2013

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Please find below former Reserve Bank of New Zealand advisor and multiple CEO, Terry “Macca” McFadgen’s, latest ‘Maccanomics’ article, where Macca provides his outlook for the global economy. Enjoy!

Macca confesses that he has been dilatory or indeed delinquent as one of his correspondents would have it. In his defence he can’t say much to excuse his prolonged silence, other than to observe that he has been distracted by other matters.

However it is now time to get the record up to date, before the year passes.

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1. The USA

Leaving to one side the Washington crazies, the US economy is now in quite good shape. The banks have been recapitalized and are lending again albeit with caution; house prices have bottomed and are firming in most regions restoring household equity in the process; the demand for new housing is accelerating and with the support of household formation will grow over the next few years bringing new jobs and providing a solid contribution to GDP; new gas and oil production from fracking has set the US on the path to energy independence in about two decades, and recently, to put some icing on the cake, the Federal Reserve has committed to keeping rates at very low levels until employment recovers to normal levels.

Add to that list the fact that the corporate sector has more than $1.5 trillion of cash itching for a home.

Provided Washington gets its act together the US will deliver close to 3% GDP growth this year and the risks are to the upside as house prices, bank lending and new house construction feed on each other in a virtuous circle-the very reverse in fact of what we saw in the 2008 downswing.

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In short, Macca is bullish on the US economy-and he is holding his nose in relation to the political risk.

2. Europe

Here too, the worse scenarios that presented themselves during the year have faded from view. The Euro Zone is not going to implode and now looks likely to muddle through with recurring mini- crises, very little growth in the short term and painfully slow progress on essential reforms and institution building. But survive it will.

Italy and Spain will continue to grab the headlines as well as the Coalition in the UK with its tedious “are we in or are we out” debate, and no doubt 2013 will bring another Greek debt restructuring.

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But beneath the tabloid dramas real progress is being made:

  • Spain has stabilized its banks, got its lending costs down thanks to the ECB’s new commitment( discussed below) and, importantly, has been rapidly closing its cost competitiveness gap with the North. Three years ago Spanish manufacturing costs were about 30% higher than those in Germany-today the figure is less than half that and coming down fast. Spain’s 10 year bond yields-which exceeded 7% at one point-are now down to a more manageable 5.25%. Italy’s likewise.
  • Ireland is now virtually out of the woods and should be able to finance itself in the open market within 12 months, subject to some modest additional support from Brussels. Ireland has met all its fiscal targets and its export sector is performing well. It has been the quiet achiever.
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  • In principle, a banking union under the supervision of the ECB has now been agreed, to come in to force in 2014 when the ECB has got its organizational capabilities in place. As sure as eggs there will be some mutualisation of the deposit guarantees that will underpin the banking union. Europe will then be one step closer to a genuine federation. One painful step after another, the Euro Zone is getting there.

Of course there are still problems. The banking sector needs to be properly recapitalized, Italy could fall off the wagon, and there will be a lot of sweat and tears before a genuine banking union is implemented. And don’t even think about growth and unemployment…or Greece.

But what has changed in the last few months is the market’s perception of political risk. However critical markets might be of the endless summits, premature declarations of victory and hollow communiqués, it is now accepted that there is enough political will to ensure the union survives.

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More importantly perhaps, the announcement by Mario Draghi on July 26 2012 that he would ”do whatever it takes” to bring sovereign bond yields down to “appropriate levels”, transformed the economic landscape of the Euro-Zone. The Bundesbank huffed and puffed, its representative on the ECB resigned, but Draghi stared them down in a moment which history may judge to have been one of the more important of our times.

Then came the IMF with a stunning acknowledgment in its October World Economic Outlook that austerity simply didn’t work. It didn’t say this of course-what it said was that its research lead it to the view that in the conditions now prevailing in Europe the “fiscal multiplier” was about 1.5. Put more transparently, the IMF had concluded that for every dollar of reduced government expenditure via austerity programs, the affected economy would shrink by about $1.50. It did not need to spell out that, in consequence, tax revenues would fall on the lower output, debt would increase and austerity would devour its creators-all of which had been argued vigorously for quite some time by economists on the other side of the Atlantic.

The IMF work was challenged on empirical grounds (it is hard to determine the counterfactual) but it was supported by some independent research from American economists which came to the same conclusion. So the austerity merchants in Brussels have had their arms and legs removed, and a good riddance to them. They have no backing from the IMF and without that backing austerity is going to be last year’s nightmare.

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Macca is consequently bullish on Europe too, but he acknowledges that it is only for the patient and the thick skinned.

3. China and Commodities

The consensus has now moved to what was the “bear “position of just a few years ago. China’s growth model is seen as unsustainable beyond perhaps a few more years, and the double digit GDP growth rates of the last decade are seen as relic of a catch up period in China’s development path which has now burnt itself out. The new consensus is that China is likely to grow at around 5% pa and consume significantly lower volumes of hard commodities-iron ore, coal, copper and the like. It will probably announce growth rates of 7.5%, at least for a year or two, but no-one takes those announcements seriously.

How it transitions from a growth model dependent on unsustainable levels of fixed investment to a model where demand is driven by household consumption remains a mystery to most observers because the party machine depends on the patronage potential of large industrial enterprises. And then there is the problem that no-one really knows how many rotten loans already infect the banking system. The China Miracle increasingly looks like yesterday’s story.

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This long term chart from the RBA really tells the story of how long commodity booms typically last:

Five to ten years is the answer suggested by history and the implications for Australia are ominous, particularly in combination with the new approach to monetary policy being forced on the world by the Federal Reserve, to which we turn next. Note also the long term trend line for commodity prices in the RBA’s chart.

4. Inflation

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If you saw in the news that the Pope had proposed a public debate on whether the Holy Mother was indeed a virgin you would be surprised-astonished in fact.

So we should all be astonished that three of the world’s four main central banks appear to have had their own “Holy Mother” moment in the last month or two. Their holy doctrine- that stable inflation is the be all and end all of a central bank’s existence-has been quietly put in the dustbin of doctrinal history.

The U S Federal Reserve led the apostasy when, in mid December, it changed its guidance and committed to a policy of free money until unemployment was down to 6.5%. It targeted a specific unemployment rate for the first time in its history. On its current forecasts that would be achieved some time in 2015-but others argue that it will take until 2018.

Many thousands of words have been written by economists as to the whys and wherefores of this policy change-but the bottom line is pretty clear-provided long term inflation expectations do not rise beyond 2.5%, the Federal Reserve is going to ignore higher inflation in the short term and keep pumping free money into the economy in the interests of lower unemployment. That means-among other things-a weaker USD.

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The radical nature of this move has been under-reported in the mainstream press. It is going to be transformational at a global level because other central banks must either react in a similar vein, or see their export sectors hammered by a more competitive USD.

Somewhat coincidentally perhaps, in Japan recently elected new Prime Minister, Abe, ran on a platform that would require the Bank of Japan to target inflation of at least 2%- a target only achievable in Japan with a massive money printing program. The BoJ, if it resists, will be ordered to do say says Abe. The JPY has already responded by weakening and will continue to do so as the looming battle between Abe and the BoJ plays out. (At the time I write this the yen has hit a 27 month low).

Then to top off the change in central bank thinking Mark Carney, the Governor elect of the Bank of England, recently made comments which were supportive of using nominal GDP as the target for central banking operations. For example, an inflation target of 2.5% of real GDP (which is the current standard) might be replaced by a target of 5% of nominal growth. This nominal target would, by definition, comprise a mix of inflation and real growth. At the bottom of the cycle (i.e. today) the nominal target might be met by a mix of low real growth, say 1%, and higher inflation-4% in this example.

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In short, under a nominal targeting regime higher inflation would be the natural concomitant of low growth. The Federal Reserve, the BoJ and the BoE are either committed to, being forced into or are considering lifting their short term inflation targets. So higher inflation is coming and savers are going to suffer, along with all creditors.

The Worry List

So far so good you might say, but what is there to worry about? Here are the two things high on Macca’s mind other than US politics:

a) The Australasian Dollars

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Australia and New Zealand are caught in a nasty trap which is going to get worse as a result of the policy changes just discussed. The RBA and RBNZ are rigidly focused on inflation control. In addition, the two economies are inflation prone and have been quite well protected by strong commodity prices from the ailments affecting the north. Both are highly dependent on foreign financing to keep their banking systems afloat and suffer from house prices which look perilously overvalued.

Both dollars offer extremely attractive homes for northern hemisphere investors. There is a positive yield margin of a couple of percent, and loose monetary policy is not seen as a risk. So the two Antipodean dollars have been strongly bid and are now substantially over priced relative to fair values.

As a result, large chunks of the export sectors of both countries are being destroyed under the weight of exchange rates that are not competitive. In Australia the effects of the punishing exchange rate have been softened by rising hard commodity prices-at least until recently-but that dynamic may now have run its course.

So what to do? Rates could be dropped dramatically (to 1-2% for Australia) to eliminate the yield margin relative to the global currencies, but that has the obvious disadvantage of risking an inflationary breakout and the re-ignition of an unwanted house price boom. It would also punish savers (that is, spenders) at a time when the economy is about to hit a severe air pocket in terms of mining investment and needs the support of the baby- boomers’ spending power. But since 2008 they have transitioned out of equities into fixed interest.

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So there is not much stomach for that approach. A more likely approach-and one increasingly being debated-is to lower rates hard to pull the dollar down but at the same time to introduce regulatory tools to control another housing boom. Loan to value ratios (i.e. minimum deposit levels) and new tools focused on bank capital adequacy requirements are two such options.

My old friend and recently retired RBNZ director Hugh Fletcher has suggested another ingenious approach which would involve differential taxation regimes for domestic and foreign investors in our dollars. Essentially, the yield margin for foreign investors would be taxed away. This deserves close study.

Macca’s prediction goes like this for what it is worth: it will get much worse before it gets better. A slow train wreck is in motion and a lot of currency exposed businesses will be crippled before there is a change in policy. Our central bankers and policymakers will bet the farm on a speedy US recovery and normalization of rates because that will provide an excuse for doing nothing.

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Macca is worried, because doing nothing is really a bad idea unless a sharp recovery in the USA, Japan and Euro-zone is imminent-and it is not.

b) Focusing on the Exit

But consider the case that Macca is wrong about that and a sharp recovery in the developed economies is just around the corner.

The economic recovery now coming into view has been purchased by the central banks of the northern hemisphere at the cost of creating a bubble in bond prices. 10 year US bonds should under normal circumstances be yielding between 4-5%. In fact they yield under 2% which suggests a massive mispricing unless you believe in a looming decade of zero inflation. Theories abound as to how much of the reduction in yields is due to central bank QE operations and how much to other factors such as exceptional investor demand for safe assets. But it doesn’t matter much because when inflation starts to rise, as it will at some stage, the mispricing has to be unwound.

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The unwinding may happen in a rush and with a lot of pain for bond investors, or it may be able to be managed by the central banks to achieve a smooth transition. Fortunately they themselves hold a lot of the overpriced bonds thanks to their QE operations and book losses are of no particular consequence for them as they are not profit making bodies. Other big bond holders-like the petro-sovereigns, the Japanese and the Chinese can all look after themselves.

But that still leaves a lot of pension plans and institutions which need to hold long bonds and who will be staring big losses in the face-with unhappy consequences for their investors and beneficiaries, and potentially for consumption as well.

Expect to hear a lot more about the bond market problem as next year progresses.

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The Case for Global Equities

But when all is said and done Macca is turning positive on global equities (not so Australian domestic exposures). In sharp distinction to the last few years it is now possible to make a credible bull case for the economies of the developed world based on:

  • a decent recovery in the USA in 2013, followed by Europe in 2014;
  •  a tailwind from persistently low oil and hard commodity prices for a long period driven by US shale output, increasing Iraqi production and significantly weaker demand from China; and
  •  a period of higher inflation that reduces the global debt overhang.

In addition, the new policy directions at the Fed and maybe the BoJ and the BoE exacerbate the stark choices facing investors-they can either continue to invest in long bonds which offer dreadful returns which are about to get worse, or they can stay in cash indefinitely with a negative real return. Or they can invest in equities yielding positive real returns and the potential for growth as the world economy recovers. It’s Hobson’s choice is it not?

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The new dynamic should see equities should be well supported and indeed some could perform outstandingly well based on current entry prices (Europe most notably, and Japan for the true believers).Investors currently remain heavily underweight equities in most markets so the shift into equities, when it comes, could be quite dramatic.

So all up I am looking for a much better 2103. There is still too much debt, the bond bubble is a worry and households everywhere are going to remain cautious. And who knows how crazy Washington could get?

But the healing balm of free money is finally delivering results and now it is going to be turbocharged by some inflation. It just might work.

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Macca

About the author
Leith van Onselen is Chief Economist at the MB Fund and MB Super. He is also a co-founder of MacroBusiness. Leith has previously worked at the Australian Treasury, Victorian Treasury and Goldman Sachs.