Today’s Top 10 is a guest post from Kiwibank chief economist Jarrod Kerr.
As always, we welcome your additions in the comments below or via email to [email protected]
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See all previous Top 10s here.
In my last Top 10, I talked about risks. All of those risks remain at large. Last week, we put out our outlook for 2019 and beyond, see Hood the hawks. And again, the risks were prevalent. 2019 will be another interesting year, and everything will play out in the financial markets. Investing in this world is particularly difficult. Here’s the Top 10 things worth watching, at any given point in time:
1) Treasuries, Tr(i)umphant Trumpisms, and fake Truisms.
US Government bonds, Treasuries, are the global benchmark for interest rates. Whether we like it or not, New Zealand interest rates, and therefore interest.co.nz, are benchmarked off US interest rates. The US bond market is highly rated and by far the largest, most liquid bond market in the world. Even after S&P downgraded the US in 2011, the market remains the most widely recognised for quality and depth. Until the US dollar is replaced as the global reserve currency, probably not in my career, the US bond market is the first market I look at every morning. And the US 10-year is the gravitational point on the curve. The chart shows the rise in US, relative to other markets, as US growth has outstripped others. Well, until next year…
An interest rate is the most beautiful of market beasts. An interest rate encompasses everything we know in financial markets. An interest rate includes expectations for future monetary policy, and therefore growth, inflation and a little forgotten something called term premium. Term premium is currently negative. You see, savers are meant to demand positive term premium for the time value of money. But as beautiful as the interest rate beast is, it can be manipulated. Quantitative Easing, is better known as the unbridled printing of money to buy all things beautiful – i.e. interest rates. QE slashed interest rates and slayed the inner dragon of term premium.
Interest rate strategists, my self included, have forecast higher US interest rates for years. I had forecast a “modest” rise in the US 10-year yield to 3.25% by year-end 2018. We got there in October. But the thought of even higher interest rates next year, with the Fed (dots) showing an expected 3.5% cash rate (more hikes), Tr(i)umphant Trumpisms on China, meltdowns in Europe, and the prospect of real disruption, have caused investors to flee equities for the safety of bonds. And yes, in bad times you buy US Treasuries first, other bonds second. Here we are with a US 10-year of just 2.9%. That 35 basis points miss on my forecast means I’m 35bps off my NZ Government bond forecast. So Kiwi bonds are 35bps cheaper at just 2.49%. Yes that’s a record low. We have data back to 1938, and long term yields have never been below 3% – the “low” recorded in 1947.
The most important gauge for US, and even global sentiment, is still the US 10-year. A yield of 2.9% shows a lack of conviction in future growth, and fear of contagion. Trump’s tax policies gave a sugar-rush to equity markets and expectations. The market is telling us the sugar-rush is coming to an end. Love him or hate him, there’s barely anyone in-between, Trump is a populist President at war with the world. And the world’s buyers of US Treasuries are hiding for safety.
If we end 2019 with a 10-year US Treasury yield of 3.25%, where I thought we’d be today, the world would have fought its way through its many challenges. If we end at today’s 2.9%, we will remain in disbelief. Anything below 2.5%, and we’d be facing a potential recession in the US, and abroad.
Let’s now look at the fake truism of the US Treasury interest rate curve shape.
2) The perversion of inversion.
The curve, normally explained by the difference in 10-year to 2-year interest rates, has been a useful leading indicator of recessions. The US curve is on the cusp of inverting. The 2s10s curve has dropped to just 13bps. So the US Government can issue 10-year debt at just 13(ish) bps above 2-year debt. And why wouldn’t they?
Historically, the 2s10s curve has inverted, when 10-year rates fall below 2-year, well in advance of recessions (see chart). It’s the market’s way of saying, short end rates (usually the central banks’ cash rate) is too high and the economy is expected to slowdown (or even crash) in response. Most market analysts believe in the religious-like signal of interest rate inversion.
It’s kind of like watching a prophet walk across your computer screen. A nice balancing (re-steepening, not inverting) of US interest rates is needed to stop trader talk of an inevitable recession. The Fed is now rebalancing expectations. If the Fed tightens too aggressively from here, all the hard work done to date would be undone. Not tightening any more, however, would be the signal of the end, and admission the economy is faltering.
So what the Fed should do is hike 2 times more to 2.75%, and pause. In the process of pausing, keeping short end rates where they are, they can simply allow their balance sheet to unwind. You know, that behemoth of a US$4trn balance sheet inflated by US$3.5trn of printed cash. Allowing the balance sheet to reduce, by letting owned bonds roll off and evaporate, will allow term premium to return out the curve.
The Fed believes the US2.5trn in US Treasury purchases took off over 100bps from the US 10-year interest rate. Some of that will return, steepening the curve (lifting 10s relative to 2s). That’s the genius. In stopping cash rate hikes, Trump will grow less aggressive against the US Fed. And a steepening curve will (hopefully) quell mechanical recession fears based on inversions. Normalising policy was always going to be like landing an A380 at Wellington airport with 8 on the Beaufort scale, earth shifting on the Richter scale, and concerns with runway length.
3) It’s the E in P/E that makes equities hard to value.
If interest rates aren’t exciting enough, well equities will be. The US S&P 500 will tell us most of what we need to know in the world of punting stocks. In terms of action, global foreign exchange markets see the most. Interest rate markets are a close enough second. And equities markets are a distant third. But we’ve all seen the movies, like Wall Street, and we have a love affair with picking stocks, like Xero! I have to be one of the worst stock pickers. If you hear of me buying a stock, sell it the next day. So I simply take Buffet’s advice, and buy the index. And the S&P 500 has been on a tear since Trump was elected. Well, it was, until October.
US corporate profits margins are at record highs. But expectations have turned sharply from expecting big profits, to expecting declining profitability. Trump’s policies inflated expected earnings (E) and fuelled the stock market. Tax cuts do that. But rising interest rates deflated expected discounted cashflows. Yes, everything comes back to interest rates.
Many managers have grown cautious with the expected rise in US interest rates and valuations were looking stretched in September. From here, the outlook is unclear. But the S&P 500 will tell us how the world is balancing out over 2019.
4) The Kiwi flyer gives us risk sentiment, globally.
Alan Greenspan famously looked at the Aussie and Kiwi dollar every morning. They would give him a quick idea on the state of financial markets overnight. If the Aussie and Kiwi dollars were up, it was a good night, risk on! If they were down, well, risk off and investors had run for the hills.
95% of trading in Aussie and Kiwi dollars is speculative, not required by actual trade in goods and services. Global investors, hedgies, punters and algorithms – you know, the machines – use Antipodean currencies to express global views. If the world is good, the Antipodean currencies will be higher. If the world is tearing itself apart, well, they’ll be pushed off a cliff. They’re also used as a proxy for Asia. You may not be comfortable in trading Yuan, for example, as the liquidity might not be good enough, or you might not like the fact it’s manipulated managed. But most of all, they have good history since floating in the 1980s. And it’s all about the data.
If you think the world is bulled-up and on a tear, geek talk for all-good, then you buy Antipodean currencies. Or, if you think the world is bulled-up and on a tear, and you’re limit long up to the eyeballs in equities, geek talk for you own too many, you may consider a hedge in Kiwi dollars. Why? Well if the world is good, you make money in your equities. If Trump hits a red button, then at least you’re “short” in Kiwi dollars pays off massively as you lose money hand over fist in equities. That’s a hedge.
So basically, if the Kiwi ends next year higher, we’re in a better world. Because we will be talking about RBNZ hikes in 2020. If the Kiwi ends the year materially lower, below 60c, then Trump didn’t make it onto your Christmas card list again next year. We have the most beautifully volatile currency in the world, and it tells us more than we like to admit.
Credit Suisse produces the best “risk sentiment” index in the world, in my opinion. And our currency leads their index. By the way, the Credit Suisse EM (emerging market) risk appetite index is in panic. There is contagion within the EM world that is linked to a stronger USD, higher US interest rates, and the end of QE (and thoughts of it in Europe). So that sucking sound you hear when you look up EM equities, is investors pulling out their funds.
5) EM contagion is not good, but expected.
My colleague Jeremy Couchman wrote a cool Top 10 on EM earlier in the year. JC spoke of Russian mules and Tequila slammers. It’s worth a look. And we’ll keep watching.
Concerns around future growth does not just centre on developed economies, with emerging economies having a tough time in 2018 – in particular Turkey, Argentina, Venezuela and Brazil. Emerging market currencies have plunged and falling commodity prices are ravaging EM current accounts. When the US Fed hikes interest rates, and the USD rises, there is much pain for EMs to bear. That’s because their debt is denominated in US dollars and we have seen USD strengthen through much of 2018. Debt repayments become more expensive and (unlike NZ), EMs bear the currency risk, not the investors. When their currency falls, the local currency amount of USD debt required to be repaid lifts violently. And global capital is a fickle beast. Interest rates have been trending higher in the US. Emerging markets must now pay up to convince investors to stay in EM. A cost they cannot afford without the nominal growth to pay for it.
6) Italy’s debt is too big to fail.
The ECB also wants to stop printing money (QE), and look to normalising policy. But we all know they are kidding themselves for now. They’d love to try and land in Wellington, but the control tower won’t accept old WWII planes running on one German engine (the other French engine is in flames), and without landing gear.
Europe is a never-ending source of uncertainty. The ECB has a negative cash rate, and may enter the next downturn without an interest rate lever. So they may actually have to embark on MORE money printing, not less. And when that fails, they’ll have to invent new unconventional measures. Why? Well Brexit is more of a UK concern, but shows the door to others. Italy’s newly formed populist coalition government is facing off with the European Commission (EC) over budgetary constraints, exposing a potential debt crisis in the making. Italy argues that years of fiscal austerity have unnecessarily weighted down growth, and they’re right. Italy wants to be able to break the shackles of the EU’s fiscal rules to reverse the post-crisis malaise.
Finance Minister Giovanni Tria is aiming to lift Italy’s 2019 budget deficit to 2.4% of GDP and the EC is not happy. Italian government bond yields have shot up in a sign of investor risk aversion, making it more expensive for the Italian government to borrow. Adding more concern to the mix has been the Italian banks (a banking sector that is shaky) increasing their share of Italian Government debt as foreign investors take flight. A broader concern is the rising risk of a debt crisis emerging that draws in the whole EU, as Grexit did. The level of Italy’s Government debt is eye wateringly high at over 130% of GDP – remember NZ’s is around 20%.
Another complication is that Brussels will not want to be lenient towards Italy, as it could open the door for other highly indebted nations (PIGS) to try and spend their way out of trouble. The faceoff could send Italy towards the exit door. An Italian debt crisis is worth keeping an eye on. Greece, or Grexit, was the decidedly harsh precedent set for this very reason. When speaking of PIGS, Greece is a rounding error in terms of debt (~85bn), whereas the PIS in PIGS are impossible to bailout. Italy has the 4th largest bond market in the world. It’s hard to write down over 3 trillion in debt.
So watch Italian interest rates. And Italian bond yields are higher, as investors dump their bonds in fear of not getting their money back.
7) It’s all about wage growth!
Weak wage growth has been the main source of frustration across most countries. And weak incomes have exacerbated inequality and caused the spike in populism and protectionism. The RBNZ’s dual mandate is a Philips’ curve. They must try to contain inflation near 2% over the medium term, whilst keeping the economy fully employed. Both inflation and employment are embodied in wages.
The strength of the Kiwi labour market confirms the strong economic growth already recorded. We’re growing at trend and will likely grow above trend next year. Inflation is finally running close enough to the RBNZ’s 2% year-on-year midpoint. Core inflation, which strips out volatile stuff like petrol, is a little more stubborn at 1.7%, but should move higher next year. The good news here, is wages are likely to rise in response to rising inflation.
Wage growth is starting to rise thanks to the tight labour market, and the start of large minimum wage hikes. Further large hikes are in the pipeline. Some chunky hikes to the minimum wage will be needed if the Government is to hit its target of $20/hr by April 2021. The labour market should play its part in lifting confidence and spending over 2019. We are picking that wage inflation will begin to accelerate from around 2%yoy now to 2.4%yoy by mid-2019. We see further upside into to 2020s, see LCI chart.
We’d argue good workers are much more likely to get wages rises next year, than when they asked in prior years. Go on, prove us wrong. It’s worth the chat.
8) We lack confidence!
Another thing we should keep an eye on is confidence.
Businesses continue to complain of sharp labour pain. Businesses complain of Labour policies and labour shortages. Complaints that have yet to translate into weaker growth. But votes of no-confidence in the Labour coalition may restrict investment. And at this point in the cycle,we need more investment. The important measure of firms’ “own activity” sits below average. There is an element of protest voting against Government policy. The uncertainty generated out of the Beehive has persisted all year, especially in regards to labour market reform, tenancy reform and taxation reform. However, the strong economic data fails to match the downbeat business sentiment. Nevertheless, if firms continue to express displeasure, we could see a reluctance to hire and invest. We need firms to hire and invest.
Consumers’ expectations of future conditions have driven confidence lower. In contrast to consumer confidence, the labour market is surprisingly strong with the unemployment rate dropping to 3.9% in the third quarter. Employment growth is robust, and the labour force participation rate is at a record high 71.1%. The third quarter figures may have overstated things a bit. But what is clear, is that people want to work, and they are finding work.
General uncertainty seems to be playing a larger role, rather than the reality on the ground. But poor consumer and business confidence can easing become self-fulfilling.
9) The 3 Ps of property are positive.
And of course we all have an interest in housing.
Population growth has slowed. Net migration is still elevated, but is gradually waning. In October annual net migration hit 61,700 a level last seen in 2015. And the down-trend now looks set in train.
The construction sector is no longer a primary driver of growth and hasn’t been since 2017. But tradies are still building full tilt, and will have to for the next decade to address the 100,000 housing shortage. The industry is unable to build at a much faster clip, given constraints on materials and staff. The high-profile failure of major construction firms, have only made matters worse.
Monetary policy is still in expansionary mode. The RBNZ even pushed the case for an OCR cut in August. We simply have a more dovish Governor. The stubbornly dovish bias is understandable given inflation has been too low for too long.- Extraordinary stimulus will remain in play. Mortgage rates hit historically low levels in November, as wholesale rates fell. The fall in lending rates is yet another positive development for households, with debt servicing costs down. And low rates support housing.
The housing market has entered a period of consolidation (see our Property Insight note for details). National house prices have risen just 4%yoy since mid-2017, and we expected prices to move broadly sideways for the next year or so. Meaningful house price appreciation is not expected until we approach the mid-2020s (see our forecast chart). We used a divining rod made up of the 3 Ps of property – population, preference and policy – to formulate our view. We modelled an undersupply in the order of 100,000 homes, and the shortage is likely to get worse before it gets better. Preferences are slowly changing too, in part by the shortage, and in part by demographic change. For younger buyers priced out of the cities, or boomers looking to unlock equity, the regions are increasingly attractive. And the regions are likely to continue to outgrow the cities in a period of catch-up.
The housing market is well supported, and unlikely to experience a sharp Australian-style correction, in our view. Mortgage rates are very low, and the unemployment rate has dropped to 3.9%. NZ’s population has outgrown the supply of housing for the last 10 years. And while population growth is slowing, thanks to easing net migration, it will continue to grow. Eventually, the current shortage in housing will be addressed, but it’s a fair way off.
The housing market has been contained by Government policy uncertainty and tough restrictions on investor lending. Investors are likely to stay cautious for a while longer. We still have a few policies in the pipeline, such as the removal of the negative-gearing tax loophole, and the debate around capital gains tax. The RBNZ has loosened LVR restrictions in November, see The RBNZ has lifted speed limits on lending. More easing will come. The minor LVR tweaks are unlikely to ignite loose lending or fuel house prices, the changes are for stability. Unlike Australia, our lending capacity has not been crimped by a Royal Commission.
10) The battle of two economic (and military) Titans.
The dispute between two economic titans worries all. The Trump administration’s ‘America First’ mantra is heard loud and clear. The Trump administration has pulled out of the UN human rights council, and stepped back from bodies such as the WTO and NATO. Trade disputes have started. To date, import tariffs have been lumped onto +US$250bn of Chinese imports. China has responded in kind. But on bilateral trade, China holds a losing hand. President Trump is threatening to increases tariffs on existing, and extent tariffs on an additional US$267bn imports if China refuses to alter its trade practices. Markets participants are rightly worried. The US-China trade spat is a moving beast, and markets still hold out some hope that a trade deal will be reached – similar to the ceasefire reached between the US and the Eurozone earlier in the year.
Talk from last weekend’s G20 produced a 90-day ceasefire. But the conditions of the ceasefire are near-impossible for China to accept in just 90 days, without losing face. The trade-dispute will most likely reignite in March. For NZ, the ongoing US-China dispute is concerning as we are heavily export reliant, and reliant on the smooth running of global financial markets. So far, the tariff wars are not yet reminiscent of full blown trade wars. The difference is country of origin. If a trade war were to develop, the US would start physically diverting trade away from China, not taxing trade. The potential for escalation scares us. The trade dispute is symptomatic of a larger, geopolitical, pushback on China. And we will hear a lot more about the Silk Belt and Road project, which excludes the US. The rise of China has coincided with a weakening in Western governments. The EU is dealing with their own mess, with French riots, Italian fiscal denial, and general weakness outside of Germany. The UK is paralysed into (and potentially after) Brexit. And even Australia has a new Prime Minister every year.
If left unchecked, we may find ourselves looking up at a full-blown trade war, geopolitical manoeuvring, and the end of the EU itself. It’s simply impossible to gauge the impacts, but they’re not positive. To date, the political resolve to hold trade and established regimes together remains.
We put this as a “thing to watch” in 2019. But it’s been a “thing to watch” since 2009, and may still be in 2029.