Weekly Impressions

The 173k lift in non-farm payrolls in the month of August fell modestly short of consensus expectations but confirms that the labour market in the United States continues to strengthen. The unemployment rate edged down to 5.1%, its lowest level in over seven years.

Despite these encouraging trends, growth in the US economy has stalled. In the past five years, nominal GDP has expanded at an average annual rate of 3-4%. Disinflationary forces have intensified in the past three years; core PCE inflation has trended down to sub-1.5% yoy at a time when the unemployment rate has declined by 300 basis points.

In prior posts, I have suggested that a flattening of the slope of the Phillips curve since the financial crisis can help to explain the positive correlation between US inflation and unemployment. With inflation expectations well anchored, inflation has become far less responsive to changes in the unemployment rate (and other measures of economic slack more broadly). The unemployment rate might have also become a less reliable barometer of labour market conditions because an ageing workforce has contributed to a structurally lower participation rate.

Despite this, the Federal Reserve has clearly interpreted the decline in the unemployment rate as a signal that the labour market is approaching full employment. But the disinflation of the past three years has challenged the conventional view of what constitutes full employment (see chart).



At the annual Jackson Hole symposium, Vice Chairman Stanley Fischer attributed the disinflation to three factors: US dollar appreciation, fall in commodity prices and stable inflation expectations.  He suggested that some of these factors are temporary and would be expected to diminish over time.  Mr Fischer said that the Fed would likely need to proceed cautiously in normalising the stance of monetary policy (read: don't expect rapid fire rate hikes) but in a clear signal that lift-off is imminent, added that the Fed should not wait until inflation is back to 2% before tightening given the long and variable lags associated with the operation of monetary policy.

At a time when core inflation is undershooting the Fed's target by over 50 basis points, no wonder market participants remain unnerved and puzzled by the Fed's determination to tighten policy and its blatant disregard for its inflation target.  It is too complacent that inflation will naturally return to 2% and I suspect is being distracted by concerns that an extended period of near zero interest rates will undermine financial stability. 

The proximity of the crisis suggests that the Fed is justified in being concerned about financial stability.  But more targeted macro-prudential policies designed to reduce the size and influence of the shadow banking sector, and lift the amount of equity finance on the balance sheets of financial institutions would do far more to reduce systemic risk of the financial system.

A tale of two central banks

The difference in language and communications between the US Federal Reserve and the ECB is striking.  During the week, ECB President, Mr Mario Draghi, highlighted that the outlook had weakened and re-iterated the central bank's willingness to use all the instruments within its mandate, and that the asset purchase program provides sufficient flexibility in terms of adjusting the size, composition and duration of the program.  He added that the current schedule of monthly purchases of 60 billion euros is intended to run until the end of September 2016 or beyond if necessary until there is a sustained adjustment in the path of inflation towards 2% over the medium term. 

The open ended nature of the ECB's large scale asset purchases (LSAP) suggests that unlike the US Federal Reserve, the ECB does not take for granted that inflation will naturally return back towards 2%.  Since the current program of LSAP was announced in early 2015, it has been associated with the end of the three year long disinflation (see chart above).  The more aggressive approach by the ECB relative to the US Fed probably stems in part from the lesson learnt from a policy error in 2011, when the ECB lifted its official interest rate twice - at a time when the core Harmonised Index of Consumer Prices (HICP) was running at only 1.5% yoy - only to retreat soon after (see chart below).


A policy error in real time

 The key risk to the global economy is that the US Federal Reserve is committing a policy error by contemplating a policy tightening at a time when the economy is suffering from an extended disinflation and at a time when inflation continues to undershoot the central bank's target by a long way. 

Investment strategy: Overweight Euro Stoxx; Underweight S&P500

Against this backdrop, I recommend investors move overweight the Euro Stoxx index.  The chart below shows that analysts have been modestly lifting their growth outlook for the Euro Stoxx index this year, coinciding with the ECB's more aggressive monetary stimulus.  At around 14x, the market is not cheap but will remain expensive as investors continue to price in a recovery in earnings and gain more confidence that the ECB is determined to address the euro zone's shortfall in aggregate demand.

I recommend that investors fund the overweight position by having underweight in the S&P500 index.  The chart below shows that in the past year, around the time that the Fed started to communicate to market participants its intention to end its zero interest rate policy, analysts' expectations of growth have stagnated after a five year long period of upgrades.  US dollar appreciation - associated with expectations of rate hikes - has clearly crimped the US dollar earnings of offshore earners.


RBA's patience continues to wear thin

The June quarter National Accounts confirmed that growth in Australia remains tepid.  Real GDP expanded at rate of 2% yoy, with the key contributions coming from consumption, dwelling investment and net exports, while inventories and private business investment provided significant drags (see chart).  I noted in last week's post that despite the weakness in business investment already evident in the past year, the economy is on the precipice of a capex cliff over the 2015/16 financial year, in the order of 20% or $30 billion. 

The renewed depreciation of the Australian dollar will help to further lift the competitiveness of exporters and boost the contribution to growth from net exports.  But as long as the much anticipated transition from mining to non-mining capex remains elusive, the RBA has little choice but to ease policy further to ensure that consumption and dwelling investment continue to support the outlook.

The tepid state of growth in the Australia's economy owes much to the terms of trade shock, which have fallen by over 50% since global commodity prices peaked in 2011, and the RBA's caution in easing policy during this period.  Despite the magnitude of the terms of trade shock, the Overnight Cash Rate of 2% remains well above official interest rates in most other advanced economies. 

Against this backdrop, EPS growth prospects have stagnated for five years now and the consensus 12 month forward EPS estimate remains 25% below its pre-crisis peak (see chart).  Thus, the ASX200 has been hostage to periods of multiple contraction and expansion.  At current levels, the PE of around 14x is broadly in line with historical norms by the standards of the past decade.

A dividend discount model for the market tells a very different story.  The price to dividend ratio has remained broadly steady over the past five years, but a 25% lift in analysts' dividend forecasts have underpinned the rise in the ASX200 over this period (see chart). 

The recent market volatility has seen the P/D ratio decline to around 21x.  Rather than representing a buying opportunity, in my view the lower P/D ratio suggests that market participants are becoming more sceptical of the ability for the ASX200 companies to lift dividends at the same rate as the past five years have shown.  Indeed, the chart below shows that the rate of analysts' dividend upgrades have slowed over the past year.