PWA June Market Commentary
The next Eurozone crisis may be building – “Quitaly”
One of the outcomes of the Quantitative Easing (QE) that has occurred since the 2008 Global Financial Crisis (GFC) is that anyone with investments has seen their wealth grow, while those without investments have struggled. This has led to the gap between the “haves” and the “have nots” increasing substantially.
In the democratic world, where the majority can vote for change, the widening gap has led to a rise in power for the “populist parties”. The most recent example of this is in Italy where the Five Star Movement and Lega parties have formed a coalition and are now sworn in as the new Italian government. Both these parties have come to power on the back of campaign promises to address Italy’s debt levels and the perceived Eurozone imbalance that the country suffers from. Both parties are also seen as “Euro-sceptics”.
The coalition did not get off to a good start with their first choice for new Finance Minister, Paolo Savona, being vetoed by the Italian President Sergio Mattarella. This led to a massive spike in Italian bond yields (chart below) and a drop of over 20% in Italian bank share values as the markets priced in higher political uncertainty; and the increased potential for a new Italian election which could end up being a proxy vote as to whether Italy would stay or exit the European Union.
There was also a leaked document (that was quickly debunked) that suggested the new coalition may be planning to go to the European Central Bank (ECB) and request forgiveness of some of the US$2.4 trillion that Italy owes.
Since the GFC we have had many new acronyms being invented, on the back of the instability in Europe, such as Brexit (Britain leaving the Euro), Grexit (Greece almost left the Euro), Frexit (France almost left the Euro), and now we have Quitaly (Italy potentially quitting the Euro).
The chances of Italy leaving the Eurozone are small, but the ramifications if they were to try to do so would be a major blow for the continued stability of the Eurozone. So, what would an investor in the BBB rated debt of Italy expect to get paid for taking on this higher level of uncertainty? How does 2.54% gross per annum for the next 10 years sound?
Market commentators all seem to agree that this low yield is not commensurate with the underlying country risk, but that financial markets will continue to purchase Italian debt on the back of support from the ECB, who currently holds €340 billion of Italian Govt Bonds. The ECB can (and likely will) purchase more Italian bonds to assist in keeping Italian interest rates low. However if uncertainty continues we may still see the Italian 10-year bond yield move as high as 5% over the next 12 months, before the ECB would be forced to step in.
US government bond rates move higher
As unemployment in the US falls to the lowest level seen in decades, inflationary pressures continue to increase. The US Federal Reserve (the Fed) is continuing to increase the Federal Funds Rate (FFR). The FFR moved from a high of 5.26% in 2007 to a low of 0.07% in 2014. The FFR started increasing again in early 2016 and is now at 1.70% with commentators forecasting that the rate will move a further 1% higher over the next 12 months.
The Fed is also continuing to remove the QE stimulus, at a pace of US$30 billion per month, increasing to US$50 billion per month later this year. To date the Fed has removed a total of US$188 billion, which has reduced the Fed’s total assets from US$4.5 trillion to c.US$4.3 trillion. They will continue to remove stimulus until their balanced sheet is “normalised”. What normalised means is still unclear, but the removal of these funds is removing some of the pressure that kept interest rates lower.
US Federal Funds Rate
Share markets remain uncertain
In February 2018 share markets declined across the world as investors started to price in rising uncertainty around rate rises in the US. New Zealand (NZX50) largely missed the initial sell off, due to the market correction occurring over a period when the markets were closed (Waitangi Day).
The US economy continues to grow and may reach 4% GDP growth in the coming quarter. Earnings growth on the S&P500 has grown 24.6% y.o.y, and unemployment is at record lows in the US. Given this, why are some commentators forecasting a decline in share markets?
Share prices reflect what investors are forecasting will happen in the future, hence current financial data is not as relevant as what might be expected. Given the accelerating nature of the US economy, interest rates are likely to be raised by the Fed, which in turn may cause a slowdown in both the share and bond markets.
Global Equity Markets – local currency
Cost of borrowing closer to home
Domestic banks typically raise a large percentage of the funds they lend from offshore. As the London Inter-Bank Offered Rate (LIBOR – which is the daily cost of banks’ lending funds to each other) has increased so has the cost of borrowing funds from offshore for the local banks.
We have heard anecdotal evidence that around 25% to 30% of the total New Zealand bank lending book is raised from offshore lenders at present. This means that interest rates on mortgages in New Zealand are likely to move higher as interest rates increase in the US.
To date we have seen little movement in the shorter term domestic mortgage rates (in fact the 1-year mortgage rate has moved lower over the past two months). The banks’ ability to keep mortgage rates on-hold as offshore rates rise has mainly been due to the recent decrease in demand for borrowing, as well as the Official Cash Rate (OCR) remaining anchored at 1.75%.
We expect this period of low mortgage rates to end soon as interest rates offshore continue to rise and the RBNZ finally starts to increase the OCR in early 2019. If the global LIBOR rate continues to climb then funding for all banks, both locally and globally, will become more expensive and mortgage costs could move higher sooner than expected.
Kiwis continue to have a love affair with local property, which is understandable when we consider the performance of this asset class over the longer term. Domestic property has been a stellar performer, but more recently we have seen the heat come out of the market with Auckland house prices only up 0.9% year-on-year. We expect that rising interest rates, and pending changes by the government, may continue to provide a strong headwind to further growth in prices through 2018 and into 2019.
Data has historically shown that household debt in New Zealand is around 170% of household income. In data released from ANZ Research last month (which removes home owners that are debt free), we can see that if we focus on home owners with debt, the percentage has increased to 325%. This highlights the high level of debt those with mortgages on their property carry, and how any rate rise will likely have a meaningful impact on their interest costs as a percentage of the borrower’s disposable income.
Australian banks under the microscope – Part 2
Last month we discussed some of the findings from the Australian Banking Royal Commission. This month in part two of a review of this process we focus on the Commonwealth Bank of Australia’s (CBA) breach of their requirement to positively identify their clients, and report on suspicious transactions, under the Australian Anti-Money Laundering and Countering the Financing of Terrorism Laws (AML/CFT) – an Act we also operate under in New Zealand.
Within the finance sector criminals are always looking for easy and cheap ways to launder (clean) their proceeds from illegal activity. As reporting requirements around suspicious transactions have increased it has become harder for criminals to clean their funds, as is apparent in some of the more famous drug raids where large piles of cash are found. One of the simplest ways to clean proceeds from crime would be to deposit the funds into a registered bank account and then redraw them as clean funds. This was stopped and regulated a long time ago, or so we had thought.
According to findings from AUSTRAC, which is an intelligence agency responsible for monitoring AML/CFT breaches, CBA failed to monitor 778,370 cash transactions through their so called “intelligent deposit machines” over a period of three years. Of these transactions 53,506 were for $10,000 or more, which are required to be reported within 10 business days, something CBA has failed to do. CBA was also found to have failed to perform suitable checks on 80 suspicious customers.
CBA has agreed to pay a fine for these breaches of AU$700 million, which is the biggest fine in Australian corporate history. CBA’s share price has fallen over 13% since the start of 2018 and is down almost 27% since its high in early 2015.
There are many further stories around poor governance from executives, misleading behaviour from advisors, and even poor conduct from the financial regulators who were supposed to be protecting investors. The banking inquiry is continuing to shine a light on these behaviours and we would expect to see further fines (and possibly criminal charges) for institutions, which will hopefully force the industry to review their practices and become genuinely client focused.
The stories coming out of this enquiry underscore why we are proud to be independent with our advice, and why we have designed a business where the client is put first in all engagements. The enquiry is far from over, with no doubt many more revelations (and Director/Executive resignations), however it has posed the very real question of “can vertically-integrated organisations both manufacture product and provide advice that is in the best interest of investors?”.