Boom and bust cycles

In previous blogs I’ve explored the possible causes of boom and bust cycles, in particular the origins of the Global Financial Crisis. I recently came across Dr Mark Skousen’s book The Structure of Production. He explains how modern macroeconomics is flawed as it ignores the structure of production and time. He advocates a microeconomic approach to macroeconomics, where the vertical structure of production, which captures the full production process from raw inputs to final consumption, is analysed in addition to the traditional aggregated horizontal view.

He discusses how different segments of the economy react to changing interest rates. As a general rule, the further a segment is from the retail sector or consumer end of the production line the more sensitive it is to changes in interest rates, as these segments generally involve large investments in capital, with long life spans. This includes property and engineering construction, infrastructure and R&D. They also tend to be the most volatile sectors throughout the business cycle.

Skousen explains how the Keynesian approach to economic policy tends to perpetuate the boom and bust cycle as it ignores the time preference of consumers. Consumers make a decision about what portion of their income they’re willing to save, in other words how much current consumption they’re willing to forgo in order to increase future consumption. Aggregate private savings are then diverted to the business sector for investment. The greater the level of saving, the lower the interest rate and the more available funding the business sector has for expanding operations and investing in capital. As interest rates fall, the profitability of longer term projects increase.  This investment drives the expansion of future consumption and economic output.

An issue arises when interest rates are artificially lowered, via expansionary monetary policy. A mismatch occurs between saving and investment as consumers haven’t changed their preferences. The ratio of consumption versus savings remains unchanged. The gap between investment and saving is filled by expansionary monetary policy. As interest rates fall businesses are encouraged to commence longer term projects and invest in capital, and as a result the economy expands. Employment and incomes increase, which leads to increased consumer demand. Since consumers haven’t adjusted their preferences, demand will rise. As this scenario plays out there may be pressure on central banks to raise interest rates as increased consumer demand ultimately stimulates inflation.

Businesses and sectors closer to the retail end of the production line will face increased profits as consumer demand rises. And as a result may compete for labour with the more capital intensive end of the production line, which may lead to cost pressures. Those sectors that have invested in longer term and longer term projects will find that the profitability of these projects will fall as demand for their output wanes and interest rates, if inflation becomes an issue, rise. Ultimately longer term projects will be put on hold, unemployment will rise and incomes will fall. The boom cycle goes into reverse and an economic downturn emerges.

He also explains how GDP is a misleading representation of the economy. It is the sum of final output and excludes intermediate goods to prevent double counting. A more accurate view of economic activity is gross output, which incorporates total spending, the sum of spending on intermediate and final goods. Consumption represents 70% of GDP, however it only represents 30% of gross output, while business and capital spending represents 70% of gross output and only 30% of GDP. Thus business and capital spending have a much greater importance than GDP figures portray.

This theory makes a lot of sense to me, particularly when you consider the situation in the US at the moment. The Fed has kept rates low for an extended period, not just since the GFC but prior. This has without a doubt created distortions in the structure of the economy and a consumer society that spends way more than it saves. As I’ve discussed in previous blogs, China and the emerging world has aided this consumption through financing government debt and the export of cheap goods. This theory really drives home the fact that you can only use expansionary policy to a certain extent before it distorts an economy and creates dangerous imbalances.

Now the Fed is struggling to raise rates and put an end to quantitative easing. Each time the Fed attempts to prepare the market for a future rate rise, confidence falls. This week is a perfect example. The bond market went into a frenzy, yields dropped by more than they did in the 2010 flash crash and then recovered before closing. This was in response to less than positive data and the anticipated end of quantitative easing. Bond yields in Australia fell due to global financial market volatility, deflation threats in Europe and the prospect of US interest rates not being raised for some time.

Should you buy into the Australian dream?

Home ownership has long been the Australian dream. According to the 2011 ABS Census 67% of Australian households are owner occupiers. However with property prices continually rising it’s becoming increasingly difficult to get on the property ladder. Living in Sydney, which has experienced some of the highest rates of growth, I’ve often wondered whether I’m better off renting or buying my own place. The RBA recently released a report that investigates this very question; are Australians better off renting or buying? The findings may surprise you.

According to this report real house prices increased at an average annual rate of slightly less than 2.5% since 1955. If house prices continue on this trajectory then the financial cost of renting and owning a home are equivalent. However if home price growth ends up falling below this historic average, which according to this report many observers have suggested, then the average household is probably financially better off renting, subject to the length of tenure. It compared the costs of owning a property and expected capital appreciation to the cost of renting. The report states that if you plan on owning your home for a few years and then moving on it may be better to rent, unless you’re expecting high capital gains from selling the property. This is a powerful finding that raises questions about the real value of owning your own home. Of course there are many non-financial benefits of being a home owner that should also be considered.

Are property prices overvalued?

The other interesting aspect of this report was an investigation into whether property prices are overvalued. The residential property sector is always a hot topic and in recent times there has been a lot of discussion about the stability of the property market. The different components that contribute to housing values including rents, interest rates, expected appreciation and other factors can provide some insight into whether property prices are overvalued by identifying the key drives of price movements.

Overtime these key drivers have changed. The report states that in the 2002-2003 boom, price movements were largely driven by expectations of further capital appreciation, while in other times interest rates and rents have been the main contributing factors. Being able to determine what is driving price movements can assist in the early detection of bubbles and can also help guide policy, lending and prudential standards.

In isolation some of these factors can be misleading. The report discusses a number of different ratios that have been used in the past to gage the future trajectory of property prices. The idea is that if the ratio rises above its long term average you’d expect property prices to fall in the future. The only issue is that these ratios may not actually be mean reverting, in other words they may continually trend upwards.

1. The price-to-income ratio

As outlined in the report this ratio can only be used if it is mean-reverting, which in Australia’s case it’s not. In other words in Australia price growth is continually outpacing income over the long term. This is not surprising in situations of limited land supply. As income grows, so does prices and rents and since demand for housing is price-inelastic ie not highly price sensitive, house prices tend to rise faster than income.

2. Price-to-rent ratio

This is another popular approach. As outlined in the report, based on this ratio, the Economist (2013) and the OECD (2013) conclude that Australian house prices are 46% and 37% ‘overvalued’. Like the price-to-income ratio the price-to-rent ratio in Australia has increased over the past decades and hasn’t remained stationary. This is because buyers also consider other variables such as interest rates, running costs and other user costs associated with owning a property. The report outlines previous studies that have been conducted that indicate that the price-to-rent ratio moves with changes in user costs so unless user costs are mean reverting then the price-to-rent ratio will not remain steady, making it difficult to predict future housing price movements.

You can read the RBA report here.

Healing the global economy

5 years on from the 2008 Global Financial Crisis (GFC) and many parts of the world are still struggling to recover. The other week I saw Reserve Bank of Australia Governor Glenn Stevens present at the Anika Foundation Luncheon, supported by Australian Business Economists and Macquarie Bank. He spoke about the global economy post GFC and the challenges that policy makers continue to face.

Living in such an interconnected world, it’s important to have an understanding of what is happening in the broader global economy. We all witnessed first-hand the effects of financial contagion during the GFC and how quickly a financial crisis can spread from one economy to another.

Australia fared better than most during the GFC for various reasons, one being the strength of the resource sector and our trading relationship with China. We continue to hear how difficult the recovery journey has been for the US and Europe. For me 3 key questions were addressed by Glenn Stevens that are definitely worth sharing.

 

How successful was monetary policy during the GFC?

In short, Glenn Stevens said that the situation could have been a lot worse, potentially as catastrophic as the Great Depression, if it weren’t for the intervention of policy makers.

In terms of evaluating the success of monetary policy, Glenn Stevens stated that “The decline in global output and trade in the last quarter of 2008 was at a pace that rivaled the contraction in the 1930s. Had it gone on, we can be sure that tens of millions more people would be unemployed and trillions of dollars more wealth would have been destroyed……..These initial interventions achieved what they were supposed to”.

He also highlighted that today’s policy makers, in particular Ben Bernanke, were armed with the lessons learnt from the 1930’s great depression. Ben Bernanke, Chairman of the Federal Reserve from 2006 until early 2014, is a scholar of the 1930’s great depression, thus was well placed to tackle the crisis.

 

What are the limits of Monetary Policy?

Monetary policy can only do so much. It aims to influence the cost of borrowing relative to the expected return on real capital. Expansionary monetary policy attempts to lower the cost of borrowing by influencing the cash rate. The cash rate is the interest rate financial institutions pay to borrow or charge to lend funds in the money market on an overnight basis.

The most interesting limitation he discussed was a low ‘natural rate’ of return on capital. In this scenario the cash rate must be cut to a very low level in order to stimulate the economy. How does a very low ‘natural’ rate of return on real capital come about in the first place? In relation to the global economy and in particular the US economy, 4 main causes were discussed: overinvestment, lower population or lower productivity growth, lack of innovation and animal spirits.

  • Overinvestment results in lower perceived expected returns, resulting in a low natural rate of return on capital. In the US, leading up to the GFC there was some overinvestment in housing but this didn’t seem to be the case with business investment.
  • Lower population or productivity growth can lead to a fall in the potential growth rate of an economy. He pointed to Japan and some parts of Europe as examples of those that are experiencing a declining population. He also clarified that a declining population is not an issue for the US.
  • Innovation is a precursor to productivity growth, which is why a lack of innovation can lead to a lower natural rate of return on capital. He stated that this doesn’t appear to be an issue for the US; “since 2008, the number of patents granted in the US has risen by nearly two-thirds. While only a crude measure, that doesn’t suggest the desire to innovate has collapsed”.
  • Animal spirits is another term for confidence. He explained that confidence influences the expected rate of return, “If people think, for whatever reason, that returns for future possible investments will be low, or subject to high risk, then they will be reluctant to invest even if past and current returns are quite satisfactory. Conceivably, this could be a self-reinforcing equilibrium.”

 

What about other policies?

Given the limits of monetary policy, Glenn Stevens discussed the below initiatives, that if implemented may aid some G20 nations in moving from a low return, pessimistic equilibrium;

  • Supply side reforms that encourage dynamism and opportunity in the G20 nations
  • Opening up both public and private sector investment in infrastructure, once governance risk sharing and other issues have been resolved
  • Financial regulation that creates financial system stability without stifling growth
  • Genuine free trade agreements

Are foreign investors distorting the Australian residential property market?

A large portion of the Australian population own property, which is why the state of the property market is always a hot topic. At the time of the 2011 Census, 67% of Australians owned their own home. According to the ATO, in financial year 2010/11, 19.2% of individuals that reported a taxable income owned investment properties.

Lately there has been a lot of discussion about the stability of the market and whether property prices are too high. According to RP Data, home prices rose by 1.4% in June and are up 10.1% over the year. There has also been a lot of talk about what is driving the market. Some claim that foreign buyers are distorting prices and pushing first home buyers out of the market.

Doubts have been raised over the Foreign Investment Review Board’s ability to ensure that foreign investment is restricted to new housing. RP Data recently supported a parliamentary inquiry into foreign investment by supplying data extracted from Treasury figures. In the last 9 months $5.5bn worth of existing housing has been purchased by foreign investors. RP Data estimates that almost 16,000 properties worth $24.9bn were approved for sale to foreign buyers in the year to March. This represents 13.2% of the total value of real estate sold, roughly double last year’s value. NAB estimates that in terms of total demand, foreign buyers now account for just over 1 in 7 new properties and around 1 in 10 established homes.

These figures raise questions about the future trajectory of property prices as investment, particularly foreign investment, tends to be speculative in nature. The concern is that high levels of foreign investment is not only distorting the market but may also lead to instability and a sharp decline in property prices in the near future.

Foreign investment is not the only trend that is important when evaluating the health of the residential property sector. Below are some other important factors to consider.

 

1 (2)

2 (1)

 

Supply

It’s often stated that property prices are higher than they should due to the lack of housing supply. There are a number of regulatory restrictions that make it difficult for land to be released. RBA Governor Glenn Stevens in a recent Q&A forum in Hobart agreed that the supply side of the housing sector in Australia is quite constrained. He stated that it’s “….a huge issue in housing and in a sense if we’re too rigid on the supply side then fundamentally housing prices have to be higher. That’s not a bubble, that’s fundamental…” he then went onto say “…really in a country this size, and the land we have, I can’t see how we shouldn’t be able to have fairly inexpensive shelter…”.

In spite of these known housing supply issues, CommSec Economist Savanth Sebastian stated in a research release this week that “While the discussion of a housing bubble will continue to be mentioned in media headlines, it is likely that increases in land sales, healthy building approvals and solid new home sales will result in a greater supply of homes over 2014. And, as a result of increased home supply, price gains will become more restrained later in the year”.

Indicators to watch

Dwelling Approvals

Approval is one of the first stages of the construction ‘pipeline’ and is thus a key leading indicator of future activity. Dwelling approvals are on the rise and increased by 9.9% in May – the first gain in four months. Approvals are up 14.3% over the year. The current number of dwelling approvals (16,425) is still well above the decade average (13,501) and five-year average (14,092).

Demand

Housing demand can be split into owner-occupier demand and investment demand. As mentioned previously investor demand tends to be more speculative in nature. The RBA’s March 2014 stability review found that the low interest rate environment and rising asset prices have encouraged households to take on greater risk. In the March 2014 quarter, 41.24% of new lending was for residential investment. This was slightly lower than the December 2014 quarter, which was 41.53%. The pick-up in residential investment approvals is particularly evident in NSW and VIC, while there has been a decline in the activity of first home buyers across all states. At the Q&A forum in Hobart, Governor Glenn Stevens stated that “….for most owner-occupier borrowers I don’t think we’ve seen imprudent borrowing in this recent period. The area where we need to watch is the investor market in Sydney”.

Indicators to watch

Housing Finance

The risk appetite and lending practices of financial institutions has a direct impact on property prices and the longterm stability of the residential housing sector. If lenders aggressively expand their portfolios and adopt more lenient lending terms then you can expect to see a jump in property prices. Demand will rise as a greater portion of the population will have access to funding. The total volume of lending indicates the degree to which the market is expanding. The value of investment loans is closely watched as it may indicate an increase in speculative demand. Below is a table of some calculations I’ve done using APRA lending statistics. Lending to investors has steadily increased since the March 2013 quarter. In the March 2014 quarter, 41.24% of new lending was for residential investment. This was slightly lower than the December 2014 quarter, which was 41.53%.

Mar-13 Jun-13 Sep-13 Dec-13 Mar-14
Owner-occupied 741,544 755,239 766,780 782,144 795,241
Owner-occupied (as a percentage of all loans) 67.10% 66.95% 66.85% 66.66% 66.52%
Investment 363,566 372,774 380,197 391,110 400,302
Investment (as a percentage of all loans) 32.90% 33.05% 33.15% 33.34% 33.48%
Total 1,105,110 1,128,013 1,146,977 1,173,254 1,195,543

 

Graph 3.3: Housing Loan Approvals

Loan to Value Ratio (LVR)

LVR is a measure of the risk appetite of lenders. The higher the ratio the more willing lenders are to extend credit to those who have low deposits. According to APRA in the March 2014 quarter, 15.56% of new residential lending had an LVR > 90%. The below table shows LVR rates for the last 5 quarters, which have been consistently over 15%. There was a slight fall in the March quarter.

Mar-13 Jun-13 Sep-13 Dec-13 Mar-14
Loans approved LVR<60% 30.75% 33.21% 29.48% 28.76% 27.81%
Loans approved LVR 60%-80% 46.13% 44.50% 46.60% 47.35% 47.59%
Loans approved LVR 80%-90% 23.12% 22.29% 23.93% 23.89% 24.61%
Loans approved LVR>90% 17.26% 15.63% 16.39% 15.67% 15.56%

(ADIs with greater than $1 billion of residential term loans held 98.3 per cent of all residential term loans as at 31 March 2014.)

Debt to Income Ratio

This measure indicates the ability of borrowers to repay outstanding loans. It’s a measure that should be closely watched by regulators as it indicates the risk appetite of lenders and the degree to which borrowers have extended themselves financially. The RBA’s March 2014 stability review found that the household savings rate remained within the 10% range. According to this study many households have used lower interest rates to pay down mortgages at a quicker rate than required, which has meant that an almost 15% aggregate mortgage buffer (balances in mortgage offset and redraw facilities), equivalent to 24 months of payments at current interest rates will offer some protection against a temporary fall in income or unemployment. The review also found that household gearing and indebtedness remained at historically high levels as illustrated in the graph below.

Graph 3.1: Household Indebtedness

Mortgage Stress

Digital Finance Analytics (DFA) mortgage stress survey maintains a rolling sample of 26,000 statistically representative households using a custom segment model nationally. Each month DFA executes surveys to 2,000 households.

DFA defines mortgage stress as:

Mild = households maintaining repayments, but by reprioritising expenditure, borrowing more on loans or cards, and refinancing

Severe = households who are behind with their repayments, are trying to sell, are trying to refinance, or who are being foreclosed

DFA’s January 2014 survey indicates that 15% of first time buyers are in some form of mortgage stress, with 41,200 first time buyer households in mild stress and 19,800 in severe stress. Amongst other owner occupied households, 4% are in stress, with 30,000 in mild stress and 12,200 in severe stress.

Rental Yields

RP Data publishes rental yields on a regular basis. Rental yields are an important indicator to watch as this in addition to capital appreciation represents the total return on investment. Logic states that as rental yields decline there will be a fall in the demand as investors seek higher yielding opportunities. As demand falls so should property prices. There is an inverse relationship between yield and price. When they move too far out of sync with one another there will inevitably be an adjustment. Gross rental yields are lowest in Sydney and Melbourne, which have both experienced the highest price growth.

Capital versus labour

Recently I’ve spent quite a bit of time reading about the GFC and financial crises in general. I’ve come across some really interesting books that I feel get to the root of what caused the GFC. I’ve read many times before that the GFC was caused my irresponsible mortgage brokers, investment banks and other financial institutions that created complex financial products such as mortgage backed securities and collateralised debt obligations. What really interests me is that there is some sort of financial or currency crisis every 10 years. This regular occurrence makes me think that there’s a deeper issue that is inextricably linked to the capitalist system.

I found Graham Turner’s 2 books; ‘No way to run an economy’ and ‘The Credit Crunch’ particularly insightful. In ‘No way to run an economy’ he discusses the balance between capital and labour. In a capitalist economy the primary objective of the business world is to maximise profit and accumulate as much capital as possible. He explains Karl Marx’s theory; in aggregate when businesses accumulate capital the result is excess capacity. If each firm reinvests profits by investing in additional capital, at the aggregate level, this will ultimately lead to excess capacity. When wage growth fails to keep pace with capital accumulation and industrial expansion it’s unlikely that consumer demand will be able to match increases in supply. This will lead to a decline in prices and falling profits.

Why haven’t wages kept pace with capital accumulation? There are a number of reasons. One reason is that after the high rates of inflation experienced in the 1970’s and 1980’s, wage growth which tends to be one of the primary sources of inflation, has been suppressed in the US and other advanced economies. The influence of unions and collective bargaining has diminished and wages, particularly at the lower end of the labour market, haven’t kept pace with other sectors of the economy. Another factor supporting low wage growth in the US and other advanced economies has been the rapid urbanisation in China and other emerging economies. Urbanisation in China, has meant that a large portion of the labour force has migrated from regional areas to the urban sector. Since wages tend to be lower in regional areas, as agriculture is the dominant industry, industrial sectors are able to attract labour without facing sharp increases in labour costs. The marginal product of labour is a lot higher in the industrial sector which allows for labours share of output to be maintained at a much lower level than the agricultural sector. Thus labour’s share of output does not greatly increase as the industrial sector expands. As a result more capital can be ploughed back into industrial expansion.

The lack of social infrastructure and social security in China, particularly in urban regions also results in high rates of saving. Those who do migrate to the urban sector earn more than they would in regional areas thus tend to save more. High rates of saving in China has led to excess global liquidity. China has now reached the point where consumption must rise if growth is to be sustained. Excess industrial capacity as well as an overheated property market is threatening China’s 7.5% growth target.

Not only is excess supply and suppressed wages an issue but the capitalist system is also subject to speculative activity. Huge saving rates in China and debt fuelled consumption in the US has created a global imbalance. At a global level there is excess liquidity that countries like the US have really taken advantage of. Hedge funds, private equity firms, complex instruments including derivatives and commercial property loans are established with the intention of seeking high rates of return. Issues arise when these vehicles chase a declining pool of opportunities; riskier and riskier investment decisions are made in order to keep pace with the market and fierce competition. The rapid rate of innovation in the financial sector and the fact that regulation hasn’t kept pace has meant that tail end risk and the probability of large losses has been underestimated and largely ignored. This risk tends to be overlooked until the market turns and participants are no longer willing to bet on further asset price rises. At this point a financial crisis is likely to occur. When a crisis emerges there is a devaluation in the value of speculative capital which will lead to a fall in the availability of credit followed by a fall in demand. This fall in asset values not only destroys speculative capital but impacts the real economy by exacerbating spare capacity and the devaluation of real assets.

Yield chasing and excess capital accumulation coupled with low wage growth are significant contributing factors to financial system instability and severe economic downturns. Even though the capitalist economic system has its weaknesses it’s important to remember that there is no perfect economic system. History has taught us that communism and socialism also have their disadvantages. Rather than rejecting the free market economy I believe that being aware of its weaknesses and using regulation and economic policy to address these weaknesses is our best best in fostering greater economic and financial system stability.

Predicting exchange rate movements

There are 2 main approaches to predicting exchange rate movements; fundamental analysis and technical analysis. Fundamental analysis can be thought of as the ‘why’ and technical analysis can be thought of as the ‘how’.

Fundamental analysis relies on macro economic indicators to forecast exchange rate movements. The economic indicators that tend to have the biggest influence on foreign exchange markets are:

1) Interest rates

A change in the stance of monetary policy can move currency markets by impacting capital flows. Institutional investors search the globe for the highest rates of return and will redirect large volumes of capital based on changes in interest rate differentials.

2) GDP

GDP indicates the health of an economy and it’s growth rate.

3) Terms of trade and the current account balance,

Impact both the demand for a particular currency as well as its supply.

4) Employment,

Like GDP, employment indicates the health of an economy.

Technical analysis is different to fundamental analysis in that it focusses solely on historical prices, charts and the tools that enable the identification of patterns that indicate future activity. Technical analysis unlike fundamental analysis is not concerned with the intrinsic or fundamental value of a currency.

Currency traders are generally advocates of the latter approach however may still take into consideration key macro economic developments and political announcements.

In 1982, Meese and Rogoff published a paper discrediting fundamental analysis. The key finding being that a random walk model performed just as well as any other exchange rate model based on economic fundamentals. Due to the difficulty in predicting exchange rates, and the lack of success that fundamental analysis has had in exchange rate determination, a third approach has emerged. Order flow has been the subject of much academic research in recent years. Order flow is defined as the net buyer and seller initiated orders, in other words net buying pressure. This model of exchange rate determination is an approach adopted from the micro finance field, an area of study which rarely crosses paths with the field of macro economics.

Analysing order flow allows one to bypass fundamental analysis. Market participants’ interpretations and reactions to economic and political news have already been incorporated into the order flow. Order flow is the direct result of the market’s reaction to new information and changing market demands. It can be thought of as the transmission mechanism from information to price.

In practice this approach is best used by those who have access to oder flow data ie brokers and financial institutions, who have access to their clients’ foreign exchange orders. Unfortunately aggregate order flow data is not available to the broader market. This is where financial institutions and large trading houses have a distinct advantage, they do not have full visibility of aggregate order flow but have access to greater knowledge than the rest of the market.

Taking exchange rate determination one step further is the General Theory of Reflexivity. This theory bridges the gap between fundamental and technical analysis. George Soros, one of the most successful hedge fund managers, founded this theory, which is really a framework that has helped him both to make money as a hedge fund manager and to spend money as a policy oriented philanthropist. Soros studied philosophy which gave him a unique edge. This framework is not about making money but rather the relationship between thinking and reality.

This theory opposes the perfect information and efficient market assumptions that fundamental analysis relies on. It postulates that the behaviour and perceptions of market participants impact a currency’s value. The fundamentals or the reality is not what determines a currency’s value, rather it is the behaviour and perceptions of  market participants. It is argued that the theory of reflexivity is simple logic and is only stating the obvious. Obvious or not the success of this framework lies in the feedback loop between currency movements and the psychology driving the market. There will come a point where the value of a currency will be so out of sync with its intrinsic or fundamental value that there will be sharp reversal forcing the currency back into alignment. This framework can also be applied to other property and equity markets. In practice, Soros achieved great success in using this framework until his trading volume became so large that any change in his position sent currency and equity markets into a free fall.

Considering 95% of foreign currency transactions are speculative in nature there is great value in understanding the psychology of the market and familiarising oneself with the approach that currency traders take when evaluating the market. The theory of reflexivity is a great example of this. It’s about understanding the dynamics of the market and being one step ahead, being able to turn on a dime and reverse a position just before the market catches on. 

The great global imbalance

The great global imbalance started to emerge in the 1980’s after Japan became the second largest economy in the world. In the 1960’s Japan began to re-engineer its economy by adopting economic policies that fostered rapid growth. By 1978 it was the second largest economy in the world. Japan used an export orientated growth strategy to create rapid economic growth, which some decades later, China on a much larger scale would replicate; changing the global economic landscape forever. This in conjunction with financial deregulation in the US and much of the developed world and the adoption of a more laissez fair approach to economic policy laid the foundations for what was to come, the worst financial crisis since the Great Depression.

The US has the largest current account deficit in the world while China has the largest current account surplus. Some have argued that this is due to China maintaining a fixed exchange rate. The argument is that China has purposely maintained an undervalued renminbi in order to support its export market. The renminbi was fixed to the USD until 2005, when it was then allowed to float in a narrow margin around a fixed base rate, determined with reference to a basket of world currencies. According to Purchasing Power Parity, when it was fixed to the USD prior to 2005, it was estimated to be undervalued by as much as 37.5%. In the second half of 2012, according to Purchasing Power Parity, it was only 8% away from its equilibrium value with the USD.

Maintaining tight control over its currency has meant that China has accumulated a huge amount of USD denominated reserves. The balance is higher than the GDP of some economies in Europe. China’s foreign currency reserves have not just sat on the sidelines but have financed much of the US private and public sector debt. This has enabled the US to continue to import Chinese exports and maintain the largest current account deficit in history. The difference between what China is producing and consuming has led to a glut of global savings and capital. China’s penchant for saving has created easy global money, which has fuelled excess consumption and large current account deficits in the west and low levels of consumption in the east.

How did these high rates of saving come into existence? In a previous blog post, I outlined Lewis’s Turning point, an economic theory that explains the development process. It accurately explains Japan’s and South Korea’s evolution and offers valuable insight into China’s current situation. According to Lewis’s turning point an emerging economy, that is on its way to escaping middle income status, is characterised by large rates of urban migration as rural workers relocate to the urban sector. This enables the industrial sector to rapidly expand and earn increasing profits as the excess supply of labour keeps the wage rate steady. As a result a very competitive export market is born. Income in the urban sector is higher than in the rural sector which enables a higher proportion of saving. In China due to the lack of affordable housing and social infrastructure, including social security and health care, migrant workers save a large portion of their incomes in comparison to the west.

High profits and savings rates have led to high rates of investment. It has now become apparent that investment in China hasn’t been directed to the most productive pursuits. There is concern that over investment in the property sector and government led infrastructure projects will not generate the economic returns warranted by this high level of investment. Rising bad debts and slower growth is now very much on the cards for China. Policy makers face the difficult challenge of redirecting growth to a more sustainable path that involves higher rates of consumption and lower rates of investment.

This urbanisation in the emerging world and the resulting global over supply of labour has enabled the US Federal Reserve to keep rates lower for longer. Wage growth, which is a key source of inflationary pressure in an economy, has been subdued. This is particularly the case at the lower end of the US labour market. Low wage growth coupled with cheap imports from China, has meant that inflation has been kept in check. Thus the Federal Reserve has kept interest rates at levels lower than would otherwise be justified.

According to the Taylor Rule between 2002 and 2005 interest rates were kept too low for too long. This further consolidated the excess liquidity issue and encouraged increasing levels of private and public sector debt. John Taylor argues that keeping rates at this low level for an extended period of time fuelled the housing boom and created the bubble that started the GFC. I would argue that this in conjunction with regulation that didn’t keep pace with financial innovation is what led to the GFC. The deeper and more fundamental cause being the global imbalance. The developed world primarily the US and Europe are still struggling to recover from the worst recession since the Great Depression. The threat of deflation and anaemic growth has caused policy makers to take drastic action. Some believe that it’s unlikely we’ll see the developed world return to its former years of steady growth until this great global imbalance is rectified.

 

18 April 2014 – Weekly Market Movers

 

Image

Image

Image

Summary of share market, bond and currency movements

US data releases were positive for global share markets and indicate that the set backs earlier in the year were in fact weather related. Retail sales in March increased by the highest rate since September 2012. Industrial Production exceeded expectations and the Philadelphia Federal Reserve’s April manufacturing index rose to a seven-month high. The S&P 500 equity index rose 2.7% over the week, it’s strongest gain since July.

US government bond markets were negatively impacted by talks in Geneva to calm tensions in Ukraine. The more policy sensitive 2 year bond yield increased despite Janet Yellen reiterating that interest rates would stay low for a considerable time after the Federal Reserve ends its bond buying program ends. 

The ASX 200 ended the week almost 0.5% higher.  The Aussie dollar rose from lows near US93.40c to around US93.85c before finishing US trade around US93.70c. 

Quarterly Chinese economic growth fell compared to the last quarter, although the results weren’t as bad as the market anticipated.

Definition and Importance of Indicators

US key data releases:

1. Retail Sales:

Definition: Retail sales measure the total receipts at stores that sell merchandise and related services to final consumers. Retail sales are a major indicator of consumer spending trends because they account for nearly one-half of total consumer spending and approximately one-third of aggregate economic activity.

Importance: Strong retail sales are bearish for the bond market, but favourable for the stock market, particularly retail stocks. Sluggish retail sales could lead to a bond market rally, but will probably be bearish for the stock market.

 

2. Consumer Price Index

Definition: The consumer price index is the most widely followed monthly indicator of inflation. The CPI is considered a cost-of-living measure since it is used to adjust contracts of all types that are tied to inflation. For monetary policy, the Federal Reserve generally follows “headline” and “core” inflation. This latter measure excludes the volatile food and energy components. The Fed’s preferred inflation measure is not the CPI but the personal consumption price index because it reflects what consumers are actually buying during any given period-the component weights are updated annually while those for the CPI are updated infrequently. However, the subcomponent price data of the CPI are used to compile the PCE price index (PCE prices are released almost two weeks after the CPI). Thus, the CPI and the PCE price index are inextricably linked. In the long run, the overall CPI and core CPI track each other.

Importance: The bond market will rally (fall) when increases in the CPI are small (large). The equity market rallies with the bond market because low inflation promises low interest rates and is good for profits.


3. Industrial Production 

Definition: Industrial production and capacity utilization indicate not only trends in the manufacturing sector, but also whether resource utilization is strained enough to forebode inflation. Also, industrial production is an important measure of current output for the economy and helps to define turning points in the business cycle. The production of services may have gained prominence in the United States, but the production of manufactured goods remains a key to the economic business cycle. A nation’s strength is judged by its ability to produce domestically those goods demanded by its residents as well as by importers. Many services are necessities of daily life and would be purchased whether economic conditions were weak or strong. Consumer durable goods and capital equipment are more likely purchased when the economy is robust. Production of manufactured goods causes volatility in the economy. When demand for manufactured goods decreases, it leads to less production with corresponding declines in employment and income.

The three most significant sectors include motor vehicles and parts, aircraft and information technology. Volatility in any these single sectors could affect the total.

Importance: The bond market will rally with slower production and a lower utilization rate. Bond prices will fall when production is robust and the capacity utilization rate suggests supply bottlenecks. Healthy production growth is bullish for the stock market only if it isn’t accompanied by indications of inflationary pressures.

 

4. Housing Starts

Definition: A housing start is registered at the start of construction of a new building intended primarily as a residential building. The start of construction is defined as the beginning of excavation of the foundation for the building. This narrow piece of data has a powerful multiplier effect through the economy, and therefore across the markets and your investments. By tracking economic data such as housing starts, investors can gain specific investment ideas as well as broad guidance for managing a portfolio.

Home builders usually don’t start a house unless they are fairly confident it will sell upon or before its completion. Changes in the rate of housing starts tell us a lot about demand for homes and the outlook for the construction industry. Furthermore, each time a new home is started, construction employment rises, and income will be pumped back into the economy. Once the home is sold, it generates revenues for the home builder and a myriad of consumption opportunities for the buyer.

Importance: The bond market will rally when housing starts decrease, but bond prices will fall when housing starts post healthy gains. A strong housing market is bullish for the stock market because the ripple effect of housing to consumer durable purchases spurs corporate profits. In turn, low interest rates encourage housing construction.

 

5. Philadelphia Fed Survey

Definition: The general conditions index from this business outlook survey is a diffusion index of manufacturing conditions within the Philadelphia Federal Reserve district. This survey, widely followed as an indicator of manufacturing sector trends, is correlated with the ISM manufacturing index and the index of industrial production.

Importance: The bond market prefers more moderate growth so that it won’t lead to inflation. The Philly Fed survey gives a detailed look at the manufacturing sector, how busy it is and where things are headed. Since manufacturing is a major sector of the economy, this report has a big influence on market behavior. Some of the Philly Fed sub-indexes also provide insight on commodity prices and other clues on inflation. The bond market is highly sensitive to this report because it is released early in the month and is available before other important indicators.

 

Australian data releases:

1. Dwelling starts

Definition: This is similar to US Housing starts outlined above.

Importance: As outlined above dwelling starts have a multiplier effect across the economy.

2. RBA Policy Stance

Definition: This gives the market additional information about where the RBA believes the economy is headed and the future path of interest rates.

 

China: Consumption versus Investment

For almost a decade there has been wide spread agreement that China’s growth model is not sustainable. Investment and exports have been the key drivers of growth and now raising consumption has become a top priority. In 2013 investment represented 54.4% of GDP, while household consumption’s share was only 35%. In most developed countries investment’s share of GDP is 20% and household consumption’s share is 60%.

Rebalancing the economy is no easy feat.  Dramatically reducing investment is not the best approach to take as it will ultimately lead to lower growth and endanger China’s 7.5% growth target. A sharp contraction will negatively impact consumption through lower employment and wage growth. Perhaps it’s not the high rates of investment that are the issue but more where it’s channelled. Ideally investment should be geared towards what is really needed including environmental sustainability, health services, a public transport network and infrastructure that will reduce road congestion. Rather than being directed to heavy industry that is underutilised, monuments and state buildings that serve little purpose and residential buildings that remain empty.

Some claim that financial repression in the form of deposit rate restrictions and a closed capital account have created this unsustainable growth model that favours construction over household income. The Chinese real estate sector, which has been a key driver of economic growth, is a illustrates this imbalance. According to China’s National Bureau of Statistics, this sector represents 15% of GDP. There are wide spread concerns that a property bubble has emerged and that it is close to bursting. This sector has experienced consistent price rises and overdevelopment backed by the government. Ghost cities throughout China are evidence of this. Newly created apartment buildings sit virtually empty. Sales of land-use rights are also a key revenue source for local governments’ financing of much of the quasi-fiscal activity that has driven the continued rise in the investment share since 2008. Local government will typically sell land-use rights to property developers and then assign the revenue stream to their own financing vehicles (LGFVs). These revenues are then used as collateral to finance further real-estate or infrastructure projects (see macrobusiness)

As a result of this overdevelopment, property developers are now cutting prices and there are fears that smaller developers in second and third tier cities may become insolvent. According to China Confidential, March sales were down 34% compared to the same time last year.

 

A contrasting view

The Lewis Turning Point offers a different view on the investment and consumption imbalance. This turning point is a key feature of Arthur Lewis’ Dual-Sector Model, devised in 1954. In this model, which he won a Nobel Prize for, he explains the development process. There are 2 distinct sectors: the capitalist sector and the agricultural sector. The capitalist sector is characterised by:

  1. A capital-intensive manufacturing process, relying on the use of reproducible capital
  2. Higher average wages
  3. Higher marginal and average productivity
  4. Higher demand for labour

While the agricultural sector consists of:

  1. A labour-intensive production process
  2. Low dependency on capital
  3. Low marginal and average productivity
  4. Low average wages

Naturally at the early stages of development the agricultural sector is very large. Land is limited so the marginal productivity of labour is the main limit on production. As this limit is reached the marginal productivity of labour approaches 0. As this limit is reached the surplus labour moves to the capitalist sector. During this early phase there is no shortage of labour, which means no wage pressure, as rural workers migrate to the urban sector. High marginal productivity, coupled with stable wages, leads to increased profits. These profits are then invested back into the sector, which results in an expansion of output. This process will continue until the point at which moving additional labour from agriculture to the capitalist sector results in a decline in agricultural output. At this point the capitalist and agricultural sector will compete for labour, resulting in increased wages. This is Lewis’s turning point. Through-out this process consumption as a share of GDP declines as labour’s share of output falls to around 50%, compared to 90% in agriculture.

Japan and South Korea’s rise followed this growth pattern. Consumption fell to 20-30% of GDP, while investment peaked at around 40%. Both economies had high rates of urbanisation and managed to reach a more balanced structure as their economies matured. However Japan has been plagued by stagnation since the asset price bubble burst in 1992.

China’s goal should not necessarily be to raise consumption but to create a more sustainable growth model. Increasing productivity, improving the urbanisation process and the source of funding are key. Consumption will then increase as a result of this. An alternative policy prescription, that directly targets consumption, is to transfer wealth from the government to the household sector through privatisation and the expansion of social infrastructure and welfare.

The Westpac-Melbourne Institute Leading Index

Leading indicators provide an early indication of where the economy is headed. Leading indices combine a number of leading indicators into one measure, with the objective of forecasting likely tuning points in the economic cycle. One of the most followed leading indices is the  Westpac-Melbourne Institute (WM) index, which attempts to provide a guide to how growth is tracking and likely turning points in the economic cycle, 3 to 9 months into the future.

There was a study completed by the RBA in 2002 which analysed the success that leading indices had in forecasting real economic activity in Australia. The focus was on forecasting the level of growth rather than turning points in the business cycle. As previously mentioned leading indices tend to be more focussed on anticipating turning points in the economic cycle than forecasting a specific level of growth.

This study compared the performance of the Westpac-Melbourne Institute (WM), NATSTAT and ABS leading indices’ accuracy in predicting real GDP, employment and unemployment in Australia. It was found that the WM index performed quite well relative to the Gruen and Shuetrim model over  a forecasting sample of relatively stable growth but didn’t perform as well over a longer forecasting period, which included the downturn in the early 1990s. WM index outperformed both the ABS leading index and the NATSTAT.

Since the study was completed the composition of the VM index has changed.  It’s most recent iteration includes the following leading indicators, which are published on a monthly basis.

S&P/ASX 200
Westpac-Melbourne Institute Expectations Index
US industrial production
commodity prices
Yield spread
(10Y bond – 90D bill)
Aggregate monthly hours worked
Dwelling approvals
Westpac-Melbourne Institute Unemployment Expectations Index
RBA Commodity Prices
Index (A$)

 

Using monthly leading indicators rather than quarterly means that the WM index is more timely and is less likely to be subject to revisions. It has been found that the new index is better correlated with GDP than the previous index, it peaks at the 3-month lead time but still displays strong relationship with GDP at the 6-month and 9-month lead time.

 

S&P / ASX 200

Movements in the Australian share market reflect overall market sentiment and investor confidence in the future of the Australian economy. A rise in the S&P / ASX 200 indicates that investors anticipate an improvement  in company earnings and a stronger economic environment.

The issue with relying on the share market as a leading indicator is that earning estimates are not always accurate and can at times be misleading. Accounting practices adopted by listed companies can greatly influence earning estimates and may overstate the earning potential or financial position of a company. Share markets are also subject to bubbles and price movements that are inconsistent with underlying fundamentals.

Westpac-Melbourne Institute Expectations Index

Westpac-Melbourne Institute Expectations Index is forward-looking and attempts to measure household confidence. It’s based on a set of questions aimed at surveying household expectations and sentiment.

Yield spread (10Y bond – 90D bill)

The yield spread is a proxy for the  expected impact of monetary conditions on the economy. It provides a stronger and more reliable guide than real money supply. The stance of monetary policy impacts economic growth, with a lag. If the RBA adopts an expansionary position by lowering the cash rate this will boost economic growth while a contractionary stance will have the opposite effect.

US industrial production

US Industrial Production is a proxy for US GDP. Historically, turning points in industrial production have coincided with turning points in GDP. Changes in the US economy have an impact on the Australian economy.

Aggregate monthly hours worked

A sustained increase in aggregate monthly hours worked indicates an increase in economic activity and a rise in the employment rate. As the number of hours worked increases businesses will seek to bring on new staff to expand operations. This will in turn lead to an increase in consumer confidence and consumption.

Dwelling approvals

Dwelling approvals provides an indication of future residential construction. A rise in construction leads to increased employment and a rise in GDP. However the relationship between housing supply and demand should be taken into account. An increase in construction may result in excess demand, which will inevitable lead to a fall in house prices. Dwelling approvals tend to be closely correlated with consumer confidence.

Westpac-Melbourne Institute Unemployment Expectations Index

The Unemployment Expectation Index provides a guide to how confident households are in relation to the labour market and their employment prospects.

Manufacturing activity

An increase in manufacturing activity can indicate an increase in the demand for consumer goods and a rise in employment. Increases in manufacturing activity may be misleading if the products produced do not make it to the end consumer. Retail sales data should also be considered.

Inventory levels

An increase in inventory levels can indicate 1 of 2 things:

– Businesses are building up their stock of inventory as a increase in consumption is anticipated

– Consumer demand has fallen and as a result businesses are holding excess inventory

Retail sales

An increase in retail sales directly boosts GDP, which translates to higher employment and in turn leads to stronger consumer demand. It’s also important to consider how this increase in retail sales has been funded. If debt levels aren’t sustainable over the long term, then an increase in debt fuelled consumption may indicate an impending recession or fall in economic activity.