24 Feb 2021
Global Macro-economic and Geo-political Update
Since our last newsletter a lot has happened in the post Christmas 2020 period.
There is a new US President while American society appears polarised, global stock markets are at all time highs, unemployment remains high in all major economies and global GDP in 2020 fell by 6.5%. Governments are continuing to enact fiscal stimulus through range of initiatives, e.g. Job Keeper, albeit at lower rates. The US government has extended its moratorium on mortgage foreclosures, eviction of tenants, and deferral of mortgage interest payments. In summary, governments are continuing to support their economy meaning that government debt levels are increasing and will do so for the foreseeable future. Central banks are manipulating the yield curve (interest rates) so as to keep interest rates very low and have signalled that interest rates will remain low (negative real – after inflation) for a number of years. This has generated an asset price boom, e.g. residential property market has taken off.
Because of the above approach by central banks there is no price discovery in debt markets which flows through to valuation of equity prices. In summary, investors are flying blind as historical measures of value do not make sense.
On a geo-political level Australia is in a trade dispute with China which is impacting exports of coal, fish and wine. This is part of the wider trade/geo-political dispute between the US and China.
Finally, COVID-19 vaccines are starting to be rolled out across the globe. Although this will take most of 2021 to vaccinate large numbers, it appears to be a turning point in the fight against COVID. Markets have factored this into their “valuations” as well as low interest rates for a number of years and current unemployment levels. Most of those jobs lost will not return although new job types will.
There are two ways of measuring inflation which are related. Firstly, through the velocity of money (M2), i.e. how far a dollar travels around an economy, e.g. a person earns a wage and then spends that money on groceries which the supermarket uses to pay more salaries, suppliers, etc. who then all spend it on more groceries, etc. Simply, the more that dollar moves through the economy the higher its velocity.
This example tells part of the story as groceries are necessities. The question is what does the wage earner do with the money which is not used for groceries. Do they save it or spend it on discretionary goods, e.g. buying a new car? If the wage earner saves it, then those dollars sit in the bank earning a low level of interest and does not flow through the economy so the velocity of money is not growing. In uncertain economic times folks tend to save for the “rainy day”, not spend. It is true that the bank may lend those funds but this is not for consumption. During economic slow-downs banks tend not to lend which they do by tightening their credit underwriting standards meaning they are only lending to people they believe can afford a loan.
The spending measure is CPI. We are not seeing a broad increase in CPI for a number of reasons. In our newsletter (June 2020) we predicted that the Australian dollar would appreciate against the USD. This prediction turned out to be correct as it has gone from about 65 cents to 79 cents. This means that imports are cheaper so we are not importing inflation. With unemployment at 6.4% there will not be wage push inflation. We are seeing increase in food prices for a range of reasons including effects of drought last year. This needs to be watched closely to see if it is a trend.
Inflation v Deflation
Japan is a very good case study as to what is happening globally. Specifically, Japan for over 30 years now has run major budget deficits and debt levels as a percentage of GDP. QE and large fiscal (Government spending) has been their primary methods for stimulating their economy and it has produced deflation, not inflation. The Japanese economy has staggered along for 30 years now with very low levels of GDP growth and its aging population has contributed to this problem. Only this last week did the Nikkei reach 30,000 again being some 32 years ago (1989), so equity markets can produce negative returns over many years, if they become grossly overvalued and the economic settings are not correct. Of course Japan has other challenges, notably aging population which is exacerbating the economic growth challenges as an increasing percentage of the population stop work.
Capital Protection Investment Strategy
About 12 months ago we adopted a capital protection strategy which has proved to be the correct approach. As we all know hindsight is a beautiful thing and of course the markets have roared along so being invested in bonds means the upside is missed. For our younger clients we did not adopt a capital protection strategy because they have time on their side meaning they can recover, if there was a major equity market correction.
Our investment strategy
There continues to be a disconnect between Main street and Wall street, as governments and central banks have signalled their intention to do what it takes to keep an economy from collapsing. We continue not to invest in international bonds because they are negative yielding, while adopting an asset diversification (by country, currency and product/theme) strategy as the best approach to capital protection.
If you wish to discuss, please feel free to contact us.