The dangers of safety

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.

An open letter to CBA Chairman, Mr David Turner

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.

Launch of Evidente's Model Portfolio - Executive Summary

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.   

Reflections on Brexit and the future of the European Union

‘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.

Weekly Impressions: Home truths about housing affordability

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.

The reluctant rate cutter reflects on his legacy

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. 


Will someone pass the Panadol to Mr Stevens, please?

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. 

Weekly impressions: Light at the end of the tunnel for corporate America?

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.

Weekly Impressions - Australia's political culture at a crossroads (Part II)

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. 

Weekly Impressions: Neutralise tactical bet in risk assets as scope for more multiple expansion is limited

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.

Look through the spin - The economy remains mired in an income recession

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.

Weekly Impressions: What the capex cliff reveals about Australia's 'big short'

In the past week, two bottom up developments dominated the financial market news flow in Australia: the belated announcement of CEO succession at Woolworths and renewed concerns that Australian banks represent a 'big short' thanks to rumours of the imminent collapse of residential house prices.  These two developments have more in common than meets the eye because they are revealing of the causes and consequences of corporate Australia's dormant animal spirits. 

The elevation of Mr Brad Banducci as Woolworths' new CEO comes not long after the Chair, Mr Gordon Cairn, announced that the company would be exiting its home improvement business.  Together with its joint venture partner, Lowe's, Woolworths has invested more than $3 billion in the Masters business and generated losses of around $1 billion in less than five years. 

At the time of establishing the business in 2011, then newly appointed CEO, Mr Grant O'Brien, had made a compelling case for entering into the fragmented home improvement space, whose size then was estimated to be over $30 billion in revenue, which has since been revised up to over $40 billion.  Surely the pie would be big enough to accommodate two big box hardware retailers?

Corporate Diversification: RIP

Woolworths effectively bucked the trend towards corporate clarity that has been a recurring theme in Australia and globally since the financial crisis, reflected in a wave of demergers and divestments.  Diversified and globally dispersed business models have given way to more geographically and product focussed models, including BHP, Amcor, Brambles, Fosters, Orica, and more recently NAB and ANZ.  By eschewing long held growth options that have failed to meet their cost of capital, Australian firms have effectively unlocked free cash flow which has been used to lift dividends, and  recognised that investors can engage in DIY diversification at low cost, via passive open ended funds and closed end exchange traded funds.

The decline in Australia's terms of trade by one-third from its peak five years ago has accelerated the trend towards corporate focus, as firms have sought to restructure, defer or abandon capital investment projects, and trim costs aggressively to combat strong revenue headwinds.  The outcome has been impressive; profitability has declined by less than 10% over this period (see chart).

Australia's Imminent Capex Cliff

The thematic of dormant animal spirits in the corporate sector remains strong.  During the week, the December quarter CAPEX data released by the ABS confirmed that firms continue to downsize their future capex plans. Each quarter, the ABS surveys a representative sample of firms across all industries who provide estimates for their capex spend in the current and next financial year. 

For the December quarter data just released, firms provided their fifth quarterly estimate for FY16 and first quarterly estimate for FY17.  The profile of capex intentions for FY16 most resembles those for FY11 (see chart).  The first estimate for each of those two years both started at a little above $100 billion, with the fifth estimates (the most recent one for FY16), pointing to $125 - $130 billion.  If the actual outcome for FY11 is any guide, total capex spend for FY16 will come in at around $120 billion (in nominal terms), which represents a shortfall of $30 billion or 20% from the previous year. 

To put this is context, this would amount to the largest nominal percentage decline in business investment in over 25 years.  During this time, the next largest decline occurred in Australia's last recession, where capex posted a 17% decline in 1992.

The preliminary estimate for FY17 of $83 billion points to further downside risk to the capex outlook beyond the current financial year.  The chart below provides the first of seven quarterly estimates (blue columns) for each financial year as well as the final actual outcome (yellow columns).  Typically, firms under-estimate their capex spend up to two financial years out, which is reflected in the fact that most of the yellow columns lie above their respective blue column.  The initial estimate for FY17 is marginally below that of the initial estimate for FY10.  If the actual outcome for that year is any guide, capex will come in at around $105 billion in FY17, around 12% lower than the implied outcome for FY16. 

Where is Mr Stevens' Growth Plan?

A drop in mining sector capex was to be expected after the end of the commodities boom.  But contrary to the RBA's expectations, the non-mining sector has not stepped up to the plate, which has frustrated the central bank's efforts to re-balance economic growth.  In the past, Mr Glenn Stevens, the RBA Governor, has asked rhetorically where corporate Australia's growth plan is, has bemoaned the lack of entrepreneurial risk taking and implored analysts and investors to encourage the companies they cover to invest for growth rather than focus on trimming costs. 

Woolworths' failed experiment in home improvement should offer the RBA a valuable data point why most of corporate Australia is reluctant to invest for growth, particularly at a time when the ABS release during the week showed that private sector wages grew by only 2% yoy in the December quarter, a new record low (see chart).

What the capex cliff means for Australia's big short

The reluctant rate cutter has had little choice but to deliver more monetary stimulus in recent years while the terms of trade have fallen by one-third and animal spirits in the corporate sector have remained dormant.  The re-balancing of growth hasn't exactly gone to the RBA's script but there has been a re-balancing of growth away from mining investment towards dwelling investment, household consumption and net exports. 

The RBA has felt that it is between a rock and a hard place; providing accommodative monetary settings given the shortfall in aggregate demand, but careful to ensure that multi-decade low interest rates do not stoke speculative activity in housing.  The strong lift in house prices in Melbourne and particularly Sydney from 2012-15 caused the RBA and APRA enough concern to encourage banks to reduce growth in lending to housing investors and adopt more prudent lending standards. 

It is against this backdrop that the talk about Australian housing and the major banks representing the 'big short' has polarised opinion if the news flow is any guide.  The quality of lending standards is a good starting point to gauge how widespread speculative activity is.  But any talk of a bubble discounts the important role that dwelling investment still has to play to support the economy until a revival in the corporate sector's animal spirits emerges.  The updated losses announced by Woolworths home improvement this week and decision to exit the sector altogether served as a timely and powerful signal to other corporates about the dangers associated with investing for growth in the current environment of deficient demand.  If there is a bubble in Australian housing, it therefore might well persist for quite a bit longer. 

Weekly Impressions: Global bankers should be more grateful for Basel

The past six months has been a challenging period for global bank shareholders.  The global bank stock index has declined by 20% since August, well below the 5% decline in the broader global market index (see chart). 

Emerging market banks have been the worst performers over this period, but some developed market banks haven't been spared either.  European banks, particularly those in the periphery countries, have delivered dismal returns.  Despite the reduction of European banks' non-performing loans in the past two years, they still account for 7% of total loans, well above other developed markets (see chart).  Non-performing loans as a percentage of total loans in North America and Australia are below 2%. 

Among the emerging markets, the credit bubble in China continues to pose a key risk to the global outlook.  Total debt of the private non-financial sector in China has lifted to 200% of GDP, double most other emerging markets (see chart).  The debt build-up has been associated with over-investment, particularly amongst property developers. 

Evidente has developed profitability adjusted book multiples as a framework for identifying pricing anomalies amongst stocks.  I have extended this model to the largest 60 developed market banks (see chart).  Valuation theory predicts a linear and positive relationship between an asset's expected ROE and price to book ratio.  The trend line is associated with a strong R squared of 80%.  A stock can lie above the regression line (ie. It has a higher profitability adjusted book multiple than the average of its peers) for a number of reasons: it is over-priced, it is cum an upgrade to its book value, it has stronger future growth prospects than its peers, investors are assigning a lower discount rate than its peers, or the consensus' ROE expectations are too conservative. 

The chart shows that a number of UK and Australian banks lie above the regression line, but at different ends of the profitability spectrum.  Some of the German banks, including Deutsche Bank, lie well below the regression line.

Global bankers should be more grateful for Basel and conservative prudential regulators

To dissect the under-performance from global banks in the past six months, I have sorted the 60 largest DM banks into quartiles, based on their respective deviations from the regression line.  The premium stocks (those that lie above the line) have been far more resilient, declining by 15% while the discount stocks have fallen by over 30% (see chart).  Many of the stocks that have high profitability adjusted book multiples probably have lower perceived risk or lower betas which has been associated with defensive attributes.

The volatility of returns for the premium banks (20%) is significantly lower than for the discount banks (26%) confirming the defensive characteristics of the former group.  Moreover, the premium banks have 50% more loss absorbing capital in their liability mix.  The ratio of shareholders equity to assets is 8.3% for this group, well above 5.2% for the discounted banks.  Despite global bankers' predictable chorus since the financial crisis that regulatory requirements to lift the amount of equity finance in their liability mix are impeding their ability to lend, the analysis here demonstrates that banks with more loss absorbing capital have been resilient to the market turbulence of the past six months.  Although more capital reduces expected ROEs (other things being equal) it also reduces a bank's risk profile.  Bankers should therefore be more grateful to Basel and conservative prudential regulators.

The chart below shows the stocks with the largest positive and negative deviations from the regression line.  I am not suggesting that the premium stocks are over-valued or that the discount stocks are under-valued.  As cited above, premium stocks with defensive characteristics can continue to trade at higher profitability adjusted multiples than their peers for extended periods.  But the model allows us to identify pricing anomalies.  For the premium stocks, RBS and Standard Chartered stand out because they have low capital ratios and high return volatilities.  Of course, its possible (but probably unlikely) that the stocks are cum-earnings upgrades.  After all, analysts have downgraded their 12 month forward EPS forecasts for RBS and Standard Chartered by 15% and 50% respectively in the past six months.

There do not appear to be any anomalies amongst the ten stocks trading on the largest discounts.  They all have low capital ratios and high return volatilise, suggesting that their defensive attributes are poor.  As long as global risk appetite remains low, I recommend investors stay underweight this group of stocks as well as RBS and Standard Chartered.  The key risk to this view is if global market sentiment swings quickly from risk aversion to risk appetite. 

RBA Governor waves white flag on Australia's growth prospects

The RBA Governor today delivered his twice year testimony to the Australian Parliament.  The central bank appears to have waved the white flag on Australia's growth prospects, with the Governor hinting that it had revised down the economy's potential growth rate.  Mr Glenn Stevens cited that the economy had expanded by around 2.5% in the past year and that 'real GDP is expanding at pace a bit lower than what we used to think of as normal'.  This might explain why the RBA has been a reluctant rate cutter at a time when animal spirits in the corporate sector have been dormant.

A good deal of the testimony was devoted to the puzzle of reconciling strong labour market conditions in the past year and the associated reduction in the unemployment rate to below 6% with record low wages growth and weak growth in GDP.  Mr Stevens suggested that benign wages growth is encouraging firms to lift hiring.  This may well be the case, but I suspect that an expansion in the supply of labour has probably played an important role. 

Mr Stevens is right to highlight the persistent weakness in unit labour costs is contributing to stronger growth in employment.  Productivity adjusted wages or wages per unit of aggregate output have not risen for four years (see chart).  In the past three decades, there have only been two other episodes where unit labour costs have been stable: the recession of the early 1990s and the latter part of the same decade.  It is noteworthy that these periods were associated with tight money.

A salute to corporate Australia's resilience

The Governor has previously bemoaned what he considers to be the absence of entrepreneurial risk taking, but corporate Australia's belt tightening, restructuring and trend towards corporate clarity have helped to boost efficiency, restrain growth in unit labour costs and ultimately facilitated a strong employment recovery in the past year.  This behaviour represents a rational response to what has been one of the largest negative terms of trade shock in Australia's history; the ratio of the prices the country receives for its exports relative to the prices it pays for its imports has declined by one third in less five years. Yet, corporate profitability has been remarkably resilient, falling by less than 10% over this period (see chart).

RBA Governor leaves the door further ajar for more monetary stimulus

The Governor re-iterated the central bank's easing bias, drawing attention to the fact path the inflation outlook does not pose an obstacle to further monetary stimulus if deemed necessary to support demand.  In contrast to the Governor's last testimony in September, Mr Stevens did not cite concerns that very low interest rates could foster a worrying debt build-up, nor did he refer to the macro-prudential measures implemented by APRA to maintain sound lending standards.  This suggest that central bank has left the door further ajar for more monetary stimulus.

Offshore earners struggle despite A$ weakness

Since September, the Australian dollar has remained broadly steady at a little above 70 US cents.  In the past five years, the local currency has been resilient, depreciating by 35% against the US dollar at the same time as global commodity prices have declined by 60%.  But the longer sweep shows that the A$ and commodity prices do not necessarily move lock in step; the lift in commodity prices during China's boom of the mid-2000s far outstripped the A$ appreciation at the time (see chart).  At its current level of 71 US cents, the A$ is 8% below its level that prevailed the last time the RBA commodity price index was at these levels in mid-2005.

Evidente's econometric model of the currency shows that at current levels, the A$ is broadly in line with fair value (see chart). 

After what had been strong out-performance for a little over three years, ASX listed US dollar earners have struggled in the past year, despite renewed A$ depreciation (see chart).  During this time, the overweight bet in offshore earners has remained a crowded trade.

The large cap US dollar earners have been de-rated in recent months, in line with the broader market.  The basket is trading on a median prospective earnings multiple of 18x, but continues to trade at a premium to the market (16.5x).  The premium reflects stronger long-term growth prospects and a lower beta (see chart).  Despite this, the percentage of buy recommendations from analysts is comparable across US$ earners and the top 100.  Despite the lofty multiple for Cochlear, the stock has continued its strong performance, jumping by 15% on its interim result.

From a longer term perspective, the Big Mac index suggests that the A$ is under-valued against the US$ by 25%, which represents the biggest under-valuation since 2003 (see chart).  Deviations from purchasing power parity can extend for long periods.  But short-sellers of the local currency should be cognisant that the US$ at present, is over-valued against all but three currencies based on the Big Mac index, notably the Swiss franc, Swedish krona and Norwegian krone.

Australian growth to remain stuck in the slow lane

At its first meeting for 2016, the RBA Board left the Overnight Cash Rate unchanged at a multi-decade low of 2%, as widely expected (see chart).  There was little change in the communication from the last meeting's statement two months ago.  It cited that global growth is lower than earlier expected, particularly in China and other emerging economies.  Risk appetite has diminished somewhat and credit conditions for low quality corporates has tightened, although funding costs remain low for high quality corporates. 

GDP growth came in below average in the second half of 2016, but business sentiment lifted to above average levels and labour market conditions continued to firm, reflected in a pick up in employment growth and a lower unemployment rate.  Underlying inflation is expected to remain at 2% thanks to the prospect of still low growth in productivity adjusted wages (ie. Unit labour costs) and spare capacity in the global economy. 

Against this backdrop, the RBA re-iterated that monetary policy needs to be accommodative.  Macro-prudential policies are helping to contain risks in the housing market, reflected in a moderation of house price increases in Sydney and Melbourne, and a changing composition in lending towards owner-occupiers and away from investors.  

The RBA identified two key developments it would monitor closely; whether the firming of labour market conditions would continue and whether the recent financial market turbulence points to prospects of weaker global and domestic demand.  It maintained its easing bias, stating that the inflation outlook provides scope for further policy easing if deemed necessary.

The RBA appears to be content for the Australian economy to operate with a degree of spare capacity.  It is clearly drawing some comfort from the improvement in labour market conditions, which is a welcome development.  While increased labour demand has played a role here, I suspect that an expansion in the labour supply can help to reconcile strong growth in employment with the absence of wage pressures.  

On face value, the renewed depreciation of the Australian dollar appears to be contributing to an easing of financial conditions.  But on closer inspection, it seems to reflect the weaker global growth environment and US dollar strength.  In the past five years, the Australian dollar has declined by 35% against the US dollar but by only 20% on a TWI basis (see chart).  Moreover, based on the Economist magazine's updated Big Mac index, the US dollar is under-valued against only three other currencies.

Australian growth to remain stuck in the slow lane

The RBA is content for growth in the Australian economy to remain in the slow lane over the course of 2016 and is hoping that the non-mining sectors grow enough to ameliorate the effects of the slump in mining business investment.  Evidente remains of the view that at least one more rate cut (and most likely two) is necessary to revive animal spirits in the corporate sector and boost household consumption.  International developments might well force the hand of the reluctant rate cutter, notably more monetary stimulus from central banks in response to further deterioration in the global growth environment.   

Weekly Impressions - Reminder to investors: Do not under-estimate Haruhiko Kuroda

In last week's post (Super Mario to the Rescue?) Evidente recommended that investors take a tactical overweight position in global equities on the expectation that the Bank of Japan and European Central Bank would have little choice but to deliver more monetary stimulus given the persistent weakness in their economies and the continued shortfall of underlying inflation measures relative to target. 

The announcement from the Bank of Japan of more stimulus was therefore not surprising to Evidente, but the introduction of a negative interest rate was.  Gauging by the deprecation of the yen and lift in global stock markets, the announcement was a shock to investors more broadly.   An interest rate of -0.1% will effectively apply to incremental or new reserves that commercial banks hold at the BOJ.

As Evidente read through the BOJ's press release on Friday, I was struck by the complex nature of the framework.  It has adopted a multi-tiered system in which the outstanding balance of each commercial bank's current account at the BOJ will be divided into three tiers in which a positive rate of +0.1% will apply to the basic balance, a zero rate will apply to a macro add-on balance and a negative rate of -0.1% will apply to the policy rate balance (see chart).

This might account for why the volatile reaction of the Topix following the announcement, as investors clearly sought to digest the news.  The index ended up strongly, suggesting that investors gradually understood that the negative interest rate on incremental commercial bank reserves would be unambiguously stimulatory for the economy by encouraging financial institutions to lend out funds to households and businesses.

The scale of the market reaction was probably disproportionate to the quantum of the negative interest rate.  But I suspect that the reaction reflects two developments.  First, the BOJ effectively drew  investors' attention to another unconventional policy tool it has at its disposal at the zero lower bound to complement its asset purchase program, including 80 trillion yen a year in government bond purchases.  The market would have more easily processed an expansion of the BOJ's asset purchase program.  But the already large scale of the program meant than any such announcement might have had a muted market reaction due to concerns about diminishing returns.  Second, the recent experience of the Swiss National Bank, which has a target range of its policy rate of -0.25% to -1.25%, suggests that the BOJ has ample scope to lower its negative interest rate further if deemed necessary.

Despite the narrow 5-4 majority vote in favour of the negative interest rate, the BOJ's announcement should provide investors a timely reminder of Mr Haruhiko Kuroda's determination to rid Japan of its fifteen year long deflationary mindset.  The next two central bank developments to watch for are the prospect that the FOMC members have little choice but to downgrade their internal projections for a further three hikes to the federal funds rate this year, and the next monetary policy meeting of the ECB's Governing Council on March 10th, in which Evidente expects the ECB to deliver more monetary stimulus.  With the prospect of more central bank stimulus globally, Evidente continues to recommend that investors take an overweight tactical bet in global equities and risk assets more broadly. 

Tame inflation data and market turbulence unlikely to sway the RBA

Australia's December quarter CPI confirms that inflation remains benign and that the inflation outlook does not pose an obstacle to further monetary stimulus.  The RBA's preferred measures of underlying inflation increased by 0.5%-0.6% during the quarter and are now around 2% higher than a year ago, which is at the bottom end of the RBA's target range of 2%-3%.  The disinflation in the underlying measures has persisted now for around two years (see chart).

The 10% plus depreciation of the Australian dollar in the past year is gradually passing through to higher consumer prices, with inflation of tradeables lifting to a year-on-year rate of almost 1%.  Considering the scale of A$ deprecation in recent years, the pass through to higher retail prices remains modest probably thanks to intensive competitive pressures amongst retailers and supply chain efficiencies.  At the same time, disinflation in non-tradeables remains strong, with the year-on-year rate moderating to sub-2.5%, well below the he peak in 2013 of over 4% (see chart).

The provision of non-tradeables has a high labour content.  The disinflation of non-tradeables in recent years is therefore consistent with the moderation in private sector wages growth to a record low since the inception of the series in the late 1990s (see chart).  The slowdown in wages growth is at odds with the pick-up in employment growth in the past year.  I suspect that an expansion of the supply of labour can reconcile low wages growth and firming labour market conditions.

The Australian economy set to remain in the slow lane in 2016

Mr Glenn Stevens has proven to be a reluctant rate cutter during this prolonged easing cycle.  The tame December quarter inflation data are unlikely to sway the RBA board at February 2nd meeting.  In the central bank's latest communication about the inflation outlook in November, it expected underlying inflation to remain around 2% over the course of 2016.  Today's release would have come in broadly in line with the bank's own forecasts and thus will do little to change that view. 

Nor is the renewed turbulence in financial markets of recent months influence the RBA's deliberations.  Mr Stevens' has communicated from time to time that he believes that risk premia in financial markets are compressed and that investors are too complacent about risk.  He would therefore see the renewed volatility of recent months as a welcome development.

I have long held the view is that more monetary stimulus is necessary to revive the animal spirits in the corporate sector, particularly given that the economy is on the precipice of a capex cliff.  The inflation outlook does not represent a hurdle to further rate cuts as is reflected by the RBA's own easing bias.  The tame inflation data combined with the slide in global oil prices provides a great opportunity for the central bank to deliver more stimulus at next week's board meeting, and frame a rate cut with a positive narrative. 

But the reluctant rate seems to be content with the Australian economy growing at a sub-trend rate for a while longer, and probably wants to see more tangible evidence of a cooling property market before cutting rates again.    Although the economy needs more monetary stimulus, my view is that another rate cut won't be forthcoming next week. 

Weekly Impressions: Super Mario to the rescue? Not just yet

The relationship between market participants and the President of the European Central Bank has been a turbulent one in recent times.  Financial markets were clearly disappointed at the outcome of the meeting of the ECB’s Governing Council in early December, with the euro strengthening and global stock markets falling sharply despite the announcement that the ECB would extend its asset purchase program by six months, which is now intended to run to March 2017 or beyond if necessary.

Mr Mario Draghi has long struggled to convince the inflation averse Bundesbank for the need for more aggressive monetary stimulus.  The unnecessarily wordy and absurdly low inflation target of a 2% ceiling adopted by the ECB reflects the influence of the Bundesbank.  The widely documented upward bias of consumer price indexes globally, thanks to the rapid improvement in the quality of e-services suggests that a 2% measured inflation rate equates to a modest deflation.

The poor market response to the ECB’s decision in early December and an assist from the recent slide in oil prices appears to have given Mr Draghi the upper hand against the inflation hawks internally.  At the latest ECB press conference on January 21st, Mr Draghi flagged that the ECB would need to re-assess its monetary policy stance at the next meeting in early March because euro area inflation dynamics continue to be weaker than expected.  The ECB now expects the path of annual HICP inflation in 2016 to be significantly lower compared with the outlook in early December.

To boost the ECB’s credibility in terms of its ability and willingness to achieve its inflation target, the central bank will likely need to announce an expansion and extension of its asset purchase programme at its next meeting.

Decisive action necessary to rid Japan of its deflationary mindset

The Bank of Japan is similarly facing a battle to combat persistent disinflationary headwinds.  At the time of writing this post, Reuters has reported comments from the BOJ Governor at the World Economic Forum that indicators of inflation expectations have been somewhat weak and that the central bank would not hesitate to adjust policy settings again to achieve its 2% inflation target.  At present, consumer prices in Japan excluding fresh food and energy are only 1.2% higher than a year ago.

These comments echo those made in a speech by the BOJ Governor on January 12th, in which Mr Kuroda acknowledged that the central bank’s efforts to achieve its price stability target of 2% are only halfway there, and that decisive action is necessary to eradicate Japan’s fifteen year long deflationary mindset.

Since the launch of Abenomics in 2012, analysts have lifted their expectations of profitability for the Topix companies by 75%.  In contrast, forecasts of profitability for the Euro Stoxx 600 companies have remained stagnant for the past five years (see chart).  Along with the disinflationary headwinds buffeting the euro area, this represents another clear signal that Mr Draghi has more work to do.

Tactical overweight in global equities

In the past month, investors have clearly been unnerved by renewed concerns around persistent disinflationary headwinds in the euro area and Japan, China's growth prospects, and the FOMC members' projections pointing to at least another three hikes to the federal funds rate over the course of 2016.  It is difficult to reconcile these projections with communications from various Fed officials that the process of monetary policy normalisation will be gradual.  The Fed Governors are likely drawing some comfort from the continued firming of labour market conditions, but at the same time various indicators of US manufacturing activity are contracting.

Despite the weakness in global stock-markets in the past month, earnings multiples for the S&P500, Euro Stoxx and ASX200 remain above their ten year medians.  Nonetheless, with Messrs Draghi and Kuroda signalling that more stimulus is on the way, and increased likelihood that the FOMC participants will have little choice but to downgrade their projections for the federal funds rate as the IP cycle in the United States tips over, Evidente recommends investors have a tactical overweight bet in global equities.