Tuesday 19 June 2018 by Craig Swanger Opinion

Global outlook – chickens are coming home to roost

Craig reviews his top five global themes and explains why Australian investors need a material hedge against the AUD 

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The current economic environment is one of the most benign in the past 100 years. There is little risk of inflation breaking out, employment markets are relatively stable, emerging market economies show few signs of crisis, and geopolitical risks while ever present, are stable. 

Benign doesn’t mean low risk though.  Benign conditions often result in complacency and investors accepting risk without sufficient returns as compensation.  For example, US long term PE ratios (CAPE-10) have only been higher once before, in 1999 just ahead of the tech-wreck NASDAQ crash.  Credit spreads, while not as out of line with history as equities, are also very tight at the BB and higher ratings levels. 

This complacency means that the nature of the risks investors face shifts from the risk of sudden changes causing volatility, to more subtle changes not perceived to be a risk at the time – much like the proverbial boiling frog that doesn’t notice the heat slowly rising. 

Following on from my commentary on the Australian economy over the past two weeks, this week we look at the global economy, global interest rates with a focus on the implications for Australian investors investing in corporate bonds offshore, concluding with a projection of interest rates in the major economies and currencies relative to the AUD. 

The global economy remains stable, but medium term risks have edged closer.

When we started looking at the top five global economic risks facing Australian investors back in 2015, the top five moving from least to most significant were:

   #5. EU instability, particularly due to Italy

   #4. US economy failing to maintain its momentum

   #3. Housing market downturn in Australia

   #2. Falling global trade

   #1. Escalating debt in China

Three years on and most of these risks have worsened, with the only exception being the US economy maintaining and even extending its pace of growth.  Long term investing is all about understanding what these macro risks are and managing to ignore the short term noise that crowds the media. 

So let’s look at where these risks are now:

#5. EU Instability

In 2015, the key risk was the imbalance between Europe’s ‘haves’ and ‘have nots’.  Italy posed the largest risk to the stability of the EU, in particular the likelihood of the nationalistic pushback against austerity imposed by Germany and the EU.  Since then, nationalism has escalated globally, with the Five Star Movement in Italy rising from obscurity in 2015, to take government in 2018.  Now the ability of the EU to control its third largest economy is severely challenged and along with it, the control over the union as a whole. 

Implications: Like Brexit, the break up or restructuring of the EU might not mean much over the long term, but it will certainly create a lot of uncertainty and therefore currency, equity, bond and property market volatility in the meantime. 

Don’t invest in the Euro unless you have to.  Australian investors are simply not being paid enough return on Euro based investments to take this additional risk. 

#4. US economic momentum

While Europe and to a lesser extent, Japan, has somewhat recovered since 2015, or at least can be said to have stabilised, the world still needs the US economy to maintain its pace of growth.

This risk is smaller now than it was in 2015.  The US economy has shown its ability to maintain growth even when interest rates are pushed higher.  There are of course some risks, not the least of which is the unpredictable Trump administration, but so far the US remains in strong health. 

For example, in 2015 underemployment in the US was 10.0% and we said that it needed to get to below 8.0% to be considered healthy.  The rate today is 7.6%, only beaten by the boom period of the Clinton administration. 

Implications: If there is a risk for Australian investors, surprisingly it probably isn’t the Trump administration’s chaos (unless they win another term).  The larger risk is that the Fed increases rates too fast, the USD jumps, and that ends the economic growth phase prematurely.  That risk so far is very low as the Fed has shown persistent restraint during this slow recovery phase. 

#3. Australian housing downturn

This was covered in our previous article, but it is fair to say that the risk identified three years ago, namely that investment lending and construction would overshoot, has become much more short term by 2018.

Implications: Falling home prices and lower construction point to lower interest rates for longer

#2. Global trade

In the 1800s, Great Britain was the world’s economic leader.  They pushed for free trade, dominated manufacturing and financial trade, and prospered.  Eventually prosperity meant wages were too high in Britain, so manufacturing moved offshore, encouraged by lower trade barriers.  Then the UK voters pushed back and demanded jobs at home.  Global trade growth faltered, nationalism rose, trade tariffs increased and then trade fell sharply. 

One hundred years later the US rose to the position of global economic leader, pushed for free trade, dominated manufacturing and financial trade, prospered, wages rose, jobs went offshore, and then along came Trump speaking for millions of underemployed Americans. 

This risk to the global economy – that is, nationalistic movements forcing politicians to push up trade barriers –  has become even more acute since 2015.  The following year saw Brexit and Trump, the rise of nationalism in France, Austria, Germany and Italy, and the rise of trade tensions between the US and all of its major trade partners. 

Implication: Australia is highly geared to global trade, both directly as a major exporter of commodities, but also indirectly as 35% of our trade goes to China who is heavily dependent on exports.  Investors looking to hedge this risk should take non AUD positions. 

#1. China’s debt bubble

In 2015, China’s debt binge was hardly mentioned.  In the years since, it has become a more mainstream topic in investment media and organisations like the IMF.  But so far so good.  China has managed to ease back the pace of its economic growth without destabilising its economy or global trade, the key risks in 2015. 

But China’s total debt to GDP ratio has grown from 180% to 260% since then.  Should a credit crisis emerge in China, the severity of the impact on China and the world would be more significant today than three years ago. However, China’s management of the situation so far has reduced the odds of such a crisis. 

On the other hand, China’s domestic savings rate (% of GDP that is unspent each year) is still 48%, compared to 23% in Australia.  This means that while China’s debt is high, it could pay debt down should it choose to divert savings to debt reduction, and China’s centrally controlled economic model enables this better than in any other major economy. 

Implications: For Australian investors, this remains the most significant potential shock to their investment portfolios.  The probability is flat and maybe even falling, but the higher the debt ratio gets, the potential impact worsens.  Our economy could not withstand a major downturn in China with our banks, resources and property investments taking the largest hit. 

So, it remains prudent to spread one’s portfolio globally, including taking non AUD positions that will profit in the event of a drop in the AUD.

Forecast currencies and interest rates

In terms of forecasts, if the world avoids a trade war, the AUD fair value remains in my opinion – 70c against the USD and 52p against the GBP.

I expect Australian interest rates to remain at 1.50% to the end of 2019 at least, in contrast to rising rates in the US, up 0.50% by the end of 2018, before slowing to just two increases totalling 0.50% for the whole of 2019. 

On the other hand, if this trade war continues and forecasts for global growth fall sharply, the AUD/USD rate will likely fall below 70c by some margin.

Conclusion

After three years of writing about the top five risks facing long term investors in Australia, little has changed.  The US economy continues to perform; China has held on well and will hopefully navigate through its transition. However nationalism is growing, creating risks for the stability of the EU and the ability of trade dependent China to avoid a credit crisis.

For Australian investors, avoiding risks to the Euro is relatively simple, but the rest of the risks will impact Australian equities, the AUD, our property markets and our interest rates.  Complacency is our biggest downfall while conditions seem benign, and as we’ve seen in the past, our ignorance can last for years.  This means that investors need to stay in the market but hedge against a sudden change that could be triggered by any of the risks identified above. 

For Australian investors, one of the best hedges is to leave a material amount of investments in non AUD currencies.  Any hit to the Australian economy, whether caused by a domestic issue such as a housing market correction, or by a global issue such as a credit crisis in China, will likely create a drop in the AUD.  Then non AUD investments will rise in value, offsetting or hedging some of the losses on assets such as equities. 


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