The author has been described by News Ltd as an "iconoclast", "Svengali", a pollie's "economist muse", and "pungently accurate". Fairfax says he is a "Renaissance man" and "one of Australia’s most respected analysts." Stephen Koukoulas concludes that he is "85% right", and "would make a great Opposition leader." Terry McCrann claims the author thinks "‘nuance’ is a trendy village in the south of France", but can be "scintillating" when he thinks "clearly". The ACTU reckons he’s "an enigma wrapped in a Bloomberg terminal, wrapped in some apparently well-honed abs."

Friday, December 3, 2010

Volatility is a good thing

Reading Glenn Stevens’ speech this week reminded me of a little appreciated investment theme that I suspect will get more traction as time passes.

The short summary is that Australia’s economic destiny over the next 10-20 years is likely to be much more uncertain and volatile than it has been in the last two decades. This is both a good and bad thing. As Glenn Stevens might say, it is one of the challenges of prosperity—with higher returns come higher risk. And it has ramifications for how investors think about the way in which they deploy their capital.

One consequence of Australia’s heightened uncertainty will be that the two major levers of economic management, monetary and fiscal policy, will become more complex to set, and thus more difficult for investors to anticipate.

Allow me to walk you through the logic.

First, as the RBA has been eager to repeatedly explain to the community, the ratio of the prices we receive for the goods and services we export overseas relative to the prices we pay for our imports, which is known as the ‘terms of trade’, is at its highest level in over a century (see Glenn Stevens’ chart below).

This is because we happen to be fortunate enough to be endowed with extraordinary iron ore and coal resources, amongst other commodities, which are critical ingredients to facilitating the historic urbanisation and industrialisation processes taking place in the world’s two largest nations, China and India (see next chart). Between them, China and India account for about a third of the global population, and have rapidly emerged as two of Australia’s most important trading partners. As the table below shows, China and India collectively bought just 6.7 per cent of our exports ten years ago. Today they acquire more than 31 per cent. And these linkages are deepening all the time. We also import more products from China than any other country.

The good news is that our growing—and it needs to be remembered, mostly providential—ties to these twin supertankers mean that we are getting the benefit of an enormous income shock as the demand for our produce inexorably rises. This is reflected in quite remarkable growth in real national incomes relative to the market value of national output (ie, GDP), as the next chart from ANZ illustrates.

The RBA’s best guess is that this income shock is not a temporary phenomenon, but rather likely to be a more permanent affair due to the expected duration of the structural changes occurring in China and India. In short, they are multi-decade processes.

Phase two of China’s development, which is just starting to take place, will be the emergence of a middle class that will help to foster internal demand and reduce its reliance on old world export markets, like the US. This will also work to further the separation between Australia and our historic trading partners.

One challenge for the RBA and Treasury is how to help Australia’s economy handle the huge increase in private investment that is currently underway (estimated at about 20 per cent of GDP) while avoiding a concurrent boom in household spending, which typically accounts for 50-60 per cent of economic activity, as a function of the income consumers are being showered with. That is, how do the RBA and Treasury avoid all sectors of the economy firing simultaneously when the supply-side has limited ability to respond to this increase in demand?

The RBA’s solution has been that the household sector has to make room for the rest of the economy by, amongst other things, saving more. In his speech this week Governor Stevens spent a lot of time advocating higher public and private sector saving. This partly explains why the RBA has been quick to normalise interest rates, thereby supplying households with every incentive to squirrel money away in high-yielding bank deposits. It also doesn’t hurt that consumer risk-aversion is probably greater than it has been in the recent past thanks to the effects of the GFC.

While I was initially sceptical of the RBA’s ‘conservative consumer’ thesis, I did not appreciate that the central bank was not actually giving households a choice: it would force this thriftiness upon them if they did not comply.

And one must say that the RBA has been successful in engineering this result with a stunning circa 10 per cent savings rate recorded in the latest National Accounts (see next chart). The RBA wants to see these parsimonious patterns in consumers’ consumption and saving choices persist, which may be one reason why it will keep on nudging up the cash rate in advance of what the real-time economic data would suggest apposite.

The not-so-good-news is that the profound change in Australia’s trading partner mix—away from the old world to focus on China and India—has resulted in a telescoping of our economic linkages. This also means that our future is likely to be a more volatile one as we are buffeted around by the unpredictable wake thrown off by Chindia. As Stevens noted this week, these countries have business cycles too. And Australian growth will likely rise and fall alongside Chindia’s fortunes. This is the downside associated with being so highly leveraged to the two turbochargers propelling global growth (see next chart).

In some ways, the third quarter GDP print, which suggested the economy hardly expanded between July and September, inclusive, portends this more variable, but, over the long-term, prosperous future.

The dynamics described above also mean that policymakers have to be more forward looking in their decision-making if they are to avoid a sudden build-up in imbalances between different sectors of the economy. This means paying less attention to contemporaneous economic data flows, such as the low inflation numbers in the second and third quarters, or the weak GDP and retail trade prints we have seen in the last two days, and placing more weight on their expectations of the future.

In his testimony to Parliament last week, Glenn Stevens made several interesting remarks on this front. One meme he kept on returning to was that if you wait until you are certain that interest rates have to move, you have likely waited too long. That is, if you defer the decision to move rates today until you can actually observe, say, higher inflation data, the bad times have likely already arrived.

Threading all this together yields an insight: where policymakers have a more difficult decision-making task, and must increasingly rely on inherently uncertain forecasts, they are also more likely to make mistakes.

Yet the monetary policy authorities in particular should not be afraid of this. If you accept that you are making decisions under conditions of uncertainty, then you must also accept that there will be occasions when you make mis-steps. Our central bank is lucky that it can quickly reverse any errors given that most debt in Australia is set at variable rates. If, for example, rates are too high, the RBA can cut them and deliver borrowers immediately cash-flow relief.

Of course, if you are an inflation-targeting central bank with a (recently) weak track-record of keeping the modal distribution of price increases within your target range of 2-3 per cent per annum, then you are also likely to err on the side of conservatism. That means that you have an implicit preference for undershooting, as opposed to overshooting, your inflation target, all other things being equal.

Such uncertainty also engenders opportunity. Investors will probably face a wider distribution of potential outcomes, and thus more chances to make or lose money depending on their ability to divine our economic destiny. That's worthwhile keeping in mind.