Fureyous

Can’t believe I missed this…one of the finest finance thinkers around, Satyajit Das, has a blog entry on Economonitor discussing the current risks of the Australian economy…please click here for Part 1 and here for Part 2. So these are the must read, not Fureyous…

In these articles Das eloquently articulates the major influences on the Australian economy (China, Europe, Cost of funding, commodites, etc) and breaks down how these could play out.  I enjoyed his comments on why Australia handled the GFC better than others

APRA and politicians take credit for the banks being relatively unaffected (during the GFC). This is curious given that banking regulations are largely uniform around the world. One can only assume that Australia has superior regulators and politicians to the rest of the world – an example of “Australian exceptionalism”.

In reality, Australia’s swift recovery was driven by large cuts in interest rates, government guarantees for banks, government stimulus and a commodity boom

and his concuding remarks cannot be discounted

Australia remains vulnerable. A slowdown in Chinese growth and fall in commodity prices and volumes would affect the economy adversely. Australian history suggests that mining booms are finite and end suddenly causing significant disruption.

Problems in sovereign debt and attendant pressures on banking system may decrease available funding and increase borrowing costs for Australian banks and companies. Overvalued house prices and high household debt increases vulnerability to an economic slowdown, with an accompanying rise in unemployment or to higher mortgage rates. A credit crunch or recession could cause house prices to fall worsening domestic conditions, which would in turn affect domestic banks.

The perfect storm for Australia would be the coincidence of those events.

Das mentions the key positives for Australia, which are our low levels of  government debt, interest rates with room to move, and the abillity for our currency to significantly depreciate. However the complacency that I believe exists in this country that I’m unsure we ackowledge is that just because we made it through the GFC and have had 20 years of consistent economic growth without a technical recession…

Australia’s economy remains vulnerable to a variety of external factors over which it has no control.

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Source: RBA

Its been a few weeks since I provided an update on the local government yield curve and consistent with the slight improvement in the sharemarket the Australian Government Bond Yield Curve has indicated a better outlook for the local economy. As the chart shows, since 6 January the yield curve has increased around 20bps across all maturities which isn’t a bad increase but yields still aren’t as high as they were last November.

Current figures still suggest the Reserve Bank will decrease its cash rate next meeting and the shape of the curve is consistent with weaker economic outlook suggested by the IMF and World Bank reports. It also suggests that inflation continues to be a non-threat and the ABS inflation figures showed that the market was pretty much correct by dismissing inflation over recent months.

Since October the S&P500 has rallied around 20% in the face of some pretty ugly political behaviour in both the US and Europe regarding their respective economies and that’s quite a surprise. This is also supported by the downtrend in the VIX…see below chart…given the current downside risks I tend to think this trend will reverse and volatlility will increase.

Source: Bloomberg

I don’t know what direction equity markets will go but my thoughts are to stay conservative…there’s a lot of water to pass under the economic bridge before catastrophic risks (global/European banking meltdown) is off the table. Whilst the market’s suggesting the risk is reducing its still there.

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Source: RBA

The above chart shows the latest Australian Government Bond Yield curve which is around 5 to 2obps higher than it was a little over three weeks ago. On the scale of yield curve movement over the last few months its largely market noise and is therefore relatively meaningless…the market is still pricing in further RBA rate decreases and the outlook for the Australian economy is still relatively weak…its currently difficult to find any strong economic growth driver that doesn’t carry significant risk of not fulfilling its potential and that includes China.

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Source: RBA

The above chart shows pretty much what happened to the outlook for the Austrlaian economy and why bonds were the best investment for the year.

It shows the longer terms yields (3 years and above) dropping by up to 200bps thus providing very large capital gains for bond investors who had the courage of buying long term bonds at the start of the year. This yield curve movement also indicated the declining outlook for the Australian economy thanks largely to the Euro crisis and its potential impact on the banking system across the world.

For the short term bond holders (terms of 1 to 3 years), yields dropped by up to 150bps still providing strong capital growth. Whilst the yield to maturity dropped enormously across all maturies for Australian Government bonds, the Reserve Bank took a while to start the decrease and then only decreased by 50bps by the end of December. This curve still suggests the RBA has a few rate decreases to come and the Euro crisis will probably be the main determinant of that. That is despite the weak retail sales and weak residential property sales that provide increasing evidence of our weaker than you know economy. The Reserve Bank are also forecasting lower commodity prices which doesn help our resources sector so the outlook for growth across our economy may be moving closer to a one speed economy than we think.

Anyway, the year 2011 was certainly a year where the conservative bond investor was a winner and whilst I haven’t seen the final numbers yet, it looks like the gross returns should be a comfortably in double digits.

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I’ve read a few too many times how Australia is well positioned because of its exporting links to China and how this should help us escape any serious economic issues flowing out of Europe. Obviously our markets haven’t quite agreed with that with bond yields dropping massively over recent months and our equity market continuing to show high volatility and dropping arond 20% since recording 2011 highs around 5000 back in April.

Overnight we have just had three articles from prominent economists indicating concerns about China …

• Will China Break? – Paul Krugman
• China: Hard landing in sight? – Patrick Chovanec
• China: Lots of News signifying nothing new – Michael Pettis

Of course, a seriously troubling Euro crisis will spill over everywhere including China. Our economy is nowhere near as secure as many commentators or fund managers indicate and I have to admit to being the most bearish on our economy for quite some time…my perceived complacency and frustration with government and opposition focusing on budget surpluses is driving me nuts.

For investors, finding good investment return potential is very difficult indeed and takes some courage. Equity markets still carry plenty of downside risk let alone the usual day to day volatility, bonds have yields in the 3%s, and with an economy looking to slow more than we hoped, property looks scary, and even commodities are bound to drop signficantly in the face of a slower China.

I’m sure the focus of investors will continue to be capital protection over capital apreciation for some time yet. So I can only imagine that cash and term deposits will continue to be the investment of choice…particularly whilst term deposits continue to pay 1.5% to 2% over government debt. Personally, I believe if you can handle the volatility and hang in there for a while I tend to think corporate debt, which on average is paying a significant premium above governemnt debt, should provide the best return potential…only record default levels should stop a decent return on corporate debt (not that its out of the realm of possibility) in the next few years so ensure the portfolio is well diversified and be prepared for a bumpy ride.

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Normally I don’t like to comment on actions by the Australian Government but with the announcement of a cut in expenses in order to obtain a budget surplus I have to.

Its widely recognised that the level of Australian Government debt is very low by world standards. If you look at my last post on Australian Government Bond yields you can see that there is also little concern from markets about the size of government debt because yields are so low. Yields are also very low because the outlook for the Australian economy is not particularly strong.

The level of unemployment is a reasonable indicator of measuring the relative quality of life the average person has. Obviously, if we are out of work then our income’s are lower and our quality of life suffers somewhat. One of the primary objectives of the Reserve Bank is in fact the maintenance of  full employment, along with currency stability and economic prosperity and welfare of Australians. No doubt these objectives equally apply to the implementation of fiscal policy also.

The fact that yesterday’s decision will result in higher unemployment in order to control an already well controlled level of government debt is ridiculous.

The simple approach of any government over time should be to save during the good times (which occurred in the Howard years) so it is in a position to spend when times are tough (which occurred during the Rudd years). Taking this approach increases the chances of achieving smoother levels of employment, economic stability and therefore increased prosperity for us all.

By the government’s own admission, unemployment is expected to increase and if the government is reducing expenses then this will be a significant contributor to this increase…hardly improving our economic prosperity.

The Australian economy is operating at two speeds and if Europe gets worse then it will be one speed and that speed is slow. With our debt levels low, cutting expenses in the hope of a budget surplus given the fragility of our economy in the context of global macro uncertainty is unlikely to help. When times are tough, cutting expenses is likely to reduce revenue and this won’t help our debt position at all…it will make it worse.

The problem with the budget over the last 6 months has been lower revenue and increasing revenue (such as through a resources tax in these incredible resource boom times) is far more important and its clear the government does not have the courage to implement this.

It is obvous the budget surplus is simply addressing a political agenda which is independent to our prosperity as a nation and the fat cat miners win again at the expense of the rest of us.

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Source: RBA

Just when you think the yield curve can’t get any lower, the last 8 days have taken another 10 to 15bps off. Sharemarkets have obviously dropped on the Euro-debacle and this yield curve demonstrates not only significant interest rate reductions in the months to come but a significantly slowing Australian eonomy thanks to the global pressures.

Futures markets are banking on 25bps drop in the RBA next month and another 50bps in February 2012. This doesn’t mean the yield curve will drop but either way, I am still happy to lock in my home loan for the next few years at a rate that is significantly below variable rates, but that’s enough about me.

Investment strategy-wise, loads of uncertainty is the norm and term deposits continue to pay a massive spread over government bonds. Our sharemarket carries a bit of risk amongst banks and resources so I’m sure if there’s any value its bound to be in other sectors.

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Source: RBA

Since August the Australian Government Bond yield curve has dropped massively indicating the lower expectation of interest rates and the deteriorating outlook for our economy. I’ve voiced my increasingly bearish view of the Eurozone situation so I won’t go on any further about so I’ll mention the new addition to my yield curve…the new 2027 Australian Government bond. It was issued near the end of October and as the chart shows it is trading at around 4.4%!!! A near 16 year government bond trading below the cash rate…mmmm, cash rates are coming down and clearly I’m not the only one bearish about our economy, the market is too.

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Source: RBA

In just 3 business days the yield curve has dropped down to where it was at the end of September where markets had experienced eight weeks of gloom and doom. Mind you, a lot happened in the three days to the end of yesterday…including the Greek’s putting significant doubt in the Euro rescue package, sharemarkets subsequently plummeting, and our Reserve Bank dropping their cash rates by 25bps.

According to the ASX’s Target Rate Tracker the market is placing the probability of another rate cut in December at 100%. The above yield curve certainly agress with that sentiment and with 5 month bonds trading around 4.1% the market is also saying there’ll be at least 75bps in cuts through to April.

Obviously, this all means that inflaiton is a non-issue for the Reserve Bank and the focus is on the local economy whose sentiment is being driven by the Euro Sovereign concerns. Whilst I usually go with market expectations regarding RBA activity I didn’t when incorrectly predicting last week’s RBA decision. Europe still has a long long way to go so the current theme of sharemarket volatility will undoubtedly continue. Term Deposits are the overweight position for me.

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The last month has shown a bit of a bounce-back in the sharemarkets but as the above yield curve indicates, so far its more of a dead cat bounce and there’s a long way to go. The yield curve is still negatively sloping to beyond two years indicating the market is expecting a few rate rise drops by the Reserve Bank in the months/years to come.  I tend to think the Reserve Bank will stay on hold once again on Tuesday simply because I think they’d rather wait and see how this latest Euro rescue package pans out. The early signs are positive but there are still a few concerns, notably the yields on Italian bonds are still very high (see below) and if they stay high then that spells trouble for Europe as Italy is the biggest debt holder in Europe and the third biggest in the world (behind Japan and USA) and they can’t be bailed out.

Italian 10 Year Bonds – 28 Oct 2011

Source: Bloomberg

Anyway, there’s a long long way to go before Europe is aywhere near out of trouble and the details of their latest plan aren’t even finalised so I imagine the Australian bond market will be tentative for some time yet and equity markets will continue their high volatility.

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