The US Federal Reserve has announced a tilt of $400bn of its $2tr+ portfolio of securities away from short term and into long term securities. This has reduced interest rates to multi-decade lows and increased bond prices at that duration.
The news headlines today suggest the market fell because of the Fed Governor Bernanke’s comments that the US economy was in trouble. This is a “Duh!” level statement, as “operation twist” to twist the interest rate market would not have been done if the market were in good shape. In addition, this was a widely expected outcome, which means that many people would have been moving out of the sharemarket and into the bond market to take advantage of the large short term gains. This hot money will inevitably move back into the sharemarket in the short term to take advantage of what will be an even bigger arbitrage of long term income expectations of profitable companies versus fixed income investments.
In other words, the market price movements are most likely predicated on the movements of highly speculative traders and represent little in the way of fundamentals.
Here is the look of last nights market movements for Australians today (from the Bell Potter update)
Of course, there is data and there is data. Here is a snapshot from todays’ web-IRESS screens, showing the percentage moves for US bonds. Imagine agreeing to a return of 1.86%pa for 10 years, with no upside unless the interest rate falls…
Meanwhile, Australia’s RBA had Mr Ric Battelino tell Americans that the outlook for Australia remains very strong and we don’t really want to reduce interest rates. Here is an excerpt from his speech, in which he pondered how Australia’s outlook appears to be diverging away from that of the United States :
Certainly, by the first decade of this century, the paths of the economies had clearly diverged. Whereas the United States experienced recessions in 2001 and 2008/9, the economic downturns in Australia around those times were relatively mild. It has been 20 years since the Australian economy experienced a year of negative growth. This represents the longest period of uninterrupted growth in Australia’s economic history, and one for which there are few precedents among the developed economies.
Dr Lowe (Deputy Governor RBA) tells us that Australians are moving back to “traditional” levels of savings – basically very elevated levels from where we were in the early 2000’s. This should make the country even stronger and more resistant to overseas turmoil. In fact, even the fall in retail sales doesn’t necessarily presage a dying economy or terrified citizens… again, an excerpt from Ric Battelino’s speech:
The one area of the national accounts that surprised was the strength of household consumption. Retail sales had been subdued through much of this year, and this had generally been taken as a sign of weak consumption overall. But the national accounts showed that household spending on services has been strong. Households are spending more on entertainment, eating out and travel, particularly overseas travel.
What are we to take from this?
Let’s Get Pessimistic for a Moment…
My interpretation is that the economy is not being correctly reflected in the sharemarket, and that long term wealth accumulation can continue at current levels. There remains elevated risks of short and sharp downward movements owing to the inability of politicians globally to formulate and pass economy enabling legislation. However, for long term accumulators this is merely the latest worry out of the continuous worries of the past 200 years or so.
The tail end risk is a large sovereign default leading to the much-hyped “contagion effect”. Greece is the name in the news and it might be them but so many people are watching them, and their respective size is so small that my thoughts would be any such shock would be from an unexpected area. This tail end risk is of a very small probability. However, its outcome would be of such a large impact that i believe it is virtually impossible to plan for – if the EU were to break up (as an example) in a disorderly fashion then our theoretically strong and well capitalised banks would struggle to find their required annual funding, leading to strong restrictions on lending. Even stronger than those in force for businesses and self-employed today, and most likely including those comfortably employed and the residential property market. This would cause a large downshift in employment and house prices, causing a spiral of US levels. The self-feeding spiral downwards would not be pretty, and the deflation supporters such as Bob Prechter of Elliott Wave fame would see their doomsday scenarios fulfilled. At that stage, not even gold would keep its value and cash would be of less value in an uncertain world (believe it or not).
It is my belief that this tail end risk is almost impossible to plan for. Moving the entire country to cash is hardly an option, and buying puts for such outcomes has become very expensive – meaning people will not pay that much money to secure their portfolios even if they expected large drops in prices.
If we are going to forecast tea-leaves then my genuine fear is that the global dislocations currently under way will lead to major wars. I completely understand that this is an extreme view when considered from the safety of our little continents’ shores. However, large social disparity causes emotive reactions to otherwise logical positions, and single-issue crusaders get more lattitude and audience than they or their ideas deserve. This allows demagogues free reign, with all of the chaos in outcomes that such folks always engender. Just consider the United States, which has allowed income disparity to reach horrific proportions that the country is moving further and further towards being little more than a capitalist aristocracy – 46 million (!) people are currently eking out a living below the poverty line, measured as less than around $22,000 of income a year. All of the major Government and statutory authority moves post GFC have been to the benefit of the “haves” at the cost of the “have nots”.
What If We Are Optimistic…?
So how is the average person to take all of this in?
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Ok. So how is an optimistic person to view all of this? Well, you’d have to say that it is a short term opportunity to accumulate quality long term assets at a good price.
If the financial fabric of our world does not fall apart, and if the global dynamics of a huge population with associated hunger for basic raw materials and foodstuffs continues – then it is reasonable to expect that prices for these goods will rise in the face of increased demand. Alternatively, you could look at it as a matter of long term returns on capital. Debt has a cost, and in Australia the cost of debt remains at “standard” levels, which means that the potential capital return required for all those debts to be repaid must remain above that level or all those debt laden folk are going to go broke – which wouldn’t be a great outcome for the country. So, those folks are going to be pushed to work harder, think more, innovate more and knuckle down to the job of making “stuff” or selling stuff at a higher price than they pay. That’s basic, i know. However, the point is that the potential “equity premium” in the USA can be considered to be limited – long term debt is at 60 year lows, so folks don’t need to earn much to pay the interest and keep going. That is supposed to stimulate riskier investments but i’m not thoroughly convinced that this is a logical expectation.
Of course, there will be the experts that come our of the woodwork, telling you that long-held financial basics are “old economy” and that you need to send them money/ referrals/ website hits or whatever else, so that you can be lucky enough to share their insights into the future. Insights that will ensure you miss the duds and own the profitable assets. Not just that – but being sure to buy the right things at the right time, and sell those right things at the right time. If i sound cynical then take it that i am. i consider myself relatively up-to-date in money matters but that doesn’t mean a thing in the face of “Black Swan” type events and times. The best research doesn’t guarantee anything when you are trying to trade in and out of assets and making high levels of selection risk. That is, and has always been, called speculation. It is NOT investing, and the confusion over this concept is fundamentally instilled in the financial world of today. At least, that’s my opinion and i’ve been wrong before, so feel free to ignore it.
IF you are optimistic, and if you can take care of your daily income to buy your daily bread THEN you are likely to find that any genuinely spare income you can throw into well-diversified, long term profitable assets should provide you with a return at least in line with that found when measuring the last 100 years in rolling 10 year periods. If that isn’t a long term outlook then i don’t know what is.
Of course you will find that any attempt you take to identify suitable places for your money will bring up the age-old issue of what to do buy. And that, i guess, is the $64 question.
RBA speech by Ric Battelino http://www.rba.gov.au/speeches/2011/sp-dg-210911.html
RBA speech by Dr P Lowe “Changing Patterns in Household Saving and Spending” http://www.rba.gov.au/speeches/2011/sp-ag-220911.html
Elliott Wave http://www.elliottwave.com/