“Billions wiped off share values! Market meltdown! Shares in freefall!” Well, drama sells newspapers and brings in viewers but we’d like to know where they were when the stock markets rose 30% over the last year! After all, the US share market is back where it was just 2 months ago, while Europe, the UK and Australia are back at levels last seen in January.
To decide what’s going to happen and what to do, you need to know where we are now and what’s happening now.
The GFC (Global Financial Crisis) which began in early 2008 was very unusual. In fact you have to go back to the 1930s to find a similar crisis. Between then and now, the most common cause of an economic slowdown was a boom which led to rising inflation. The central bank (for example, The Federal Reserve Bank in the US, or “Fed”, or the Reserve Bank of Australia, or “RBA”) would raise interest rates causing a slowdown which often turned into a recession. In time, the recession would cause inflation to fall, and eventually, the central bank would cut interest rates and the economy would start to grow again. But the GFC was different. It was caused by too much debt. Banks in the US and Europe lent too much to people to buy houses, lent too much as a percentage of property values, and lent money to individuals who were obviously too poor to repay the loans. This flood of money caused a house price boom. When the boom came to an end, individuals and banks and eventually even sovereign governments went insolvent.
This kind of recession is called a “debt deflation” recession. What that means is that the ratio of debt to income is so high that economic growth stops, and the economy falls into deep recession. Why is that? Well, the ratio of debt to income or GDP has to be reduced. And the only way to do that is to repay debt. Selling assets doesn’t help, because somebody else has to buy them, and so for the system as a whole, that doesn’t reduce the debt ratio. What it does do is drive down asset prices, which worsens the crisis, as the man or woman on the street finds that their collateral for loans has shrunk and keeps on shrinking. Meanwhile, banks’ capital is destroyed and bank lending grinds to a halt. Recovery from this kind of recession is very slow and sluggish, because it takes a long time for debt relative to income to fall. Rapid repayment only worsens the crisis, because everybody’s spending is someone else’s income — if you cut your spending you make others cut theirs too.
The response of the US government and the Fed were exactly what was needed. The US federal government ran massive deficits, and the Fed cut interest rates to zero. When short-term interest rates reached zero, and the economy still hadn’t recovered, the Fed started a policy of quantitative easing (“QE”), i.e., expanding its own balance sheet to buy government stock and mortgage-backed securities. The policy has started to work. The housing market, which had collapsed, bottomed and started a gradual recovery, unemployment started to fall, personal debt ratios fell, and yet inflation remained benign. The economy recovered. But now the extreme measures needed to prevent a re-run of the 1930s Great Depression are no longer necessary. So, earlier this year, the US federal government ended temporary tax cuts and imposed spending cuts (“the fiscal cliff”) and over the last couple of weeks, the Fed has made it clear that QE will end sometime over the next year and after that, the cash rate will be gradually raised.
The response of Europe and the ECB, the European Central Bank, on the other hand, was hopelessly inept: either the opposite of what was needed, or where it was the appropriate policy, it was too little too late, too slow and too cautious. The result is that Europe hasn’t even begun its recovery yet, while the US is well into the recovery phase.
So why are share markets falling? Well, psychologically, they have become accustomed to the intravenous drip of QE. Take that away and you have to start valuing shares on more old fashioned things like earnings and PERs! Also, in the US (but not here or in Europe) government bond yields have risen from 80 year lows as the bond market comes to terms with the major buyer of the last 5 years withdrawing from the market (the Fed is unlikely to actually sell government bonds for many years yet.) And if bonds are selling off then shares will fall somewhat too. Yet earnings growth will continue. All the evidence is that the “fiscal cliff” has caused only a very small slowdown in economic growth in the US and with the housing market now firmly in recovery, growth in the economy and in profits is likely to continue.
The Australian economic cycle is different. As a result of good luck (the resources boom) and good policy (rapid tax cuts and spending programs; big cuts in the cash rate) growth in Australia barely faltered. But this led to an unsustainably strong Australian dollar, and now, as the resource boom ends, growth has to be found elsewhere, outside mining. This will require a fall in the A$ (which has started but has further to go) and probably further cash rate cuts too.
From a foreign investor’s perspective, Australia has been a “safe haven” over the last five years. Sustained growth, a strong currency, good policy, the resources boom all made Australia very attractive to overseas investors especially when their own markets seemed so unsafe. Now their own markets look better and share investments in Australia will underperform even if our market rises as fast as overseas markets because of the weakening A$. So they are selling. And yet our market is now compelling value. Even though domestic growth is slowing, the falling A$ will help exports and cut imports and will also cut the wages (in foreign currency terms) of Australian workers. These sectors of the economy will start to do well. In addition, with the cash rate declining, housing will stabilize, and at the same time, the yield on shares will seem even better relative to deposit rates. After adding back franking credits, the banks and Telstra are yielding 10% (CBA: 8%) This means that even if share prices don’t rise over the next year, the returns from these key shares will still far exceed the return on deposits.
We remain convinced that Australian share prices will resume their upward trend soon, even though within the market, different sectors will dominate (e.g., retailers dependent on cheap imports will struggle, while the banks will do well). And though US share prices are more vulnerable, if only because they have risen much more than our own shares, the end of QE is a sign that the fundamentals are strengthening, not weakening.
