It is our view that the financial year 2016/17 will be one where the current currency battles develop into outright currency war. Over the past few years, the major economic powerhouses have attempted to stoke economic growth through holding down or driving their currencies lower. However, what is defeating their efforts is the obvious fact that currencies are abundant in number and are relatively priced. Hence currency battles occur on many fronts.
Of the majors, it is only China that has a semblance of control over its currency through its dynamic peg with the USD. China undertakes its exchange rate policy for its sole benefit. This is illustrated in our first chart which shows that the Renminbi (the Chinese currency) has devalued by about 10% against the USD over the last year, despite its reported economic growth being three times that of the US. Concurrently, China runs a consistent trade surplus against the US, so why should its currency devalue?
Figure 1. Renmimbi Exchange Rates (RMB per $)
Source. Bloomberg, Capital Economics
Across the developed world, Central Banks are battling to hold down their currencies to stimulate export growth and trigger inflation on imports. However, their strategies to push their currencies lower are becoming increasingly ineffective. The next chart show that 10 major economies now have negative 5 year bond yields. None of these countries are reporting a surge in growth from lower interest rates; these yields reflect a failure of monetary policy.
Figure 2. 5 year developed government bond yields (%)
Source. Bloomberg, QIC
The result is that economic growth is stalling, requiring yet further unconventional responses. When quantitative easing (QE) commenced, it was labelled as “unconventional”. Today it has become the norm, and was recently reintroduced in the United Kingdom. If there are new unconventional policies adopted, then a real currency war may be the outcome.
This could stall the momentum for free trade and restrict capital flows across the world. While policy settings for free trade and open economies are noble ambitions, they are not possible unless all major participants adopt them and abide by basic rules of engagement. We shudder to think what a President Trump might mean for global trade; hopefully this still represents a low probability risk.
The largest Central Banks have seemingly lost control of their policy settings while smaller players (like Australia’s RBA) are held hostage to interest rate and currency manipulation. It seems that the G20 leaders forum (which reached its zenith in February 2009) has lost its ability to co-operatively address major international issues and create the framework for growth.
Back in early 2009, the G20 came of age when it co-ordinated a world wide response to the GFC. Massive fiscal stimulation and the underwriting of major financial institutions dragged the world back from the economic abyss and depression was averted. However since that date, many members of the G20 have simply maintained policies to protect themselves from the rigours of the market place. The clearest examples are the open-ended quantitative easing programs that have meant that bankrupt countries need not restructure their economies, and cash rate settings at or below zero that have driven long term bond yields to negative in both Europe and Japan. Bond defaults have been averted because governments are required to pay hardly any interest on debt they cannot possibly repay.
* Main refinancing rate until the introduction of 3-year LTROs in December 2011; deposit facility rate thereafter
** Since April 2013, the bank of Japan’s main operating target has been the money base
Figure 3. Policy Interest Rates – G3
Source. Central Banks
Today, the G20 struggles to formulate a co-ordinated strategy to deal with sluggish world growth, burgeoning debt, zero interest rates and the growing wealth divide. This continued failure will lead many countries to initiate independent strategies focused upon their own well being. As that occurs, more volatility in markets will occur with some economies benefiting while others falter. Unfortunately such policies will create even further instability.
It is our view that Australia would prosper by taking constructive steps to mobilise the abundant superannuation capital at its disposal. Australia should review its open market rules as it relates to countries that undertake interest rate and currency manipulation, open ended quantitative easings, covert trade barriers and significant under-payment of their workforces. Unfair advantages take many forms, but manipulation should not be meekly accepted. The adjustment of cash rates, like that undertaken recently by the RBA, simply seeks to buy time while we wait in hope for the US Federal Reserve to lift its interest rates.
Clearly the recent cash rate cut was a response to international interest rate settings and it was forced upon Australia. Our open economy framework has driven growth for the past few decades, but unfortunately it will likely detract from growth in this current era of economic manipulation. We forsee a period where Australia will need to respond to slow growth and offshore interference with unconventional (for Australia) policies that protect and enhance our economic prospects. While a form of Australian QE is likely if the major Central Banks continue with their policies into 2017, we forsee that foreign capital controls might also be a legitimate response.
Rather than cutting interest rates and destabilising our economic growth, it seems logical to take affirmative action. QE and capital controls would either buy out or scare off foreign short term capital (that is holding up the $A) by owning the majority of our government debt. Further, we should encourage longer term foreign risk capital through an adjustment to tax rates on export income. Australia should think and act independently – thereby respond to the US, Europe, China and Japan which are each undertaking policies for their sole benefit. Australia will be forced into action, but forecasting the timing is near impossible given the current political landscape.
Key issues for Australia in 2016/17
- Maintenance of low cash rates in response to international settings;
- High foreign debt;
- Low export commodity prices;
- Continued growth in services economy;
- Inflated currency against poor trade outcome;
- Low wages growth;
- Chinese tourist demand strong and growing;
- Solid population growth; with
- Political quagmire.
We put the following charts forward to explain why Australia must be both careful and forthright in its response to growing global currency tensions. The first chart shows that Australia has over the last two years significantly increased the level of net foreign debt. At 62% of GDP, this level of net debt is historically high and it has grown steadily for the last 25 years. The good news is that the maturity of the debt has been extended from short term to longer term as lenders world wide have chased yield. Unlike 2008, Australia is no longer greatly exposed to short term borrowings and thus less vulnerable to a short term spike in interest rates.
* Short-term includes debt with residual maturity of one year or less; long-term includes all other debt
Figure 4. Net Foreign Liabilities (by type, per cent of nominal GDP)
The next chart matches gross foreign debt and gross foreign assets. While the balance between the two sides is a trillion dollar deficit, it does show that Australia’s net imbalance would greatly improve if the $A devalued. This is because the great bulk of our foreign debt is in $A while 50% of our foreign assets are in foreign currency.
* Hedge ratios inferred from ABS Foreign Currency Exposure surveys
Figure 5. External Position (Composition after hedging, quarterly)
Source. ABS; RBA
Thus a rise in the $A (currently occurring) has two detrimental effects on our net external position: as commodity prices remain weak, export income declines (unless volumes dramatically lift); and second, the rising $A devalues our offshore assets.
Australia cannot withstand a higher currency for it adversely affects national income, thereby putting downward pressure on wages and incomes across the economy. The next chart shows that wages growth is at is slowest level in twenty years, and should this continue (combined with low bank deposit rates), Australia will suffer from slowing household consumption.
Figure 6. Wage Price Index Growth
An offset to slower consumption growth could come from additional credit, but that would require a lift in consumer confidence and an increase in Australia’s already bloated household debt levels. One positive is the growing consumption coming from the influx of Chinese inbound tourists. They will continue to add to retail sales and stimulate the services part of the Australian economy.
* Disposable income is after tax and before the deduction of interest payments
** Excludes unincorporated enterprises
Figure 7. Household Finances (Per cent of household disposable income*)
Source. ABS; RBA
Outside the household sector, Australian business is passing through a period of investment malaise. While business investment was buoyed by the resources boom, the rapid decline in investment is now close to twenty year lows (when measured against GDP). The transitioning of the economy is occurring and today’s dynamic emerging businesses are not capital hungry enterprises. It is these emerging companies rather than the traditional large capitalisation and capital hungry companies that will prosper. Thus, equity investment portfolios must adjust in response.
* Adjusted for second-hand asset transfers between the private and other sectors
Figure 8. Business Investment* (Share of nominal GDP)
Our final chart in this section focuses on inflation. Central Banks are desperate to stoke inflation, but the emergence of cheap Chinese manufacturing, low energy prices and excess labour supply has worked against inflationary pressures. Even the depreciation of currencies is having a limited effect and Australia is a prime example. The 25% depreciation of the $A over the last three years has done nothing to move inflation – which today sits at 30 year lows.
* Excluding interest charges prior to the September quarter 1998 and adjusted for the tax changes of 1999-2000
Figure 9. Consumer Price Inflation*
Source. ABS; RBA
All of the above leads us to conclude that based on current economic settings, Australia will maintain a low growth trajectory of about 2.5% (real, that is, after inflation). This growth is below our long term average and suggests that the economy will remain constrained unless the $A depreciates towards US70 cents.
Figure 10. GDP Growth
We maintain our view, which we suspect is shared by the RBA, that the Australian economy will be seriously challenged if the Australian dollar appreciates towards US80 cents. In a war of currency depreciation, Australia may become an unfortunate casualty if it does not have proactive policy settings.
A purposeful and proactive approach to equity investing
Earlier in this letter, we outlined the difficulties of the present world economy and the possibility of an affirmative economic policy response in Australia. Unfortunately, investment cannot be undertaken by speculating on government policy development – no matter how logical or persuasive. Rather we invest on the basis that current policy is maintained, world economic manipulation continues and a currency war unfolds. However, we will keep a watchful eye on any change in policy.
Therefore, based on current policies enduring, we expect that there will be continued equity price volatility and poor returns from large Australian companies. The end of the resources capital investment boom and the maintenance of low cash rates require a considered investment approach. What follows below are the major considerations for equity investing and our suggested tactical responses.
First, it seems likely that the bulk of the large-cap Australian companies represented in the ASX 20 are in for a challenging period. They will struggle to grow earnings due to a variety of factors. Major banks will require more capital and suffer declining margins from sustained low interest rates. Resource companies are confronted by oversupplied commodity markets and slow world growth. Retailers and Telecommunications companies are engaged in fierce price wars to hold market shares. Builders will be trading through a construction market that has clearly peaked.
Second, the supportive growth trends are better represented in the middle part of the Australian equity market. There are discernible growth trends across inbound tourism, heath care, aged care, retirement living, education, financial services and IT development. Recent success stories abound in this part of the market and the outlook remains strong.
Third, the Australian economy is transitioning from a resources base to a services base. The ultimate success will be judged by the transitioning in composition of Australia’s exports. The cycle is currently shifting from bulk commodities, through energy and into value added services and manufactured exports. A key support mechanism for this transition will be a low $A. The transition of exports needs substantial assistance and a long period to transpire. This supports our thesis that the $A will remain low for a sustained period and supports a level of international investment in the portfolio.
Given the above, we believe the Australian and international parts of equity portfolios can be built into purposeful sub-portfolios to capture the above opportunities, and to move away from the low growth part of the Australian equity market. The following are key characteristics of a purposeful equity management approach:
- An international portfolio should be maintained, but with a constant overlay view on currency exposure. While multi-national companies with highly recognisable brands demonstrate better value and quality than large-cap Australian companies, there is little doubt that valuations are becoming stretched. The international portfolio should target a return from currency and stock gains of 8% above inflation;
- The Australian large-cap companies are solid dividend payers. Solid dividends with franking are valuable in generating returns for pension and superannuation funds. Some exposure to Australian large-caps should be maintained with returns predominantly from dividends. The targeted return from this portfolio will be 6% above inflation; and
- The middle capitalisation and emerging part of the Australian market should be targeted with a sub-portfolio that provides capital growth and some yield. The targeted return from this sub-portfolio will be 8% above inflation.
Projected returns across all asset classes
With volatility in asset prices comes volatility in asset returns. The last few years, marked by extreme use of monetary policy around the world, have led to some extraordinary outcomes for investment asset classes. The following table from Vanguard presents nearly 30 years of asset returns and shows that selecting asset classes is as critical to overall returns as is the ability to stand aside from markets when trouble is brewing.
Figure 11. Financial year total returns (%) for the major asset classes
Our observations from the above table are as follows:
- The Australian equity market index has over the last two years returned well below its long term average. Given the index is dominated by banks and major resource companies, we see this as continuing. As outlined above, we recommend a purposeful structuring of portfolios to focus on the mid-cap area;
- International equities (hedged and unhedged) produced a poor return last year. The $A was not as weak as expected because of manipulative monetary policies across Europe, China, Japan and the US. Recent economic indicators in the US suggest reasonable local conditions for US corporations. Thus, selective US companies appear attractive, but the index looks elevated at record highs. We remain unexcited about the outlook for European and Japanese equities. Emerging markets continue to be speculative and uncertain. A weaker $A in 2016/17 will enhance returns from the US equity market;
- Australian bonds have performed well over the last few years. Indeed, total returns have matched international bond returns where price bubbles have now appeared. Given Central Bank policies and the likelihood of currency wars, international bonds may hold their prices but total returns (interest and capital gain) will be poor. Without active intervention to stem foreign ownership of Australian bonds, there seems a likelihood of further gains in the Australian bond market. However, the yield and total returns do not justify the risk of owning bonds at this point;
- Australian cash yields have crashed, but Australian retail investors will benefit if banks continue to chase stable retail funding. The recent lift in one year term deposit rates to 3% presents a positive real return for savers, but remains well below long term averages; and
- Listed property securities, local and offshore (unhedged), have seen extraordinary returns over the last two years and well above what is regarded as sustainable. To some extent, the returns are still recouping the disasters of 2008/09, but we observe that listed property securities can trade at anything up to 20% above the value transacted on direct property markets. Clearly listed property has been a major beneficiary of monetary policy settings, massive bond rallies and the chase for yield. The trend seems likely to be maintained for 2016/17, but at some point a price correction will occur. In our view, direct property presents as a better alternative.
Written by John Abernethy, Clime’s Chief Investment Officer.
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