IFM Debt Markets Insight Q3 2011

By IFM Debt team - 6 September 2011


Where are the global economy and markets in terms of recovery in a post GFC world? What impact will recent developments in global markets have on Australia relative to other developed countries?


Still a cloudy global outlook, recession risks rising

As we enter the latter half of 2011, there seems to be as much uncertainty as ever in the global economic and financial markets outlook. Much of this uncertainty is associated with modified versions of the same problems that were around two or three years ago, and this is no coincidence in our opinion. As we have suggested previously, many of the problems facing developed world economies have been the result of financial institutions and households being over-leveraged. We have long held the view that a prolonged deleveraging period will be required before a self-sustaining recovery of any strength is able to gain traction. In fact, it is entirely possible that it will be a decade-long wait for this to happen. Time is running out quickly for authorities to get ahead of the game and protect what is already a fragile global economic recovery. When we look back in history we note that the Great Depression had a second leg down which many would attribute to policy mistakes and protectionism. Fiscal tightening by Japan in 1997 and the subsequent slowdown is another example. Our immediate concerns surround the policy gridlock in both Europe and the US that threaten to push these regions into a synchronised global slowdown.

Australia has been a standout post GFC, but is not immune from global risks

Australia has stood out in stark contrast to the US, and to most economies in Europe, in its ability to navigate its way through the post GFC volatility. This is due in large part to a stronger starting point in terms of the national balance sheet and its associated links to strong emerging market growth, in particular China. However, the path for domestic growth has not been pain free. The term “two-speed economy” has become regularly used in market parlance, as numerous sectors have been adversely impacted by the high Australian dollar and associated effects of the mining boom.

Our economy is well placed relative to others to weather any storms

Against a backdrop of elevated house prices and high household debt levels, the RBA would be well pleased to see that consumers have improved their balance sheets by increasing their savings. China is also playing an increasing role in the outlook for Australian growth, largely through its fixed asset investment and associated demand for commodities and we expect this to continue. Australia’s starting point of low unemployment and strong income growth, combined with the availability of fiscal and monetary levers place it in an enviable position to deal with the rising risk of a global downturn. On balance, while Australia is by no means immune to global volatility, we do believe it continues to be well placed to weather any storms relative to most other developed economies.


Downside risks to US recovery rising

Source: Bloomberg

As stated above, it is becoming clearer by the day that the developed world is in the midst of a multi-year deleveraging phase which will be associated with sluggish growth. The protracted length and weakness of the current US employment cycle (pictured above) bears witness to a difficult task ahead for US authorities. The Federal Reserve admitted as much recently by committing to an extended period of low interest rates until 2013. The current environment has similarities to Japan in the early 1990’s where credit growth and consumption growth were stymied by a focus of both households and corporates on paying down debt in preference to spending.

There has been a massive quantum of both monetary and fiscal stimulus thrown at these problems, and much of this has been funnelled into higher asset prices, which has supported wealth effects and sustained some of the more intangible animal spirits. Unfortunately this has had little effect on the real economy which continues to struggle under the burden of post GFC deleveraging. Corporate America having by and large shored up its balance sheet after the 2001/2 “tech wreck” is in good shape, but is unwilling to invest, leaving the Government to pick up the tab for growth (see chart below). Recent market volatility will have no doubt adversely impacted consumer and business sentiment, increasing the risk that an already slowing economy tips into recession.

US Government picking up the tab for growth

Source: Westpac/Federal Reserve

European growth is slowing with Germany looking more likely to support wider Europe The recent bout of market volatility has also hit confidence hard in Europe at a time when growth is slowing. In an environment of fiscal austerity and fragile confidence, it is hard to envisage a smooth resumption of trend growth in Europe any time soon. Unfortunately, the market will continue to exploit perceived weaknesses in the Euro system until there is a clear circuit breaker that allays investor concerns. These potentially include a move to greater fiscal union through issuance of Euro bonds or a material increase in the European Financial Stability Fund. Germany as the core strength of Europe has the most to lose under this scenario as they are required to do the heavy lifting to support wider Europe. The Germans and some of their Northern European counterparts have so far resisted calls for greater fiscal unification of the Euro area. However, time is running out for authorities to get ahead of the game, provide a circuit breaker and restore market confidence in the Euro as a viable entity.

Emerging markets the engine of growth, are now facing policy tightening

Growth prospects for emerging markets relative to developed markets are solid. Countries such as China and India have much higher absolute growth rates and the main challenges are around managing that growth in a sustainable noninflationary fashion. While there are some concerns over potential bad debt problems and policy mistakes by authorities, we do not believe these represent imminent risks to world growth. We believe Chinese authorities in particular, stand ready to further support their economy if necessary, with large FX reserves at their disposal.

Australia looks somewhat removed from many of these countries, but challenges remain

The Australian economy has performed very well in the second phase of the GFC environment.

When we consider the reasons behind this, we arrive at the following (in no particular order):

  • Composition and growth profiles of our major trading partners
  • Our natural resources base
  • Strong starting position – less public debt
  • Fiscal and monetary policy flexibility
  • Strong economic management through the GFC
  • Strong regulatory environment.

As noted, Australia has a very low unemployment rate relative to other developed economies and has continued to enjoy strong income growth. In this environment, the RBA has been able to lift official cash rates up to close to neutral levels.

While Australia is well placed to deal with a potential global downturn, challenges remain, including (in no particular order):

  • The rising risk of a global downturn and negative growth implications for the domestic economy
  • A slowdown in China and emerging markets that lower the robust terms of trade via lower commodity prices
  • Elevated house prices. Our base case is to see house prices track sideways for an extended period, however, a new phase of the GFC would stretch an already extended household sector
  • Low productivity and high labour costs feeding into inflation
  • Headwinds from the strong Australian dollar on various sectors of the economy (e.g. inbound tourism/exporters, education etc.)

In an environment of sluggish global growth and continued event risk, Australian credit should continue to offer strong selective opportunities for investors

We see domestic credit spreads remaining at current levels with the ability to widen slightly on episodes of heightened event risk, and this is likely to be a continuing feature of the economic landscape. We don’t expect material GFC type widening in spreads as more credit securities are now being held by their natural holders (as opposed SIV’s or conduit structures). Further, we expect selected opportunities in domestic credit to provide a solid risk/reward proposition for investors in the near to medium term.

Perversely though, we could even see the increased bias to defensive assets lead to further tightening in spreads favouring existing portfolios, but hindering volume in new investments. An international search for yield, or at least a return above inflation, combined with a desire to diversify away from volatile offshore sovereign bond risk, has seen Australian Government bonds enjoy particularly strong demand. This has led to an inversion of the yield curve, in what we see as a quasi rate cut for the Australian economy. Businesses now have the ability to lock in lower funding costs and falling fixed rate home loan rates are a further benefit to households.

Opportunities have also presented themselves in the short end of the yield curve. Offshore accounts have been expressing bearish global economic views through Australian interest rate derivatives, whilst domestic fund managers participating largely in the physical market, have been unwilling to accept returns below the cash rate on bank bills. All this leads to opportunistic return enhancing strategies that can exploit the spread differential between the derivatives and physical bank bill market (see chart below).

3 Month Bank Bill versus 3 Month Overnight Index Swap

Source: Bloomberg