Friday's 'relief rally' in US and Australia probably premature

After record losses on Thursday, the Australian market started out badly on Friday but then recovered (and actually ended with slight gains) in the afternoon. Then the US market did quite well in Friday trading, recovering a large fraction of Thursday's decline. As usual, market commentators attempted to attribute the market movements to one 'sound bit' cause - in this instance the 'prospect' of the US congress and the US President getting their act together and providing some financial support in terms of sick leave and other measures to provide financial support to victims of Covid-19. However, I don't think that 'fiscal measures' are going to be particularly effective in ameliorating what is a medical and social behaviour crisis. Normally providing financial support (e.g. $750 government hand-outs to welfare recipients in Australia) would boost spending, and have a 'multiplier effect' (you give someone $100 extra cash and they go to the shops and spend $200). But in this crisis I don't think that having some spare cash will encourage people to go shopping if they are sitting at home in order to avoid catching Covid-19. Similarly, while providing 14 days sick leave in the US will replace income for those required to self-isolate for two weeks, it won't go far for those that actually catch Covid-19 and end up in hospital for treatment, and will be of limited help for those that finish off two weeks self-isolation due to exposure ('close contact') to a Covid-19 case, but find out that they are 'negative' for the virus. In those cases they are still likely to eventually catch Covid-19 for real - and will have already used up their sick leave. I suspect people will be extra cautious and any financial support will end up being used to reduce household debt or kept as an emergency reserve (to pay bills when you are actually sick with Covid-19). People are only likely to spend the extra cash on household consumption (and hence provide economic stimulus) if they feel that the crisis is being mitigated and will be brought under control by government action - and I can't see this happening any time soon.

Given the continued rate of growth in global Covid-19 cases (about 4% increase in numbers each day), and the worrying death rate (about 3%-4%, which suggests considerably under-reporting or lack of testing), the economy is likely to suffer more and more as patient numbers overwhelm medical capacity and death rates rise exponentially. This is likely to disrupt business and the economy no matter what fiscal stimulus measures are taken.

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Looks like the markets might finally be reacting to the possible impact of COVID-2019

After doing some 'rebalancing' on 6 Feb in response to the developing corona virus outbreak, it appears that 'Mr Market' has finally reached the same conclusion as me - that while the economic impact of the corona virus is still uncertain, there appears to be considerably more downside risk than any upside potential, so why not play it safe and go 'risk off'? For the past two weeks I had been wondering if the bull market was going to completely ignore the corona virus outbreak, but it turns out that it had already run off a cliff and was just taking a while to notice -- a bit like Wile E Coyote in a road runner caroon!

I had managed to shift our ~$1.5MM SMSF investment in the Vanguard 'high growth' index fund to a mixture of the Bond index fund and the Conservative index fund (having to mail in a signed paper switching form meant that it took several days to implement the decision I made on 6 Feb), and I also liquidated my $250K investment in the Colonial First State (CFS) geared share fund and my $100K investment in ETFs and used the proceeds to pay down most of my 'portfolio loan' (that had been used to fund the ETF purchases early in 2019, and my $100K deposit and $42K stamp duty for the investment unit purchase at the end of last year). I'll now be able to fund a large part of the 'settlement' for the investment unit using my 'portfolio loan' when construction is finished in 2023, and will only have to take out a relatively modest mortgage (around 50% LVR).

I had also intended to sell off my ~$50K investment in the CFS and ~$100K Vanguard International Index Fund and High Growth Fund investment but as these were 'collateral' for a couple of my margin loan accounts it turned out that I also needed to mail/upload redemption forms for those requests (the phone/online redemption requests I made on 6 Feb weren't actioned). As the market is currently already down by about 5% from the recent highs, I've decided I'll now just leave these investments 'as is' and avoid the headache of having to do additional capital gains tax calculations when I do this year's tax return. In any event, having paid off my margin loan balances there at least isn't any risk of getting margin calls and being forced to sell out of these positions at an unfavourable time (at least I learned something from the GFC!).

For the next 6-12 months I'll be keeping an eye on how severely COVID-19 affects the global and Australian economies, and the next decision will be trying to pick a suitable time to shift our SMSF investments back towards a 'growth' weighting, and when/if to utilize my available margin loan facilities to make geared investments in the stock markets. These things typically seem to take at least six months to 'wash through', but it could be a lot longer if the impact turns out to be a global recession (and possibly Australia could finally break its record run of economic growth and enter its first recession of the 21st Century).

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When is a target not a target?

The Reserve Bank of Australia (RBA) has an official inflation target band of 2%-3% "over the economic cycle". Apart from the difficulty of determining exactly what time period defines an "economic cycle", the target also seems to only affect RBA behaviour when it's broken on the upside. When inflation had spiked above 3% due to the oil and commodity price bubble, the RBA was intent on preventing inflation getting out of hand, raising interest rates in 2007 even when the US sub-prime crises was apparent.

At the moment inflation in Australia as just dropped back within the "target band" - dropping to an annual rate of 2.8% with the release of the latest 0.1% rise in CPI for the March 2009 quarter. This was lower than expected (0.5% was the consensus), and follows on from a -0.3% decline in the previous quarter.

With the past two quarters producing a drop in CPI of -0.2%, and the global economy not yet showing much sign of recovery, I can't imagine the next two quarters will show CPI increases of more than 0.5% each. That would see annual inflation drop to below 1% by the end of 2009 - well below the RBA target.

And yet despite the definite prospect of inflation dropping below 2%, the RBA seems more worried about cutting interest rates too far and creating excessive inflation pressures once the economy starts to recover. Indeed, the RBA only seems to show concern if there is a prospect of deflation. If that's the case, why not set the inflation "target" as 0%-3%, rather than having a target that isn't fair dinkum?

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A tale of two stimulus packages

With Australia having just passed it's A$42 billion (US$26 billion) 'economic stimulus package' and the US$789 billion stimulus pack in the USA close to final approval, it's interesting to see how the two compare.

The first obvious difference is the size of the packages - the Australian effort is around 3.5% of Australia's GDP, while the US package is almost twice the size in terms of GDP, coming in at 5.7% of US GDP. On the one hand this is surprising given Australia was starting from a Federal budget in surplus while the US Federal deficit is already US$10.7 thousand billion (!). On the other hand, the Australian economy is in much better shape than the US (although we will suffer more from the impact of the global recession on our exports) and still has some fiscal stimulus available. Coupled with the problems the US is facing regarding future social security and medicare funding, I think the size of the US Federal deficit will be a drag on long-term growth (due to the need for higher taxes). Even if the US stimulus package is effective in boosting growth in 2009-10, it may just create worse problems down the track.

In some regards it seems that the global economic crisis was due to western consumers bringing forward too much consumption using personal debt, with low interest rates amplifying a feedback loop of inflated asset prices being used to obtain further borrowing at historically low interest rates. Once the private global credit limit had been reached and consumption dropped in order to repay debt and increase savings rates around the world, governments began trying to boost spending by increasing public debt. At some stage public debt will exceed the borrowing capacity of sovereign states (for example Iceland has already gone 'broke', and it seems as if Russia is also getting close to the point of defaulting on debt repayments), and when both private and public borrowing is constrained, the global economy is likely to suffer many years of minimal growth as debt is slowly unwound. It may not happen for quite a while though - the US dollar has remained relatively strong for the past couple of decades despite a huge and growing debt problem.

The second difference I think is very significant is the "quality" of the two packages. Despite considerable debate about how best to stimulate the economy (public spending vs. tax cuts for example), there appears to be a consensus that such a package should satisfy the "three T's" as much as possible - that it should be timely, targeted and temporary. The US package has been reported as delivering around 54% "3T", while only 12 to 20 cents in the dollar of the US package will be timely, temporary and targeted. The graphs below show when the spending is expected to feed into each economy:



It appears that around 75% of the Australian stimulus will be implemented by June 2010, whereas just over half of the US stimulus will be implemented before the end of 2010. Stimulus spending in 2011 is quite likely to fuel inflation and exacerbate the next boom-bust cycle, rather than fix the current crisis.

Overall, I'd give the Australian package a B+ (points off for political ideology and horse trading that has shaped the spending decisions) and the US package a C-, with quantity being substituted for quality in an effort to make the grade.

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A whiff of panic in the air

Today the Australian government announced a second economic stimulus package of A$42 billion on the same day that the Reserve Bank slashed official interest rates by another 100 basis points (1%) to a 50-year low of 3.25%. It appears that the full impact of the GFC on our local economy is finally being admitted by the government, with an element of panic as a technical recession seems unavoidable and the steps taken in 2009 woefully ineffective. The series of interest rate cuts in the past six months is unprecedented. Most charts though underplay just how dramatic the fall has been, choosing to use simple bar charts showing the series of rises and cuts as if they were evenly spaced:



In reality, plotting the changes against time shows that the controversial interest rate rise during the last election campaign was "one too many", and after making jsut one unusually large cut in March 2008, the RBA held fire for a long while, probably expecting the single cut would be enough "shock therapy" to insulate Australia from the impacts of the sub-prime crisis. It was only in Sep/Oct last year that the magnitude of the GFC became apparent, with the drop in economic growth rate in China showing that Australia couldn't hope to avoid being affected.



So far I've tried to keep my stock portfolio as intact as possible, only selling the minimum necessary to avoid getting a margin call. But looking at the stock market and interest rates over the past 5 or 10 years it doesn't look like we're going to see a recovery any time soon. However, I'm too stubborn to give up on my long-term "buy and hold" strategy and high-risk asset allocation. So I think I'll still hang in there in the expectation that the Australian economy does start to recover in the second half of 2009, and that the stock market recovery leads the economy by the usual 6 months or so. However, if the stock market continue to fall I'll be forced to sell off stocks fairly rapidly to settle my margin loans. In the worst case I could end up with no direct stock investments, no margin loans, but a $250,000 HELOC debt (my St George "portfolio loan") offset by only $50,000 or so value in unlisted funds (such as Ord Minett OM-IP) and agribusiness investments. Those investments don't mature for several more years, and the unlisted funds only have a price guarantee if held to maturity. If that happened I probably wouldn't be in a position to reinvest in stocks when the market eventually recovers, so I'd be unable to recover my losses even in the market reached new highs at some time in the future. C'est la vie.

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When is a recession not a recession?

The news services are buzzing about the prospects of a "global recession", after a statement that "The IMF now sees a 25 per cent chance that global growth will drop to three per cent or less in 2008 and 2009 - equivalent to a global recession," was released in the latest IMF's World Economic Outlook report. But what does "equivalent to a global recession" actually mean? In this case it means the exact opposite - that the current IMF forecast is that the world is NOT heading into a recession (even using the generous definition of a global recession as being growth below 3%pa - which is roughly the rate required to avoid global per capita output growth that is zero or negative) within the next two years. In fact the IMF's latest forecast is for global growth to moderate to "just" 3.7 per cent this year and 3.8 per cent next year (as measured in terms of purchasing power parity)- still ABOVE the long-term average.

All that the latest IMF report is actually saying is that the worsening US economic conditions now makes a global recession a possibility - increasing the likelihood from essentially being no chance to now being a "a 25 per cent chance that global growth will drop to three per cent or less in 2008 and 2009.". Put another way, there is now a 75% chance that the world will have growth above 3% in 2008 and 2009 - but that wouldn't make a good headline.

Copyright Enough Wealth 2008