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Discussion in 'Off Topic' started by Tropo, 8th Aug, 2006.

  1. Tropo

    Tropo Well-Known Member

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    From cyber space...

    If you put two economists in a room, the chance of them reaching a consensus is about 50%. Put six economists in a room and simple probability suggests the chance drops to about 3%. But an economy is not just a matter of thumbs up or thumbs down – there are countless influencing factors.

    This proved to be so when TD Securities held its annual "Breakfast with the Economists" on Thursday. The key-note speaker was David Wyss, chief economist with Standard & Poors in the US. Wyss clearly has pulling power, evident by the 700 guests that turned up. They certainly weren't there for the food.

    Wyss joined a panel of five other economists chaired by the droll Chris Caton, chief economist at BT Financial Group. Shane Oliver, head of investment strategy and chief economist at AMP Capital Investors, Alex Erskine, head of research at absolute return fund manager (Asia-Pacific) Sequoia Capital Management, Michael Thomas, chief economist at leading Australian OTC dealer ICAP, and Stephen Koukoulas, chief strategist (Asia-Pacific) at TD Securities made up the entertaining group.

    Wyss had the floor to begin with, and this is a summary of what he had to say:

    The world is undergoing an "economic rotation" as the US economy slows and the economies of Europe and Japan pick up. If you look at world growth on the IMF's purchasing power parity (PPP) basis, rather than using exchange rates, it is presently about 4.8%. Last year it was about the same and next year is predicted to be 4.5%.

    That's four and a half years of 4-5% world growth which is the best run in living memory.

    The US has slowed to 3.5% and should slow to about 2.5% next year. The housing market has topped out and consumer spending is falling, but capital spending is growing and the trade deficit is actually levelling off. Next year should see 2.5% growth, 2.5% inflation and 4.5% unemployment, which is a combination you'd take any time. However, there's one caveat…

    The Middle East has gone mad yet again and who knows what might happen. Oil prices should be falling – there is a reasonable supply/demand balance at present and there is oil that can be tapped at US$40-50/bbl. But the world is building in a huge risk premium, and with good cause.

    If Iran withdraws its 2.7 million bpd production the price will hit US$100/bbl. Not enough to cause a recession, but enough to take 1.5% off GDP growth.

    Energy is actually a much smaller part of the world economy than it was in the last oil shocks of the 1970s. Then it took 0.33 tons of oil to produce US$1000 of GDP. Now it takes 0.22 tons. Oil is also less of a percentage of the energy complex now too. Then it was 44%, now it's 33%. This means that on a relative basis oil has to go much higher than it did in the 1970s to cause a 70s-style recession.

    If Iran withdrew its production AND blocked the Strait of Hormuz [in the Persian Gulf between Iran and Saudi Arabia and through which 66% of the world's oil normally passes] then oil could hit US$250/bbl and a deep recession would ensue.

    The Middle East makes the xpression "foreseeable future" simply an oxymoron.

    Middle East aside, there is a 50/50 chance the Fed will raise rates again next week. It may come down to employment numbers due on Friday. However, we should be nearing the end of the tightening cycle. Europe is in the middle of its cycle and Japan has just begun. Excess liquidity will be "mopped up" in the next several quarters, but rates will still be historically pretty low.

    Long term bond yields in the US have barely moved despite 17 cash rate rises. That is because bond markets are now very much part of a global market. In 2004 world bond rates converged at about 4% (with the exception of Japan). By 2005 the US rose to 4.5% but Europe fell to 3%. Japan was still much lower. Hence the world invested in US dollars. Most of this was private, rather than central bank, investment.

    The US current account deficit is around US$800 billion, which should imply huge risk, but if the US dollar falls foreign central banks jump in to support it. So where's the risk in investing in US dollars?

    The lack of a perception of risk is "scary". The current premium over cash of world investment grade bonds is about 1.3%. In 2003 it was 2.6%. The premium for US speculative grade (junk) bonds is 3.5%. In 2003 it was 8%. Spreads are currently not wide enough for "normal" risk.

    One problem is that last year the default rate on junk was only 2%. During the 2001-02 recession it was 9%. Most of the rubbish was forced out back then, leaving the good stuff, but this creates a false impression.

    More bonds have been issued since then that are rated as junk or "single B" by S&P. By definition these bonds should soon begin to default. If default rates reach 3-4% then current risk spreads are going to look way too low.

    Bond markets have become "global", and so have equity markets. In 2000-02 equity markets moved as one and lost 50%, except for Australia which lost only 15% [Australia had no tech bubble because we have very few techs]. Now four of the seven major indices have exceeded 2000 lows. The big three – US, Europe, Japan - are three quarters of the way back. But if you were to take out techs, world indices have performed very well.

    Every time a new form of technology enters the world – canals, railroads, telephones, electricity, automobiles – there is an overblown investment rush and subsequent bursting bubble. The internet was no exception. Each time someone says "This time it's different", and it never is. When the railroad bubble burst a company started evaluating railroad bonds. That's how Standard & Poors was born.

    That ended David Wyss's formal address, but the Chairman posed some questions. Firstly, what about China?

    Wyss: On a PPP basis China is now the second biggest economy in the world. It also represents 31% of world growth. China/India/US represents 56%, so there's no surprise that's where all the money's going. China will continue to grow rapidly, but needs to slow down.

    Chinese government policy is inconsistent because as it tries to slow the economy on one hand, by raising rates and tightening lending standards, it is still keeping the currency artificially low to encourage exports. This is dangerous. Inflation is starting to pick up and the currency must be allowed to rise. However, the Chinese are probably still put off by [the Asian Currency Crisis of] 1997-98. If the government is too slow to act China will be in for a crunch.

    Chairman: How big of a problem is the US trade deficit?

    Wyss: Everyone agrees the deficit is at an unacceptable level. But no other country is prepared to give up its trade surplus. The world has to balance. OPEC has a US$300bn surplus, Japan US$250bn, Asia (ex-Japan) US$200bn. The US, UK, Australia and New Zealand all have trade deficits of around 7% of GDP. Something has to give, but no one is budging.

    Europe is now moving from surplus into deficit. It will probably now also start "screaming at China" as well. Whether or not that helps…

    Chairman: Where do you see equity markets?

    Wyss: The correction was caused by three factors: oil prices, interest rates, and the seasonal "sell in May and go away". While the first two remain unstable, the markets will be soft. The US will probably stop tightening soon. If oil prices can stabilise then the traditional late buying spree after October should kick in.

    (At this point Shane Oliver offered that research shows the "Halloween Effect" – that in which markets fall after May and rise after October (Halloween) – is an inexplicable, deeply entrenched truism of all world markets, except New Zealand. It is even consistent in UK markets back to 1694.)

    Chairman Caton then turned to the panel members for their individual views.

    Koukoulas: TD Securities is very worried about building global inflationary pressures. US inflation is up. Japan is moving from deflation to inflation. Chinese prices are rising. Australian inflation is up. After five years of low inflation and low rates the effect of increased commodity prices has begun to be passed through. We are only half way there. Labour markets are tight and wages are rising. There will be more central bank tightening next year.

    Chairman: Is there a risk central banks will over do it?

    Wyss: They already have. The Fed will begin easing next year. The problem with central bank monetary policy is that what you do today flows through to the economy in another year or 18 months. For inflation, two years. Yet central banks are making policy decisions based on economic data from last month.

    Oliver: US private consumption is now at the same level it was in 1995 when the Fed started cutting rates. History shows the peak in interest rates occurs six months before the peak in inflation. The Fed has done enough, and will start easing next year. Global inflation is hardly at disastrous levels at the moment, even in China. Oil prices will go higher in the next two months, and history shows August-September are high oil price months due to the driving season and hurricanes. But oil prices will begin to recede in October (Iran notwithstanding) and then equity markets will start to run again.

    Erskine: Another year of above-trend global growth will do "exciting" things for commodity prices [meaning they go up], including oil. Supply is still constrained, and no one has made any significant investment in alternative energy sources. The world is extremely dependent on oil and will be for at least another five years. Interest rates globally are still relatively low. Fed policy has meant the US has now reached "neutral" territory, but not "restrictive". The global economy is headed for a soft landing next year, but after that..?

    As far as Australia is concerned, there will be two more rate rises yet. Heir apparent Glenn Stevens [anointed RBA chairman] has in the past suggested that rates in Australia are not restrictive until they hit 6.25%. We have to get there yet. The economy is still picking up speed and we're at full capacity. There is no alternative but to raise rates.

    Thomas: It should not be overlooked that the US economy is extremely important within the world economy. China is currently the focus, but when commodity prices took off in 2003 it was not because Chinese growth moved from 9% to 10% or thereabouts, it was because US growth moved from 1% to 4%. That's what made the big change in the global economy. If US growth falls to 2.5% (S&P forecast), that puts a big question mark over the sustainability of commodity prices.

    Does the Chinese currency really need to rise? Apart from the US China actually runs deficits with most of the rest of the world. Most growth in China is domestically driven. Consider this example:

    Until the late 1990s the Chinese were not allowed to own a house. Hence they would never bother spending money on the place they lived in. Not only are they now able to own a house, but they have every incentive to renovate it – that's a lot of paint. The world imbalance is only a China/US thing. Domestically they're still on a bandwagon.

    On the Australian front, wages actually don't look that bad. The economy has been on an upward trend for the last two years. Import prices are well-behaved. There's nothing really to be worried about on the inflation front. There will be no more rate rises.

    Koukoulas: There will be one more rate rise this year, and maybe another one early next year. Cheap Chinese goods have been keeping Australian inflation down. Now those prices are beginning to come under upward pressure. Take China out of inflation and it would presently register at about 5.25%. Take out petrol and bananas and it would be 3.5% - still above the RBA comfort level. There's a housing shortage and rents are at five year highs. Housing prices are going to rebound in the next two years.

    Oliver: There will be no further rate rises. The RBA will begin cutting next year. The average Australian household is suffering. Levels of household debt are now three times higher than they were in 1980. A 6% interest rate is thus equivalent to 18% in 1980. Households will respond, and the rate rises to date will head off inflation.

    Chairman: I think we've all agreed to disagree on rates, what about commodity prices? If US growth slows to 2.5%, what will this do to prices?

    Erskine: The US represents 20% of world growth. Hence if US growth falls by 1%, that's only 0.2% on world growth. Europe, China and India are growing, and the latter are far more commodity-intensive than the US. World demand is undergoing an adjustment, and all at full capacity.

    Analysts are still under the misconception that commodity prices will soon fall back to 1990s average levels. They may not surge much higher from here, but they won't fall back that far. Resource company earnings, however, are set to grow regardless.

    Thomas: The supply side is starting to make its presence felt and will be more so next year and the year after. Demand is still solid, so prices won't collapse, but they will fall.

    Oliver: Heading into 2001, the commodity price trend was down. Since then it's been up, driven by China. However, it is true the US has the influence over the traditional "commodities cycle" so its influence will ensure volatility over the next few months.

    Nevertheless, the longer term trend is still up due to the continuing industrialisation of China. Consider that currently, the Chinese consume two barrels of oil per capita. Australians consume 15 barrels and the US 25 barrels. The Chinese may never catch up, but the figure will definitely rise. The same rule applies to the rest of the commodity complex – falling US growth will push prices down in the short term, but the long term trend is still up.

    Chairman: If you had $500,000, where would you put it right now?

    Koukoulas: Sydney housing. The share market looks okay as well.

    Oliver: Not interested in housing – the yields are too low. I'd put it in the stock market after October.

    Thomas: Yields favour the stock market in the short term, but in the long term, from next year, I'd put it into housing.

    Erskine: Housing will head down as rates rise. However, the New Zealand experience suggests Australian banks are prepared to slash margins in a market share war. This will be positive for housing. Invest in the stock market, but leave out the banks.

    Wyss (who only has US$380.000): The US housing market is running six months behind Australia. I wouldn't invest in housing, I'd invest in the stock market after October.

    And that wrapped up the discussion.
    We all left the building none the wiser.
    :eek: + :rolleyes: = :p