Over six articles we're publishing a detailed outlook from ANZ NZ's economics team on six key themes for 2015.
Here is the fifth one. (Links to the previous themes are at the bottom of this page.)
By Cameron Bagrie*
There’s no shortage of risks and hot spots around the globe.
Slow growth and deflation in Europe, the Russia/Ukraine conflict and sanction related tension with the West, Syria, sharply lower oil prices, Greece threatening to (or should we say needing to!) exit the euro, continued leverage excesses (now amongst emerging markets), and ongoing concerns about the impact of gradually slowing growth in China and East Asia.
Time and time again changes in New Zealand’s economic fortunes have been tied to international events.
Rather than take a scattergun approach, we’re going to focus on two particular issues.
However, before doing that, we need to understand the nature of the GFC, the responses and the outcomes.
A POTTED HISTORY OF THE GFC
The broad causes of the GFC are generally agreed upon: global – and particularly US – interest rates were kept too low for too long; the fabled Greenspan "put" in the face of financial market asset price gyrations kept getting rolled out.
This led to excessive growth in leverage, consumer largesse, the formation of asset bubbles, and general irrational exuberance.
Impacts were exacerbated by global financial liberalisation, light-handed regulation, financial engineering and borrowers fully prepared to leverage up and discount the risks.
After the fallout, the policy prescription was also fairly clear-cut; fix the financial plumbing and get asset prices back up. Interest rates were reduced to record-low levels and quantitative easing (QE) was undertaken.
It doesn’t matter which asset class you look at, the response has been phenomenal.
Between 2009 and 2014, the S&P 500 rose by 84%, yet US nominal GDP rose by just 16% over the same period. The market cap of the Dow Jones US Total Stock Market Index rose from 90% of GDP in 2009 to 137% of GDP by the end of 2014. Bond yields fell to multi-decade lows, credit spreads contracted sharply, and carry currencies like the NZD – a classic bellwether for “risk” – appreciated to a record high and remain reasonably elevated.
It makes perfect sense too; when the risk-free rate (think US 10-year Treasury yields) goes down in yield and up in price, so too should all asset classes. The policy response delivered both benefits and collateral damage to NZ Inc.
• Restoring stability to the global financial system, which allowed the credit wheels to resume turning as offshore credit markets unfroze.
• Lower long-term interest rates. Falls in longer term US interest rates fl owed through locally, boosting local assets.
• An elevated NZD.
• A New Zealand yield curve close to inverting, encouraging longer-term fixed-rate borrowing over shorter terms and diluting RBNZ policy traction.
• Financial flows became far more “internationalised” as investors chased yields lower as US bond yields collapsed. According to the IMF, advanced economy allocations to emerging market bonds more than doubled from around 4% of total allocations in 2008 to around 9% at the end of 2012. New Zealand is not an emerging market, but offshore ownership of NZD denominated bonds tripled between October 2008 and October 2014. Some of that was driven by rising bond supply but our yields look compelling versus those offshore.
• Monetary policy stimulus in the US quickly engulfed emerging market economies such as China. Capital flows raced into the region. Growth boomed. Fancy terms such as the BRICs (Brazil, Russia, India and China) were coined to describe the new market darlings. Emerging markets were celebrated as the place to be. Property values, leverage, and activity all climbed. Commodity prices soared in association and became an asset class. New Zealand received a GFC “get out of jail free” card in the form of the soaring goods terms of trade.
• Asset prices and regional prospects became increasingly driven by liquidity as opposed to fundamentals. The question “but where do I put my money?” became a regular one.
• Western policy (think US QE) created conditions for Japan to begin “Abenomics” which has kick-started a “race to the bottom” in currency markets across Asia, giving the new NZD TWI a boost (which has now partially unwound).
WHERE DO WE STAND (6 YEARS AND 4 MONTHS SINCE THE “PEAK” OF THE GFC)?
• The Fed has concluded its QE programme, as has the Bank of England (BoE).
• The BoJ and the ECB are still in expansion mode, with the BoJ announcing an escalation in its QE programme within days of the Fed ending theirs, and the ECB announcing plans for sovereign bond buying in January. Given how globalised markets are, it doesn’t matter too much where the liquidity is coming from, only that it keeps coming.
• We appear on the cusp of a full-blown currency war. Currency misalignment and offshore capital flows chasing long-end yields are making life increasingly difficult for the likes of the RBNZ.
• Markets continue to turn a blind eye to fundamentals. They can afford to focus on yield and momentum rather than quality and valuations if liquidity keeps coming. But when the music stops, we need to more seriously consider the real value of the assets that have been procured by the central banks and the private sector.
• Leverage, and thus global exposure to interest rates, has never been higher. BIS data show that the total value of bonds outstanding reached $100 trillion in May 2014, up a staggering $30 trillion since mid-2007. Private sector leverage problems have become public sector ones.
• Growth remains anaemic in Europe, and global infl ation is trending lower as oil prices continue to tank. Central bank actions to suppress yields merely bought policymakers time; policymakers unfortunately didn’t use it well.
• There’s been a failure to drive microeconomic reform, which is a precondition to growth and solvency. Arguably, central banks have done too much and have been so successful driving asset prices higher that they have removed many sources of market tension, which are actually needed to drive the right behaviours. Indeed, it was only September last year when the yield spread between Greek and New Zealand 10 year government bonds was around 1%. That spread is now closer to 7% (having risen by close to 1% in a single day in the week following the Greek election).
• Growth is slowing in China (a good thing given the need to rebalance) but this is creating clear tensions between the economic objective (more balanced growth, albeit slower) and the social/ political objective of maintaining people in jobs. All amidst a sizable build-up in leverage.
• The US economy is looking far stronger, having made dramatic improvements on the jobs front. The US Federal Reserve appears on target to hit its dual mandate (despite a pending near-term fall in inflation due to lower oil prices).
• We’ve seen a rout in some commodity markets. Rising supply and waning demand are partly to blame but some can be put down to the financialisation of commodities as an asset class in a QE world. While QE is still being driven by the ECB and BoJ, the Fed has been key for commodities as an asset class. The so-called commodity super-cycle is defunct and leverage is being exposed.
• Markets are oscillating from taking a benign attitude towards risk one day to trading wildly the next; recall the 20% movement in the value of a US 10-year bond in a day last October. This year has started with the bears having the upper paw after the bulls closed 2014 with the upper hoof.
So all up, a host of problems remain. Some central banks have to “do more” to combat challenges, but the Fed – the world’s largest and most important central bank – is set to continue to take the foot off the accelerator.
WHERE TO FROM HERE?
Two issues are particularly relevant going forward. The first is Europe, and the second is the impact of the upcoming normalisation of Fed policy, particularly on asset prices and Asian economies.
Our sovereign risk framework flags continued problems in Europe. To recap, we analysed 38 key countries using both “worry” variables (things like government debt, the fiscal balance, the current account, net external debt) and “flexibility” variables (GDP per capita, population, the existence of a floating exchange rate, political stability, competitiveness, etc).
The data points to ongoing stresses in Europe, particularly on the periphery. Whereas countries like Italy and Ireland are slowly improving in our rankings (which are relative, rather than outright comparisons), France, Portugal, Spain and Greece remain at the bottom of the table. France is Europe’s second-largest economy, yet its net debt is expected to continue to grow (from 74% of GDP this year, up from 32% in 2007). Real yields in Europe are above real GDP; solvency parameters are worsening.
The German “bund” yield curve is starting to look a lot like Japan’s JGB curve, which was once regarded to be a special case.
We now also have every point on the US Treasury bond curve out to 10 years below 2%, yet the Fed is supposed to be tightening this year!
Such low yields have created an unsustainable “bond ladder”, with yields in each market trading at multiples of other markets. Look for example at 10 year bonds. Japan is at 0.25%, Germany is currently at 0.3%, the US is roughly fi ve times that at 1.7%, and New Zealand is almost twice that at 3.2%. This is what we call the “bond ladder”, and you can’t have such divergence in interest rate markets when currencies are deviating materially from fundamentals, in a world that is coupled as opposed to decoupled.
The bigger issue – for both New Zealand and the broader global economy – is how the global financial system and various economies respond to a prospective tightening in US monetary policy, given US rates are the implicit bellwether for the global cost of capital.
That’s a classic game of chicken; interest rates will hardly be moving up if the economy cannot sustain it, and there is the bond ladder to consider.
Can US rates really move up if BoJ and ECB policy rates are at zero bounds and QE is being undertaken?
It makes little sense in a coupled world.
However, the Fed will ultimately do what is necessary and the US economy is looking sound under the bonnet. Few would have predicted that the Fed would have needed to embark on QE1, QE2, Operation Twist and then QE3 to get us to where we are now, or would have predicted the “taper tantrum”.
In that context, it seems nonsense to think that monetary policy will simply slot back into its normal cyclical place. The level of asset prices and leverage makes the process of normalisation a highly delicate operation.
Still, the Fed has made it clear that it is keen to embark on “normalisation” as soon as it can, even if inflation remains low. Most commentators read this as signalling that the fi rst fed funds rise will occur mid-year, and in turn, they expect US bond yields to rise slowly in 2015 (although the plunge in oil prices is a potential spanner in the works).
Cyclically and structurally, there are compelling reasons to expect US bond yields to rise.
But if the QE-inspired fall in yields (higher bond prices) buoyed other asset prices, then what happens to those asset prices when yields rise (i.e. bond prices fall)?
Any asset you can borrow money to buy is potentially riding for a fall.
Quite aside from the likelihood that the short-term price action will be nothing short of chaotic, we doubt if anyone, including policymakers, really knows how things will unfold. We’ve already seen numerous examples over the past two years where the path to lower interest rates was via higher interest rates first. Yields eventually hit a certain level that undermined asset values, necessitating a rally back into bonds. The threshold for “wobbles” appears to be getting lower.
Looking through the uncertainty, we can make some simple observations.
• Fundamentals cannot be ignored indefi nitely; in fact the longer they are ignored, the greater the odds of a pending dislocation.
• Policymakers’ ability to ring-fence a “black swan” event is low; interest rates are already at the zero bound (though some nations have negative policy rates) and sovereign debt is high (the average level across the Euro area is now 94% versus 65% in 2007, pre-GFC). Policy makers have been effective at containing volatility, but they too face challenges and cannot lean against the market for ever, as the Swiss National Bank found out.
• The lower-for-longer interest rate steroid appears to be losing its effi cacy. Recall when bad economic news became good news, because it meant interest rates would be lower for longer? That steroid appears to be diluting. Asset prices may be at elevated levels, but we’re seeing larger swings in volatility. More policymakers are becoming attuned to the negative (and unintended) consequences of interest rates remaining low, and other issues such as income equality (Theme 6) have arisen. Many feel that Wall Street has benefi tted at the expense of Main Street.
• There are compelling reasons to believe any lifts in interest rates will be modest. Inflation is tame and the trend growth rate lower; that supports low yields. There are still risks to manage. Lifting a policy rate from 0.25% to 1% represents a large proportionate shift (i.e. a quadrupling in the rate). As the RBNZ has witnessed; rates do not need to go up far to get some bang for your buck.
• Policymakers will need to be consistent if the removal of policy stimulus is to be successful. Historic swings in everyday cash rate cycles have been volatile, but this time you have the complication of transitioning from quantitative policy too, and at a time when others are still undertaking QE, and more and more secular forces are in play. Recall market volatility from October, after which we saw mixed messages from policymakers. Suddenly dollar strength became ex-post relevant for the Fed. We even had one Fed member postulating about an end to QE3 being delayed – the month it was due to end! UK policymakers’ comments were confusing: “Volatility shouldn’t influence policy normalisation” (BoE Governor), but interest rates could remain lower for longer (BoE Chief Economist), though rate increases in mid-2015 were still “not a bad bet”. Meanwhile France, Germany and Italy argued over austerity and China eased policy after saying an economic slowdown is healthy!
• What is not clear is whether the phenomenal rise in asset prices was the result of “trickle down” (i.e. money that would have been invested in bonds being invested in equities), investors being enticed to “borrow and invest” as part of a rational response to the dramatic fall in bond yields, other factors, or a combination of the two. If it was more “borrow and invest”, then expect there to be fewer rate rises and more asset price dislocation.
• Many investors appear to have based their investment decisions on the flawed assumption that low interest rates will persist indefi nitely, and further, that somehow super-easy policy would stimulate a supernormal recovery. Neither statement is correct. Policy will normalise – though what is “normal” is open to some conjecture given the rapid pace of change, and the post-GFC recovery has been modest by historic comparison. Basic equity valuations tend to look extremely favourable if one assumes a low discount rate and a high growth rate. The gap between G10 GDP growth and yields (i.e. nominal growth exceeds nominal yields) is back at historic highs, suggesting yields have more upside. That’s not good for equities, and suggests we will see less of a policy adjustment.
• Rising US interest rates are not just a problem for borrowers (who are often considered to be the losers). In the short term, it is also a problem for investors exposed to the capital losses that come with rising interest rates. There is some offset provided as the value of future liabilities fall (for pension funds and the like), and as reinvestment rates rise, but the kneejerk reaction to rising interest rates is typically very nasty for borrowers and investors alike.
• The “financialisation” of housing across the developed economies of the world has dramatically increased household exposure to interest rates. Just look at New Zealand, where million dollar mortgages are no longer uncommon. When the cost of basic needs like housing fluctuate with the interest rate cycle, so too does consumer confi dence and consumption.
The more relevant indirect concern for New Zealand is the impact on the wider Asian region, which is now strategically entrenched as critical for our economy.
Diversification of money flows (from the core into the periphery) when US liquidity was being exported are at risk of being replaced by “reversification” – flows from the periphery to the core. The massive carry trade – which New Zealand has been heavily impacted by – must unwind, and if the ructions seen during the so-called “taper tantrum” are anything to go by, brace for more volatility.
Asia has been at the forefront of leverage since the GFC. According to the FT, total public and private sector debt in China rose from 176% of GDP to 258% by mid-2014. Money supply (as measured by M2) has also expanded rapidly since the GFC – not just in China (+106%) but across the ASEAN economies too, led by Indonesia (+101%), Philippines (+93%), Thailand (+63%) and Malaysia (+56%). Nominal GDP has been stronger across the region but the buildup in leverage has been substantial and centred in countries with the least-developed financial markets. Much of this debt is secured over property, and prices are no longer rising (more on that later). Two of the fabled BRIC’s (Brazil and Russia) are now in free-fall.
House prices in China are falling, with prices in Tier-1 cities down 2.7% in the year to November. Sales volumes have fallen sharply, creating an unintended build-up in inventory across the 35 largest cities that our China economics team estimates will take at least 15 months to clear. If prices and sales fall further, it may take even longer.
Some of this reflects steps taken by policymakers to cool the market, but it’s a fine balancing act amidst a large build-up in leverage, the reining in of corruption (a good thing) and shadow banking, and central government curbs on Local Government Financing Vehicles (LGFVs). Unable to borrow from banks, or issue debt in their own name without central government permission, many local authorities in China have raised debt through LGFVs, often using land as collateral. But the central government has recently said that debt raised through LGFVs is not guaranteed by the state, rattling investors. Some regions have banned the use of LGFVs, creating a liquidity squeeze. Property default rates are also on the rise, and although uncertainty surrounds the true extent of non-performing loans, estimates are vast.
Chinese financial conditions have tightened. We take a lot of guidance from our financial conditions measures and have noticed a tightening of late.
More worrying is that our FCI for China has a material weight on asset prices, far beyond what is typical for an FCI, but we let the data speak for itself matching closely to GDP. Such a high weight makes us suspicious of non-linear dynamics coming into play; the fallout from lower asset prices could quickly manifest into tighter financial conditions, weaker asset prices and the spiral is then in motion. Partial indicators such as electricity consumption are also inconsistent with official GDP estimates.
Commodities have also been “financialised”. Emerging market demand for commodities – a huge driver of the terms of trade for New Zealand and Australia – has grown substantially over the past two decades. But some of this demand has been the result of USD liquidity, USD weakness, and the “financialisation” of commodities as an investment asset.
The channel is simple: abundant USD liquidity and a weaker USD boosted demand for commodities as a financial asset. That’s game-changing.
Turbocharged theories of commodity super-cycles abounded (and went against two hundred years of experience) and few acknowledged the financialisation or liquidity angle. That’s significant because this channel has a fi nite timeframe; the USD is firming and USD liquidity is increasingly restricted.
A financialisation model is more difficult to apply to soft commodities (limited shelf life etc) though still appeared indirectly (an overcooked supply-side response; think of the huge investment in the likes of dairying globally to capture the new wave of demand for infant formula as well as leverage into others including oil and associated build-up in leverage). Oil exporters have been large buyers of milk powders, so there is some cross-over between the so-called “hard” and “soft” commodities. There have been fun and games in iron ore and oil as dominant suppliers attempt to undermine marginal and high-cost producers. However, these moves have not occurred in isolation: the broad CRB index is also down.
Asian central banks are under enormous pressure to ease policy or allow their exchange rates to depreciate. While the Fed is expected to tighten this year, many Asian central banks will be acting in the opposite direction, which has ramifi cations for their currencies, which is an issue for New Zealand exporters.
Markets are calling for the RBA to ease, as are we. The impact of this is being felt strongly via the NZD/AUD exchange rate.
This is partly an Australia story, partly a New Zealand story, and partly an Asia/commodities story.
Australia is New Zealand’s largest trading partner (in bilateral trade in goods and services), China is number 2 and ASEAN is number 3. All roads thus lead to Asia.
All else equal, weaker Asian currencies mean less demand for NZ exports.
So while we may welcome the Fed shifting policy driving the USD up and NZD/USD down, we need to be coy about the broader indirect consequences.
*This report was written by the ANZ New Zealand economics team which consists of chief economist Cameron Bagrie, senior rates strategist David Croy, senior economists Sharon Zollner and Mark Smith, economist Peter Gardiner, senior FX strategist Sam Tuck, and rural economist Con Williams. It is used with permission.
A link to Theme 1 - Change is the new normal, is here.
A link to Theme 2 - Localised focal points, is here.
A link to Theme 3 - The trend is your friend, is here.
A link to Theme 4 - Our key downside risk, is here.
A link to Theme 5 - Liquidity vs fundamentals, is here.
A link to Theme 6 - Addressing income inequality, is here.