Moving with the times

With a lurch towards political populism and isolationism to a degree not seen for decades and a growing divergence in global monetary policy, the KangaNews DCM Summit gathered a group of leading market economists to gauge the state of play in geopolitics and ponder the potential impact on markets and economies.

PANELLISTS
  • Stephen Halmarick Chief Economist COLONIAL FIRST STATE GLOBAL ASSET MANAGEMENT
  • Su-Lin Ong Chief Economist RBC CAPITAL MARKETS
  • Matthew Peter Chief Economist QIC
  • David Plank Head of Australian Economics ANZ
MODERATOR
  • Craig Michaels Director, Sovereign and Public Finance Ratings S&P GLOBAL RATINGS
PARSING TRUMP

Michaels There is much for markets to digest in the geopolitical arena, including the rise of populism and nationalism in various parts of the world. Let’s start with the US. One of the anomalies of the Donald Trump regime so far has been that risk markets are almost universally positive while bond and currency markets – and also many economists – have remained more conservative. What is behind the disparate responses?

ONG There are a number of factors. Following the US election, the theme was risk-on and bond and risk markets reacted accordingly. Over time uncertainty has grown in regard to policies, timing and details and this has delivered some caution. However, the general trends are moving in the direction one would expect with regard to broader reflation, and really this comes down to two key factors that ebb and flow at different times.

The first relates to data, specifically that US data continue to print extraordinarily well. With the raft of strong labour-market and consumption indicators, the pickup in wages and confidence indicators at multi-decade highs, it is easy to see why risk appetite in equity markets is strong and why there is trepidation in bonds.

The second factor is the Federal Reserve (Fed). A much clearer picture has emerged during February and March when it comes to the path to normalisation and an increase in rate hikes.

Over the last few months, while there have been periods when risk and bond markets have moved in opposite directions, overall the data, the global backdrop and the Fed rhetoric have made it relatively clear that asset markets are well supported in risk terms and that bond yields will climb higher. There are likely to be setbacks and uncertainty but the broad trajectory, for us, is very much the improving picture.

PETER There was a disconnect between the bond and FX markets and equity markets. When there was a ‘bad Trump’ episode bond yields and the US dollar fell but equity markets played to their own dynamic and continued to rise. There has certainly been an element of short-run profits driving the equities dynamic. But picking up on what Su-Lin Ong said, what has markedly changed is the dynamic between the market and the Fed.

Until about the middle of February the Fed was conditioned by the market so that if the market spotted a bad event around the corner it would expect the Fed and other central banks to come to the party by easing monetary policy. Consequently, bond yields and the US dollar would fall.

This has changed substantially and now the causation is the other way around, with the Fed leading markets. In the eyes of the Fed, the US economy is fundamentally sound enough for the central bank to be able to engage in a more strategic approach to monetary policy. So it can plot a more steady profile of rate hikes rather than being governed by the week-by-week data.

This means that if there is anything other than a major risk event the market can no longer rely on the Fed moderating its position to anything other than a gradual but steady increase in rates over the next two years.

SU-LIN ONG

With the raft of strong labour-market and consumption indicators, the pickup in wages and confidence indicators at multi-decade highs, it is easy to see why risk appetite in equity markets is strong and why there is trepidation in bonds.

SU-LIN ONG RBC CAPITAL MARKETS

Michaels How much of this has been driven by the Fed proactively reconditioning markets’ expectations around the most recent hike?

PETER Lots, and the difference in expectations is amazing. Going back a month or so the market was factoring in a 30 per cent chance of a Fed rate hike in March. This moved to 100 per cent rate probability of a March hike and to a lift in the Fed ‘dot plot’. But the Fed didn’t deliver on increasing the number of rate hikes, with Janet Yellen at pains to hose down expectations and the market getting ahead of itself. The market responded immediately, bringing a complete switch in the interaction between the Fed and the market.

PLANK What is important, though, is despite where the market expects the Fed to end up the 10-year bond yield hasn’t sold off beyond this level. This means the market is still of the view that the Fed funds rate will end up somewhere between 2.5 and 3 per cent. This is important. If these expectations move much higher the long-end of the curve will sell off. If they don’t, we could see a repeat of the 2004-07 cycle where the Fed kept hiking and the long end essentially did nothing.

What matters for the long end is market expectations around where the Fed will end up over the medium term, rather than whether the Fed’s next hike will be in June or July.

Michaels Could Trump's policy be the trigger for markets reassessing where long-term rates are going?

PLANK I think it could – if we ever find out what he is going to do! Of course, the unknown is the extent to which Trump will move on fiscal policy. The area will be constrained. Don’t get between a Republican and a tax cut! So I’m sure there will be tax cuts. We know there’s a lot of contention on the infrastructure side so whether Trump can get this through remains very unclear.

ONG You would have to think there is some upside to the Fed’s dot plots. Yellen and the Fed have made it clear that this is their base case at the moment. It does not assume fiscal stimulus, in whatever form it may take, and the timing is uncertain. But as the year unfolds there has to be a risk that this is taken into account, that growth and inflation forecasts are revised higher along with the dot plots. I expect this to be the focus for the next six months.

HALMARICK The aspect of Fed policy we haven’t talked about yet is the balance sheet. In December 2016, the Fed was looking for three rate hikes in 2017. We have already had one, partly because there are only really four live ‘press-conference’ meetings in a year. If the Fed is planning three rate hikes it has to hike at the first opportunity in order to leave one of those press conferences to discuss the balance sheet.

With two rate hikes still to come, I think the Fed will move in June and either September or December, and the other will see Yellen detail her plans for the balance sheet. Yellen’s term expires in February 2018 and one has to imagine she is unlikely to be reappointed. She is unlikely to want to leave balance-sheet readjustment to her successor – as who Trump might nominate is unclear.

What is clear, though, is that before the end of the year we should expect a very detailed blueprint on the wind-down of the balance sheet.

STEPHEN HALMARICK

We have to play the ball and not the man. Trump will make crazy statements like ‘Obama wiretapped me’ but we have to see through this to try to predict where the economy and financial markets are going.

STEPHEN HALMARICK COLONIAL FIRST STATE GLOBAL ASSET MANAGEMENT

Audience question Most observers seem to be too focused on Trump’s politics and not
on US economic fundamentals, which still look okay. For instance, S&P Global Ratings has not taken any rating actions on the US which would suggest the fundamentals are stable. What are panellists’ views?

PLANK I think there is a massive disconnect between the analyst, business and consumer communities. I think the upside risks to US growth are very real for this year. The US numbers will be fine for the next 12-18 months but, as Su-Lin Ong mentioned, the policy-mix risks are in the medium term.

Every time we get a series of Fed rate hikes eventually we start to see a reaction where the US data start to turn down. We have some way to go yet, but if US rates start to rise there could be negative implications for US data.

HALMARICK I have US rate hikes in my forecasts this year, 2018 and 2019, but if the Fed funds rate reaches a peak of 2.5 per cent, bond yields will move higher and the US dollar tighter. These financial conditions will lead the Fed to cut rates in 2020.

ONG I have US rate hikes in my forecasts this year, 2018 and 2019, but if the Fed funds rate reaches a peak of 2.5 per cent, bond yields will move higher and the US dollar tighter. These financial conditions will lead the Fed to cut rates in 2020.

GEOPOLITICAL RISK

Michaels Markets breathed a sigh of relief at the outcome of the Dutch elections, but with French and German polls later in the year it is probably not an overstatement to say that the future integrity of the Eurozone hangs in the balance. In the US, there is the potential for trade policies to turn against China and Mexico. How should economists – and markets – be thinking about these kinds of geopolitical risks?

HALMARICK The immediate reaction to Trump was that it was unexpected and a big change. For the first 12 hours we saw panic in markets, but we all woke up the following morning to find markets had rallied.

To use an Australian term, we have to play the ball and not the man. Trump will make crazy statements like “Obama wiretapped me” but we have to see through this to try to predict where the economy and financial markets are going – to help our clients invest their money. We are more focused on what policies Trump might implement and what they mean for
the potential growth rate of the US economy.

It is difficult, but we have to ignore some of the craziness and focus on what’s getting done and what’s good for the economy. Volatility in markets is near all-time lows, just about, which is a very important factor to consider.

The Dutch pulled back from falling to the extreme right and the opinion polls – for what they are worth – say Marine Le Pen will not be the president of France. In Germany, the alternative to Angela Merkel is better than we previously thought.

PLANK As always, you have to establish a central scenario and then look at the risks around it. It is important to consider whether these risks are sufficiently large to affect the main scenario. In my view, they are not.

My view on Trump has always been that he had two options. He could either keep fighting the establishment, banging his head against a wall. Or he could drop some of his more extreme positions and become more mainstream. He likes doing deals and so he will, I think, fall into a centrist camp with the odd tweet to remind us he is a bit extreme. He has shown this already on foreign policy and I expect it will occur in domestic policy as well.

I was never particularly worried about the very extreme behaviour – actually, even on the trade side. But there is something more concerning in the longer term. Trump is focused on protecting the status quo with the bulk of his commentary related to the firms that are already in existence, not those that are yet to be born. But it is new entrants that create productivity. Thanks to Justin Wolfers for highlighting this. For this reason, I think Trump’s presidency will probably be bad for US productivity and longer term I think Trump is a risk.

MATTHEW PETER

We have modelled a downside scenario in which China growth falls below 5 per cent for three years. In this scenario, the Australian economy falls into recession, the RBA cuts rates to 0.5 per cent and the Fed reverses recent rate hikes.

MATTHEW PETER QIC

ONG If you look at whatever form some of the Trump policies take when they come into being, they are probably net positive for the US economy for the next couple of years. But whether the same policies are good for productivity and lift long-term potential is more questionable. It is here where we are more cautious in our outlook for US growth, on the implications for where the Fed funds rate ends up and the direction of global rates moves.

PETER We have three major risks that we are looking for: Europe, the China and emerging-market hard landing, and the breakout of a trade war prompted by Trump’s policies. At the moment, we have each of these modelled in our suite of scenarios and we assign them an even level of risk – at 10 per cent each. For Australia, without a shadow of a doubt the most devastating would be an emerging-market or China hard landing.

The risk-associated trade-war breakout sparked by Trump policies depends on who joins in and how large it becomes. We have modelled a 40 per cent tariff hike – which was Trump’s stated policy – as an extreme scenario on Chinese imports and a roughly 40 per cent tariff on Mexican imports, with practically full retaliation by China and Mexico.

In a situation where this type of trade war would be sparked, it is really devastating for Mexico. Mexico is very exposed to and has a massive trade surplus with the US, so if it retaliated with hikes on US imports, which are still substantial for the Mexican economy, this would drive price levels through the roof. The currency would devalue but at such a rate that pressure on inflation would start to see capital flight and the Bank of Mexico would have to raise interest rates. This scenario would be devastating for the Mexican economy, and for this reason the US is pretty safe in putting tariffs on Mexican
imports without too much fear of retaliation.

On the other hand, trade is far more balanced between China and the US. China has a modest trade surplus with the US and the US a modest trade deficit with China. However, if China retaliates this neutralises the impact on each country’s trade account and the US fails to achieve a competitive advantage for its domestic industries.

In this scenario, we see the renminbi appreciating by about 3.5 per cent but the impact on growth would be more substantial, with both the US and China experiencing around 0.5 per cent loss in GDP growth over the next four years. It also drives inflation higher, so the US inflation rate is about 30 basis points higher per year in this scenario. Because this scenario is negative for growth and positive for inflation it is bad news for the US equity market, leading equity prices to fall by 7-10 per cent. This is the type of scenario that is possible with a trade war and, if generalised globally, things could get pretty ugly. But at this stage it is unlikely the scenario will be generalised outside of the specific countries discussed, largely because of the risks to the major players.

Forever bursting bubbles

Global investors tend to view the local housing market as a key downside risk for Australia. Economists insist there is little more to worry about than pockets of weakness. But with many moving parts future risks are not insignificant.

MICHAELS Is now the time to consider property as a key risk to the Australian economy?

HALMARICK What is true is that for about the last 25 years we have been told there has been a housing bubble in Australia, particularly by overseas experts. They have been wrong for 25 years and they are still wrong.

This is not to say there are not pockets of problems, for instance an oversupply of apartments in Brisbane city centre. But the main problem in Australia is that there is more demand than supply of residential property, and of the right type of property.

Offshore analysis focuses on debt-to-income as being very high in Australia – 180 per cent or thereabouts – and admittedly this is very high compared with global averages.

But this refers to gross debt and entirely misses the point on the net-debt side, which is that the way our mortgage market works is very different from others around the world.

Most Australian mortgages are variable rate, and as interest rates have fallen so people have repaid their principal much faster. This means there is a large pool of equity redraw and offset account balances available. If you include this, net debt to household income has effectively been flat for the last decade.

I recently saw a newspaper article that said millions of Australians will face household ruin if interest rates go up by just 3 per cent. There is no way interest rates are going up by 3 per cent in the near-to-medium term! Our view is we can expect an interest-rate rise probably in the middle of 2018 when the Fed funds rate hits 1.5 per cent or when it goes above the Australian rate.

There are some problems in the system – house prices are rising quickly and bank lending is growing quickly, perhaps too quickly. But we know that the reserve bank and the regulator are on point. Is this a systemic problem? I don’t think so.

CHINA IN FOCUS

Michaels It seems clear markets haven’t priced in these sorts of scenarios. A year ago markets were assuming the China hard landing was here. Now markets are more sanguine on China, notwithstanding that authorities are still targeting growth of a similar level to last year, and the level of corporate indebtedness is still huge. Why aren’t markets as concerned about China as they were in parts of 2016, and should they be more so?

ONG There are probably a few reasons. Chinese data in general, like a lot of global data, have been reasonably firm. The economy has come into 2017 with a reasonable degree of momentum and it is possible to see this across a range of indicators from the PMI to production data and sales numbers. The data is suggesting a fair degree of comfort about growth.

Second, this is a key political year for China, which makes us suspect that the adoption of 6.5 per cent as a growth target is somewhat of a goldilocks figure. It is not so high that we worry about further acceleration in credit growth and not so low that we worry about growth in general. There is a sense ahead of the People’s Congress later in 2017 that this is very much a year in which stability is the focus.

For these reasons, at this juncture markets appear to be reasonably relaxed – although I don’t believe they can afford to be. We know this can change very quickly. For China, the key is the ongoing trade-off between growth and reform. This ebbs and flows and we saw this throughout 2016 – it also has potential consequences across the globe and especially for Australia.

HALMARICK This time last year we were all in a panic that 2016 was going to be the year that China blew up. There is always lots to worry about with China, but actually there is lots to worry about everywhere. Certainly, the keyword for this year will be ‘stability’.

Last year, when things looked like they were about to go off the rails, the Chinese authorities responded – aggressively at times. This year they will need to keep everything well contained, because of the political changes later in the year.

China has the long-term target of economic reform with the goal of making it more consumer- and services-led. But the long-term target never stands in the way of ensuring growth is where it needs to be today and that the system remains intact.

We are not expecting a Minsky moment this year in China, but as the years go by pressures will continue to build.The Chinese authorities have shown they have a good handle on how to manage this process, though.

Michaels It seems to me that when markets get skittish about China it is often because while the authorities have one plan they are trying to implement, for instance liberalising the currency regime, markets take a very different view about what the ‘real’ intentions are. Is part of the problem to do with communication?

PLANK There were obviously some issues around the currency regime which raised concerns. However, as time goes on what we’re seeing is that each time China wants to stimulate it gets less of a multiplier effect. So, the amount of credit it needs to pump in to get growth at 6.5 per cent is a lot more than it was a few years ago to get growth to 8 or 9 per cent.

This demonstrates the strains in the system are building and even with good communication and solid policies at some point these pressures become impossible to manage. The unknown is whether this occurs in five or 10 years’ time or in a timeframe that affects forecasting over the next period.

Michaels Clearly Australia has strong trade links with China, and these put Australia very much front and centre of the ‘risk tsunami’ if there are problems in China. Is this the correct way to think about the Australian economy’s exposure or are there reasons to think it could be reasonably resilient even to a downside-China scenario?

PETER As a large institutional fund manager, we spend time exploring the downside and upside scenarios as well as our central case. The reason is we have investment teams with long-run investment horizons in real estate, infrastructure and a defined-benefit portfolio for the Queensland state government.

For asset managers, changes in regime are very important and it is certainly the case that Australia is hostage to a shock to China and emerging markets. Where this can come from has already been alluded to – that is, the unsustainability of the current policies that the Chinese undertake to support growth.

They are forced to support further infrastructure spending and the property market, leaving them to support inefficient and unprofitable state-owned enterprises (SoEs) which dominate the economy. These SoEs have to borrow from banks at low interest rates that are set by the authorities, which in turn puts downward pressure on the renminbi. The threat of devaluation prompts capital flight and, as David Plank has said, at some point this is unsustainable.

Because of this risk, we have modelled a downside scenario in which Chinese growth falls below 5 per cent for three years. In this scenario, the Australian economy falls into recession, the Reserve Bank of Australia cuts rates to 0.5 per cent and keeps them there until the end of 2019, and the Fed reverses out its recent rate hikes and keeps the Fed funds rate at zero until 2018. The probability of this scenario occurring in my view is somewhere around 10 per cent. Is this something we want to ignore? Probably not.

DAVID PLANK

Each time China wants to stimulate it gets less of a multiplier effect. So, the amount of credit it needs to pump in to get growth at 6.5 per cent is a lot more than it was a few years ago to get growth to 8 or 9 per cent. The strains in the system are building.

DAVID PLANK ANZ

Audience question After the election results in Austria, the Netherlands and, closer to home, in Western Australia, is it too early to say that the high watermark for the populist right has passed?

PLANK Yes! It is interesting to remember that the national polls in the US were correct. They had Hillary Clinton winning the national vote by 3 or 4 per cent – and she did. Where the polls were wrong were in a couple of specific states where Trump won by a net total of 80,000. It wasn’t an overwhelming victory by Trump, despite him talking it up to be one.