|Summary: A number of key global economic indicators point to a continued money flow into Australia, including higher-yielding assets such as equities. These include the ongoing growth in China and India, and the impact of quantitative easing programs on offshore bond returns.|
|Key take-out: Yield will continue to be an important component of investment returns for the foreseeable future.|
|Key beneficiaries: General investors. Category: Growth.|
On a weekly basis I write and outline the major economic events that are affecting and shaping markets. When doing so, I scan across many commentaries and graphs from sources around the world.
In the last few weeks I have identified what I believe are five key charts and graphs that are vitally important for investors to note and understand. The first few graphs are from the recent update by the International Monetary Fund on the likely outlook for world economic growth in 2013. Next, there is a significant chart that focusses on the US bond holdings of the Chinese Administration. The final table is a fascinating historic review in the movements of financial assets over the last 20 years.
Last week the IMF updated and downgraded its expectations for world growth in 2013. As you can see, the downgrades were right across the economies of the world but with one exception. The growth outlook for Japan was upgraded in direct response to its massive quantitative easing program and the 25% depreciation of the yen. Also noteworthy was the forecast contraction in the Euro zone economies.
The relative good news is that the pathetic growth from “advanced economies” of about 1.25% is more than offset by the projected growth from emerging or developing economies. These economies are projected to grow by 5.25%. The world forecast growth of 3.25% has more to do with the emerging world (dominated by China) than the developed world. Indeed, if you are worried about China (and you shouldn’t be), then you would literally sell every share that you own.
The point about China’s dramatic effect on world growth is illustrated by the next graph, which tracks actual incremental contributions to world growth rates. In 2012, China contributed a startling 37.4% to the world’s incremental growth. Half of the world’s incremental growth came from China and India combined. The incremental growth in China was four times greater than the combined G7 advanced nations.
So let’s be very clear; the world is relying heavily on the economic growth of China. Those commentators who claim that China is a potential growth or debt problem need to understand the economic consequences of what they are claiming. I suspect most are merely manipulating market psychology, and in 2013 China will once again account for one-third of the world’s growth.
The IMF also updated its forecast for inflation, and this saw a dramatic lift in the expectations for Japanese consumer prices. You can see that the IMF is now forecasting Japanese inflation to lift to 3% in 2014 from the current negligible levels. Should this occur, then there would be a massive negative valuation effect on Japanese bonds and potentially world bonds.
However, do not be alarmed – just be aware of the risk. What is likely to occur has already happened. The Japanese central bank (JCB) will continue with its massive quantitative easing program to hold the Japanese bond market together. This means that Japanese institutions will probably reduce their bond holdings by selling to the JCB, and redirecting their investment capital to external markets. Thus, the rally in Italian and Spanish bonds of the last week is a byproduct. So too is the rush for yield stocks and securities in Australia. So, QE in Japan (also US) has a dramatic flow-on effect on yield investments around the world.
These are powerful forces and investors need to understand the perverse effects of QE and acknowledge that there is more to come.
The next set of charts is a fascinating reflection of outward bound Chinese capital flows. It shows that China stopped being a net buyer of US bonds in mid-2010. This decision was probably covertly communicated to the US administration before it happened. The US subsequently introduced QE2 and now QE3. Quite simply, the US Federal Reserve (Fed) had to fill the financing hole left by the Chinese.
The charts suggest to me that the Fed has no option but to continue with its massive QE program. The level of US government indebtedness and continued budget deficits suggest that capital markets could not cope with the supply of government debt.
Further, the effect of QE on interest costs is shown by the drop in interest paid to China by the US on the same face value of securities. QE appears to have engineered a 1% drop in the US government’s cost of debt. No wonder China has had enough of US bonds. Again, these tables show the perversion of interest rates by QE and investors need to understand that, as a result, capital is flowing to higher-yielding countries like Australia and pushing upwards on our currency.
Finally, and most importantly, this next graph tracks the levels and movements of global financial assets as a percentage of GDP. The 20-year snapshot shows one glaring predictive measure of sharemarket corrections.
The last two major corrections in sharemarkets were in 2000 (dot com bubble) and 2007-08 (the GFC). It is interesting to see that, on both occasions, the market capitalisation of world stockmarkets lifted above 110% of GDP before correcting sharply. Today, the US equity market is 105% of GDP and the Australian market is about 90% of GDP.
In my view, the US sharemarket is pumped up from excessive QE and ridiculously low interest rate settings. The Australian market is just fair value, but we certainly benefit from a better growth profile than that of the US.
Unfortunately it suggests to me that the Australian sharemarket has no possibility of reaching 6,800 in the next three years. Therefore, this equity cycle, measured from the previous peak (October 2007) to a new high, will be one of the longest cycles in 70 years.
From an investment perspective, it suggests to me that yield will continue to be an important component of investment returns for the foreseeable future and there are no changes to my income portfolio.
John Abernethy is the chief investment officer at Clime Investment Management.
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Clime Income Portfolio Statistics
Returns since June 30, 2012: 28.74%
Returns since June 30, 2012: 22.43%
Average Yield: 7.72%
Start Value: $118,757.19
Current Value: $152,884.62
Dividends accrued since December 31, 2012: $2,613.79
Clime Income Portfolio - Prices as at close on 24th April 2013
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