Returns fall but still running

It would be premature to call an end to the bull market, but investors need to pare back their return expectations amid an increasingly volatile environment.

And central bankers, rather than China’s flagging economy, pose the biggest risk to equity markets in the longer term.

Those are some of the risks highlighted by JBWere New Zealand’s Investment Strategy Group, whose latest asset allocation update describes the global economy as “stuck in third gear”.

Last week, the United States Federal Reserve opted to keep interest rates unchanged within a zero to 0.25 per cent range due to heightened uncertainty in world markets.

The US interest rate setting has been a major contributor to the equity bull run that has taken place over the past several years.

JBWere said an eventual US rate hike was not an “insurmountable hurdle” for equities.

“Our focus is the dynamic between wages, growth and inflation. Strong growth, accelerating wages and rising inflation are what have historically hurt equity markets. Why? Because it is this dynamic that turns the Federal Reserve from growth cheerleader to punch-bowl remover.”

JBWere strategist Bernard Doyle said central bankers became dangerous for equity investors when they began worrying about inflation and hiking rates accordingly.

“At the moment no central banker in the world has that as a real concern,” Doyle said. “It’s when we get far closer to that point that we’ll start worrying about an end of the bull market.”

But Doyle said JBWere had been “dialling down” clients’ return expectations. “A double-digit (return) year in equities is not the norm.”

The S&P/NZX 50 Index gained 18 per cent in 2014, following a 16.5 per cent lift in the previous year.

As of Friday afternoon, the index was up only 2.7 per cent in the year to date and 4 per cent below its August 3 peak.

JBWere’s New Zealand equity manager, Rickey Ward, said investors often associated bull markets with double-digit returns.

“A bull market can still be high single-digit returns – it’s just positive sentiment around a market rather than the actual return you get from it,” Ward said.

But, with volatility increasing, JBWere has been putting clients into overseas hedge funds, which can profit in both rising and falling markets.

“A big push for us has been filling out our suite of low-correlation assets, including hedge funds,” Doyle said, adding that seven of the eight hedge funds JBWere clients were invested in had positive returns in August, one of the most volatile months for equity markets in recent years.

Ward said the local sharemarket’s recent “pull back” was creating buying opportunities. “Fletcher Building is a good example – look back a year ago and it was trading above $9, or close to. It went to $6.95 the other day and on what new news? The economy’s still pretty strong and Fletcher has got a forward order book of $2.4 billion … for any long-term investor that presents an opportunity in a very good company.”

Doyle said he didn’t think the Chinese economy was heading for a so-called “hard-landing”.

“We think it’s a bumpy, managed slowdown,” he said, adding that a severe downturn would put political stability at risk. “A (Chinese) recession would have political ramifications that they’re keen to avoid.”

NZ Herald – 21 September 2015

Sky high stocks point to coming crash

Here’s a somewhat scary statistic for those meant to know about these things. After a six year bull market, the typical stock in America’s S&P 500 shares index is valued on a multiple of more than 18 times estimated forward earnings. This is not just expensive by historic standards but super expensive. In fact, according to analysis by Goldman Sachs it ranks in the top 98th percentile of historic valuations since 1976 – or in other words one of the highest in nearly 40 years.

It scarcely needs saying that these peaks tend to signal the top of the cycle, with some kind of bear market or crash just around the corner. But hold on a moment, you might say, we’ve barley recovered from the last downturn. It surely cannot already be time for another? Regrettably it can. Most business cycles last little more than seven years and if anything they tend to be getting even shorter. The US economy contracted in the first quarter and has shown few signs of significant recovery since. As for the eurozone, spring has brought a rare burst of growth, but few believe it will last, let alone be strong enough to undo the damage caused by the crisis.

Meanwhile, the prospect of Greek default continues to hover over everything like a permanent sword of Damocles, threatening at any moment to plunge much of the advanced world back into financial and economic turmoil. If economic prospects look so precarious, why are stocks, bonds and other asset prices so high? Part of the answer lies in central bank money printing, or so called “quantitative easing”. This has now all but ceased in Britain and America, but where the Anglo-Saxon world has left off, Europe, Japan and China have taken over. The world is awash with cheap liquidity.

This in turn is creating new sources of financial instability to replace the old incubators of it in the banking system. History rarely repeats itself exactly, and if looking for crisis there is absolutely no point in looking for them in the last one. Banks are no longer a threat to the financial system or the economy. To the contrary, they have become so shrunken by credit loss and neutered by regulation that they have gone be the other way, and if called on to help counter renewed turbulence elsewhere in financial markets would no longer be up to the job. As Kevin Corrigan, head of fixed income a Lombard Odier, puts it: “New regulation designed to make the financial sector less risky has paradoxically damaged  the shock absorbing capabilities of the banking sector, and thereby made other parts of the system more risky.”

Banks are no longer willing to act as warehouses for ordinary buyers and sellers of financial assets. Denied this ‘market making” capacity volatility in some markets has already picked up significantly, with often violent swings in prices and yields form one day to the next. With eurozone bond yields climbing sharply this week, Mario Draghi, president of the European Central Bank, warns us to expect further turbulence to come. So where do the new threats come from?  Hedge funds and other leveraged operators such as private equity – according to popular imagination, the original evil of finance- can reasonably be excluded. Even if they were thought dangerous, they are too small to be systematically important. Rather the main threat comes from conventional asset managers. Their portfolios have been swollen to bursting since the onset of the crisis by central bank money printing. Recent analysis by the International Monetary Fund found that globally these funds today hold intermediate assets worth some US$76 trillion ($106 trillion), equivalent to 100 per cent of world GDP. Via burgeoning bond markets, they have come to replace the banks as primary sources of finance for governments, corporations and even households. The upshot is that great chunks of credit intermediation have shifted from the banking to the non-bank sector. Assets under management of some of the bigger players in advanced economies are as large as those of the largest banks, and show similar levels of concentration. Now add to these markets the wholly price incentive buying power of the central bank printing press, and all the conditions are again in place for a major train crash. Normally an investor judges value on the basis of perceived prospects for the asset involved – credit – worthiness, market position, the outlook for growth, inflation, interest rates and so on.

The central bank printing press has rendered these market judgments substantially meaningless, and by flooding the system with cheap money, encouraged indiscriminate, herd-like pursuit by asset managers of credit risk almost any price. Worse, the downtrodden banks no longer have the capacity to act as effective market makers if and when perceptions change. In a panic, prices would plummet, with nothing to act as financial fire breaks. Nobody can tell you when the next crisis will come, but the notion that governments have somehow got on top of the forces of financial instability is for the birds. Credit expansion obeys the water bed principle – push it down in one area, and it merely rises up somewhere else. Central bank money printing undoubtedly helped stem the last crisis, but if it has also sown the seeds for the next one, you have to wonder about its long term consequences.

Article from NZ Herald, Thursday 11 June 2015 – Telegraph Group Ltd

There's a riot going on

Markets are crowds and behave like crowds. Both are simply collections of people and both can be wise or irrational. The behaviour of the Auckland housing market is starting to resemble a crowd gone rowdy and riotous; not too different from a few hundred teenagers on a Coromandel beach on New Year’s Eve. It may not be at the drunken, bottle-throwing stage yet but by all appearances, one more step and it’s out of control. The Reserve Bank is shouting for everyone to go home, property investors and other interested parties are still handing out the liquor.

Crowds of all kinds become extreme because they work on social approval: when one person throws a bottle it is OK for others to so; one person paying $1 million for a dilapidated shack justifies others to do the same.

I am always looking for good investments but I have chosen not to join the Auckland housing riot – the hysteria in no way reflects underlying value. This is a speculative binge where people are paying fortunes for houses because everybody is doing it. By any sensible measure, this bash should have ended years ago and it should never have spilled out on the streets with cops involved. I remain hopeful that it will end nicely but when a crowd gets to this stage, you just never know how the party will finish up.

Article from Sunday Star Times, 31 May 2015 – Martin Hawes

Reserve Bank right to fight housing bubble

There has recently been considerable commentary and even criticism of the Reserve Bank of New Zealand for holding interest rates above other countries despite CPI inflation being temporarily below the 1-3 per cent target range. The RBNZ has also been criticised by Treasury for failing to make a robust case to “intervene” against the housing market with policies such as LVR that attempt to curb the most aggressive lending practices.

Some have even called the RBNZ Muldoonist. Is the criticism justified? Should the RBNZ simply leave the market to its own devices and allow Aucklanders to indulge in our favourite pastime of swapping debt funded houses among ourselves at ever high prices? There are many arguments and stories justifying the Auckland housing bubble. Immigration is perhaps the most frequent cited. Try telling somebody in Florida, Nevada, Spain or Ireland that this factor will prevent a subsequent bust. Likewise construction costs. Likewise restrictive planning rules…. the list goes on.

The Auckland bubble is big. Deutsche Bank estimates overall NZ housing is 30 per cent overpriced relative to income and 82 per cent versus rent, with Auckland presumably being worse. However such extremities are nothing that the world has not seen before and nor are the usual stories that temporarily justify it.

A recent study involving the Federal Reserve Bank of San Francisco looked at 17 advanced economies since 1870 and examines the long term economic impact of housing bubbles, equity market bubbles and bank loan booms. The findings are that the financial stability risks of a moderately leveraged equity market boom/bust are very small but the risks from a loan financed housing boom are huge. In recent times, the impact of the Nasdaq crash in 2000 was painful for those who paid absurd prices for companies specialising in vapour ware but the wider economic impact was limited. Indeed, the sharp interest rate cuts by the Fed to limit its aftermath arguably paved the way for the remarkable housing and credit boom that followed and whose bust in 2008 is still being recovered from today. The study finds that over time, real house prices experienced a number of booms and busts but largely trended sideways from the 1870s to the 1950s, after which they have risen substantially in conjunction with bank loans. Examples of past boom/busts include the Australian real estate boom of the 1880s financed by overseas inflows and immigration which blew apart in the early 1890s and caused a deep recession verging on depression.

A US real estate boom/bust in the 1920s centred on outside money investing in Florida and preceded the equity market crash of 1929 by several years. Rather than immigration financial deregulation was the driver of the Scandinavian boom of the 1980s and bust of the 1990s.

Japanese real estate peaked in 1991 and the study points out that by 2012, the nominal value of real estate was about half of its 1991 level. House prices always go up … yeah right. Contrastingly, the study finds numerous examples of popped equity bubbles that did not turn into wider financial crises because they had very little bank finance underpinning them. Without a parallel credit boom, equity bubbles have no statistically significant effect on the depth of the economic recession that follows their bust or the speed of recovery.

The study finds that when an equity bubble coincides with a credit boom, the subsequent economic recession lasts a year longer than it would otherwise have and there is a 3 per cent drag on the level of GDP per capita after five years; that is, the economy is 3 per cent smaller than it would otherwise have been. As an example, NZ in the aftermath of the 1987 crash springs to mind. Conversely, house price bubbles have been less frequent but their busts have been far more damaging due to their loan financing frequently taking the banking system down with them. A house price and credit bubble crash, “can sink the economy for several years running so that even by year five the economy is still operating below the level at the start of the recession.”

Spain and Ireland since 2009 are clear recent examples along with those cited earlier. Hopefully, NZ will not join them in the period ahead. These findings are stark. Auckland’s credit financed housing bubble is a grave threat to the NZ economic outlook – never mind the “reasons” of immigration, building costs, land availability and so forth. Every bubble in history has had its reasons. These pass but the permanent effects of the bubble bursting most certainly do not. Immigration may weaken; planning rules can change but the mortgage debt that has funded the price bubble remains. Thank goodness that Graeme Wheeler and the RBNZ are beginning to pay attention to the issue. It is simply bizarre that they are being criticised for being the one official institution to show some leadership and tentatively use their limited tools to lean against Auckland house prices.

The RBNZ’s tools need to be sharpened rather than tempered, with other countries providing plenty of evidence for the success or failure of tools such as stamp duty, removing the tax advantages of so called investors, overseas investment restrictions, loan restrictions et al. The evidence is compelling that the aftermath of a credit financed housing bust is dire. Those who do not learn the lessons of history are doomed to repeat them.

Article from NZ Herald Thursday 2 July 2015 – Matthew Goodson