Transcript: Five questions for the Chief Investment Officer - April 2019

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Victoria Place (VP): Welcome to Five questions for the Chief Investment Officer. My name is Victoria Place, and I'm a senior analyst working with our Chief Investment Officer, John Pearce, in the investments team. Hi, John.

John Pearce (JP): Hi, Vicki.

VP: John, when we met in February, we spoke about how the US central bank had moved from a stance of raising interest rates, to a neutral one. And I note since then, other central banks have changed their stance. Can you elaborate on the key drivers at play here?

JP: You're spot on, Vicki. We've had the Bank of Japan, the Bank of England, the Reserve Banks of Australia and New Zealand all moving in lockstep. And that's typical because the Federal Reserve of the US does set the stage. Why are they doing this? Central banks really respond to two key drivers. One is the real economy, because the real economy impacts employment, and the other is inflationary expectations. Now, the last time we spoke, we talked about how expectations of growth in the global economy were falling, IMF reducing forecasts, etc.

Another statistic that central banks look at is the Purchasing Managers' Index (PMI). It sounds technical, but it's pretty easy to follow. It's a survey of senior managers and it gets their expectations around key variables such as inventories and employment and the like. In one sense, you could see it as a confidence index about the future. If you look at this graph, it’s telling you that in the last half of last year—particularly the last quarter—confidence was really on the decline, and this frightened the central bankers. It was saying that expectations of the future were declining.

Purchasing-managers-index-USA-and-China

Now, a lot of it could be related to the trade war [between the US and China], so we have to watch the outcome of that.

The second point is inflationary expectations. Central banks typically target inflation of around 2%, because that's considered consistent with a growing, healthy economy. However, the fact is that they haven't been very successful in achieving this target. What are the expectations of the future? The best way to get that is to look at what the bond market has done, because if the bond market expects inflation to fall, people buy bonds because they want to lock in a return. What's happened to the bond market? It's actually collapsed. If you look at the Australian market, for example, in as little as four months from November last year, 10-year yields fell by 1% to a low 1.7%. This is quite dramatic. But if you think we're doing it pretty tough, think about other people in the world. We now have $7 trillion of bonds that are actually returning negative yields. Incredible.

Record-volume-of-negative-yielding-bonds

VP: So the bond market is rallying, meaning that bond yields are falling. This implies that we might have a recession. But then the share market is also rallying, implying that the outlook is good. This has been great for returns across the board, but which market is ultimately right?

JP: What a difference three months makes. If we were sitting here at the end of December, we would have seen a reasonably grim picture, particularly for growth assets. If you look at the 12-month return of some of our key options—international and Australian share options—very flat. Now, we roll the clock forward three months to the end of March 2019 and we see the returns. 

what-a-difference-three-months-makes

As you pointed out, it's been great for all assets.

Can these ‘Goldilocks’ continue? Can the bond and share markets hold their gains? The answer is yes / maybe. It really is contingent upon two key things. Firstly, we do need a resolution to the trade war and from what we hear, there is potentially good news. I think the market is building a bit of optimism. Indeed, if we look back on the PMI, roll the clock forward, have a look at it now—we see an uptick in confidence.

Purchasing-managers-index-USA-and-China2

So, as I said, we're getting a bit more optimistic. The second thing is that central banks around the world have to maintain their commitment to low rates. Not necessarily cut, but low rates and constantly providing the market with liquidity.

As an aside, I was in Hong Kong two weeks ago. We’re very fortunate at UniSuper—given the quality of our institution, we get to meet some key people. And in Hong Kong, there were two current Federal Reserve (Fed) presidents that are actually voting members of the Fed. I also got to meet Janet Yellen, who is the ex-governor of the Fed. I came away convinced that the Fed is going to stay on hold for quite some time. Indeed, I wouldn't rule out the possibility that the next move is a cut in interest rates in the US.

VP: You point to the need for central banks to remain accommodative by keeping interest rates low, but with interest rates already so low, how would they respond if the world does experience a recession?

JP: That's a really tough question, Vicki. Historically, central banks have needed somewhere between a 4% and 5% cut in interest rates to get economies out of a recession. But if your starting point is [interest rates at] 2% and you don't want to go negative—which I think is sensible, nobody should go negative—you've only got one choice, and that is quantitative easing, QE. A quick reminder about QE—interest rates is really the price of money, so when the price of money hits zero and you can't cut it anymore, you move to impacting the quantity of your money. And that's why we call it quantitative easing.

With QE, some will say, "Well, that's not such a bad thing because the last time we had QE, that was good for share markets. All this excess liquidity was just used to go and buy financial assets." That’s generally true, but it has its critics. The critics point out the fact that indeed, the beneficiaries of QE are those who own assets. What we're seeing here is the potential rise in inequality between wealth and income. We've seen a rise of anti-capitalism sentiments, we've seen a rise of populism and I don't think this is going away soon, and I think this could be another consequence of more and more of this easy money getting into the system. When the critics talk about inequality, they look at graphs such as this one. Since the 1980s, when we've had a long-term decline in interest rates, we've had growth in wealth that is far outstripping growth in incomes. That gap is a concern.

In-the-USA-wealth-is-growing-faster-than-incomes

History suggests that the best way to fix that gap is you have a revolution or a war—that's the best way to get rid of excess capital. Now, I'm not suggesting that anyone wants that—but suffice to say, I think it's in everyone's interest, even for those who own capital, to see a steady rise in incomes.

VP: Turning our attention to Australia, there's been a fair bit of commentary about the ‘per capita recession’ we're now experiencing. Can you explain this?

JP: When you think about the definition of a recession, it's two consecutive quarters of negative gross domestic product (GDP). And the definition of GDP? In simple terms, it’s the aggregate value of all the goods and services that we produce in a year. If you look at this graph, on a quarterly basis it's pretty impressive—for the better part of three decades we've experienced no recession. No consecutive negative quarters of GDP.

Real-GDP-growth-quarterly

But all we're seeing here is really an increase in ‘the size of the pie’. But as human beings, we're not just interested in the size of the pie, we're actually interested in the size of our slice of the pie. To get a better idea of what the size of our slice is, you divide that aggregate number by the population. After all, Australia's population has grown.

Now let's have a look at the picture once you’ve divided by the population. You're actually seeing a lot more negative bars there. In particular, you're seeing two consecutive quarters of negative GDP per capita—hence the term ‘per capita recession’.

Real-GDP-growth-per-capita

I do think it's another reason why the Reserve Bank of Australia is definitely on hold, with the next move more likely to be a cut than a hike.

VP: And lastly, John, the Federal Budget was announced last week and soon we'll be going to an election. Are we changing our portfolio positioning in response to the Budget or in anticipation of the election outcome?

JP: The short answer is no, Vicki. Having said that, from an individual member level, a change in government could have an impact. So if any of our members do feel that they could be impacted, I think it's important to seek financial advice. I'm talking more at a total fund level—at a macro level, we are not positioning our portfolios any differently. I'm much more concerned about global developments, as I think they are a much bigger consideration. I'm much more concerned about how the trade war or the ‘cold war’ between the US and China plays out.

It's always important to remind ourselves how important China is to Australia. Think of our top exports. In front of you here are three graphs: tourism, iron ore and education—China dominates.

China-is-our-number-one-customer

I could add coal and I could add gas and the story will be exactly the same—China will be either number one or number two in terms of our customer base there. So, while this might sound a little bit controversial, I actually think the policies emanating out of Beijing are just as important as the policies emanating out of Canberra.

VP: Thank you for answering these five questions, John. If you have any questions you'd like answered, please email us at superinformed@unisuper.com.au. Thanks for watching.


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