In a recent research paper, former Chair of the Federal Reserve, Mr Ben Bernanke, proposes price level targeting as an alternative framework for monetary policy. This paper is likely to be a catalyst for a welcome re-assessment around the costs of traditional inflation targets.
The RBA's biannual Financial Stability Review has become essential reading since the financial crisis. The central bank has used the October issue as an opportunity to vent about its concerns surrounding investor complacency in global financial markets. The language it is now resorting to suggests that its patience is wearing thin.
Market volatility conditions have remained subdued for some time. Daily return volatility of the Australian dollar Trade Weighted Index has dropped to its lowest level in a decade despite the recent appreciation of the Australian dollar against the US dollar. Volatility in the 10 year CGS yield has exhibited a regular cycle since the financial crisis, but the the peaks and troughs have tended to trend down. While stock market volatility is close to a decade low (see chart).
Although not shown here, global macro volatility is not as benign in Australia. Although return volatility of the S&P500 is anchored to its lowest level in four decades, volatility of the US dollar has been rising and volatility of US Treasury 10 year yields is high by historical standards. So the persistently low level of stock market volatility in Australia probably reflects an exposure to a global volatility shock, while subdued volatility conditions in the TWI and Australian bond yields may have arisen thanks to domestic developments.
The benign stock market volatility in the United States has coincided with a drop in the expected risk premium (ERP) to its lowest level since 2010 (see chart). Even at current levels, the ERP remains higher than the levels that prevailed during the credit boom. The implied volatility of index puts on the S&P500 also are low by the standards of the past decade (not shown here). Evidente has previously suggested that if the ERP in the United States continues to trend down, it would be expected to precipitate a revival in animal spirits and business investment, and ultimately sew the seeds of the demise of the profit boom.
The Australian experience differs from that of the United States. Although stock market volatility conditions are subdued, the implied ERP has been broadly unchanged over the past five years (see chart). The ERP divergence between the United States and Australia might have contributed to the multiple expansion of the S&P500 to close to historical highs, while the ASX200 continues to trade in line with historical norms. Evidente believes that a renewed drop in the ERP is necessary to revive animal spirits in the corporate sector and kick-start growth of capital investment.
One of the key macro risks in Australia remains the historically low rental yields in residential property. The gross yields on apartments and detached houses have dropped to 4% and around 3% respectively. Evidente has previously suggested that when net rental yields and the lift in lending rates for investors are taken into account, the economics for new property investors are becoming more tenuous.
Investors appear to be alive to the risks associated with historically low rental yields, with the Australian bank sector currently trading on a 35% book discount to non-bank industrials (see left panel below). This represents the largest discount since 2000 and comparable in size to the discount that prevailed in the late 1980s and early 1990s. The size of the discount might also reflect negative sentiment surrounding what many consider to be bad bank behaviour. Higher capital requirements have probably played little role since the sector continues to post higher profitability - in terms of return on equity - than non bank industrials (see right panel below).
Investors also seem to be alive to the risks associated with high and rising corporate debt in China, particularly in the construction sector. The metals & mining sector is trading on a book discount to non-bank industrials of around 35%, which remains low by historical standards (see left panel below). The size of the discount persists despite the fact that the profitability of the metals & mining sector has recovered from its recent trough and is now comparable to non-bank industrials (see right panel below).
Against this backdrop, Evidente has re-balanced its thematic, high conviction model portfolio, which under-performed marginally in the September quarter and out-performed marginally in the twelve months to 30 September. Given the size of the sector discounts, the model portfolio retains an overweight in banks, and metals & miners, funded from an underweight in non-bank industrials. Despite some of the macro tail risks discussed in this post, Evidente believes that the risk-reward for these two sectors remains attractive for now.
It has been a good week for APRA and the RBA. Their announcements surrounding the expansion of the use of macro-prudential policy tools and warnings around slow growth in rents and the outlook for property prices have had the initial desired effect of maximum media coverage. They would hope that lenders and potential property investors are getting the message.
The head of APRA yesterday, further weighed in on the debate surrounding banks' loss absorbing capital buffers. Mr Wayne Byres had already bought into the key recommendation from the Financial System Inquiry (FSI) that Australia's financial system should be unquestionably strong due to the fact that Australia has historically been a net importer of financial capital, and the high concentration of residential mortgages on banks' loan books. To that end, the FSI suggested that Australia's banks' capital positions should be in the top quartile globally. APRA hasn't committed to this hard edged quantitative aspiration or target and it is at their discretion which capital ratios they focus on.
In mid-2016, APRA lifted the risk weights used by banks with internal risk based models (ie. larger banks) by 50%, from 17% to 25%. In yesterday's speech however, Mr Byres took a more glass half empty approach by drawing attention to the fact that Australia's banks had indeed lifted their risk weighted capital ratios since the financial crisis, but their leverage ratios had remained little changed during this time. The leverage ratio, the ratio of total assets funded by shareholders' equity, has increased marginally to around 6.5% from 6% in 2007 (see chart).
The Tier 1 capital ratio - which represents the ratio of shareholders' equity to total risk weighted assets - has increased to 12% from 8% over the past decade (see chart). Risk weighted assets assign lower risk weights to loans that are considered less risky (eg. residential mortgages) and higher risk weights to more risky loans such as commercial lending. The key implication is that a bank must therefore must use more shareholders' equity to fund a commercial loan than a residential mortgage.
Because housing loans attract low risk weights, growth in risk weighted assets has been slower than growth in total assets as banks have lifted the share of residential mortgages in their loan books (see chart). A cynical interpretation is that the banks have gamed the risk weights; a more generous interpretation is that a lift in mortgage lending has helped to offset the persistently weak demand for corporate lending since the crisis.
Against this backdrop, Mr Byers announced that it would release an issues paper later this year, outlining a road-map on how it intends to further strengthen banks' loss absorbing capital ratios, and hinted at the prospect of a further lift in the risk weight for residential mortgages used by the larger banks.
The key development in Evidente's view is the focus on the leverage ratio. APRA has left itself plenty of flexibility at this stage, and I am not suggesting that that APRA intends to target a desired leverage ratio. But as a guide only, we undertake a global comparison of leverage ratios and a sensitivity analysis. At present, the leverage ratios for the Australian majors range from 6% to 6.5%, which puts them below the median of the largest 100 developed market banks by over 100 basis points (see chart).
Assuming that the sector's assets remain unchanged from current levels, the majors would need to top up their shareholders equity base by 18% or $40 billion to reach the global median of 7.6%. To get to the top quartile would require an additional $70 billion or a 30% more equity. These are large numbers and I suspect for this reason, APRA won't be imposing a hard edged target on the leverage ratio.
Finally, it is not just possible but likely that the path to stronger capital positions will involve some contraction of assets. This has already been evolving, with annual asset growth in the sector turning negative for the first time in over two decades recently (see chart). ANZ and NAB have been seeking to 'shrink to greatness' by shedding low return international businesses, and Evidente expects this process to continue with ANZ and CBA looking to sell their wealth management businesses.
Dwelling investment represents one one of the highly cyclical components of aggregate demand. Since the inception of the National Accounts in the late 1950s, investment in housing has been subject to numerous cycles, but in the past dozen years the cycle has become more extended and less volatile (see chart). At present, total dwelling construction accounts for 6% of GDP, a peak reached only five times in the past sixty years. Usually, housing activity of this scale has reflected overbuilding, and subsequently been followed by a sharp downturn, including: the 1980s, mid-1990s, early 2000s and mid-2000s.
New dwelling investment close to a record high
What is particularly unique about the housing expansion since 2012 is the composition of dwelling investment. The GDP share of renovation activity - 'alterations and additions' - remains low by historical standards at around 2%. This was the basis for Evidente suggesting in prior posts that the renewed growth in house prices this time didn't reflect an emerging property market culture, like that which prevailed in the early 2000s, when renovation activity lifted to 2.6% of GDP. Many home-owners became DIY experts over this period, and the turnover of the housing stock lifted as owner-occupiers sought to renovate and sell quickly at a handsome profit. Rather, new dwelling investment has underpinned the current expansion, which has lifted to 4% of GDP, its highest level since 2000/01 (see chart).
Australia's apartment boom
The second dimension of Australia's housing revolution has been a shift towards higher density living; Australia's apartment and townhouse boom. The number of residential building approvals for higher density dwellings is now comparable to that for detached houses, at between 110k and 120k per annum (see chart).
In its February Statement of Monetary Policy, the RBA notes that within the higher density segment, there has been a shift towards apartment blocks with four or more storeys (see chart).
Australia's housing revolution towards higher density living has been felt across the entire eastern border; the number of residential building approvals for apartment blocks and townhouses has posted strong growth since 2012/13 across NSW, Victoria and Queensland (see chart). In the past year however, there has been a substantial drop in high density approvals in Queensland and Victoria, probably reflecting the tightening of bank lending standards to housing investors and lower price growth. The RBA notes that the boom in apartment construction has been particularly concentrated in inner city Brisbane and Melbourne, which make these cities vulnerable to rising risks of over-supply emerging.
According to the RBA, the number of cumulative apartment building approvals in the three years to 2015 added around one third to the stock of apartments in both inner city Brisbane and Melbourne, but less than one-fifth in inner city Sydney. These divergent trends probably reflect the relative scarcity of available land for development in inner city Sydney.
Why the shift to higher density housing?
Higher population growth
A lift in population growth in the past decade has supported the dwelling investment cycle. Year on year growth in the population has remained above 1.4% for much of the past decade (see chart). This follows a fifteen year period in which population growth typically was below 1.2% pa.
Evolving consumer preferences towards more affordable living
Higher population growth can explain some of the shift towards higher density living thanks to land supply constraints, which have been associated with higher prices for blocks of land and detached houses. This has induced a shift in consumer tastes towards apartments, which use land more intensively and are therefore more affordable than detached houses.
Limits to the urban sprawl
Given the topography of Australia's major cities, there are physical limits to further urban sprawl. Consequently, there has been an increase in the availability of former industrial or brownfield sites relative to urban fringe or greenfield sites, which are mostly used for detached housing.
Australia's low urban population density slowly catching up to the rest of the world
Despite the shift towards higher density housing, Australia's urban population density remains amongst the lowest in the world, which reflects postwar policies designed to encourage construction of detached housing on suburban land blocks - particularly for war veterans and their families - and the culture of aspiration for a house on a quarter acre block (see chart).
Australia's housing revolution - Here to stay
Evidente believes that developments that have led to the shift towards higher density living are likely to persist over the medium term: limits to further urban sprawl, shift in preferences to the convenience of living close to employment centres, Australia's still low population density and the waning aspiration of owning a detached house on a quarter acre block.
- Given the topography of cities such as Melbourne and Sydney, there are limits to which the urban fringe can further expand, not to mention the high transport infrastructure costs associated with developing greenfield sites that are more distant from the city. The aversion of Australia's governments to lift debt levels or raise tax rates to fund infrastructure has seen a rush of sorts to sell or lease government assets. For instance, the Victorian government last year announced the long-term lease of the Port of Melbourne, with the proceeds linked to the replacement of around 50 railroad crossings across metropolitan Melbourne.
- The growing demands of white collar occupations are such that many workers in these roles will want to continue to live close to employment centres, in addition to the convenience and diversity of choice associated with living in or close to the inner city.
- Australia's population density remains low by international standards. The scope for Australia's capital cities to accommodate a growing population and increase population density probably depends in part on an easing of planning laws that allows higher apartment towers to be built across metropolitan areas.
- The substitution effect from detached housing to townhouse and apartment living is expected to continue. Notwithstanding the risk of a correction in house prices, the average price of residential land and detached houses is likely to remain high, encouraging people - particularly young people - to live in more affordable, higher density housing than their parents were accustomed to. Against the backdrop of the shift that has already been occurring, the aspiration to own a detached house with a good size backyard on a quarter acre block is not ingrained in Australian culture as it once was.
Investment implications - The long view...
Planning laws have promoted the development of apartment buildings and other high density dwellings along major roads and railway lines, that have easy access to public transport. But the demand on existing infrastructure is such that congestion has continued to increase. Traffic congestion remains a political hot potato for Australia's federal government, as well as state governments, particularly in the two most populous states, NSW and Victoria. In addition to the removal of 50 railway crossings across metropolitan Melbourne cited, a number of other transport infrastructure projects are underway, including the construction of Melbourne's metro tunnel and the widening of Transurban's City Link.
Evidente believes that the two listed stocks most leveraged to the construction of infrastructure projects designed to ease traffic congestion are toll road operator, Transurban, and Downer, which generates over one-third of its revenues from its rail and transport services divisions. Downer has lifted its operating profitability in recent years to over 20%, continues to trade at a discount to the broader market, and has a sound balance sheet with a gearing ratio (which includes off balance sheet debt) of less than 15%.
Hardware retailers such as Bunnings might need to modify their product range over the medium term, with the growing army of apartment dwellers presumably having less need for garden appliances and power tools. Moreover, there is less scope for apartment dwellers to engage in DIY renovation than those living in detached houses.
...but don't forget the cycle
Despite the prospect that the structural shift towards higher density housing will continue over the medium term, booms and busts around the new normal are inevitable. As cited above, new dwelling construction remains close to a record peak of 4% of GDP. The RBA has already warned about the growing risks of an apartment oversupply emerging in inner city Melbourne and Brisbane. By late 2016, half yearly growth in inner city apartment prices in Sydney, Melbourne and Brisbane had trended down to zero (see chart).
If conditions in these markets deteriorate substantially, banks would likely experience more material losses on their development lending than on their mortgages. Development lending is typically associated with a higher default probability and higher loss given default than on their mortgage lending for apartment purchases. Nonetheless, banks' aggregate exposures to inner city apartment markets- particularly in Sydney - are greater through their mortgage lending than via development lending (see chart). The aggregate dollar value mortgage exposure translates to 2-5% of banks' total outstanding mortgage lending to inner city Sydney, Melbourne and Brisbane.
Australian mortgage lending has historically been profitable due to low default rates - around 1/2 per cent - and high levels of collateralisation. Price growth of inner city apartments in Sydney has been strong in recent years, so that a large price fall would be necessary for banks to experience big losses due to lower loss given default assumptions. The buffers are smaller for Melbourne and Brisbane because capital appreciation in apartments has been subdued. The RBA estimates that combined inner city apartment values across Sydney, Melbourne and Brisbane would need to fall by 25% or more before banks started to incur significant losses.
In its quarterly update this week, the CBA showed its exposure to apartment developments by city, which amounts to a little over $5 billion in aggregate. Sydney apartments represent 60% of its exposure where the buffer is larger, while Melbourne and Brisbane in total account for a little under 30% (see chart). The total loan to value ratio of 60% is conservative and the CBA indicates that it has lowered its share of foreign pre-sales.
Despite these risks, Evidente's model portfolio remains modestly overweight Australia's bank sector. Although the P/B discount that banks trade on relative to industrials has narrowed in recent months, it remains high by historical standards (see left panel below). The sector's ROE has dropped in part thanks to de-gearing associated with a lift in loss absorbing capital buffers, but the ROE prospects for the industrials universe have deteriorated by more (see right panel).
Last year, Evidente published a report entitled The Dangers of Safety. Assets with safe haven characteristics - notably sovereign bonds, corporate bonds and low beta stocks - had delivered strong returns since the financial crisis, with bond holders doing better than shareholders. From the perspective of valuation theory, investors had lifted their expectations of future cash flows and dividends from defensive stocks relative to cyclical stocks. But the rush to safe haven attributes also pointed to lower expected returns from bonds and low beta securities.
Evidente has previously argued that a rise in the equity risk premium represents the most plausible explanation for the discount rate effect which benefited defensive stocks, because in the CAPM there is a multiplicative relationship between the risk premium and a stock's beta. So a rise in the risk premium, controlling for other factors, is associated with a lift in the expected cost of equity of high beta securities relative to their low beta counterparts.
Of course, the risk premium is not directly observable, unlike the risk free rate. But it was reasonable to infer from developments that the risk premium had risen since the financial crisis: the spread between earnings yields and government bond yields had been widening even before the onset of the financial crisis, corporate bond spreads had increased - moreso for sub-investment grade issues - and hurdle rates used by the corporate sector for the purposes of capital budgeting had remained sticky despite the decade long decline in the yield to maturity on long dated government securities and the historically high rates of return on capital.
It remains puzzling that the high profit share has not induced a capital boom. After all, the basis of capitalism is mean reversion in rates of return on capital; activities that are highly profitable should encourage an influx of capital, from both incumbents and new entrants, which subsequently erodes abnormal returns.
Network effects, high barriers to entry and capital light
Larry Summers has developed a widely known theory that seeks to resolve this puzzle. The US stock market has come to be dominated by a small number of large IT firms that have high profitability and low capex requirements, including the likes of Apple, Google and Microsoft. The benefits of first mover advantage associated with network effects has facilitated a shift towards highly profitable and capital light activities that are characterised by high barriers to entry. In contrast, the old economy firms that once dominated the US economy were typically capital intensive.
The data lend some support to Mr Summers' view. First, there has been a rising trend in the corporate profit share over the past four decades. Since the late 1980s, the cyclical peak in the profit share has continued to increase from 8% (1989), 10% (1997), 12% (2007) to 12.5% (2014). The chart below denotes the last three peaks with green circles. Despite this trend, the US economy's capital intensity has diminished since the early 2000s. The peaks in the capital cycle - denoted by the red circles - have declined from 14.5% (2001), 13.5% (2008) to 13% (2015).
A decomposition of the aggregate data on non-residential gross private domestic investment reveals an even weaker picture of 'old economy' capex. Investment in intellectual property products has expanded by almost 50% since the financial crisis to $800 billion (see chart below). In contrast, more traditional and capital intensive activities have been much weaker. Investment in equipment is around 10% higher than its pre-crisis peak, while investment in structures (eg. infrastructure and buildings) remains below its pre-crisis peak.
Despite the long-run divergence between the US economy's profit share and business investment share in recent decades, there has been plenty of cyclical variation of both series in between. Most obviously, the profit share plunged to 7% at the depth of the financial crisis. This cyclical variation provides scope for complementary or competing theories of the divergence. I believe that the lift in the risk premium that precedes the financial crisis complements Mr Summers' theory of a compositional shift towards more capital light activities associated with high barriers to entry. Mr Summers cites the low level of the VIX index of implied volatility as evidence that the risk premium has not increased. I believe that the VIX represents a poor proxy of investors' perceptions of risk.
More risk = less investment
The perception of greater risk from the perspective of a company undertaking capital budgeting decisions ought to be reflected in higher discount rates used, or the target of a higher internal rate of return (IRR) before a project is accepted. After all, a higher discount rate - controlling for a prospective project's projected cash flows - reduces its net present value. The fact that the decade plus long decline in the risk free rate has not induced a capital boom suggests that corporate hurdle rates have remained sticky. In other words, there has been a commensurate lift in the equity risk premium implicitly used by companies. The higher risk premium has therefore meant that the rising profit share and profit margins of the US corporate sector has not lifted expected risk adjusted rates of return. This represents a viable explanation for the divergence between profits and capital investment.
The great reversal
In the report The Dangers of Safety, I suggested that the at some stage, the reversal of the rising risk premium would have significant implications for stock markets as well as the divergence between profit share and capital investment. Two key financial market developments since mid-2016 suggest that this reversal is now underway.
Convergence in bond and earnings yields starts (finally)
A school of thought had emerged in the past decade that argued that stock markets were cheap because the decline in the risk free rate had not translated into lower earnings yields (or higher multiples). The earnings yield for the S&P 500 companies of around 6% at present is comparable to the level that prevailed in around 2002. Up until mid-2016, the yield to maturity on 10 year Treasury bonds has declined by over 300 basis points (see chart below). A lift in the equity risk premium that broadly offset the lower risk free rate can explain the divergence. Conversely, the earnings yield has remained little changed since mid-2016 when long term sovereign bond yields have increased by 100 basis points, lending support to the view of a decline in the risk premium, particularly given that long term growth expectations for GDP and corporate profitability have remained little changed over this time.
Lower corporate default risk
Corporate bond spreads have fallen substantially over the past year, pointing to expectations of lower default risk as well as higher recovery rates. The yield on triple A rated bonds minus the risk free rate has fallen to 1.5% from over 2%, while the spread on lower investment grade Baa rated bonds has fallen by proportionately more to 2.2% (see chart). Despite these falls, they remain higher than historical norms.
The outlook for the equity risk premium and animal spirits in the household sector
The reversal of the decade long plus rise in the risk premium is unlikely to be a linear one; asset market developments rarely are. Although Evidente has provided a framework for understanding market implications of shifts in the ERP, what remains unexplored are the underlying causes of swings in the ERP. Whatever the right theory is, the discount rates that investors use to discount future expected cash flows or dividends, and the hurdle rates used by CFOs in capital budgeting must surely be related to the discount rates that households implicitly assign to their own future expected cash flows. In other words, a plausible theory must link discount rates and risk premia across financial markets, corporate sector and household sector. It would be difficult to reconcile evidence of a lower risk premium in financial markets and the corporate sector, with a rising risk premium in the household sector.
But given that the present value of human capital (simply the sum of discounted household cash flows) is not directly observable, what can be used to infer something about the state of animal spirits in the household sector? The consumption of durable goods represents a good starting point. After all, consumers are more likely to purchase white goods and other long lasting items when they become more optimistic about their own future economic prospects. It is has been a volatile path for durable goods consumption in the United States since the financial crisis. It took five years before spending on durable goods spending returned to its pre-crisis peak and even now it is only 20% higher than its pre-crisis peak (see chart). The green circles denote the frequent episodes of either a slowdown in growth or outright contraction in durable goods consumption.
Evidente has suggested that financial market developments since 2016 point to a lower risk premium, but that it probably remains high by historical standards. The more recent reversal seems to line up with renewed growth in spending on durable goods in the past year. If the shift to a lower ERP is to continue, much will depend on the psychology of the consumer. To that end, Evidente will be closely monitoring trends in durable goods consumption.
Concluding remarks: The coming compression (and the dangers of safety re-visited)
To the extent that the risk premium continues to fall, the dangers of safety will continue to evolve. In the cross section, stocks will out-perform corporate bonds which will out-perform government bonds. Within the stock market, high beta securities will outperform stocks with safe haven characteristics, proving a challenge for systematic funds seeking to exploit the low volatility anomaly.
As far as the US corporate sector goes, a lower ERP will be associated with a revival of animal spirits amongst CEOs and CFOs. Even if hurdle rates remain sticky, higher expected cash flows and higher risk adjusted rates of return from prospective projects will usher in an influx of new capital. The subsequent boom in capital investment is likely to erode abnormal rates of return on capital. If history is any guide, episodes where a capital boom coincides with a compression of the profit share are not kind to shareholders.
Biggest quarterly decline since the financial crisis
Real or inflation adjusted GDP fell by 0.5% in the September quarter, the worst quarterly outcome since the financial crisis and the second worst outcome since the recession of the early 1990s (see chart).
Nominal, not real income, matters for stock investors
For a while now, Evidente has suggested that for the purposes of discounting company’s future cash flows, the key overreaching macroeconomic indicator that matters is nominal GDP, not real GDP.
Nominal GDP represents the dollar value of the flow of production during the quarter, which captures both quantity and price effects. Statistical bureaus measure the price effects or inflation (in the National Accounts known as chain price indexes), and from this and nominal GDP, they then back out the implied growth in aggregate volume or real GDP. So the accuracy of the real GDP growth estimate is only as good as the estimate of the price index.
Increasingly, price indexes are becoming unreliable proxies for inflation due to the quality improvements associated with the diffusion of information and communication technologies. Practically speaking, it is notoriously difficult, subjective and resource intensive to accurately measure these quality improvements, despite the development of hedonic price indexes. Consequently, conventional measures of inflation have a significant upward bias.
Setting aside the measurement issues, nominal GDP represents the key macroeconomic barometer for stock markets because analysts and investors forecast nominal company cash flows, not real cash flows. Similarly, employees do not earn inflation adjusted compensation.
Australia pulling out of its prolonged income recession
Evidente has long argued that the Australian economy has effectively been stuck in an income recession for the past five years, broadly coinciding with the peak in global commodity prices. For most of the past five years, annual growth in nominal GDP has remained below 4% (see chart).
From its peak to trough, Australia’s terms of trade – the ratio of export to import prices – fell by around one-third (see chart). The persistent weakness in growth of nominal GDP and incomes has made it a challenging environment for corporate sector profitability and government taxation revenues, particularly income tax.
A careful analysis of nominal GDP in the September quarter paints a far more optimistic picture of the economy than the shocking drop in real GDP. Nominal GDP lifted by 0.5% and expanded by 3% in the year to the September quarter. The terms of trade appears to have bottomed this year and has lifted by almost 10% since, which has given growth in nominal GDP a strong assist. Subject to the state of residential property markets in China, the September quarter National Accounts confirmed that the economy is pulling out of its long income recession.
Business investment has been a drag on growth for a number of years now. The drop in commodity prices since their peak has underpinned a substantial fall in private business investment – particularly mining capex - which is 20% lower than its peak in 2013 (see chart). This includes the pull-back in development of iron ore and oil projects, as well as LNG projects that have approached completion.
But even outside the mining sectors, animal spirits in the corporate sector have remained dormant despite record low interest rates. The much anticipated handover from mining to non-mining capex has not transpired. Evidente has previously drawn on analysis from the RBA suggesting that hurdle rates have remained remarkably sticky due to a lift in the expected equity risk premium, which has contributed to persistent weakness in capex.
A sharp drop in public sector investment contributed to the poor GDP outcome in the September quarter, but as the chart below shows, this follows a year in which it had ramped up strongly.
As noted above, the income recession has created a difficult environment for corporate profitability. Consensus 12mth forward EPS estimates for the ASX200 companies remain around one-third lower than their pre-GFC peak (see chart). Consistent with the recent re-bound in global commodity prices and nominal GDP, forecast profitability appears to have bottomed in early 2016.
The surprise election of Mr Donald Trump as 45th President of the United States – by a convincing majority in the electoral college – raises four questions that forecasters and investors need to confront.
- Why did Mr Trump win?
- What inferences – if any – can investors make about a global anti-establishment movement?
- Following on from the surprise Brexit decision, why did the polls fail to predict Mr Trump’s victory.
- Going forward, what does a Trump presidency look like for risk assets?
Why did Mr Trump win?
The consensus appears to have focussed on income disparities and growing disillusionment in the community around globalisation. The fact that Mr Trump was able to break the Democratic ‘fire wall’ of the rust belt states – Michigan, Pennsylvania, Wisconsin, Ohio – lends support to the view that the President elect was able to mobilise disaffected and marginalised working class males who had either lost their jobs in manufacturing or who harboured aspirations of a return to the once dominant manufacturing base in those states. Moreover, Mr Trump was able to mobilise and tap into a growing anxiety and frustration among the working and middle classes who have borne the brunt of growing income inequality, which has increased to a level not seen since the early part of the 20th century.
Mr Trump represents the ultimate anti-establishment figure with striking similarities to Mr Silvio Berlusconi, the former Prime Minister of Italy. Voters in other countries – including Thailand – have also previously elected anti-establishment figures that have had successful business careers. Of course, an anti-establishment movement is unlikely to gain traction without a sense of economic stagnation, low income growth and anxieties around job security for those who are employed.
Nonetheless, the current President’s ratings are at their highest level in over six years. If a sense of economic stagnation by the forgotten working classes had underpinned Mr Trump’s election, then surely Mr Obama’s approval ratings would have been plumbing new lows rather than lifting to close to historical highs. Nor would US voters have voted for a Republican controlled Congress.
In terms of the arithmetic of the outcome, it appears that Ms Clinton will win the popular vote by up to 1.5 percentage points but lose the electoral college vote. For whatever reason, she was not able to mobilise enough supporters in the key swing states. As the President elect, Mr Trump could well have the lowest popular vote since Mr Bill Clinton in 1992.
What inferences – if any – can investors make about a global anti-establishment movement?
Mr Trump was able to tap into the mood for change and backlash against the establishment not just because of his status as a political novice. Importantly, he projected an image of a person who was able and willing to speak his mind, and be a straight talker rather than resort to political speak. It is reasonable to think that his messages and communications were not hostage to spin doctors or focus groups. Of course, going down this path gains traction only if the message resonate with voters.
The anti-establishment movement was evident in Australia’s federal election in July, where One Nation gained a number of Senate seats and where micro parties more generally won a bigger slice of the Senate and House of Representatives. The Brexit vote also arguably reflects growing anti-establishment sentiment.
Against this backdrop, investors should be looking ahead to elections in 2017 in Germany, France and the Netherlands, and the prospect of a resurgence of fringe parties (both on the left and right). If the backlash against establishment politics and political correctness represents a global phenomenon, investors will need to confront the prospect of renewed political instability not just in the United States.
Following on from the surprise Brexit decision, why did the polls fail to predict Mr Trump’s victory?
According to political forecaster, Mr Nate Silver (founder of 358.com), the polls – on average - were assigning a probability of a Trump victory at less than 30% immediately before election day. The predictions of most polls was incorrect for three reasons according to Mr Silver. The final result was well within the margin of error. Polls are far from perfect, particularly if Trump supporters (like Brexit supporters) were reluctant to reveal their preferences to pollsters. Second, the unusually high number of undecided voters contributed to greater uncertainty surrounding the outcome. Third, the main cohorts of Clinton supporters – college educated whites and Hispanics – were not concentrated in swing states.
Going forward, what does a Trump presidency look like for risk assets?
This represents the key question for investors and market watchers. At one stage as the day unfolded, futures markets pointed to a 750 drop in the Dow Jones. At the time of writing (2200 AEST), this has been pared back to a 350 point drop or around 2%. The conciliatory nature of Mr Trump’s acceptance speech might have allayed some investors’ concerns. In fact, some might have been encouraged by his focus on infrastructure spending to kick-start growth, as well as a conciliatory tone to leaders of other countries and no mention of any dividing walls (for now anyway).
Those tempted to draw parallels between the outcome of this election and the risk on trade soon after the Brexit decision should tread cautiously. The Bank of England calmed market jitters immediately following Brexit and announced that it would stand ready to inject liquidity into the financial system if necessary. The path forward for the Federal Reserve is a difficult one. During the election campaign, Mr Trump openly politicised the independence of the central bank by criticising Ms Janet Yellen’s policy of maintaining low interest rates. In the event that Mr Trump continues to not respect the independence of the Federal Reserve, I believe that Ms Yellen’s position is untenable. Political instability around the central bank is not conducive to risk assets outperforming. Nor is the prospect – cited above – of the spread of anti-establishment fringe parties in key elections in Europe next year. With the S&P500 earnings yield currently at 6%, its lowest level in over a decade, there isn’t much margin for error for risk assets.
Much of the focus on central bank deliberations in the past month has been on the US Federal Reserve Governor’s comments at Jackson Hole around the prospect and timing of an imminent hike in the federal funds rate; it appears that a 25 basis point lift is a forgone conclusion, whether it is at the September or December meeting of the Federal Open Market Committee.
The main measure of inflation tracked by the Fed – core PCE inflation – remains below the central bank’s 2% target. Ms Yellen and her colleagues clearly remain faithful to a Phillips curve view of inflation dynamics; in the short run, low unemployment is associated with rising inflation. With the unemployment rate below 5%, the internal view at the Fed is that the US economy at or close to full employment which offers confidence that core inflation lifts back towards the 2% target once the transitory effects of lower energy prices and a stronger US dollar wear off.
Differences of opinion amongst economists around whether the Fed should tighten policy at a time when inflation continues to undershoot the target therefore hinge on whether the short run Phillips curve is the right model. If it is, then the central bank is justified in giving weight to strong labour market conditions. Evidente has previously suggested that the unemployment rate has increasingly become an unreliable gauge for inflation. Prior to the crisis, the Phillips curve was steep; since then it has flattened considerably.
The bond market remains at odds with the Federal Reserve. With the yield to maturity on 10 year Treasuries at less than 1.6%, it is sending a powerful signal that it doesn’t buy into the short-run Phillips curve view of the world. And for good reason; surveys and market based measure of inflation expectations remain well anchored.
Perhaps the current cohort of central bank governors have under-estimated just how successful their predecessors had been in slaying the inflation dragon over the past two decades, as well as the scale and persistence of the global glut in saving. The world has been awash with excess financial capital, driven primarily by a strong appetite to save at a time when profitable investment opportunities have apparently diminished. No wonder that the global price of money is at a record low.
The global glut in saving was cited recently by the Governor of the San Francisco Federal Reserve as one of the key reasons for the decline in the neutral rate of interest; the interest rate that is consistent with the economy growing at potential output. The theory goes that entrepreneurs and companies will be encouraged to invest when the actual interest rate is below the neutral rate, and conversely will be discouraged when the actual rate is higher than the neutral rate. Weak business investment since the financial crisis suggests that the prevailing interest rate – even at these low levels – lies above the neutral rate.
To the extent that the neutral rate of interest remains low going forward – some estimates point to close to zero – this points to a world where the Federal Reserve and other central banks will be hitting up against the zero lower bound to deal with the next downturn and beyond. Ms Yellen in her Jackson Hole admitted as much when she explained at length that the Federal Reserve could continue to rely on forward guidance and large scale asset purchases, if necessary.
For fixed income managers, the timing of a US rate hike in September or December matters. More importantly, they will be looking for hints that reveal the likely trajectory of the fed funds rate over the course of 2017. If the recent history of the dot plots of the Fed’s own internal projections is any guide, the central bank’s senior officials continue to under-estimate the powerful effect of the drop in the neutral rate of interest and the associated powerful disinflationary forces.
Much has been made of the rise in bond duration to a record high globally; the sensitivity that bond prices have to changes in the yield to maturity (YTM). A decline in the YTM is associated with an increase in a bond’s price. Governments around the world are clearly taking advantage of record low interest rates and issuing more bonds at longer maturities. Much in the same way that some CEOs take advantage of their stock price being at a record high to issue equity to fund an acquisition and/or capital investment. With the US 10 year Treasury bond price to coupon ratio pushing beyond 60x, Treasuries are clearly vulnerable at some stage to a lift in the YTM (in the same way that a glamour stock is vulnerable to a lift in the discount rate used by investors).
For equity managers versed in financial statement analysis, and forecasting net cash flow and dividends, the timing of the next rate hike in the United States matters less. What is more relevant are the reasons underlying the drop in the neutral rate of interest and why animal spirits in the corporate sector remain dormant when corporate profit shares across many developed economies are high by historical standards. Economists I believe have over-simplified the investment implications of the neutral rate of interest. Companies just don’t look at the rate of interest, but their cost of equity capital, which is the sum of the risk free rate and equity risk premium (ERP), however measured. In the past, Evidente has suggested that stocks have not re-rated despite the lower risk free rate because of the offsetting effect of a rise in the ERP. The decade long widening in corporate bond spreads in the United States and survey evidence that hurdle rates remain sticky is also highly suggestive of a higher ERP.
The higher ERP would help to explain a number of empirical phenomena.
- First, a higher risk premium has probably reduced expected risk adjusted returns of prospective capital projects despite high expected profitability, which would account for why there is little appetite for risk taking. This represents a more coherent thesis for persistent under-investment than Larry Summers’ view that the capital light firms dominate stock indexes globally.
- Second, low beta stocks ought to trade on a higher multiple than normal due to the interaction of their beta and the ERP. In the CAPM, the relationship between the two variables is multiplicative so that a rise in the ERP and a fall in the risk free rate reduces the cost of equity capital. The math is not so kind to a high beta stock because the interaction of a higher beta and higher ERP overwhelms the effect of the lower risk free rate. Low beta stocks have also benefited from the bond like attributes of a stable dividend stream.
Much research needs to be done to understand the causes of the higher ERP. A good starting point is to better understand the dynamics around households’ stock of human capital, what Milton Friedman called permanent income; the stream of expected discounted future cash flows. Specifically, economists need to better understand why households are assigning higher risk premia to their expected cash flows, which has led to a substantial drop in permanent income. This is fertile ground for those looking to understand the sources of timing of a reversal of the rising ERP. This will lead to a tectonic shift in the relative performance of 'safe' assets: low beta stocks, low volatility stocks, high grade corporate bonds and sovereign bonds. The dangers of safety will re-emerge, but not just yet.
* Charts accompanying the analysis are available on request.
Dear Mr Turner,
It has been two years since the Senate Inquiry into the Performance of ASIC demonstrated the misconduct by financial advisers and other staff at Commonwealth Financial Planning Limited (CFPL). According to the inquiry, multiple CFPL advisers failed to meet required compliance standards and provided advice that was irresponsible, self-serving and incidental to client interests.
Specifically, it was found that CFPL failed to have a reasonable basis for advice, failed to provide Statements of Advice, made statements that were false or misleading in a material particular, made forecasts that were misleading, false or deceptive, failed to make reasonable inquiries before implementing advice, provided asset allocation advice far above that recommended for the client's risk profile, and failed to complete 'financial needs analysis' documentation. The inquiry noted that an aggressive sales-based culture prevailed wherein advisers pushed clients into inappropriately high-risk products both to earn bonuses.
The inquiry found that most of the misconduct appears to have taken place between 2006 and 2010. This gets Mr Narev off the hook, whose tenure as CEO commenced in 2011. Although your own tenure as Chairman commenced in 2010, you should bear some of the responsibility for the misconduct by financial advisers CFPL as you presided over this behaviour as a board director since 2006.
More recently, the quality and independence of financial advice has come under renewed scrutiny. Mr John Edwards, former member of the RBA Board, has publicly called for an inquiry into the conflicted nature of financial advice offered by wealth management arms owned by banks. The Productivity Commission has recently announced that it would be assessing the costs and benefits of vertically integrated models of financial advice.
The regulatory risks associated with the CBA owning Colonial First State (CFS) therefore continue to grow. The CBA should consider de-merging CFS and listing it as a stand-alone entity on the ASX. If the recent history of de-mergers is any guide, CFS will be better managed with a cleaner and simplified ownership structure.
What is more damaging for your own and Mr Narev’s reputations are allegations of misconduct at your insurance arm, Comminsure, aired by the 4 Corners program earlier this year, which relate to allegations of Comminsure’s deceptive behaviour designed to not payout on legitimate TPD claims. There were also allegations that whistle blower and former Chief Medical Officer was sacked for seeking to bring the organisation to account. Mr Narev's own admissions that the bank needed to do better confirms that the firm’s culture encouraged behaviour that undermined integrity. This strikes at one of the bank’s own core values; the annual report from last year states that ‘integrity is one of the Group’s core values and has a range of policies, frameworks, compliance measures and education programs to ensure our people maintain the highest professional standards.’
Given the bank’s apparent failure to live up to its own high standards of integrity, it will be interesting to see whether yourself, Mr Narev and the bank’s group executives should be entitled to Short Term Incentives and Long Term Incentives, particularly given the potential long lasting damage that the Comminsure scandal has done to the bank’s reputation and brand.
Finally, the Prime Minister last week, in announcing that the major banks be brought to account by appearing before Parliament no less than once a year, cited the banks’ social license to operate. The CBA should be familiar with this; after all, the annual report from last year cites ‘Our role in society.’ Bank sector lobbyists may well bemoan the regulatory burden that the banks are subject to. But so they should be. I cannot think of any other listed firm in which no less than 60% of their liabilities are guaranteed by the taxpayer. Perhaps the path to integrity is best achieved by promoting a culture of disclosure, transparency and accountability not just to shareholders, but also to customers and taxpayers.
Interbank Cash Rate Futures point to a 65% probability that the RBA will cut the Overnight Cash Rate (OCR) by 25 basis points to 1.5% at the RBA Board's August meeting. The implied probability has hovered around this level for most of July, both preceding and following the June quarter CPI which confirmed that underlying inflation remains at 1.5% yoy, well below the bottom of the RBA’s target band of 2-3%. Real rates have effectively lifted in the first half of CY2016, with the 25 basis point cut to the OCR in May only partially offsetting the plus 50 basis point decline in underlying inflation (see chart).
Evidente is cautious about using real or inflation adjusted rates as a proxy for the stance of monetary policy. Nonetheless, over a longer sweep, the drop in underlying inflation in the past year has lifted the real OCR to its highest level in three years (see chart).
An alternative to inflation targeting
Of greater concern is that the underlying price index has undershot the mid-point of the target range since global commodity prices peaked five years ago. The divergence has grown considerably since early 2015, with the price level now 1.7% below the RBA’s target (see chart). The problem with inflation targeting is that it discounts undershoots or overshoots that might have occurred more than a year earlier. The key benefit of price level targeting is that it retains this memory such that the RBA would need to deliver more aggressive stimulus to not just hit inflation of 2.5% but make up the lost 1.7%.
Regrettably, most of the misplaced public debate on monetary policy has questioned its efficacy at low rates of interest, thanks largely to Mr Stevens’ own comments. This is occurring at time when the US Federal Reserve is contemplating another rate hike and the Bank of Japan appears to be backing away from its commitment to tackle Japan's deflationary mindset. Clearly, there is a growing (and misplaced) crisis of confidence in the power of monetary policy to revive the psychology of risk taking.
Communications from the reluctant rate cutter confirm that the RBA is not ready to abandon inflation targeting in favour of price level targeting. Nonetheless, even within its own inflation targeting framework, Evidente believes that the central bank should deliver another rate cut this week of 25 basis points. With the Governor’s ten year term about to end in September, surely Mr Stevens will not want to leave a legacy of have tolerated a 50 basis point undershoot on the RBA’s inflation target?
Central bankers are a very cautious and conservative group, rightly focussed on risk management. But the growing evidence suggests that the two decade plus phenomenon of inflation targeting is rapidly approaching its expiry date. Evidente believes that price level targeting is better suited to address the powerful disinflationary forces associated with the global glut in saving.
Evidente launches its benchmark aware, long only model portfolio for Australia for the 2017 financial year. This post provides the executive summary of the full text report, which is available to clients of Evidente.
Evidente's long only, benchmark aware portfolio is designed to be a high conviction, concentrated portfolio with no more than 30 stocks, an active share of no less than 30%, tracking error of no more than 7%, maximum individual stock weight of 10% and no sector constraints. The stock selection process represents a mix of top down and industry thematics as well as bottom-up factors.
The key macro theme that guides portfolio construction is the prospect that interest rates will remain low in Australia and globally for an extended period, thanks to the substantial reduction in the value of human capital, reflecting lower expected growth in future incomes (see chart). Evidente estimates that lower growth projections alone have cut the present value of human capital by one-third which has underpinned the grindingly slow recoveries in Australia and globally.
The model portfolio therefore has a strong defensive bias despite stretched valuations, notably overweight positions in stocks that rank strongly on Evidente's proprietary model of earnings certainty. An overweight bet in discretionary retailers represents the key cyclical exposure, based on the prospect that consumer spending will remain the key driver of growth and help to ameliorate the effects of Australia's capex cliff.
The key bottom up criterion used in stock selection is a high internal rate of return (IRR), which is backed out using a dividend discount model. Some of the stocks that have the highest IRRs and make it into the model portfolio include Wesfarmers, Bluescope Steel and Caltex.
‘After experiencing political oppression and war in the first half of the twentieth century, Europe undertook to build a new order for peace, freedom, and prosperity. Despite its predominantly economic content, the European Union is an eminently political construct.’
Tommaso Padoa-Schioppa (2004): Economist and central banker who played a key role in the birth of the euro.
Following two world wars – which centred on Europe - in less than three decades and the Great Depression of the early 1930s, the rationale for Europe integration was fundamentally political: to create a system where nation states could no longer pursue destructive and unilateral policies. The pooling of Franco-German coal and steel production in 1950 seen as the first step towards in the federation of Europe. Despite best efforts, the push for a federation of Europe failed due to the high costs associated with political integration of heterogeneous groups under a common authority. France rejected Great Britain’s initial application to the then European Economic Community in 1963, but successfully joined over a decade later.
Political economy of heterogeneous populations
Political economists have long understand the challenges of political unification when members have diverse economic and social structures, identities, cultures and languages. Ethnic heterogeneity has been linked to the under-provision of public goods at the local level, while linguistic diversity has a demonstrated negative impact on re-distribution. When the ties that bind societies are weak, there is little support for strong welfare states that offer public goods and re-distribute income. Due to the heterogeneity of peoples residing within Europe’s different regions and nation states, a European federation would likely to face significant political costs.
Professor Enrico Spolaore from Tufts University suggests that political integration across large and diverse populations usually takes place when dictatorial rulers are able to ignore the heterogeneity costs of the populations they conquer. According to Professor Spolaore, the diversity of cultural norms and across Western Europe can account for the failure of the region to ‘form a federation even when faced with an existential threat from the Soviet Union and relied instead on an international alliance (NATO) where issues of undersupply and free riding were in part addressed by the dominant role of the United States.’
Why the British confounded the consensus
The resounding victory of the ‘Leave’ campaign following last week’s UK referendum reveals a high level of antipathy that the British community has around ‘shared values’ with Europe, concerns around immigration policy and little perceived economic benefit.
- The British do not share the same language as countries in Western Europe, have a sense of isolation due the country’s island status and consider themselves to be more individualistic and less consensus bound than their Western European counterparts.
- Concerns around immigration are intriguing, because the population share of immigrants and of native born offspring of immigrants is less than 25%, broadly in line with most other European countries (see chart). But the long shadow of the financial crisis and flow of refugees from Syria and the Middle East have probably exacerbated anxieties around immigration.
- The rationale for economic integration – which was the key reason for the UK becoming a member of the EU in the 1970s - had become more tenuous in more recent times when growth in the UK and various other metrics of economic performance had outperformed Western Europe for over two decades.
The 'domino effect'
The decision of Great Britain to leave the EU is unprecedented (for any country) so the process of investor learning surrounding the future implications for the EU could well be slow drawn out. Of particular concern is ‘domino effect’; that the decision by the British to leave the EU will lead to a cascading of other secessions and ultimately the disintegration of the EU and dismantling of the single Euro currency.
Ultimately, it is up to the people and governments in Europe to decide whether the benefits of political and economic union outweigh the costs. Indeed, regaining power over monetary policy may well deliver long term economic benefits. But the costs associated with exiting the single currency and re-establishing national currencies may well be deemed to be too high.
Beware risk assets
Whatever the outcome, Brexit has set into train a re-assessment of the balance of risks of European political and economic union. Many have assessed that the response from stock markets to the referendum represented an over-reaction, particularly in the United States where the direct fallout from Brexit is considered to be small. But the maths of valuation theory suggests that the 3.5% decline in the S&P500 may well have been small considering how the balance of future risks has changed. The magnitude of the fall is equivalent to only a 10 basis point lift in the expected return from US stocks, assuming perpetuity growth in dividends of 5.5%pa has remained unchanged.
As investors continue to digest the fallout from Brexit and interpret the continued popularity of far right parties in Europe such as the National Front in France, Evidente expects risk assets to trade on lower multiples, reflecting three developments: a reduction in expected dividend growth, a lift in uncertainty around future growth, and a higher risk premium. For investors with the luxury of a long investment horizon, Brexit ought to offer an invaluable buying opportunity. For most other institutional investors at the coal face of shorter term performance pressures, Evidente expects there will be better buying opportunities in due course.
Housing affordability has emerged as one of the key battlelines between the Coalition government and ALP in the lead up to the Australia's federal election (widely expected to be on July 2nd). This owes much to the ALP's policy to scrap negative gearing available to investors for established dwellings. At present, mortgage repayments are tax deductible for all investment properties. The Prime Minister, Mr Malcolm Turnbull, has waxed and waned about whether reducing the scope of negative gearing would lift or reduce rents and house prices, but ultimately has chosen to vigorously oppose the measure.
The political heat around negative gearing reflects the fact that housing affordability has become a barbeque stopper across Australian households. The ABC's 4 Corners program recently aired an episode which focussed on the intergenerational inequity issues associated with the substantial lift in house prices. Young people are viewed as being shut out of an increasingly expensive and out of reach 'to buy' housing market. The program cites an IMF study which said that Australia's residential property market is amongst the most expensive in the world, based on ratios of house prices to incomes and rents.
In February, an Australian based hedge fund manager and London based hedge fund researcher gained publicity for posing as a gay couple looking to buy a house in Sydney. They purportedly revealed evidence of lax lending standards amongst mortgage brokers and evidence of a glut of apartments in parts of Sydney, particularly the outer west. They concluded that the growing risk of an imminent collapse of house prices represented Australia's 'big short'. While their research approach was novel, their conclusions weren't. Australia's major banks have been the subject of heavy short selling at times since the financial crisis by offshore hedge funds who share the view that Australia's housing market is significantly over-valued.
The ratio of dwelling prices to household incomes has lifted to close to record highs in recent years (see chart). The discrepancy between the two lines in the chart below reflects the use of average household income versus median household income.
Nonetheless, Australia is broadly in line with the experience of other advanced economies, except for Japan and the United States, whose low ratios make them outliers.
In a recent speech, the RBA drew attention to some key developments that have driven house prices higher in recent years; population growth (particularly immigration) has outstripped growth in the number of dwellings by a substantial margin (see chart). In the past twelve months, conditions in residential property markets have cooled thanks to a slowing in population growth and delayed supply response to higher prices, the ongoing effects of lower commodity prices on housing markets in Perth and Brisbane, and the introduction of macro-prudential measures from APRA, which have led to a tightening in home lending standards, particularly for investors.
When we take a careful look, housing affordability isn't so much of a problem as implied by the ratio of prices to household incomes. Ultimately, the size of mortgage repayments rather than the 'sticker shock' price governs housing affordability. On this measure, the situation looks far more sanguine thanks to record low mortgage rates (which the major banks reduced by a further 25 basis points last week in line with the RBA's cut to the Official Cash Rate).
Following the cut to official interest rates last week to a record low, Evidente calculates that that the repayment on a new housing loan has fallen to 26.3% of household disposable income, well below the record high of 33% plus in 2007 and lower than the average of 27.6% since 2003 (see chart). This is based on the required repayment on a new 80% loan-to-valuation ratio loan for the nationwide median priced home. Certainly compared with the credit boom years of a decade ago, it is now easier for the typical household to buy the typical home.
Evidente has previously suggested that if there was a bubble in Australia's residential property markets, it might well persist for quite a bit longer due to an extended period of low interest rates and concluded that hedge funds seeking to capitalise on Australia's 'big short' would need an abundance of patience (and capital). The analysis here confirms there is no crisis in housing affordability and that the 'big short' is a myth.
In what was close to a line ball decision - according to market economists surveyed and Interbank Cash Rate Futures - the RBA Board cut the official cash rate (OCR) by 25 basis point cut to 1.75%. This extends the current easing cycle to 55 months, with the OCR now 300 basis points below the start of the current cycle in November 2011.
The reluctance of the consensus to embrace the prospect of a rate cut has some justification. The RBA Governor, Mr Glenn Stevens, has developed a reputation as a reluctant rate cutter during the latter part of his tenure and his communication has been confounding at times. For most of 2014, the RBA used the language that interest rates would remain stable for an extended period, only to surprise economists by easing policy twice in the first half of 2015. In 2012, there was the widely cited speech from Mr Stevens that Australians should take a glass half full approach to the economic outlook, designed to douse expectations of more monetary stimulus. More recently, Mr Stevens has questioned the efficacy of monetary policy at low interest rates (to the best of my knowledge, without supporting theory or evidence).
Readers of this blog would be aware that Evidente has long held the view that the Australian economy has been mired in an income recession for some time. Nominal GDP has expanded at an annualised rate of around 4% for four consecutive years, and the calendar year outcome for 2015 was the worst growth posted since the recession of the early 1990s. It is little wonder then that nominal wages are growing at their slowest rate on record.
The RBA had acknowledged in its interest rate statement from April that the renewed appreciation of the Australian dollar could complicate the necessary re-balancing of growth. But it was the strong disinflationary forces evident in the March quarter CPI print that would have tilted the central bank's view on the outlook for the economy and interest rates. Underlying inflation now running at only 1.5% higher than a year ago - a record low - points to a shortfall in aggregate demand and a likely slowdown in labour market conditions. No doubt, the CPI print would have given Mr Stevens - whose term as Governor expires in September - pause for thought about his legacy. Had he left policy unchanged, would he be remembered as the central bank Governor who did nothing while core inflation fell 50 basis points below the bottom end of its target?
Strong population growth in Australia in the past five years - certainly stronger than most advanced economies - has helped to keep disinflationary forces at bay until now. The RBA has therefore now joined the not so exclusive club of advanced economy central banks that are struggling to meet their inflation targets. Yet, even with the overdue monetary stimulus delivered, Australia's OCR of 1.75% remains well above other advanced economies (see chart). A comparison of Australia and the United States might put things in perspective. Australia's annual core inflation rate is now lower than in the US, while the unemployment rate of 5.8% has been higher than the US for a while now. But the OCR is 150 basis points above the federal funds rate! Little wonder that the Australian dollar has remained resilient in the face of commodity headwinds for some time now.
Evidente has long argued that the OCR has been too high and that the RBA has under-estimated the power of monetary policy. Evidente does not buy into the argument that the potency of monetary policy is diminished as interest rates approach zero. Surely the widespread use of unconventional monetary policies such as large scale asset purchases, negative interest rates and forward guidance in recent years confirms that central banks are no longer constrained by the zero lower bound.
This is not to deny that a range of structural reforms are necessary to boost real productivity growth over the medium term, but there is little political consensus to deliver these reforms. It was too ambitious to expect an election year Budget to deliver a vision of economic reform. There are modest tax cuts offered to middle income earners and small business, and a scaling back of superannuation tax concessions for high income earners.
But from a macroeconomic perspective, the Budget is a sideshow to the RBA's rate cut. The economy is suffering from deficient demand and more monetary stimulus is necessary to revive animal spirits in the corporate sector. A policy rate of 1.75% is still too high given monetary developments across the advanced economies and Australia's disinflation. As long as the RBA and APRA are satisfied that lending standards for housing remain prudent, Evidente expects the central bank to deliver another rate cut this year, most likely in August.
The CPI print revealed that disinflationary forces intensified in the March quarter. Underlying inflation (which Evidente calculates as the average of the weighted median and trimmed mean estimates) posted a quarterly rise of only 0.18%, the smallest increase since the inception of the series in 1982. As a result, underlying inflation rose by only 1.5% in the past four quarters, which also represents the smallest annual increase on record (see chart).
In the past four quarters, the price of automotive fuel has dropped by 10%. Some would argue that the precipitous decline in crude oil prices have added to the Australia's disinflationary impulse in the past year. This is certainly true of the headline CPI. But the methodologies underpinning the RBA's preferred underlying measures - the trimmed mean and weighted median estimates - reduce the influence of outliers. The disinflation is widespread; of the approximately 284 sub-categories covered by the Australian Bureau of Statistics, 106 or 40% posted outright declines in the past year.
The annual rate now undershoots the bottom end of the RBA's target range by 50 basis points. Long admired as one of the few central banks that had continued to meet its inflation target since the financial crisis, the RBA now joins the not so exclusive club of developed world central banks that are struggling to meet their inflation targets.
Despite the 50% plus drop in the RBA's Commodity Price index since global commodity prices peaked in mid-2011, the fact that the annual rate of underlying inflation has remained at or above 2% for most of the past six years owes much to an acceleration in population growth and significant Australian dollar depreciation. The effects of these two developments have waned more recently; population growth has slowed and the Australian dollar is around 10% higher from its low in late 2015. Combined with record low growth in wages and unit labour costs (which are productivity adjusted wages), this could herald the start of an extended episode of sub-2% inflation.
The record low underlying inflation outcome confirms that the Australian economy continues to suffer from a shortfall in aggregate demand and is consistent with what Evidente has described as the four year long income recession.
RBA Governor, Mr Glenn Stevens, has developed a persona as the reluctant rate cutter in recent years. In a recent speech, he re-iterated his view that the potency of monetary policy diminishes at low interest rates and once again endorsed the role of structural reforms to boost growth. Evidente welcomes policies that seek to further de-regulate labour and product markets. But surely the role of a central bank is to revive animal spirits at a time when the psychology of risk taking in corporate Australia is muted.
A key obstacle to lower interest rates in the mind of the RBA for a while had been the strength in housing. But in its latest minutes, the central bank acknowledges that the tighter prudential standards in the past year had contributed to a moderation in conditions in the established housing market. The RBA added that it would also closely monitor whether the strength in labour market conditions from late last year. Mr Stevens would therefore have drawn some comfort from the solid March labour force survey released earlier this month. But the growing shortfall in aggregate demand evident implied by the record low March quarter CPI print points to the prospect of a slowdown in employment growth.
Against this backdrop, Evidente re-iterates the view that the RBA Board should deliver monetary stimulus at its next meeting on May 3rd.
In a post from December 2015, Evidente drew on comments from Federal Reserve Governor Lael Brainard, suggesting that the normalisation of the federal funds rate was likely to follow a more gradual and shallower path thanpast tightening cycles. Overnight, Federal Reserve Chair, Ms Janet Yellen re-iterated that the new normal for policy normalisation would be low and slow, based on growing evidence that the neutral rate of interest was around zero; the level of the federal funds rate that is consistent with output growing close to its potential rate with full employment and stable inflation.
Echoing comments from Ms Brainard, Ms Yellen indicated that with the U.S. economy growing at a pace only modestly above potential while core inflation remains restrained, the nominal neutral rate may not be far above the nominal federal funds rate, even now. In real terms, the federal funds rate is around 125 basis points below zero. According to Ms Yellen, the current stance of policy is therefore consistent with output growth modestly outpacing potential and further improvements to the labour market. Ms Yellen remained silent on the future prospects for the neutral rate, but Ms Brainard has previously indicated that the neutral rate will remain low (possibly close to zero) for some time to come.
Ms Yellen noted that slow global growth and the significant appreciation of the US dollar since 2014 continue to weigh on 'business investment by limiting firms' expected sales, thereby reducing their demand for capital goods; partly as a result, recent indicators of capital spending and business sentiment have been lacklustre.' The slowdown in growth of expected sales is reflected in downgrades to consensus estimates for 12 month forward revenue per share for the S&P500 companies since late 2014 (see chart). This has coincided with a 20% appreciation of the Broad US dollar index, which clearly has undermined the competitiveness and profitability of exporters.
The IMF has downgraded its 2016 growth forecasts for Emerging Markets over the past year to 4.3% from 4.7%, but marginally revised up growth forecasts for Japan the Euro area. Across this comparator group, the 20% downgrade to the outlook for the United States to 2.6% from 3.3% has been more significant suggesting that global growth conditions have been a sideshow to depressed revenue conditions (see chart).
As Ms Yellen draws attention to, the scale and speed of US dollar appreciation has clearly crimped sales growth expectations. But if the IMF has downgraded the GDP outlook for the US more aggressively than other countries, what has underpinned the US dollar appreciation since 2014? The main culprit must be the expectations of lift-off in the federal funds rate over the course of late 2014 and 2015, particularly at time when currency and bond markets did not believe that the US economy was ready for policy tightening. It is therefore not entirely surprising that in the past month, renewed US dollar depreciation has been associated with more dovish communications from the Fed and the pushing out of further rate hikes following the publication of the dot plot of internal interest rate projections.
Monetary policy constrained, but not broken
In the launch report of Portfolio Construction Assist, Evidente suggested that the discount rate channel of monetary policy had been compromised because the lift in the expected equity risk premium had broadly offset the stimulatory impact of the exceptionally low returns from low risk assets. As a result, the ability to boost expected cash flows represents the key channel through which central banks can influence asset prices.
The downgrade to sales growth expectations in the past year points to an effective tightening of policy over this time, which has contributed to the pull-back in GDP growth expectations to around 2.5% for this year and next. If the Fed Chair and Governors continue to bang the drum on the new normal of low and slow policy normalisation, the key barometer of success will likely be a welcome and much needed improvement to corporate America's revenue environment.
Following the change in leadership of the Federal Government in September, Evidente published a post suggesting that the new Prime Minister would struggle to execute on any new economic narrative for four reasons: the stark reality of a hostile Senate, persistent weakness in commodity prices, Australia's income recession and the government's revenue problem. I concluded that the great expectations for Mr Malcolm Turnbull's Prime Ministership would unlikely be met.
After a bounce in popularity that lasted a number of months, the additional support for the Government and Mr Turnbull appears to have diminished, with various opinion polls in the past month showing the Coalition and Australian Labour Party are neck and neck after preferences, although primary support for the ALP remains low by historical standards.
Mr Turnbull has struggled to articulate an economic narrative, let alone execute on an economic vision for the country. Other than the launch of the $1.1 billion National Innovation and Science Agenda in December, the Government has failed to boost its credibility on matters relating to economic management and probably conceded ground to the ALP on this front.
After testing the level of community support for a widening of the Goods & Services Tax base and/or lift in the GST rate from its current level of 10%, the Mr Turnbull quickly backed down on any proposed reforms. More recently, his government has struggled to articulate a coherent response to the ALP's proposed abolition of negative gearing for existing housing, which currently allows investors to claim tax deductions on mortgage repayments for established dwellings.
Two more recent developments have dominated the political landscape in recent weeks: the passing of the Commonwealth Electoral Amendment (CEA) Bill 2016 which reduces the prospects of a hostile Senate after the next federal election (slated for the second half of the year), and the publication of the book The Road To Ruin - How Tony Abbott And Peta Credlin Destroyed Their Own Government , by political columnist Ms Nikki Savva, which traces the demise of the former PM, Mr Tony Abbott.
Electoral reforms to marginalise micro-parties
The CEA Bill effectively implements a partial optional preferential voting system above the line for Senate elections, including instructing voters to vote for at least six parties or groups in their order of preference. At present, a voter may vote for a political party or group by putting the number '1' in one box above the black line of the Senate ballot paper (see exhibit below). By casting a vote this way, voters allow the order of preferences to be determined by the party or group they are voting for.
This effectively gives each of the political parties power to engage in deals with one another to exchange preferences. The key concern stemming from his approach is that a number of independents have been elected to the Senate with a tiny share of the votes thanks to opaque and complicated preference deals between parties. Mr Ricky Muir of the Motorists' Enthusiasts Party for instance, was voted into the Senate following the 2013 federal election despite receiving only 0.5% of the popular vote.
The reform to electoral laws empowers voters at the expense of political parties by allowing voters to vote for no less than 6 parties above the line. Votes will be allocated according to the preferences of voters, not based on preferences of political parties. Unless voters deliberately vote for micro parties, they are likely to be marginalised by the electoral reforms in the upcoming federal election. Thus the reforms ought to reduce the likelihood that the Senate will remain hostile.
A less hostile Senate should raise the prospect that the elected government will have a mandate to implement its agenda. The Abbott Government clearly under-estimated the ability and willingness of the micro-parties or cross-benchers in the Senate to block key measures proposed in the 2014 Budget, including the $7 GP co-payment and deregulation of higher education. The Turnbull Government's fast re-treat on GST reform also owes much to the stiff opposition from the Senate cross-benchers.
Mr Abbott's Road To Ruin
For a while now, Senate cross-benchers have typically failed to respect the mandate of the elected government. But according to Ms Nikki Savva's new book, The Road To Ruin, Mr Abbott failed to grasp the importance of engaging and negotiating with the cross-benchers in the lead up to the 2014 Budget. Nor did Mr Abbott or the Treasurer, Mr Joe Hockey, effectively communicate a case for budget repair or articulate an economic vision for the country.
The most successful Australian political partnerships in recent decades - Hawke/Keating and Howard/Costello - had the ability to articulate an economic narrative and press the need for economic reform. Ms Savva notes that Mr Abbott had demonstrated little interest in economic matters during his political career and that Mr Hockey was probably out of his depth.
It is instructive that in defending his record as PM, Mr Abbott has recently cited that his government stopped the boats, and abolished the mining and carbon taxes. Yet Ms Savva notes that the Trans Pacific Partnership deals negotiated with various Asian countries were not prioritised as a badge of honour by Mr Abbott. Further, Mr Abbott fails to mention that his government commissioned the Financial System Inquiry, which has enhanced the resilience of the financial system by boosting the amount of equity finance in the bank sector's liability mix. Ms Savva highlights Mr Abbott's almost obsessive focus on matters relating to national security at the expense of other important policy priorities.
Ms Savva adds that Mr Abbott failed to heed calls from colleagues and sundry to replace Mr Hockey with Mr Turnbull as Treasurer, and suggests that Mr Abbott and his office were 'completely paranoid about Turnbull.' In short, neither Mr Abbott or Mr Hockey were able to connect to, or effectively connect with members of the community on their anxieties around economic issues.
Ms Savva's most searing critique is reserved for the unwillingness of Mr Abbott and his Chief of Staff, Ms Peta Credlin to consult with colleagues about key decisions, and the unusual co-dependant relationship they shared. Ms Savva draws on evidence pointing to Mr Abbott's apparent lack of self belief and that Ms Credlin astutely understood that in his mind, she represented his crutch. This would explain why after the first leadership spill in February 2014, Mr Abbott failed to heed widespread calls from within the party to either remove Ms Credlin or reduce her authority in the Prime Minister's office.
The two failed to grasp that the machinations of Opposition were markedly different from the politics of Government. Mr Abbott not only allowed Ms Credlin to be the gatekeeper in his office, but allowed her to effectively centralise power; Ms Credlin micro-managed most communication that was directed to Mr Abbott. Mr Abbott either marginalised or ignored MPs who expressed frustration at Ms Credlin's micro-management.
Beyond the next election, the prospect of a less hostile Senate should help to enhance the authority and mandate of the government of the day. Nonetheless, whoever is elected PM, will need to articulate an economic narrative for the country that pushes the case for structural reforms to boost productivity growth and address the wedge between growth in government spending and tax revenue. This would go some way to restoring community and investor confidence in Australia's political culture after being at a cross-roads for almost a decade.
In a post published on January 25th, Evidente recommended that investors take a tactical overweight bet in global equities and risk assets more broadly (see Super Mario to the rescue? Not just yet). Despite equity valuations being stretched, the positive view was based on the prospect that the ECB and Bank of Japan had signalled to the market that more stimulus was on the way to combat renewed disinflationary forces and anaemic growth. I suggested that there was also upside to risk assets thanks to the increased likelihood that members of the FOMC would have little choice but to downgrade their projections for the federal funds rate due to core inflation continuing to undershoot its target by such a long way and preliminary signs that indicators of manufacturing activity were tipping over.
Since then, global stock markets have rallied, with the MSCI World delivering a return of plus 7%, led by the S&P500 which has lifted by over 8%, while US Treasuries have risen by less than 1% (see chart).
During this period, both the ECB and BOJ have delivered more stimulus, although the nature of the expansion of their respective QE programs has surprised market participants. At the end of January, the BOJ announced that it would introduce a marginally negative interest on incremental or new reserves that commercial banks hold at the central bank. More recently, the ECB announced that it would expand its asset purchasing program to 80 billion euros per month (up from 60 billion euros) and also start to purchase investment grade euro-denominated non-bank corporate debt securities.
The other key development overnight was a material change in the now closely watched dot charts from the US Federal Reserve, which denote the FOMC members' interest rate projections. This shows that ten of the seventeen members now expect the federal funds rate to be below 1% by the end of this year, and nine members are forecasting the rate to be below 2% by the end of next year (see chart).
This represents a significant shift in the central bank's internal expectations. As recently as the FOMC meeting in mid-December, only four members expected the rate to be below 1% at the end of this year and five members were forecasting a sub-2% rate by the end of 2017 (see chart).
The FOMC statement overnight suggests that the benign inflation outlook has underpinned the more dovish stance. The Committee cites the shortfall in core inflation relative to its medium term target of 2% and highlights that market based measures of inflation compensation remain low and survey based measures of longer-term inflation expectations are little changed. Evidente has taken the opportunity to update its econometric model of US core inflation. Assuming that oil prices and the US dollar remain unchanged from current levels, core inflation is forecast to increase over the course of this year but still remain well below the central bank's 2% target by year end (see chart).
Following the rally of recent months, the S&P500 is now trading above 16x consensus 12 month forward EPS, which is expensive by the standards of the past five years (see chart). Given that the ECB and BOJ have expanded their QE programs in recent months and the Federal Reserve has effectively delivered more stimulus by pushing out the timing of policy 'normalisation', I believe that the scope for further multiple expansion of US and global equities in the near term is limited. Upgrades to growth prospects are therefore necessary to drive the market higher but the evidence in the US isn't encouraging; consensus EPS forecasts for the S&P500 are at the same level that prevailed in mid-2014 (see chart). Against this backdrop, Evidente recommends that investors neutralise their tactical bet in global equities and risk assets more broadly.
Predictably, the Prime Minister and Treasurer spun a positive narrative around the recently released National Accounts in Question Time on Wednesday. The Prime Minister noted that real GDP expanded by 0.6% in the December quarter and by 3% over the year, and indicated that the economy remains in transition following the end of the boom in resources capital investment, and that household consumption and housing investment helped to boost growth.
It is early days for Mr Scott Morrison in his new portfolio, but the Treasurer looked out of his depth in Question Time. Mr Turnbull is far more effective in framing and articulating a vision and narrative for the economy. The Prime Minister might well be the best Treasurer that Australia never had.
The Opposition was more interested in interrogating the Prime Minister over the alleged leaking of defence related classified material. In so doing, Evidente believes it missed a valuable opportunity to question the Prime Minister and Treasurer about the fact that the economy remains stuck in an income recession. The National Accounts revealed that the nominal GDP expanded by 1.8% in 2015, which represents the worst calendar year outcome since 1992. Even during the depths of the financial crisis, the nominal economy managed to expand by 2% in 2009 (see chart).
The distinction between real GDP - the set of accounts that most economists and commentators focus on - and nominal GDP is important. Real GDP represents the flow of production in volume terms and therefore adjusts for inflation. If the same volume of coal is produced across two quarters for instance, this translates into zero growth in real terms. But if the coal price fell by 10% in the second quarter, this would translate into a nominal decline of 10%.
Nominal GDP represents the dollar value of the flow of production, and thus includes both volume and price effects. Conceptually, it is equivalent to summing up growth in real GDP, domestic inflation and the terms of trade (the ratio of export to import prices).
The industry's focus on real GDP in the National Accounts probably is a legacy from earlier decades of variable inflation. But Australia has now had low and stable inflation for three decades now. Nominal GDP offers a more accurate perspective on the income flows of households and businesses; after all, workers earn nominal wages and businesses do not generate inflation adjusted cash flows. It is little surprise then that persistent weakness in consumer and business sentiment surveys over the past four years have coincided with drop in nominal GDP growth.
The fact that nominal GDP has grown well below 4% pa since 2012 confirms that the economy has been stuck in an income recession for four consecutive years. Of course, the end of the commodities boom has underpinned this outcome. The drop in the terms of trade by over one-third since 2011 has clearly provided the basis for the RBA's prolonged easing cycle, particularly at a time when the much anticipated handover from mining to non-mining business investment has failed to emerge.
The National Accounts bear this out, with private business investment detracting more than 1 percentage point from nominal GDP growth in 2015, while net exports detracted 1.5 percentage points (see chart). In contrast, the interest sensitive sectors continue to support nominal GDP growth; household consumption and dwelling investment contributed more than 3 percentage points to growth. The public sector also made a strong positive contribution.
As per Evidente's previous post, the capex cliff evident from the ABS survey of capex intentions suggests that the drag from private business investment is expected to persist for the next 18 months. Against this backdrop, the RBA will have little choice but to keep interest rates low for an extended period, and likely deliver two more rates over the course of 2016.