Media Watch: To QE3 or not to QE3 by Brian Thomas

To QE3 or not to QE3, that is the question!

The global economic and equity market outlook for 2011 is looking positive, with the US economy showing signs of responding to policy stimulus and a lower exchange rate. A sign of growing confidence has been the market’s ability to absorb a significant bout of geopolitical instability without completely giving up the ghost. Given where global sharemarkets are in the cycle, it is worth reflecting on the massive rebound in the US equity market. The S&P 500 has now boomed nearly 100% in only two years, the Australian market is up only 54%, on an accumulation basis. In my opinion, the accumulation index (which includes dividends) is more reflective of what people actually receive, as opposed to a price index. Taking dividends into account, the US market is up over 100% and not far off its high. In terms of the real economy it is also worth noting that US real GDP is now at levels matching its pre-crisis peak. Australia continues to outgrow the US though, thanks to the emergence of Asia.

Decoupling with the US
Long-term trends in real GDP (Sept 59 = 100)

• After a long period where Australian growth mirrored that of the US, post the tech-wreck, both economies have gone their own way.
• A sharp fall in the AUD heped insulate the Australian economy in the early 2000s.
• After that, the rise of emerging Asia saw Australia benefit from a favourable structural shock.

Source: BEA, ABS, Perennial. 

You can see that Australia has been left behind, probably due to the mining tax issues and overseas investors’ concerns about a volatile AUD. The main point is just how spectacular the bounce has been in a relatively short time. The chart above shows how the Australian economy has outgrown the US. In my view, this augurs well for Australian equity growth relative to the US from this point.

The biggest issue for global markets relate to the ability of the two big boys on the block, the US and China, to behave. The US could face a huge test when the current money printing operation (QE2) ends in June. The goldilocks situation ("not too cold, not too hot, just right") would be for US unemployment, consumer and business confidence to improve so that a "QE3" is not necessary, US interest rates can start to normalise and all with inflation under control! In many ways, inflation is the key here, as the US Government can continue to print money without disastrous consequences, provided confidence remains in the US government and inflation remains under control. With the oil price under upward pressure due to civil unrest in Libya, my take is that the US will get through this, but the road will be bumpy. Given my longer term positive view, I would see any such bumps on the road as presenting some good buying opportunities, rather than reasons for major panic by investors.

China to revalue Renminbi?

 
 Chinese officials are struggling with a booming economy, inflation pressure and an out of control housing market as they go about approving their five year plan this month. Interestingly, just last week in an online “citizens” debate, Prime Minister Wen Jiabao talked about targeted growth of only 7%. However, it is arguable that talking down growth in an overheated environment probably makes a lot of sense. Interest rate rises in October, December, February and more severe restrictions on property lending ratios from the banks will hopefully deflate any developing asset bubbles. Overall, I see the Chinese as being capable of managing their economy with the likelihood of the Renminbi being allowed to appreciate to quash inflation and cool growth.

Australian reporting season and share valuations 
 

The simple summary is BHP and banks were the clear winners and large industrials were disappointing. This reflects the "two speed" nature of the Australian economy (not surprisingly resources bounced 3.7% during the month compared to 1.7% for industrials). More importantly, earnings are still forecast to grow in high double digits (again led by resources) and, with PE levels at around 12 times, the market is not stretched at these levels (long term PEs in the Australian market tend to be over 14x).

A new study on active management 
 

While indexed managers tend to sing from the same hymn book, the range of approaches and strategies used by active managers is quite diverse. It is refreshing to read a technical study by Cremers and Petajisto from Yale University. Click here for a copy that makes the observation that when you take out the so-called "closet indexers" (i.e. active managers who target quite small variations from the index) truly active managers do tend to consistently add value in the US equity market. The results should even be more pronounced in the Australian market, where the median manager tends to add more value that the US median manager (perhaps due to the sheer size and competitiveness of the US market compared to Australia’s).

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