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Rockanomics

Rockanomics - September 2015

Given all the hoopla, media frenzy, the bets taken at your local TAB, and even ones over Friday night beers (readers please note we ARE still talking about the US Federal Reserve’s interest rate decision last month and not who’s next up for Australian PM), what ever the outcome, you would have expected a reaction the likes of this across trading floors all over the planet……
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What was September 2015 in world economics?

Given all the hoopla, media frenzy, the bets taken at your local TAB, and even ones over Friday night beers (readers please note we ARE still talking about the US Federal Reserve’s interest rate decision last month and not who’s next up for Australian PM), what ever the outcome, you would have expected a reaction the likes of this across trading floors all over the planet……

Instead we got this…………

As with all things in life that typically get more than its fair share of attention and given that a lot of the much awaited decision was understandably priced in, it was all fizzle no sizzle on the day. Though it was near foregone conclusion amongst the majority of investors worldwide and even amongst us that rates would be held, it was an inquisitive reaction by the market. Not unlike previous receptions to low rate announcements, which typically fuelled the impetus to buy even more things you didn’t really need with cheap money, whilst chasing dismal yields whatever the fundamentals said (or didn’t!).

Was it possible the Fed’s failure to raise rates (after indicating the opposite) finally solidified investor concerns about the health of the world economy and expanding slack in demand? After all and by simple definition, a growing economy (with its corresponding pickup in inflation) should be one that looks forward to rate rises. Instead, bond prices (showing deflation ahead) and the continuing fall in commodity and industrial input demand are clearly painting the opposite picture. Despite supposedly stronger US growth and employment, the considerable market volatility and the Chinese slowdown are clearly messing with Ms. Yellen’s mind.

After a couple of weeks of consolidation in a slightly upward trajectory, markets resumed their decline, headed towards a re-test of their August lows. A positive finish on the final day of the month however, helped indices like the MSCI World (over 1,600 stocks from 23 developed markets) pare losses to 1% for September (though still nearly 10% off this year’s high). Emerging markets collectively experienced the largest quarter of investment outflows since the depths of the GFC. Correspondingly, their currencies experienced a shellacking. Commodities overall, despite a brief relief rally in the last week of August, resumed its trek downward albeit less vigorously than the last three months. Oil traders couldn’t make up their minds whether more or less supply was coming onto the market. The black gold went nowhere, averaging USD $45 a barrel for the month. For the common man, any savings at the bowser that nets even a pint at the bar is a win! So let’s hope these traders continue to scratch their oily heads.

On the home front, the Australian share market was down 3% and our dollar shaved another cent, but not before breaking down from the 70 cent mark several times. Iron ore, while showing some early promise wiped out all its gains for the month. A slowing China and softening resource demand continue to weigh heavily on a mostly (and unfortunately) one dimensional, commodity centric Australian economy with blue chip old boy BHP even hitting a 7 year low (“but it’s about the dividends!”). Still not convinced of a demand slowdown? Then what about Shell walking away from its Artic drilling after a USD $7 billion spend? Or a Chinese coal company shedding 100,000 jobs in one hit? Or commodity trading giant Glencore losing 75% of its market value? For a government that cut $300 million in science/research funding and instead granted tax breaks to baristas, how many coffees are they expecting the nation to sell to fill all those unused dump trucks? Don’t ask a Melburnian that. Once upon a time Australia did in fact create Wi-Fi!

Fun fact: Was the USD index the most stress free (I didn’t say risk free!) investment of the year? If you had simply held the ETF tracking this index, you’d still be up 6% for the year! Just saying. Don’t tell this to those DIY SMSFs “I eat blue chips for breakfasts then a blue chip sandwich with a side of hybrids for lunch then MOAARRRR blue chips for dinner! Hold the other possibilities!”

Bright spots?

Certainly but only if you were willing to look hard enough. Even within the gloomy commodity complex, agriculture and precious metals showed a fair amount of resilience and even demonstrated an upturn out of September. In the US, the cyclical (housing, automobiles), consumer staples (food, household) and technology sectors have overall been gainingacross the last three months. Locally, the real estate investment trust, industrial and utility sectors outperformed the broader market, eking out a positive finish for September. Heck, even the recent price behaviour on oil is throwing weight to a possible short-term break to the upside. I’d start drinking as many pints as possible, NOW, if I were you!

Gratifyingly, over an undoubtedly challenging quarter the majority of Private Wealth’s investment recommendations held up remarkably well, considering the outright bruising world markets sustained during this period. Fixed interest did what it was supposed to do i.e. DEFEND (solidly at that) and our faith in Aussie small and mid-caps investment managers was rewarded with September seeing a recoup of nearly all of August’s losses. BHP, CBA, Telstra (“but it’s the $#!@ dividends I tell you!”) anyone? Property allocations too had their head above the quarterly waters. Look it wasn’t all peachy keen as there was no running from the bushwhacking Asian shares endured during this period. However, from a longer-term perspective these investments are still miles ahead and we know our quality managers are now hurriedly doing what they are paid to do – reassess, reposition and redeploy (if need be) to quality investments with solid fundamentals that are now even more cheaply available than before.

Looking ahead

Just as extreme asset pricing (brought about by zero and even negative interest rates) continues to hold sway over markets, so is our vigilance over the investments we help manage. In an unchartered financial world with markets unhealthily and still clearly enthralled by unconventional (and untested) monetary policy – UMP - we’d like to sign off with just some implications and possible consequences of ZIRP (Zero Interest Rate Policy) & NIRP (Negative Interest Rate Policy). We wish we could say that these were your kids’ two favourite alien cartoon characters on Nickelodeon but in all seriousness:

  • Price distortion - ultra low discount rates on cash flows, boost asset prices and may incorrectly raise expectations of improved economic conditions and higher future revenues1. What would a normalisation (of rates) then do?
  • Imagine a world where you were paid to borrow money but charged to save it with a bank? What heresy is this!? Hello negative interest rate policy! Most of continental Europe now find themselves in some version of this predicament. Governments of many nations, already drowning in debt pre and post GFC, have now even less incentive for fiscal discipline and are enticed to borrow more. And how will this disrupt the traditional banking business model? Who in their right mind would want to hold cash in the bank if they are charged for doing so? Could this eventually hasten the rise of alternative virtual currencies1?
  • The exponential growth in risk taking, caused by UMP, has led to extreme compression of sovereign credit spreads1. ZIRP and NIRP are not the most discerning gentlemen when it comes to credit quality. How on earth does the yield on a 10 year Spanish government bond (a nation with 23% unemployment on a good day) come within a whisker of an equal maturity German Bund? Answer - severe risk mis-pricing.
  • The desperate search for any possible positive return has led investors to pile up into longer dated securities. History has routinely shown what can happen to overcrowded one way markets. Again, what would an eventual normalisation in monetary policy cause1?
  • The fixation on central bank actions are distracting from real economic challenges of raising real growth potential and productivity through structural reform, innovation, and good old fashioned business. It supplants the normal role of economic fundamentals in setting market valuations and the distraction effect explains why the current low rate environment has generally coincided with weak investment in the real economy1.

1 Hervé Hannoun, 2015, Ultra low or negative interest rates: what they mean for financial stability and growth, Bank for International Settlements < http://www.bis.org/speeches/sp150424.pdf>

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