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The Bank of England surprised markets this week by doing its best to keep calm and carry on. The nine-person committee voted 8-1 to keep the bank’s benchmark rate at 0.5 per cent. When rates are that low, "cut with care" seems to be the message. The chart below shows how few arrows are left in the BoE quiver.
Still, the stoic resilience may only last a month before another cut is added to the 600-plus that have occurred globally since the GFC. The pound rallied, but the potential for falling UK property prices to hit the UK banking sector are real enough. That could have some significant knock-on effects, even as far as Australia is concerned, as Callam Pickering explained this week.
Six UK property funds have now frozen withdrawals – ‘gated’ is the new term, designed to allay panic but will probably create more if it. Asset values are being slashed to make the point: if you want out you’re going to have to pay. The Bank is also looking at "swing pricing" which isn’t as weird as it sounds: the greater the amount you want to withdraw the lower the price per unit you’re going to get.
Will these measures work? Possibly, although it might just as easily work the other way because stopping withdrawals in some funds might increase the desire for investors to withdraw from those not yet frozen. Panic is not something that is easily accounted for in economists’ models so it’s hard to say. Either way, as Chris Urwin – real estate analyst with one of the frozen funds, Aviva Investors – says, “forecasts now point to property returns declining.” Let’s hope that outbreak of independent thought doesn’t cost him his job.
If you remember the AREIT sector going mad in 2006, buying up overpriced US shopping malls and office complexes before imploding in the jaws of the GFC, that Yogi Bear quote about it being “deja vu all over again” might spring to mind. So might the suspension of two Bear Stearns hedge funds in 2007, which in retrospect was a pre-GFC warning bell that almost no one heard. Awful as it is to contemplate, we have to consider the possibility: Could this be the start of another financial crisis?
People that like to worry really are spoilt for choice right now. Wherever one looks, debt magically appears, in all its varying colour and forms. Right now the focus is on Italy, where banks have struggled to make money for about 400 years. As the chart shows, non-performing (read: bad) loans have shot up since the GFC, a fact that deeply concerns the Germans.
Here, one of the biggest problems with the EU hoves into view. With 10 per cent of the country’s bank assets held in government bonds compared with 3.2 per cent in Germany, the Italian banking system is unlike any other in Europe. In Italy, banks finance government expenditures. And yet the Germans are pushing for pan-European restrictions on how much sovereign debt a bank can hold. This might make sense to them but to Italians it makes none at all. Restricting a bank’s ability to buy Italian bonds looks like a backdoor way for the EU to impose austerity on Italy as it did on Greece, entirely unsuccessfully as it happens. This chart, via Zero Hedge, explains Italy’s real problem.
Italy didn’t suffer in the same way as Germany during the GFC because Italian bank debt was largely domestic in nature. Collapsing GDP since then is the heart of the problem, not poor lending. EU-imposed restrictions on what kind of assets a bank can hold won’t much change that fact, and may make it worse. Little by little, the EU is doing a fine job of turning ordinary EU citizens against it, giving succour to the French, Dutch, Italian and Spanish versions of Boris Johnson and Nigel Farage (please, try not to dwell on that mental image). They say that history repeats, first as tragedy, then as farce; but we’ll have to see whether that’s true for one of Europe’s great political achievements.
And so the rolling crisis continues. If Brexit won’t produce a change in the way that EU policymakers address the underlying problem of anaemic economic growth I’m not sure anything will, which probably explains why markets are so worried about Europe right now, to say nothing of problems with Deutsche Bank itself. In its half-yearly global financial stability report released into the wild last April, the IMF said that a third of eurozone banks faced “significant challenges” to be sustainably profitable and that structural problems included “excess bank capacity, high levels of NPLs and poorly adapted business models.”
China’s debt is another option on the worrier’s smorgasbord. The same IMF report said that, “a comprehensive plan to address the corporate debt overhang would assist a steady deleveraging process.”
That’s a polite way of putting it. China is up there with Japan in terms of debt but nowhere close to the institutional and economic resilience the country needs to support it. The terminology in the chart below makes the point. Imagine how the EU might have responded had Italy reported its debt was held in “letters of credit” and “entrusted loans”. But don’t worry, there’s a separate category for “informal lending” so it can’t be that bad. That’s a relief.
The upshot of all this is that the flight to safety is gaining altitude. The yen has surged and, incredibly, all Swiss bonds sport negative yields. The FT’s Alphaville reporter David Keohane tweeted this incredible chart on July 5:
What does a world where Swiss 50-year bonds offer a negative yield tell us? Probably that the future looks a lot like Japan’s did circa 1995. A rising gold price and, let it be said, new yearly highs on the ASX and all-time highs in major US markets tell us pretty much the same thing. When interest rates are next to zero or below, and showing no signs of rising, why not pay up for a little earnings growth and a measly yield in stocks? This Wall Street Journal chart sums up the shift in mentality that this change requires:
10% might be the new 15%
Twenty years ago retirees could get a nice 7.5 per cent return from bonds alone. Nowadays we’ve got to move up the risk curve, which is fine by me. One of the interesting features of the last few years is how yield has become relatively expensive and growth – especially in smaller stocks that most analysts pass by – relatively cheap. We’re finding more and more opportunities among smaller caps and have recently increased the size of our team to help you profit from them.
Still, getting even a modest return is getting harder and the macroeconomic environment ever more challenging. Baby boomers like me (I’m 53 but after following a punishing regimen of high fat, low vegetable foods for a few decades I can easily pass for 60) might feel we’ve been dudded by low rates but I’m beginning to think we got the best of it. Most of us had free tertiary education and if we didn’t we could still get work that paid enough to scrape together a deposit for a house. Then we rode the property boom and voted in governments that favoured our generation at the expense of our children’s. There was a price – the kids can’t afford to leave home so their parents have to go on constant cruises to get away – but that’s not so bad, depending on your sea legs.
If you were born just after the Second World War, you’ve probably done okay. The big question now is not how you’re going to triple what you’ve got but how you’re going to hang on to it, and eke out enough to live on when term deposits and bonds pay next to nothing.
I suspect one of the keys to that is moderating expectations. Those of us that have grown used to 10-15 per cent per annum over the past few decades might want to revise our projections down. Let’s just say that 10 per cent might be the new 15 per cent. The other is focusing on value in the stocks you buy rather than worrying about what’s happening in Europe, China or elsewhere. Buy stocks cheaply enough and you’ll usually find the macro risks are accounted for in the price. In fact, the presence of these macro risks creates the opportunities. The bond market could be wrong and circumstances can change dramatically, especially over long timeframes. But if you’re keeping things simple and focusing on valuation it need not matter.
Lastly – and assuming you can afford to – don’t get too hung up on yield. When a clear preference emerges – as is the case with dividends now – mispricings follow. High-yield stocks have been bid up by hungry income investors which has left companies reinvesting profits, often at far higher rates of return, in the dust. If you don’t care too much about where your returns come from, opportunities are plenty. And as the new all-time highs in US sharemarkets reveal – admittedly one area of the global economy that seems to be doing okay – owning a small slice of even a modestly growing business is a better option than almost everything else right now.
Deutsche Bank’s woes – its share price has slumped 42 per cent this year – have raised the spectre of a global financial shock.
As Callam Pickering writes this week:
“From Australian investors’ perspective, the main risk for our major banks is that they have become increasingly reliant on offshore borrowing to keep their books ticking over.
“Cheap foreign money has been great for short-term profitability and the share price of the major banks, but such activity carries its fair share of risks...”
Callam says investors can approach the spectre of a Deutsche Bank collapse in two ways. Read the full article here.
Facebook interns get paid $8000 per month. Not bad.
There was a big decision this week on China’s claims (up to 90 per cent!) to the South China Sea. The Lowy Interpreter has the lowdown.
Now the election is over, Ian Verrender wonders whether the global economy is going to cooperate with Malcolm Turnbull’s ‘jobs and growth’ mantra.
The UK Spectator on new PM Theresa May: ‘She may well turn out to be an unexpected radical’.
And that magazine also spells out – via six graphs – the progressive successes of David Cameron.
One more from the UK: The best of Britain’s new foreign secretary, Boris Johnson.
Need to get some work done this weekend? Try out this definitive list of ambient noise generators - the Eureka office’s picks are Jazz and Rain.
23 images of Australians during last week’s NAIDOC celebrations.
This Malaysian photographer claims he snuck into the exclusion zone in Fukushima, Japan to document the city five years after the nuclear disaster.
The Murdoch-owned Wall Street Journal says Donald Trump’s economic plan will see debt soar.
There is something about Hillary Clinton’s persona that seems uniquely vulnerable to campaigning.
And Bernie Sanders has finally endorsed Hillary Clinton. Will it help her?
Will Nintendo be able to harness the power of Pokemon GO long term?
What happens if you die while waiting for a Tesla?
Australian commercial lending levels are ’really dreadful’, Eureka Report contributor Callam Pickering noted on his macroeconomics blog.
A clever app is allowing Australians to donate to charity without spending a cent.
The Liberal Party lost all its Tasmanian seats at the election. This article explains what happened in one.
Are you ready for your consciousness to live in a computer after death?
Today’s the 70th birthday of the ‘First Lady of Rock’, Linda Ronstadt, who was voted best female pop singer of the 1970s. Here's her version of Roy Orbison’s ‘Blue Bayou’.
Shane Oliver, AMP
Investment markets and key developments over the past week
It has been “risk on” again over the last week in investment markets helped by a combination of good economic data in the US and China, good US earnings news and firming expectations of more policy stimulus in Japan. US shares have broken out to a new record high, European and Japanese shares have recovered much or all of their Brexit losses, global shares have broken their down trend from last year’s high and Australian shares have reached their highest for the year. On top of this commodity prices are doing okay, credit spreads have narrowed, sovereign bond yields have increased and the $A has moved up a touch.
So markets generally have moved on from the initial panic reaction seen in the days after the Brexit vote. What gives? Eight factors explain the rebound in investment markets: global policy makers have signalled easier global monetary policy for longer post Brexit;
• the decline in bond yields has further improved the relative attractiveness of shares;
• there doesn’t seem to have been a surge in support for exiting the EU or Eurozone in other European countries post Brexit. In fact as highlighted by the Spanish election it may be the opposite. Note of course the rest of Europe always saw itself as far more “European” than the UK ever did;
• global economic data has generally been good – there has been no sign of the much feared global recession;
• US profits are showing signs of bottoming helped by a stabilisation in the $US and the oil price;
• investors have been more relaxed about the latest decline the value of the Chinese Renminbi or RMB - perhaps reflecting slowing capital outflows from China, foreign demand for Chinese assets, reassurance from Chinese officials that a collapse in the RMB is unlikely and a growing relaxation about fluctuations in the value of the RMB;
• investors have realised that Brexit may be a long time coming and may be a Brexit lite; and
• all the talk seems to have been bearish lately – Brexit disaster, Chinese debt, US slowing, messy Australian election - which provides an ideal springboard for market gains!
Japanese PM Shinzo Abe’s coalition’s big upper house election victory on Sunday looks to have cleared the way for more stimulus in Japan with Abe commenting “I think this means I am being told to accelerate Abenomics..” A large fiscal stimulus package looks to be on the way and expectations of more monetary easing (probably at the BoJ’s July 29 meeting) have seen the Yen fall. Japan looks to be getting close to using “helicopter money” – where the central bank directly finances public spending or tax cuts with no implication that it has to be paid back – but it may not be used initially.
While the Bank of England did not ease monetary policy at its July meeting it clearly signalled easing ahead with the minutes noting that “most members of the Committee expect monetary policy to be loosened in August.”
Meanwhile, new UK PM Theresa May’s decision to give prominent Brexit Leave campaigners the task of seeing the job through has effectively put them on the hook to explain any compromises (eg around immigration to maintain free trade access) or to take some of the blame if it goes wrong. There is also a long way to as Article 50 of the Lisbon treaty may not be triggered till next year and by then a weaker UK economy (owing to negative Brexit confidence effects) could have dimmed support for it. So there is still plenty of room for Brexit lite or even no Brexit. Either way Brexit will be an ongoing issue, but I suspect markets will just learn to live with it along with all the other noise that surrounds them. The key is that if Brexit is demonstrated to be more trouble than remaining in the EU
Perhaps more fundamentally, PM May has signalled a focus on reducing the perceived injustices that helped drive the Brexit vote in the first place. While it’s clear that governments need to respond to rising inequality – particularly in the US and UK where its most evident - or face longer term risks, the danger is that a shift away from economic rationalist policies will ultimately threaten productivity and growth and hence investment returns much as it did in the 1970s.
The decision by UN’s Permanent Court of Arbitration in favour of the Philippines in relation to disputed “islands” in the South China Sea signals a step up in geopolitical risks in the region. This was particularly so after China’s Foreign Ministry declared the decision “null and void” and there was talk of China having the right to declare an Air Defence Identification Zone in the area. But an ADIZ was declared by China over disputed islands with Japan in 2013 and not enforced. In China’s Foreign Minister indicated a willingness to peacefully resolve the dispute through negotiations which the new more pro-China president of the Philippines may be amenable to. Lots of risks in the South China Sea but this could drag on for years and come to nothing despite occasional flare ups.
Major global economic events and implications
US economic data was good with a slight rise in small business optimism and continued strong data on job openings (albeit down slightly) and hiring and ultra-low jobless claims. The latest Fed Beige Book of anecdotal evidence saw the economy expanding at a “modest” pace, manufacturing “mixed but improved”, wage pressures “modest to moderate” and consumer inflation pressures “slight”. Fed officials have been sounding more relaxed about the US economy after the jobs data and regarding the impact of Brexit with the implication that the Fed is still on track for one rate hike this year. The US money market’s probability of a hike this year has now increased to 35% up from just 12% pre payrolls but still looks too low. That said the reality or threat of a rising $US will act as a strong constraint on how much the Fed will tighten.
Weak Japanese machine orders and wages growth highlight the pressure for further policy stimulus in Japan.
Chinese growth has stabilised. June quarter GDP growth was unchanged at 6.7% and while June data showed that investment and imports slowed growth in industrial production, retail sales, credit and money supply all came in better than expected and mostly picked up. So after a long period of deceleration Chinese growth looks to be stabilising just above 6.5%, which is good for commodity prices and hence Australia. Meanwhile producer price deflation continues to recede which is a good sign but CPI inflation remains very low (just 1.2% year on year for non-food inflation) indicating plenty of scope for ongoing policy stimulus.
Australian economic events and implications
Australian economic data was okay. While consumer confidence fell presumably in response to the messy election result, Brexit, etc, the fall was only 3% and leaves confidence at the high end of the range of the last few years. Meanwhile business conditions in June (albeit pre-election) were solid, home loans rose in May leaving in place just a moderately slowing trend, housing starts rose to a record in the March quarter and jobs growth continued in June. Our assessment remains that the RBA will cut rates again next month but with okay economic data it’s dependent on another low June quarter inflation reading due on July 27th. Falling retail prices in the June NAB survey certainly point in this direction.
Savanth Sebastian, CommSec
The domestic economic data dries up over the coming week. In Australia the Reserve Bank will dominate the calendar and hopefully provide us with more insight on interest rates with the release of the Board minutes. In the US the focus will be on the housing sector. And investors and traders will focus on the “flash” manufacturing data released across the globe (Friday).
In Australia, the week kicks off on Tuesday, when the minutes of the July 5 Reserve Bank Board meeting are released – the meeting that decided to leave rates on hold for another month. Investors will be hoping to get a better sense of central bank thinking from the Board minutes – particularly when it comes to the near-term economic and interest rate outlook. The statement following the ‘no change’ decision in early July, highlighted the level of uncertainty regarding the Euro zone and the last paragraph took on a slight easing bias – opening the door for another rate cut. We expect the minutes to focus on domestic outlook for inflation and growth and the stronger Australian dollar and potentially even open the door further when it comes to another rate cut in August. For the record we expect another 25 basis point rate cut next month.
The weekly consumer sentiment reading will be released on the same day (on Tuesday). Confidence levels have fallen for the past three weeks, down by 3.1 per cent. It is pretty clear that the uncertainty surrounding the outcome of the Federal election dampened confidence. However, confidence levels should now improve given the certainty of a majority government.
On Thursday the NAB quarterly business survey is released alongside the June detailed labour market statistics from the ABS. The industry make-up of employment was released last month, but Thursday’s data will have regional and demographic detail on the job market.
Overseas: US housing sector in focus; “Flash” manufacturing gauges
The flow of Chinese economic data has dried up, so the US takes centre stage in the coming week. And the focus will predominantly be on the housing sector. However investors will also keep a close eye on the European Central Bank meeting on Thursday – where there a range of expectations on the degree of stimulus. In addition the “flash” manufacturing gauges from across the globe are released on Friday.
The week begins on Monday when the National Association of Home Builders (NAHB) index is released.
On Tuesday, two key indicators on the housing sector will be released – housing starts and building permits. US annualised housing starts are tipped to lift from a 1.16 million annual rate to 1.17 million in June. New building permits are expected to have risen by 1.2 per cent in the month.
On Wednesday the usual US weekly data on home purchase and refinancing is issued.
On Thursday, the Federal Housing Finance Agency issues its May data on home prices alongside the weekly data on new claims for unemployment insurance, the Philadelphia Fed business index, existing home sales and the leading index for June. Economists tip a near 1.5 per cent fall in existing home sales to a 5.45 million annual rate in June after a 1.8 per cent gain in May. Some believe a housing shortage exists with only 4.7 months of stock on hand, below the 6-month figure regarded as balanced between demand and supply. Home prices are currently 5.9 per cent higher over the year.
On Friday, the Markit “flash” readings on manufacturing activity are released in the US as well as Europe and Japan.
Sharemarket, interest rates, currencies & commodities
The US earnings season cranks up a notch in the coming week. And while hopes aren’t high for a good season of profit results, the contrarian view may prove more rewarding. Concerns for analysts and investors centre on the higher US dollar over the past year, low oil prices and the resulting hit to corporate profits, especially in the energy sector
According to S&P Global Market Intelligence, earnings amongst S&P 500 companies are expected to slump by 5 per cent from a year earlier – marking the fourth straight quarterly declines.
Interestingly the weakness will be dominated by the energy sector, where forecasts anticipate an almost 80 per cent slid in second quarter earnings compared with a year ago. In fact excluding the energy sector, S&P 500 earnings are expected to fall by a more modest 0.4 per cent.
The financial sector, is expected to be under pressure from compressed margins and higher costs. The S&P financial sector earnings are forecast to have fallen by 7.6 per cent in the second quarter.
On Monday, 31 stocks are expected to report including Bank of America, Hasbro, and Netflix. On Tuesday there are another 70 companies listed including Goldman Sachs, Johnson & Johnson, Microsoft and Yahoo!. On Wednesday earnings results are expected from 85 companies including American Express, Ebay, Halliburton, Mattel, and Morgan Stanley. On Thursday 120 companies should issue profit results including D R Horton, Domino’s Pizza, General Motors, At&t, Unilever and Visa. And on Friday there are 33 companies listed including General Electric, Honeywell, and Moody’s.