The leaders of the seven largest developed economies are just about to meet in Canada, and they will do so in an unusually acrimonious atmosphere. US president Donald Trump has been the odd man out on previous such gatherings, but that will be nothing compared with the confrontation that is likely to occur this time around. The reason of course is that the US has implemented tariffs against their allies, a move which has understandably provoked seriously adverse reactions and the all too predictable retaliatory tariffs from those impacted. The host of the G7 Meeting, Canadian prime minister Justin Trudeau was strident in his criticism of the move, described it as “insulting.”
“Trudeau said on Sunday that he is having “a lot of trouble getting around” that Canada has abruptly become “a national security threat to the United States”. The Canadian prime minister went further, saying US and Canadian soldiers “who had fought and died together on the beaches of World War II, on the mountains of Afghanistan and have stood shoulder-to-shoulder in some of the most difficult places in the world, that are always there for each other, this is insulting to that.”1 There is anecdotal evidence that this uncertainty created by the on-again, off-again trade wars is already impacting business sentiment, and at the very least leading to delays in business investment decisions.
This also includes the stalled talks between the US, Canada and Mexico on the North American Free Trade Agreement, which the US now wants to break up into two bi-lateral agreements, with a 5 year sunset clause. Canada and Mexico have flatly ruled out such an approach, and it surely must register with President Trump that his approach on trade is attracting stiff opposition from his own Republican colleagues in congress, and more broadly from the business community. This is an issue that remains very fluid, and whilst we monitor it closely for portfolio implications, there is little about which we can be certain in terms of potential impacts at this point in time. What does seem plausible though is that the effect on business and investor sentiment from the uncertainty will outweigh whatever negative consequences are eventually seen in economic growth. That is something that is likely to have some impact on investment markets, especially when the valuations in the United States remain elevated.
Some of our longer term investors may recall that in presentations delivered a few years ago, and at a time when the Global Financial Crisis was much fresher in our memories, we referred to a comment from an admired American investor. The question he was asked was “what will we learn from the financial crisis?” And he replied, “in the short-term a lot, in the medium-term a little, and in the long-term… nothing at all.” Recently regulatory authorities in the United States have enacted measures to further weaken their oversight of the financial sector. In the aftermath of the crisis, rules were imposed on large banks that were seen to represent systemic risks to the financial system and overall economy. The measures required that they must hold more capital, be subject to more regular and more intense scrutiny, and that they provide a ‘living will’ that would guide how a bank could be wound up in an orderly fashion.
On the basis of lobbying efforts from the sector, the justification for relaxing these rules was that they represented too onerous a burden on the sector, which meant that banks weren’t free to lend as they would like, which in turn was curtailing economic growth.
The legislation we are discussing came into effect in mid-2010, right where the growth in commercial and industrial lending started to grow steadily. Recent changes mean that the threshold at which banks are deemed systemically important was lifted from US$50 billion in assets to $250 billion in assets, meaning thousands of banks are now subject to more lax oversight.
Further moves are also underway which would roll back key restrictions against proprietary trading by the banks. The intent of this part of the legislation was to limit the extent to which banks that enjoy safeguards and backstops from the public can make bets for their own private gains. The trajectory of deregulation is very clear under the current administration. “Legislate. Repeal. Fail. Repeat. Meanwhile the potential damage swells because the global financial system has become ever more tightly linked. Why do we expect a different result from deregulation, which has ended in sorrow again and again?” 2
Turmoil is very much the order of the day when it comes to Italian politics, a country where governments have lasted on average a little more than a year since they became a republic following World War II. While we may have thought Australia recently had a high rate of government turnover, new prime minister Giuseppe Conte will lead the 66th Italian government in 72 years. That a new government has at last been sworn in is but a temporary salve to unrest in Europe. Conte will lead an unlikely alliance of the populist parties from either end of the political spectrum, bound together more than anything else by their skepticism with regard to an integrated Europe and the common currency.
No doubt these developments will feature high on the agenda when the European Central Bank meets in mid-June, under the leadership of the former Governor of the Bank of Italy Mario Draghi. This meeting had been one where observers thought it likely that more detail and a more definitive stance would be provided by the ECB on their plans to unwind the last of the extraordinary monetary policy support provided to the region. Specifically, that the bank’s program of purchasing bonds to provide additional liquidity to the financial sector would come to a halt at the planned date in September, accompanied by some forward guidance as to the trajectory on eventual interest rate normalisation.
Some believe that the effect of the situation in Italy means that September 2019 is the earliest date by which interest rate increases may be expected, others were more direct in their analysis. “There are still two weeks to go before [the meeting], but naming an end date … right now would be like the ECB shooting itself in the Italian boot.”3 The longer the turmoil in markets continues, the less likely progress in June becomes and on balance, it seems likely the bank will keep their options open. It is also worth noting that the ECB’s chief economist spoke of the “underlying strength” of the European economy in remarks ahead of the upcoming meeting.
To finish on an optimistic note, this week we saw a surprise to the upside on already elevated expectations for Q1 growth in the Australian economy. Economic expansion for the March 2018 quarter came in at 1.0%, pulling the year on year figure up to 3.1%. This is consistent with the views expressed by the Reserve Bank earlier in the week when they kept rates on hold at 1.5%, and provided this succinct summation of the economy in their accompanying statement. “The recent data on the Australian economy have been consistent with the Bank’s central forecast for GDP growth to pick up, to average a bit above 3 per cent in 2018 and 2019. Business conditions are positive and non-mining business investment is increasing. Higher levels of public infrastructure investment are also supporting the economy. Stronger growth in exports is expected. One continuing source of uncertainty is the outlook for household consumption. Household income has been growing slowly and debt levels are high.”4
The issue of debt levels in the household sector is of course deeply intertwined with the health of the housing market, though the risks are certainly improved by the strong labour market and the likelihood that interest rates stay at historically low levels for an extended period. HSBC’s chief economist in Australia previously held a role at the RBA where he was involved in analysis of the residential property market, so his views are informed by this valuable experience. A recent note he published was titled “Australian housing: Expect a soft landing,” which included the following assessment.
“Having had housing price booms, it is now Sydney and Melbourne that are seeing their housing markets cool, while other cities have generally continued to see subdued housing market conditions. For Sydney, housing prices have fallen by 4% since their peak in mid-2017, although they are still 66% above the mid-2012 trough. For Melbourne, housing prices are up 4% over the past year, but this is a slowing from double-digit growth over the previous year (prices are up 56% since the mid-2012 trough). These markets have both cooled more quickly than we had expected, but we are expecting them to stabilise in coming quarters.”5
These charts also argue against one of the most frequent criticisms of the property market which was that we are heading for an oversupply situation. Whilst that appears unlikely, so too is the prospect of broad financial instability. We expect that will in time be good news for the financial sector.
For more information contact Forwood Planning on 07 3103 3038.