Frontiers Capital Markets and Asset Allocation Team International - - PowerPoint PPT Presentation

ABN: 21 074 287 406 l AFS Licence No. 241266

Frontier’s Capital Markets and Asset Allocation Team

International Research Trip Insights.

What the trip entailed

• We conduct this trip annually, at around the same time each year
• Meetings were held in New York, Washington, Paris, Frankfurt, Berlin, London and Hong Kong with a range
• f economic, policy and industry representatives including:

− Central banks (France, Germany, England) − Treasuries (UK, Germany) − Supra-national bodies – International Monetary Fund, World Bank − Industry bodies (banking and broad-based industry) − Political and policy analysts − Government officials and politicians − Economic and financial market research organisations/institutes − Fund managers (top-down macroeconomic styled managers in London and New York) − Broking strategists/economists/quantitative analysts

• We also attended a conference in Hong Kong which included sessions addressed by Asian central bank

representatives, policy makers and industry representatives

1

Key themes

• Global disinflationary/deflationary forces

− The impact of a broadly-based global growth slowdown − Continued slow growth recovery

• Long term “equilibrium” real and nominal interest rates

− The impact of leverage and demographics

• Eurozone Issues

− Impact of ECB QE and the importance of keeping Greece in the Euro

• Key macroeconomic themes

− US economy − Oil − Market factors − Portfolio strategy issues

2

Key conclusions

• The unanimous consensus that global inflation and growth will remain muted

− This is a universal re-evaluation (“capitulation”) − This suggests that any change to this view would cause significant ructions in market pricing − Relatively limited liquidity in interest rate markets suggests a change in view would cause significant volatility − But for now, the ECB’s QE policy is dragging global rates lower

• Long term “equilibrium” interest rates and global growth potential are expected to be lower

− The impact of leverage and demographics

• Greece will not be forced out of the Euro currency system

− Due to geopolitical considerations

• Global policy conditions remain overwhelming growth-supportive

− This remains a generally positive environment for growth asset markets − But long term prospective returns are likely to be lower reflecting secular forces

• Key uncertainties

− Why has productivity (and growth) and capex growth been weaker than expected? − Why haven’t improvements in labour markets (in the US and UK) not led to wage increases? − Why have inflation forecasts been serially downgraded?

3

Compared with last year’s trip – what’s different, what’s the same?

• What’s different:

− Investor positioning with regard to sovereign bond duration

• Accompanying investor expectations about growth and inflation prospects

− European (ECB) policy as important (maybe more so than Fed policy) in driving asset class performance

• Less focus on Japanese Abenomics too

− Policy settings are more accommodative (policy rates are lower)

• Inflation lower (oil) and growth continually undershooting expectations
• What’s the same

− Global central bank policy still the key driver of asset class performances

• And likely to pause as long as possible before tightening conditions

− Global capex spending still underperforming − Investors are still waiting for convincing signs of global growth recovery − Fiscal deficits causing less angst − Growth assets still likely to outperform − Chinese economic “rebalancing” ongoing and success still unknown

4

Global disinflationary/deflationary forces

• All investors seem to agree on the overwhelming global disinflationary/deflationary forces

− Most bond investors are now square (some even long) on international fixed interest duration (all were short duration last year) − Inflationary pressures seem to be consistently surprising on the downside globally − Investors and central banks see relatively small likelihood of inflation surprise

• Asset price inflation seen as more likely
• This is the biggest area of investor agreement, closely followed by bullishness on the USD

− Therefore both areas are where consensus could be most wrong − A faster-than-expected rise in inflation expectations (and interest rates) is the overwhelmingly key risk

• Simultaneous global growth slowdown
• Inflation-hedging assets have de-rated relative to disinflation-loving assets
• Yield is more prized than it was last year, and last year it was already the only game in town
• A deterioration in liquidity (given current Central Bank attempts to supply liquidity) would also be a big

shock

• Deleveraging hasn’t really occurred given the increase in government debt

− Potential for growth upside where deleveraging has occurred, but still a substantial drag elsewhere

5

6

Breakdown of UST10Y yield

Source: Bloomberg, Frontier

• Nominal US sovereign bond yields appear unsustainably low

− The fall in yields to current levels has been driven in recent years primarily by a decline in growth expectations (real yields). More recently, lower oil prices have caused inflation expectations to move very slightly lower − Real yields still look unsustainably low − In sum, nominal growth expectations appear very low

US sovereign yield components suggest low nominal growth

• 1.0

0.0 1.0 2.0 3.0 4.0 5.0 6.0 7.0 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 % Breakeven Rate Nominal Yield Real Yield

US forward rates

7

1.0% 2.0% 3.0% 4.0% 5.0% 6.0% 7.0% 8.0% 9.0% 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 10Y10Y Actual UST10Y 10 Years Later

10Y10Y yield vs subsequent UST10Y yield

Source: DataStream, Frontier 0.0 0.2 0.4 0.6 0.8 1.0 1.2 1.4 2.0 2.5 3.0 3.5 4.0 4.5 5.0 Jan 14 Feb 14 Mar 14 Apr 14 May 14 Jun 14 Jul 14 Aug 14 Sep 14 Oct 14 Nov 14 Dec 14 Jan 15 Feb 15 Mar 15 Apr 15 10Y Change in 10Y Yield (RHS) 10Y10Y

US 10Y10Y nominal rates

Source: DataStream, Frontier

• Market-implied forward rates for US government bonds have continued to fall, in line with expectations

for a lower for longer official policy rate

• However, previous experience suggests there may be an element of “anchoring bias” at play

− Until this episode, historical forward rates consistently overestimated future bond yields − The opposite may now be occurring

The purple line shows what the market is pricing UST10Y yields to be in 10 years’ time. The shaded grey region shows the difference between this forward yield and the current UST10Y yield The purple line shows what the market was pricing UST10Y yields to be in 10 years time. The orange line shows that the actual UST10Y yield turned out to be 10 years later

Leverage has increased post the GFC

8

Change in Debt/GDP ratio, 2007-2014

Source: Amundi

• In a typical business cycle, it takes

approximately 7 years for a country to de-lever

• However, post the Global Financial Crisis, most

countries have increased rather than reduced debt

Continued increase in global liquidity

9

Aggregate balance sheets of BoJ, ECB, Fed and BofE (USD trillion)

Source: Commerzbank

• The stimulus impact of QE operations continues to rise

− Driving yield-seeking and rising asset prices

Economic growth among OCED countries has slowed down significantly

1.0 1.5 2.0 2.5 3.0 3.5 4.0 (Percent)

10

OECD Real GDP growth (10 year moving average)

Source: DataStream/Frontier

• Post the GFC, economic growth has slowed down simultaneously across most OECD countries

− This is significant, as in most business cycles, usually only a few countries are affected while overall global growth generally remains robust

Sub-par recovery continues

• Continued very slow global growth recovery

− Output across DM and EM economies remains much lower than was expected in 2008, just before the onset of the global financial crisis, and its growth path has also been lower − Medium-term (five-year-ahead) growth expectations have been steadily revised downward since 2011 for both − Impact of leverage in the system

• Due to the subdued performance of “total factor productivity” (TFP)

− TFP peaked ahead of the GFC (in 2003). Subsequent decline seems to reflect the waning of the exceptional growth effects of information and communications technology and a shift of resources away from sectors with high productivity

• This decline may have spilled over from the US to other advanced economies

− Softer employment growth (demographics, structural unemployment, participation rate) − Lack of capex recovery

• The collapse in economic activity during the global financial crisis, and the long and deep recession following
• Financial factors are also an important transmission channel
• Less advantageous financing terms and tighter lending standards
• Risks and uncertainty about expected returns have tended to increase
• Investment-to-capital ratios remain depressed for longer after large shocks
• Increasing structural unemployment, a persistent or even a permanent reduction in participation rates

11 Source: IMF World Economic Outlook April 2015

Future potential output growth

• Potential growth has declined in both advanced

and emerging market economies in the aftermath of the global financial crisis

• This decline was sharpest immediately after the

crisis (2008–10), but potential growth had not yet recovered to pre-crisis rates as of 2014

• This suggests the possibility of persistent effects
• n growth, which distinguishes the global

financial crisis from other financial crises:

− Previous work by the IMF examining earlier crises has not found that these episodes affect the growth rate of potential output

• Some of the decline in potential growth should

not be attributed to the crisis

− In advanced economies, there are continued effects from demographic trends − Slow recovery of capital spending

12

Evolution of Potential Output Growth

IMF World Economic Outlook April 2015 Source: IMF World Economic Outlook April 2015

Future potential output growth

• Advanced economies

− Potential employment growth is expected to decline further compared with pre-crisis rates

• Due to demographic factors
• growth of the working-age population and trend labour force participation rates

− Capital growth is likely to remain below pre-crisis rates through until 2020

• If investment-to-capital ratios remain below pre-crisis levels for an extended period, capital growth will likely return

to its equilibrium growth path only very gradually.

• Evidence from the previous financial crises suggests full reversal of the decline in the investment-to-

capital ratio by 2020 is unlikely − The deceleration in total factor productivity levels observed before the crisis is likely to be lasting

• Emerging economies have a similar outlook

− Potential employment growth is expected to decline further in the medium term − Capital growth is expected to slow further from current rates, following a gradual decline in investment after the boom years of the 2000s − Total factor productivity growth is expected to remain below its pre-crisis rates for the next five years (as EM counties catch-up to the “technological frontier”

13 Source: IMF World Economic Outlook April 2015

Long term “equilibrium” real and nominal interest rates

• There is consensus that the long term “equilibrium” interest rate should be lower, but no consensus on

how much lower

− Potential growth rates are lower and demographic trends will impact − The impact of leverage also expected to be a drag on potential growth

• Global factors are having a larger than usual impact on US long term rates
• The Bank of Japan and the ECB are now impacting global interest rate pricing
• In the 2004-07 period low rates were due to the impact of EM savings and petro-dollar recycling
• Sensitivity of US rates to German Bunds has increased
• Forward (expected future) rates do seem too pessimistic
• With global rates so low, there’s huge demand for yield (dividends/buybacks )
• Corporate focus on sending investors current income
• Investors can now lose money holding “risk-free” assets in many markets

14

Leverage impact on OECD GDP growth

• 0.4
• 0.3
• 0.2
• 0.1

0.1 0.2 0.3 0.4 0.5 1980 1990 2000 2010 (%) Year

15

Non-Financial Sector Debt contribution to OECD GDP Growth

Source: BIS, Frontier

• According to Frontier’s modelling, global GDP growth was 0.4% higher than trend in the 2000s, while it is

currently 0.3% below trend based on 2010 debt/GDP levels

− This suggests growth will be 0.7% lower than the period pre the Global Financial Crisis

demographic impact on OECD GDP growth

• 1.6%
• 1.4%
• 1.2%
• 1.0%
• 0.8%
• 0.6%
• 0.4%
• 0.2%

0.0% 0.2% 0.4% 0.6%

16

Demographic Contribution to real GDP per capita

Source: UN, University of Pennsylvania, Frontier

• The aging population of developed economies will be a significant headwind to GDP over the next 30 years

− This makes the task of deleveraging much more difficult

Eurozone issues – The quantitative easing program

• The ECB’s Quantitative Easing (QE) policy is expected to be less effective (for Europe) than was the case for

the US and UK QE programs for their economies because:

− Sovereign and corporate rates are already low and credit growth is already rising

• Bank funding is most important in the Eurozone - 75% of corporate financing - and not directly impacted by QE

− The program comprises Euro 60 billion per month

• Of which Euro 40 bill govt. bonds
• The ECB’s QE is driving global rates lower, and providing a stabilising force for peripheral Eurozone

sovereign bond markets

− Will implementation be possible given the “free-float” of available securities (that current holders would be prepared to sell) − Uncertainty regarding the potential fragility of Eurozone bank balance sheets in the event of a shock or policy tightening

• But the sharply lower Euro is the key benefit and should drive Euro-area growth higher
• French exports have the highest sensitivity to the exchange rate
• QE lets politicians off the hook for reform
• “Good times are bad times for reforms”

17

The effectiveness of the ECB’s QE program

18

Growth and contributions to Private sector loan growth

Bundesbank February 2015 Monthly Report

Money market interest rates in the Euro Area

Bundesbank February 2015 Monthly Report

• Interest rates were low ahead of the implementation of the ECB’s QE program
• Loan growth had recovered ahead of QE
• The biggest impact of the ECB’s QE program has been its impact on the Euro exchange rate

ECB’s QE: scarcity problems

19

Euro area sovereign debt holdings, in per cent of total outstanding public-debt securities

Source: Commerzbank

• In effect, only around 25% of Euro sovereign bonds are likely to be available for the ECB to buy

− This makes difficult the task of the ECB to buy the amount of bonds they have targeted − The monthly total QE purchase program is Euro 60 billion

• 40 bill. govt. securities, 4 bill. Agencies, 6 bill. EU Institutions, 10 bill. Covered/ABS

Eurozone issues – “Grexit”

• The issues with Greece (and other post-GFC Euro-area crises) stem from the fact that the Euro is a

currency union without political union

− The GFC and its aftermath has highlighted institutional shortcomings in the Eurozone structure − Has highlighted the crisis of “sovereignty” within the Euro structure − Shaky foundations from inception - the Maastricht criteria were never met − But Russian “sabre rattling” (Ukraine) has made key Eurozone political leaders more focussed on the strategic importance of Greece

• Putin has revitalised NATO
• Greece will not be allowed to leave the Euro regime as it is too important geopolitically (given Russia's

current strategy)

− Given its geographic position, the Eurozone cannot afford to have Greece as a “failed” state − Muddle-through to continue (the “European way”)

• Easier-to-achieve Greek reforms likely to be agreed

− Potential flow-on effects of “Grexit” to Spain and Italy also too significant − New Greek government is regarded as ego-driven and amateurish

• Negotiations have had to begin again from “scratch”

− The price of failure is still higher than the price of a U-turn

20

Eurozone Issues – “Grexit”

• France is more likely the weak link in the Euro regime, but this is a longer term issue
• Apart from Greece, while other “crisis” countries have rebounded economically, political risk remains

significant

− The anti-austerity Podemos party in Spain

• More likely to benefit if the new Greek government gets concessions and stays in the Euro
• A chaotic “Grexit” would likely be negative for Podemos

− The anti-Euro National Front in France

21

Key macroeconomic trends and themes – US economy

• The US economy is regarded as being at around the mid-point of its economic cycle

− But market-based indicators (pricing) seems further advanced − Its been an elongated cycle because of the very deep recession (and housing has been weaker than usual)

• In the past 6 years the US economy has done 18 months of its “usual” recovery

− Inflation indicators are “under-shooting” while financial indicators are more advanced − US expansions are usually ended by:

• Higher inflation (mid-80’s)
• Private sector financial imbalance (in surplus now)

− There is a “shyness” to repeat 1937

• Impact of the rising USD on growth and equity market earnings prospects

− Greater impact on equity market as higher exposure to the USD than across the economy at large − But the impact of the higher USD should be diffused somewhat by the diffused nature of US multinationals’ global production and the globalised nature of the value chain

• US labour market is tightening

− Increased utilisation, but no signs of wage pressures. Job quit rates have increased (sign of confidence)

• Dramatic underinvestment/Low productivity

22

Key macroeconomic trends and themes - oil

• The fall in the oil price has had a more positive impact on European growth (and growth expectations)

than has been the case in the US (no one is sure why that is the case)

− It has also impacted inflation expectations (which isn’t helpful in Continental Europe)

• Saudis haven’t responded (by cutting supply) so as halt the rise of US shale oil

− This strategy is likely to lead to elongated period of low prices to ensure change in the growth and absolute level of US

• utput
• Universally regarded as a positive supply shock that should boost growth, reduce the output gap and drive

the expected inflation higher

23

Unresponsive capital expenditure

• Given the improvement in global growth, the lack of response of corporate capital spending continues to

surprise

• A lack of corporate “animal spirits” seems to reflect the severity of the GFC
• Is the nature of investment changing?

− The rise of less capital-intensive businesses

24

Market factors

• Market dynamics/valuations

− Greater illiquidity and volatility in fixed interest markets

• October 15 2015 US Treasury market “flash crash”

− Liquidity mis-matches between products and underlying holdings

• Secondary market liquidity is lower than pre-GFC
• Regulatory factors
• More liquid assets are not being priced relatively highly enough
• Valuations

− Equities are absolutely “rich” but relatively cheap (compared with bonds)

• Is there an equity bubble?

− Probably not as IPO performance isn’t “explosive” enough − Volatility spreads are wide and “pair-wise” correlation is low

• Factors driving bonds

− ECB QE and the size of the “free float”

25

Portfolio strategy issues

• Liquidity

− Having portfolio liquidity is important now given “crowded trades”

• Won’t be easy to exit these trades
• Market liquidity has declined even as ECB and BOJ have been buying (no one wants to sell)

− Current crowded trades reportedly include:

• US Dollar
• Tech and HealthCare stocks
• How to protect portfolios from a negative growth shock or other sources of market weakness and

volatility:

− Index options are one of the best ways to “chop off the tail” − Futures/derivatives, buying volatility

• Last October’s market wobble saw an only very slight bund rally
• not necessarily much downside protection in sovereign bonds
• Increased herding and concentration

− Of financial assets with fewer, larger, asset managers

• Cyber terrorism

26

The neutral cash rate using different approaches

• Treasury Forecasts

− Using the RBA’s estimate of a neutral rate of 5.5% (referenced from a speech by Ian McFarlane to Parliament in 2006) we can use 5-6% as the “range” for the neutral cash rate during a period when economic growth was running at around 3.5% (the 1994-2007 GDP growth average) − Treasury’s forecast of potential growth declining to 2.8% by 2024/25 would suggest trimming the neutral cash rate by

• 70bps. This would give a neutral cash rate of 4.8% for the expected future slower trend GDP environment.
• Demographics

− With average growth being lower by approximately 60 bps from 2005 to 2045 as a result of demographic factors, this would be expected to reduce the “point” neutral cash rate forecast from 5.5% to 4.9%.

• Frontier’s model

− Frontier’s model (a function of GDP and global interest rates based on research by the Bank of Canada) yields a neutral cash rate of 4.67%

• The average of these models would give a neutral cash rate of (4.8%+4.9%+4.65%)/3 = 4.78%

− We “round” this outcome to 4.75%, a 0.25% reduction from our prior neutral cash rate estimate − If we consider leverage to be a structural issue, our neutral cash rate would be closer to 4%

27

Modelling the neutral cash rate

28

Modelling the Real Australian Neutral Cash Rate using the Bank of Canada’s model

Source: Bank of Canada, Frontier

• Research by the Bank of Canada suggests the real cash rate is determined by GDP and the real Fed Funds

rate.

− Our estimate of lower future GDP growth suggests a lower cash rate.

• 2
• 1

1 2 3 4 5 6 7 Real Cash Rate +1sd

• 1sd

Model

Real Cash Rate = 0.7*Potential GDP + 0.3*Real Fed Funds

Modelling the neutral cash rate

• Our estimate of lower future GDP growth suggests a lower cash rate

− Below are some Estimates and Assumptions

• Scenario 1 – Base Case Scenario
• Economic Growth rate for Australia falls to 2.8% (a 50bps reduction due to leverage and demographic

headwinds), and the Fed Funds rate returns to its 1994-2014 average of 2.9%

• Scenario 2 – Bear Scenario
• Economic Growth rate for Australia falls to 2.5%, and the Fed Funds rate returns to 2% (current market

projection) due to demographics and leverage having a bigger impact than expected

• Scenario 3 – Reversion to longer term average (1994-2014)
• Economic Growth and the Fed Funds rate return to their longer term average of 3.3% and 2.9%

respectively

• Scenario 4 – Bull Scenario
• Economic Growth rate for Australia remains at 3.3%, and the Fed Funds rate returns to 3.75% (current

FOMC projection)

29

Base Bear Reversion to Normal Bull Cash Rate (%) 4.67 4.29 5.02 5.42

Equity risk premium

30

US 10 Year GDP versus 10 year Earnings Growth

Source: DataStream, Frontier

• All else being equal, lower GDP growth would be expected to be a headwind to earnings growth and

therefore equity returns.

− Even though the relationship between earnings and GDP growth is weak, our coefficient of 1 (i.e. a 1% increase in GDP results in a 1% increase in earnings) does suggest a constant ERP

y = 1.0506x + 1.2056 R² = 0.1446

• 20
• 15
• 10
• 5

5 10 15 20

• 2

2 4 6 8 10 12

Earnings Growth GDP Growth

Important information

Frontier Advisors Pty Ltd ABN 21 074 287 406 AFS Licence No. 241266

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