Mark Draper

Mark Draper

Thursday, 07 December 2017 20:31

Bubbles, Busts and Bitcoin

Shane Oliver - Chief Economist AMP


The surge in bitcoin has attracted much interest. Over the last five years, it has soared from $US12 to over $US8000; this year it’s up 760%. Its enthusiasts see it as the currency of the future and increasingly as a way to instant riches with rapid price gains only reinforcing this view. An alternative view is that it is just another in a long string of bubbles in investment markets.

Nobel Economics Laureates Daniel Kahneman, Robert Shiller and Richard Thaler and many others shown that investors and hence investment markets can be far from rational and this along with crowd psychology can drive asset prices far from fundamentally justified levels. This note provides a refresher on the psychology of investing before returning to look at bitcoin.

Irrational man and the madness of crowds

Numerous studies show people suffer from lapses of logic. In particular, they:

  • Tend to down-play uncertainty and project the current state of the world into the future – eg, resulting in a tendency to assume recent investment returns will continue;
  • Give more weight to recent spectacular or personal experiences in assessing probabilities. This results in an emotional involvement with an investment – if it’s been winning, an investor is likely to expect it to keep doing so;
  • Tend to focus on occurrences that draw attention to themselves such as stocks or asset classes that have risen sharply or fallen sharply in value;
  • Tend to see things as obvious in hindsight – driving the illusion the world is predictable resulting in overconfidence;
  • Tend to be overly conservative in adjusting expectations to new information – explaining why bubbles and crashes normally unfold over long periods; and
  • Tend to ignore information conflicting with past decisions.

This is magnified and reinforced if many make the same lapses of logic at the same time giving rise to “crowd psychology”. Collective behaviour can arise if several things are present:

  • A means where behaviour can be contagious – mass communication with the proliferation of electronic media are perfect examples of this as more than ever investors get their information from the same sources;
  • Pressure for conformity – interaction with friends, social media, performance comparisons, fear of missing out, etc;
  • A precipitating event or displacement which motivates a general investment belief – the IT revolution of the late 1990s or the rapid industrialisation of China which led to talk of new eras are examples upon which were built general believes that particular investments will only go up.

Bubbles and busts

The combination of lapses of logic by individuals and their magnification by crowds goes a long way to explaining why speculative surges in asset prices develop (usually after some good news) and how they feed on themselves (as individuals project recent price gains into the future, exercise “wishful thinking” and receive positive feedback via the media). Of course this also explains how the whole process can go into reverse once buying is exhausted, often triggered by bad news.

The chart below shows how investor psychology develops through a market cycle. When times are good, investors move from optimism to excitement, and eventually euphoria as an asset’s price moves higher and higher. So by the time the market tops out, investors are maximum bullish and fully invested, often with no one left to buy. This ultimately sets the scene for a bit of bad news to push prices lower. As selling intensifies and prices fall further, investor emotion goes from anxiety to fear and eventually depression. By the time the market bottoms out, investors are maximum bearish and out of the market. This sets the scene for the market to start rising as it only requires a bit of good news to bring back buying.

The roller coaster of investor emotion

Source: Russell Investments, AMP Capital

This pattern has been repeated over the years. Recent examples on a globally-significant basis have been the Japanese bubble and bust of 1980s/early 1990s, the “Asian miracle” boom and bust of the 1990s, the tech boom and bust of the late 1990s/early 2000s, the US housing and credit-related boom and bust of last decade and the commodity boom and bust of late last decade into this decade. History may not repeat but rhymes and tells us asset price bubbles & busts are normal.

Where are we now?

Our assessment in terms of global share markets is that we are still around “optimism”. Investor sentiment is well up from its lows last year and some short-term measures are a bit high, warning of a correction (particularly for the direction-setting US share market) but we are not seeing the “euphoria” seen at market tops. The proportion of Australians nominating shares as the “wisest place for savings” remains very low at 8.9%.

But what about bitcoin? Is it a bubble?

Crypto currencies led by bitcoin and their blockchain technology seem to hold much promise. The blockchain basically means that transactions are verified and recorded in a public ledger (which is the blockchain) by a network of nodes (or databases) on the internet. Because each node stores its own copy, there is no need for a trusted central authority. Bitcoin is also anonymous with funds just tied to bitcoin addresses. Designed to work as a currency, bitcoin therefore has much to offer as a low-cost medium of exchange with international currency transfers costing a fraction of what, say, a bank may charge.

However, bitcoin’s price in US dollars has risen exponentially in value in recent times as the enthusiasm about its replacement for paper currency and many other things has seen investors pile in with rapid price gains and increasing media attention reinforcing perceptions that it’s a way to instant riches.

However, there are serious grounds for caution. First, because bitcoin produces no income and so has no yield, it’s impossible to value and unlike gold you can’t even touch it. This could mean that it could go to $100,000 but may only be worth $100.

Second, while the supply of bitcoins is limited to 21 million by around 2140, lots of competition is popping up in the form of other crypto currencies. In fact, there is now over 1000 of them. A rising supply of such currencies will push their price down.

Third, governments are unlikely to give up their monopoly on legal tender (because of the “seigniorage” or profit it yields) and ordinary members of the public may not fully embrace crypto currencies unless they have government backing. In fact, many governments and central banks are already looking at establishing their own crypto currencies.

Regulators are likely to crack down on it over time given its use for money laundering and unregulated money raising. China has moved quickly on this front. Monetary authorities are also likely to be wary of the potential for monetary and financial instability that lots of alternative currencies pose.

Fourth, while bitcoin may perform well as a medium of exchange it does not perform well as a store of value, which is another criteria for money. It has had numerous large 20% plus setbacks in value (five this year!) meaning huge loses if someone transfers funds into bitcoin for a transaction – say to buy a house or a foreign investment – but it collapses in value before the transaction completes.

Finally, and related to this, it has all the hallmarks of a classic bubble as described earlier in this note. In short, a positive fundamental development (or “displacement”) in terms of a high tech replacement for paper currency, self-reinforcing price gains that are being accentuated by social media excitement, all convincing enthusiasts that the only way is up. Its price now looks very bubbly, particularly compared to past asset bubbles (see the next chart – note bitcoin has to have its own axis!).

Because bitcoin is impossible to value, it could keep going up for a long way yet as more gullible investors are sucked in on the belief that they are on the way to unlimited riches and those who don’t believe them just “don’t get it” (just like a previous generation said to “dot com” sceptics). Maybe it’s just something each new generation of young investors has to go through – based on a thought that there is some way to instant riches and that their parents are just too square to believe it.

Source: Thomson Reuters, Bloomberg, AMP Capital

But the more it goes up, the greater the risk of a crash. I also still struggle to fully understand how it works and one big lesson from the Global Financial Crisis is that if you don’t fully understand something, you shouldn’t invest.

At this stage, a crash in bitcoin is a long way from being able to crash the economy because unlike previous manias (Japan, Asian bubble, Nasdaq, US housing in the chart above) it does not have major linkages to the economy (eg it’s not associated with overinvestment in the economy like in tech or US housing, it is not used enough to threaten the global financial system and not enough people are exposed to it such that a bust will have major negative wealth effects or losses for banks).

However, the risks would grow if more and more “investors” are sucked in – with banks ending up with a heavy exposure if, say, heavy gearing was involved. At this stage, I think it’s unlikely that will occur for the simple reason that being just an alternative currency and means of payment won’t inspire the same level of enthusiasm that, say, tech stocks did in the late 1990s (where there was a real revolution going on).

That said, it’s dangerous to say it can’t happen. There was very little underpinning the Dutch tulip mania and it went for longer than many thought. So it’s worth keeping an eye on. But as an investor I’m staying away from bitcoin.

What does this mean for investors?

There are several implications for investors.

  1. The first thing investors need to do is recognise that investment markets are not only driven by fundamentals, but also by the often-irrational and erratic behaviour of an unstable crowd of other investors.
  2. Investors need to recognise their own emotional capabilities. In other words, investors must be aware of how they are influenced by lapses in their own logic and crowd influences.
  3. To help guard against this, investors ought to choose an investment strategy which can withstand inevitable crises & remain consistent with their objectives and risk tolerance.
  4. If an investor is tempted to trade they should do so on a contrarian basis. Buy when the crowd is bearish, sell when it is bullish. But also recognise contrarian investing is not fool-proof – just because the crowd looks irrationally bullish (or bearish) doesn’t mean it can’t get more so.
  5. Finally, while crypto currencies and blockchain technology may have a lot to offer bitcoin’s price is very bubbly.
Thursday, 07 December 2017 20:22

Gerard Minack - what's in store for 2018

Well known investor Gerard Minack, who also sits on the board of Morphic Asset Management recently produced this video on this thoughts for investment markets for 2018.

This video was produced for the Morphic Asset Management roadshow and has been reproduced with their permission.


By Geoff Wood (Morphic Asset Management)



















Humans tend to fear spectacular, but unlikely events. This is the proposition that Bruce Schneir makes in his book “Beyond Fear”.For example, European tourism has been significantly impacted by much talked about terrorist attacks despite the extremely low probabilities of something occurring to any individual. With the anniversary of October 1987 recently, it was remarked that “the week after the crash people started worrying about a crash”. The more recent an event’s occurrence is to you, the more likely you are to think that event is going to happen (when in fact it’s actually a lot less likely).


What does this look like? Overall we tend to underestimate threats that creep up on us. Humans are ill-prepared to deal with risks that don’t produce immediate negative consequences, like eating a cupcake or smoking cigarettes. For example, surveys show more people fear dying from cancer than they fear heart disease.

As markets push on globally to new highs and talk of bubbles emerges, I thought it would be timely to take a look back at the last century to see what the world looked like when markets were making all-time highs before a big correction.

In the below table (Figure 1), we identify seven major highs in the US S&P 500 stock market. The criteria for identifying a “major high” was twofold:

  1. the market was making highs; and
  2. it was followed by a market fall of at least 25% in the following 18 months. Why 25%? Because falls of 15-20% are relatively common in a bull market. The ongoing bull market since 2009 has already had two of these episodes.

The first thing that should strike a reader is how rare these events are: seven times in 90 years so roughly every 12 years. So in one’s investing life (~40 years), there should be on average 3 “events”. For all the talk of fearing crashes every year, one should not bank on them too often – meaning the old saying “time in the market is more important than timing the market” has a ring of truth to it.

Importantly though, note that they are not evenly spread at 12-year intervals as we observe a clustering around the 1960s and the early 2000s. For whatever reason, these events have tended to “clump”.


Source:Bloomberg, Team Analysis


I then looked into a selection of market and macroeconomic data points to see what they were indicating at these market tops (Figure 2). Some statistics include:

  • the level of unemployment;
  • the Purchasing Managers’ Index (PMI) levels, which are surveys quantifying manufacturers order books;
  • consumer surveys to gauge their optimism;
  • and the Federal Reserve’s level of interest rate and perhaps more importantly how much had it changed coming into the high.

The first thing to note, which is to be expected, is there is not one consistent signal across all the outcomes. I say if there was consistency, markets would already be using the indicator! But a few pertinent points do jump out:

  • stock market highs before a crash have occurred two thirds of the time when unemployment was below 5%;
  • in most cases, the Fed has been hiking;
  • consumer expectations have been elevated but falling;
  • and PMI surveys of future expectations have been mixed.

However, the last two market highs were made with confidence starting to wane, while for prior occurrences it was strong and strengthening.


Source: Bloomberg, Team Analysis


S&P valuations have had a wide range from 10 to 25x price/earnings (P/E) over the last century, reflective of the wide range of deflation, inflation, reflation and stagflation that markets have lived through.

We find that market tops in the S&P have tended to occur when the market was expensive – but not eye wateringly so – at around 20x. The 2000 dot com top was an exception with the market trading closer to 30x.

In most cases, P/E’s are expanding into market tops, which is a sign of continued confidence about the future (Figure 3).


Source: Bloomberg, Team Analysis


Are stocks losing or gaining momentum into the peak?

Figure 4 looks at the path coming into the peak. Prices have generally risen 20% or more in the 18 months preceding the high and are 30% above any lows in that same period. The range can vary hugely with “blow-off” moves off 48% in 1987.

Breadth measures how many stocks in the S&P 500 are making 52-week highs. A strong market is driven by many areas. For the different dates studied here, there are mixed messages as the 1987 high was across the board, while the 2007 high was only driven by a small number of areas. It seems to us that the overriding factor/indicator is either low breadth or narrowing breadth.

The Relative Strength Index (RSI) in Figure 4 measures the consistency of buying and a figure over “70” is largely seen as overbought or overvalued. All market highs involved the monthly RSI being around or above the widely sighted 70 figures, signaling consistent strong buying over an extended period.


Source: Bloomberg, Team Analysis


Lastly, I thought it would be instructive to look at how other asset classes were performing into the equity market top. If something is going wrong with liquidity or the economy, these assets should be reacting as well (Figure 5).

The bond market is generally seen as a better identifier of recession risks than stock markets and as such, it typically starts to price the central bank cutting rates in advance forcing the yield curve to flatten. The yield spread between the two-year and ten-year yields in a healthy market is typically around 100bps but going into the last two corrections was significantly lower.
Credit markets are also worth watching as again there is a view that credit “fails” before equities. My examination shows this is indeed the case: in the last few cases, spreads have been widening while the market went into a top because of the credit market prices increasing default risks.


Source: Bloomberg, Team Analysis


So back to the original question. What does underestimating risk look like?
The highest risk points for investors, with the benefit of hindsight, was when there appeared little left to worry about. Unemployment was low; consumers were confident; and investors were willing buyers of equities month after month, driving big market moves upwards into the end. I would speculate that during these periods, the “fear” became more about “fear of missing the rally” rather than avoiding a crash.

On the flip side, when everyone is talking about risks such as Europe imploding or North Korea firing missiles, this may just be the time to buy.

One last thing to bring to the reader’s attention is the risk of “false positives”. We only know in hindsight what the tops were. The data can also be consistent with outcomes where a market top doesn’t take place. The most recent example of this was just last year: credit spreads widened, driven by falling oil prices; PMI surveys fell below 50 (indicating a contraction); and the market dropped more than 15% at one point. Yet the data reversed and the market rebounded to new highs. The market is not designed to be easy…

Taken all together, the analysis supports what we have written before: this bull market is moving to the late stages but these indicators I have analysed do not indicate a market top is imminent yet.

As the market continues its grind higher, we will be aiming to stay alert to market complacency and a change in these indicators.


Saturday, 02 December 2017 07:21

2018 Investment Opportunities

Clay Smolinski

(Platinum Asset Management)

Monday, 27 November 2017 19:11

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Investment research mouseEvery bull market has it's pin up boy.  In the early 2000's, it was the technology stocks where we witnessed companies 'reinventing' themselves by adding .com to their name, accompanied by large share prices increases.

Today, the Technology companies that are rising rapidly are underpinned by significant growth in revenue and profits, something that was missing from much of the tech sector early this century.

But there is a new 'Next Big Thing' that is attracting investment, probably from many who have not seen market cycles before, or fads come and go.  We are of course referring to Crypto currencies, led by Bitcoin.

At this point we wish to make the point that when discussing crypto currency it is important to separate the technology behind crypto currency from the currency itself.

The technology behind Bitcoin and other crypto currencies, known as Blockchain, is real and likely to influence the financial system around the world as banks, stock exchanges and share registries are investing heavily in the technology.  Put simply “The blockchain is an incorruptible digital ledger of economic transactions that can be programmed to record not just financial transactions but virtually everything of value.”

Picture a spreadsheet that is duplicated thousands of times across a network of computers. Then imagine that this network is designed to regularly update this spreadsheet and you have a basic understanding of the blockchain.

Information held on a blockchain exists as a shared — and continually reconciled — database. This is a way of using the network that has obvious benefits. The blockchain database isn’t stored in any single location, meaning the records it keeps are truly public and easily verifiable. No centralized version of this information exists for a hacker to corrupt. Hosted by millions of computers simultaneously, its data is accessible to anyone on the internet.

So the technology behind Bitcoin and others is real and is likely to materially impact the global financial system, particuarly to reduce processing costs and times and 'cut out the middle man'.

Our concern in this article revolves around the trading of Bitcoin and other crypto currencies by those seeking to get rich quickly.  The chart below tracks the rise of some of history's great bubbles, including Bitcoin.

What prompted us to write about this is when I began seeing a friend of mine uploading a Bitcoin market report everyday on Facebook and scoffing at those who invest in "old world" sectors like fixed interest and the share market.  I can remember these type of conversations during the tech boom of early 2000's.


We are not professing to be experts on Bitcoin, or cryptocurrencies, we simply wish to highlight the issues that we would want to satisfy ourselves with before investing.  You can then make your own conclusion.

Cryptocurrency is a form of digital money that is designed to be secure and, in many cases, anonymous, making it ideal for money laundering, organised crime and drug/arms dealers.

It is a currency associated with the internet that uses cryptography, the process of converting legible information into an almost uncrackable code, to track purchases and transfers.  There are new cryptocurrencies being issued every week, and these are known as Initial Coin Offerings.

It is being suggested by enthusiasts that cryptocurrency will become the global currency benchmark, replacing paper money and the existing financial system.  We would caution against such a view as one of the key differences between cryptocurrency and say $USD, is that there is a Government standing behind the $USD.  So unless the Government were to default, the currency has value.  There is no Government support behind cryptocurrency.  In fact recently the Chinese Government  announced that public cryptocurrency exchanges would be shut down.

Our other questions include:

1. Why are cryptocurrencies not being embraced by larger insitutional investors, often referred to as 'smart money'?

2. What legal protections are available to investors who trade cryptocurrency in the event of fraud or other online mischief?

3. What is the intrinsic value of what investors are buying?  (ie the intrinsic value of buying a company is the future cash flow a company generates)


We leave this article quoting two famous investors (made famous for different reasons).  

Jordan Belfort, the original "Wolf of Wall Street" says that initial coin offerings "are the biggest scam ever" and "are far worse than anything I was ever doing".

Howard Marks, one of the worlds most famous investors, from Oaktree Capital talked about cryptocurrencies in his recent investor newsletter.  His word of caution was "They're not real".



Tuesday, 17 October 2017 16:43

The Rise of Asia

Chinese CurrencyThis is an edited rendition of a presentation delivered by Kerr Neilson at the NAB Asia Development Congress in September 2017 in Shanghai.  It has been reproduced with permission from Platinum Asseet Management from the September 2017 Quarterly Report from Platinum Asset Management.

Over these past 20 years, some Asian economies such as China and India have been growing physically by 6-7% a year.  At that rate of growth, the nominal size of an economy doubles every 10 years, which makes these economies four times the size that they were in the days of the 1998 Asia financial crisis.

This is an edited rendition of a presentation delivered by Kerr Neilson at the NAB Asia Development Congress in September 2017 in Shanghai.

Asia has changed immeasurably over the last two decades.  It is now less susceptible to shocks, far more self-sustaining, and has managed to side-step some developmental hurdles by leapfrogging with technology.  The purpose of this paper is to try to convince you to see Asia from a new perspective.  Without doing so, you may well miss one of the great paths of wealth creation over the coming 10 to 20 years.

To start with some context, China and India together have a population of 2.7 billion and a land mass of nearly 13 million square kilometres.  This means that these two countries alone have a land mass slightly smaller than the European Union (EU) and the US combined, but a population three times larger.  Importantly, when measuring economic output on purchasing power parity, their combined GDP of US$33 trillion is 50% larger than either the US or the EU!

When official data claims that China is the world’s second largest economy and that its GDP is about 60% that of the US, some tend to struggle with these statistics because of the physical presence of these economies.  For example, how can these figures be meaningful when one considers that China produces eight times more steel than the US and 50% more automobiles, consumes nearly half the world’s copper supply and similarly in stainless steel, aluminium and cement, and originates nearly 120 million high-spending overseas travellers each year?


China & India

European Union


Population (million)




Land area (million km2)




GDP PPP 2017 (US$ trillion)




Source: UN, IMF

Income disparity is indeed a major issue for Asia.  While household income in mega cities like Shanghai and Beijing can be US$50,000–100,000 a year, rural income is only a fraction of that.  The relevance of this lies in social harmony, but as with other economies that have gone through the traumas of industrialisation, this has proven less of a challenge during that period of helter skelter growth than in its aftermath.  Either way, Asia’s economies have been growing at a remarkable pace, as shown in the per capita GDP chart below.  From an investment point of view, thinking about the rate of growth of these countries alongside that of the West adds important perspective.




Land Area

(000 km2)

GDP 2016

(US$ billion)

































% of world




Source: World Bank (World Development Indicators 2017)

GDP Per Capita 2016

One common complaint we hear about Asia is the difficulty of dealing with local regulatory and bureaucratic systems when it comes to matters such as the registration of a new business or the enforcement of contracts.  There is no denying that most parts of Asia still lag the developed countries in the “ease of doing business”, but there are clear signs of improvement.  One measure of this is the Global Competitive Index (2017-18) compiled by the World Economic Forum.  This index measures and compares the competitiveness of 137 economies based on 12 factors ranging from social institutions to physical infrastructure, labour market efficiency and technological readiness.  Switzerland and the US take out the top two spots, followed by Singapore, while Hong Kong ranked 6th, Taiwan 15th, China 27th, Thailand 32nd, Indonesia 36th, and India 40th, ahead of Portugal (42nd) and Italy (43rd).  Australia ranked 21st.  Is it not interesting that there are apparently 101 countries more difficult to do business in than say, Indonesia?

The importance attached to education among Asian families and the improving quality of these countries’ education systems are also promising signs of tomorrow’s prosperity.  The following table lists the average maths, science, and reading comprehension scores from the OECD’s Program for International Student Assessment (PISA).  Seven of the top 10 positions were filled by Asian contenders, while Australia has sunk from no. 9 in 2006 to no. 21 in 2015.  While one may not identify any strong correlation between a country’s economic or industrial might and its students’ academic achievements, the changes in ranking nevertheless indicate an encouraging trend for the Asian region.  It is worth observing that while public education spending in Asia (around 2-4% of GDP) lags that of Western countries (about 5%), around 80-90% of Asian families are willing to complement the school system with private tuition, compared to just 20-30% of households in the West.

PISA – Average Maths, Science & Reading Scores

2015 Rank



Average Score


Average Score

Change In Rank (2006-2015)







Hong Kong (China)










Macao (China)










Chinese Taipei




















B-S-J-G (China)




























New Zealand





























Source: OECD (PISA)

While the percentage of the population achieving a university degree remains low in Asia by comparison to Western standards, the number of graduates from the so-called STEM disciplines (Science, Technology, Engineering and Mathematics) as a proportion of the total number of graduates is much higher.  Today, China produces some 4.7 million STEM graduates each year and India about 2.6 million, versus around 560,000 STEM graduates from each of Russia and the US.  The amount of talent coming through suggests that China and India are far from being ill-placed in this technologically-driven age.  As an aside, it is also encouraging that they can’t all rush off to join high-paying jobs in Wall Street and, indeed, look how the Asian nations have scored in terms of patent registrations.  Note that China is now levelling with Japan, and that Korea, with its relatively small population of 51 million, ranks well ahead of several European countries which led the first industrial revolution.

Number of Patents

There is little denying that there has been a great deal of purloining of Western technology by Asian companies, but that too is changing.  A good indicator of the growing amount of original research being carried out in institutions in Asia is the number of cited publications in scientific journals.  China and India have respectively moved up from the 9th and 13th positions in 1996 to the 2nd and 5th in 2016, a strong testament of the quality and quantity of their research efforts.  These countries are now in the same league as the industrial powers of the US (1st), Britain (3rd), Germany (4th) and Japan (6th).  All this data accords with what we have witnessed on the ground.  Take the Pearl River Delta region in southern China for example.  This used to be the manufacturing capital of the world for apparel, toys and plastic flowers, built on the back of cheap labour and imitation of others.  Today, the region is motivated by technological innovation and higher value-added products – how to become more competitive with less labour.  The number of patent applications by companies such as Huawei and ZTE is double those by Sony and Intel, which is just one of the many manifestations of this powerful trend.

Number of Patent Applications

China’s share of the world’s high value-added exports has risen dramatically during the past two decades.  As its state-owned enterprises (SOEs) shrunk relative to the economy in the late 1990s and early 2000s, a wave of foreign companies relocated parts of their production from Japan, Taiwan and many Western countries to set up base in China, bringing with them capital as well as technological know-how.  This was later reflected in a rising trend of elaborate manufactured goods such as laptops and smartphones.  Incidentally, as the following chart shows, Korea has also been a winner of high value-added exports, while the share of these products from the US, Japan and Germany has been in slow decline.  In the coming decade it would not be surprising to see yet another shift with exports from China being led by companies winning orders on the basis of home-grown intellectual property.

Share of Worlds High Value Added Exports

Not only is Asia becoming less dependent on Western technology, it is also becoming less dependent on trade with the West.  In the early 1990s, exports to North America and the EU together accounted for around 44% of Asia’s total exports. This has now dropped to 29%, while the share of intra-regional trade amongst Asian countries has increased from 44% to 57%.

Share of Exports from Asia

Alongside this change as well as a high propensity to save by Asian households (typically 20-30% of income, versus 5-10% in the West), we find a region with enormous current account surpluses, China and Korea in particular, but also Thailand, Vietnam and the Philippines, with only India and Indonesia still reliant on foreign savings.  However, one implication of this tendency is that should a larger portion of the savings of these countries become absorbed at home, the cost of borrowing for deficit countries such as Australia, the UK and the US is doomed to rise.  Please do not ignore this probability as greater social support in some Asian countries (pensions, healthcare and education) will reduce financial insecurity and the attendant precautionary savings bias.

The economies of the major Asian countries are not only expanding, they are also changing structurally.  China’s service sector, which used to be pitifully small in the pre-Reform era, now accounts for about 50% of the national GDP.  In India, the service sector has always been bigger, contributing some 60% of the economy.  Combined, China and India now account for 8% of the global service trade.  Last year, 117 million people boarded flights from China’s airports to travel abroad, the largest tourist exodus anywhere in the world.

It was 20 years ago when we had the so-called Asian financial crisis where the world threw up its hands and the IMF instructed the use of harsh contractionary medicine to right their affairs in exchange for support packages.[1]  Roaring growth, massive inward investment flows to complement current account deficits and fixed exchange rates led to misadventures of extrapolation.  As the tide turned with rising interest rates and as flows began to reverse from deteriorating export earnings momentum, countries such as Thailand, Indonesia and Korea were caught in the vice of huge foreign denominated debt obligations and the shearing of their exchange rates.  The crisis scarred these Asian nations' policy makers for a generation regarding currency mismatching and credit growth, and the mercantilism that followed allowed the accumulation of massive foreign reserves.  Today, China has some US$3 trillion in reserves while India has US$350 billion and Thailand US$175 billion.  While the interventionist policies of these governments have been a source of friction with the West, they are a reflection of the lessons learned from the earlier mishap.  Today, most Asian countries have an external debt-to-GDP ratio of less than 50%, compared to some Western nations at 300%.  It is of course ironic that when the West experienced its financial crisis in 2008, the IMF’s advice was to “spend your way out of this”.

All of these facts point to an Asia that has changed beyond recognition.  This is a group of countries that are surging ahead, growing quickly, and doing so mostly with internal funding.  They have the wherewithal to continue to grow and prosper.  Yet, they barely feature in many international portfolios.  The MSCI AC World Index has a weighting of just 8.4% for Asia ex-Japan, an unjustifiable under-representation given that the region accounts for close to 40% of global economic activity.  In our view, Asia is the world’s growth driver, and investors cannot afford to miss it.

Apart from a path-dependent bias about Asia in general, investors may also have exaggerated concerns, in particular, regarding the problems facing China.  We do not seek to argue that there are no problems, but rather, that these problems are not quite as simplistic as they are portrayed in the press, and it would be a costly mistake to overlook the opportunities out of a misguided refuge in fear.

First and foremost amongst these concerns is China’s extravagant use of debt.  However, unlike many doomsayers, we do not foresee any imminent collapse.  One of the ways in which the Chinese government has sought to address the issue of bad debt in the banking system, and with evident success, has been a determined, if slow-coming, blitz to remove surplus and inefficient production capacity of commodities such as steel, coal, cement and chemical products like PVC.  What had led to this over-building was the unbridled competition that originated from an unholy alliance among growth-targeting regional governments, regional banks and entrepreneurs.  The central government has now reined them in, having despatched some 5000 inspectors to scour the country for polluting offenders.  This simultaneously addresses environmental pollution and bad debts.  The real significance of this reform is that commodity prices have risen sharply and, with them, so has the profitability of the remaining higher-quality producers.  For example, with 120 million tons of capacity shut down, steel prices have more than doubled since November 2015.  With improved profits and cash flows, commodity producers (coal and ferrous metals alone account for nearly a quarter of all SOE debt) are now either repaying their loans or building up a cash reserve after paying the banks their obligations on credit lines.  The rationalisation of industrial capacity, the so-called “supply side reform”, has been absolutely fundamental to the turnaround of China’s financial system, and the results are already being felt.  (For further details on China's supply side reform, I urge you to read Andrew Clifford's Macro Overview – September 2017.)

Many investors we meet still think of China as being dominated by inefficient SOEs.  The inefficiencies may remain, though there is change afoot regarding shared ownership and management profit participation.  However, the proportion of urban residents employed by SOEs is now about 20%, having dropped progressively from 80% at the turn of the century.  In 2000, the state was responsible for about 80% of China’s industrial output, and the private sector 20%.  That too has reversed, with the state now producing 20-25% of the physical output while the dominant share of output is coming from an increasingly robust private sector.  While SOE debt (about 115% of GDP) remains a problem, the measures cited above and the preparedness to raise prices of important utility services like power, water and waste gives clear sight of remedies.  In the meantime private enterprise that had been deleveraging since 2013 has started a capital spending cycle and is clearly the backbone of the economy.

Like its state-owned coal and steel plants, China’s spending on infrastructure is often viewed as wasteful and excessive, and a problematic product of a credit binge and loose lending.  Of course, the challenge lies in assessing need versus desire and the appropriate planning time horizon.  Our own experience is that facilities like roads, rail and airports that seemed under-utilised several years ago now feel as though they are bursting at the seams.  Without this prescience, which is being extended internationally with One Belt One Road (OBOR), bottlenecks would be common.  For example, China now has the world’s largest high speed rail network – more than 22,000 km in total.  Some might construe this as chest-beating.  But consider the movement of people between Shanghai and Beijing:  There are some 50 daily movements of aircraft each way between these cities, which are some 1300 km apart, and there are nearly the same number of express train movements.  The aircraft are moving some 10 million people a year while the express trains are moving as many as 160 million a year and have recently raised their maximum speed to 350 km/hr to complete the 1318 km journey in under 4.5 hours.  Booking in advance is advisable!  A country of such a vast area and such a large population requires infrastructure of this scale to grow and develop.  If it still feels like “over-building”, one only needs to think back to the grand projects of New York or London more than 100 years ago.

China’s property market is yet another area that raises concern.  Western media love to mention the “ghost cities” and empty apartments.  But if there really is oversupply, why do prices keep rising, and why do governments see a need for policy intervention to curb price increase?  In each of the last seven years, authorities have increased the percentage of up-front payment required on purchase (typically a minimum deposit of 30% for first time home buyers, higher for subsequent purchases and also higher in top tier cities), and restrictions on mortgage lending have become ever more stringent (loan to value ratio is estimated to be about 50%).

An answer may be found if one looks more closely at the forces of demand.  About 55% of China’s population are now living in urban areas.  Each year there is an influx of 20-25 million migrants leaving their rural villages to move to the cities.  The government has been reforming the household registration (or hukou) system, which was put in place in the pre-Reform era to control the movement of residents.  Under the hukou system, all forms of social welfare are tied to one’s place of birth and residency.  A rural resident moving to a city was not entitled to such benefits as health care, education and pensions as his or her rural hukou was not transferable.  The rules have been incrementally relaxed and modified to facilitate urbanisation, and we are seeing more and more rural residents relocating to live in towns and mid-tier cities, and not merely as temporary migrant workers in mega cities like Beijing and Shanghai.  This is the underlying driver for the sizeable housing demand in China.  Some 140 million modern apartments have been built in China since the turn of the century, and around 8 to 9 million are currently being added each year.  But an estimated 150 million households are still living in communist era dwellings, ready to upgrade, or are leaving their traditional rural villages to settle in the cities.  Our observation is that while there are some speculative developments, there is enormous inherent demand.  This is partly evidenced in the fact that second-hand property prices are growing faster than new property prices and inventory levels are at a healthy level (less than 10% in tier 1 and tier 2 cities, and about 20% in tier 3 cities).

Last but not least is the technological leapfrogging.  We have written extensively about the rise of e-commerce and digital payment systems in China.  Far from being emulators of Western companies like Facebook and eBay, Chinese tech companies such as Tencent and Alibaba have been innovating relentlessly.  Utilising the vast amounts of data from China’s 1 billion netizens, they have been pushing the boundaries of technology and creating new business models with platforms like WeChat, Taobao and their associated e-payment services.  It is not hard to find examples of remote rural villages being transformed by e-commerce.  Farm produce that was previously land-locked has miraculously found markets long distances away and been rewarded with higher prices because of improved communications.  E-commerce giant, for example, is expanding its logistics network with delivery drones on the one hand and despatching advisors on the other hand to provide online shopping assistance to villagers.

Far from slowing down, the pace of technological advancement will likely accelerate in the coming decades as the Chinese government turns its policy focus to boost investment and R&D in areas such as renewable energy, electrical vehicles, artificial intelligence and biotechnology.  Unlike the sporadic ad hoc initiatives that one finds in some Western countries, China appears to have a more coherent policy framework with a longer-term outlook, from the push for more fundamental scientific research to providing both direct and indirect support for start-ups.  By one recent estimate, China now has 89 unicorns (unlisted start-ups with a valuation of more than US$1 billion) – about one-third of the world’s total number, and they are said to be worth a combined US$350 billion.

The enthusiasm for reform and development is not confined to China.  In India, the Modi government has brought in a series of important policies with far-reaching impact.  The goods and services tax (GST) is expected to expand the country’s tax base, improve administration efficiency and ease compliance burdens for businesses over the long-term.  The enactment of the new Insolvency and Bankruptcy Code is a long over-due legislative overhaul to reshape the country’s dysfunctional banking system.  It finally provides creditors with a legal recourse to recover debt and will prevent debtors from circumventing liability by obfuscating through the courts.

We have also seen a boost to infrastructure spending.  When Modi was elected Prime Minister several years ago, India was building a few kilometres of highway each year.  They have since been on a building spree, now laying 25 kilometres of highway a day and the National Highways Authority is planning to construct 50,000 km by 2022.  As we have seen with China, infrastructure can transform a nation and lay the foundation for India’s development in the years to come.

Technology is another powerful factor in India’s roadmap to economic prosperity.  Its world-leading biometric identification system (Aadhaar) has now registered more than 1 billion Indian citizens with their fingerprints and iris scans.  Together with the spread of mobile phones, the Aadhaar ID system has enabled hundreds of thousands of India’s poor to open bank accounts and to directly receive government subsidies.  Technology has allowed the government to bypass corrupt middlemen and reach the economically disadvantaged directly.  In India’s cities, we are seeing a similar wave of innovation in e-commerce and fintech as we are seeing in China, with companies like Amazon setting up operations to compete with indigenous start-ups like Flipkart.

To conclude, it is simply meaningless to discuss the world economy today without properly understanding the tectonic transformation that we are witnessing in Asia.  It feels as though China and India are occupying the same space that America once occupied in the 1950s-70s, when its sense of purpose, scale and innovation left the staid structures of Europe gasping.  There seems a high probability in Asia’s future growth and prosperity, conscious as one is of such sweeping proclamations, given the scale, ingenuity, diligence and thrift that is characteristic of the region.

We are very optimistic about the opportunities on offer in Asia and have around 38% of the Platinum International Fund invested in the companies of the region (not including Japan).[2]  Many of these companies are on a par with the best of the West in their respective fields, and are delivering excellent returns on capital.

[1]  These structural adjustment packages (SAPs) required the recipients to reduce government spending, to allow insolvent financial institutions to fail and to raise interest rates sharply.

[2]  As at 30 September 2017.

Thursday, 12 October 2017 15:12

Business model disruption has only just begun

From a presentation by Hamish Douglass (CEO Magellan Financial Group) in October 2017


There’s a lot of business model disruption in the world and many companies will be left behind by the changes. There will be winners and losers in the years ahead, but sometimes business model disruption isn’t obvious. There are first-order effects when you have changes to business models, but when new technology and new businesses develop, it affects other businesses and other industries and it’s often not foreseeable. This is Part 1 of a two-part transcript.

Watch for second-order effects

If you look at a photograph of the Easter Parade in New York in the year 1900, it is full of horses and carriages. If you fast forward to 1913, the photograph is full of petrol-powered automobiles. Think about what had to happen, such as rolling out petrol stations. Transportation fundamentally changed in 13 years. In 1908, Henry Ford rolled the first Model-T Ford off the production line which enabled an automobile to be mass-produced at an affordable cost.

Many first-order effects are fairly obvious. If you manufactured buggy whips, you effectively went out of business. If you collected manure in the streets, you went out of business. There were 25 million horses in the United States in 1910 and 3 million in 1960.

The second-order effects aren’t as knowable. The second-order effects are what the automobile enabled to happen. An entirely new industry could move goods around far more efficiently. People could start the urban sprawl and move further away. We developed regional shopping centres due to the automobile.

Consider a simple change in technology, the automated checkout, such as in Woolworths and Coles in Australia. Walmart started rolling out these automated checkouts in around 2010 at scale and the other major retailers started doing the same. The first-order effects were a loss of jobs of the people working the checkouts, and retailers reduced their costs. And if one major competitor does that, other competitors follow, otherwise their cost structure is out of line.

But what of the second-order effects? Chewing gum sales have lost 15% of their volume since the introduction of automated checkouts in the US. The checkouts have disrupted the business model of impulse purchases. People do not drive to the supermarket to buy chewing gum, but when you used to stand in those checkout lines, you would pick up some chewing gum. I think mobile phones have had a bit to do with it too, because you now do other things when you’re standing there.

Our job as fund managers is to try and spot the next Wrigley. In 1999, at the peak of the technology bubble, Warren Buffett was asked by a group of students why he doesn’t invest in technology. He said he could not predict where the internet was going but investing in a business like Wrigley will not be disrupted by technology. And look what’s happened. Wrigley sales had gone up for 50 years, every year, before this change happened.

The pace of change is accelerating

Technology adoption appears to be accelerating. The chart below shows the number of years it takes to reach 50 million new users. We saw the rapid adoption with smart phones, and it only took Facebook five years to move from 1 billion to 2 billion users. These new technology-related businesses can scale at an incredibly fast rate.

I think there’s a whole series of factors explaining why this is happening, and a lot of things are starting to come together.

First, globalisation and the internet have enabled products to spread rapidly to much larger audiences around world. A second factor is the digitalising of goods and services. We have digitalised books, newspapers, music and videos. With Facebook, Google or Netflix, all their services are digital goods. Instead of spreading atoms around the world, we’re now spreading bits around the world where an identical copy of a digital good is produced at zero cost.

Third, the mobile phone today is more powerful than the world’s most powerful super-computer in 1986, in the year I left school, which is absolutely incredible. And now we’re connecting all these devices in ‘cloud computing’, where massive data farms don’t need computers to sit locally, and you can share all this information. So there’s a whole lot of infrastructure and change that’s enabling very rapid change.

The incredible power of two digital platforms

Consider the ‘GAF effect’ from Google, Amazon and Facebook. I don’t mean specifically those companies, but how they are affecting industries and important business models. First is the advertising industry. Google and Facebook know an enormous amount about their users. Anyone who uses Google has something called a Google timeline (unless you’ve opted out of it). On your Google timeline, in your user settings, you can go back five years and it will tell you exactly what you did five years ago if you carried your mobile phone, and most people do.

It tells you what time you left your house, whether you walked to the bus, which bus you boarded, if you went to work or not because it knows the address. If you take any photos on a day, it will put those photos on the timeline. It will tell you where you went for lunch, when you went home and if you went to dinner, it will tell you the restaurant. And this goes for every other day of your life for the last five years. It’s collecting enormous amounts of data about you, as are Facebook and others. That enables these platforms to start highly-targeted advertising and make it incredibly efficient.

In the last decade, traditional print advertising has lost about 24% market share, and I predict this will go to zero. It is extraordinary that outside China, two companies (Facebook and Google) have taken nearly the entire market share of a global industry that had many, many players in the world – magazine producers, newspapers producers, classifieds producers. All this revenue has ended up with two digital platforms that have this massive network effect. Television advertising, which is the largest pot of advertising money, has not yet been disrupted. We’re starting to see the rise of YouTube but it is still relatively small, as shown below. It’s probably got between US$6-8 billion of revenue at the moment, but it’s an industry with US$150-180 billion of revenue outside China.

Television is next

The television advertising business model is the next to fall due to two big factors. We’re experiencing the rise of these streaming video services. Think of Netflix, Amazon Prime, Stan, and Hulu, and Apple wants to enter this game. These businesses are spending enormous amounts of money on content creation. Amazon and Netflix this year will spend US$10 billion creating original content. They are far outspending anyone else on the planet. Facebook just bid US$600 million for the Indian cricket video streaming rights and were outbid by News Corp’s Fox. I think that’s one of the last-ditch efforts to protect sporting rights and there’s a battle going on between the television and the movie networks. Apple and Netflix are bidding for the next James Bond.

They are taking viewers away from television and pay TV which reduces advertising revenues. Then on the other side, the costs of producing the content and buying the best shows is being bid up. It is not a great business model if your revenues go down and your costs go up.

We’re also seeing the advent of new video advertising platforms. The streaming services are not advertising businesses, they are subscription businesses. But YouTube and now Facebook (and they’ve just launched Facebook Watch) are advertising business models, and I believe that a huge amount of the revenues that are currently in television and pay TV are at risk. It’s fundamentally different, because this is targeted advertising. These platforms know so much about the users that advertisements can be delivered specifically to what the users are watching on these new platforms.

The television advertising model as it currently stands gives a number of companies in the world a huge advantage because there are massive barriers to entry to promote products on television if you want to advertise at scale. It will be much easier to enter one of these new platforms. You can do very specific programmes if you are developing a new brand on Facebook, YouTube or Google compared with advertising on television.

The Amazon effect

Amazon is a business with an estimated US$260 billion in sales (including Whole Foods), the second largest retailing business in the world after Walmart. It’s a fascinating company. They run a ‘first-party’ business, where Amazon buys the goods, stores them in their warehouse and then sells them to their users via the Amazon website or mobile apps. Then they have a ‘third-party’ business called Fulfillment by Amazon, where other retailers put their own inventory into Amazon’s warehouse and then Amazon sells that inventory to their customers as well. So customers suddenly have a much greater selection, and Amazon charges other retailers rent for having their goods in the Amazon warehouse, then charges a commission for selling to the user base.

Amazon also is a massive logistics company. They are expanding warehouse space by about 30% a year and they are incredibly advanced from a technology point of view. They have developed with a robotics company something called the Kiva robot, with about 45,000 of these robots in their warehouses at the moment. Humans are good at putting goods in a package, adding a label and sending them off. But it’s inefficient for the human picker to run around the warehouse to find the shelf where that good is stored in these massive, multiple football field-sized spaces. So these robots automatically go around the warehouse and bring the shelves holding the product to the packers.

The loyalty scheme called Amazon Prime started out with two-day free shipping, then same-day and 2-hour free shipping in a number of cities around the world. Amazon Prime members receive free video, free music and free ebooks with the service.

Amazon is a also a data analytics company. They understand enormous amounts of information about what the customer wants to buy. Amazon members see web pages that look different to anybody else’s. There are 50 million goods available in Amazon so customers receive a particular look into the world.

Amazon’s Jeff Bezos wants to fulfil all of his customers’ shopping needs. He worked out that if you want to be in their everyday shopping, you need to be in the grocery shopping habit. They started with Amazon Fresh, an online grocery shopping business that’s very niche. But if you want chilled vegetables or meats or ice cream, it’s inconvenient to have them delivered on the verandah if you’re not there for two hours. A lot of people want to look at their fresh fruit and vegetables and not have anyone else choose that for them. So Bezos bought Whole Foods, the largest fresh food retailer in the US. It had a reputation for expensive produce, lots of organics, incredible displays. On the first day Bezos took control, on the key lines people are interested in, he dropped the prices 35-45%. People shop for incredibly good, fresh groceries then everything else can be put together.

He wants to connect your home by the ‘Internet of Things’. Many goods like washing detergent and milk will have computer chips on them that will connect to the internet to know when you are running out. Washing machines and fridges will automatically generate shopping lists. He’s adopting a voice platform for your house with a digital personal assistant.

What’s next?

There’s a massive number of these revolutions. You may think Amazon and Facebook and Google are big at moment, but we’re in the early stages of where this technology and these businesses are heading. Advertising and retailing is the start. Next week, I’ll discuss which large companies will suffer, and bring in the perspectives of Warren Buffett and Charlie Munger.


Tuesday, 26 September 2017 18:51

Rocket Man Kim - Keep calm and BUY shares

by Jack Lowenstein (Morphic Asset Management)


A few weeks ago, US Ambassador Nikki Haley to the UN intoned that “the North Korean can couldn't be kicked any further down the road because there was no more road”. But a few weeks seems to be a long time in rhetorical road building because the can has just had another boot applied, and is still on terra firma. 

Meanwhile after brief jitters when North Korean missiles were flying and the dust from underground nuclear tests was settling, global stock markets reached new all-time highs again last week, and several major central banks confirmed they were moving ahead with monetary policy tightening. 

Many investors ask us why we don’t tend to get more nervous about potentially catastrophic geopolitical events.

This note is a brief description of why we try to stay calm even in the face of potentially devastating instability on the Korean peninsula, and what might make that wrong. For the record, we used recent jitters to slightly top up our investment in Korea’s largest company Samsung Electronics, which makes it now the largest holding in our portfolios.

I first had to contemplate the implications of tensions on the Korean Peninsula and their potential resolution in 1990. In most regards, nothing has changed. That doesn't mean it never will - but probably not for some time. 

That year, when I was still a journalist at Euromoney magazine, I was sent to Seoul to write about the financial consequences of the Koreans copying Germany and reunifying. It must have looked like a smart idea from the distance of London, where people were still excited about the end of the Cold War and the demolition of the Berlin Wall. 

In Seoul, it quickly became apparent the proposition was laughable. 

The South, with its population of 45m or so had a per capita income generally estimated at eight times as much as that ‘enjoyed’ by the 25m in the North. Having only just escaped extreme poverty, itself, however it could little afford the cost of investing in the North to bring it up to its level quickly or cope with an influx of starving northerners moving south. So few in the leadership had any real interest in reunification, even if they had to go through the motions of aspiring for it in public. 

In North Korea, the ruling elite would lose all their privileges if not their lives if their regime collapsed, so they would never support reunification. 

The other four interested parties also had no real interest in demarche. China didn't want a western-leaning democracy on its doorstep. Russia didn't want to lose a distracting irritant to the other superpower, the US. The US didn't want to lose valuable forward bases in Korea and Japan that were nominally justified by a belligerent Pyongyang. And Japan didn't want to lose a fully engaged US military in the region. Nor did it have much appetite for a larger northeast Asian economic competitor.

Today similar factors apply. 

Pyongyang has buttressed its position through nuclearisation. “Rocket Man” Kim, as President Trump has undiplomatically dubbed him, would know his chances of preserving power, wealth or indeed his life would be negligible under a united regime.

South Korea could probably afford to integrate the North now, but the challenge from internal migration would be acute, given per capita GDP in the south is now at least 20 times higher than the north. 

Japan might worry less about Korean reunification than in the past, given the greater threat the present situation poses than in the past. The increased challenge from China now also justifies the retention of US bases in Japan to both Washington and Tokyo. A resurgent Russia, however, would probably be more opposed.

The Chinese dilemma is exquisite. Many in the Beijing leadership probably hate being held hostage by Rocket Man. But to give him up, would entail a loss of face. There would still be no interest in a country with a western orientation being directly on the border, even if it was agreed US bases would be closed.

Sadly the most likely way this impasse changes is by accident. And it is almost impossible to manage money in preparation for that kind of discontinuous event. 

Challenger superpowers like China are highly prone to start wars. Sometimes this is to distract from temporary economic setbacks, like the three wars Germany fought against Denmark, Austria and France between 1860 and 1870. Sometimes, like emerging Japan prior to WW2, wars can happen because a field commander can make a blunder and no one at the capital wants to lose face by bringing him into line. 

Pyongyang has too much to lose from deliberately attacking anyone, but what if a rocket veers off target and lands in Japan or South Korea? Or someone in the line of fire erroneously believes a rocket attack is under way?

My old friend Jonathan Allum of SMBC Nikko today drew my attention to the story of Stanislav Petrov who has died at the age of 77. On the 26th September 1983, he was the duty officer at a Soviet military facility that monitored the threat of missile attacks. The following is condensed from the BBC version of what happened that day.

In the early hours of the morning, Soviet early-warning systems detected an incoming missile strike from the United States. The protocol for the Soviet military would have been to retaliate with a nuclear attack of its own. But duty officer Stanislav Petrov decided not to report it to his superiors, and instead dismissed it as a false alarm.

"If I had sent my report up the chain of command, nobody would have said a word against it… The siren howled. All I had to do was to reach for the phone; but I couldn't move. I felt like I was sitting on a hot frying pan…Twenty-three minutes later I realisedthat nothing had happened. If there had been a real strike, then I would already know about it. It was such a relief”

A subsequent investigation concluded that Soviet satellites had mistakenly identified sunlight reflecting on clouds as the engines of intercontinental ballistic missiles… 

A salutary tale. Let’s hope the world stays this fortunate. But these really don’t seem to be risks we can hedge.

BillEvans small headshot WIBIQBill Evans - Chief Economist - Westpac

Markets have moved to price in three hikes for the RBA’s cash rate by end 2019. Other major banks concur broadly with that view.

Recall that in mid-August last year, these same players (markets and most other banks) were forecasting rate cuts over the course of the remainder of 2016 and 2017. Westpac’s view at that time was “rates on hold” in 2016 and 2017.

Readers of the Westpac Market Outlook publication for September will be aware that Westpac continues to forecast the cash rate to remain on hold out to mid-2019.

Indeed we are not convinced that the cash rate will need to rise any time throughout the course of 2017, 2018 or 2019.

This approach is clearly different to the thinking of the Reserve Bank Governor himself who expects to be tightening over that period (note his speech on “the next chapter” which was delivered yesterday).

However, we continue to point out that the RBA has a very different growth outlook for the Australian economy and Australia’s trading partners to our own.

The RBA expects growth in Australia to be 3.25% in 2018 and 3.5% in 2019 (above trend of 2.75%). Westpac expects a below trend pace of 2.5% in both years.

The RBA is also forecasting 2% underlying inflation in 2017 and 2018 (bottom of target band) to be followed by 2.5% in 2019.Underlying inflation is currently running at 1.8% (to June) and the upcoming revised weights are likely to reduce annual underlying inflation by 0.2-0.3%.

Going forward, the RBA’s inflation forecasts also look to be overly optimistic and are likely to be subject to downward revision. Recall that in 2016 when the RBA was forced to revise its inflation forecasts below 2% it believed it had little choice but to cut rates.

While the RBA does not provide detailed forecasts outside growth and inflation, comments from the RBA Governor and written reports point to a much more confident outlook for wages growth; incomes; employment; consumption; non-mining investment and the residential construction cycle.

The Reserve Bank expects wages growth to increase over the forecast period. A major puzzle for central banks globally has been the limited response of wages to stimulatory monetary policies since the GFC. Despite these policies in the US; Germany; the UK and Japan driving labour markets to near or full employment, wages have failed to respond. Explanations for this phenomenon have been structural: globalisation; technology; retiring higher paid baby boomers; low productivity growth; absence of pricing power for employers; low inflationary and wage expectations; high risk aversion following the GFC and job insecurity.

Consistent with that global theme, wages growth in Australia has also been weak. Australia’s wage price index has increased by 1.9% over the last year compared to average growth of 3.5%. The unemployment rate has held in the 5.5%-6.0% range compared to a generally accepted full employment rate in Australia of 5%.

Further, underemployment in Australia has been high at around 8.8% making total excess capacity around 14.5%. Given the global lessons on the structural wages outlook, it seems unlikely that wages in Australia (where spare capacity is higher than in these other developed economies) will lift significantly even in the medium term.

This weak wages performance has lowered annual real income growth to 0.6% while real consumption growth has held around 2.5%. The shortfall has been funded by a falling savings rate, particularly in the highly stressed mining states. Overall Australia’s household savings rate has fallen from 9% to 4.6% over the last three years.

Households will need to protect that fragile savings rate and pressures will emerge on consumer spending. Of course, other pressures are impacting households – rising energy prices; record high debt levels and political uncertainty. The latter effect will work through the business sector as businesses restrain employment and investment until political clarity is achieved following the 2019 election.

Markets may be underestimating the impact on the interest rate sensitive housing market of developments which are unfolding without official rate hikes.

The four majors (90% of the mortgage market) have been raising investor and interest only mortgage rates while applying tighter lending guidelines. House price inflation is slowing and regulators are unlikely to have any patience with a reversal of this trend.

To that point, six month annualised house price inflation (CoreLogic data) in Sydney has slowed from 22.4% in January to 4.8% in August. We observed a similar response to macroprudential policies in 2015/16 when six month annualised house price inflation slowed from 25% (July 2015) to -4.4% (April 2016).

Housing activity is also slowing despite a steady cash rate. Other factors, specifically relating to foreign investors, have turned the cycle. High rise building approvals have tumbled by 40% in the last year. This has been particularly due to investment restrictions in China; lending constraints by banks; and sharp increases in state government stamp duties for foreign investors. This downturn is likely to continue for at least a further two years.

While markets are currently captivated by expectations of a coordinated lift in global growth, we are more circumspect particularly around Australia’s trading partners.

With Chairman Xi likely to cement power following the National Congress in October, we expect that he will have little choice but to adopt policies to gradually deal with the excessive build up in corporate debt in China (now 166% of GDP), largely driven by the circa 30% compound growth rate of small and medium sized banks and non-banks over the last six years. These small banks now represent comparable asset bases to the heavily regulated policy banks which have only been growing at around 12% over the same period. It will be incumbent on the administration to arrest the growth rate of these small banks; off balance sheet vehicles; and non-bank institutions. Asset quality for these institutions must be suffering while reliance on overnight funding has lifted sharply.

Tighter credit conditions will slow China’s growth rate – we forecast a growth slowdown from 6.7% in 2017 to 6.2% in 2018.

Finally, the ongoing legacy of elevated risk aversion, which continues ten years after the Global Financial Crisis, is contributing to unusually steady interest rates around the world. Under our figuring, on the basis that this risk aversion persists for a few more years, a 40 month stretch of steady rates in Australia would not be out of place.