Economic Update
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2021 was another harrowing year.
Many businesses continue operatingon life support.
Supply chains remain disrupted withcritical workers furloughed throughwaves of COVID-19.
A troubling and contradictory pictureof China’s growth miracle isemerging.
More American’s have died fromCOVID-19 than both World Warscombined.
As we commence 2022, the Omicronvariant reminds us that a return tonormality is impossible to predict.
Amore transmissible sub-variant ofOmicron is emerging in Europe.
Meanwhile, markets remain near all-time highs, although cracks areemerging.
Economists were absorbed by thespectre of inflation in 2021 and‘Transitory’ was the overused word infinance circles. Inflation, having beensubdued for many years, was a growingconcern. Camps were formed, those whobelieved inflation would pass – teamtransitory – and those who felt inflationwould continue. Mounting inflationarypressures have seen the Fed announcethey are likely to raise interest rates in March.
“I would say that the committee is of amind to raise the Federal Funds rate atthe March meeting,” Mr Powell, FedChair.
Government Debt
The growing and ignored elephant in theroom remains government debt. Following on from the GFC, COVID-19has seen fiscal balance sheets continueto balloon. Government debt will be thehangover waiting for us on the other sideof COVD-19 (whenever that might be). Inplaces like the US, EU, China andJapan, fiscal imbalances (some hiddenas in China) are sufficiently dire thatthere are limited pathways for budgetrepair. The options are:
Default – Heavily indebtedgovernments could default ongovernment bond repayments.
Austerity – Indebted governmentscould exercise fiscal constraint,dramatically curtailing spendingand/or raising taxes.
Deflate – Have inflation remainelevated for the medium term todeflate debt relative to GDP.
Something new – This covers otherpossible options, includingquantitative forbearance (QF)-something we’ve made up.
Defaulting
on government debt would bepainful. It would lead to a crash in thatgovernment’s currency and a rapiddecline in that country’s living standards.If in the US, it would upend USD fiatcurrency systems[1].
A government in default would be unableto issue new bonds or rely entirely oncentral banks for borrowing, furtherdevaluing currency. A default wouldlikely force an instant balancing ofbudgets, requiring dramatic cuts toessential services and social securitybenefits. It could even lead tohyperinflation should currencydevaluation be sufficiently severe thatinflation was imported[2].
That currency might even lose it’sstanding as an acceptable store of value. Defaulting is a poor pathway to budgetrepair.
Austerity
Political will for Austerity does not existand even if it did, COVID-19 economicfrailties make curtailing governmentsupport economically risky.
Deflating Debt
That leaves Deflating Debt. This requiresinflation to run above trend for anextended period. This worked post WW2,when government debt, accumulatedfrom fighting a war, needed to be‘rationalised’.
Inflation spiked to nearly 20% and wasabove 5% for many years. We are not
suggesting such dramatic pricinginstability, but inflation running between3-5% for several years is a palatablesolution to budget repair.
Psychology is fascinating. The fear ofmodestly elevated inflation ismisplaced (although hyperinflation isto be avoided). In fact, we welcomeelevated inflation (so long as it isaccompanied by wage growth) in thecontext of global fiscal imbalances
Government policies can support a debt deflationary pathway through targeted policies that address inequities inflationexacerbates. Government policies should target elevating wage growth andkeeping/making housing affordable.Governments might consider, forexample, raising public servant wages, acatalyst for wage competition in theprivate sector.
Quantitative Forbearance
This next section comes with a warning –sleep inducing monetary policytheoretical discussion.
How else might fiscal balance sheets berationalised?
Central banks set cash rate targetsthrough open market operations (transacting bonds, repos[3] and exchange settlement accounts).
When targeting a cash rate, centralbanks transact in both directions, buyingand selling to manipulate markets todrive the ‘cash rate’ to their desiredtarget. Quantitative Easing (QE)introduced money creation to facilitatethe purchase of government bonds. Thistoo was to manipulate the market pricingof government bonds to ensuregovernments retained access to fundingat stable and low rates. However, whilstgovernments operate elevated deficits,Central Banks have no mechanism tocontract money supply without triggeringa spike in government debt fundingcosts.
The idea of Quantitative Tightening (QT)[4] was more broadly introduced 4 yearsago when Janet Yellen indicated the Fedmay not rollover all government bondpositions at maturity. QT occurs when acentral bank does not fully repurchaseall government bonds at maturity. Indoing so, central bank government bondassets will contract over time (and with-itmoney supply). This is the naturalpathway for unwinding the unorthodoxpolicy of printing money to buygovernment bonds (QE).
Unfortunately, most indebtedgovernments are operating deficits, socontinue to issue an increasing supply ofbonds to fund spending commitments. IfCentral Banks undertook QT (not thatthey are considering it) the market wouldquickly resume price setting ofgovernment bonds.
There is no precedent, and legalwrangling is required to ensure QF isnot classified as a default (allowingongoing bond issuance).
Morale hazard. Once a central bankforgives debt, is pandora’s boxopened on government spendingprudence?
This would drive bond yields vastlyhigher, increasing government debtfunding costs, exacerbating the demise ofgovernment balance sheets as bonds arerolled over at maturity.
A missing Central Bank tool is thesomewhat exotic idea of debt forbearance(or Quantitative Forbearance/forgiveness(QF)). Should Central Banks write-downgovernment debt, a correspondingmonetary value would be removed fromthe Central Bank’s balance sheet andgovernment debt ledger.
Esoterically, and a question foracademics, is whether that money hasdisappeared from circulation? Or,because that money was spent bygovernment, does the value of the write-down only evaporate from central bankasset and government debt ledgers via accounting measures, whilst simultaneously not impacting moneysupply?
The question then follows, how is QFaccounted? That is beyond us andreserved for the academic accountants; awild cohort of people to be sure.
Two big headaches with QF are:
There is no precedent, and legalwrangling is required to ensure QF isnot classified as a default (allowingongoing bond issuance).
Morale hazard. Once a central bankforgives debt, is pandora’s boxopened on government spendingprudence? What stops governments takingadvantage of central bank forbearance,crowding out private markets fromlimited resources and drivinginflationary pressures that ultimatelyresults in financial market instability?So, counterintuitively as some mightargue QF is reducing money supply,yet QF could be inflationary. Like othermonetary tools, QF has an inflationaryedge and it might best be deployedmodestly in benign inflationaryconditions, but that is our speculation.
It may seem an unnatural tangent, butthe debt positions, political gridlock inthe US and demographic headwindsfaced in China, make traditional fiscalrationalisation difficult to imagine.
Perhaps the right question is – is QFworse than a government succumbingunder the weight of their own debtwhilst the economy struggles?Probably not.
Inflation
To be or not to be’ is still the question.
An uptick of COVID-19 has furloughed critical supply-chain staff. Resultant cost increases boost inflation pressures as does demand pull inflation via heightened pricing instability (think Rapid Antigen Tests).
Looking at the year ahead, even as some temporary supply chain disruptions abate, moderate inflationary pressures are likely to remain. The most recent inflation data in Australia surprised on the upside at 3.5%.
Our rationale for the likelihood of more persistent inflation is the interplay of two drivers – Employment and Money Supply.
Employment
Unemployment has recovered remarkably quickly, but that only tells half the employment picture.
In the US, the employment rate measures the number of people who have a job as a percentage of the working age population. This is a different measure to unemployment or the participation rate. As the below graph demonstrates, the employment rate has been on a broadly downward trend. Earlier retirement, intergenerational wealth and prolonged periods of education are increasingly keeping working age people out of labour markets.
One biproduct of COVID-19 stimulus was increased household savings and higher asset prices. The resultant increase in household wealth, and reduced willingness to participate in health risk employment activities, led to an increase in the retirement of baby boomers.
Older workers are generally more productive than younger workers. Although younger workers are often more technologically advantaged, older workers have superior experience. 30+ years of experience can deliver increased productivity gains through the nuanced application of learned skills at senior levels within business.
In short, there has been a rapid decline of human capital within the economy. Human capital scarcity supports labour competition and wage growth.
Money supply
Central bank government bond purchases, suppressing yields, has forced investors to allocate capital into other financial assets.
These capital flows have driven asset prices higher. With a lower cost of capital now available to businesses, there is increased capacity to fund competition for labour. All things equal, this should support wage growth and we anticipate this bringing the first significant increase in wages for some years.
Technology innovation
Technology adoption has worked against traditional inflationary pressures. The marginal-cost of supplying an additional software license is negligible. That is, when Xero sells another software subscription, it is not resource constrained by factory/worker output capacity. The traditional resource constraints economists discuss that lead to cost push inflation as economies expanded are less of a feature of the digital revolution.
Digital productivity improvements are also highly profitable. They have fuelled economic expansion without inflationary consequences. Because they have become an increasingly larger component of capital expenditure of businesses, they have diminished employee bargaining power, supressing wage growth. Furthermore, software/digital innovation has increased the productivity of existing labour, diminishing the need to expand an employee base.
Vendors of these mass digital productivity innovations have captured some of the forfeited wages of employees. The graph below demonstrates how immense an impact seven technology businesses have on the US S&P500 performance.
Digital innovation may continue to supress inflation pressures. However, the growing labour constraints in human dependant industries like hospitality, tourism and professional services make it inevitable that wage growth will arise in these sectors.
China
We’ve discussed China’s economic challenges in previous quarterlies. The demise of China’s overleveraged property development businesses and deflation of their property bubble continues to gather pace. 2021 saw a 9% fall in property prices and 17% fall in land sales (by area).
The second order impact of a deflating property bubble will be the financial collapse of local government municipalities. The first municipality to go into financial distress appears to be Hegang, Northern China, where officials announced on December 23, 2021 that they have frozen hiring and begun ‘fiscal restructuring’.
“Their [all Chinese municipalities] outstanding debt amounted to $8 trillion at the end of 2020, Goldman Sachs estimated, equivalent to around half of China's gross domestic product; last year they also replaced property developers as the biggest Chinese debt issuers offshore, with $31 billion of dollar bonds coming due in 2022” – Reuters, Yawen Chen, January 11, 2022.
Xi Jinping has called for interest rates to remain low in western countries. As mentioned above, municipalities are saddled with dollar bond debts. China is presently lowering rates to stimulate a faltering economy. Should the west begin raising rates, the relative cost of dollar bond exposures is further exacerbated. That would lead to an increased flight of capital out of China.
Within state owned enterprises there is further evidence of poor governance and excessive leverage. For China’s high speed rail network, the cost of servicing interest on debt has been higher than operating profit since 2015. The solution has been to issue more debt to cover the interest servicing shortfall. This puts the state-owned enterprises into a compounding debt trap. The CCP has quashed further investment in high-speed rail.
Headline Chinese government debt to GDP appears modest at approximately 66% in 2020, but that is in part because;
1) Data is unreliable; and
2) State owned company debt and municipality debts are not included.
In addition to a slowing economy struggling to execute a zero-covid policy, with mounting debts, there is a longer-term demographic challenge. As the saying goes, China looks to be growing old before it grows rich.
Predictions of Chinese economic collapses have abounded for decades. We are certainly not making such a forecast. However, the deeper you dig into the Chinese economy, the more troublesome the picture appears. And, if interest rates begin climbing in Western economies, that may expedite China’s challenges.
Will 2022 be the year of financial reconning for China?
Investment Update
Our central thesis is that inflation is somewhat desirable to address fiscal imbalances and central banks may be more accommodative in allowing inflation to persist at slightly elevated levels. Being long term investors, in inflationary conditions, investors should focus on real assets (property and infrastructure) and equity within businesses that possess some form of pricing power. Cash should be avoided where possible.
In the past we utilised iShares Asia 50 within portfolios to take a tactical weighting to Asian markets (where portfolio scale lacked capacity for direct investment). Our growing pessimism towards China has warranted a shift in exposure. We believe technology exposures within this market remain reasonable and are complimentary to a traditional Australian ‘blue-chip’ share investor. We have largely exited iShares Asia 50 and incorporated a more targeted Asian market exposure in BetaShares Technology Tigers ETF (ASIA).
A recent inclusion into some portfolio’s has been Magellan Financial Group (MFG.ASX). Valuation makes this attractive. The market appears to be pricing in a permanent loss of performance fees (unlikely) and ascribing negligible value to direct investments in an investment bank (Barrenjoey) and Guzman y Gomez (Mexican fast food retail chain). The business actively manages capital and if share-market weakness abounds, is likely to outperform.
Establishing an investment in a business succumbing to negative market sentiment can be challenging. It is impossible to predict when market participants decide negative sentiment is no longer justified relative to valuation. Morningstar retain a fair value estimate of $38 (as opposed to current $18.16 share price).
Some negativity towards Magellan Financial Group from UBS and other investment banks may need to be taken with a grain of salt. Magellan Financial Group are part owners of Barrenjoey Investment Bank, which poached a swath of investment banking talent and have begun eating into investment banking market share. Therefore, some banks may have a bias against Magellan.
Another business we think remains undervalued is Alibaba (BABA:US). This business has suffered with general negative sentiment towards Chinese listed businesses. Although geopolitical risks are problematic, the negativity has made the business very attractive in respect to the current share price. By way of comparison, Alibaba (BABA:US) has a current price to earnings (P/E) ratio of 18.66x with a 3-year annualised revenue growth rate of 42.05%. By comparison, Coles, Woolworths, WBC and CBA all have P/E ratios between 15- 25x with 3-year annualised growth at less than 4% and in some instances negative growth!! Charlie Munger has doubled his position in Alibaba and that shows his confidence in this company.
Our most recent material shift in asset allocations occurred in the beginning of 2021 when we further shifted asset allocations weightings away from fixed interest and into floating credit. We also increased exposures into infrastructure assets and where clients were eligible, explored private equity opportunities. Investment and asset allocation positions remain much in line with previous quarterly updates.
If the Global economy, and particularly China, slow, it would lead to weakness in the AUD as commodity demand diminishes. Australian investors should continue to remain unhedged to their international positions.
[1]Fiat money is a government-issued currency that is not backed by a commodity such as gold.
[2] Imported inflation occurs when a currency declines in value, causing a relative increase in the price of imported goods andservices, increasing the price of consumer goods. I.e. a 50% drop in USD relative to AUD would make Australian beef 50% moreexpensive in USD terms for US consumers. Thus, lead to an increase in US consumer prices. This is a concern for centralbankers.
[3] Repos are Repurchase Agreements of loaned exchange settlement accounts. A good explainer - How the ReserveBank Implements Monetary Policy | Explainer | Education | RBA
[4] A good explainer of QT - What's Quantitative Tightening? Why Does It Follow the Fed's Quantitative Easing - Bloomberg