The Restless Investor, Trust and the Global Cycle

On face value, Woodside Petroleum and Macquarie Bank have little in common.  One is an oil and gas company, the other an investment bank.  For a long time, investors have considered both to be growth stocks; their revenue growth is projected to exceed growth in the broader economy.  Woodside is exposed to strongly growing demand for liquefied natural gas (LNG) from Asia while Macquarie has transformed itself into a global asset manager, exposed to the growing demand for private pensions among ageing developed country populations.

Both companies raised their dividend payout ratios in 2013 and announced they would maintain a higher than normal payout ratio going forward.  Investors normally interpret higher dividends from growth stocks as a signal of lower future growth prospects and mark them down accordingly.  But these announcements were favourably received by the market and each stock delivered higher returns than the ASX200 over the course of 2013.

In recent years, companies globally have deferred or abandoned growth options and increasingly returned cash or capital to shareholders via higher dividend payments and stock repurchases.  Skeptikoi believes this phenomenon stems largely from the financial crisis and the rise of the restless investor, with an assist from the disappointingly slow global recovery which has dulled investors’ appetite for risk.

The defining feature of the restless investor is a loss of trust arising from the financial trauma of 2008.  Research studies have shown that low levels of trust discourage stock market participation.  Trust might have an important bearing on the finding that macroeconomic experiences can have life-long effects on attitudes towards risk; investors who experience low market-wide returns in their formative years tend have more conservative financial portfolios through their lifetimes, reflected in smaller stock allocations.

The restless investor has lost trust in the ability of companies to undertake value accretive acquisitions or large capital expenditures that have distant payoffs.  Against the backdrop of still weak revenue growth, higher discount rates and shorter expected payback periods, companies have eschewed grandiose growth options and turned to a new cost discipline to boost profitability.  While a subdued nominal GDP growth environment has undermined the ability for companies to achieve meaningful top line growth, they are aggressively attacking their operating expenses and deferring capital expenditures where feasible to boost margins and free cash flow.  And strong free cash flow helps to support a sustainable lift in payout ratios.

Is there a risk that the restless investor’s loss of trust and preference for capital now over future capital growth could undermine the ability for firms to deliver sustainably strong growth in earnings per share?  Skeptikoi doesn’t think so.  The new cost discipline is a welcome development following decades where CEOs remained focused on growing revenues – at times, at the expense of profitability and shareholder value.  The renewed cost discipline will continue to focus the minds of CEOs on what they can control rather than chasing the pipedream of double digit revenue growth and market share gains that destroy shareholder wealth.

Stocks with sustainably high payout ratios will under-perform when the supply of income from the corporate sector eventually outstrips demand.  At that point, expect companies to re-engage their growth options more aggressively, which will put a smile back on the faces of the shrinking army of downtrodden investment bankers.

But if market gyrations are any guide, the journey to equilibrium is rarely seamless or linear.  Do not discount the role that the disappointing global cycle in recent years has played in fostering the rise of the restless investor.  The IMF and other forecasters have consistently downgraded world growth prospects since 2010.  The IMF’s preliminary estimate shows that world nominal GDP expanded by around 6.5% in 2013, down from 9% in 2011 and the lowest annual growth in over a decade excluding 2009.

Skeptikoi is wary that material upgrades to world growth prospects would raise the appetite for risk and be associated with under-performance of stocks offering strong and sustainable yield.  But the signposts suggest that we are not at one of those junctures just yet.  The IMF is projecting global nominal GDP growth to pick up over the next two years to around 7.5%, still weak by historical standards.  And the IMF has a long history of producing excessively optimistic world growth forecasts.  The persistence of large output gaps in many developed economies remains a headwind and should keep central bank policy rates close to zero for at least another year.  Moreover, any snap-back in risk appetite typically occurs when stock markets are very cheap, which isn’t the case at present.

Looking through the vicissitudes of the global economic cycle, the restless investor’s loss of trust will continue to constrain the parameters of corporate financial policies for some time yet.  Skeptikoi believes that the process of healing from the financial crisis is far from over; we have only just passed the fifth anniversary of the collapse of US investment bank Lehman Brothers.  In the wake of the financial trauma of 2008, the corporate sector is learning an expensive lesson about the asymmetric nature of trust; it can be lost very quickly, but takes a very long time to re-establish.

The Conglomerate's Fall From Grace: Two Tales of Diversification

By the time he had stepped down from the roles of Chairman and CEO of one of America's largest and oldest industrial companies in 2001, Jack Welch was arguably one of the country's most successful business men, a CEO superstar.  During the two decades he ran General Electric (GE), the stock rose 4000%.  Following his retirement from GE, Mr Welch was in hot demand on the public speaking circuit; many were prepared to pay handsome sums to get insights on how he had successfully managed a global, sprawling conglomerate.

GE represents an anomaly to text book theory and the trend in recent decades towards corporate focus. Long gone are the days where it was common practice for firms to undertake mergers and acquisitions in unrelated industries to boost flagging growth prospects. 

The development of Modern Portfolio Theory (MPT) through the 1950s and 1960s espoused the benefits of financial diversification; the value of corporate diversification is limited to the extent that investors can achieve diversification for themselves.  But at the time, the reality of high transaction costs was far different from the assumptions underpinning MPT; it was expensive for investors for investors to achieve home made or DIY diversification.  Corporates were all too willing through the 1960s and 1970s to help investors diversify by buying up target assets in unrelated industries.

By the 1980s, two developments had changed the conventional wisdom towards corporate diversification.  It had become apparent to investors that the conglomeration of corporate America has failed dismally.  Growth prospects for many diversified enterprises had not met expectations.  The failure stemmed from a lack of focus and the inability of internal capital markets to allocate resources efficiently across often disparate and unrelated divisions.

Second, the growing institutionalisation of the stock market had made it easier and cheaper for investors to achieve financial diversification themselves.  In particular, the launch of the world's first index funds in the 1970s by Wells Fargo and Vanguard was a game changer not only for the asset management industry but also for corporate diversification.  The ability to access low cost funds that tracked the S&P500 index meant that investors no longer had to rely on companies to undertake diversification themselves.

By the early 1990s, corporate America had undone most of the legacy of the conglomeration experiment.  Many diversified firms restructured voluntarily, selling off underperforming assets that were not central to their key competitive advantage.  And where management refused to see the writing on the wall, capital markets obliged, in the form of highly geared and aggressive private equity firms.  Some of these firms would spectacularly fail burdened by excessive levels of debt.  But investors had already delivered their verdict; corporate focus had won over corporate diversification.

The Schumpeter column in the Economist magazine suggested recently that the conglomerate might be staging a return ('From Dodo To Phoenix').  After all, the prospect of still subdued growth in nominal GDP around the world continues to undermine the corporate sector's ability to achieve meaningful revenue expansion.  Corporate diversification could help to boost flagging growth prospects and larger firms might be able to offer higher salaries than their focussed counterparts thus attracting and retaining the best minds the labour market has to offer.  The internal capital markets of conglomerates can also reduce reliance on at times fickle capital markets.

But Skeptikoi believes that a sequel to the first conglomerate wave is unlikely for three key reasons.  The costs of financial diversification have continued to decline sharply.  The advent of exchange traded funds (ETF) has revolutionised the asset management industry by increasing liquidity and transparency, as well as further reducing the costs of tracking a wider range of country and sector indices.  An S&P500 ETF typically attracts a management expense ratio of less than 10 basis points and can be traded on the market just as easily as a stock can. 

Second, a loss of investor trust since the financial crisis has meant that shareholders have little faith in CEOs to undertake value accretive acquisitions, particularly in industries unrelated to their core focus.  They are increasingly rewarding companies for returning cash or capital back to them in the form of share repurchases and higher dividend payments.  To this end, Skeptikoi expects the trend towards corporate focus to become even more entrenched; more companies are likely to break-up and sell off underperforming and unrelated assets to boost free cash flow and cater to investors' insatiable appetite for income.

Third, the financial crisis has failed to revive the fortunes of conglomerates.  If there was ever a time for conglomerates and their internal capital markets to shine, it was in the wake of the financial crisis, where external sources of funding either became prohibitively expensive or even dried up completely for smaller firms.  But if anything, their prospects have continued to deteriorate.  Emerging markets - where conglomerates are more common - have underperformed significantly in recent years.  And the great aura surrounding GE is no longer.  From the lofty heights of the credit boom where the stock typically traded at a 20% book premium to the broader market, it now trades closer to a 20% discount.  It remains to be seen what judgement history will deliver on the legacy of GE's superstar CEO.

The Most Dangerous Idea at the RBA: Monetary Policy Doesn’t Matter

“In the end, though, firms and individuals have to have the confidence to take advantage of the situation.  They have to be willing to take a risk – on a new project, a new product, a new market, a new worker.  Monetary policy can’t force spending to occur.”

Glenn Stevens, Reserve Bank of Australia Governor, December 2013

Leading up to Christmas, Glenn Stevens probably feels that he has received an early Christmas gift in the form of a lower Australian dollar.  For more than a year, he has cited concerns about a persistently high dollar as impeding competitiveness of the non-commodity export sector.  It has finally succumbed recently; at the time of writing, it had depreciated by close to 10% against the US dollar since mid-October and by 7% on a trade weighted basis.  Whether this has been due to Mr Stevens’ jawboning is debatable.

But as Mr Stevens indulges into his Christmas lunch, he might well feel that his glass is half empty.  By his own admission during this week’s opening statement to the House of Representatives Standing Committee on Economics, growth has been below trend this year and he expects this to persist for a bit longer yet.

Nor would this week’s updated Mid-Year Economic & Financial Outlook (MYEFO) provide Mr Stevens with much reason for optimism.  On the heels of a dismal outcome for nominal GDP growth of 2.5% in financial year 2013, the Treasury downgraded growth estimates for nominal GDP to 3.5% in each of the financial years 2014 and 2015, down from the preliminary forecasts of 5% contained in the May Budget and well below the two decade average growth of 5-6%pa.  If this outlook transpires, the RBA’s nominal recession is set to extend for three consecutive years.

But his main concern appears to revolve around what he considers to be the limit of his power as the country’s top central banker; according to Mr Stevens, monetary policy cannot effectively revive animal spirits and encourage households and businesses to take risks.  Skeptikoi is shocked by this.  Yes, monetary policy cannot force spending to occur.  But what is the role of monetary policy, if not to influence people’s perception of risk and discount rates?

To better understand this, it is instructive to re-assess the concept of the neutral rate of interest, originally developed by the Swedish economist, Knut Wicksell.  Monetary equilibrium is achieved when the real rate of interest is equal to the expected real rate of economic return.  A lower real rate of interest encourages businesses to borrow and invest, which leads to inflation and conversely, a higher real interest rate is associated with deleveraging and either disinflation or deflation.

Skeptikoi believes that incorporating risk into Wicksell’s framework can better shed light on the crucial role that central bankers can play to revive the private sector’s appetite for risk.  Investment is still weak in Australia (and most other developed economies) because discount rates or perceived risks are high, which continues to pull down risk adjusted rates of economic return.  Renewed capital discipline, and high business and household savings rates across most of the developed world confirm that animal spirits remain dormant.  No wonder; October 2013 marked only the fifth anniversary of the financial crisis, the largest global downturn since the great depression.

Given the depth and breadth of the crisis, the process of healing could take a long time to play out.  A new and growing literature that marries psychology with economics and finance suggest that macroeconomic developments during a person’s formative years can shape their lifelong attitudes towards risk.  Various academic studies show that firms run by CEOs who grew up during or around the great depression had lower leverage than other firms.  And stock market participation was lower for investors who grew up during the great depression.

Against this backdrop, it is reasonable to think that financial crisis ‘babies’ (and those that have been adversely affected by the financial crisis) will remain cautious for a while yet.  People have either lost their homes or jobs, witnessed the value of their homes decline or have remain employed but with a heightened sense of job insecurity.  Consequently, people are implicitly applying still high discount rates to their stream of expected future cash flows, which is depressing the present value of their human capital.  And the household sector’s lower permanent income flows through to an underwhelming recovery of consumption and still weak investment intentions of corporate sectors around the world.

Central bankers have been on a steep learning curve in the past five years.  Concerns surrounding the liquidity trap associated with zero interest rate policies have given way to the growing realisation that monetary policy can still be effective and affect agents’ expectations, risk taking attitudes and asset prices through forward guidance and large scale asset purchases (LSAPs).  Christina and David Romer from the University of California argue that the most dangerous idea in the Federal Reserve’s history is that monetary policy does not matter.  They attribute the prolonged downturn of the great depression and the great inflation of the 1970s to policy errors committed by the Federal Reserve, stemming from an ‘unduly pessimistic view of what monetary policy can accomplish’.

The authors also draw parallels between prevailing views of monetary policy since the financial crisis with the great depression, regarding the ineffectiveness of monetary policy at the zero lower bound, as well as the costs associated with non-traditional tools.  But more recently, the Federal Reserve’s announcement of QE3 in 2012 suggests that it considers that the benefits of forward guidance and LSAPs outweigh the costs.  And other central banks have clearly reached a similar conclusion, including the Bank of Japan, European Central Bank and Bank of England.

Glenn Stevens is clearly frustrated that monetary policy’s role in promoting the recovery is not getting an assist from government policies that facilitate higher productivity.  While monetary policy is limited in its ability to affect long-run dynamics of productivity growth, it is the role of a central bank to prevent a cyclical shortfall in aggregate demand or act to prevent any shortfall from continuing.  Skeptikoi is afraid that the RBA’s timidity and its unduly pessimistic view that monetary policy does not matter, will unnecessarily condemn Australia to a prolonged nominal recession.

The Bond Conundrum and Global Saving Glut Almost a Decade On

“…the available information increasingly suggested that the economic expansion was becoming less fragile and the risk of an undesirable decline in inflation had greatly diminished…the Federal Reserve came to the judgement that the extraordinary degree of policy accommodation that had been in place…was no longer warranted and…signalled that a firming of policy was likely.”

One could be easily forgiven for thinking this passage is an apt description of recent deliberations at the Federal Reserve.  In fact it was delivered by the then Federal Reserve Chairman, Alan Greenspan, in February 2005, following an eight month period in which the target fed funds rate had been raised by 150 basis points (bps) to 2.5%.  Yet by February 2005, 10 year treasuries were yielding close to 4% significantly lower than 5% in June 2004.  Greenspan described the divergence in the fed funds rate and long term interest rates as a conundrum.

Given the ongoing decline in long term interest rates since then – US 10 year treasuries are yielding less than 3% at present – that semi-annual report to the Congress in 2005 has become amongst the most widely cited speeches from Greenspan’s chairmanship.

A month later, then Governor Bernanke attributed the relatively low long-term real interest rates in the world to an excess of desired saving over investment intentions.  The global saving glut could alternatively be thought of as inadequate or under-investment.  In a closed economy, a country’s saving imposes a constraint on the maximum funds available to the corporate sector for investment.  In the event of a shortfall in desired investment relative to the desired saving, the excess supply of saving causes the price of money (ie. the real interest rate) to decline.  Conversely, when expected domestic investment opportunities exceed desired saving, the real interest rate rises.  So in a closed economy, the current account remains in balance and the real interest rate equilibrates desired levels of investment and saving.

In an open economy, a country’s account balance is equivalent to the imbalance between investment and saving.  When a country’s investment exceeds its saving, it can borrow from abroad, so national saving does not impose a constraint on the maximum funds available for investment.  Although the country runs a current account deficit, its real interest rate is no longer governed by the supply and demand for domestic saving.  The ability to tap into foreign sources of saving lowers the real interest rate relative to a closed economy.  Conversely, a country whose investment opportunities fall short of its desired saving, runs a current account surplus and is a net lender of funds offshore.

According to Bernanke, the global saving glut had its antecedents in a wave of financial crises in emerging markets a decade earlier, which raised the precautionary motive for saving amongst those countries affected directly as well as other emerging markets unscathed.  Developing countries swung from being modest net users of capital in 1996 to being significant net lenders by 2003; according to the IMF, these countries swung from running an aggregate current account deficit of $68 billion in 1996 to a $150 billion surplus in 2003.  The size of the surplus confirms that any growth in investment opportunities during this time was not commensurate with the sharp rise in desired saving to safeguard against future crises.  In contrast, the aggregate current account deficit of developed countries had ballooned to $212 billion by 2003.

Bernanke acknowledged that the new status of developing countries as net lenders of capital to developed countries represented a role reversal from the experience of most of the 1990s and a challenge to the standard neoclassical model which says that capital ought to flow to developing countries; their low capital to labour ratios yield higher expected rates of economic return.  What the neoclassical model neglects is the role of risk.  Many developing countries have poor quality governance and institutions, including vaguely defined property rights, and relatively under-developed contract enforceability mechanisms and financial markets.  Consequently, few of these countries have successfully developed globally tradeable financial assets but have had more success in developing income producing assets.

Following the end of the dotcom boom in 2000, the associated steep decline in stock prices further reduced the appetite for capital investment in the US and globally.  According to Bernanke, “…with desired saving outstripping desired investment, the real rate of interest should fall to equilibrate the market for global saving.”  Ricardo Cabarello from MIT draws an analogy between safe assets and parking slots; a rise in the number of cars and contraction in available car parks causes the equilibrium price of parking slots to increase.

10 year treasury yields have continued to decline since 2005 and are currently yielding less than 3%.  In observations earlier this year, Bernanke attributed lower long-term interest rates primarily to a decline in the term premium with an assist from falls in the expected average real short rate and inflation expectations.  The term premium is the additional return investors demand for holding a long dated bond as opposed to buying and rolling over a series of shorter dated securities.  According to Bernanke, the lower – and at times negative – term premium has reflected among other things, the safe haven status and deep liquidity of longer dated treasuries which has attracted strong demand from foreign central banks and governments.

Those foreign central banks and governments are still predominantly from emerging markets.  Trends in current account balances confirm that developing countries continue to save in excess of their investment requirements; their aggregate current account surplus has grown to almost $240 billion from $150 billion a decade ago.  IMF data shows that the developed economies are also running a current account surplus, the first of its kind since 1998.

While Bernanke did not cite the ‘global saving glut’ in his recent speech to explain why long term interest rates are low, it is clear from developments in current account balances that the financial crisis exacerbated the global savings-investment imbalance; a heightened precautionary saving motive amongst developing (and now developed) nations, coupled with a dearth of perceived investment opportunities in developing (and now developed) countries.  Like the end of the dotcom boom, the financial crisis has ushered in a period of capital discipline and cost restraint, and raised companies’ propensity to either hoard cash or payout cash to shareholders in the form of stock re-purchases and/or dividends.

Looking forward, Skeptikoi expects the global savings-imbalance to persist and believes this can shed light on the outlook for real interest rates and monetary policy.  The depth and proximity of the financial crisis – October marked only the fifth anniversary of the collapse of Lehman Brothers – suggests that the healing process is far from over.  Worldwide, the precautionary savings motive remains strong across corporate, household and public sectors, while dormant animal spirits continue to dull the corporate sector’s appetite for increased leverage, capital investment and new hiring.  Against this backdrop, long-term interest rates are likely to remain low for an extended period.  Skeptikoi believes that monetary policies in developed countries ought to remain accommodative – through ongoing central bank purchases of debt securities and strengthened forward guidance – to revive animal spirits and encourage dissaving.

Looking through the cyclical legacy of the financial crisis, the global saving-investment imbalance will diminish only when emerging markets develop stronger institutions and governance mechanisms that reduce perceived risk and encourage investment - particularly in much needed infrastructure for rapidly growing populations.  But this thematic will take a while to play out.  The persistence of low treasury yields might no longer be a conundrum, but Skeptikoi’s view is that another decade on, the global saving glut and low real interest rates could still be with us.

The Great Disinflation

Economic historians and academics specialising in finance and macroeconomics have been and will continue to be the main beneficiaries of the financial crisis.  Academics are still debating the causes of the Great Depression; one can easily extrapolate that academics will be publishing journal articles debating the antecedents of the 2008 Great Recession in 2100 and beyond.

Skeptikoi believes that another phenomenon associated with the financial crisis has not been as well documented as persistently high unemployment; the Great Disinflation.  Inflation and inflation expectations have dropped below the central bank target levels in most developed countries since around 2008.  In the United States, the core CPI (which excludes food and energy) has followed three distinct phases in the past decade.  From 2003 to mid-2008, the core CPI expanded at annualised rate of 2.3%.  This dropped to 1.1% in the two years to September 2010 and has posted compound annual growth of 1.9% since then.

Australia’s disinflation also commenced around the time of the collapse of US investment bank, Lehman Brothers.  The trimmed mean CPI – which excludes items in the CPI basket that experience the most extreme movements – grew at a compound annual rate of 4.3% from March 2007 to September 2008 before slowing to 3.2%pa from September 2008 to March 2010.  Since then, the trimmed mean CPI has grown at 2.2%pa.  So for three years now, underlying inflation has remained at the bottom end of the Reserve Bank of Australia’s (RBA) target range.  This should come as little surprise considering that the RBA’s excessively tight monetary policy coincided with Australia’s deepest nominal recession in over two decades; nominal GDP posted average annual growth of 2.5% in the 2013 financial year.

Labour market developments do a pretty good job of explaining Australia’s disinflation.  Nominal unit labour costs – which are a measure of productivity adjusted wages – are currently at the same level as they were in September 2011.  Excluding the financial crisis, this represents the longest period of stability since the late 1990s.  The unemployment rate of 5.6% remains close to the financial crisis trough and has climbed by close to 15% in the past two years, the largest proportionate rise in over a decade, excluding the crisis.
 

Later this week, the release of Australia’s September quarter CPI will once again bring into focus the RBA’s policy deliberations.  The consensus forecast points to a 0.6% rise in underlying inflation.  The deprecation of the Australian dollar represents some upside risk; the Trade Weighted Index fell by an average of 7% in the September quarter.  But movements in the currency have become less reliable than labour market developments in explaining inflation trends in recent years, possibly reflecting the strength of competitive activity at the retail level.

Some commentators have suggested that the easing cycle is over and are forecasting that the RBA will raise the overnight cash rate (OCR) as soon as in the first half of 2014.  A number of recent developments have brought the RBA some time.  On the local front, there has been a post-election bounce in business confidence and auction clearance rates remain high in Sydney and Melbourne.  Meanwhile, there is growing evidence of a synchronised recovery in world growth; the chances of a hard landing in China have diminished, renewed vigour in quantitative easing is having the desired effect in Japan (Abenomics) and the United Kingdom (Carneynomics), economists are no longer downgrading growth prospects in Europe, and have recently started to upgrade their forecasts, the US recovery remains modest but on track, with tail risk of a default on Treasuries having reduced for now, and the deferral of tapering has stemmed the flight of capital from emerging markets.

But Skeptikoi believes that the RBA’s easing cycle is not over.  The prospect of a synchronised recovery in the world economy is a welcome development for a small open economy like Australia’s, and should help to support commodity prices and the terms of trade.  But the renewed appreciation of the Australian dollar is already mitigating part of the stimulatory benefits of improving global conditions.  And mining companies are unlikely to kick-start large capex programs, having sought to educate the market over the past year of their new 'laser like' cost focus.

Despite the recent significant improvement in business confidence following the Coalition’s decisive victory at the September election, the renewed cost discipline that pervades the corporate sector will keep in check growth in capital investment.  Feedback from the ASX200 companies is that they remain focused on cost containment, the deferral of growth options where feasible and the return of capital to shareholders to cater to the market’s insatiable appetite for income.  Consequently, dividend payout ratios remains close to a record high, no mean feat for a country that already had among the highest payout ratios in the world due to the low effective tax rate on dividends.  Of course, higher payout ratios help to reduce the agency costs of free cash flow, an important development in light of investors’ loss of trust in corporate governance structures since the financial crisis.

A corporate sector that remains focussed on returning capital to shareholders and lifting productivity to combat the prospect of still anaemic revenue growth is good news for earnings growth and investors, but bad news for the labour market and nominal GDP growth.  The RBA reminds us that private sector savings rates remain at two decade highs, that business and household sector balance sheets remain in rude health and that both have the capacity to lift spending and withstand an adverse income shock.  The RBA’s key mandate at present should be to revive the dormant animal spirits that permeate the business and household sectors by further easing monetary policy.  But their reluctance to do so appears to stem from the misguided notion that persistently low interest rates would stoke a future property bubble and undermine financial stability.

The September quarter CPI should confirm that inflation remains benign and that the inflation outlook provides the RBA with ample scope to continue to ease monetary policy.  If the RBA does indeed believe that its job is done and that the OCR has bottomed at 2.5%, Skeptikoi is afraid that labour market conditions will continue to deteriorate and that Australia’s own Great Disinflation will persist.

The Commitment Phobic Fed

Stock market investors have long understood that company guidance can be a double edged sword.  Investors use company guidance to make inferences about trading conditions and the level of conviction that insiders have about their own growth prospects.  But in periods of low earnings visibility, the supply of guidance shrinks at precisely the time that the demand for guidance from investors grows.  During the financial crisis for instance, many listed companies sought to manage their reputational risk by ceasing to give guidance to the market.

Central banks of course don’t have the luxury of ceasing communications to the market when macroeconomic uncertainty increases.  In fact, they should (and most do) talk more during such periods.  In his pioneering paper presented to the 2012 Jackson Hole symposium, Professor Michael Woodford argues that what central bank speak reveals about the bank’s policy reaction function has greater market impact than what the bank says about the economic outlook.  After all, investors can form their own views about the outlook based on alternative sources of information, notably the flow of economic data.

Central bank speak has taken on a new meaning for many central banks in recent years given the unprecedented nature of quantitative easing.  The volatile market reactions in recent months to the Fed’s mixed messages on the likely timing of tapering illustrates the perils of interpreting central bank speak.  The past week was no exception.

The fundamental problem that the Fed faces is that animal spirits remain dormant in the business and housing sector and this continues to weigh on the broader US recovery.  Despite the profit share of GDP being at a record high, corporate gearing remains low, firms continue to hoard cash, real business investment remains marginally below the peak from five years ago and businesses remain reluctant to hire new workers; the hiring rate of 3.2% remains close to historical lows.

Although the flow of residential investment has grown by one-third since 2010, it remains almost 50% below its 2006 peak.  Inflation expectations remain well anchored and various measures point to still substantial slack in the labour market: the employment to population ratio has barely recovered since the financial crisis, the unemployment rate remains above 7% and the participation rate continues to decline to its lowest level in over thirty years.

Given that the Fed Funds rate hit the zero lower bound a number of years ago, the Fed has used the two remaining levers available to it: quantitative easing and forward guidance on the Fed Funds rate.  In so doing, the Fed is seeking to revive animal spirits through the wealth effect – via higher asset prices – and by reducing the level of long term Treasury yields and mortgage rates.

What is crucial to the Fed’s task is using central bank speak to influence and manage investors’ expectations.  But this is turning out to be more difficult than the Fed had probably envisaged.  Woodford argues that the zero lower bound does not render monetary policy impotent, but that effective forward interest rate guidance can influence agents’ expectations of the term structure.  If the central bank can convince economic agents that it will keep interest rates close to zero for an extended period, then it will be more effective in bringing forward agents’ decisions to spend and invest, and in so doing, revive animal spirits.

The problem that the Fed faces relates to its reputation, credibility and commitment; how to credibly convince the market that it is going to commit to a certain course of action in the future.  Skeptikoi’s interpretation of Woodford’s thesis on forward interest rate guidance is that it is best achieved on a calendarised basis; the central bank commits to not raising the operating interest rate for a fixed period, with a clause giving the bank the flexibility to lengthen the amount of time if necessary (but not shorten it).  The market will be sceptical of a central bank’s commitment to keep rates low for an extended period if they believe that the bank will take away the punch bowl just as the recovery is taking hold.  Calendarised forward guidance is credible precisely because it locks central bank into a pre-determined course of action, thus denying the central bank the flexibility to tighten policy during this period.

But Fed speak suggests that it wants to have its cake and eat it too.  Rather than use calendarised forward guidance, it has adopted conditional forward guidance; the interest rate will remain close to zero until (deliberately ambiguous) thresholds relating to unemployment and inflation are hit.  Data dependent forward guidance allows the Fed to retain a fair degree of policy discretion and flexibility to change its course of action.  This represents an important trade-off for the Fed to manage between policy flexibility and committing to a certain course of action in the future.  But the Fed’s desire to retain policy flexibility undermines the efficacy of its forward guidance.  No wonder that markets are confused and frustrated by Fed speak.

Interestingly, the Fed’s decision to defer the tapering of its quantitative easing program demonstrates the central bank’s willingness to sacrifice some policy flexibility for credibility of a different kind.  The decision to defer speaks to the recent rise in uncertainty surrounding the outlook and the Fed’s determination to manage its reputational risk.  Rightly or wrongly, the Fed believes its credibility as a forecaster would be undermined if it needs to re-initiate QE after a decision to taper has been made.  But prior to its recent downgrade to its economic projections, its GDP growth forecasts of 2.45% and 3.25% for 2013 and 2014 respectively, sat well above consensus estimates.

Fed speak suggests that the central bank appears to be more concerned about managing its reputation as an economic forecaster than its credibility to committing to a future course of action of keeping the Fed Funds rate low for an extended period.  But Skeptikoi believes that the Fed’s credibility on forward rate guidance is more important to sustaining the recovery than its own track record as a forecaster.  To re-visit Woodford’s thesis, markets pay more attention to communications that reveal information about a central bank's policy reaction function than its views on the outlook.  

Skeptikoi can only speculate that the Fed’s commitment phobia on forward rate guidance stems from an aversion to inflation that has its antecedents in the spectre of the Great Inflation of the 1970s, a time in which many of the senior members of the Federal Reserve were in the formative (and impressionable) years of their economics training.  The Federal Reserve will continue to be confounded by the market’s reaction to its communications and markets will continue to be frustrated by a lack of clarity in Fed speak as long as the Fed's commitment phobia on forward rate guidance persists.

Overlearning from History and the RBA's Nominal Recession

Most of the recent media’s focus on the Reserve Bank of Australia (RBA) has been on the withering character assessment of Kevin Rudd from RBA board member and former Woolworths CEO, Roger Corbett.  Which is a shame, because the focus should be on the fact that the June quarter National Accounts revealed that in the 2013 financial year, Australia experienced its deepest nominal recession for two decades, due largely to excessively tight monetary policy.

Although many economists focus on the real GDP estimates, Skeptikoi believes that nominal GDP – which captures growth in real GDP and inflation - is a better indicator of the household and business sectors’ cash flows.  The June quarter National Accounts revealed that the nominal economy expanded at an annual average rate of 2.5% in the 2013 financial year.  This represents the softest outcome since the last recession, when nominal GDP grew by less than 2% in 1992.  And it is well below trend growth in nominal GDP, of 5-6%.

The widely used metric for defining a recession in Australia is two consecutive quarterly declines in real GDP.  By this standard, Australia has not had a recession in over two decades.  But if a more comprehensive measure of a recession is used, based on annual average growth in nominal GDP falling below a trigger of 4%, then Australia has just experienced its worst nominal recession since 1992.  By this measure, the economy was also in recession in the 2010 financial year, a period in which average annual growth in nominal GDP was only 3%.

There is a small but growing view that central banks ought to augment or replace inflation targeting with a nominal GDP targeting framework.  On this report card, the RBA scores a fail for two of the past four years.  The 15% decline in the terms of trade from its peak, the associated downgrade to the mining sector’s future growth prospects and persistently high value of the Australian dollar are not responsible for the worst nominal GDP growth outcome for two decades.  Skeptikoi believes that the RBA ‘owns’ the nominal recession.  Despite the record low official cash rate of 2.5%, monetary conditions in Australia remain tight.  Credit growth is tepid, the housing recovery is uneven (approvals for private sector detached dwellings remain at a cyclical low) and the much anticipated handover from mining sector capex to non-mining sector capex remains a long way off. 

The National Accounts provided some encouraging signs.  Nominal GDP posted a 0.9% gain in the June quarter which lifted annualised growth for the June half to 4.5%, while financial sector profits grew by almost 3% to a record high and the terms of trade increased for the second consecutive quarter – albeit marginally – thanks largely to higher iron ore prices.  But non-financial sector profits have now declined for six of the past seven quarters and households remain cautious; the household saving ratio continued to creep up and has averaged more than 10% for the past five years, a level not seen since the mid-1980s.

Animal spirits in the business sector remain dormant and this is unlikely to change in the near-term, even given the likely resolution of uncertainty following the Federal election.  In it updated Economic Statement release in early August, the Treasury downgraded its growth projection for nominal GDP to 4.25% for the 2014 financial year, enough to lift Australia out of its nominal recession, but only just.  The reporting season and cautious guidance comments provided by the ASX200 companies provide further evidence of the unfolding shortfall in aggregate demand.  Large companies including RIO Tinto, BHP, Woolworths, Telstra, Woodside Petroleum, Brambles, Coca Cola Amatail (the list goes on) announced plans to further boost productivity, pare back costs, defer capex plans where feasible and in some instances reduce capex from current levels.

Companies continue to either hoard cash – net gearing levels remain close to record lows – or cater to the market’s insatiable appetite for income; the aggregate dividend payout ratio for the ASX200 has lifted to 70%, close to an historical high.  Corporate Australia’s focus on cost containment is reflected in weakness of the National Accounts measure of unit labour costs – productivity adjusted wages.  Despite a modest 0.8% rise in the June quarter, unit labour costs have stagnated over the past year, the first time this has happened since 1999 (ex the financial crisis).  The guidance comments from the ASX200 companies in the reporting season suggest that growth in unit labour costs (and inflation) will remain well contained, providing scope for the RBA to further ease policy.

The Economist magazine attributes the reluctance of the Obama administration to intervene in Syria to the lessons learnt from the occupations of Iraq and Afghanistan.  Skeptikoi believes that the RBA has been a reluctant rate cutter due to similar ‘overlearning from history’; the view that central banks contributed to the financial crisis by keeping policy too accommodative for too long in the aftermath of the dotcom bust.  The moral hazard view of the crisis largely discounts the role of a range of other proximate factors, notably a glut in global savings and strong demand for safe haven assets.  Importantly it is not clear that the counterfactual of tighter monetary policies through the early to mid-2000s would have prevented the financial crisis, particularly given that long term interest rates – which at the time central banks had little power to influence – continued to decline to record lows during this time.

The RBA would be well placed to learn the lessons from policy errors committed by the Federal Reserve over the past century.  David and Christina Romer present a persuasive thesis that the most dangerous idea in the history of the Federal Reserve is that monetary policy doesn’t matter, a view which they argue contributed to the Great Inflation of the 1970s and Great Depression.  The more the RBA seeks to jawbone the Australian dollar lower – without much success - the more Skeptikoi is convinced that the RBA continues to under-estimate the power of monetary policy to re-balance the economy, revive the business sector’s animal spirits and boost nominal GDP.  In time, Skeptikoi hopes that the RBA’s record as a reluctant rate cutter and its ownership of Australia’s nominal recession will come under greater scrutiny.