Caton's Corner - July 2013
At the current low point for this correction, during the day on 13 June, the Australian market was down by more than 10% from its 14 May close of 5221. That low point may, however, be challenged on 21 June.
There is no doubt what the major international force driving markets is: the continued concern that the Federal Reserve may end its programme of quantitative easing (QE). QE expands the Fed's balance sheet, and the chart below shows the apparent effect this has had on the US share market in recent years.
Source: Deutsche Bank, Bloomberg Financial, L.P.
Earlier this week, in a press conference after an FOMC meeting, Fed Chair Ben Bernanke indicated that the Fed is likely to begin to "taper" QE - that is to buy fewer long-term securities than the current $85 billion per month--before the end of 2013, with an eventual aim of ceasing such purchases altogether by mid-2014. Note that this wasn't a statement of what the Fed will do so much as a statement of what it plans to do provided that the economy still shows consistent signs of growth.
Note also that "tapered" purchase would still result in further expansion of the Fed's balance sheet, so if the above chart has any meaning that should still be consistent with a rising share market.
The share market fell significantly that afternoon, and again on the following day. Meanwhile, long-term interest rates have risen sharply, with the 10-year bond rate now at 2.44%, from 1.64% as recently as 1 May. This, in turn, causes mortgage rates to rise and thus calls into question the ongoing housing recovery.
I continue to think that market analysts are jumping at shadows, and that a world in which the Fed is comfortable ending its programme is a world that should be conducive to further share market gains. It is, however, just as well that these issues are being discussed long before we get to the end of the process the more market volatility this causes now, the less there may be later.
In addition to the US effect, the Australian market has been held back by concern about the state of the Australian economy, along with continued soft Chinese data.
The national accounts for the first quarter, released in early June, depicted an economy growing at just 2.5% in the past year, down from 4.4% as recently as a year ago. They also suggested that the mining investment boom has already peaked, which removes from the economy a major source of growth in recent years. We knew the end of this boom was coming it just arrived a little earlier than anticipated.
This slowdown led to calls of recession, and to assessments that the Australian economy would already be in recession were it not for exports. The latter statement is meaningless: as a general rule, if one excludes all the stuff that is growing strongly the average growth rate always falls.
A couple of well-regarded private-sector economists have gained some publicity with their estimates that there is a 20-25% chance of a recession within a year. Think about that. What they are saying is that it may happen but it probably won't. Who can disagree with that?
The issue is that it's not clear that the rest of the economy will pick up the pace quickly enough to offset the loss of growth from mining capital spending. I am frequently asked just where the replacement growth is going to come from, and the answer does not always convince doubters. The response must be that it won't come from any one sector, but from everywhere that is helped by lower interest rates and a lower exchange rate (along with an improvement in business sentiment that seems likely to occur after 14 September).
Real GDP growth in Australia and the US
Source: Datastream
While I acknowledge that the current circumstances are challenging, there is simply no inevitability that economic growth in Australia will slow further. Prior to the GFC, year-to growth dipped to 2.5% or less in 2006, 2003, 2000 and 1997 (see chart). So a slowdown of the magnitude of the current one seems to happen about every three years or so. In none of these four cases did the economy finish in recession and it remains an unlikely outcome in this current case.
The $A continues to fall
The exchange rate has continued its plunge towards fair value. At time of writing, it stands around 92 cents (still well above my estimate of 80 cents for its "fair value"). The RBA is standing on the sidelines cheering the dollar on. As a rule of thumb, a 5-cent drop in the currency has a stimulative effect on the economy about equal to a quarter-point rate cut. It makes our exports easier to sell, and makes domestically produced goods more competitive with those from offshore (fresh-baked bread at Coles, for example). Thus the decline in the currency to date should do the work of two rate cuts.
The fall in the currency has added to the perils of the Australian market for overseas investors. Since the recent peak in our market, the $A has fallen by 8%, so a US investor in our market is down by about 16% in the past five weeks.
Financial markets continue to think that the cash rate has further to fall, and they may be right. My view is that, given that the cash rate is at a record low, the RBA will be extremely parsimonious in cutting further. It is probably hoping that the rate cuts already in place will get more traction, and that the lower exchange rate will help enough to obviate the need for further cuts.
Mea Culpa
Three weeks ago I stood by my then forecast of 5300 for the ASX200 at the end of the year. The ongoing weakness so far this month has persuaded me to revert to my original forecast, published in early January, of 5100. Last year, the reverse happened I cut my forecast by 200 points in mid-2012 and my original forecast finished up being too high by just 51 points. The lesson: never change a forecast until you are absolutely sure that it’s wrong.
Chris Caton
Chief Economist
BT Financial Group
The views expressed in this article are the author’s alone. They should not be otherwise attributed.
Frequently Asked Questions about this Article…
The correction was largely driven by concern that the US Federal Reserve would 'taper' its quantitative easing (QE) program. After an FOMC meeting Fed Chair Ben Bernanke signalled the Fed was likely to begin buying fewer long‑term securities before the end of 2013, which sparked a sharp market fall on 13 June and again the following day. The article notes the market low reached then could be challenged on 21 June and warns that talk of tapering can increase near‑term volatility.
Taper talk tends to push up long‑term US interest rates (the 10‑year rate rose to 2.44% from 1.64% in early May), which can create global market volatility, raise mortgage rates and pressure housing recoveries. The article also points out that a 'tapered' purchase program would still expand the Fed's balance sheet, so if the historical association holds it could still be consistent with a rising share market — but the transition increases uncertainty for investors.
Rising US long‑term yields have pushed global long‑term rates higher; the article links this to higher mortgage rates in Australia and says that increase 'calls into question the ongoing housing recovery.' In short, higher long‑term bond yields tend to translate into higher mortgage costs and greater stress for a recovering housing market.
National accounts for the first quarter showed Australia growing at about 2.5% over the past year, down from 4.4% a year earlier, and indicated the mining investment boom has likely peaked. Some private economists put a 20–25% chance of recession within a year, but the author argues that slowdowns of this size have happened several times pre‑GFC and did not end in recession. He views a recession as unlikely and says replacement growth will need to come from multiple sectors helped by lower interest rates, a lower exchange rate and improved business sentiment.
At the time of writing the Australian dollar was around 92 US cents (the author's estimate of 'fair value' is about 80 cents). The article notes a rule of thumb that a 5‑cent drop in the currency has a stimulative effect roughly equal to a quarter‑point interest‑rate cut. The fall in the dollar should therefore act like two rate cuts so far, but it also makes returns for overseas investors worse — since the Aussie fell about 8% from its recent peak, a US investor in the market could be down roughly 16% over the past five weeks.
Financial markets expect further cash‑rate falls, but the author thinks the RBA will be cautious because the cash rate was already at a record low. The RBA is likely hoping existing rate cuts combined with the lower exchange rate will provide enough stimulus, so it may be 'extremely parsimonious' about cutting further unless necessary.
The author reverted to his original January year‑end forecast of 5100 for the ASX200, down from a more recent 5300 view. He made the change because ongoing market weakness persuaded him that the lower forecast was more likely, and he cautions against changing forecasts unless you are certain they are wrong.
The article suggests investors should expect increased near‑term volatility as markets price the Fed's tapering plans, but that an end to QE in a healthy economy could ultimately be positive for share markets. Slowdowns are cyclical rather than automatically recessionary, and the author believes replacement growth will come from many sectors aided by lower rates, a weaker dollar and improving business sentiment (which he expects to pick up after 14 September). The overall tone is cautious but not alarmist — volatility may rise now but it does not necessarily mean a long‑term downturn.
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