6 July 2023
Global Macro-economic and Geo-political Update
Happy New Financial Year!
Welcome to the new Australian financial year. The macro-economic re-structuring challenges previously written about continue and will do so for some time. As all readers will recognise that after 30 years of falling interest rates and rising asset prices along with unprecedented growth in money supply, it takes some time for an economy to adjust to the new paradigm of higher interest rates and contraction in money supply.
Debt to GDP Ratio
The US government Debt to Gross Domestic Product (GDP) ratio is on track to reach 133% this year, whereas Australia’s is forecast to be 39%. Last time the US reached this level of debt was during World War II which was before it took over as the dominant global economy and implementation of the Bretton Woods agreement, (i.e., USD as the global reserve currency tied to gold) and creation of the Eurodollar system, so a direct comparison is potentially misleading, although this level of debt compared to GDP is still concerning.
Stagflation has arrived!
In our newsletter dated 22 September 2021, we first mentioned that the world was heading into a stagflation environment, which is characterised by high levels of debt and low economic growth. Well we are now here! The latest Australian March quarter GDP figure was 0.2% which equates to 2.3% for the 12 month period and the household savings ratio fell from 4.4% to 3.7% as consumers (mortgage holders) dip into savings to pay for their higher mortgage repayments and non-discretionary expenses, e.g., food, petrol, etc. This shows that the lagged effect of monetary policy is working and the RBA decision not to increase rates on 4 July 2023 supports this analysis. The Baby Boomer cohort is continuing to spend, particularly on travel even though the Australian Dollar is weaker which makes overseas travel to OECD countries expensive.
The “inflation tax” is benefitting the Federal Government as tax receipts have jumped. Individual taxpayers are being caught out by bracket creep, the low level of unemployment and the lower Australian dollar is increasing commodity prices in Australian dollar terms, these are all contributing to revenue windfall for the Federal Government. The budget has moved from deficit to surplus which is a good thing; however, the budget now represents 24% of GDP which is the highest percentage since 2007/8. As outlined in the last newsletter Australian monetary and fiscal policy are not aligned and rather than increasing spending the Government should be reducing it, so that the Budget/GDP ratio moves back to lower historical levels.
Where is the macro-economic environment heading?
Many of the key economic indicators reveal we are starting to move from a stagflation environment to a deflationary world. Commodity prices, e.g., minerals and agriculture products such as meat, except cocoa, and energy have been falling. The Saudis in a 6 week period announced two cuts in oil production of 1million barrels per day each without any impact on oil prices. Normally, it is expected such a move will drive up oil prices because supply was reduced. In fact, oil prices have fallen further because global demand has dropped, and the Chinese are happy to buy sanctioned oil from Russa and Iran at a discount. On the positive side unemployment remains low, however it is a lagging indicator and as interest rate pressure continues to mount on corporates budgets, cost cutting will accelerate.
Electronic Money and Bank Liquidity
Electronic money is having a major impact on the liquidity of financial institutions. Silicon Valley Bank (SVB) collapsed in a 24 hour period when USD42million was transferred out of customer accounts. Thirty years ago, a “bank run” would happen over several days when customers would queue up at the bank branch to get their cash. A tactic used in those days to prevent a bank’s collapse, included limiting cash withdrawals and reducing the branch opening hours, while regulators and politicians etc., reassured depositors that the bank was safe, and their money was secure. This new electronic world as seen through the events at SVB can bring a bank down overnight. This is having a major impact on institutional fund flows and liquidity needs of institutions, and thus one reason for the huge increase in demand for short term US treasuries which are the most highly sought after collateral. Internationally this area still needs to play out, whereas the Australian Government has explicitly guaranteed our Approved Deposit Taking Institutions, i.e., banks which should assure depositors.
This liquidity crisis is manifesting itself in an inadvertent crowding out by governments in the bond markets, as investors seek out AAA/AA paper, e.g., US Treasuries instead of investing in corporate debt. This is part of the “credit crunch” and is deflationary as corporates are starting to find it difficult to re-finance.
Energy is life!
We continue to closely monitor climate change related events, as the world transitions away from fossil fuels and with the new focus on critical minerals (see newsletter 24 May 2023).
Norway has approved 19 new oil and gas projects in its territorial waters valued at NOK200 billion, and at the same time Sweden has walked away from its 100% renewable target because of ongoing concerns about short-term energy security, as it looks to join several European nations in building new nuclear plants.
This change means that nuclear generation can count towards Sweden’s energy targets. Sweden is already among the world’s leaders in transitioning to a clean energy economy, with around 98 per cent of electricity generated from hydropower, nuclear and wind. In February 2023, it generated 27% of electricity from wind and about 30% from nuclear.
We are seeing a greater acceptance of nuclear power and anticipate an increase in demand for Australian uranium, and long-term opportunities.
Australian Property Market
As we have been advocating for some time now investment in store value assets is the way to protect wealth from the effects of inflation. This is best illustrated in the residential property where price growth continues as a hedge against inflation, demand/supply imbalances, and overseas investors looking for legal safe havens (democracies) and the increase in immigration. Whereas, as reported in newsletter 28 April 2023 commercial property is suffering major valuation corrections between 15-75%, not only in Australia but also globally. In contrast, industrial property is booming with rents increasing between 20-40%.
Another area we have been concerned about for some time is the unlisted asset market, i.e., infrastructure and property funds, Private Equity (PE) where the valuations have been questionable. This has allowed industry funds in particular to inflate their returns for many years. APRA has finally stepped in and are now requiring valuations every 3 months. Hostplus has decided to leave parts of the unlisted space where it has $1.6billion invested.
In terms of the stock market there is enough data points to support a bull case with continuing low levels of unemployment and excess funds in the monetary system from the covid stimulus. On the bear side there are sobering statistics some of which have been mentioned above. Another concern is that there are 8 stocks (Apple, Nvidia, Google, etc.) that are driving up the S&P 500 index, whereas 42% of stocks in the Russel 2000 are unprofitable.
Reduction in Dividends
In the March quarter of 2023, dividends across the globe grew by 12%. Unfortunately, this trend did not occur in Australia because mining stocks cut their ASX dividends by 6.6%. BHP that was the second largest dividend payer in the world reduced its interim dividend by 40%. Franked dividends for many years have provided a regular income stream for many, especially retirees, so the smaller dividends will ultimately flow through into reduced spending in the later part of 2023. This statistic does highlight the importance of having some level of exposure to international equity markets and dividend paying markets. It also signals that the level of dividends in FY 2024 will probably be less, so it is a good opportunity to factor that into your planning.
As we move from a stagflation to a deflationary environment what are the best investment opportunities? Please feel free to reach out to discuss.
General Advice Warning: Any advice or information provided is general advice only and has been prepared without taking into account your personal objectives, financial situation or needs. Before acting on any General Advice provided, you should consider the appropriateness of the advice, having regard to your own objectives, financial situation and needs. If you wish to discuss the contents of this newsletter, please do not hesitate to contact us.