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Published in MOB
Friday, 14 February 2014 19:17

US Recovery - It's real!

There continues to be much skepticism among the general public about the recovery of the US economy.

In this article, we provide a series of charts that show that the US recovery is very real.

Further evidence can be seen in the US share market.  During the most recent company reporting season we saw 68% of companies in the S & P 500 beating earnings expectations.

US Labour Market recovery

The next chart shows the average monthly employment growth - note that a number of 200,000 new jobs is required to lower the unemployment rate.

US Employment GrowthThe US Housing market has a multiplier effect throughout the economy both in terms of employment as well as consumer spending.  Activity and prices have most certainly turned as can be seen in the chart below.

US Housing Market RecoveryThe US Budget position has dramatically improved as economic activity has turned.

US Budget PositionUS energy sufficiencyUS Corporates are also in good shape - earnings have beaten expectations and their balance sheets are in good shape.

US Corporates in good shape


DISCLAIMER: The above information is commentary only (i.e. our general thoughts).  It is not intended to be, nor should it be construed as, investment advice.  To the extent permitted by law, no liability is accepted for any loss or damage as a result of any reliance on this information.  Before making any investment decision you need to consider (with your financial adviser) your particular investment needs, objectives and circumstances.



Published in Investment Advice
Sunday, 02 February 2014 14:53

Emerging Market Risks - How Serious?

Key pointsWorld Peace

- Concerns about emerging countries on the back of various political problems and trade imbalances that leave them vulnerable as the Fed slows down its monetary stimulus appear to have triggered a correction in share markets.

- However, while it makes sense to be cautious about emerging market shares generally, a re-run of the 1997-98 Asian crisis is unlikely and emerging markets are unlikely to pose a major threat to global economic recovery.


The past week has seen renewed concerns about the emerging world reflecting a combination of political problems in several countries including Turkey and the Ukraine, a currency devaluation in Argentina and ongoing concerns about Chinese growth. Such concerns also reflect the impact of the Fed slowing its monetary stimulus at a time when parts of the emerging world are vulnerable.

This has seen falls in emerging market shares and currencies. Moreover, fears about exposure to the emerging world and a possible threat to global growth have seen share markets in advanced countries fall nearly 4% over the last week. Concern has returned that we may see a re-run of the 1997-98 “Asian-emerging markets crisis”.

Our assessment remains that another “Asian-emerging markets crisis” is unlikely. However, it is even clearer that the secular cycle has now turned against emerging market shares (EMs) relative to developed markets (DMs).

The 1997-98 Asian/emerging market crisis

Economic history reminds us repeatedly about the prevalence of cycles – both short term and long term. Asian and emerging countries and shares are not immune having gone in and out of favour several times over the last few decades. In the mid 1990s there was much talk of an “Asian miracle”. Growth was thought to be assured by high savings and investment rates, strong export growth and a shift in labour from rural areas to cities. However, as is often the case during good times, excesses set in including a growing reliance on foreign capital, current account deficits, excessive debt levels and over-valued fixed exchange rates. Eventually foreign investors had doubts. In mid-1997 Thailand experienced capital outflows that became a torrent and triggered a collapse in its fixed currency, which then led investors to search for countries with similar vulnerabilities (so-called “Asian contagion”) which led to the crisis spreading across the emerging world ultimately contributing to Russia’s debt default of 1998 that briefly dragged down developed market shares in August 1998.

In the 2000s, Asian and emerging countries mostly got their act together thanks to a range of productivity enhancing reforms, less reliance on foreign capital, low and floating exchange rates and high foreign exchange reserves and this along with the industrialisation of China and a related surge in commodity prices (which benefited South American countries and Russia) saw their growth rates improve. The enhanced perception of emerging countries and a secular slump in the traditional advanced economies of the US, Europe and Japan at the same time saw them once more come into favour amongst investors.

This reached a crescendo after the global financial crisis with talk of a “new normal” of poor growth in advanced countries and their rounds of quantitative easing encouraging capital flows to the “stronger” emerging markets leading in fact to talk of “currency wars” as EM currencies rose. The surge in the value of Asian currencies versus the $US over the last decade as a result of strong capital inflows can be seen in the next chart. Recent weakness has only reversed a small portion of the rally from Asian crisis lows, but emerging market currencies generally have been a lot weaker, having been in a down trend since 2011 (just like the $A!).


Back to the future?

Has Asia and the emerging world just gone full circle such that it’s now standing on the precipice once more? Several factors are driving current worries:

  • Fed tapering has led to fears of a reversal in the money flow to the emerging world that may have come from quantitative easing. Transitions in Fed monetary policy often have implications beyond the US, eg the Mexican crisis when the Fed moved to tighten in 1994.
  • This has occurred at a time when the flow of news in developed countries – the US, Europe and Japan - has continued to improve.
  • Some emerging countries face political problems – the Ukraine, Turkey, Argentina and Thailand.
  • Several emerging countries, notably Brazil, India and Indonesia, used the capital inflows that occurred as a result of quantitative easing in the US to finance budget and current account deficits.
  • Slower growth in China has taken its toll on the emerging world generally by putting downwards pressure on commodity prices and dragging on the demand for imports from the Asian region.
  • More fundamentally, the boom years of the last decade allowed several emerging countries to go easy on necessary structural reforms. Poor infrastructure, excessive regulation and restrictive labour laws are key problems. The end result has been inflation and trade imbalances and reduced potential growth rates.

The end result has been for investors to start rethinking the outlook for emerging countries with flows heading back to the advanced countries. The problem for emerging countries in raising their interest rates to support their currencies – as has occurred in several including Brazil, India and Indonesia – is that it further serves to slow economic growth making the investment outlook in such countries even less enticing.

Put simply, there is no easy way out for countries with current account deficits when foreign investors start to withdraw their capital. In the short term domestic spending must fall, interest rates must rise and exchange rates fall to bring this about. The only way to sustained stronger long term growth is to reform their economies, but that takes time.

Still not 1997, but the risks have increased

The next table compares the state of current account deficits & inflation today with the situation before the 1997-98 crisis.

Not as vulnerable as in 1997

  Current account, %GDP FX reserves, $USbn Inflation rate, %
  1996 Now 1997 Now 1996 Now
Indonesia -3.2 -3.9 17 99 7.9 8.4
Thailand -7.9 -1.6 27 167 5.9 2.2
India -1.6 -3.1 20 295 9.0 9.9
Korea -4.4 4.6 20 345 5.1 1.1
Taiwan 3.9 10.0 84 421 3.1 0.3
Malaysia -4.4 5.0 15 136 3.5 2.9
Singapore 13.8 18.5 73 272 1.1 2.6
HK 3.9 2.3 93 309 5.9 4.3
China 0.9 1.9 140 3726 8.3 2.5
Brazil -2.7 -3.7 58 376 9.6 5.9
Russia 2.8 2.3 25 524 21.8 6.4

Source: IMF, Bloomberg, AMP Capital

The overall position of emerging countries remains stronger today. Current account balances are generally in better shape, central banks have much higher foreign exchange reserves, exchange rates are floating rather than fixed and not as high as they were before the Asian crisis and inflation is lower. Having mostly floating rather than fixed exchange rates is a big distinction today because, as IMF research has confirmed, floating exchange rates are less prone to crises than fixed: they create less economic distortions and don't need to be defended from speculative attacks.


Source: IMF, AMP Capital

However, several countries are vulnerable, particularly Brazil, India and Indonesia where current accounts have moved heavily into deficit indicating a now heavy reliance on foreign capital inflows. See the previous chart.
Other emerging markets that are vulnerable thanks to current account deficits and hence a reliance on foreign capital inflows are the Ukraine, Turkey, South Africa and Chile.
By contrast China, South Korea, Taiwan and Russia with large current account surpluses are far less vulnerable.

While we don’t see a re-run of the Asian-emerging market crisis or a sharp collapse in emerging market growth the risks have clearly increased particularly for countries that now have large current account deficits. Emerging market growth generally is likely to be softer in the years ahead than what we got used to last decade.

Implications for investors

There are several implications for investors:
First, while emerging market shares are relatively cheap (with forward price to earnings multiples of around 10 times compared to 14 times for global shares) it’s too early to strategically reweight towards them. Notwithstanding likely bounces in relative performance along the way, the secular underperformance by emerging market shares relative to developed market shares could have a fair way to go yet, particularly given the extent of outperformance last decade.


Second, investors in emerging markets should focus on current account surplus countries as these are less vulnerable to foreign capital flows, eg China and Korea. And in any case Chinese shares are amongst the cheapest in the emerging world.
Thirdly, emerging markets are unlikely to pose a severe threat to growth in advanced countries. Yes the emerging market share of world GDP is now just over 50% compared to around 35% in the mid-1990s, but more fundamentally a sharp slump in emerging market growth is unlikely given the stronger position of many emerging countries today compared to that prior to the Asian-Emerging Market crisis.
Fourthly, emerging market worries appear to have provided the trigger for a correction in advanced country share markets that high levels of investor sentiment had left them vulnerable to. But once investor sentiment falls back to more normal levels the rally in shares is likely to resume.

Finally, while a recession in emerging market countries is unlikely, slower growth than seen over the last decade will act as a bit of a constraint on commodity demand, providing another reason why the broad trend in the Australian dollar will likely remain down. Ultimately I still see the $A heading down to $US0.80.

Dr Shane Oliver

Head of Investment Strategy and Chief Economist AMP Capital


DISCLAIMER: The above information is commentary only (i.e. our general thoughts).  It is not intended to be, nor should it be construed as, investment advice.  To the extent permitted by law, no liability is accepted for any loss or damage as a result of any reliance on this information.  Before making any investment decision you need to consider (with your financial adviser) your particular investment needs, objectives and circumstances.


Published in Investment Advice
Monday, 06 January 2014 08:43

Fed Tapering - what it means for investors

Wall St ImageKey points

- After much talk since May, the US Federal Reserve is finally reducing (or tapering) its asset purchase program - by $US10bn a month.

- However, the Fed has enhanced its very dovish forward guidance, highlighting that interest rate hikes are still a long way off and dependent on the economy.

- Fed policy remains market friendly & generally supportive of further gains in shares.

- While, Fed tapering and speculation around it has and will contribute to bouts of market uncertainty, it should be seen as good news as it indicates the US recovery is becoming more sustainable.


In what was perhaps the most anticipated event this year the US Federal Reserve has announced it will reduce the pace of its third quantitative easing (QE3) program by $US10bn a month. The Fed has been foreshadowing a “tapering” since May 22nd so it’s a surprise to no one. This note looks at what it means for US monetary policy and investment markets.

The Fed tapers

The key aspects of the Fed’s decision to taper are:

  • A cutback in QE from $US85bn a month to $US75bn.
  • This to be focussed on both reduced Treasury bond purchases (which drop from $US45bn a month to $US40bn) and reduced purchases of mortgage backed securities (which drop from $40bn a month to $35bn).
  • Tapering is not a “not on a preset course” but dependent on further economic improvement & higher inflation with Chairman Bernanke implying the wind down will be such that QE will likely continue into late next year, implying an ongoing reduction of about $US10bn in bond purchases each meeting, which is slower than many expected,
  • More dovish guidance on the outlook for interest rates with the Fed indicating rates will remain near zero well beyond the time when unemployment falls below 6.5% and 12 of the 17 Fed committee officials not seeing a rate hike until 2015. In other words the clear message is that tapering is not monetary tightening and does not mean that the first rate hike is any closer.

The Fed’s dovish guidance is significant as Fed research suggests it has greater effects on the economy than signals about asset purchases.* Specifically, it’s aimed at pushing back against rising bond yields as it has led to higher mortgage rates.

Our assessment

The first thing to note is that the Fed’s move is positive as it indicates the US economy is getting stronger and the recovery more self-sustaining and so the US can start to be gradually taken off life support. However, the emphasis is on gradual. It’s quite clear the Fed is still committed to easy monetary policy until more spare capacity is used up. While the economy is on the right path, it’s still got a way to go, particularly with inflation running well below the Fed’s 2% target.

In this regard, tapering is not the same as monetary tightening. Pumping cash into the US economy is continuing but at a slightly lower rate. It’s very different to the premature and arbitrary ending of QE1 in March 2010 and QE2 in June 2011 that went from $US95bn & $US75bn respectively in monthly bond purchases to zero overnight at a time when US and global economic data was poor and contributed to 15-20% share market slumps at the time. This time around QE is only being reduced gradually and only because the economic data shows the US economy improving.

More fundamentally, tapering does not signal earlier interest rate hikes. Quite clearly the Fed has gone out of its way to stress this message by indicating that near zero interest rates will likely remain well beyond the time when unemployment falls below its previous target of 6.5%. Our own view of the US economy is very similar to the Fed’s in seeing growth of around 3% next year driven by housing, business investment and consumer spending. However, barring a much faster acceleration in growth, interest rate hikes are still probably 18 months or more away:

  • Growth is still far from booming.
  • Spare capacity is immense as evident by 7% official unemployment, double digit labour market underutilisation and a very wide output gap (ie the difference between actual and potential GDP).

Image 1
Source: Bloomberg, AMP Capital

  • A fall in labour force participation has exaggerated the fall in the unemployment rate. While much of this is structural some is cyclical and at some point will start to bounce back slowing the fall in unemployment.
  • Inflation is low at just 1.2%.

Comments during her nomination hearings quite clearly indicate that Janet Yellen, the likely next Fed Chairman after Bernanke’s term ends at the end of January, will not be rushing to raise interest rates.

Put simply the Fed may be easing up on the accelerator, but they are a long way from applying the brakes.

Finally, while the US is slowing its monetary stimulus this is not so in other key developed regions with both the ECB and Bank of Japan likely to ease further if anything.

Implications for investors

While the days of expanding US monetary stimulus are probably over, the message from the Fed remains market friendly. The pace of quantitative easing is slowing only gradually, this is contingent on the US economy continuing to strengthen and rate hikes are unlikely until 2015, at least.

For sovereign bonds our medium term view remains one of poor returns. Despite the back up in yields, they remain low relative to long term sustainable levels suggesting the risk of rising yields and capital losses over time as the global economy mends. Even if bond yields stay flat at current levels they offer poor returns, eg just 2.9% for US 10 year bonds and just 4.3% for Australian ten year bonds. However, a 1994 style bond crash which saw extreme long bond positions unwound triggered by a sharp 300 basis point rise in the US Fed Funds rate looks unlikely.

For shares, the period of dirt cheap share markets and support from ever expanding monetary stimulus seems over. More significantly, taper talk since late May has clearly made some nervous given the positive relationship between rounds of quantitative easing in the US and share markets, with many fearing that a move to end it will be followed by slumps as occurred after QE1 and QE2 ended. See the next chart.

Image 2

Source: Bloomberg, AMP Capital

Slowing QE suggests share market returns are likely to slow from the 20% or so pace of the last 18 months. Bouts of uncertainty regarding the Fed’s intentions are also likely, as we saw in May-June and more recently. However, the overall picture remains favourable for shares:

First, the tapering of QE3 is very different to the abrupt and arbitrary ending of QE1 and QE2. This time around US data is stronger and the wind down in QE3 is dependent on further improvement in US economy.

Second, although the Fed isn’t undertaking monetary tightening many tend to see it as such so past monetary tightening moves, which have been via rate hikes, are instructive. The next table shows US shares around the first rate hikes in the past 8 Fed tightening cycles. The initial reaction after 3 months is mixed with shares up half the time and down half the time. But after 12 and 24 months a positive response tends to dominate. So even if this were the start of a monetary tightening cycle it’s not necessarily bad for shares.

The reason for this lies in the improvement in growth and profits that normally accompanies an initial monetary tightening. It’s only later in the cycle when rates are going up to onerous levels to quell inflation that it’s a worry. Right now we are seeing improving growth and profits, but with the start of rate hikes (let alone rises to onerous levels) looking a long way off given very low inflation.

US shares after first Fed monetary tightening moves

First rate hike -3 mths +3 mths +6 mths +12 mths + 24 mths
Oct 80 4.8 1.6 4.2 -4.4 2.4
Mar 84 -3.5 -3.8 4.3 13.5 22.5
Nov 86 -1.5 14.0 16.4 -7.6 4.8
Mar 88 4.8 5.6 5.0 13.9 14.6
Feb 94 2.9 -6.4 -4.9 -2.3 14.9
Mar 97 2.2 16.9 25.1 45.5 30.3
Jun 99 6.7 -6.6 7.0 6.0 -5.6
Jun 04 1.3 -2.3 6.2 4.4 5.5
Average 2.2 2.4 7.9 8.6 11.2

Source: Thomson Reuters, AMP Capital

Thirdly, the rally in US shares recently has been underpinned by record profit levels. It’s not just due to easy money.

Finally, shares are likely to benefit from long term cash flows as the mountain of money that has gone into bond funds since 2008 is gradually reversed with some going to shares.

Image 3

Source: ICI, AMP Capital

While next year will no doubt see a few corrections in shares along the way, the key point is that the broader picture – of reasonable share market valuations, improving global growth and still very easy monetary conditions - suggests the bull market in shares has further to run.

The Australian share market is also likely to benefit from the rising trend in global shares, but is likely to remain a relative underperformer reflecting better valuations globally and a bit more uncertainty over the Australian economy. Sector wise, mining stocks look cheap and best placed to benefit from the global recovery.

In terms of the Australian dollar, Fed tapering may make life a bit easier for the RBA in getting the $A down. While I wouldn’t get too excited as near zero interest rates in the US look like remaining in place for some time, the broad trend in the $A is likely to remain down.

Finally, in the very short term getting the Fed’s taper decision out of the way likely clears the way for the seasonal Santa rally in shares that normally gets underway around this week and runs into early January.

Dr Shane Oliver
Head of Investment Strategy and Chief Economist
AMP Capital


Important note: While every care has been taken in the preparation of this document, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) make no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This document has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this document, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This document is solely for the use of the party to whom it is provided.


Published in Investment Advice

665200-health-insurance-moneyIn just a few weeks' time we will pass the anniversary of one of most profound economic policy decisions in Australia's modern history. I refer of course to the decision taken by the Hawke Government in December 1983 to float the Australian dollar and to abolish most restrictions on the international movement of capital.

The decision had been a long time coming. The possibility of a float had been contemplated for years. But the right combination of intellectual climate and circumstances did not arrive until 1983. When it was taken, the decision was a key part of a sequence of very important decisions that opened up the Australian economy and its financial system to international forces, and which changed it profoundly.

Much has been written about that broader reform process. I will speak just about the floating of the dollar itself. I shall pose, and offer answers, to several questions. Why did we float? How has the market developed? How has the exchange rate behaved? What difference did the float make for monetary policy in particular and the economy in general? Has the currency been ‘misaligned’ in ways that have been damaging? And what can be said about intervention?

1. Why did we float?

In a nutshell, I think it is true to say that Australia finally floated the exchange rate because the feasible alternatives had been shown to be ineffective. We had tried just about all the currency arrangements that were known to human kind, with the exception of a currency board: a peg to gold/sterling, a peg to the US dollar, a peg to a basket and a moving peg. All proved ultimately unsatisfactory.

From first principles it could be questioned whether Australia, a country that on occasion experiences quite large shocks in the terms of trade, should have had a fixed exchange rate. The background was the complete breakdown of the international trade and financial system in the 1930s followed by war, which left private capital flows small, central banks and governments dominating capital markets and a distrust of the price mechanism generally. The experience of the early 1950s, however, showed how hard it could be to maintain stability in the face of terms of trade shocks with a fixed exchange rate.[1]

By the early 1980s the intellectual climate had clearly changed. Things had moved on from the post-Depression set of assumptions. More people were conscious of the shortcomings of the regulated era, and were prepared to argue for allowing market mechanisms to set prices and allocate resources.

So there was a case for exchange rate flexibility on ‘real’ or resource allocation grounds. There was also one based on monetary grounds. On the one hand, a fixed exchange rate with a suitable major currency can serve as a ‘nominal anchor’ if we are prepared to accept the monetary policy of the other country through all phases of the cycle. The countries to whose currencies we had pegged, however, had their own circumstances and policy imperatives that evolved differently from our own. Private capital flows had become much larger and our commitment to make a price in the foreign exchange market meant we could not control liquidity in the domestic money market. Inflows of funds in anticipation of a revaluation led conditions to become too easy, and outflows in anticipation of a devaluation tightened up the system. By the early 1980s, with inflation quite high, the lack of monetary control was a serious problem. This was the situation in the lead-up to the decision to float.[2]

2. How has the market developed?

Thirty years ago, the Australian foreign exchange market was relatively small and underdeveloped. At the time of the float, the participants in the market were primarily the domestic commercial banks, though this quickly changed after a number of foreign banks were given licences, increasing competition significantly. After the float, the market matured and grew. Today the Australian dollar is one of the most actively traded currencies. Global daily turnover runs at about $460 billion.[3] The AUD/USD is the fourth most traded currency pair, accounting for just under 7 per cent of global foreign exchange turnover. Compared with the US dollar, the euro or yen, these are small numbers but compared with currencies of several other countries whose economies are noticeably larger than Australia's, the size of the AUD market is remarkably large. It offers the full range of foreign exchange products.

These days more of the trading activity in our currency occurs outside our jurisdiction than inside it, a pattern that is common to most currencies. This reflects the role of international financial centres such as London, which retains a dominant role as a financial hub. Other centres such as Singapore and Hong Kong have made it part of their national ‘business model’ to provide an environment conducive to major financial firms setting up to offer a full menu of financial services to the global investor community. Most countries that are not themselves international financial hubs find that an increasing proportion of trading in their currency takes place ‘offshore’.[4]

3. How has the exchange rate behaved?

At the time of the float, the Australian dollar against the US dollar was actually not very different from its current value (Graph 1). It was worth about 90 US cents in December 1983. That was down from its highest point in the 1970s under the fixed exchange rate system, of US$1.4875. The trade-weighted index was 81 (today about 72), down from a high of around 120. People forget how high the exchange rate was for much of our history.

Graph 1

Graph 1: Australian Dollar 

Click to view larger

Initially after the float, the exchange rate rose for some months before settling back. There was a further very distinct leg down beginning in early 1985. There was quite a lot of drama at the time – this was the era of credit rating downgrades and ‘banana republics’. I think there was a genuine fear at various times that the currency might simply collapse to some ludicrously low value.

With the benefit of that most powerful of tools, hindsight, one can observe that the currency had by the mid 1980s adjusted to a lower mean value, around which it fluctuated for nearly 20 years. One can further note that those trends had some association with developments in Australia's terms of trade (Graph 2). From this vantage point, the market might be argued, on the whole, to have moved the exchange rate to about the right place. And despite the occasional worries about large downward movements, there was probably less high drama associated with them than would have accompanied decisions to devalue a fixed exchange rate.

Graph 2

Graph 2: Real Exchange Rate and Terms of Trade 

Click to view larger

Some trends did seem less explicable, such as when the exchange rate fell below 49 US cents in March 2001 and lingered at very low levels for a while. This was in the wake of a slowdown in the Australian economy, but was also the era of excitement over America's so-called ‘new economy’, and the sense that Australia was an ‘old economy'.[5]

The ‘old economy’ elements like mining would come into their own only a few years later. In 2001, the terms of trade were already rising, and a powerful upswing ensued over the next decade. Even those who were prescient enough to understand the importance of the rise of China have, I suspect, been surprised by the extent of increase in Australia's terms of trade and its longevity. And of course this trend has carried Australia's currency to historically high levels – back, in fact, to about where the floating journey began thirty years ago.

Has the mean value around which the currency fluctuated from the mid 1980s to the mid 2000s now given way to something higher, or will it reassert itself? That is a fascinating question.

4. What difference did the float make?

For the Reserve Bank in its monetary policy responsibilities, the float made all the difference in the world. We no longer had an obligation to stand in the foreign exchange market at a particular price. An earlier decision of the Fraser government to issue government debt at tender meant that the Reserve Bank did not have to stand in the government debt market either. As a result of these two decisions – and they were both important – for the first time the Bank had the ability to control the amount of cash in the money market and hence to set the short-term price of money, based on domestic considerations. This is the hallmark of a modern monetary policy. The extent of short-term variability in interest rates declined while, naturally, that of the exchange rate rose somewhat (Graph 3).

Graph 3

Graph 3: Australian Interest Rate and Exchange Rate Volatility 

Click to view larger

A flexible exchange rate is also a critical component of inflation targeting, which is Australia's monetary policy framework of choice. Admittedly, for some years exchange rate considerations were still sometimes seen as something of a constraint in the conduct of monetary policy. This has been progressively less the case, though, as the credibility of the inflation target has increased.

Even if all the flexible exchange rate did was to allow monetary policy to operate effectively, that was a major benefit. But the float did more than just that. Real exchange rates move in response to various forces affecting an open economy, even if the nominal exchange rate is fixed. Given the slow-moving nature of the bulk of prices, allowing the nominal exchange rate to change makes the process more efficient unless there is excessive short-run variability in the nominal rate. As hedging markets develop the cost of short-run noise is usually lessened. In my view the flexible exchange rate has helped adjustment in the real economy in its own right.

The combination of allowing monetary policy to operate effectively and fostering real economic adjustment is very important. One very telling comparison is between the macroeconomic performance in the most recent commodity price upswing and that in the episodes in the early 1950s and mid 1970s (Graph 4). It is obvious that there has been a first-order reduction in macroeconomic variability on this occasion. The flexibility of the exchange rate has been a major contributor to that outcome.

Graph 4

Graph 4: Terms of Trade, Exchange Rates, Inflation and Real GDP Growth 

Click to view larger

5. Has the exchange rate been ‘misaligned’?

The currency has certainly moved through a very wide range over the thirty years since the float. If our metric were some constant target level of ‘competitiveness’ measured, say, by relative unit costs, then we would be drawn to the conclusion that it has been ‘misaligned’ much of the time.

But such a simple calculation alone isn't the right metric. For a start, over the course of a business cycle the exchange rate should move in ways that help to maintain overall balance between demand and supply. In a period of strong demand it will rise, spilling demand abroad by lowering prices for traded goods and services. This lessens ‘competitiveness’ in the short term, but helps preserve it in the longer term by maintaining discipline over domestic costs.

Moreover, the level of relative unit costs in, say, manufacturing, that is ‘needed’ is a function of several factors, including the terms of trade. A country with an endowment of natural resources will find that when those resources command high prices, it will have a high exchange rate and low manufacturing ‘competitiveness’, compared with the situation when the terms of trade are low. The high resources prices draw factors of production towards the resources sector, pushing up labour costs for other sectors and drawing capital from abroad, so pushing up the exchange rate. The terms of trade rise is an income gain, and may well prompt an expansion in investment in the resources sector. Hence aggregate demand is likely to increase, which among other things will also require a higher exchange rate than otherwise to maintain overall balance. These forces diminish ‘competitiveness’ for other traded sectors. At a later stage, when those adjustments to the capital stock have occurred, the exchange rate may be lower than at its peak, though still higher than what would have been observed had the terms of trade not risen.

So it is not surprising that the exchange rate responds to changes in the terms of trade. It is nonetheless striking how close the empirical relationship has turned out to be. Of course it is not to be assumed that the parameters of that particular empirical relationship are necessarily optimal. But nor is the contrary to be assumed. Over the thirty-year period since the float, that relationship seems not to have led to long periods of the economy either having excess demand or supply. Australia has had one serious recession in that time, in 1990–91, and the principal cause of the depth of that downturn was asset price and credit dynamics, not the exchange rate. Overall, variability of the real economy has been lower in the post-float period. While there are several factors at work in producing that result, the flexible exchange rate is clearly one.

My conclusion, then, would be that evidence of large and persistent exchange rate misalignments is actually rather scant over the floating era as a whole. Arguably some of the bigger misalignments occurred under previous exchange rate regimes.

But what of recent levels of the exchange rate? They have been blamed for many disappointing corporate results and triggered numerous restructurings, instances of ‘offshorings’ and job shedding. The only other factor so frequently offered to explain disappointment is ‘consumer caution’. One can imagine that many people would see this as prima facie evidence of the exchange rate being significantly misaligned.

There are a few difficulties in evaluating that claim. First, very high terms of trade can be expected to lead to some loss of ‘competitiveness’, as noted above. Just how much of this would be expected depends, among other things, on how permanent the terms of trade rise is, but this episode has been very persistent so far. The euphemism ‘structural adjustment’ hardly conveys the difficulties faced by firms and their workforces affected by these forces. But a big and persistent shift in relative prices, which is what the terms of trade shift amounts to, was always going to produce some such effects.

A further difficulty in assessing the exchange rate's level lies in that very persistence. The relationship between the exchange rate and the terms of trade has, broadly speaking, continued to hold (Graph 5). Nothing looks very unusual right at the moment. But this relationship is estimated over a period in which the changes were generally cyclical. It is at least conceivable that a large and persistent rise in the exchange rate may have effects on the economy beyond those discernible from the experience of the past thirty years, if previous rises in the exchange rate were not long-lived enough to cause significant structural change. This is a possibility the Reserve Bank has noted in the past couple of years.[6]

Graph 5[7]

Graph 5: ‘Equilibrium’ Real Exchange Rate 

Click to view larger

There is at least one more complication in assessing the exchange rate's recent behaviour and that is the extraordinary monetary policy measures that are being undertaken in the major economies of the United States, Japan and the euro zone. These too are outside any historical experience. Such measures are in place because they are required by the circumstances of those economies, but there is no doubt that they have fostered the so called ‘search for yield’. That, after all, was the whole point.

Added to this is the lessening, even if only at the margin, of perceived creditworthiness of a number of sovereigns, while our own sovereign rating has remained at the highest level. This has contributed to an increase in ‘official’ holdings of Australian assets as reserve holders sought diversification.

These ‘yield-seeking’ and ‘diversification’ flows have, no doubt, pushed up the Australian dollar. Quantifying that effect is not straightforward. Models suggest that interest differentials have had an effect on the exchange rate, but that effect is dwarfed by the estimated terms of trade effects. But again, the conditions we have seen are unlike anything seen in the period over which the models are estimated.

The flows have surely been important at times, though not necessarily lately. The available data suggest that foreign holdings of Australian government debt stopped rising in the middle of last year. Earlier flows into Australian bank obligations have also generally continued to reverse over that time. As my colleague Guy Debelle has noted, the most obvious capital inflows in the past couple of years have been in the form of direct investment into the mining sector. Those flows were of course responding to expected returns, but not ones that were affected very much by the interest rate policies in the major economies.

In the end it is not possible to come to a definitive assessment on the extent of currency misalignment at the moment, on the basis of standard metrics (and having regard to the statistical imprecision of such metrics). Having said that, my judgement is that the Australian dollar is currently above levels we would expect to see in the medium term.

6. Intervention

In the early period after the float the Reserve Bank undertook market transactions for the purposes of so-called ‘smoothing and testing’. As the market developed and the Bank gained more experience, intervention became less frequent but more forceful. A key motivation for intervention was often trying to avoid the currency moving downwards too quickly. For most of the floating era, until recently at least, a currency that seemed prone to weakness seemed more frequently a problem than the reverse.

As has been well documented, the Bank's intervention strategy has tended to be profitable over the long run.[8] The success of this strategy was helped considerably by the fact that, for much of the floating era, the exchange rate's behaviour could be characterised as fluctuating around a stable mean. If a situation came along that shifted the mean, the strategy might need to be altered.

It might be argued that this is what has happened over the past five years or more. The terms of trade event we have lived through is without precedent in its size and duration, at least in the past century. The exchange rate has responded. Notwithstanding that, in my view, the Australian dollar is probably above its longer-run equilibrium at present, it is far from clear that we can assume that the mean level we saw in the 1980s to the early 2000s will be the relevant one in the future. In evaluating the merits of intervention, the Bank has been cognisant that the current episode is unlike the experience of the first twenty or twenty-five years of the float. Some very powerful forces have been at work.

A further factor relevant to intervention decisions has been cost. Intervening against the Australian dollar would have involved selling Australian assets yielding, say, 3 per cent, and buying foreign assets yielding much less – in fact earning almost nothing over recent years at the areas of the yield curve where the Bank operates. This ‘negative carry’ would be a cost to the Bank's earnings and therefore Commonwealth revenue.

Now it might be argued that a negative carry for the Reserve Bank, and therefore the Commonwealth, and an acceptance of the associated very large valuation risks, would be a price worth paying, if it corrected a seriously misaligned exchange rate. If such a policy were effective, it could turn out to be profitable, if a fall in the exchange rate offset the negative carry. The point is simply that costs have to be considered alongside the likely effectiveness. Often those who argue for intervention don't work through those costs, or they assume it would be entirely costless. That can't be assumed and the idea should be considered in a cost-benefit setting.

Overall, in this episode so far, the Bank has not been convinced that large-scale intervention clearly passed the test of effectiveness versus cost. But that doesn't mean we will always eschew intervention. In fact we remain open-minded on the issue. Our position has long been, and remains, that foreign exchange intervention can, judiciously used in the right circumstances, be effective and useful. It can't make up for weaknesses in other policy areas and to be effective it has to reinforce fundamentals, not work against them. Subject to those conditions, it remains part of the toolkit.


When the foreign exchange market opened on 12 December 1983, without the Reserve Bank making a price for the first time in decades, people would have been uncertain what would happen. Yet policymakers had tried all the alternatives and the float was an idea whose time had come. It was a profound decision – part of a recognition that Australia was part of a wider world, and that we had to reform our own policy and economic frameworks in order to have the sort of prosperity that we wanted as a society.

On 12 December this year we can expect the exchange rate to move a little, one way or the other, and for this to be reported in a very matter-of-fact way on the news broadcasts. We will be able to get updates on our smart phones and to read seemingly limitless quantities of analysis about why it moved the way it did, and predictions about what it might do next, most of which we shall (sensibly) ignore. We would be able, if we wished, to trade foreign currencies from those devices in a way unimagined thirty years ago. (For the record, I am not recommending the practice.) For the dollar to move around in the market as the various players balance supply and demand is now considered normal, and most of the time it is considered no more newsworthy than the price of milk or petrol, and less newsworthy than the price of houses.

Over the past thirty years, the exchange rate has on occasion been the subject of excitement, concern, even shock. It has acted as a shock-absorber, as intended, but it has also served as a disciplining constraint at times. Generally speaking, that was good for us.

At various times we have worried that the market was behaving irrationally, believing that the exchange rate should have been somewhere other than where it was. And sometimes we were right about that. Yet, looking back, on balance the evidence suggests, I think, that the market has mostly moved the exchange rate to about the right place, sooner or later. We sometimes didn't like the pathway. But if I ask the question of whether I would have consistently done a better job setting that price, even had that been feasible (which it wasn't), I don't think I could confidently answer in the affirmative.

No doubt at some Australian Business Economists' occasion on a future anniversary of the float, these matters will be re-examined. We cannot know what the conclusions will be. But for now, and probably for quite some time to come, we remain best served by the floating Australian dollar.


* I thank Alexandra Rush for assistance in preparing these remarks.[BACK TO TEXT]

  1. In the early 1950s the Korean War induced a wool price boom, increasing Australia's terms of trade dramatically. Under the fixed exchange rate and without the stabilising effect of an appreciation, the associated increases in national income and aggregate demand led CPI inflation to peak at almost 24 per cent.[BACK TO TEXT]
  2. Remarkably, the decision was taken as the exchange rate was under upward pressure, only a matter of months after a discrete devaluation had been forced on a newly elected government by large capital outflows.[BACK TO TEXT]
  3. Figures from the BIS Triennial Central Bank Survey of foreign exchange and derivatives market activity in April 2013.[BACK TO TEXT]
  4. Should this worry us? At one level it might be concerning that people elsewhere in the world take decisions that have a major bearing on the value of ‘our’ currency. But decisions elsewhere in the world have a major bearing on the price of lots of things we care about: traded products of all kinds, the stock market valuations of our companies, the interest rate on government debt and so on. It is part and parcel of participating in the global economy and being open to foreign trade and capital flows that foreigners have a say in pricing the currency. They can and will do so whether the traders sit in Sydney or Singapore or London. That is a separate question from whether we would benefit from our firms offering more value added in financial services to the investors of the world.[BACK TO TEXT]
  5. We found ourselves ‘out of favour’ despite the fact that it was almost certainly the use of information technology rather than its production that made for the biggest gains to a society and on that score Australia ranked highly. The price put on our currency by the market seemed at odds with other things and that episode saw the first use of results from a model in a speech by a Reserve Bank Governor to demonstrate that point (see Macfarlane 2000).[BACK TO TEXT]
  6. See Lowe P (2012), ‘The Changing Structure of the Australian Economy and Monetary Policy’, Address to the Australian Industry Group 12th Annual Economic Forum, Sydney, 7 March.[BACK TO TEXT]
  7. Graph 5 shows the results from a standard model maintained by the Reserve Bank's staff (Beechey et al. 2000; Stone, Wheatley and Wilkinson 2005). The estimated ‘equilibrium’ level is based on the real exchange rate's medium-term relationship with the goods terms of trade and the real interest rate differential with major advanced economies. In this sense, the estimated equilibrium is the value of the exchange rate justified by these medium-term fundamentals, based on historical relationships. In practice, the terms of trade has historically been the most important determinant of this estimated equilibrium. At any point in time, divergences between the actual real exchange rate and the estimated equilibrium will reflect some combination of the model's short-run dynamics, which include a number of variables that account for financial influences on the exchange rate and an unexplained component. The short-run variables include a financial market-based commodity price measure and variables that capture changes in risk sentiment in financial markets.[BACK TO TEXT]
  8. See Andrew and Broadbent (1994) and Becker and Sinclair (2004).[BACK TO TEXT]
Published in Australian Economy
Friday, 14 February 2014 19:29

CSL - Company Update - January 2014

CSL has long been a company we have liked.

Mark Draper (GEM Capital) talks with Daniel Moore (Investors Mutual) about some recent developments with the company as well as an important accounting measure that investors should be aware of when valuing CSL.


DISCLAIMER: The above information is commentary only (i.e. our general thoughts).  It is not intended to be, nor should it be construed as, investment advice.  To the extent permitted by law, no liability is accepted for any loss or damage as a result of any reliance on this information.  Before making any investment decision you need to consider (with your financial adviser) your particular investment needs, objectives and circumstances.



Published in Investment Advice
Sunday, 24 November 2013 10:15

Bank Shares - Safe as Houses?

Mark Draper (GEM Capital) talks with Daniel Moore (Investors Mutual) about the impact of a potential property bubble in Australia on Australian Banks.

The average punter on the street considers Bank Shares to be a safe haven , but just correct is that assumption.


DISCLAIMER: The above information is commentary only (i.e. our general thoughts).  It is not intended to be, nor should it be construed as, investment advice.  To the extent permitted by law, no liability is accepted for any loss or damage as a result of any reliance on this information.  Before making any investment decision you need to consider (with your financial adviser) your particular investment needs, objectives and circumstances.



Published in Investment Advice
Wednesday, 13 November 2013 16:22

"Nein" to Nine

Channel-Nine-LogoChannel Nine is being floated on the share market shortly, and for many investors the thought of investing in a household name might be appealing.

Here we outline some of the reasons that investors should be wary of this listing:

1. TV advertising spending has gone nowhere over the last 5 years - here is a chart sourced from the Channel 9 prospectus









2. Traditional TV is facing a significant threat from the internet such as YouTube, Apple and Google TV just to name a few.

3. Channel Nine's price to earnings ratio is 14-15 - which doesn't strike us as cheap for a business that is being structurally challenged.

4. Current owners are selling 40% of their shares in this offer, and only have to hold their other shares for 12 months.


Before subscribing to shares in Channel Nine, investors should seek professional advice.


DISCLAIMER: The above information is commentary only (i.e. our general thoughts).  It is not intended to be, nor should it be construed as, investment advice.  To the extent permitted by law, no liability is accepted for any loss or damage as a result of any reliance on this information.  Before making any investment decision you need to consider (with your financial adviser) your particular investment needs, objectives and circumstances.




Published in Investment Advice
Friday, 01 November 2013 13:11

Deeming rates lowered by Centrelink

Interest Rate ImageHere is the press release from the Commonwealth Government announcing a lowering of the Deeming Rate for the Income Test to determine Centrelink allowances and pensions.

More than 740,000 Australian pensioners will benefit from the lowering of the social security deeming rates from 4 November 2013.

The Minister for Social Services, Kevin Andrews, said the deeming rate will decrease to 2 per cent from 2.5 per cent for financial investments up to $46,600 for single pensioners and allowees, $77,400 for pensioner couples and $38,700 for each member of an allowee couple.

The upper deeming rate will decrease to 3.5 per cent from 4 per cent for balances over these amounts.

“The deeming rules are a central part of the social security income test,” Mr Andrews said.

“They are used to assess income from financial investments for social security and Veterans’ Affairs pension/allowance purposes.

“This announcement means that part-rate pensioners and allowees will have less income assessed from their investments and receive a boost in Government income support.

“Returns available to pensioners and other allowees have decreased since deeming rates were last changed, in March 2013.

“This announcement brings the deeming rates in line with available financial returns,” Mr Andrews said.

Deeming rates reflect the rates of return that people receiving income support payments can earn from their financial investments. If income support recipients earn more than these rates, the extra income is not assessed.

Payments affected by the deeming rates include means tested payments such as the Age Pension, Disability Support Pension and Carer Payment, income support allowances and supplements such as the Parenting Payment and Newstart, paid by the Department of Human Services and the Department of Veterans' Affairs.

GEM Capital Comment:

For the want of spoiling a good press release, we hasten to add, that this change is likely to only benefit those people who are currently paid under the income test, rather than the assets test.  For those who are currently paid under the assets test, this change is likely to have no effect on their entitlements. (remembering that Centrelink apply an assets test and an income test and pay the recipient a benefit based on which test delivers the lowest outcome)

Nevertheless this is a welcome move considering the downward movement we have seen in interest rates.

Published in Investment Advice
Wednesday, 30 October 2013 15:21

Australian Share Market Outlook - October 2013

John Grace (Deputy CEO, Ausbil Funds Management) and one of Australia's most respect Australian Share investors talks about the most recent company reporting season.

John also talks about his outlook for the share market, and his optimism despite a solid rally over the past 12 months.

More importantly he discusses how he has positioned his fund to take advantage of what has been very much a two tier market.



DISCLAIMER: The above information is commentary only (i.e. our general thoughts).  It is not intended to be, nor should it be construed as, investment advice.  To the extent permitted by law, no liability is accepted for any loss or damage as a result of any reliance on this information.  Before making any investment decision you need to consider (with your financial adviser) your particular investment needs, objectives and circumstances.

Published in Investment Advice
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