Kohler's Week: Central Banks Are Destroying The World

Last Night

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Central Banks Are Destroying The World

Let me explain.

Global disinflation, and in some places deflation, is caused by two things: debt and technology. In fact these are the two big issues in the world economy today, full stop – they are the twin elephants in the room.

1. Debt

According to the latest figures from the Bank for International Settlements, the debt-to-GDP ratio for the world's advanced countries is 265 per cent. When the credit crisis began at the end of 2007, it was 229 per cent. For emerging economies it was 117; now it's 165 per cent.

Here's a rundown of a few of the most significant countries: US, then 218, now 239; Europe, then 235, now 270; UK, then 230, now 271; China, then 153, now 235; Japan, then 316, now 393; Australia, then 197, now 230.

By the way, Australia has the highest household debt-to-GDP ratio – the BIS figure, as at the end of 2014 was 119 per cent, but other more recent data show it is now up to 134 per cent. In most western countries, most of the debt is held by governments. In emerging countries, it is the private companies. Every significant country apart from Argentina and India has significantly increased its debt-to-GDP ratio, and those two reduced theirs by 1 percentage point only. 

So, to sum up … global debt was very high at the beginning of the GFC and it's now much higher.

When it's not causing bankruptcy and crisis, high levels of debt have the effect of suppressing activity and inflation. Households and government that have too much debt don't spend, companies don't invest. When interest rates rise they spend and invest even less, and in many case owners lose everything and banks lose something.

Meanwhile central banks are trying to get inflation up to 2 per cent because, as Janet Yellen explained the other day, if there's no inflation, central banks can't prevent recessions by cutting interest rates. But not only does monetary policy not work when there's a lot of debt already, it has the opposite effect to that intended. 

Monetary policy (manipulating interest rates up and down) attempts to control the business cycle by encouraging or discouraging borrowing. However those that are already deep in debt can't or won't borrow more.

And to the extent that monetary policy works and more borrowing actually occurs (and note that debt has, indeed, increased since the GFC as a result of zero interest rates) this tends to suppress demand and therefore inflation. 

The only impact of zero interest rates has been to encourage speculation in assets – bonds, shares and property. It has zero impact on inflation, in fact it reduces it.

2. Technology

This is the main reason inflation is low. The digital revolution is fundamentally a cost event – costs in almost every part of business life, in fact life in general, are being brought down. Cloud computing is a cost reduction (see interview with Dubber, below), the “collaborative economy” is basically a cost reduction, likewise the “internet of things” and 3D printing, among many other aspects of new technology. 

Small example: on Thursday I interviewed Professor Kate Drummond, a neurosurgeon at Royal Melbourne (for a series in The Australian) and she talked about how 3D printing has dramatically lowered surgery costs and reduced operating theatre times.

Perhaps the most important factor in low global inflation is the price of oil, which has fallen by half, from an average of $US100 between 2011 and 2014, to around $US50 now. Energy is the second biggest cost input for most businesses (the biggest is labour) and when it comes down that has a big impact. The oil price also has a macro economic impact: in a note yesterday, Gerard Minack wrote: “A number of markets seem to have become increasingly correlated to the price of oil.  Oil matters, of course, but its current influence seems out-sized: for example, oil prices affect inflation, but the spot price now seems to hold sway over long-run inflation expectations in the US.”

The halving of the oil price last year was entirely a consequence of technology, specifically the invention of horizontal drilling and fracking which unlocked vast supplies of oil and gas in the US. True, it's not exactly part of the digital revolution, but it's all about technology.

Something similar is happening with other commodities. Mining has been automated: Rio Tinto runs its iron ore mines from Perth, with driverless trains and trucks, and demand for fossil fuels is being reduced by the growth in renewable energy.

In light of the above, why are central banks still pulling on the monetary policy lever when it clearly doesn't work, and is probably having the opposite effect – by encouraging more deflationary debt?

The trite, superficial answer is that if all you have is a hammer, then everything looks like a nail. Central banks have only one tool, or two if you include quantitative easing, which is really just another way of cutting interest rates, and monetary policy is the only macroeconomic policy tool left, since wages have been deregulated and fiscal policy is spent (too much government debt).

But there is a deeper reason: Keynesian theory is the dominant economic paradigm and has been for 75 years – by which I mean the idea that the cause of all economic woes, recessions and deflation, is a shortage of demand. Therefore the only way to fix any problem is to stimulate demand. Keynes played into the desire of political and economic leaders who like the idea of being benign dictators, benevolently manipulating the behaviour of the populace through the levers of macroeconomic policy. And they still want to believe that.

In fact as Jean-Baptiste Say (1767-1832) taught, what matters is supply, not demand. Keynes misquoted Say in order to discredit him, that: “supply creates its own demand”. Which is not what Say said. “Say's Law”, which Keynes essentially overturned, was actually that production is the source of demand – that individuals and companies can't consume unless they produce first. It is a statement of the obvious, but entirely forgotten by modern economists.

These days, the economic paradigm is that demand can be created and manipulated by the activity of governments, conjuring it up through interest rates or government spending. Simply wrong. Interest rates need to be deregulated and set via supply and demand for credit.

Hopefully this will be understood before central banks entirely destroy the world. And actually, it does seem to be vaguely understood in Martin Place, Sydney. The deputy governor of the Reserve Bank, Philip Lowe gave a very good speech this week, which he concluded with the following words:

“But, ultimately, the rate at which our living standards improve is unlikely to be driven by the actions of the central bank. Instead, the improvement in our living standards rests on our ability to improve our fundamentals and enhance the flexibility of our economy so that it can take full advantage of the opportunities in our ever-changing world.”

Amen.

Well, OK, at least they're destroying retirement

Maybe they're not destroying the world, in the way of an alien invasion or nuclear war, but they're certainly making a mess of retirement.

In general, low interest rates take money away from the most important class of spenders – retirees and savers. Savers don't end up with a large enough sum with which to start their retirement and those in retirement don't get enough income, which is another way in which monetary policy is not working.

We've been talking about the “hunt for yield” for a while now, but what we are seeing is a developing crisis – low returns plus longer life equals serious problems. And as discussed, it's not as if the low returns are actually achieving anything!

This week's Interest Rate Observer missive from Jim Grant had a few words on this subject:

“Bliss it was when 10-year sovereign securities delivered 10 per cent per annum. To pay out $10 million a year, an annuity provider needed $100m of bonds. At 1 per cent yield, the annuity provider requires $1 billion worth.  This humble arithmetic informs the crises of annuities, pensions and life insurance contracts in Europe, Japan and America – in fact, wherever a central bank has administered quantitative easing and zero-per cent (or lower) interest-rate policies.”

Those countries still have quite a few defined benefit pension plans, whereby the retiree gets a known, guaranteed living allowance from the employer, union or government. These schemes are now all going broke because of low bond yields and long-living customers. Jim Grant cites the case of the Teamsters Central States, Southeast and Southwest Areas Pension Plan petitioning the Treasury to be allowed to cut payments to its 200,000 beneficiaries.

In Australia, employers and pension funds saw this writing on the wall some time ago and shoved the risk onto beneficiaries via the euphemistically named “defined contribution” or “accumulation” funds, which now predominate. The few remaining defined benefit schemes exist mainly in the public service, and they are now funded by the Future Fund, which was in turn established from the privatisation of Telstra.

So in Australia the crisis is not one of pension plan solvency, as it is in Japan, Europe and America, but retiree misery. The constant refrain we hear is that Australians don't have enough super and the common solution is to increase the deductions from their salaries – that is, to rob the present to pay for the future.

As I have previously written, a $500 per month savings plan over 40 years earning the average super fund return of 6 per cent produces an end sum of $995,000. The same savings plan earning the Future Fund's return of 11.6 per cent produces an end sum of $5.1 million. Big difference. On the other hand, increasing the monthly contribution by 10 per cent to $550 increases the end sum to $1.09 million. Tiny difference.

Unfortunately in all the discussion about super, the returns are taken as a constant and the only variable is regarded as the thing that makes the least difference – the contributions.

Liquidity

Pointless monetary policy is not the only reason for the retirement crisis, although it's a big one. Another one is the cost of liquidity.

Super funds value liquidity very highly because it protects their own businesses – they are subject to many liquidity events, every day in fact, and need to be ready for them. Savers, on the other hand, usually have just one liquidity event – their retirement. Up to that point, the ability to exit the assets that provide the investment return is not important.

Liquidity is a very expensive attribute. The reason the Future Fund's return is 11.6 per cent, double the average super fund, is that it has only a third of its assets in liquid markets (not counting cash, at 20 per cent). Private equity and infrastructure produce higher returns but they are illiquid. The same goes for small-cap listed securities.

Two weeks ago I interviewed Mark Sowerby of Blue Sky Alternative Investments, who makes a specialty of illiquid investments for SMSFs. In case you missed it, he explained the difference in returns: “The returns for us for private equity is over 20 per cent.  It's over 15 for private real estate, it's over 13 for real assets and 10 per cent for the liquid hedge funds.  And so what you're seeing there is the price of liquidity or the premium you can get for illiquidity.  And so, you know, the real power in investing, Alan, is compounding.  So if you're in an illiquid investment that's going well and compounding up for you, that's a big payoff for the risk that you're taking.”

To drive that point home, a savings plan as described in the previous item which earned the 10 per cent return provided by Mark's hedge funds, would produce a retirement sum of $3.1m. Sounds OK? Well yes, but the same savings plan earning the 20 per cent provided by private equity would provide a retirement sum of $83m. That is not a misprint – it's the power of compound interest. 

By the way, Mark's largest and most prized illiquid investment is, ironically, water, but that's another story.

And another “by the way” – I'm 63 but I have a largely illiquid portfolio of small caps and funds like Blue Sky. That's because I expect to work for another 5-10 years, so my single liquidity event won't be for a while. I only wish I had thought of it in my 20s instead of just having a good time. Oh, but then again …

Webster

Speaking of water, I interviewed the new CEO of Webster, Richard Haire, by phone this week. This is basically a water business that has become Chris Corrigan's next project after Qube.

Webster was a Tasmanian walnut and vegetable grower that has been transformed into a big owner of land and water rights. The plan is not to just sell the water to other growers, but to convert it into food themselves – walnuts, cotton and whatever makes sense. Mark Sowerby is adamant that Australian water is a very undervalued asset, and that the crops it is used for will raise its value. In Australia, water is far more scarce than land.

On Tuesday Richard Haire gave us a very frank and fascinating explanation about how Webster operates now as well as a rundown on how the water market works. It's well worth taking 30 minutes to have a listen.

Westpac

If you are a shareholder of Westpac, you'll be pleased that customers will be wearing at least some of the cost of the extra capital demanded of the banks. If you are a shareholder of CBA, NAB or ANZ, you'll be hoping that they follow suit, and increase mortgage interest rates. Of course, if you are a borrower you'll be getting whipped into a frenzy of outrage by the political and media cheerleaders, who like to use banks to increase popularity and ratings.

However, it's important to understand what's actually going on here.

Most bank capital, especially for big ones like Westpac, is irrelevant. If any of the big four banks got into trouble, god forbid, they would be bailed out by taxpayers. Deposits under $250,000 are still explicitly government guaranteed, but in general they are too big to be allowed to fail. Whether capital was 1 per cent of assets or 50 per cent, depositors and other lenders to the banks would not be allowed to lose money if the assets collapsed in value or there was a run on deposits. 

And anyway, as if an increase from 8 to 10 per cent in the banks' risk-weighted capital is going to make any difference to whether the bank goes broke or not! The banks know that and the regulators know that.

So the higher capital requirement is, in fact, a tax on shareholders in return for the implicit government guarantee. There has been intermittent talk of a bank deposit levy to explicitly charge depositors for taxpayer protection, but that never gets up. So capital is increased instead, which is a sort of silent tax – on shareholders and, for Westpac, depositors.

And the politicians get to posture about how terrible it all is that interest rates are going up to pay for the extra capital because they are either too stupid to understand what's going on, or don't want to know.

Telstra

Telstra has fallen while the rest of the market has gone up this month because the ACCC has issued its final pricing decisions on wholesale mobile and fixed line access. Andrew Penn and his team were not happy: they have estimated that it will cost $350m in revenue but have no material impact on profit, but the market doesn't believe this. For example, the analysts at Deutsche Bank have estimated an $821m revenue reduction and a $130m cut in EBITDA (earnings before interest, tax, depreciation and amortisation – basically, cash flow).

Analysts have therefore adjusted their price targets downwards. Telstra's challenges from competition and regulation have only just begun.

As a generalisation, the best yield stocks now are those that benefit from a lower currency and are relatively unaffected by a slower Australian economy – that is, not banks and Telstra, but miners (BHP yields 6.7 per cent, Woodside 8.9 per cent) and some industrials. James Samson's income model portfolio can be found here.  

RXP Services, Dubber

On video this week, I interviewed Ross Fielding of RXP Services and Steve McGovern of Dubber Corp.

RXP is an IT consultancy business that has been growing rapidly through acquisition and now employs 600 people around Australia, and Dubber is what Steve calls a “classic transformative cloud business”, moving a traditional capex business – phone call recording for compliance onto servers and data storage that is owned by each business – into a purely opex (operating expenses) service using the cloud for storage. 

RXP is an hourly charge-out business that has recently bought a creative design and user experience operation with higher margins, and Dubber is a highly scalable subscription business. Both are about five years old.

Gartman

I was struck by this passage in Dennis Gartman's newsletter on Wednesday. Make of it what you will.

“…all the markets that comprise our International Index have fallen, a very rare occurrence indeed. In fact, when this sort of thing happens following bullish moves it has almost always signaled the end of the bull-run.

“Couple this unanimity of price movement with the 'reversals' noted above and we have a situation that concerns us greatly. Indeed it concerns us enough to exit our long positions entirely upon receipt of this commentary… positions that only a day or two ago seemed to us to be insulated from random noise, able to withstand a day or two of normal consolidation, but unable now to withstand the technical deterioration that has taken place as swiftly as it has. Certainly we do not like switching positions this quickly, for we appear to be flippant and foolhardy, but history tells us that we have no choice." 

Readings & Viewings

A short film about calm. To stay sane, we need to hear a different, more humbling message: that everything we do, and are, is in truth meaningless – when viewed from a sufficient distance.

Men and women – it's not about the nail.

This is a ‘bad lip reading' of the first Republican debate. Pretty funny.

British reporter gets angry and tells us the real news.

Sustainable, responsible or ethical investing – what's the difference?

After all that volatility in (US) summer – China, Glencore, Volkswagen, Fed – the market is right back to where it was.

Stephen Koukoulas: Dear Scott Morrison: stop waffling and learn to master your brief, quickly.

Here's part of the reason Aldi is causing problems for Coles and Woolworths – they look after the staff better. Another reason: they look after suppliers too.

This article, published on the San Francisco Federal Reserve's website this week, explains why the “natural rate of interest” will remain low for a long time.

I used to love the comic, Peanuts. Here's a nice article about how Charles Schulz used it to make an art of difficult emotions.

The September seas container counts show that the trade recession is continuing.

China's verdict on Uber has come in: If it looks like a taxi and quacks like a taxi, it should be regulated like a taxi.

What would the ‘Star Trek' economy actually be like – where all material needs are met and money doesn't exist?

Here are a couple of my columns this week: Diane Smith-Gander says boards should be 50/50 men and women, and Cabcharge's plan to tie up with a booking app has been knocked back by the ACCC.

Goldman Sachs: What to expect from commodities as China slows.

If you haven't been paying attention to the big drama going on in the Catholic Church, this is essential reading. Well, interesting reading anyway.

A car that turns into a flying drone. Obviously, it's the future.

No your Tesla can't drive you home when you're drunk.

Here's where Asia's rich are putting their money.

Yanis Varoufakis: Greece without illusions.

The trailer for the new Coen Brothers movie, Hail Caesar! Looks great!

HL Mencken: Frankness ruins romance. “What is neither hidden nor forbidden is seldom very charming”.

Pass all the laws you like, but domestic violence victims just need shelters.

Interesting perspective on the TPP – it's the trading away of land rights.

Hillary Clinton is definitely not going to reintroduce Glass-Steagall.

But Britain has actually introduced a version that might be called Glass-Steagall lite.

Happy Birthday Les Murray, 77 today. Here's one of my favourite poems of his:

The Meaning of Existence

Everything except language

knows the meaning of existence. 

Trees, planets, rivers, time

know nothing else. They express it 

moment by moment as the universe.

Even this fool of a body

lives it in part, and would 

have full dignity within it 

but for the ignorant freedom 

of my talking mind.

Last Week

By Shane Oliver, AMP

Investment markets and key developments over the past week

While shares had a rough patch mid-week, they recovered into the end of the week helped by better US earnings reports and some positive signs out of China. While Australian shares ended down 0.2 per cent for the week most other share markets rose with Chinese shares up 6.5 per cent. In fact, the Chinese share market is now up 16 per cent from its late August low. While shares did well, commodities were soft and bond yields generally fell as inflation remains (mostly) missing in action. The Australian dollar fell slightly.

After the strong gains from the September low some volatility was to be expected and we have seen a bit of that over the last week. The share market recovery won't go in a straight line, but with China risks receding, the Fed showing that it is keen to avoid a policy mistake in raising interest rates prematurely and shares cheap versus bonds the trend is likely to remain up as we go through the seasonally strong period into year end.

Rising mortgage rates add to pressure on the RBA to cut the official cash rate again. Westpac's move to increase its variable mortgage rates next month by 0.2 per cent for owner occupiers and investors is not particularly surprising as it flows from the rise in the cost of funding that will result from higher capital requirements being imposed on the banks by APRA. The other big banks are likely to follow, although they may wait to see what the RBA does next month. With growth stuck around 2 per cent and the mining investment downturn only about half way through, the last thing the economy needs now is a rate hike for the 30-40 per cent of households who have a mortgage given the threat it will pose to consumer spending. The best way to avoid this is for the RBA to cut the official cash rate in order to offset the higher funding costs the banks now face. This may mean that there is only around a 0.05 per cent pass through to mortgage holders from the banks (depending on what other banks choose to do) but it's better than a rate hike. As such, a November (Melbourne Cup Day) rate cut is looking likely. If not in November, then early next year.

A watershed moment for the Sydney and Melbourne property markets. Slowing auction clearance rates, slowing lending to property investors, more mainstream talk of potential property price falls ahead and now Westpac's move to hike rates are all piling on the bad news for the hot property markets of Sydney and Melbourne. I don't see prices starting to fall till around 2017, but it's looking increasingly clear that the property cycle in Sydney and Melbourne is starting to turn down after a couple of years of very strong gains. Other Australian cities were already cool, but risk also being affected by talk of mortgage rate hikes, unless it's quickly offset by the RBA.

Major global economic events and implications

US economic data was a bit disappointing over the past week. Jobless claims fell, small business optimism rose slightly in September and the Fed's Beige Book refers to “continued modest expansion” but New York and Philadelphia regional manufacturing surveys were weak and retail sales disappointed. Inflation data was mixed with producer price inflation weaker than expected and the CPI flat over the year to September, but core inflation a bit stronger than expected. Meanwhile, Fed Governors Brainard and Tarullo added to the view that the Fed won't hike until 2016. Fed Governors tend to carry a greater weight than the regional Fed presidents and their dovish comments may be reflective of Fed Chair Janet Yellen's sympathies. The US September quarter profit reporting season is off to a mixed start with a disappointing Wal-Mart result but good bank results. So far only 51 S&P 500 companies have reported, with 76 per cent beating profit expectations.

Chinese trade data for September was a mixed bag with stronger than expected exports but weaker imports, although the latter may reflect lower commodity prices rather than reduced demand. Lending data was more positive though with both bank lending and credit up more than expected indicating that PBOC easing measures are working. Meanwhile, inflation was lower than expected in September with non-food inflation of just 1 per cent year on year and producer prices down 5.9 per cent year on year providing plenty of scope for further monetary stimulus. In fact the last week saw more easing with the PBOC now making it easier for banks to obtain cheap funding from it to lend to small businesses and farmers.

Australian economic events and implications

Australia saw modest lifts in confidence – both for businesses and consumers, presumably in response to the change in PM to Malcolm Turnbull. However, consumer confidence remains pretty subdued and will likely fall back in response to all the talk about rising mortgage rates. September jobs data was uneventful with a fall in employment but after several solid months and unemployment unchanged at 6.2 per cent.

A turn in property market sentiment is also recognised by the RBA's Financial Stability Review. Overall the RBA sees the risks to the Australian financial system as being “comfortably manageable at this stage.” While the RBA expressed concerns about a weakening in bank property lending standards around the end of 2014/early 2015, it sees them as having been tightened more recently, presumably in response to enhanced pressure from APRA. As a result the RBA is also seeing some moderation in indicators of housing demand and “a few tentative signs that sentiment may be turning down in the housing markets” of Sydney and Melbourne. Our expected November rate cut is more about avoiding a hike in mortgage borrowing rates rather than providing more stimulus. If, as seems likely, signs continue to gather pace that APRA's macro-prudential measures are working to cool the hot Sydney and Melbourne property markets, then it will provide more scope for the RBA to cut interest rates again next year if needed.

Next Week

By Craig James, Commsec

Quiet week ahead

A quiet week lies ahead in terms of Australian economic data. The focus is very much overseas, with Chinese economic growth figures due in China on Monday.

The week kicks off in Australia on Tuesday when the Reserve Bank releases minutes of the Board meeting held a fortnight earlier. The Reserve Bank board left interest rates unchanged for the fifth month and there were scant changes made to the accompanying statement. So it would be surprising if the board minutes provided much in the way of new information.

Also on Tuesday, CommBank releases its latest indicator of economy-wide sales (business sales indicator) while the Australian Bureau of Statistics releases data on the imports of goods (merchandise imports). Given these figures are for the September month, they are one of the timeliest indicators of economic activity. The main complication is that the weaker Aussie dollar may inflate the estimates of imports, via higher prices.

On Thursday the ABS releases the detailed labour market figures for September. While data on employment by industry won't be available (the quarterly figures were released last month) there are break-ups on a demographic and regional basis.

Also on Thursday Reserve Bank Assistant Governor (Financial Markets) Malcolm Edey delivers a presentation at the International Swaps and Derivatives Association's 2015 Annual Australia conference in Sydney.

Plenty to monitor on overseas markets

There is plenty to watch in China and the United States over the coming week.

The week kicks off on Monday in China when a raft of indicators is released. Most interest will be in the economic growth figures for the September quarter. Growth is tipped to have eased from the 7 per cent annualised rate recorded in the June quarter.

However, on the same day, data on investment, production and retail sales are expected for the September month. While production growth has softened to a 6 per cent annualised rate, retail spending is growing at a 10.4 per cent annualised rate in real (inflation-adjusted) terms.

It takes a while for this to sink in: the second largest economy on the planet is recording 10 per cent annual growth in real consumer spending.

In the US, the week kicks off on Monday with the National Association of Home Builders activity index. Economists expect this was steady at 62 in October.

On Tuesday, yet more indicators on the housing market are released. Data on building permits and housing starts are released with economists tipping a small 0.5 per cent fall in permits but expect a near 2 per cent lift in starts (commencements).

Also on Tuesday is the usual weekly data on chain store sales. While on Wednesday the weekly report on mortgage transactions (purchases and refinancing) is also scheduled.

On Thursday, the focus shifts back to the US housing sector. The monthly home price index is issued together with existing home sales. In August home prices lifted 0.6 per cent to stand 5.8 per cent on a year ago. Some are worried that prices are lifting a little too quickly in some cities, but generally supply of homes are rising. The strength of the housing market is highlighted with existing home sales and economists expect that sales lifted just over 1 per cent In September.

Also on Thursday in the US weekly data on claims for unemployment insurance is issued together with the leading index, national activity index and the Kansas City Federal Reserve survey of business activity.

And on Friday so-called 'flash' or preliminary readings on manufacturing activity are expected in the US, Europe, China and Japan. While the value of producing an extra indicator can be questioned, (the final reading is released around a week later) some analysts continue to follow the data.

Sharemarkets, interest rates, commodities & currencies

The US earnings season cranks up a notch in the coming week.

There are around 30 companies to report earnings on Monday. Among those to report are Morgan Stanley and IBM.

On Tuesday, almost 60 companies are to issue earnings including Lockheed Martin, Verizon and Yahoo!.

On Wednesday, around 120 companies are scheduled to report profit data including Texas Instruments, CoreLogic, eBay, American Express, Baker Hughes, Boeing, General Motors and Coca-Cola.

On Thursday, around 190 companies will report earnings. Included are Amazon, AT&T, E*TRADE, Microsoft, ResMed, NASDAQ, 3M, Caterpillar, Eli Lilly and McDonald's.

And on Friday, almost 25 report profit figures including American Airlines and Procter & Gamble.