the extraordinary return from Australian bonds, which have generated a 9% return over 12 months and with ten-year yields rallying from 3% to 1.5% (an all-time low yield). It is pertinent to note that for a similar return to be replicated over the next 12 months would require ten-year yields to approach zero. That would require the introduction of a sustained Quantitative Easing (“QE”) policy by the RBA (we will return to this possibility later).
Another standout has been Australian listed property securities (A-REITs) where market prices moved from slight discounts to NTA to an average of a 10% premium. The rally in property security prices pre-empted the RBA cash rate cut and reflected a general decline in bank term deposit rates. The performance is very much generated by the chase for yield and particularly by retail investors and savers.
The volatility of equity prices across the world is captured in the next graph, which shows that US stocks have generated the best return over 17 months – approximately 10% (in USD terms). But there are two other observations from this graph.
- The return from US equities over lesser periods has moderated. For instance, the S&P500 is virtually at the same level as in September 2018 and only mildly above the February 2018 level; and
- The MSCI World Index has risen by just 3% with gains in the US and Europe offsetting losses in Japan and emerging markets.
The last few years have seen rollercoaster movements in both equity and bond markets as asset managers grappled with the prospects of lower growth, trade wars, more QE and sustained interest rate cuts.
The Trade War
The trade negotiations between the US and China is complicated and made more so by President Trump’s desire to achieve too much too quickly. The two way trade deficit for the US (or trade surplus for China) is approximately US$400 billion. To rectify this seemingly requires a focus over a longer period (say, a decade) by creating a pathway and then maintaining the agreed course. The aim – to adopt China’s language – should be to create a “win win” solution.
Logically, this would involve the US steadily replacing imports that currently flow from China, either with local production (replacement) or with imports from third countries (e.g. Vietnam or Mexico), and China increasing its imports from the US in specific areas where there is competitive price or quality advantage.
It is these opportunities that should be focused on first. The US should negotiate greater access for energy, food and services exports to China. Concurrently China – possibly through capital investment – should agree to allow a transfer of Chinese production to the US mainland. It is this second part that is most difficult to structure. It will require unrestricted transfers of capital to replace or replicate the productive mechanisms inside production lines that are currently sourced from inside China.
The logical pathway should have an agreed target (timeline) whereby the US to China trade deficit is progressively reduced. A good plan would aim to increase US exports to China by, say, $10 to $20 billion per year, with Chinese exports to the US to reduce by a similar amount. Thus, over ten years the deficit could be reduced and possibly eliminated.
However, there is a problem with my view. The respective negotiators have different time constraints determined by their electoral or administrative cycles. Trump has an election in November 2020 and may achieve another 4 year mandate. The Chinese Administration under Xi Jinping has no time constraint over its governance of China. The pressure is thus on Trump to quickly deliver and/or show that the US has the upper hand. In any case, the Chinese would realise that he has limited capacity to lock in future US Administrations. Indeed, China knows that Trump does not have bi-partisan, international, US business or broader market support for tariff walls.
Some context of the Trade War
The total US trade deficit widened in 2018 to a 10-year high of $US621 billion despite President Trump’s pledge to reduce it. It was Trump’s policy to introduce tax cuts that boosted domestic demand for imports while the strong USD and retaliatory tariffs weighed on exports.
More importantly, the merchandise-trade deficit with China hit a record $US419 billion in 2018.
For goods only, the US deficit with the world surged in 2018 to a record $US891 billion in 2018 from $US807 billion the prior year. The merchandise deficits with Mexico and the European Union also hit new records.
However, there is a continuing positive development inside the US trade account, with the surplus in trade services rising to a record $US270 billion. In fact, the US is by far the world’s dominant exporter of trade services and services with high growth potential for the US include sectors such as travel and tourism, environmental and transport services, banking, insurance and financial services, education, training and professional services.
As mentioned above, trade in services includes tourism and education. China is the largest destination for US tourists in the Asia-Pacific and the US is the largest overseas destination for Chinese students. The two-way trade in services has risen from US$27 billion in 2006 to US$125 billion in 2018, a 3.6-fold increase. In 2018, China’s services trade deficit with the US reached US$48 billion.
The US trade deficit is with the whole world and not only with China. As the graph below shows, the trade deficit (measured against US GDP) has been constant with both China (2% of GDP) and the RoW (4.25% of GDP). It is observable that the deficit has grown at roughly the same rate as US GDP.
As the US GDP has grown, so too has the USD trade deficit in USD terms. The total US trade deficit in the March quarter of 2019 was about 10% greater than the same corresponding quarter of 2017. However, the makeup of this deficit (particularly in March) changed as the Chinese deficit declined and the RoW deficit increased.
The US is a large consumer of imported goods (part-made or finished) and this has grown at a faster rate than incremental US GDP. It is not dissimilar to many other advanced countries (including Australia) which transferred manufacturing capability to China as it became a reliable (from about 1990 onwards) and cheap source of product.
In terms of world merchandise exports, US–China trade represents about 22% of total world trade. Therefore, it is very significant, and any dislocation will influence total world trade and growth figures.
The next graph shows that world growth is slowing as the US engages in aggressive trade tactics against China, Mexico, Canada and parts of the Eurozone.
Trade dislocation has resulted in a devaluation of those US companies that have the greatest percentage revenue exposure to China. The graph below shows that the prior gains in valuation in early 2018, driven mainly by Trump’s corporate taxation cuts, have been given up as the trade war rolls forward. In 2017, the total annual sales revenues of US-invested companies in China were US$700 billion, with profits exceeding US$50 billion. Total investment by US companies in China is estimated at US$80 billion and only slightly greater than Chinese investment in the US of about US$75 billion.
Interest rates, earnings and the yield chase
The world’s major central banks – the US Federal Reserve (Fed), the ECB and the Japanese central bank – are grappling with slowing world growth that has been accentuated by the trade dispute. Whilst the use of the main monetary tools of QE and interest rate settings has been excessive, they are still being maintained and relied upon.
For instance, up until January, the Fed had embarked on a path of monetary policy normalization characterized by sequential 25-basis-point hikes in interest rates and an “auto pilot” contraction of its balance sheet. By March of this year, this policy stance had given way to the Fed signaling no more policy hikes for 2019, and to adopting a glide path to a September end to the balance-sheet-reduction program. Recent commentary now suggests that interest rates may be cut in the next few months and there is a market expectation being built into market prices.
Today the world’s bond markets are characterised by historically low yields with about US$11 trillion of negative yielding bonds. Since mid-2016, bond yields have steadily declined as many developed economies encountered anaemic growth.
The world’s economic cycle, particularly for the larger developed economies, appears to be oscillating between below average growth that is intermittently followed by mild downturns. A Japanese-like economic syndrome seems to have arisen from the excessive use of QE and the maintenance of negative real cash rates. The term “Japanification” reflects a situation where interest rates are permanently pinned at or close to zero and deflationary pressures take hold. The ageing populations across Europe, Japan and the US, with lower birth rates and stagnant wages, add to the pressures.
The setting of sustained lower bond yields and cash rates is causing two significant investment problems – particularly for pension funds.
First, moderating growth is compressing the earnings of major multinational companies, mainly in the US, and we see this in the chart below.
Second, the yield compression has extended from bond markets into corporate and money markets. The challenge for low risk yield investment is shown in the next chart. Twenty years ago, a passive investor could generate a 5% yield from a low risk government bond portfolio. That yield was 2% to 3% above inflation. Today, bond yields extending out to ten years do not cover inflation, with many international bonds having negative yields. Targeting a 5% yielding portfolio requires today a blend of corporate debt, hybrids and mortgage-backed securities. In the present environment, government debt is of limited utility in the quest for yield.
The yield compression of today is the result of a 30+ year bond market rally. The last ten years of this rally has been enhanced by QE. It has been a phenomenal period for bonds as yields compressed and inflation wilted away. The compound returns from bonds match that of growth assets like equities.
Looking forward, the returns from bonds are set to decline and at some point capital losses are likely if QE is relaxed or inflation reappears.
Quantitative Easing will likely come to Australia
We remain positive for the outlook for Australia and expect its economic growth to exceed that of most other developed economies. This view is informed by observations of trade and expected population growth.
However, we believe that Australia will succumb to the pressures of international monetary policy, the deflationary cycle and the need to deal with excessive household debt.
We expect that Australia will adopt policies that have been used overseas and which now form the basis for the expression “Modern Monetary Theory” (MMT). This theory suggests that sovereign nations (those that issue their own currency) do not face financial budget constraints. Their fiscal or financial deficit can be funded by everyone else’s surpluses which can be created by printing currency.
MMT is confronting to conventional economic thinking. It has developed following the responses and mechanics of QE across Japan, Europe and the US in the wake of the GFC. The success of QE is not measured in economic growth but in the observation that it has neither created an economic catastrophe nor a massive inflationary surge. It has driven down bond yields so that highly indebted governments can trade on, or “kick the can down the road”.
The proponents of MMT argue that sovereign countries need not worry about fiscal deficits for they can be funded by creating monetary surpluses. This argument will continue to gather acceptance for as long as deflationary pressures persist. However, along with deflation has been slowing economic growth and this has now reached Australian shores.
Recently, the RBA reduced its economic growth forecast to 2.75% for 2019 from its previously forecast 3% while consumption growth, which makes up 60% of the economy, was reduced to 2% from 2.75%. In coming quarters, we expect that growth forecasts will be cut further.
Australia’s growth so far in 2019 has been supported by exports (as LNG exports come onstream) and direct government (public) expenditure. These sectors have offset the weakening residential building sector and soft business investment (particularly in working capital). Labour productivity has also been on the wane with a sluggish 0.4% growth reported in 2018 – well below the long run trend of 2.2% growth.
The development of LNG has been impressive, and Australia is now the largest supplier to world markets. Concurrently, iron ore prices have continued to hold at levels around $100 per tonne and, with LNG, have helped drive Australia’s trade account into a healthy surplus.
Outside resources or energy (and much like the US), Australia has abundant trade potential in services (especially tourism and education) with China. The table below gives an interesting insight into the opportunity with China and the emergence of tourism and beverages companies that are attracting the interest of the burgeoning inbound tourism sector.
Australia’s trade opportunity extends past China and a focus on Indian consumers must soon develop. The opportunity is enormous and the next table which focuses upon a very basic aspect of Indian development creates an interesting possibility for a closer trade relationship. It is worth remembering that Australia was once at the forefront of the development of the two flush system.
However, these positive opportunities are currently being overwhelmed by the excessive level of household debt following the housing price bubble. Further, the Australian economy is being managed with a lack of co-ordination in economic management across monetary and fiscal policy. The political imperative to balance the Commonwealth budget will soon give way to economic reality.
This leads us to speculate on what lies ahead for Australia’s monetary policy settings and the likely drift into some form of QE over the next two years.
First, we believe that at some point the RBA will move from cutting interest rates (aimed at protecting over-geared residential borrowers, many with negative equity) to a program of asset purchasing. This program will be introduced when it becomes apparent that extremely low cash and borrowing rates do little to stimulate economic activity or lift residential property values. Indeed, there is much overseas proof that lower rates can deflate an economy. Thus, the RBA will eventually conclude that it is better to buy the bad loan books (using QE) from the banks and deal with them outside the financial system. If readers believe this is far-fetched, then simply ask yourself why this is any different to the ECB buying Italian bonds, or the BoJ buying Japanese property securities?
Second, the driving down of long term bond yields will eventually create a significant financial problem that only QE can nullify. Thus, in many countries where bond yields have been compressed, it has become the norm for QE to continue even though it is no longer theoretically needed. This is because it is extremely difficult to reverse low bond yields once they are embedded in the financial system. The capital losses that would be felt across the financial system, particularly by banks, insurers and pension funds if long term yields rise would be catastrophic. At that point, QE becomes a perpetual band aid.
Now that the RBA has succumbed to lowering interest rates in the face of local market and international pressure, it has set in motion a course that will naturally lead to QE at some point. Today, Australian long term bond yields have reached historic lows, with ten year bonds yielding less than inflation. A further surge down in yields to, say, 1% would force the RBA to intervene.
Whether that is MMT or not, does not matter. It is the consequences for financial markets and the effect on investment returns that will.
What does this mean for investors?
While unconventional monetary policy has been in existence for a decade: this is a relatively short period for observation in the history of the financial world. Thus, the winding up of QE and the lowering of interest rates has been a “one way affair” to this point. The flipside of the unwinding of excessive monetary stimulation has not been observed and can only be speculated upon.
However, we can predict, based on the observation of overseas central banks, that once the RBA starts on unconventional policy and supports the market for low interest rates, it will be present for a long time. The unwinding will be delayed for as long as possible.
Thus, we are likely to see and feel the effects of lower interest rates in Australia for quite a while and this will mean that returns from all investment assets will succumb to deflationary pressures.
In the early stages, there are capital gains made as yields crunch and this explains the returns from bonds and A-REITs over the last year. There will also be growing support for high yielding equities and hybrids. Passive investors will drift out of bank deposits into other higher yielding (but riskier) investments.
At some point, most of the value of income returns (present value) will be fully priced into markets and overall returns will begin to stagnate, or market prices will oscillate allowing returns for active asset managers to be generated.
The logical offset is to seek growth in emerging or developing economies and particularly by focusing on international companies that have products or services that are well respected and sought after. What upsets this logic is the current trade war that surely must be settled at some point.
Over the next few years, portfolios must be set to generate sustainable yield, above inflation, with an eye for capital maintenance.
A balanced approach with good diversity across asset classes is suggested with the allocation requiring a deep and comprehensive understanding of an individual’s circumstances.
Investors should be willing to accept lower returns and appreciate when these returns are exceeded, or when asset market declines are to be avoided.
We have little doubt that at some future point we will endure challenging times. These challenges also bring opportunity and it will be the enduring focus on the fundamental process, the diligence to complete the research and the patience to hold the spotlight on a long-term horizon that will build value over time.