FYI | Mar 04 2009
By Andrew Nelson
Westpac managing director of economics and research, Bill Evans recently toured the US, spending time with many of the bank’s largest customers. These are some of the largest hedge funds and trading houses in the US and his discussions indicate little interest in investing in Australia, but a belief that signs of a US recovery may only be a few quarters away.
Westpac’s US hedge fund customers are in a state of despair. The industry has shrunk from about US$2trn a year ago to about US$1trn on the back of massive redemptions and sharp downward revaluations. While the pace of redemptions has slowed from the rapid pace of the fourth quarter they are still coming and the risk profiles of some of the world’s biggest traders are still declining.
This almost-panicked flight from risk has been seen across equity markets, in private equity, and is taking its toll especially in emerging markets and other once high yield sectors. The flow on effect is that not only is this flight making life hard for investment markets like Australia, but also for some of what used to be the better performing macro funds in the US.
When Evans visited the bank’s customers this time last year, he noted there was enthusiastic interest in Australia. Overnight cash rates were still rising at a time when global forces were decidedly deflationary and AUD bonds were trading around 250bp above US Treasuries. Now they are only offering 120bp above Treasuries and these same investors are now no longer in a hurry to purchase them, as the rising offshore funding requirements for countries such as Australia more than offset the argument that Australia has little government debt.
It is well understood by the big US funds that commercial banks have been the vehicle for financing Australia’s foreign debt and as the banks are now using government guarantees to fund their offshore borrowings, Australian government debt has become readily available. Given Australian interest rates have largely replicated the rest of the world, and given the pervading aversion to global risk, the AUD now holds scant interest for these investors. In fact, Evans notes, there was little resistance to Westpac’s prediction that the AUD will eventually fall to USD 0.55 through 2009.
On top of that, Evans notes that it is understood there is further easing to come in Australia. However, this has already been priced in, so it is felt that Australia will need to offer at least the current 120bp margin above Treasuries to encourage the purchase of government bonds, given the likely continuing supply and opportunities in other markets. But with growth prospects in Australia more buoyant than most of the developed world, it is believed that a deflation trade is better placed elsewhere.
At the same time, the bank’s US customers are generally not expecting to see the US economy show any signs of a return to trend growth (being healthy growth, and not just a return to positive growth) in 2009, or well into 2010. Nevertheless, despite rising supply, 10 year bond rates near the current 3% are looking attractive, especially given that the Fed is likely to be a buyer of bonds around these levels in order to settle fixed mortgage rates, which have recently started to rise again.
Add that to the fact that the bottom seems to be falling out of Europe, and Evans points out there is little to no interest from both hedge funds and bond managers in purchasing Australian debt. In our region, the big investors only seem concerned about whether the yen and other Asian currencies will be able to adjust to the precipitous fall in the region’s exports. Overall, notes Evans, this points to further strength in the US dollar and therefore the renminbi, as China is seen to have the best chance to be able to handle current global challenges.
No wonder then that Evans found it difficult to tell any sort of story about Australia. In fact, he reports that “One sceptic described the First Home Owner’s grant as, potentially, Australia’s own sub prime disaster with people who should not be owning a home being funded into a home with ‘no skin in the game’ just when they were about to lose their job.” However, the general belief was that Australia was almost unique given its current housing shortage, pre-emptive monetary policy and ample fiscal flexibility (subject, of course, to the usual offshore funding constraints), which again means it is hardly the best market to make the deflation trade.
Evans pushed and prodded to see if there were any signs that the bank’s customers might take on more risk. Apart from those watching the China story, his queries were met with significant resistance. He notes there was also a degree of fear that some short term and unsustainable improvement in the data due to Canberra’s stimulus package might generate a sell off in bonds that would be very damaging. This leads him to predict that the AUD will be vulnerable while AUD bond spreads remain close to their floor given the funding tasks faced by the broader economy.
Moving on, Evans advises that he visited four of the US’s big economic forecasting houses, who similarly believe a recovery is not too far off but a return to trend is. They suggest the low point of growth in the US will be first quarter of 2009, with annualised growth of around minus 5-6%. Q2 will be around minus 1-2%, while Q3 and Q4 will register 1.5%-2.5% per quarter positive growth. Growth is expected to continue in 2010, with estimates ranging from 1.3%-2.5%. This recovery is expected to be driven by a rebound in consumer spending and a gradual easing in the declines in both business and residential investment.
These forecasting houses also expect the ongoing programs of fiscal stimulus will play a vital role in the US growth recovery. On an annualised basis, they estimate stimulus will add around 3 percentage points to growth in each of the final three quarters in 2009, but will subtract around 1-2 percentage points to growth from the second half of 2010.
But Evans thinks that these forecasts will prove to be way too optimistic, with assumptions about the propensity to spend the tax cuts and transfers in the stimulus package looking far too best-case. Assumptions about the impact of the credit crunch on business investment and housing investment also seem too optimistic, he says. Negative growth extending into the second half of 2009 seems more likely, notes Evans, despite the fiscal stimulus.
With the federal funds rate effectively zero, interest rate policy can only really be enacted through other means, especially given 80% of mortgages in the US are on a fixed rate that is determined by the bond rate and the margin between the bond rate and Federal Agency rates. Thus the Federal Reserve is planning to purchase US$600bn in Treasury bonds to help narrow the margin over the bond rate and therefore lowering the effective mortgage rates. [This is know as the “monetization” of debt, and is very inflationary.]
However, concerns about the Fed “printing money” should be played down, notes Evans, as when banks sell securities to the Fed, these banks are credited with reserves. The “printing money” concern is only relevant if the bank then withdraws the reserves and lends them to the private sector, which is not happening. Banks’ reserves are remaining on the Fed’s balance sheet and the “printing money” concern will only emerge when the excess reserves are lent out, explains Evans.
Evans belief is that a swift, large and targeted fiscal stimulus coordinated with massive support to ease the transition to lower leverage in the private sector is the solution to the nation’s current challenges. The US political process isn’t helping matters and while Australia’s process was hardly smooth, the political complications in the US, which are compounded by undue worry about the deficit, will only delay the recovery. This leads Evans to expect yet another package in the US, with American pundits also expecting China also to announce another large package well before the US authorities realise that their first and second attempts have been inadequate.
With an economy well and truly in the hands of policy makers, subject to little debate and coupled with a strong fiscal position, Evans agrees that China is the best placed economy to deal with the current global crisis. However, he feels that markets are currently way too optimistic about the speed with which the China can achieve a turnaround that many are hoping will drag the world with it.
