30 September 2015
Themes For September
September largely carried on where August finished, with equity markets declining and volatility levels remaining high. There was a clearer trend for government bonds this month, with bonds rallying and yields declining, and credit spreads continue to price rising risk in the corporate bond markets. These moves were driven by increasing concerns over global growth and trade, and by a backdrop of heightened risk aversion which remained in place after a long period of “buying the dip”. Market fears were compounded, perversely, when the Fed chose not to raise rates. This was taken to mean that perhaps global growth prospects are worse than had been thought, even though the Fed in theory has a purely domestic mandate. In September bad news was bad news, meaning that whilst bad news most likely means rates will stay lower for longer, the market was focusing on the upstream issues of what this bad news actually entailed. For much of the post financial crisis period the market has taken bad news as good news, as lower rates meant more money moving in to riskier assets seeking out a return. Notwithstanding these issues our discretionary portfolios have been performing strongly. We discuss these themes below.

Returns for the month of September:
Returns For Month of September

Global Growth and Trade Concerns
We have discussed in previous reviews how the slowing of China’s economic growth, and of emerging markets in general, has impacted global growth rates. Aside from the direct impact on global growth the associated decline in commodity prices has also been an important dynamic. According to Credit Suisse, commodity-related capex accounts for around 30% of global capex. They estimate that the 13% decline in oil capex, and 31% decline in mining capex over the last 12 months, has taken around 1% off global GDP. In addition to this there have been large rounds of redundancies in the sector, meaning a subset of employees are spending less.

Of course lower commodity prices, in particular oil, should produce greater consumption and even increased investment over time in projects where commodities are a large input cost. In the longer term lower commodity prices tend to boost growth as commodity-consuming countries spend and invest the savings more readily than commodity-producing countries, which tend to save a higher portion of any windfall. For oil in particular the IMF estimates that the fall in price should eventually boost global growth by around 0.5% to 1.0%, even accounting for lower capex. However in the first instance commodity-producing corporates have acted more rapidly, the boost from consumers may take longer to arrive.

Another key concern for the global economy has been the slowing of global trade. South Korea, a forerunner for the global economy, saw its exports fall 15% year-on-year in August. Chinese exports were down over 5% over the same period. The CPB Netherlands Bureau for Economic Policy Analysis, a group that monitors global import and export volumes, found that world trade had declined over 3% in May from its December peak. This was the sharpest fall since the financial crisis, though trade has rebounded somewhat since then.

World Trade

Looking over a longer time frame, trade has generally grown faster than global GDP. This was especially true in the 1990s as liberalisation in China and the former Soviet Union, the creation of the WTO, and the expansion of global supply chains, saw a rapid expansion. From the mid-1980s until the middle of last decade annual trade grew at 7% per annum. However since the financial crisis trade has generally been growing at or below GDP growth levels. To be fair part of the recent decline in trade has been due to a rising US dollar reducing the notional value of goods traded in other currencies. If you look at volumes, trade was still growing at 1.7% year-on-year in the first half of 2015. Though this is down from a long-term average of around 5% a year.

Worse for most

What has been driving this recent shift? Partly it has been Europe, which is responsible for 25% of global GDP and one third of global trade, and has been growing only weakly. Clearly China’s demand for raw materials is declining as it transitions away from investment to consumption. And one-off factors such as the recent West Coast ports disruption in the US have played a hand. But structural factors have also played a part as America takes step to energy independence, and China in-houses much of its supply chain. In addition rising incomes in emerging markets, particularly China, has meant that manufacturing some goods in their end markets is once again becoming economic. In 2013 Lenovo, a Chinese PC-maker, opened a factory in North Carolina.

We believe it is still too early to make a call on whether the recent softness in global trade is part of a longer-term trend, or whether it is part of a more typical cycle. We will be watching the space closely, though one event which may be positive for world trade in the future was the recent agreement on the Trans-Pacific Partnership (TPP). A breakthrough compromise on protections for new drugs brought the 12 nations TPP negotiations to a successful conclusion. It represents the biggest trade deal in 20 years and should provide a positive sentiment boost, though we will wait to see the details in a few weeks. Australian farmers should get a major boost with tariffs for beef, dairy, wine, sugar, rice, horticulture and seafood slashed. This includes the export of rice to Japan for the first time in 20 years, and a doubling of the amount of sugar to be exported to the US. In both these cases the amounts were not as high as hoped, but are certainly an improvement on the current situation.

The Fed Holds Fire
Citing the persistence of downward pressure on inflation, the US Federal Reserve left its policy rate unchanged in September. It seems likely that global economic uncertainties and market turmoil also tipped the scales towards a more dovish stance in what is a finely balanced decision process. On the one hand inflation remains low. Indeed the Fed has downgraded its own inflation forecasts from the June meeting.

However as can be seen in the below graph, much of the recent decline in inflation is estimated to have come from reduced energy prices and the rising US dollar, both of which are likely to be transient factors.

Why has PCE

Despite this the market continues to price inflation well below Fed forecasts. The below graph shows the inflation rates priced in US Treasury securities with an inflation protection mechanism.

US Breakeven

Monetary policy changes are estimated to take around 18 months to achieve their full effect. Therefore the Fed is looking well past current inflation data, and is presumably more driven by their own forecasts than market pricing. Furthermore the employment market remains strong, despite some weaker jobs reports in recent months.


This pictograph, produced by Bloomberg, shows some of the key employment indicators that would be monitored by the Fed. Many of these are at, or approaching, pre-crisis levels. The notable exceptions are the labour force participation rate and long-term unemployed share. These figures have been cited as reasons why wage growth and inflation have not risen, as there is a large group of workers ready to jump in to the employment market when an opportunity arises.

However the ratio of job openings to applicants is at elevated levels, and importantly whilst wage growth has been stuck around 2%, a survey of firms stating they plan to raise compensation is rising rapidly. The red line in the below graph shows the results of that survey, shifted one year forward to show how it is a strong leading indicator of future rising wages as demonstrated by three different measures.

US Wages

All this leads us to believe that the market is under-pricing the potential for wage growth and inflation to pick-up. Incidentally the potential for wage growth is also leading us to turn more cautious on US equities in the medium-term as the portion of economic growth going to capital is at a post-war high. A reversion to mean would entail a contraction in profitability.

Indeed the Fed is still indicating that it may still raise rates this year. From an equity market point of view there would possibly be relief over such a move, assuming that the language around future rate rises was sufficiently dovish. There is a perception in the markets that central banks are distorting asset prices, and a move to normalisation would signal faith in the US and world economy being able to grow in the future, a world where good news is good news. However one of the largest risks we perceive in the market currently is the growing disconnect between what the Fed is intimating, and pricing in the bond markets. Many bond traders feel that the market and economies are not ready for a rate rise, and will not be ready for some time. Because of the gap between market pricing of inflation and rates between the market and the Fed, there is room for a lot of volatility.

The below graph shows the now-famous dot chart of the Fed, which gives a kind of probability distribution of the pace of rate rises with each dot representing the forecast of an individual member on the FOMC. The grey line is the trimmed mean of these projections, and the black line is the market pricing of future rates. Traders’ bets following the Fed decision indicate they see interest rates only rising to around 0.7% by the end of 2016, about half as high as the median forecast from Fed policy makers. The gap is the widest since Yellen started her term in early 2014, and is of great concern. If the market ends up moving to what the Fed is pricing there will be a lot of volatility in the bond market, which will undoubtedly spill over in to the equity markets. This is a key risk which we are monitoring.

Market waging

Discretionary Portfolio Changes
In the Australian portfolio we executed the following trades:

In the International Growth portfolio we executed the following trades:

Please be in contact if you wish to discuss any of these themes further, or wish to make any changes to your portfolios.