Market Synopsis – April 2015

Market Synopsis – April 2015
In last month’s Market Synopsis we mentioned that “the
fairly dovish message from the … Federal Open Market
Committee (“FOMC”) statement should help limit further
USD strength. A deferred lift-off in interest rates would
boost bond prices. Lower rates should also support
equities.” Over the short-term, this has occurred with the
USD/EUR depreciating by 4.56% since the bottom of USD
1.0496 on 13 March 2015 to USD 1.0975 at the time of
writing. Where markets, and especially currency markets,
are headed over the short-term is, in our opinion,
anyone’s guess. We are hence not trying to insinuate that
we “were right” in calling a change in the trend the USD/
EUR exchange rate over the short-term. On the contrary,
we rather wish to reiterate that we believe that the USD
has appreciated too far, too soon on the market’s
expectation of imminent interest rate hikes in the US. Since
the debate on the expected timing and extent of the
Federal Reserve (“Fed”)’s interest rate hike cycle has
reached fever pitch and remains relevant for investment
markets over the medium to long term, we continue our
assessment of the market’s expectations thereof. We
assess the most common arguments made in favour of
earlier rate hikes by examining a recent BCA Research
Figure 1: Full employment remains elusive
report on the subject matter below:
the past five years, there are still roughly 900,000 fewer
Argument #1 – The economy is almost back to full
employment
Assessment: Partly True
The labour market has improved significantly since the
depths of 2009. The headline unemployment rate is back
down to 5.5% and initial unemployment claims have
fallen to the lowest level since the Global Financial Crisis.
Yet, to say that the labour market is back to “normal” is to
paint too flattering a picture. Figure 1 shows that the
employment-to-population ratio for those aged 25-to-54
has recovered only half the lost ground since 2009. And
many of those who are working have only managed to
full-time workers in the US than in November 2007.
Argument #2: Wage pressures are mounting
Wage growth has accelerated over the past year, but it
remains subdued by historic standards. BCA Research’s
composite wage tracker – which distils the overall rate of
change of five separate wage indices – has increased
from 1.5% early last year to 2% at present. Figure 2 shows
that this is still well below the average of 3.2% in the precrisis period.
find part-time jobs. This is one reason why the U-6
unemployment rate (a wider estimate of unemployment
than the headline unemployment figure) remains at an
elevated 10.9%. As mentioned in previous additions of
the Market Synopsis this level is well above levels that
coincided with the start of the past two tightening cycles.
Indeed, despite all the progress that has been made over
Figure 2: US Composite Wage Tracker
* First principal component of the following five wage series: Average hourly earnings of total private nonfarm production and nonsupervisory employees; Employment
cost index: private industry compensation; Nonfarm business sector unit labour costs; Nonfarm business sector compensation per hour; and Median usual weekly earnings
of full-time wage and salary workers. Analysis based on US Bureau of Labour Statistics data and BCA Research calculations.
There is also little micro evidence of rapid wage inflation if
rate, that is consistent with full employment, may only
one disaggregates wage data either by geography,
eventually rise to 2%.
industry, or educational background. Wages for college
graduates, for instance, have actually fallen by 0.1% over
the past year. At the bottom of the occupational ladder,
wages have begun to grow more quickly. However, given
that real median weekly earnings for workers with only a
high school diploma are still down 7% since 2004, this
should be regarded as a welcome development rather
Assessment: False
Argument #4: Hiking rates now will give the Fed room to
cut rates in the future if there is another recession
This is a bit like arguing that you should shoot yourself in
the foot so that you can go to hospital and get better. At
than a cause for concern.
its core, the argument confuses levels with changes. The
In addition, the actual numbers are less impressive than is
interest rates, not whether they are going up or down. If
widely presumed. For example, Goldman Sachs
estimates that the average wage at Walmart will increase
by only 3% from the current level of $11.17 to $11.50.
Workers at McDonalds will see average wages go from
$9.01 to $9.90, a respectable 10% increase. However,
this applies only to company-owned stores. So far, there is
little
evidence
that
franchise-owned
stores,
which
account for 90% of the total, intend to follow suit.
Assessment: Mostly False
level of aggregate demand is determined by the level of
the idea is that central banks should have the scope to
cut real rates in response to weaker demand, then it
makes sense to keep rates lower for longer in order to
increase inflation. If inflation is running at 3%, a central
bank can cut real short-term rates to negative 3%. In
contrast, if inflation is only 1% the lowest that real rates
can go, is negative 1%. Put differently, if one is truly
concerned about the zero lower bound of nominal
interest rates, the best way to avoid it tomorrow is to keep
rates low today.
Argument #3: Zero rates are not natural
Assessment: False
Knut Wicksell, a late-19th century Swedish economist, first
defined the natural rate of interest as a “certain rate of
interest on loans which is neutral in respect to commodity
prices, and tends neither to raise nor to lower them.”
Today, the natural is seen the interest rate that leads to full
employment and stable inflation.
Argument #5: Low rates are leading to financial
instability and a misallocation of resources
A prolonged period of low interest rates can probably
lead to a less stable financial system by increasing asset
prices to unsustainable levels, encouraging investors to
Unfortunately one cannot observe the natural rate
chase yield above all else, and by reducing the discipline
directly; it can only be inferred from what is gauged in the
that borrowers face from having to make regular interest
real economy. The fact that the US economy has
payments.
operated below its potential for the past seven years,
despite the presence of zero rates, suggests that the
overinvestment in interest rate-sensitive sectors such as
housing.
natural rate has been negative for most of this period. This
may sound incorrect, but remember that an interest rate
is just the reward received for saving or deferring
spending. In a world overflowing with excess savings, a
negative natural rate is entirely conceivable.
In
addition,
low
rates
can
lead
to
In the wake of the Global Financial Crisis, such concerns
cannot be easily dismissed. Yet, at least so far, one would
be hard-pressed to point to any large-scale economic
and financial imbalances that have resulted from ultralow rates. Granted, equity prices have risen dramatically,
Over the medium term and as the economic recovery
but the sort of capex boom that accompanied the
gathers momentum, the natural rate is likely to creep into
positive territory. However, as we argued in previous
Dotcom stock market bubble has not occurred. Likewise,
editions of the Market Synopsis, the nominal Fed Funds
while financial conditions have eased, household
borrowing has remained restrained. Meanwhile, there
continue to be many workers who cannot find full-time
yields averaged 4.6%. And even within the top 10%, most
employment and many more who are working in jobs for
of the interest income flowed to the very wealthy. For
which they are grossly overqualified. This is possibly also a
example, the Saez-Piketty database on income tax
resource misallocation which should first be corrected.
returns shows that individuals in the 90th to 95th
percentiles of total income received just 2.5% of their
A recent Fed study sought to quantify the trade-off
between the benefits of tightening monetary policy in
response to financial stability concerns and the resulting
income from interest payments in 2007, compared with
15.2% for the top 0.01%.
economic costs in the form of lost output. The results
As such, it is not surprising that the wealthiest individuals
provided little support to those who claim that the Fed
experienced the biggest decline in interest income when
should raise rates to quell speculative activity. In their
the Fed began cutting rates. Individuals in the 90th to
baseline simulation, the researchers found that an
95th percentiles saw their share of total income from
optimal monetary policy, which incorporated financial
stability concerns, would result in a short-term interest rate
interest fall by 1.9 percentage points between 2007 and
that was only three basis points higher than if such
2013, while those in the top 0.01% saw a 7.3% decline.
Having said this, the wealthiest Americans also benefited
concerns were ignored. To assess the robustness of their
from rising asset prices, which, in most cases, dwarfed the
conclusions, the researchers also considered a scenario
decline in interest income.
in which the likelihood of a crisis was assumed to be two
standard deviations more sensitive to monetary policy
than suggested by the historical data. Even in this extreme
scenario, the optimal monetary policy called for a shortterm rate that was only 25 to 45 basis points higher. A
different scenario assumed that every crisis generated a
loss of output commensurate with the Great Depression.
In that case, the authors concluded that the optimal Fed
Funds rate would need to be a modest 30 to 75 basis
points higher.
It does thus seem prudent to aggressively raise rates only
at times when there is clear evidence of large-scale
macro imbalances, as opposed to times (such as the
present) when there is merely a possibility that such
imbalances could eventually arise.
What about pensioners? Most pensioners rely much more
on social security than interest on their savings. In fact,
social security accounts for the majority of cash income
for about two thirds of pensioners; for one third of
pensioners, it accounts for over 90% of their cash income.
To be fair, many pensioners also rely on private pensions.
However, while low interest rates reduce the income flow
that pension funds receive, they also boost asset values.
A Bank of England study from a few years ago concluded
that falling interest rates and QE had a broadly neutral
impact on the net asset value of a typical fully-funded
pension scheme.
Assessment: Mostly False
Assessment: Partly True
Argument #7: Low rates are enabling governments to
run large budget deficits
Argument #6: Low rates are hurting the middle class,
especially pensioners who depend on interest income
The US Federal Government deficit is on track to hit an
eight-year low of 2.6% of GDP this fiscal year. Meanwhile,
Lower interest rates tend to redistribute income from
savers to borrowers. Many middle class families have
mortgages, and as a result, have benefited directly from
falling interest rates. What about those who do not have
Federal Government spending on goods and services –
the component of government spending that enters
directly into the national accounts – currently stands at
7% of GDP, down from 10% during the Reagan era.
much debt? The Fed’s Survey of Consumer Finances
One could plausibly argue that low interest rates have
shows that the bottom 90% of households sorted by net
enabled other countries such as Japan to run larger
worth received less than 2% of their income from interest
and dividends in 2007, a year in which 10-year Treasury
budget deficits than they could have otherwise. However,
what is the policy implication of this? Presumably, it is not
that the Bank of Japan should have engineered a fiscal
face an overheated economy and rising inflation or
crisis by purposely jacking up rates. A more sensible
“ahead of the curve” and face a weakening economy
answer is that the chronic inability of the private sector in
and falling inflation.
Japan to spend more than it saves has pushed interest
rates to zero and forced the government to run large
budget deficits in order to support demand.
Assessment: Mostly False
It may seem that this is a symmetric risk, but it is not. We
know what to do about an overheated economy: You
raise rates until inflation comes back down. What we do
not know is how to effectively use monetary policy to
increase inflation when short-term interest rates are up
Argument #8: It is better to raise rates slowly now than
against the zero lower bound. Yes, QE is an option, but it is
be forced to raise them quickly later
a
Neither the Fed nor anyone else knows with any high
economic benefits remain in great dispute. This suggests
degree of confidence how much slack there truly is in the
economy. Thus, there is a legitimate question of whether it
that the Fed should err on the side of raising rates too late
rather than too early.
is better for the Fed to find itself “behind the curve” and
Assessment: Mostly False
politically-contentious
strategy
and
one
whose
Having considered the eight most bandied about
arguments for the Fed to start its interest rate hiking cycle
sooner rather than later, we conclude that these are
assessed as not providing clear cut evidence to when the
Fed will start its interest rate hiking cycle.
What matters, however, is not what we think, but what the
Fed thinks and does. On the question of economic slack,
we fear that the Fed sees the economy as being closer to
full employment and more vulnerable to higher inflation
than we do. Crucially, the Fed also sees the neutral rate
as eventually reaching 3.75%, whereas we would see it
closer to 2%, as mentioned above. Taken together, this
implies that the Fed would prefer to start hiking earlier and
ultimately raise rates to a higher level than we would
consider advisable.
As counterargument, Janet Yellen, Stanley Fischer, and
William Dudley (respectively the Fed Chairperson and
Vice Chairperson and the Vice Chairperson and a
permanent member of the FOMC), have generally
downplayed worries that low interest rates are generating
financial instability. They have also dismissed suggestions
that the Fed is enabling fiscal profligacy and unduly
punishing savers. Most critically, the FOMC leadership has
acknowledged the asymmetric risk of tightening too early
in the presence of the lower bound on nominal short-term
rates. As Yellen noted in a recent speech, the experience
of countries that were forced to reverse course after lifting
Figure 3: Government expenditure
borrowing rates suggests that “… a tightening of monetary
policy when the equilibrium real rate remains low can
does not have sufficient evidence in support. We reiterate
result in appreciable economic costs.”
our view communicated in last month’s edition of the
On balance, while our baseline expectations remains that
the Fed will start hiking rates in September, this would
require that economic growth gather momentum from
current levels, inflation expectations start rising, and the
dollar stabilize. None of these things is assured, suggesting
that the risks are skewed towards a later lift-off date.
Market Synopsis: Should the Fed be forced to defer the
first rate hike, “we expect continued tailwinds for bond
and equities, and a reprieve in the headwinds which
commodities have experienced over the last six months.
In addition to this, and taking the fire-sale prices offered
for many resources producers into account, we believe
this sector is one of the only sectors on the local market
To conclude, most, if not all, of the arguments presented
still offering significant value over a medium to long term
by market participants to justify an earlier Fed rate hike
investment horizon.”
For more information on this Market Synopsis or to discuss solutions provided by Integrity Asset Management, please
contact us at:
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[email protected] / [email protected]
www.integrityam.co.za
Gold
Brent Crude
USDZAR
EURZAR
GBPZAR
JSE All Share
JSE Resources
JSE Industrials
JSE Financials
JSE Listed property
S&P 500
Euro STOXX 50
FTSE 100
Nikkei 225
Hang Seng
1 183.68
55.11
12.13
13.02
17.98
52 181.95
41 011.45
65 630.61
17 181.20
664.18
2 067.89
3 697.38
6 773.04
19 206.99
24 900.89
-2.4%
-11.9%
4.1%
-0.3%
-0.1%
-2.2%
-10.3%
-1.1%
1.6%
1.3%
-1.7%
2.7%
-2.5%
2.2%
0.3%
-1.4%
-4.8%
4.9%
-7.4%
-0.1%
4.9%
-3.0%
5.5%
10.3%
11.0%
-0.6%
17.9%
3.5%
8.3%
6.0%
-7.8%
-48.9%
15.2%
-10.2%
2.4%
9.2%
-26.2%
20.3%
27.0%
33.0%
10.4%
16.9%
2.6%
29.5%
12.4%
Source: Bloomberg, as at 31 March 2015
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