FYI | Mar 14 2011
(This story was originally published on Wednesday, 8th March 2011. It has now been re-published to make it available to non-paying members at FNArena and to readers elsewhere).
– The world will have to get used to higher priced oil
– There will be no QE3, unless the US experiences another shock
– Europe remains a troubled, high risk proposition
– Forecasts for equity returns this year likely too bullish
By Rudi Filapek-Vandyck, Editor FNArena
Bond experts are less easily fooled than equity experts. At least, that's my personal observation from the past two decades. Maybe it's because to become a genuine expert in fixed interest, you need to know a lot more about a lot more things?
My personal interest was piqued when Russell Investments sent me an invitation to enjoy lunch in a Sydney hotel while listening to some expert views and analysis on global bond markets. I have not been disappointed and below are some of the key take-aways as I remember them. As shown from the report below, presentations and questions from the audience proved much wider than simply interest rates, asset diversification and inflation (the usual themes at fixed income events).
Time to start thinking about higher oil prices. Whether you believe in peak oil or not, or whether the Saudis are truthful about their supply capacity, fact is the world has been confronted with uproar and social unrest in major oil producing countries and this is likely going to leave a long-lasting mark. David Rolley, vice president and investment strategist at fixed income specialist Loomis Sayles, believes the market will now permanently price in a "risk premium" of US$15-20 per barrel into the price of crude oil. This will have immediate effect, leading Rolley to make the prediction that consumer spending data in the US are likely to surprise to the downside in the months ahead.
When asked about a scenario whereby crude oil shoots up to US$200 per barrel, Rolley showed no hesitation. It would put the US in a "war-like" situation. Oil would be rationed, processes and technologies to become more oil efficient would go into acceleration but above all the Federal Reserve would announce QE3, even if this meant the price of oil could potentially surge further to US$300/bbl. Because it is the only thing left that can be done in a US economy crippled by debt and mass unemployment. States Rolley: if you think US$600 billion was a lot of money, try US$2 trillion this time.
However, potential oil-mayhem aside, QE3 is not on Rolley's outlook for the year. The end of QE2 by the end of June is, and with a surprise: Rolley doesn't believe the Federal Reserve will start reducing its balance sheet anytime soon. All those US bonds that have been purchased over the past two years can just sit there while the world gets accustomed to the fact the Fed is no longer buying US Treasuries. If the Fed wants to start targeting liquidity it will have to start lifting the repo rate, argues Rolley.
He also thinks all talk about the world no longer purchasing US bonds is just that, talk. Long dated US Treasuries will remain the ultimate safe-haven for a long time to come, predicts Rolley, because of the simple fact there are no viable alternatives around. Europe, Japan, they all have their own set of problems. The world would like to increase its exposure to renminbi, but it is not allowed to (the Chinese haven't allowed their currency to freely float yet, let alone develop a large and viable fixed income market). So investors have en masse flocked to the next big thing: RMB correlation. Think commodities. Think currencies and bond markets in commodity producing countries.
As such, the Australian dollar should remain supported even if it looks like a very crowded trade. One of the key questions regarding the Aussie dollar is how much leverage has been built-in those massive market positions, asks Rolley rhetorically, "because at some stage someone is going to take away the liquidity". Rolley wouldn't want to be "long" the Aussie currency from the moment the Fed starts raising interest rates. In the same breath, he doesn't think this will happen anytime soon either.
And just so we are all clear about QE1 and QE2: US liquidity is pushing up asset prices worldwide and thus spending power in countries outside the US. This always was the Fed's intention from Day One, says Rolley. The US needs the rest of the world to be healthy, to grow and to spend. This means there's ongoing strong demand for US products and services across the world. Unfortunately, most central banks in developing countries have been reluctant to raise rates and let their currencies revalue. Inflation is now increasingly becoming a problem for them and thus these central banks will increasingly lift interest rates. Rolley doesn't foresee any inflation problems for G-4 countries.
As far as the Australian bond market goes, the curve has flattened because the RBA should be near the top of its tightening cycle. This means overall risks are considered low and given the RBA, with a cash rate of 4.75%, has a lot of room to act if and when things go pear-shaped, the potential returns in case the world does turn into the wrong direction should be in double-digits, just like happened in 2008. Anne Anderson, Head of Fixed Income, Asia Pacific for UBS Global Asset Management advises investors should buy shorter-dated Aussie bonds, as there is effectively no bonus left for being long (as in: beyond 4 years).
She also believes the term "sovereign risk" has become the most inflated and mis-used term amongst asset managers and financial commentators in Australia over the past year. Australia might be leading the world in terms of trying to introduce a carbon tax, or an extra tax on miners, but that's all there is to it, she says. Other countries will have to go down that same path and large asset managers know it. (She was backed up in this view by Rolley).
Want to know about real "sovereign risk"? European countries are likely to default on their debt, while banks in Europe have far too much (troubled) property on their balance sheets, they own far too many government bonds and have far too little leeway on their balance sheets. Free advice from Rolley: don't go anywhere near them.
Because there are still so many property assets that have to be off-loaded as yet by the banks, house prices in countries such as Spain, but also in the US, have not seen their lows as yet, predicts Rolley.
Australia is not facing a similar outlook, but investors should no longer expect to see big leaps in house prices, in the view of Anderson. She's talking "prices plateauing for an extended period". The good news is thus while the boom years are now well and truly over, there won't be a collapse in house prices in Australia. Immigration, high employment, limited supply,… there are plenty of factors supporting property markets in Australia, says Anderson. Of course, many foreigners have their doubts and this is why they steer away from Australian banks. A fact confirmed by Rolley (who intends to learn a lot about the Australian property markets while he is in the country).
This, in the end, puts Australian banks somewhere in between a rock and a hard place. Overall credit demand in Australia remains weak, momentum has left the property markets and finding cheap funding (overseas) remains a problem. Add pesky regulators and populist politicians and it would seem the road is to remain uphill for a while. (Having said all this, Anderson also stated Australian banks are in excellent health, they make a lot of profits, at high margins and the quality of their assets is equally high and still improving.)
Below are Loomis Sayles' key predictions for 2011:
– a sustainable recovery in the US and China
– Asia and LatAm GDP expected to remain strong. Europe more modest growth
– G4 central banks still likely to continue to hold rates at an “exceptionally low” level for an “extended period”, but first hikes possible this year in U.K., Euro
– No QE3 in US, expect policy rate hikes in 2012; Fed funds can rise before balance sheet is reduced
– Core inflation remains low in US, Germany and Japan, but commodities moving higher
– Emerging market inflation moving higher, a driver for higher policy rates and FX appreciation
And here are some charts from today's presentations:
The argument whether Australian interest rates are now restrictive or neutral should be considered in relationship to mortgage margins at the banks. Accordingly, the first chart below argues interest rate settings in Australia are now "mildly restrictive", which puts the onus back on the RBA. Was that November rate hike now really necessary?
The second chart below puts everything into sobering prospective. The three lines trending upwards from left to right show what usually happens when the US economy climbs out of recession. The lonely line that merely goes sideways on the chart is what has actually happened this time around. Whaddya mean it wasn't so bad?
The third chart below shows one key factor why inflation is not a problem in the US, as well as why corporate margins are so high: labour costs have been sharply negative over the past two years, and they are still negative, though gradually trending to zero. The RBA, as well as businesses in Australia, would love to swap, but that's unfortunately not going to happen. What is going to happen is that the trend will remain upwards and thus labour costs in the US will become positive too. It has been a while…
It's not just China that is facing an inflation challenge. The fourth chart below shows inflation in South American countries, and it is rising fast. Higher interest rates, anyone?
The fifth, and final chart, reveals that if present forecasts prove correct the RBA may have three more hikes of 25bps up on its sleeve. One would presume there is no hurry at this stage.
Finally, the equities division of Russell Investments put out a press release plus research report today arguing most predictions for share market returns this year are likely too bullish. Instead of 20%-plus, Russell suggests investors should be expecting returns closer to 10%. I couldn't agree more. I still expect to write that story about why most projections are probably too rosy for this year…
P.S. I – All paying members at FNArena are being reminded they can set an email alert for my Rudi's View stories. Go to Portfolio and Alerts in the Cockpit and tick the box in front of 'Rudi's View'. You will receive an email alert every time a new Rudi's View story has been published on the website.
P.S. II – If you are reading this story through a third party distribution channel and you cannot see charts included, we apologise, but technical limitations are to blame.
