Economic update

Introduction and risk assessment

As economic trends signal an end to the steep cyclical downturn, future sustained recovery remains problematical amidst conflicting signs. The US economy continues to digest a never ending cocktail of mixed signals to post meager gains which suggest sustainable economic growth is still probably a year or more away.

Globally tentative improvements remain buffeted by stiff headwinds; more conservative capital consuming banks,vulnerability in asset prices,the circumspect consumer and the unwinding of unprecedented monetary and fiscal stimulus packages which increased government indebtedness by 50%. The continued nuclear ambitions for Iran & North Korea also cast a shadow over global outlooks.

The consensus outlook by the Board of the Reserve Bank of Australia is slightly more upbeat for Australia, aided by the resilient economies of China and Asia recovering faster than expected. Australia benefits from these faster growing regional ties and a very modest level of government debt combined with a well regulated banking system. Our risks lie in the relatively high level of household debt secured on residential property; any pronounced weakness in housing prices exerts pressure on a banking system captive to overseas funding. Rising house prices have reduced home ownership affordability by 24% since April this year. Any risk of a pronounced housing price fall is low since housing stock is under supplied and demands continue to flow on from record levels of immigration. Banks reliance on overseas funding leaves the economy vulnerable to any credit squeeze imposed by overseas lenders, because,apart from forced superannuation saving and government surpluses, we remain a nation of spenders not savers. Increased saving remains a key initiative for the country to be more sustainable in the future.

Interest rates

The Reserve Bank of Australia today raised the cash interest rate 25 basis points to 3.75% to record a unprecedented 3rd straight monthly rate increase; expect another rate increase in February 2010 and a cash rates of 5% by 2010. Such increases represent an unwinding of a previous accommodating monetary policy stance in response to the GFC to one that returns to a position of neutrality. The rise in interest rates and in our exchange rate will contain the prices for traded goods and services but dampen growth in the trade-exposed sector of our economy. The Reserve Bank has also expressed some concern over rising house prices and hopes the interest rate increase will dampen consumer sentiment and propensity to continue to pay inflated prices for housing.

The current yield on the Commonwealth Government March 2019 bond is at 5.267 per cent while the yield on the April 2012 bond was at 4.430%.


Currency

Because of the continued weakness of the US dollar speculation is rife the US dollar may lose the world’s currency reserve status. Throughout the 18th and 19th century the English pound enjoyed reserve status before an elected dollar came to power, many years after the US had become the world’s largest economy.

Bearing in mind the reluctance for sudden changes, the requirement for deep markets and the need for ease of convertibility you can reliably conclude it will take several decades before any change become feasible.

In the meantime ongoing US Dollar weakness could be a catalyst for continued political and economic tension, particularly if China continues to avoid a Yuan appreciation, although I think fears here are overblown.

Lessons from the great depression and recent GFC after shocks

As the past tumultuous events of the global financial crisis continue to hover in our collective consciousness, inevitable comparisons continue amongst economic commentators and share chartists with the great depression. The great depression was preceded by the roaring twenties which tended to add a flavour of assumed speculation and bubble bursting scenarios to most of the economic commentary at the time and subsequently.

However an analysis of stock indices (earnings to stock price ratios) just prior to the massive falls of the thirties reveals stock price was not excessive except for one industry sector. That sector was the popular leveraged Investment companies whose specialty was utility stocks. As inevitably more realistic profit reports undermined inflated values of utility stocks the leveraged investments companies were forced to sell their entire share holdings to satisfy liabilities to margin lenders. That event triggered a train reaction as investors in their now defunct management investment companies were forced to sell their entire shareholdings to satisfy their margin lenders.

The operative lesson is the extreme danger of gearing. The final straw during the depression that led to the now famous double dip in stock prices was governments action taken to stem perceived greedy speculators initiated by tightening credit which caused widespread panic selling and subsequent larger scale insolvencies due to lack of liquidity.

I don’t think we are in danger of following that same fearful path today but the risk nevertheless remains, particularly whilst the US banking system (unlike Australian) is not adequately regulated and could still inflate a bubble from excess liquidity and leverage.

However Banks in Europe are 25% and in the US 20% bigger now than pre 2007 crash levels -when the cry was heard too big to fail ! This scenario provides is an ongoing challenge to regulators in relation to capital adequacey and to internal risk managers who need to be given authority to influence bank practices and policies.

Another lesson learnt in recent times was it only took the huge indebtedness of one tiny nation - Iceland to undermine the house of cards that had enveloped the globe. Investors are now more recently worried about Dubai; since it has borrowings of $US80billion to finance a 4 -year construction boom now subject to a pronounced property slump. Dubai world surprised markets when it called for a halt on paying back $US60 billion debt until next year. Dubai's debt problems will be well contained, but expect a few more surprises like this over the next year or so until we reach a point of renewed confidence.

US Banking system still inadequate in regulation.

Federal lawmakers and regulatory officials continue to grapple with what new regulations are needed to be introduced to avoid a repetition of the conditions that led to the Global Financial Crisis. Policies and proposed recommendations remain bogged down within the political process with the administration unable to obtain a bipartisan approach. The current US policy settings which ensure the benchmark interest rate remain near zero, carries the risk such an accommodating monetary policy setting, will fuel a surge in assets and the so called “carry trade” risks another bubble occurring. The unwinding of this “carry trade” would not be pretty. The Fed itself is aiming to better identify risks, drawing on its 220 PHD qualified economists to be more effective in identifying potential bubbles and improve regulatory oversight according to a recent article appearing on Bloomberg.

Federal Reserve Chairman Ben S. Bernanke said he doesn’t rule out using monetary policy to pop asset-price bubbles, while stressing that financial regulation is his preferred approach.

Corporate Profits

Disregarding the US fragile banking system the one bright feature is the recovery in corporate profits largely driven by cost cutting and stabilization in inventory levels previously slashed in response to faltering weak demand. However the cost has been high in widespread human misery and unemployment to leaves a continued deep scar well into the future. Given this caveat and apart from the banking sector, most of the corporate sector (with a few notable exceptions) are in relatively good shape and should continue to improve. Historically current stock price earnings ratios are only slightly in excess of long term historical averages to assume an inbuilt profit improvement inherent in 2010, which is also true for Australia and most of the western world.

Conclusion

You cannot legislate morality or a perfect a set of banking indices which alienate risk. Rather, what is needed is for regulators to be prepared through improved training - to get their hands dirty and carry out periodic due diligence's and exercise a common sense regulatory service which demands transparency.
If you can’t understand what is going on that is usually a clear signal that something is fundamentally wrong. If you’re subject to a financial services or banking license it is preposterous to think a company’s operations can rely on a complex computer generated model which generates huge profits and counterparty risk but whose risk profile remains unintelligible or a mystery to inexperienced regulators.

“Banking should be boring – it is boring. When banking becomes exciting, then it becomes very dangerous “

Quote from Mike Smith - ANZ's chief executive who operates one the largest and most profitable successful banks in the world today-'In the black' -December 2009

Gearing ratios vary according to the quality of the risk – if you’re gearing to invest in government bonds ratios of 20 or 30 to 1 won’t matter – if your investments are risky 4 to 1 may be far too much leverage. I am afraid there is no easy answer but a return to integrity and the constant need to evaluate different scenarios with industry experience.

Financial services as an industry also needs to ensure fees and charges are transparent and easy to undestand, just as regulators can incorporate such requirements into sensible regulatory oversight.

Insofar as transparency for operations are concerned free enterprise markets always needed to be transparent to be effective and equitable and nowhere is this more apparent than in the derivatives market. Since the crash we have merely increased market liquidity sufficiently by massive injections of funds to substitute existing counterparty risk with increased liquidity.

There also needs to be more regulatory measures for boards of directors of public entities to set sensible remuneration limits – particularly in relation to draw backs on share options arising in the event of subsequent failed results.

Classic Bank Run

President Barack Obama has blamed compensation tied to excessive risk-taking for fueling the deepest financial crisis since the Great Depression. The administration has named a special master to approve compensation packages at firms that have received the biggest government bailouts.