Why has the Federal Reserve deferred the decision to reduce its bond purchases and what can we expect for the US economy this year and the next?
The Federal Reserve surprised markets on 18 September with its decision to continue the current pace of bond purchases as part of its quantitative easing program. The explanation for this is that the Fed is still concerned about the softness in the labor market, as measures of employment growth and economic activity have not improved much since the begining of the year (average real GDP growth was 1.8 per cent for the first half), while core inflation metrics followed by the Fed are still well below the 2 per cent ceiling. At the same time, another factor weighing in their decision may have been the effect of rising interest rates on the housing recovery and related mortgage activity, paradoxically a result of the Fed's own tapering talk in the months prior. Finally, a factor that encouraged the Committee to adopt a wait-and-see approach was the looming fiscal debate in Washington over authorizing a new rise of the debt limit for the US Federal Government.
The Fed has reiterated that asset purchases are not on a preset course but remain contingent on economic conditions. So, in terms of the economy, our expectations are for economic activity and employment to pick up pace over the second half of the year. The fiscal drag from spending cuts and tax increases adopted earlier in the year, which are estimated to have reduced real GDP growth by about 60 bps, is expected to ease towards the end of the year. As a result, the economy could get closer to potential GDP growth of about 2.5 per cent , in the second half perhaps even a bit higher in 2014. The current stand off in Congress could create volatility in the markets and in sentiment indicators, but provided that some form of agreement is achieved soon it should not spoil the strengthening economy.
After two quarters of disappointing GDP numbers from China, what can we expect for the second half of the year?
The Chinese government have set a 7.5 per cent economic growth target for 2013 which is likely to be achieved but only with the aid of increased infrastructure spending and other growth oriented government policies.
In the first half of 2013 economic growth figures disappointed markets, but the Chinese government subsequently announced a mini stimulus package in July which included additional railway infrastructure spending, tax cuts for small businesses and cost reductions for exporters. We have already seen early signs of a boost to economic activity from the package, with a rise in key leading indicators such as industrial production, manufacturing sentiment indicators (such as manufacturing Purchases Manager Indices) and electricity production. The pickup is showing mainly in heavy industry firms and state related sectors, not much among small businesses and consumers. This is something similar to what happened in the second half of 2012. If the boost is sustained, growth is likely to exceed the government target for this year.
Looking beyond 2013, the government have set a 7 per cent average annual growth target for the next five years. The target may be more difficult to achieve than in past years because the historical drivers of economic growth, including strong export growth and high levels of domestic infrastructure investment, are no longer as effective for two broad reasons. First, Chinese export growth has consistently diminished since the Global Financial Crisis of 2008 due to a lack of demand from developed economies, with exports now contribution around 25 per cent to GDP, compared with 35 per cent before the crisis. And second, the productivity of capital has come into question as over-investment may have led to misallocation of resources. Because some investment spending has been financed with debt, there is also a growing concern about the sustainability of the public and private debt accumulated. If the productivity of capital is low, the ability to service and repay the underlying debt could be compromised.
In order to create a sustainable future economic growth model, the Chinese government will need to transition from the old investment and export led growth model to a domestic consumption led growth model. This will require significant economic and financial market reforms, including policies to encourage household spending. Ultimately, the economy should settle at a lower but more sustainable rate of growth.
Source: CEIC
In 2013 the unemployment rate has risen in Australia while economic growth has slowed. Is Australia heading for a slowdown?
In 2013 the unemployment rate has risen in Australia while economic growth has slowed. Is Australia heading for a slowdown?
In recent times the Australian economy has exhibited signs of softness
including below trend economic growth and rising unemployment, however economic
fundamentals remain strong and the probability of a sharp slowdown is small.
The observed softness is a result of weak global economic conditions in the first half of the year, particularly in Europe and the US, coinciding with the slowdown in China, and poor business and consumer confidence at home. The Reserve Bank of Australia (RBA) has cut interest rates to record lows to support the economy and is expected to maintain an accommodative stance while growth persists below its potential rate of 3 per cent . If the Chinese economy stabilises in the second half of the year while the US economy strengthens, we may also see some mild improvements in Australia growth and labour indicators.
The Australian economy is also undergoing a structural transition which has contributed to a dampened economic activity. Since the GFC, some recent historical drivers of domestic growth, most notably credit growth and mining investment, have started to fade. Credit growth was very high in the 2000's and following the 2008 Global Financial Crisis it slowed notably as households deleveraged. Mining investment, which contributed as much as 70 per cent to Australian growth in some years, has more recently slowed. There are two factors behind the slowdown in mining. First, commodity imports from China have increased at a much lower rate since 2008, and have been flat since 2011. This put an end to the commodity price boom, with most commodity prices still below the peak reached in early 2011. Second, past investments have created enough production capacity in this sector to meet the stagnant commodity demand. As a result, in coming years, mining companies will cut back on investment. Mining will still contribute to economic growth through strong exports, although other sectors of the economy will need to pick up the slack if overall real GDP growth rate is to be maintained at pre-2008 levels. Already we have seen some recovery in interest rate sensitive sectors such as housing, but others have been less responsive. The RBA remains confident that the structural transition will gradually occur with a return to trend growth in 2015.
The observed softness is a result of weak global economic conditions in the first half of the year, particularly in Europe and the US, coinciding with the slowdown in China, and poor business and consumer confidence at home. The Reserve Bank of Australia (RBA) has cut interest rates to record lows to support the economy and is expected to maintain an accommodative stance while growth persists below its potential rate of 3 per cent . If the Chinese economy stabilises in the second half of the year while the US economy strengthens, we may also see some mild improvements in Australia growth and labour indicators.
The Australian economy is also undergoing a structural transition which has contributed to a dampened economic activity. Since the GFC, some recent historical drivers of domestic growth, most notably credit growth and mining investment, have started to fade. Credit growth was very high in the 2000's and following the 2008 Global Financial Crisis it slowed notably as households deleveraged. Mining investment, which contributed as much as 70 per cent to Australian growth in some years, has more recently slowed. There are two factors behind the slowdown in mining. First, commodity imports from China have increased at a much lower rate since 2008, and have been flat since 2011. This put an end to the commodity price boom, with most commodity prices still below the peak reached in early 2011. Second, past investments have created enough production capacity in this sector to meet the stagnant commodity demand. As a result, in coming years, mining companies will cut back on investment. Mining will still contribute to economic growth through strong exports, although other sectors of the economy will need to pick up the slack if overall real GDP growth rate is to be maintained at pre-2008 levels. Already we have seen some recovery in interest rate sensitive sectors such as housing, but others have been less responsive. The RBA remains confident that the structural transition will gradually occur with a return to trend growth in 2015.
Source: ABS
What does this outlook mean for interest rates in Australia, considering that the RBA has already lowered rates to record lows?
What does this outlook mean for interest rates in Australia, considering that the RBA has already lowered rates to record lows?
The consensus outlook among market participants is for interest rates to fall a further 0.25 per cent by early 2014, to 2.25 per cent , and reverse by a similar amount later in the year. The RBA have signalled however a more neutral stance on interest rates following a two year period of monetary policy easing. The neutral stance means the next interest rate move could be up or down depending on the economic outlook.
At present key Australian economic indicators are a little soft with below trend economic growth and low, rising unemployment. The RBA forecast these indicators to return to more normal levels by 2015. If the forecasts are realised then interest rates will most likely remain on hold through 2014. However if the indicators do not improve and inflation remains around the lower end of the RBA's 2-3 per cent target range then the central bank is likely to cut rates again. A less probable outcome would be for interest rates to rise due to an upside economic surprise and rising inflation.
Given the low interest rate environment, should be investors looking for higher yield alternatives?
In the current low interest rate environment investors are increasingly reaching for yield in new places. What these investors may fail to realize is that moving away from a broadly diversified portfolio and concentrating on certain sectors can potentially result in a less diversified portfolio, increased risk, and/or an increased chance of falling short of long-term financial goals. The two most common trends among investors are to increase their allocation to (i) high yield corporate bonds and emerging market bonds which are exposed to significant credit risk; or (ii) dividend paying equities.
Increasing a portfolios allocation to high yield corporate and emerging market bonds would increase exposure to credit and sovereign risk. Credit and sovereign spreads tends to be highly correlated to equity markets, so during a bear market the bond portfolio has a greater probability of loss. A balanced portfolio is also likely to experience greater volatility owing to increased correlation between equities and high yield or sub investment grade bonds.
Increasing a portfolios exposure to dividend paying equities represents
a shift in asset allocation out of bonds and into equities. In this instance
the portfolio will experience greater volatility and is at greater risk of loss
during falling markets.
Investors who pursue these strategies must acknowledge the risks involved and understand that the strategy may result in a less diversified portfolio and a decreased probability of meeting long term financial goals.
Given that the world is now in a low economic growth, low interest rate environment should I expect both equities and bonds to underperform?
To answer this question let's consider each asset class separately. First, do low economic growth expectations imply low future equity returns? In short the answer is no. In a recent Vanguard research paper, ‘Forecasting stock returns: What signals matter, and what do they say now', we discovered that consensus GDP growth expectations have almost no power to predict forward equity market returns. The study showed that growth expectations are already priced into financial markets and that only economic surprises affect returns. In fact the best predictor of future returns is current valuations, as represented by the price to earnings ratio. Valuations are currently in the normal range for both Australian market and international equities so we therefore expect future returns to be consistent with the historical average, which is approximately 9 per cent p.a.
The second part of the question refers to the relationship between interest rates and bond returns. Studies have shown that the best predictor of forward bond returns is the yield to maturity of a bond. Given that current yields are so low it is reasonable to expect forward returns to underperform historical averages. This does not mean that investors should sell investment grade bonds and purchase higher yielding securities. Investment grade bonds play an enduring role in a portfolio even when returns are below average. Bonds act as a source of diversification to growth assets, and provide income and capital stability, which are particularly important during falling equity markets.
So, overall we expect the equity risk premium (the difference between equity returns and fixed income returns) to be wider than the historical normal.
However, we recommend investors to proceed with caution in rebalancing portfolios, as fixed income assets continue to serve a critical diversification and risk mitigation role.
Indices:
The Australian All Ordinaries Index has moved up increasing by +1.7% since closing last Friday to 01:00 pm today.
The rest of the world as measured by the MSCI index increased +2.0% in A$ from closing last Friday to end of trade Thursday.
Have a great weekend,
The team at IPS
Investors who pursue these strategies must acknowledge the risks involved and understand that the strategy may result in a less diversified portfolio and a decreased probability of meeting long term financial goals.
Given that the world is now in a low economic growth, low interest rate environment should I expect both equities and bonds to underperform?
To answer this question let's consider each asset class separately. First, do low economic growth expectations imply low future equity returns? In short the answer is no. In a recent Vanguard research paper, ‘Forecasting stock returns: What signals matter, and what do they say now', we discovered that consensus GDP growth expectations have almost no power to predict forward equity market returns. The study showed that growth expectations are already priced into financial markets and that only economic surprises affect returns. In fact the best predictor of future returns is current valuations, as represented by the price to earnings ratio. Valuations are currently in the normal range for both Australian market and international equities so we therefore expect future returns to be consistent with the historical average, which is approximately 9 per cent p.a.
The second part of the question refers to the relationship between interest rates and bond returns. Studies have shown that the best predictor of forward bond returns is the yield to maturity of a bond. Given that current yields are so low it is reasonable to expect forward returns to underperform historical averages. This does not mean that investors should sell investment grade bonds and purchase higher yielding securities. Investment grade bonds play an enduring role in a portfolio even when returns are below average. Bonds act as a source of diversification to growth assets, and provide income and capital stability, which are particularly important during falling equity markets.
So, overall we expect the equity risk premium (the difference between equity returns and fixed income returns) to be wider than the historical normal.
However, we recommend investors to proceed with caution in rebalancing portfolios, as fixed income assets continue to serve a critical diversification and risk mitigation role.
Indices:
The Australian All Ordinaries Index has moved up increasing by +1.7% since closing last Friday to 01:00 pm today.
The rest of the world as measured by the MSCI index increased +2.0% in A$ from closing last Friday to end of trade Thursday.
Have a great weekend,
The team at IPS
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