Having earlier acted to stop a credit crunch in Europe via cheap three-year loans to eurozone banks, the ECB is now moving to deliver on its commitment to keep the euro together and to remove the tail risk of a much deeper economic slump, say a 5% fall in GDP. The recession remains in Europe but it is likely to remain “mild”. Interestingly recent European PMI readings have been flat lining consistent with a “mild” recession. This is all consistent with a 1% fall in GDP this year, followed by a return to modest growth next year.
> The problem in the US is that growth has been too slow in order to sustainably reduce unemployment. However, the Fed looks to be on to the case and likely to soon announce another round of quantitative easing (QE) – possibly on an open ended basis so they can keep it going from meeting to meeting until they get the outcome they want. All the evidence suggests that the costs of QE are manageable – certainly there’s no sign of the hyperinflation many feared from QE1 and QE2 – and that it has helped boost growth relative to the alternative (just look at the US versus Europe).
Much like a drip keeps a person in a coma alive until they heal enough to come out of the coma, the Fed has been doing the same for the US economy. Both QE1 in 2009 and QE2 in 2010 were associated with gains in US and global shares (and upwards pressure on bond yields) and there is no reason not to expect a similar positive impact from QE3, albeit it may be a bit smaller as shares are coming from a higher level.
Longer-term healing in the US is continuing – the housing recovery is looking entrenched, companies are continuing to expand manufacturing operations in the US, private sector debt levels are coming under control, shale oil and gas is a real game-changer and the tech boom is still centred on the US. This, along with ongoing monetary stimulus, is likely to see US growth edge up to 2.5% next year. The “fiscal cliff” next year is a risk but likely to be substantially reduced after the November election.
> China has been the big surprise this year with growth continuing to lose momentum and looking like it’s going to come in about 7.5% this year, rather than our expectation of 8%.
However, while we are yet to see a large stimulus announcement (and probably won’t given the overheating experience from the 2008-09 stimulus) there are some positive signs: money supply growth and new loans appear to be stabilising and picking up consistent with easier credit conditions; a speed up in the pace of infrastructure (notably road and rail) project approvals appears aimed at boosting infrastructure investment after it slowed to a crawl earlier this year and a pick-up in housing starts, land purchases and floor space sales points to a pick-up in residential construction.
The Chinese leadership lately seems to be providing more assurances that it is focused on meeting its growth forecasts for this year and providing more stimulus if needed. These considerations point to a stabilisation and modest pick-up in the pace of growth over the next six months. Meanwhile, non-food inflation at just 1.4% means there is plenty of scope for further stimulus.
> Finally, growth in Brazil looks to be picking up following a 5% cut in short-term interest rates.
Overall, this suggests global growth is on track for about 3% growth this year ahead of a modest improvement to around 3.5% growth next year. Not brilliant, but not the disaster many have been fearing and factoring into share markets. And enough to underpin modest profit growth.
In 1996 the term “irrational exuberance” was coined to explain the rush of funds into shares and particularly tech stocks. For several years it looked to be the right thing to do until we hit the tech wreck from 2000. In recent years we have had something similar, but with the exuberance focussed on safe assets like cash and bonds. It is evident in huge fund flows out of equity funds into bond funds in the US. It is also evident in Australia in a huge build up in cash to double its normal level in the Australian superannuation system and in a record 39% of surveyed Australians saying bank deposits are the wisest place for savings compared to a near record low of 5.5% nominating shares.
Again with hindsight, so far it has proven to be the right thing to do, but the problem is that all investment trends get taken to an extreme and the fad for cash and bonds is likely in the process of becoming irrational, particularly as cash and bond yields are getting lower and lower.
The outcome has been that equity markets have become very cheap relative to bonds as indicated by a 6% or so gap between equity yields and bond yields, which is a measure that provides a rough guide to the risk premium of shares over bonds. This is well above the levels that prevailed prior to the GFC and also at the high end of the range that has prevailed since the GFC.
The August to October period is often the toughest time of the year for share markets. And the next few weeks is still riddled with various events that could trip up markets. However, the fact that we are already into mid-September and share markets are holding up well – climbing the proverbial wall of worry – is a positive sign.
Our assessment remains that any setback in market should be seen as a buying opportunity. With the risks of a eurozone financial meltdown and return to global recession receding, the global growth outlook improving, shares remaining very cheap relative to bonds and monetary conditions very easy, the odds favour further gains in share markets into the year end and over the year ahead.
By contrast, low bond yields point to low returns from bonds and falling interest rates in Australia are likely to further depress bank term-deposit rates.
Dr Shane Oliver is the head of Investment Strategy and Chief Economist at AMP Capital.
