Economic Update – April 2018

Economic Update – April 2018

In our economic update for April Dan Purves of Kaplan Professional speaks with Brian Parker, chief economist at Sunsuper, about the apparent breakdown in the long-held economic relationship, synchronised global growth and trade wars.

Question 1

The RBA acknowledged in March that wages growth remains persistently low in Australia. What are the factors affecting this and has that long relationship between economic growth and wages growth broken down?

Answer

Broken down is probably too harsh a term. If you look at the underlying causes of why wages have really fallen short of people’s expectations, I think lower inflation expectations has played a part, but the big story really is underlying trends in the labour market.

Full-time jobs have really recovered very strongly in 2017, but in the years prior to that most of the jobs growth we saw in Australia was all part-time. When you looked at measures of labour force underutilisation — at measures of unemployment and underemployment — those measures were a lot more elevated than the official unemployment rate. That underutilisation has really kept a lid on wages overall.

Now if you look at more recent trends, those underutilisation rates have started to come down. It’s still early days. But given the usual lags, I think a reasonable assumption to make is that wages do pick up from here, that you do see an acceleration of wages over the next year or two, but it’s coming off quite a low base.

Question 2

February saw volatility come back into the markets on the back of expected rises to inflation. Has this altered your outlook for Australian and overseas fixed income over the next 12 months?

Answer

The short answer is not really. The unusual thing was not so much the volatility we saw in early February, the unusual thing was the almost total lack of volatility we saw for the last 12 months.

If you look at US equities, for example, US equities went up pretty much every month during 2017. That hasn’t happened for decades, so I just think the reaction to some of the wages we saw out of the US in early February says more about just how complacent markets have become rather than the data itself. Yes, wages were a little higher than expected, don’t get me wrong, but I think the market reaction was overblown.

Now in terms of the outlook for fixed income, yes, yields have risen over the last few months, and yes, yields are higher than they were, but they’re not exactly all that high; future returns from sovereign bonds, future returns from investment-grade fixed income are going to be very low. In the case of sovereign bonds, investment returns are going to be quite poor.

Now that’s important to bear in mind. It is a frustration for a lot of investors out there, especially for retirees. When they look at the interest rates on offer and they look at the yields on offer they say, “Well, how do we do something about this?” and the answer is, “You can’t”. The yields are what they are. We can’t conjure higher yields out of thin air.

Can we do something in credit for example? Can you just increase your exposure to non-government bonds? Well even there, a lot of the easy runs have been made. Credit spreads have narrowed quite considerably. It’s too early in the cycle to actually be calling for spreads to widen dramatically, but the bottom line is those credit spreads have come a long way, so the future returns even from non-government securities are also going to be quite a bit lower than we might have previously expected. We need to accept that.

Another important point from an asset allocation point of view, there’s a limit to how much credit, how much non-government exposure you can ram into a fixed income portfolio. You want fixed income to provide defensive characteristics, especially during tough equity market conditions. The more credit you have in there, in particular the more lower-quality credit, then the more dangerous that becomes during a period of equity market turmoil.

Question 3

In traditional asset classes, Sunsuper has favoured emerging sharemarkets. What’s been the rationale behind this and are there any markets that you do prefer?

Answer

That’s a really good point. If we were sitting here about 12 to 18 months ago, I would have said to you that, if I look at the public markets, if I look at the traditional asset classes, emerging; sharemarkets are probably the only place that we could find genuine value where you could buy quality assets at decent prices. But that was 12 to 18 months and 30% ago.

Now, it’s fair to say that our enthusiasm for emerging sharemarkets has waned a bit, given the value just isn’t anywhere near as compelling as it was. If you look at where we’re finding value, it’s kind of challenging at the moment. The feedback from our investment managers and our own modelling is it is very tough to find asset classes from traditional markets that offer genuine value.

If you look at the major regions, the US equities in our mind are expensive — not disastrously so, but they do look expensive. If you look at Europe, it doesn’t look cheap, but at least we’ve got some more earnings upside to come. We still see European earnings as still cyclically depressed. We think there is upside there.

Japan is interesting. If you are prepared to give Abenomics the benefit of the doubt, in other words if you believe that getting returns on equity from Japanese companies, getting those returns sustainably higher, if you believe that that’s going to succeed, then Japanese equities offer real value. If you don’t [believe that], then they don’t [offer value]. It really is “Are you prepared to give Abenomics the benefit of the doubt or are you not?” That’s really what it comes down to.

Question 4

In the current economic environment, what’s your view on alternatives? Are there any assets that you find particularly attractive?

Answer

Again, let’s just go back to the public markets by way of introduction. Public markets have had a very, very good run in the years following the GFC. Equity markets in particular have performed very, very strongly, but that’s all in the rearview mirror. The key question for anybody whose job it is to generate long-term real returns for investors, for super fund members or advice clients is, “Where are real returns going to come from?”

Now, they’re not going to come from fixed income. The future returns for fixed income are likely to be lousy. The future returns on offer from cash are terrible. If I look at credit, yes, I can do a little bit better in credit, but again future returns there are not going to be high enough to meet the kind of return objectives that people actually need.

Equities may deliver reasonable long-term returns, but if I look at the US, for example, US valuations are stretched which means the future returns from the US equities — they are half the world — they’re going to be a hell of a lot lower than we’ve been used to and may actually fall miles short of the kind of returns that investors actually need.

What it means is that from our point of view, we don’t want to limit ourselves to traditional asset classes. We think the alternative space still provides decent long-term returns. By this, I’m talking about carefully selected hedge funds — [I] stress carefully selected — but also property, infrastructure, and private equity. We’re still finding opportunities in this unlisted space that are capable of delivering real returns that members need, but even here there’s a caveat.

If you look at the economic environment we’ve seen over the last six to seven years where monetary policy is so aggressively expansionary, basically a rising tide has lifted all boats, so all assets have benefited from that including assets in the unlisted space. For example, if five or six years ago I looked at an infrastructure deal or a private equity opportunity and did the maths and said, “Okay, well what sort of returns am I likely to get out of this?”, the deal might have given you say 15 to 16% per annum. You’d say, “Well great, I’ll take that any day of the week”. Now scroll forward to today, if I looked at exactly the same deal, I might only be looking at 9 to 10%. Now, I’ll still take 9 to10%, don’t get me wrong. It’s just not 15 to16%. So, even there, return potential has been depressed, but thankfully we’re still finding opportunities in that space.

Question 5

What is your approach to private equity?

Answer

With private equity, the key thing for us is firstly partnering with really, really good managers. If you compromise on manager quality, it’s a recipe for disaster.

Secondly, look at whatever ways you can to bring the cost of doing business in private equity down and that’s investing less in funds and doing more co-investments or direct investments alongside one of your preferred managers. We’ve certainly done quite a lot of that.

We’re also finding that discipline is crucial. The managers that we are using have been very disciplined about valuation. In other words, they’ve been prepared to sit on cash and wait for opportunities, wait for what Warren Buffett has traditionally called the “fat pitch” — call it the “slow, hard volley”, to use an Australian analogy — really to be very disciplined about valuation because if you compromise on valuation in the interest of just putting money to work, that is a recipe for very poor future returns from private equity.

We like private equity. We are still finding opportunities in that space. In fact, private equity assets to us look relatively more attractive compared to public equity, and that’s certainly the case in the US. But as I said, it’s important to be disciplined about valuation, and important to focus on high-end quality managers.

Question 6

We’ve entered a relatively rare period of synchronised global growth. What are the drivers behind that?

Answer

[I can] identify a few things that have been responsible for this. One is, globally, monetary conditions have been very, very pro-growth, so monetary policy has been very, very pro-growth. Even in the US with the end of quantitative easing and with interest rates going up, overall, it’s very hard to argue that monetary policy is anywhere near tight. Even in the US, it is very pro-growth monetary policy, very pro-growth financial conditions. In other words, when you look at indices of financial conditions, if I want to get a corporate bond issue away, can I? If I want to get an equity issue away, can I? If I’m a bank and I fund my loan book in world money markets, can I? Yes, I can, so financial conditions are also very pro-growth.

The other issue is fiscal policy. If you think about the years that followed the GFC, the initial period of crisis, fiscal policy was actually very pro-growth, but then governments hit the brakes too soon, especially in Europe but also elsewhere. At a time when you still had very high levels of unemployment, you had governments obsessing about deficits and you saw the fiscal policy tightening around the world especially in Europe. That acted as a real drag on growth.

Now more recently I think you’ve seen a big, big change there. You’ve seen fiscal policy become much less of a drag on growth. Governments have sensibly realised that if you slam on the brakes and throw a heap of people out of work at a time that you’re going to be paying and you get voted out, and governments tend to respond to that. So, the fact fiscal policy hasn’t been a drag has been a big plus as well, easing monetary conditions.

Japan has been the traditional laggard, and I think don’t underestimate the importance of Japan here. This is still a very, very major world economy. Japan has now had eight consecutive quarters of growth. That by Japanese standards is gangbusters. We haven’t seen that kind of consecutive growth performance out of Japan since the 1980s, and that’s been really quite extraordinary. So, the fact that Japan has actually contributed to this synchronised growth story has been really impressive.

Question 7

Trump has announced trade tariffs on steel and aluminium. What effect will this have on Australia’s economy and on China, whom we’re so closely dependent and related?

Answer

It’s actually not that big a deal by themselves, for either China or Australia or for the world economy. What’s more problematic is the signal it sends. In other words, is this the first of many such moves by the US administration? If it is a warning sign of much more to come, then that’s a really dangerous signal for the world economy over the coming years. If you want to really help engineer the next global downturn, then stymying world trade is a really good way to do that.

So, I’m not as concerned by the measures themselves per se, they’re unhelpful, they’re annoying but they are not in and of themselves enough to derail global growth. But if they’re a warning sign for more to come, then watch out.

Question 8

There’s a lot of talk about Australia’s household debt levels. How worried are you and how do you view Australia’s household debt?

Answer

It’s a really good question. I’d make a few points here. Is Australia’s household debt higher than virtually any international comparison you care to name? Yes, it is, but I think we need to keep it in a little bit of perspective. Firstly, let’s look at household balance sheets in their entirety, so household net worth over the last, call it seven to 10 years, has increased from about six times household disposable income to be closer to eight times household disposable income, so the asset side of the balance sheet has done very, very well.

You also need to bear in mind things like we’ve got very high mortgage-related debt, but there’s also a sizeable pull of cash sitting at mortgage offset accounts. It’s something the RBA has drawn attention to. So look at both sides of the balance sheet. Look at the fact that assets have actually grown a lot, but also let’s look at who owes the debt. By and large, the debt is owed by households that can afford to repay it.

Am I worried about it overall? I am, but I’m not as worried about it as some of the headlines would suggest. I’m not as worried about it as [much as] some other commentators. Does it provide a medium-term vulnerability to Australia? Yes it does. It does mean that households are more vulnerable to any sort of external shock. It means that households are more vulnerable to interest rate rises, for example.

I think a lot of people have made comments that, “Look, if interest rates were to rise through the roof, the RBA would really jack up rates aggressively that would really hurt households terribly”. Well, that sort of rationale implies the Reserve Bank doesn’t know that. They clearly do, which means you’d expect quite reasonably to see the Reserve Bank calibrate any interest rate changes to take into account the reality of Australia’s household debt and just how sensitive households are to interest rate moves.

 

Sacha Loutkovsky
sacha.l@orionfg.com.au
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