‘Move along, there’s nothing to see here’ appears to be the attitude of some of the country’s finance bigwigs, when asked about New Zealand’s high level of household debt.
Housing debt hit a record $231 billion in December, while consumer credit hit $16 billion. Together, total household debt is up 8.7% year-on-year.
While debt grew at faster rates during the housing boom 10 years ago, the value of the debt was about a third lower than it is now.
Yet delivering his first speech as Finance Minister on Thursday, Steven Joyce didn’t acknowledge this as a risk threatening the economy.
“Both the Reserve Bank and Treasury have highlighted that unusually, the current risks to New Zealand’s continued economic expansion are almost exclusively international,” he said, before proceeding to affirm New Zealand’s commitment to free trade despite US President Donald Trump’s push for protectionism.
Roger Kerr: ‘I wouldn’t overrate that as a big risk’
Asked during a panel discussion at PwC’s CEO Survey breakfast on Friday whether he saw high household debt as a threat to the New Zealand economy, PwC partner Roger Kerr said: “In Australia, as well as New Zealand, if interest rates went up one or two percent, there might be a bit of an issue.
"The Reserve Bank is concerned about that and is doing good reporting and having good interaction with the banks about that.”
He said the pinch would really be felt if asset values came down at the same time as interest rates rose.
While the Official Cash Rate is expected to remain on hold for the year, banks have started hiking their mortgage rates, largely due to increased funding costs.
House prices have also been cooling off - the national median selling price falling to $490,000 in January from $516,000 in December and its peak of $520,000 in November last year, according to the Real Estate Institute of New Zealand. In Auckland, the median price declined to $805,000 from $840,000 in December and $851,944 in November.
While fewer people are expecting house prices to keep rising, the majority believe they'll continue trending up, according to ASB's latest Housing Confidence Survey. It found only 10% of survey respondents expect prices to fall in the next year.
Kerr said: “I wouldn’t overrate that as a big risk to the New Zealand [economy] right now. I don’t think short term interest rates will go up for another year, or year and a half. Let’s hope the housing market has a soft landing, not a hard landing.”
Anthony Healy: It’s a 'medium-term' issue
BNZ CEO Anthony Healy then went on to say: “Interest rates go up and go down. Asset prices go up and go down. So at some point, we’re going to face more challenging times around interest rates and asset values.”
With a house price to income ratio of 10:1, Healy acknowledged the unaffordability of housing in Auckland is up there with London, Sydney and Melbourne.
“I have enormous sympathy for the Reserve Bank Governor, because everyone blames him for it. There are about 15 tools or levers that drive this issue, and one of them is the Reserve Bank’s role.
“I think they’ve done a reasonable job on the macro-prudential tools... They got laughed at by other central banks and now other central banks all over the world are trying to apply macro-prudential tools.
“You don’t want too many, because you’ll end up with unintended consequences, but I think they’ve done a reasonable job with that.”
Healy said housing affordability was a complex problem involving a number of factors.
“Interest rates is one of the issues, and there’s a risk there, but I agree with Roger that it’s probably not a short-term risk, it’s a medium-term issue.”
New mortgage lending still increasing
Having a closer look at RBNZ figures, homeowners took on $5.9 billion of new mortgage debt in December. This is down from when it peaked at $7.3 billion in May, but the amount of new mortgage debt taken on every month has generally hovered at around $6 billion over the past year.
Taking the number of borrowers into the equation, the amount of mortgage debt accrued by the average borrower has been trending upward in recent years.
As shown in the graph below, the average mortgage taken out by 26,245 borrowers in December was $223,090.
At $383,231, average first home buyers took on 72% more debt than the average mortgage holder across all borrower types in December.
Meanwhile at $344,488, the average investor took on 54% more debt than the average mortgage holder across all borrower types.
Wide funding gap taking a turn
Comparing how much debt (housing and consumer) households are racking up with their banks, with the amount they're saving, the difference shot up from mid-2015, nearly to levels hit in the 2007 housing boom.
However at $78 billion in December, the funding gap has started to make a turn and begin closing.
ANZ economists last month commented on this funding gap, saying: “We noted extensively over the latter part of 2016 that the large gap between bank deposit and credit growth was unsustainable, and that without a further ramping up of banks’ offshore borrowing (which would not be desirable from a financial stability perspective), higher deposit rates and increased credit rationing would result. We are now clearly seeing that.
“And while RBNZ data from November showed the gap between credit and deposit growth has now started to narrow, it is still wide. That flags more pressure on retail interest rates to rise to a) attract more deposits and b) slow lending.”
If ‘disruption’ is the buzzword of the year in the business world, ‘disclosure’ is the ‘it’-word in the world of financial markets regulation.
The rhetoric is consumers will be better off if financial service providers tell us more about what we’re buying or investing in, the fees we’re paying and any conflicts of interest that exist in the transaction.
Yet when it comes to financial advice, the Ministry of Business, Innovation and Employment (MBIE) doesn’t want disclosure requirements to be set in stone through legislation.
Rather it wants to ensure there’s flexibility around the way they’re derived and implemented.
MBIE, in its consultation paper for the draft Financial Services Legislation Amendment Bill released on Friday, says: “More meaningful disclosure requirements for all types of advice will be introduced to improve consumer understanding and transparency. Detailed disclosure requirements are yet to be determined as they will sit in regulations (rather than in the primary legislation).
“However, disclosure will be re-designed to ensure consumers receive core information such as remuneration (including commissions) at the time most relevant to their decision making.
“In addition a client-care obligation will be introduced, requiring advisers and representatives to ensure that consumers are aware of the limitations of their advice, such as how many products and how many providers they have considered.”
The bill, which the public have until March 31 to make submissions on, replaces the Financial Advisers Act by amending the Financial Markets Conduct Act and the Financial Service Providers Act.
MBIE’s decision not to tackle disclosure through legislation comes further to it being pressured to use the review of the Financial Advisers Act as an opportunity to follow the UK and Australia in capping, and in some cases banning, commissions altogether.
Actuaries from Melville Jessup Weaver controversially made this suggestion in a report the Financial Services Council commissioned them to do in 2015.
A Financial Markets Authority (FMA) report on ‘churn’ released in June also found there are at least 200 advisers likely to be encouraging their clients to change life insurers, even if it isn’t in their best interests, so they can earn up-front commissions of up to 200% of their clients’ annual premiums, or soft commissions like overseas trips.
It concluded: “Current remuneration structures used by the insurance providers present the risk of conflicts of interests that may harm consumers and could negatively affect the overall price, and therefore accessibility, of life insurance to New Zealanders.”
Yet the former Minister of Commerce and Consumer Affairs, Paul Goldsmith, in July told interest.co.nz he wasn’t keen on banning commissions. Rather he touted “full disclosure” as the way to address conflicts of interest.
Now the door is being kept open to enable disclosure to be dealt with in any number of ways and avoid politicians getting involved.
MBIE says addressing the content, format and timing of disclosure in regulations rather than legislation will “allow flexibility to tailor different disclosure requirements for wholesale versus retail services. For example, the disclosure obligation for those who only advise wholesale clients could be to disclose to those clients that the service is not a retail service and the implications of this for the client.”
As for the issue of soft commissions - IE overseas trips and other non-monetary incentives - MBIE says it has considered whether these should be formally reported.
“For example, this could take the form of a public register of soft-commissions paid by providers to advisers,” it says.
“In the first instance, the FMA will undertake further work on the impact of soft commissions on advice. This work will inform future policy decisions on whether additional disclosure and/or other actions are needed in relation to soft commissions.”
Overall, MBIE says it will spend 2017 engaging with consumers and the industry to develop the draft disclosure regulations.
This won’t be the first time MBIE is endeavouring to enforce disclosure rules through regulation rather than legislation.
After consulting with the industry, the Government in December announced it would require all KiwiSaver providers to start disclosing their fees in dollar terms in their members’ annual statements from 2018.
It introduced this regulation under the Financial Markets Conduct Act 2013.
Dr Alan Greenspan was Chairman of the Federal Reserve from 1987 to 2006 and has advised government agencies, investment banks, and hedge funds ever since. Here, he reveals his deep concerns about economic prospects in the developed world, his view on gold’s important role in the monetary system and his belief in gold as the ultimate insurance policy.
WGC: In recent months, concerns about stagflation have been rising. Do you believe that these concerns are legitimate?
AG: We have been through a protracted period of stagnant productivity growth, particularly in the developed world, driven largely by the aging of the ‘baby boom’ generation. Social benefits (entitlements in the US) are crowding out gross domestic savings, the primary source for funding investment, dollar for dollar. The decline in gross domestic savings as a share of GDP has suppressed gross nonresidential capital investment. It is the lessened investment that has suppressed the growth in output per hour globally. Output per hour has been growing at approximately ½% annually in the US and other developed countries over the past five years, compared with an earlier growth rate closer to 2%. That is a huge difference, which is reflected proportionately in the gross domestic product and in people’s standard of living.
As productivity growth slows down, the whole economic system slows down. That has provoked despair and a consequent rise in economic populism from Brexit to Trump. Populism is not a philosophy or a concept, like socialism or capitalism, for example. Rather it is a cry of pain, where people are saying: Do something. Help!
At the same time, the risk of inflation is beginning to rise. In the United States, the unemployment rate is below 5%, which has put upward pressure on wages and unit costs generally. Demand is picking up, as manifested by the recent marked, broad increase in the money supply, which is stoking inflationary pressures. To date, wage increases have largely been absorbed by employers, but, if costs are moving up, prices ultimately have to follow suit. If you impose inflation on stagnation, you get stagflation.
WGC: As inflation pressures grow, do you anticipate a renewed interest in gold?
AG:Significant increases in inflation will ultimately increase the price of gold. Investment in gold now is insurance. It’s not for short-term gain, but for long-term protection.
I view gold as the primary global currency. It is the only currency, along with silver, that does not require a counterparty signature. Gold, however, has always been far more valuable per ounce than silver. No one refuses gold as payment to discharge an obligation. Credit instruments and fiat currency depend on the credit worthiness of a counterparty. Gold, along with silver, is one of the only currencies that has an intrinsic value. It has always been that way. No one questions its value, and it has always been a valuable commodity, first coined in Asia Minor in 600 BC.
WGC: Over the past year, we have witnessed Brexit, Trump’s election victory, and a decisive increase in anti-establishment politics. How do you think that central banks and monetary policy will adjust to this new environment?
AG: The only example we have is what happened in the 1970s, when we last experienced stagflation and there were real concerns about inflation spiraling out of control. Paul Volcker was brought in as chairman of the Federal Reserve, and he raised the Federal Fund rate to 20% to stem the erosion. It was a very destabilising period and by far the most effective monetary policy in the history of the Federal Reserve. I hope that we don’t have to repeat that exercise to stabilise the system. But it remains an open question.
The European Central Bank (ECB) has greater problems than the Federal Reserve. The asset side of the ECB’s balance sheet is larger than ever before, having grown steadily since Mario Draghi said he would do whatever it took to preserve the euro. And I have grave concerns about the future of the Euro itself. Northern Europe has, in effect, been funding the deficits of the South; that cannot continue indefinitely. The eurozone is not working.
In the UK, meanwhile, it remains unclear how Brexit will be resolved. Japan and China remain mired in problems as well. So, it is very difficult to find any large economy that is reasonably solid, and it is extremely hard to predict how central banks will respond.
WGC: Although gold is not an official currency, it plays an important role in the monetary system. What role do you think gold should play in the new geopolitical environment?
AG:The gold standard was operating at its peak in the late 19th and early 20th centuries, a period of extraordinary global prosperity, characterised by firming productivity growth and very little inflation.
But today, there is a widespread view that the 19th century gold standard didn’t work. I think that’s like wearing the wrong size shoes and saying the shoes are uncomfortable! It wasn’t the gold standard that failed; it was politics. World War I disabled the fixed exchange rate parities and no country wanted to be exposed to the humiliation of having a lesser exchange rate against the US dollar than it enjoyed in 1913.
Britain, for example, chose to return to the gold standard in 1925 at the same exchange rate it had in 1913 relative to the US dollar (US$4.86 per pound sterling). That was a monumental error by Winston Churchill, then Chancellor of the Exchequer. It induced a severe deflation for Britain in the late 1920s, and the Bank of England had to default in 1931. It wasn’t the gold standard that wasn’t functioning; it was these pre-war parities that didn’t work. All wanted to return to pre-war exchange rate parities, which, given the different degree of war and economic destruction from country to country, rendered this desire, in general, wholly unrealistic.
Today, going back on to the gold standard would be perceived as an act of desperation. But if the gold standard were in place today we would not have reached the situation in which we now find ourselves. We cannot afford to spend on infrastructure in the way that we should. The US sorely needs it, and it would pay for itself eventually in the form of a better economic environment (infrastructure). But few of such benefits would be reflected in private cash flow to repay debt. Much such infrastructure would have to be funded with government debt. We are already in danger of seeing the ratio of federal debt to GDP edging toward triple digits. We would never have reached this position of extreme indebtedness were we on the gold standard, because the gold standard is a way of ensuring that fiscal policy never gets out of line.
WGC: Do you think that fiscal policy should be adjusted to aid monetary policy decisions?
AG: I think the reverse is true. Fiscal policy is much more fundamental policy. Monetary policy does not have the same potency. And if fiscal policy is sound, then monetary policy becomes reasonably easy to implement. The very worst situation for a central banker is an unstable fiscal system, such as we are experiencing today.
The central issue is that the degree of government expenditure growth, largely entitlements, is destabilising the financial system. The retirement age of 65 has changed only slightly since President Roosevelt introduced it in 1935, even though longevity has increased substantially since then. So, the first thing we have to do is raise the retirement age. That could cut expenditure appreciably.
I also believe that regulatory capital requirements for banks and financial intermediaries need to be much higher than they are currently. Looking back, every crisis of recent generations has been a monetary crisis. The non-financial part of the US economy was in good shape before 2008, for example. It was the collapse of the financial system that brought down the non-financial part of the economy. If you build up enough capital in the financial system, the chances of serial, contagious default are much decreased.
If we raised capital requirements for commercial banks, for example, from the current average rate of around 11% to 20% or 30% of assets, bankers would argue that they could not make profitable loans under such circumstances. Office of the Controller of the Currency data dating back to 1869 suggests otherwise. These data demonstrate that the rate of bank net income to equity capital has ranged between 5% and 10% for almost all the years of the data’s history, irrespective of the level of equity capital to assets. This suggests we could phase in higher capital requirements overtime without decreasing the effectiveness of the financial system. To be sure there would likely be some contraction in lending, but, arguably, those loans should, in all likelihood, never have been made in the first place.
WGC: Against a background of ultra-low and negative interest rates, many reserve managers have been large buyers of gold. In your view, what role does gold play as a reserve asset?
AG: When I was Chair of the Federal Reserve I used to testify before US Congressman Ron Paul, who was a very strong advocate of gold. We had some interesting discussions. I told him that US monetary policy tried to follow signals that a gold standard would have created. That is sound monetary policy even with a fiat currency. In that regard, I told him that even if we had gone back to the gold standard, policy would not have changed all that much.
This article was sourced from this World Gold Council publication.
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By Gareth Vaughan
New Zealand bank executives believe an ideal debt-to-income (DTI) ratio set by any Reserve Bank DTI tool should be between five and seven, according to KPMG's annual Financial Institutions Performance Survey (FIPS).
The report notes bank bosses are in unanimous agreement that the Reserve Bank's consideration of a DTI macro-prudential tool is happening too late given current DTI ratios have already topped levels that would have been considered ideal.
"According to executives an ideal DTI level would be in the range of five to seven. However, they say that most borrowers are already at levels of nine to 12," the FIPS report says.
Both the Bank of England and the Central Bank of Ireland have introduced DTI ratios in recent years. The Bank of England's DTI ratio of 4.5 applies to no more than 15% of the total number of new mortgage loans for owner-occupiers. And for Irish banks the DTI limit of 3.5 should not be exceeded by more than 20% of the value of all housing loans for owner-occupier homes during an annual period.
The table below comes from the Reserve Bank's November 2016 Financial Stability Report.
In the November report the Reserve Bank said about one-third of new mortgage lending was being done at a DTI ratio of over 6.
The Reserve Bank says a macro-prudential DTI policy would allow it to limit the degree to which banks can reduce mortgage lending standards during periods of rising housing market risks, in order to protect financial system soundness. It also says an important feature of a DTI policy is that the borrowing capacity of constrained borrowers grows in line with their incomes.
"DTI policies can support financial stability by reducing the scale of mortgage defaults during a severe economic downturn. All else equal, borrowers with higher DTI ratios have less disposable income to draw on as a buffer to avoid defaulting on their mortgage, without selling their home, in a period of lost income or higher mortgage rates. Loan serviceability is a crucial determinant of probability of default, reflecting that many borrowers will attempt to service loans even if they are in a position of negative equity,' the Reserve Bank says.
"Forced house sales by high-DTI borrowers would likely amplify house price declines, impair the ability of banks to resolve distressed loans, and increase loss given default for banks. High-DTI households are also likely to reduce consumption more sharply during a severe downturn, in an attempt to continue servicing loans and increase precautionary savings."
New Zealand's debt-to-disposable-income ratio recently hit a record high of 167%. And household debt rose 8.7% last year to reach $246.877 billion. The latest Real Estate Institute of New Zealand figures show both the national and Auckland median house prices fell in January, hinting at a potential cooling of the hot housing market.
Sympathy for young families
Meanwhile, KPMG says NZ bank executives "sympathise" with young families, arguing the implementation of DTI restrictions could block them from buying a house. This, they suggest, could be an unintended social consequence the effect of which "might not have been adequately researched."
Bank executives also told KPMG any Reserve Bank DTI tool would need a clear, fair and explicit definition of what constitutes income and what constitutes debt, with this being something banks and the Reserve Bank could be at odds over.
The Government has kiboshed the Reserve Bank's attempts to get a DTI tool for the timebeing. Finance Minister Steven Joyce last week requested a cost-benefit analysis and public consultation before any decision is made on potentially adding a DTI tool to the prudential regulator's macro-prudential policy toolbox.
Joyce's decision came after the Reserve Bank requested a DTI tool be added to its Memorandum of Understanding on macro-prudential policy with the Minister of Finance.
*This article was first published in our email for paying subscribers early on Thursday morning. See here for more details and how to subscribe.
The Financial Markets Authority (FMA) is turning its attention to the risks our low, but about to be tightened, interest rate environment poses.
It warns low interest rates and volatile equity markets have seen more complex financial products emerge to meet the demands of investors seeking higher yields.
“We see possible harm to consumers, as complex products and the risk-return dynamics involved are more difficult to understand,” the FMA says in its Strategic Risk Outlook 2017.
Released on Wednesday, the document identifies the existing and emerging risks threatening the fairness, efficiency and transparency of our financial markets, and details how the FMA will respond to these. Its last Outlook was published in 2014.
Complex and risky products
The FMA says complex products often have unclear disclosure documents, making them susceptible to being mis-sold to investors who don’t fully understand what they’re getting into.
“For example banks’ increased use of sub-ordinated unsecured debt instruments to meet their regulatory capital requirements has led to concerns in several jurisdictions over whether these instruments are suitable for retail customers,” it says.
“More broadly, if investors are classified (or classify themselves) as ‘wholesale investors’ in order to gain access to certain products but lack requisite knowledge, this also brings increased risk, as wholesale investors do not have the same protections, such as disclosure, as retail investors.
“Similarly, retail investors may not fully understand the inherent risks in non-mainstream property-related offers (syndicated or other indirect investment structures) in New Zealand.
“We have also noticed an increase in foreign exchange and binary option trading providers who target New Zealand investors to trade through their platforms.
“While the products are not necessarily complex, they often use leverage, with the suggested higher returns never materialising, and investors not fully understanding the risks of loss. In some cases, the businesses are just operating investment scams.”
The FMA has committed to keep monitoring these products and how they’re sold.
Changing market conditions
The regulator also recognises the risks posed by looming interest rate rises.
“The extent and pace of this change may challenge many investors’ investment plans,” it says.
“One example is conservative and balanced KiwiSaver funds which often include a high proportion of long-term bonds that carry some risk. Bond issuers may not repay the money, especially in an environment of rising interest rates. What’s more when interest rates rise, the bonds decrease in value, providing negative returns over the short term.
“Default funds, specifically, tend to have a higher proportion of investments in long-term bonds so, when interest rates rise and bond values fall, there is a risk that those funds will experience negative returns. This could lower the overall confidence in KiwiSaver and drives ill-considered switching.”
The FMA plans to keep working with default KiwiSaver providers to ensure investors have confidence in their long-term investments and KiwiSaver members improve their financial capability.
Reliance on technology and dodgy foreign companies
Unrelated to interest rates, but also a “developing theme” on the FMA’s radar are the risks associated with people being increasingly reliant on technology-driven products and services.
“These include: increased exposure to complex products for retail investors, data security vulnerabilities, and a time lag between their release and effective regulation to manage risk.”
It maintains its regulatory settings are “flexible enough to embrace innovation”, noting how quickly it acted to implement licensing of peer-to-peer lending and equity crowd-funding.
Nonetheless, it says: “Balancing the reduction of risk with innovation and improved efficiency in the sector is the challenge that we and other international regulators currently face.”
The FMA also raises its concerns over the number of companies included in the Financial Service Providers Register, that don’t have much to do with New Zealand, but want to be seen to be regulated in New Zealand, as this makes them appear more legitimate.
“We want to prevent offshore businesses form using, or damaging, New Zealand’s good financial reputation and effective regulation.”
The FMA will keep working with other authorities and “take enforcement action” where necessary in this space.
Other drivers of risk
The FMA also identifies the following drivers of risk:
- Low investor capability and gaps in investment knowledge.
- New regulation, which may cause financial service providers to be uncertain about what’s expected from them.
- The concentration of the New Zealand market, which can “amplify existing market frictions, conflicts of interest and information asymmetries”. There are also challenges being a small market adopting overseas regimes like that around anti-money laundering.
- The international movement, which has seen the government pass on the risks and responsibilities of funding retirement, to individuals. Retirees might not have provided for as much as they need and there’s a risk they’ll be mis-sold products.
- Younger, tech-savvy investors bypassing traditional investment models. Financial service providers need to adapt accordingly.
- Cultural diversity, which can result in changing business norms and migrants not understanding the law , the financial products and services on offer and their consumer rights.
- Poor company culture and employee incentives that can lead to mis-selling and unclear product design.
- Information asymmetry, where people have uneven access to, and ability to understand, important information.
- Conflicts of interest inherent to certain business models, which are intensified in a small market like New Zealand. This relates to the way retail sales staff are incentivised, as well as the conduct in wholesale markets.
- New technology and globalisation of financial services are creating new business models, which regulators may struggle to keep up with.
FMA’s plan of action
Pulling everything together, FMA CEO Rob Everett says: “Since the Financial Markets Conduct Act came into full effect in December 2016, and with confirmation of our funding, we now have certainty over our mandate and resources, which means we can take a longer term view of our strategic planning.”
He says the FMA will remain focussed on the seven key areas it's been working on:
- Conflicted conduct
The FMA says it will use its review into churn in the life insurance sector as a benchmark for similar reviews into sales practices and incentives in the future.
- Capital market growth and integrity
“We have worked to improve our relationships with market participants and their advisers. We now want to extend this approach to investment banks,” the FMA says.
“We have begun to look at wholesale activity and its impact of retail investors. For example, we have begun engaging with NZX, banks and other trading businesses to clarify the boundaries of acceptable wholesale trading practices and behaviour.”
- Investor decision-making
The FMA plans to continue working with issuers to improve the quality of disclosure documents. It will move towards a more “risk-based and thematic monitoring” of disclosure documents.
- Sales and advice
The FMA says it will apply what it’s learnt about the advice KiwiSaver investors need, to the way it regulates all managed investment schemes.
- Effective frontline regulators
- FMA effectiveness and efficiency
- Governance and culture
By Gareth Vaughan
Is a major structural change underway with some New Zealand savers and investors falling out of love with bank deposits? Or is it just that they're looking elsewhere for higher returns due to the low interest rate environment?
This is a question pondered in KPMG's annual Financial Institutions Performance Survey (FIPS), out today.
Covering the year to September 30, 2016, the survey notes banks experienced their fastest lending growth in eight years, with their loan books growing by 8.1%, or $29.7 billion, to $395.71 billion. This outstripped growth of deposits, used by banks to on-lend to borrowers and meet their Reserve Bank enforced Core Funding Ratio requirements. Lower levels of deposit funding mean banks need to borrow more money through volatile overseas wholesale funding markets.
In a low interest rate world with the Official Cash Rate cut to a record low of 1.75%, banks' deposit interest rates have dropped to very low levels by historic standards with stiff competition among lenders to raise deposit funding.
"One of the questions raised with executives was whether the decrease in deposits experienced by some banks was the beginning of a structural change or more of a blip. Some executives speculated that it was the beginning of a move away from deposits, caused in part by a greater flow of money into KiwiSaver and other investments, which was caused partly by the low deposit rates and partly by consumer preference in the younger demographic," the FIPS says.
The million dollar question
John Kensington, KPMG's head of banking and finance, told interest.co.nz whether this was a structural change or a blip was the million dollar question. He points out many New Zealanders haven't had as wide a range of investments as people in some other countries, but the introduction of KiwiSaver in 2007 has given us an opportunity to understand a broader range of investments.
"There's only ever so much money going around and people only have a certain amount to invest. In the past it probably went into property, or maybe it went into deposits until you had the deposit for a property and then it went into paying off your property. And once it was paid off you went into deposits. So the New Zealand psyche was fairly simple and structured and straight forward," said Kensington.
"Maybe we've had too much [money] in property and deposits and not enough in other things. One catalyst will be that deposit rates are low, [and] another might hopefully be that people have become a little more educated on where to put their money, and how to spread their money around to diversify their risk."
"But is it a structural change or is it just a blip? That's the million dollar question I can't answer. Are we seeing younger people that are perhaps a bit more savvy, a bit more impatient and not just prepared to put their money in a deposit? If that is the case it could be driven by the fact that rates are so low. Or alternatively it could be driven by the fact, and it'd be nice if it was, that people understand more about investing now," Kensington adds.
"It's probably just too soon to tell. If you look at other countries there has to be some shift in where we are because we are heavily, heavily biassed toward property and heavily biassed, after that, to bank deposits for convenience. It could be the beginnings of structural change but I honestly don't know."
Banks battling for deposits has a flow-on effect to the non-bank sector comprising finance companies, building societies and credit unions. Executives in this sector say they are finding it increasingly difficult to compete with banks for deposits, especially when the banks carry out special six-to-nine-month deposit offers at the same rates as offered by credit unions and building societies.
"Finance companies that are backed and funded by a bank are also being cautioned that they can no longer borrow the same level of funds at the same historically low interest rates that they have enjoyed. This is a clear signal from the banking sector to expect tougher times ahead as they shore up their capital balances and source additional deposits, while also trying to rein in lending growth," KPMG says.
Return on equity & return on assets both drop
The FIPS report notes bank sector profit fell for the first time n seven years, dropping 6.5% from the 2015 record high of $5.17 billion to $4.84 billion. The drop came as the sector interest margin fell 13 basis points to 2.15%. KPMG attributed this to "less relief on the funding side of the balance sheet and intense competition on the lending side."
Funding costs across the sector fell 62 basis points to 3.25% as interest expense, or what banks themselves pay to borrow money, fell 10.6%, or $1.5 billion.
KPMG also points out that the banking sector's return on equity (ROE) and return on asset (ROA) levels fell on an annual basis. ROE fell 200 basis points to 13.96%, and ROA dropped 16 basis points to 1.00%.
"The decreases in ROE and ROA played a large role in why banks have scaled back lending growth in recent months, as they look for deals that are appropriately priced as opposed to primarily looking for loan book growth. These decreases are also a reflection of an increasingly challenging environment where banks are finding it more difficult to maintain current levels of earnings. The cost pressure of growing regulatory compliance, increased competition, volatility in markets and the costs associated with staying digitally competitive are examples of the current challenges the industry is facing," the FIPS says.
"Funding's going to be as challenging, if not a little bit more challenging, to get. Banks, especially the large Australian ones, [are] recognising they may have some tightness on the funding side coming up, and it might be a good time to be a bit careful because the property market is quite heated up. Over the last two years they have hit some return on equity and return on asset triggers that have meant that there's deals that they need to look closely [at] to see if they want to do it," Kensington says.
Meanwhile, the FIPS report also says bank executives perceive that the Reserve Bank is "becoming increasingly cautious" about the banking system's liquidity and credit quality.
*This article was first published in our email for paying subscribers early on Thursday morning. See here for more details and how to subscribe.
A 60-year-old man is denying Serious Fraud Office (SFO) accusations he was operating a Ponzi scheme, involving supposed investments in the diamond trade, a chicken farm in New Caledonia and brokering deals in Thailand.
Shane Richard Scott has today pleaded not guilty to 30 Crimes Act charges in the Auckland District Court. The total of Scott’s offending is alleged to involve about $6 million.
The SFO alleges he used money obtained from new investors to pay returns to previous investors. It maintains there was no direct evidence of any legitimate investments in this case.
“It is believed that Mr Scott had some investors who invested with him over a number of years and some who were relatively short term," The SFO says.
“The long term investors became involved with Mr Scott on the understanding that their money was being invested in brokering deals in Thailand, as well as some additional miscellaneous investments, including diamond trade, South African trade deals, and an investment in a chicken farm in New Caledonia."
“The short term investors became involved with Mr Scott from approximately 2008 onwards. Mr Scott received payments from them after promising high returns in relation to supposed property developments and non-existent exporting/importing deals."
“Mr Scott built up trust with some investors over a long period of time (over a decade for some), and as a result of Mr Scott’s alleged offending, they have lost significant amounts of money. Some of the short term investors received their money back from Mr Scott, but only after extended delays and excuses.
“The total of Mr Scott’s offending is alleged to involve approximately $6 million.”
Scott faces four charges of ‘obtaining by deception’, 23 charges of ‘theft by person in special relationship’, one charge of ‘using document with intent to defraud’ (for offending prior to 1 October 2003) and two charges of ‘obtaining by false pretence’ (for offending prior to 1 October 2003).
He first appeared in court on January 17 and was given interim name suppression, which lapsed today.
SFO Director Julie Read warns: “People who are thinking about investing need to do their own due diligence and get appropriate professional advice before committing any money. This simple step might just save an investor or multiple investors from being deceived by false promises of high returns.”
Scott has been remanded on bail. A trial date is yet to be set.
A four-year high in investment in gold drove price gains and demand growth in 2016, according to the World Gold Council.
But that enthusiasm waned sharply in the December quarter.
2016 full-year gold demand gained +2% to reach a 3-year high of 4,308.7 tonnes.
Annual bar and coin demand was broadly stable at 1,029.2 tonnes, helped by a Q4 recovery from a very weak Q3, and taking the quartely demand back to 2013 levels.
Source: Metals Focus; World Gold Council
The World Gold Council is talking up the overall 2016 changes. But shifts in the final quarter of 2016 undermine their story.
Yes, demand by retail investors for coins and bars did pick up in Q4, but it languished at unusually low levels for most of the year.
Yes, annual demand by exchange traded funds (ETFs) was higher in 2016 than 2015, but these same ETFs bailed out of the yellow metal in the December quarter in a big way.
And these is no hiding from the lackluster jewellery demand. 2016 brought a 7-year low for this segment. Rising prices for much of the year, regulatory and fiscal hurdles in India and China’s "softening economy" were key reasons for weakness in the sector.
India’s shock demonetisation policy brought the market to a virtual standstill. An initial rush for gold following the policy announcement came to a swift halt in the ensuing cash crunch. This is exactly the sort of regulatory shock you might have thought would raise demand for gold, but in fact the opposite happened. It is an event that has undermined a key reason why investors thought they should buy and hold gold.
Nor is there any hiding from declining central bank demand. It has been a favourite acquisition by bully states (Russia, other ex-Soviet states, some Arab states), but even they now show disenchantment with gold's store-of-value possibilities. They may still be net buyers but they bought a massive one third less in 2016 than 2015. And investors need to be wary when about 10% of the demand underpinning the price is determined by such dodgy sources. Despite this, 2016 was the 7th consecutive year of net purchases by central banks.
The gold price ended the year up +8% in both US dollars and New Zealand currenmcy. Having risen by an impressive +25% by the end of September, gold relinquished most of those gains in Q4 following Trump’s election win and the FOMC’s interest rate rise.
However, that +8% rise needs to be seen in the context of an unusually low starting point. See the chart below. In fact, for most of 2015 it traded at levels much higher than where it ended in 2016.
Here are the long run global gold demand charts (in tonnes):
On the supply side, things were not much better.
Mine production was down. Scrap sources were lower too. You would think lower supply would have supported prices in a fundamental way. Perhaps they did, but it was demand factors that seemed to drive pricing more than restrained supply.
The reaction of gold demand in India, and international prices, to their demonetisation policy is perhaps the most interesting and surprising event of 2016. And one that will worry gold bugs because it shows gold is not 'money' in a crisis; it is just another commodity.
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The New Zealand First leader Winston Peters is pledging to block the sale of UDC Finance to a Chinese conglomerate, if he is in government.
ANZ has agreed to sell New Zealand’s largest asset financing company to the HNA Group - a giant on an acquisition spree - for $660 million.
Yet Peters says the government should “draw a line in the sand” and use its powers under the Overseas Investment Act 2005 to stop the sale.
“We have outsourced our financial sovereignty at great harm to the economy,” he says.
“It is one of the reasons why the Reserve Bank admits its Official Cash Rate is largely an irrelevancy. Foreigners are calling most of the financial shots and enough is enough. Until a majority of the sector comes back into Kiwi ownership there must be no further such sales.
“This financial utility has a potential New Zealand buyer and plainly it should be going before the Overseas Investment Office (OIO) to ensure that the potential New Zealand purchaser gets a fair run.”
The sale will in fact go before the OIO as ANZ is seeking to sell a New Zealand business asset worth more than $100 million to an overseas investor.
The potential New Zealand buyer Peters is referring to is Heartland Bank, which has a sharemarket capitalisation of $783.69 million.
Asked how confident he is Heartland actually has the funds/capacity to make the purchase, Peters doesn’t provide a clear answer.
He says: “Anyone who has been following UDC since its sale was first mooted knows that Heartland has been especially keen, with TSB also reported as a potential suitor.
“Then again if ANZ wanted to prevent a domestic competitor from growing, selling out to China’s HNA Group makes a lot of sense.”
“HNA Group turns the plotline of the movie, The Big Short, into real life. Here is a company which slices and dices its finances so complexly, no one truly knows the real picture. What is for certain is it has access to free money with Bloomberg revealing interest on its billions of debt is 0.1%.
“What happens when that House of Cards collapses? New Zealand First is not against inwards investment but unlike this government we’re against being used and we need to take back control.”
Under the Overseas Investment Act, the Finance Minister has the ability to give the final sign off on a decision before the OIO.
Asked on which basis he would decline HNA’s application to buy UDC - if Finance Minister - Peters says: “Section 18(b) of the Overseas Investment Act stipulates that an applicant must show demonstrated financial commitment to the overseas investment.
“HNA Group is a byzantine conglomerate that is engaged in highly leveraged transactions across a disparate range of industries and resembles a House of Cards.
"Section 18(a) of the Overseas Investment Act requires experience in managing New Zealanders but its track record is that of the financial wild west and the antithesis of UDC.
“In December 2016 it paid 25% above the market rate in Hong Kong for residential land (at HK$13,600 a square foot) and these sort of dealings here could expose UDC and New Zealand to risk.”
Yet Peters says: “Given the OIO’s record they would probably rubber stamp any deal against New Zealand’s interest or not and not be held accountable by the government because these politicians are in the thrall of foreign ownership…”
Asked whether he believes the Act needs to be reformed, or simply interpreted differently, Peters says: “The OIO Act is a buggers muddle. It does not require a floor for overseas ownership of any industry or sector and seems to operate like an honesty box with little money to verify claims or data.
“The $100m test for business assets is ridiculous and we’d drop that because the chips are heavily stacked in favour of the investor and in the case of business assets, there is not even an NZ interests test as there is with land.
“Frankly there needs to be prominent advertising of any asset, be it land or a business and if a New Zealand entity can buy it, then they should get a fair-go. If the offer is too low there are alternatives especially with business assets that include listing on the NZX. Selling overseas is too easy and is a default option.
“Finally the OIO needs to be resourced to police the conditions that it sets.”
By Jarrod Kerr*
We are in the middle of a seismic shift.
The post‑war baby boom was the largest in human history. The baby boomers are now retiring. Their influence on interest rates is profound, and understated.
The three Ps of growth are in metamorphosis. The first P, population, is waning as fertility rates decline. The second P, participation, is declining as populations’ age. The third P, productivity, is also being weighed down by ageing populations.
Fed researchers say demography explains ALL the decline in real interest rates. We think this fits with other work showing the US real neutral rate is near zero and that market pricing for the Fed to only slowly raise rates to 2% is not too aggressive.
We are not all created equal. There is one differentiator. Immigration is the fountain of youth. Interest rates in high migration nations like the US, Australia and New Zealand, should diverge further from old Europe and Japan.
The risks are evening up and we see room for Treasuries term premiums to lift and take 10yrs to 3.0%. But the demographic story tells us we shouldn’t be looking for much more on a through‑the‑cycle view.
The end of two world wars spurred the greatest boom in human history.
We often hear of the impact of demographics. Demographic shifts influence just about everything we touch. We are in the middle of the largest demographic shift ever experienced. The seismic shift will keep a lid on potential growth and real yields. Yields can rise from here, off historic lows. But we are unlikely to see the levels once deemed “normal”, prior to the great financial crisis.
Interest rates experienced during the great inflation period of the 1970s and 80s are the anomaly – generated by the largest surge in population ever recorded. A population surge that boosted growth, put an enormous strain on resources, and caused inflation to spiral to levels no longer allowed.
Expansionary fiscal policy and regulated market structures, compounded by OPEC, no doubt contributed to higher interest rates. But, according to the US Fed, demographics explain ALL of the subsequent decline in real interest rates, and potential growth rates. That may be excessive, but it fits neatly with theories of a new normal that we think will keep interest rates and bond yields low. Notwithstanding some rise in term premiums to come.
The population boom like no other, drove the never before seen spike in interest rates
In Figure 3, we overlay global population growth with global interest rates back to 3000BC. What stands out is the baby boom, and the impact on interest rates. The peak in population growth is long behind us, so too is the peak in interest rates. We are now in a “new normal”, with lower terminal rates. We are not all created equal, however. Australia is much younger than most. And fertility is not the source of Australia’s youth. Immigration is the fountain of youth. Immigration policy influences the three Ps of potential growth, and suggests growth and interest rates will be higher in countries like the US, Australia and New Zealand.
Early interest rate settings ~3000BC were between 20‑40%. Interest rates declined as markets evolved, and averaged a much more civilised 5.5% between 500BC and 1910. Churches and Kings were known to control interest rates, from time to time. By 1950, following two world wars and a great depression, interest rates had fallen to the lowest levels ever scribed. A record low that was smashed 66 years later with the advent of negative interest rates. The ‘great inflation’ period of the 1970s and 80s stands out. The spike in population preceded the spike in rates.
Global population jumped from ~2‑to‑2.5bn in 1945‑50, to ~4.5‑to‑5bn in 1980‑85. In just 35 years we more than doubled our population. The impact of the tsunami of baby boomers was profound. The surge in population induced the highest levels of interest rates in 5000 years. Interest rates peaked in the early‑80s. From 1985 to 2020, the subsequent 35 years, it is estimated our population will rise to ~7.7bn. That’s another 2.7bn increase, but off a much higher 1985 base of 5bn. The rate of growth has halved from that experienced in the baby boom.
The decline in population growth has coincided with a 30 year decline in interest rates. Population growth will continue to slow for the next 35 years. From 2020 to 2055, the next 35 years, global population is forecast by the IMF to hit 9.5bn (+1.8bn). Population growth will halve again. Society has changed. Fertility rates have declined since the 1960s. Family sizes have declined (Figure 4). There has been a steady rise in childlessness, higher divorce rates, and later marriage. There has also been a healthy lift in female labour force participation. Reduced population means reduced pressure on resources and rates.
An interest rate is simply a price for credit. The two most beautiful lines that shall ever meet are supply and demand (Figure 5). The supply of credit, (savings), balances the demand for credit, (investment), at a price, (interest rate). Baby boomers became productive in the late 60s and demanded interest rate product. The greatest spike in global population growth preceded the greatest spike in global interest rates. A surge in demand for global resources, played out most notably in commodity markets, but also interest rates (the “D” line shifted out). The three Ps rose, real growth rose, real rates rose, but inflation pushed nominal rates into the stratosphere.
The demand shock for all resources took place at a more supply‑constrained time. Regulated labour markets and product prices, and geopolitical oil shocks (plus “peak oil” theories) were rigidities that took years to overcome. Rampant commodity price inflation fuelled the rise in nominal interest rates. Deregulation was the response of the 1980s. Global trade and competition took off as Eastern Europe, Asia’s tigers and China entered the world economy, with the impact exacerbated by disruptive technology and globalisation.
Fast forward to today. There is push‑back against immigration, competition and globalisation. That could give rise to an inflation pulse in due course. But more importantly, baby boomers have been retiring and supplying interest rate product. A large driver of the glut in global savings has been the saving of baby boomers into their retirement (the “S” line has shifted out). We do most of our savings in our working years, and savings accelerate into retirement (Figure 6). That wave of baby boomers may have reached “peak” savings in developed countries but there’s still a global wave to flow through as populations age in many developing countries.
The supply “glut” has occurred at a time of higher production capacity, globally. China’s export‑led investment boom has run into a western savings boom and a (related) global financial crisis, but it hasn’t yet developed a consumption model of its own. We’re simply producing much more for less. Labour markets are more flexible, prices are generally market driven, and the supply of commodities, globally, has now caught up and risen substantially. The increased supply of commodities has driven much of the decline in prices in recent years. Reduced commodity price inflation has reinforced deflation fears.
The next phase, is retirement, where savings declines (Figure 6). The baby boomers will slowly unwind their savings over the next 20‑30 years. Eventually, the supply curve (of loans) will contract back. But it will be a long, slow process. Roy Morgan recently produced the results of a survey on intending retirees in Australia. The average age of intending retirees has lifted from 57.5 to 61 (Figure 7). The average age rose post crisis, dropped in 2014 with the rejuvenation in financial markets, and has now blown higher with the continued decline in deposit savings rates. Not surprisingly, the survey of ~50k respondents showed that gross wealth (excluding owner‑occupied homes) of intending retirees is up just 3.6% since 2014.
The other, yet to be tapped, source of wealth is the family home. “A clear majority (85%) of intending retirees either own or are paying off their home, with an average value per person of $495,000 or 73% higher than the average ($286,000) in all other retirement funds.” The value of that dwelling has jumped 43.5% since 2008. Demographics shape property markets. Retiring owner‑occupiers supply large dwellings in search of small, high density, dwellings. Young families and migrants upsize.
The Bill Kerr example: there’s at least one in every family, probably four.
My father was born in 1947. He is the second of four baby boomers. He became productive in the 1970s when he joined the workforce, after a tour or two in the NZ navy. He demanded an interest rate, in the form of a mortgage, to build his first house. Later, he demanded another interest rate, to start his first business. Interest rates were in demand. Interest rates went well into the teens, some were above 20%. 35 years later the business has been sold. The family home went under the hammer. And the old boy has downsized and retired to Mangawhai Heads (north of Auckland) with a war chest of savings. He now supplies an interest rate. The interest rate he supplies, in the form of a fixed rate deposit, is far less than he had imagined.
Despite his son, an interest rate strategist, convincing him to fix into the falling yield environment, yields are much lower than any forecast a decade ago. And fixed rates only last so long. Risk appetite is something the old boy does not have, not at his age. Supply of term deposits are sticky for this age bracket.
Of course the four Kerr boomers had children of their own. But they had ~2 children each, not four like their parents. And the grandchildren are having fewer children than their boomer parents. We only want 1 or 2. Four children just seems inhumane…
Bill Kerr is just one man, one example, one in the millions of baby boomers now retiring into a low yield environment. Asset rich retirees have much lower risk appetite. Interest rates are currently on the rise. But the stock (supply) of global savings hunting yield remains high. Baby boomer savings rates will naturally run down, as retiree’s consume their nest eggs. And interest rates may eventually lift to higher levels. That may be a problem I’ll leave to my son Lachlan to figure out, on behalf of his old man.
Demography is destiny
The correlation in global interest rates has strengthened since WWII. Globalisation has strengthened the interconnectivity of markets. The great inflation period was case in point. All populations surged, all markets rose. Inflation was then deemed evil by central banks. Despite poor record keeping, the Kiwis were the first to directly target inflation in 1989. Don Brash, then RBNZ Governor, referred to the great inflation period as a great tax on savers. Brash also noted real estate as an inflation hedge, during the 1970‑80s. Central banks spent the next 25 years riding inflation down to targets of ~2%, successfully anchoring inflation expectations. Job done. Well, they did some of the job. It turns out demographics did most of the heavy lifting, on the way up, and on the way down.
Phillips curves have now inverted. The decline in the Phillips’ curve can be attributed to demography, globalisation, and central bank behaviour. Inflation targeting anchored expectations. The decline in inflation was also driven by globalisation, or the rise of Asian manufacturing. The Asian rise has in part fuelled political discontent in the West (Brexit and Trump). Future inflation expectations have also become more backward looking2. Post‑GFC, the threat has been losing control of expectations to the low side.
Demographic forces have ballooned in the last decade as baby boomers retire. The decline in inflation has been weighed down by ageing populations. Ageing populations have lower productivity and wage expectations. Figure 11 highlights the cliff in participation past the age of 60. A cliff that has worsened since the 1960s. Deflation was (still is?) the threat. And risk appetite remains impaired. Panicked investors still pay for protection of capital. Negative interest rates are an intergenerational wealth transfer. Negative rates “transfer” wealth from savers (elderly) to borrowers (younger generation). Negative rates are a tax of savers.
According to the US Fed, demographics explains ALL of the decline in real interest rates and potential growth rates. The Fed’s demographic model:
“accounts for a 1¼ percentage‑point decline in both real GDP growth and the equilibrium real interest rate since 1980 ‑ essentially all of the permanent declines in those variables... The model also implies that these declines were especially pronounced over the past decade or so because of demographic factors most‑directly associated with the post‑war baby boom and the passing of the information technology boom. Our results further suggest that real GDP growth and real interest rates will remain low in coming decades, consistent with the U.S. economy having reached a new normal."
The Fed notes that the influence of demographics has been “easily misinterpreted as persistent but ultimately temporary influences of the global financial crisis”.
The implication from the Fed’s research is “the persistence of a low equilibrium real interest rate means that the scope to use conventional monetary policy to stimulate the economy during typical cyclical downturns will be more limited than it has been the case in the past for a given inflation target.” Demographics explain much more than most dare admit. Policy makers may be at the helm of a ship, with a tiny rudder.
Figure 12 shows the decline in the real rate of growth from a peak above 2%, to a current rate sub‑1%, and a forecast decline to ~0.35%. Figure 13 illustrates a similar forecast decline in the real rate of interest from ~1.75% in the 1970s‑80s to ~0.35% out to 2030.
The Fed’s demographic work fits with other aspects of the ‘new normal’ theory, including Larry Summers’ ‘secular stagnation’. San Francisco Fed President Williams re‑published estimates of the natural rate of interest last year, arguing that it had fallen to near zero in the United States and Europe. He believes this rate, where monetary policy is neither accommodative nor expansionary, has fallen to historically low levels, and will stay there.
Figure 14 plots the estimated natural rates of interest since 1980. Natural interest rates had declined from a 2.5‑to‑3.5% range in the early 1990s to 2.0‑2.5% pre‑crisis. Following the GFC, the estimated ranges have collapsed to 1.5% for Canada and the UK, near zero for the US, and well below zero for the Euro Area.
The underlying determinants for these declines are related to the global supply and demand for funds, including shifting demographics, slower trend productivity and economic growth, emerging markets seeking large reserves of safe assets, and a more general global savings glut... Importantly, this future low level of interest rates is not due to easy monetary policy; instead, it is the rate expected to prevail when the economy is at full strength and the stance of monetary policy is neutral. - (Williams, San Francisco Fed).
We think very high global debt dynamics and abundant spare capacity in the global economy also explain why the real natural rate of interest has dropped. Fed Chair Janet Yellen added a possible paucity of attractive capital projects and a more cautious consumer after the GFC to the list of possible reasons for the decline in the neutral rate of interest last August (though these are really just demographics at work).
Yellen believes “that monetary policy will, under most conditions, be able to respond effectively” to future downturns in the economy even if interest rates are much lower than in the past (through the use of more QE and interest rate guidance). But she didn’t sound confident. And she didn’t disagree with the notion that the real neutral rate is 0%. Which means she won’t be in a rush to raise rates to this level even if inflation ticks up.
“If the natural rate remains low, future episodes of hitting the zero lower bound are likely to be frequent and long‑lasting… This will necessitate a greater reliance on unconventional tools like central bank balance sheets, forward guidance, and potentially even negative policy rates.” - (Laubach and Williams, US Federal Reserve)
A real rate in the US that averages 0‑0.5% would equate to a nominal Fed Funds rate averaging around 2‑2.5%. We maintain that it will be tough for the market to price a terminal Fed Funds rate of much more than this. For bonds, the question is how much term premium should be added on top. The factors cited above point to a continued low or negative term premium. But, with a new regime in the White House embarking on a stimulatory fiscal policy and intent on changing currency, finance, trade and foreign policies, we argued in our 2017 Outlook that this is precisely one occasion when the term premium should rise.
The Fed’s QE programme, or size of balance sheet, continues to exert significant downward pressure on US yields (figure 15). Fed modelling shows that QE has pulled the US 10‑year yield down by around 100bps. Ending reinvestments would cause a "passive" removal of this accommodation but seems a long way off. Still, Janet Yellen recently noted that even the current policy is resulting in a shortening of the Fed’s maturity profile that "could increase the yield on the 10‑year Treasury note by about 15 basis points... over the course of 2017… all else being equal."
Figure 16 shows that normalisation of the term premium has been a source of the rise in bond yields over the last 6 months. But there is likely more to go. If the nominal Fed Funds rate averages around 2‑2.5%, a rise in term premium for 10‑year bonds back to 50‑100bps implies that yields on 10‑year US Treasuries may range between 2.5‑3.5% in the years ahead, averaging about 3.0%.
A lower term structure in the US means a lower term structure globally. US Treasuries are the global benchmark, because of size and liquidity. Real rates have entered a 'new normal', but divergences persist. Figure 14 shows a divergence in estimated natural rates.
We think Australia’s real neutral rate has come down to around 0.75% (Figure 17, which updates numbers for analysis published in 2014, when we had the estimate at 1.0%). Adding a higher long‑term inflation target suggests there is a healthy margin versus the US of at least 1.0% in nominal terms and closer to 2.0% versus Europe and Japan (not that we expect Australia to be near capacity or the mid‑point of the 2‑3% inflation target for a number of years).
We’re interested in whether these divergences are likely to persist. The US has a relatively young population because the US attracts young migrant workers. Australia and New Zealand even more so. It’s a numbers game.
Figure 18 plots the stark divergences in population growth, indexed back to 1980. India, Australia, New Zealand, Canada and the United States have well above average population growth. China’s growth is slowing, quickly, and off a very high base. Population growth in France and the UK are a bit below the OECD average, but well above the EU 28 average. UK growth has picked up dramatically since 2005, a trend that the populous has voted to break through Brexit. Germany’s population was contracting, until the Syrian referee crisis. Japan’s population is contracting, with no end in sight.
Real rates in the US are higher than ageing peers such as Germany, Japan, and Italy. US rates will remain well above Japanese and European rates. Antipodean rates will remain above US rates. In this numbers game, migration matters the most.
Migration is the fountain of youth
As we age, we participate less. The fall in participation rates across much of the ageing world is related to the rising share of people over 60. The ‘normal’ so‑called global population pyramid now looks more like a Trump tower (Figure 19, males on left, females on right). There’s a lot of advertising up top. Although it’s what happens around the foundations that defines us. In 1950, less than 1% of OECD population were over 80 years old. By 2050, more than 10% will be over 80 years old. Japan has the oldest of the old.
Figure 20 shows Japan’s population pyramid is now upside‑down. The remarkable, and difficult, swing in Japan’s population is the most extreme. In 1950, after WWII, 45% of Japan’s population was under the age of 20. By 2050, 45% of Japan’s population will be over the age of 60. Japan will have 15‑20% of its population over 80 by 2050. Germany and Italy also have much older populations (though Germany has rapid productivity growth and the Syrian refugee crisis will alter the population projections across Europe).
We may all end of like Japan, eventually… But not over the next 50 years. The US, Australia and New Zealand have much younger populations (figures 21 to 23). The most important difference is immigration. Migrant flow can solve (or at least postpone) a lot of our “first world” problems.
The best work I have found on migration comes from Guy J. Abel, Nikola Sander, and Ramon Bauer (http://www.global‑migration.info/). Figures 24 and 25 are the coolest charts ever created. I have borrowed them to hypnotise many audiences over the years. Figure 22 beautifully displays the world’s migration flows in 2010‑2015. Figure 23 has the largest flows.
North America attracts massive flow from Latin America, India, and China. African flow to the US is fourth. Most African flow remains on the continent. Most Asian flow also remains on the continent.
Migration paths do not lead primarily from very poor to very rich countries, but rather adhere to a graduated model. People move to countries where the economy is somewhat stronger than in their native country… from Bangladesh to India or from Zimbabwe to South Africa. - Guy J. Abel.
The largest flows on the planet come from the most populous places on the planet. Outside the Syrian crisis, the largest flows are Mexico to the US, India to the US, Bangladesh to India, China to the US, India to UAE and Oman. The US has been the largest recipient. But has just voted to build a wall to stop the flow. The potential growth rate of nations with higher immigration is simply higher. The population pyramids are fatter and younger. The growth in number of workers is larger and so is GDP, even if not on a per capita basis. The US, UK, and Antipodeans attract migrants. A flow Trump was voted to address, and Brexit voted to break.
Figure 26 shows the number and percentage of 5‑year migration flows, back to 1960. Despite the Syria crisis, there are fewer migrants as a percentage of total population, dating back to the 1960s. In absolute terms, there are fewer migrants than during the 2000‑2010 decade. Abel and Sander note: “Our data suggest a stable intensity of global five‑year migration flows at about 0.6% of world population since 1995.” A finding that is contrary to common belief, which is that migration trends are on a larger and ever‑increasing scale. Abel and Sander show migration rates are holding, with recent numbers actually declining. It appears it is our tolerance of immigrants that has diminished.
Beware the wrath of a patient man
The relatively normal flow of migration is interesting, given the political revolt. Anti‑immigration sentiment defined 2016. Votes for Brexit, Trump and Australia’s Pauline Hanson are against globalisation. The revolt has arisen out of economic discontent, post crisis. Discontent in having to postpone retirement plans. Discontent in having to work without wage growth.
“Across Europe parties of the far left and the far right are seeking to exploit this opportunity — gathering support by feeding off an underlying and keenly felt sense among some people — often those on modest to low incomes living in relatively rich countries around the West — that these forces are not working for them… And those parties — who embrace the politics of division and despair; who offer easy answers; who claim to understand people’s problems and always know what and who to blame — feed off something else too: the sense among the public that mainstream political and business leaders have failed to comprehend their legitimate concerns for too long.” Theresa May, British PM.
One of the repercussions from the financial crisis and demographic shift, is isolationist actions. Professor Simon Hix from the London School of Economics, reduced the Brexit vote to an issue of immigration. Because the “leave” voters voted on immigration3. The vote was divided by class, education, age, and ethnicity.
Voters who classed themselves as “English” wanted to leave. “British” voters wanted to remain. Voters from lower social classes with lower levels of education voted to leave. Older baby boomers voted to leave. There was a great divide across skilled labour. Professionals voted to remain. Lower skilled workers voted to leave. “A revolt against the elite, the wealthy, and the immigrant…: “A class of people are very angry about mass immigration policies.” “In aggregate mass immigration is great for the economy... Cheaper costs for business. Great if you’re higher income… But if you’re a lower skilled worker, there’s much more competition for your job…” (Pr. Simon Hix).
“We’ve been ignoring the negative distributional consequences of mass immigration… [Immigration] Leads to pressures on lower skilled wages… Leads to pressure on local public services. Pressure on schools...doctor’s surgeries… local council housing… and social integration pressures with different languages, different cultures… this had all been ignored……We need public polices to address these distributional consequences” (Pr. Simon Hix). Immigrants are generally of high participation age, 20‑40, and they are generally cheaper. Studies show migrants are entrepreneurial, setting up a small business (taxis, child care, or stores). In good times, society enjoys cheaper migrant labour. In bad times, displaced locals regret migrant competition.
Tolerance of foreigners has fallen with weak income growth, and poor distributional consequences. Fiscal policy is needed to alleviate stresses on the system. Fiscal policy is the policy missing.
"Why has monetary policy been ineffective in bringing inflation up to target levels in the US, Europe and Japan? ...monetary policy effectiveness requires that...at low inflation rates interest rate declines generate fiscal expansion. The persistence of low inflation and low interest rates is not a surprise when, as has been true in fact, the low interest rates fail to generate substantial fiscal expansion[and thus aggregate demand expansion]." Christopher Sims
The lucky country. Lucky to be in demand
Australia fares better than most advanced countries. Because Australia imports more people. When compared to Japan, the glaringly obvious (but often ignored) difference is migration. Figure 27 highlights the difference. Japan’s population has peaked. Australia’s population has a long way to grow.
The UN’s population division projects the contribution to future population growth across four demographic factors: fertility, mortality, momentum and migration. “All four demographic components can have a significant impact, positive or negative, on future population growth.” The stark divergence between the oldest nation Japan (figure 28), and the younger nation Australia (figure 29) is momentum and migration. The US and New Zealand (figures 30 and 31) are similar to Australia.
The source of Australia’s migrant flow is important. Figure 32 plots population projections for the world’s two most populous countries, China and India. India’s population is projected to outgrow China’s in 2022. The path thereafter is very different. China’s population, thanks to the one‑child policy, peaks much earlier, and contracts beyond 2030 (though that policy has recently been relaxed with some immediate effects on the growth rate). India’s population peaks much later, around 2070, and contracts at a slower pace.
Australia’s proximity to Asia is increasingly important. Australia has one of the youngest populations because of proximity. Australia’s economic prospects are better because of proximity. Being at the end of the Earth was once a hindrance for economic trade. Australia is now closer to the economic centre of the world. Because the economic centre of the world is gravitating towards the greatest populous in the world.
We include the “economic centre of gravity” map from McKinsey Global Institute (Figure 33). The map works nicely with our economic team’s own version (Figure 34). Australia and New Zealand are part of the hottest club on the planet.
Our inner circle has most of the world’s population. Our inner circle generated most of the world’s economic growth. A large chunk of global migration flows are born in our inner circle. The world’s best cricket players, and the hardest rugby players, are forged in our inner circle.
Our inner circle, is where the cool kids play.
Figure 35 shows the 2010‑15 flow of migrants for Australia. The greatest change in Australian immigration flow has been the source. Australia now attracts more migrants from East Asia, South Asia and Africa than Europe. India sends the largest flow of immigrants, followed closely by China. When Australians leave, they go to Europe. That flow hasn’t changed a lot.
Figure 36, shows a time series of immigrants to Australia. The highlight has been the persistent rise in Indian and Chinese immigration since the late 1990s. Conversely, the sharp spikes in UK and Kiwi migrants have largely unwound. Kiwis are, for the first time in 25 years, leaving Australia.
So what’s the attraction?
Australia is a developed nation, with great beaches, reefs, and an old English game called cricket (the Kiwis took rugby). Most of all, it’s safe. Ok, there are loads of creatures that will kill you on sight, but “she’ll be right mate”. It’s the drop bears you have to watch out for. There are many peoples attracted to the great down under. Most immigrants have been European, some Middle Eastern. But today, most immigrants are Asian.
The greatest flow comes from India. For a poorer country like India, another former English colony, there’s a lot to love. Australia offers a massive upgrade, with the “simple” things like water, food and transport well catered. The Australian language is even similar to the English language, with just a slight twang. The education is top notch. There’s a common love affair with bat and ball. And the legal system is close enough. Being a Kiwi, I understand the attraction.
Then there is the Chinese flow. Again, the attraction is clear. Everything is cheaper in Australia. The water is crystal clear. You can drink it from the tap. The food is fresh. You have to wear sunglasses, because there is no smog to block it out. The quality of the housing is better, and far cheaper per sqm. And then there’s a little something called English property rights. I buy it, I actually own it. And I can bequeath it. Aussie apartments make for great safety deposit boxes. Matching the safety deposit boxes used in Singapore, Canada, New Zealand, and the source of those property rights, the UK. The Aussie apartment could also be used by children sent here to study hard at university. We know they’re safe. And the children will probably convince the entire family to move down later. No wonder Chinese developers in Australia ask us for our student visa forecasts.
The third flow of interest is the flightless bird. Kiwis come to Australia in the good times, and return in the relatively bad. I think the clearest signal of the current weakness in Australia’s labour market, is the exodus of Kiwis. Kiwis are the cheapest, most mobile part of the Australian workforce. And they don’t all show up in unemployment. Because they go home. For the first time in 25 years net permanent migration turned to an outflow in 2016. Kiwis are returning home after years of mining boom related work. The return of the Kiwi miner has induced a sizeable spike in Auckland house prices.
Another persistent flow has been South African. I should know, I married one. The reasons my wife, and her family of +50, left South Africa for Australia and New Zealand are sad and violent. Again, there is a lot to love about Australia. It’s safe.
Australia’s immigrants are from the power houses of the future. And they will strengthen our ties
In the 1990s few took China seriously as an economic power. China barely made it into the top ten economic heavyweights. Today, China sits at number 2, a swift move from number 9 (Figure 37). By 2030, China will still be number 2, according to the IMF. China is Australia’s largest trading partner. China is the largest trading partner of 125 countries, and China is rebuilding the silk road. By comparison, the US is the largest trading partner of just 55 countries.
There is another relationship, with another country that deserves more airplay: India. India was not on the economic map in 1990, but had risen to 7th behind the UK in 2016, and is forecast to knock off Germany and Japan by 2030. India needs resources to feed and house the greatest population on Earth.
India will have more people than any other nation in 2022. India will be the third largest economy by 2030. It’s a numbers game, and India has more numbers than any other. When it comes to economic size (and importance), it is no coincidence that the oldest (most ageing) nations, Japan, Germany and Italy, are falling in the global rankings. Japan will slip from 2nd to 4th. Germany will slip from 3rd to 5th. Italy will slip from 5th to 10th. France is also ageing, and falling from 4th to 7th. The UK is holding tight to 6th position, with strong migration growth (at least up until Brexit).
Progressive economic policies and a lot of investment are needed for India to truly succeed. But the potential of India is enormous. And the rise of China and India (eventually) is supportive of the Asian region as a whole.
Australia has just been through the greatest mining investment boom in its history (figure 38). Australia has developed its largest ever stock of mining resources. And there are plenty of other holes that can be dug, at the right price. China’s industrialisation was far greater and faster than any forecast.
India’s industrialisation may mimic China’s, one day. If India develops, the emerging nation will demand a great deal of resources, including coal, iron ore, gold, and LNG. Mining investment in Australia, figure 33, could easily see an India induced spike in the 2020s, or 2030s. Developing nations also demand increasing food, education, and travel services. Australia is well equipped to leverage these three industries.
But the connections between Australia and Asia also mean that migration flows are likely to continue. And that means higher population growth, higher economic growth and higher interest rates than other developed nations. Our final Chart, just domestic in nature so as to eliminate measurement problems and the like, shows that population growth is by far the largest determinant of relative growth performance amongst the Australian States.
Queensland and Western Australia have out‑performed over the long haul due to their abundance of natural resources. But, for all of the claims made about relative economic performance, and who’s leading the nation, etc, it turns out that the difference in GDP per capita among the four remaining states is negligible. It is the difference in population growth that explains the difference in GDP growth. And it is that difference in population that growth that will mean Australia and New Zealand continue to average higher interest rates against the new normal of low interest rates around the world.
An attempted summary of what it all means
Over the coming decades the ageing of Australia's population and a projected slowing in the rate of population growth are expected to affect the nation's economic growth. The components of the above decomposition most likely to be affected by the population changes are average hours worked and the participation rate, as people get older and move into part‑time work or out of the labour force. Australian Bureau of Statistics.
Demographics explain much of the decline in potential GDP growth and real yields.
• We are in the middle of the largest demographic shock ever seen. The surge of the 1970s‑and‑80s was baby boomer induced. It can be argues that the decline in growth and interest rates ever since has simply been the result of slowing in population growth, and ageing in populations. Growth rates, inflation rates and interest rates will all be lower for longer as our population ages.
• Real rates are likely to remain well below 1% into 2050. Term rates globally will remain in a much lower for longer band. At least until the baby boomer savings unwinds. Policy makers must consider “alternative monetary and fiscal policies that are more likely to succeed in the face of a low natural rate.” John C. Williams
• There is a lot that can be done to prolong and improve our outlook. “Productivity isn’t everything, but in the long run it is almost everything.” Paul Krugman. The focus of policymakers, especially governments, must turn to productivity. Investment in education, technology, and infrastructure are all part of the equation. The investment requires large, long term, Government policy. The weakness in Governments, or lack of fiscal response is unusual historically. Voters want change.
• "The persistence of low inflation and low interest rates is not a surprise when, as has been true in fact, the low interest rates fail to generate substantial fiscal expansion.” Chris Sims. We need to invest more. We need to invest for productivity. We have ample capacity.
• Short of that, voters want inflation. More insular politicians are starting to deliver policies that will limit competition and supply flexibility, creating an environment where inflation pricing over and above on‑going low real interest rates should creep higher. Ourforecasts for higher bond yields reflect expectations for the term premium in the bond market to rise, not for much change in pricing of terminal policy rates.
• Embrace the ageing. Retiring at 65 doesn’t have to be. Innovative solutions to keep people employed for longer, through flexibility and technology, are needed to stem the tide. My father was bored out of his mind when he first retired. Now he heads the North Island Returned Services Association (RSA), and runs around more than he did when he was “working”. There’s a lot of untapped labour, with ample experience, should we want it.
• Immigration is the fountain of youth. Countries that attract immigrants will fare better than those with closed borders. The outlook for Australia is better than most because it attracts people, and at this point in time mainly Asians tapped into the world’s strongest growth story. Relative higher growth in population points to on‑going relative higher interest rates.
For all Notes and Sources, see the original piece Strategy-30-Jan-2017-1401-1.pdf.
Jarrod Kerr is the director of interest rate strategy at the Commonwealth Bank of Australia, based in Sydney. This piece is an extract from this daily publication. It is here with permission.