This article is from the Australian Property Journal archive
No sooner had the new Chairman of the US Federal Reserve, Ben Bernanke, been shown where the coffee machine was in his new office, than financial markets began to do what all financial markets do when a new Fed Chairman takes the helm – become more volatile.
Recent market action is nothing more than a combination of reality catching up with overzealous investors, and miscommunication between the markets and Bernanke as they get to know each other. Neither has anything to do with the underlying fundamentals driving global growth – these, so far, remain unchanged.
The recent market rout has seen the US S&P500 down by 5%, after being down as much as 7% from its May 10th peak. The ASX200 is down 9.2% from its May 11th peak. US 10-year bond yields fell 23 basis points between May 12th and June 13th but have since rebounded 13 basis points. Similar moves were experienced in Australian bonds. The Aussie dollar has fallen 4.5% since May 11th, while the US dollar has risen 4.1% against the yen. Such movements signal a downshift in investor risk-seeking behaviour.
The correction in financial markets has been long overdue. So far, we have had 819 trading days without a 10% correction in the US S&P500. That is the third longest winning streak ever and is well above the average stretch of 222 days. The last time the US market fell by 10% or more was in March 2003 when 14% was lopped off the index. In the three years prior to that, the market experienced five similar episodes where the average decline was 22.8%.
Australia’s winning streak, similar in length to the US, came within a cats’ whisker of coming to an end this week. The last time the ASX200 fell by 10% or more was also in March 2003 when the index dropped 12.3%. The difference between then and now is the speed in which the market has corrected. It took the market three months to correct in 2003. This time around the correction has been faster, occurring within just one month.
The tipping point for the recent spate of volatility harks back to March of this year when the Bank of Japan announced an end to its policy of quantitative easing, effectively signalling to the market a near-term hike in interest rates. With signs of life beginning to emerge in Europe, it became apparent to global investors that after experiencing a synchronised cut in global interest rates in the years between 2000 and 2003, the reverse was about to happen. For the first time in 17 years, interest rates in the US, Europe and Japan were about to move higher in unison. Indeed, the move toward monetary discipline has been broader than that. Of the 28 central banks that we monitor, 18 have raised rates this year; all but 7 have raised rates since October last year. This month alone we have seen no fewer than six central banks raise rates.
For the risk-seeking, liquidity-loving, leveraged global investor, the super-charged era of historically low interest rates and rock-bottom volatility, was about to end. The easy money trade of borrowing cheap in Japan and investing in anything that offered a higher yield, including assets in the US, Australia, and New Zealand, no longer looked as attractive.
This realisation was most clearly seen in the US where funds fled the Treasury market. The resulting lift in US bond yields saw interest-sensitive sectors of the US economy come under pressure. As a result, housing took a turn for the worse and consumers began to feel the weight of their debt-laden balance sheets. The picture being created was one of slightly weaker growth in the US offset by an acceleration in growth in other countries. As the IMF noted in its upbeat April assessment of the world economy – global growth was becoming stronger, broader and more balanced.
All of this was good news because it meant that the many imbalances that have plagued the world for the past six years or so were finally about to be unwound. Slower US growth meant higher household saving; lower household debt, and a much improved current account deficit. Faster growth in the rest of the world meant less reliance on the US consumer to drive growth, giving them room to rebalance their books.
So what happened to this seemingly ideal outcome? In a word: Bernanke! Ben Bernanke took over the reigns as Chairman of the US Federal Reserve in February of this year. Since that time, he has been finding his feet in the way he communicates with the market. After confessing to a journalist that the market misinterpreted his comments to be too soft on inflation earlier this year, it seems “Bumbling Ben”, as some have labelled him, has come out swinging, making it very clear he will be tough on inflation. Bond markets have been bouncing in all directions as a result – rallying after his earlier comments and more recently selling-off.
This kind of volatility should not come as any surprise. History shows market volatility always rises when a new Fed Chairman takes the helm. Even the Maestro himself, Alan Greenspan, saw considerable volatility in the early days. Ominously, in the name of establishing his inflation-flighting credentials, Greenspan tightened interest rates so much in 1987 that…well, we all know what happened. The hope is Bernanke will not be so zealous.
In support of their new Chairman, a string of Fed Governors have also come out swinging on inflation. In general labelling it as “unwelcome”, “a serious concern”, “bothersome”, “troubling”, “adverse”, and in the “upper-end of the comfort range”. After several years of flooding the economy with cheap and easy credit, the Fed it seems is trying to reclaim its tough-guy image.
How much of a concern is inflation? It is true, core CPI has risen recently from 2.1% at the start of the year to 2.4% currently. Likewise, the Fed’s preferred measure of inflation, the core personal consumption expenditure deflator has risen from 1.8% to 2.1% over the same period, just outside the Fed’s 1-2% comfort zone.
There are reasons to be optimistic on the inflation front, however. An expected slowdown in US economic growth should put some downward pressure on prices while an accelerating productivity picture will keep unit labour costs in check. It should also be noted, that despite the surge in commodity prices, the pass-through to final consumers has been substantially less than was the case when commodity prices spiked in the early 80s and early 70s. Moreover, thanks to the tough talk from the Fed, market-based measures of inflation expectations have come down.
Has the fundamental picture changed for the global investor? Not so far. Recent data to come out of China suggests growth there is accelerating. In annual growth terms, exports have accelerated from 23.9% in April to 25.1% in May; imports are up 21.7% compared to 15.3% in April; industrial production is up 17.9% compared to 16.6% in April; and retails are up 14.2% versus 13.6% in April. Retail sales have surprised on the upside in the UK, employment is stronger in Europe, and business confidence continues to rise in Japan.
Another rate hike in the US is now a near certainty. Less certain is what happens after that. The risk for all investors remains the same, however. The weakest link in the global rebalancing story is a new Fed Chairman. If the Federal Reserve makes one false step in finishing-off this rate hike cycle, by lifting rates too far, the modest slowdown in US growth we have pencilled in will quickly turn into a sharp slowdown. That will not be good for anybody.
By Tracey McNaughton, senior economist with BT Financial Group.*
