29 Jan 2015
Just as we experienced a very different December to the norm with plenty of news flow and market activity, 2015 has started off with a bang mostly centred on events in Europe. The Swiss National Bank suddenly removed the currency peg they had against the euro for the last few years, and the European Central Bank confirmed their quantitative easing program, followed by the election of a new government in Greece.
To cover off on our around the globe update, we will talk more about these events and their ramifications for investors, along with an update on the United States, China and Japan. We already covered falling commodity prices, Russia and the Australian share market in part 1 of our economic and market outlook for 2015.
Swiss National Bank action
On 15 January, the Swiss National Bank (SNB) unexpectedly exited the minimum exchange rate regime, pegging the Swiss franc against the euro. The SNB adopted this regime back in 2011 when it was fighting a sharp appreciation of the Swiss franc (crippling the Swiss export-led economy), as investors globally saw the franc as a safe haven currency in the midst of the Eurozone sovereign debt crisis.
Under the exchange rate regime, the SNB promised to keep the Swiss franc at a minimum price of 1.20 francs per euro by printing unlimited quantities of Swiss franc. This had the effect of stopping the franc from rising, but resulted in the SNB’s balance sheet expanding by 525 billion francs by the end of November 2014, representing a staggering 86% of the country’s GDP.
Following the sudden removal of the peg, the franc closed up almost 20% after briefly reaching highs of 30% immediately after the announcement, as the market sought to reflect the true value of the franc against the euro. The SNB’s actions came as a shock to financial markets given the SNB had been reassuring the market (as recently as 12 January) of their commitment to the exchange rate policy. The shock was made all the more sudden given the Governing Board of the SNB told no one of the impending move in the day and age where central banks pride themselves on their transparency, openness, and ability to communicate policy change well in advance of impending changes.
Why did they make this sudden U-turn without communicating it more effectively? Essentially, they were caught unawares by the strong push of the European Central Bank (ECB) for quantitative easing (QE - money printing) sooner than expected, and the relative ease with which the ECB was able to get the QE program approved.
Rumour has it that someone in the SNB was tipped off to the impending QE move, quickly did the calcs on how much it would cost them to further defend the currency peg, and realised they would effectively bankrupt themselves in doing so. Given the speed at which ECB’s QE move transpired, they were unable to telegraph the sudden back-flip over a period of time forcing the SNB to make a sudden and swift move instead.
In addition, it has become clear since the move that the SNB thought the sudden removal of the peg would have a much lower impact (complacency) on the Swiss franc’s exchange rate than it did, given they also lowered interest rates deep into negative territory at the same time in the hope it would limit appreciation pressure on the currency.
The resultant effect of the change is largely detrimental to the Swiss economy given their dependence on exports, but there is also a chance that we could see casualties in financial markets, i.e. leveraged investors, foreign currency investors/dealers, hedge funds, etc. who may have placed large positions with the view that the currency peg against the euro would remain in place for some time.
Quantitative easing in play
About a week later, we saw ECB President Mario Draghi announce the anticipated QE program (money printing/asset purchasing program) for the Eurozone in order to shore up inflation, which had fallen as low as 0.40%, and to support risk assets and financials, particularly those from peripheral Europe. There was concern leading up to the announcement that the program wouldn’t be of sufficient size and length to reassure markets of the ECB’s commitment to stabilising inflation and supporting the Eurozone.
President Draghi largely met market expectations when he announced a program of asset purchases of 60 billion euros per month until September 2016, implying a total of just over 1 trillion euros. However, he beat expectations by making it clear that the program had no defined end date and would be in place as long as it was required in order for inflation to stabilise and rise to their 2% target.
The program should be further enhanced by the negative deposit rate the ECB charges banks in the Eurozone when they deposit their excess reserves with the ECB, thus encouraging European banks to lend rather than hoard the excess reserves (as occurred in the US experience of QE).
The program will effectively reduce the interest rates at which European governments borrow money, thus enabling them to refinance their dire budgets and refinance debt more cheaply. The program will also put downward pressure on the euro against other currencies, thus supporting the Eurozone’s export sector. And finally, it will boost growth assets (like equities) in the Eurozone whilst depressing returns on defensive assets (cash and bonds).
Only days ago, the anti-austerity party Syriza won the Greek elections by forming a coalition with the conservative, nationalist party Independent Greeks. Alexis Tsipras, the 40 year old leader of Syriza, was sworn in as the youngest Greek Prime Minister in 150 years.
There are now renewed fears that Greece could be forced out of the Eurozone if it defaults on its debt repayments. This resulted in the euro falling to an 11 year low against the US dollar, whilst Greeks stocks sank and bond yields rose (higher borrowing costs for the government). The bigger fear is that Syriza’s victory could inspire other anti-austerity and anti-EU parties in Europe, notably in France, Spain, Italy and Portugal.
Syriza campaigned on policies that it will demand an easing in the terms of their bailout, bring back the minimum wage, stimulate the economy, rid Greece of corruption, stop the leakage of wealth to the ‘Greek oligarchs’ and secure a reduction in Greece’s huge national debt. Most pressing is the terms of their bailout; they will no doubt be asking for both a writing-off of some of their national debt and lengthening maturity on the remaining debt with smaller payments along the way.
Eurozone officials have been holding strong in recent days, saying the new Greek government must comply with existing conditions, but have indicated they are more than willing to sit down and ‘work closely’ with the new government.
There is some talk that Eurozone officials will refuse to meet Syriza’s demands for a reduction in austerity for fear it will encourage other bailed out European states to demand similar help. Either the Greek government will have to backtrack on its promises, or its financial system will lose access to emergency lending from the ECB and the country will crash out of the Eurozone. Syriza, however, believes it has a strong bargaining position because Eurozone officials will be even more fearful of the knock-on economic and political effects of a Greece exit from the euro.
There is a possibility that if Syriza takes Greece out of the Eurozone, its banking system would implode, the economy would sink back into recession, unemployment would shoot higher and there would be severe civil unrest. The Greek people certainly seem to think life would be harder outside the Eurozone, with polls showing a large majority for staying in. Yet, there is also a possibility that a Greek exit would ultimately be economically beneficial for Greece, giving the country’s exports and tourism industries a massive boost from a lower currency exchange than it currently has in the Eurozone.
Whilst all of this possible, it is more likely that the bailout deal is restructured so that outstanding Greek debt is paid off over a much longer time-frame (maturity extension) with smaller payments, and that some debt is allowed to be written-off.
All this occurs whilst the ECB undertakes QE, which should help to lower rates at which the Greek government refinances it debt at. The Greek economy has shrunk 25% in the last five years, youth unemployment remains at 50%, prescription drug prices have gone up 30%, unemployment benefits end at 12 months, and the long term unemployed lose access to state health care. The Greeks simply can’t continue on the current path of austerity. Both the Greeks and the Eurozone have too much to lose from a Greek exit.
Whilst required, the SNB move was poorly timed and telegraphed. In the current market environment, a central bank without credibility has no power. But it goes to show how important central bank policy action is and how big a role central banks now play. At this stage, we expect limited to no effect on investor returns.
The ECB’s QE program will boost stock prices across Europe whilst further depressing the returns on defensive assets. In saying that, highly skilled fixed interest managers should still be able to make money from European bonds. Investors should re-evaluate their international equity exposure and look to seek further diversification abroad.
Syriza’s win in Greece means greater uncertainty for European markets given the risk of a Greek exit from the Eurozone. However, it also gives Greece a chance to break out of depression and push forward, possibly with some lessons for Italy and Spain. We suspect the result will ultimately be supportive towards growth assets over the medium to longer term.
The US economy continues to do well, but not all is well. Growth is not as strong as it should be this far into a recovery, especially with three bouts of QE and interest rates at zero. Inflation is falling, pushed lower more recently by the fall in energy prices and lack-lustre wages growth, and retail sales over the Christmas period appear disappointing so far given the information at hand. On the flip side, employment data and housing data continue to improve.
The fall in the oil price is a big positive for US consumers and manufacturing. However, the free-kick a lower oil price usually provides to the US economy may not eventuate to the degree we expect, as much of the economic growth and fall in unemployment over the last couple of years has been due to the shale oil and gas revolution. The fall in the oil price has already resulted in the closing down of rigs and wells, big cuts in capital expenditure for oil and gas companies and mining services companies, and large cuts to their workforces.
Recent company reporting of December quarter results has been quite poor in the month to date. At this stage, the US central bank is in no rush to raise rates, with the first rate hike now expected in the third quarter of 2015, but it will all be data dependent. In addition, the Republicans now have majorities in both the lower and upper houses of parliament with a Democrat President in Barack Obama. Political tensions lie ahead.
Given the mixed signals and uncertainty regarding when the central bank may raise rates, the US economy and investment markets will most likely hold in a consolidation phase for much of 2015. But it is important to not get to down-beat on the US economy as it remains the pick of the bunch globally.
US equity markets remain well supported given central bank policy. Everyone will be closely watching the US central bank for indications regarding the timing of the first rate rise and flow on effects for investment markets. The US dollar should continue to rise, but at a slower pace than it did in 2014.
Whilst China is clearly slowing, as it must, it is important to remember the economy grew at a very impressive 7.4% in 2014. A lot of noise was made recently over that number given it was the first time in more than 15 years that the growth objective (set at 7.5% at the beginning of 2014) has not been met or exceeded. The growth rate is the slowest in 24 years and concern exists regarding the flat-lining property market, which may exert further downward pressure on the growth rate.
In saying that, Chinese equity markets have traded very strongly over the last three months and are continuing to rise. Retail sales and industrial production growth are both rising, whilst fixed asset investment (the major driver of growth in the past) only fell slightly in December.
Despite the slowdown last year, we expect the government to stick to the path of transforming the economy into one where growth is driven by consumer spending (rather than investment spending), emphasising the quality of the growth rather than the size of growth. The Chinese government has continued to be very targeted in their stimulus measures to date and this is expected to continue this year.
A slowing Chinese economy has big implications for the strength and health of the world economy, with even greater implications for Australia. As the composition of their growth changes and their growth levels fall, they will demand less commodities from Australia which will significantly impact our economy, the government’s budget, and our terms of trade. Though, we expect the Chinese government to engineer somewhat of a soft landing over the next few years, which may mean a reduced and prolonged negative effect on the Australian economy (rather than a sharp and drastic negative effect). Chinese equities look somewhat attractive at the expense of Australian equities.
Japan – reforms still to come
Prime Minister Abe consolidated his power in 2014 after gaining a super majority in an election result which cemented support for his policies. The election result means he will now be free to easily pass structural reforms through parliament. The first two arrows of ‘Abenomics’ had their intended positive effect of stabilising the economy, pushing inflation higher, and encouraging investment in growth assets.
The third arrow is largely yet to be fired. If and when it is fired will largely decide the fate of the Japanese people into the future. If the arrow isn’t fired, Japan falls back into deflation and stagnation. If it is fired, Japan stands a chance of revitalisation and relevance on the world stage once again.
Given Abe’s and the Bank of Japan’s policies, Japanese equities continue to remain well supported whilst the Yen faces continued downward pressure in order to assist Japanese exporters. A stronger Japan is something everyone will welcome.
As always, if you wish to discuss any of the above, or your current situation/portfolio, please don’t hesitate to contact us on 02 9324 8888 or book an appointment