Investment Enews
MARCH 2017

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Dateline: Paris, 9 August 2007The French bank BNP Paribas suspended operations of three of its funds and the European Central Bank injected cash into the financial system, both in the wake of turmoil in the United States mortgage market...

...the central bank… said it would provide unlimited amounts at 4 percent, its current benchmark rate...

“It’s quite exceptional to suspend funds” [BNP spokeman Jonathon] Mullen said. “But we hope this is going to be temporary and that the market will come back… This is just a technical problem about liquidity.”

... Share of Deutsche Bank and BNP dropped last week, even though both reported better-than-expected profit in the first half. Investors are reducing their exposure to banks with large investment banking arms.”

James Kanter & Julia Werdigier, New York Times, 10 August 2007

So began the extraordinary episode in economic and social history that has come to be known as the global financial crisis (GFC). In truth, the GFC had roots significantly deeper and further back than 2007. Risky investments and increased debt had been building for years. The balance of savings and debt between developing and developed nations respectively was unsustainable and growing. The US mortgage market had seen arrears increasing significantly from 2006.

All these forces began to crystallise in 2007. As has been well-documented, the BNP episode was followed by the collapse of Bear Sterns (14 March 2008) and the Lehman Brothers (15 September 2008). The UK banks Northern Rock (22 February 2008) and RBS (13 October 2008) were fully or partially nationalised. Unconventional monetary policy became a commonplace.

Standing almost a full decade after these extraordinary events, it is hard to argue that we have put the GFC behind us. In this edition of Investment Enews we consider the Australian and world economies since the GFC. In particular, we consider how we have fared against three of the key goals of economic management.

Three key goals of economic management

The history of economics revolves around the fundamental question of ‘scarcity’. Human beings generally want more things than are available to them. And when their first list of desires is fulfilled, they create another. How do we satisfy these unlimited needs and wants with limited resources?

At a practical level, governments and regulators typically focus on a series of more specific objectives or goals. The precise definition and ambit of each of these goals varies from list to list, but the substance is consistent. Three of the most frequently-cited and important economic goals are economic growth, full employment and price stability. Each of these has experienced significant and long-lasting effects from the GFC.

1. Economic Growth

Economic growth is an increase in the amount of goods and services produced by an economy over time. Conventionally, it is measured by Gross Domestic Product (GDP). It is probably the single most-watched indicator of how an economy is performing, although it has been the subject of much criticism over the years.

The GFC had a profound and longlasting effect on GDP prints across the world. The first chart below shows that yearly GDP growth in the USA and the UK was extremely hard hit by the GFC. In 2009, those economies experienced a profound recession that materially shrunk their economies. Even Australia, which escaped the worst of the damage courtesy of strong demand from China and population growth, saw GDP growth drop from 4.5% in 2007, to 2.5% in 2008 and just 1.8% in 2009.

Just as importantly, a careful viewing of the charts will show that each economy’s growth has trended lower since the GFC. It is as if the GFC has triggered a ‘new normal’ of lower trend GDP growth.

This presents a significant challenge for governments and other policy makers. In the Australian context, as the graph inset, right, shows, the trend to lower GDP growth since the GFC is unmistakable. Despite the natural variability in GDP growth on a year-to-year basis, we are seeing lower ‘peaks’ and ‘troughs’ in yearly GDP growth than in the decades prior to the GFC. The commentators writing of ‘secular stagnation’ in economic growth find much here to support their thesis.

The situation is even more alarming when considered on a ‘GDP per capita’ basis. This measure eliminates economic growth arising from population increase and focuses on how living standards are changing for Australians. Senior economist at the Commonwealth Bank, Gareth Aird, adjusted GDP for population growth and his chart is inset, left.

Not only does it show GDP as considerably lower than is normally stated, it also shows that we experienced a ‘per capita recession’ during the GFC. Were this, arguably more relevant, measure of economic growth more common, Australia’s much-vaunted run of recessionless growth would have come to a halt during the GFC. Our migration program has been a key contributor to our prosperity.

2. Full Employment

Unquestionably, one of the most important socially critical economic objectives is maintaining full employment (or, to look at it another way, minimising unemployment). People can generally withstand a reasonable period of low or even negative income growth if they can keep their jobs.

The graph below shows the impact of the GFC. Following the early 1990s recessions, most advanced economies experienced a long-term downward trend in unemployment. That changed dramatically as the GFC began to bite. Corporate collapses and company downsizings were experienced across developed nations. Even here in Australia, protected as we were by a growing population and demand from China, our unemployment rate rapidly increased by about two percentage points.

The situation since the GFC has been mixed across the developed world. After unemployment peaked in 2009- 10, there was a noticeable improvement in most economies, although it took far longer to take effect in the UK, probably due to persistent difficulties in the broader EU area. However, by 2013, the UK joined the US as experiencing significant improvement and both economies are now at around the same levels experienced just before the GFC.

The same factors that buffered Australia from recession also protected our labour market from the worst effects of the GFC. On the other hand, our labour market has not recovered to the same extent as that experienced in the US and the UK. We entered the GFC with an unemployment rate of 4%. The GFC saw that rate increase to the high 5s, before recovery began. Unfortunately that recovery has never really taken root. After decreasing back to 5%, our unemployment rate began a steady increase and has since sat around 6%. Both the US and the UK are performing substantially better on this metric, sitting at around 5%. Although these figures are relatively positive against historical comparisons, they also obscure significant underemployment and low wage growth, which together indicate that labour markets in developed nations are yet to return to pre-GFC levels.

3. Price Stability

One of the great economic achievements of the last generation was the “snapping of the inflation stick”. This followed a tumultuous period in the 1970s and early 1980s, which featured stagflation (slow economic growth coupled with sharply increasing price rises) and surging energy prices on the back of the 1973 oil crisis. The uncertainty created by out-of-control inflation was a significant negative for world economies. People experienced sharply declining purchasing power, which was especially damaging for those on fixed income. Wage claims increased sharply in response, locking in an inflation spiral. Finance arrangements became very difficult to manage, as potential lenders struggled to calculate the likely future value of today’s money. In short, high and uncontrolled inflation was ruining economies.

Through the 1980s and 1990s, controlling inflation and restoring price stability became the key objective of policymakers across the developed world. Central banks were given specific target inflation outcomes (2-3% per annum in Australia) and were in many cases given independence and a mandate to use the tools at their disposal (monetary policy, especially official interest rates) to achieve these targets.

This approach brought outstanding success. As the graph on the left shows, inflation plummeted from 10-20% per annum (and even higher at times in the UK) to much lower levels. The Official Cash Rate (OCR) was used to great effect in Australia to achieve price stability. The population generally became wellaccustomed to the Reserve Bank adjusting interest rates upwards to ward off higher inflation, or lower when further stimulus was required.

The GFC changed this dynamic dramatically across the world. With GDP stagnating, policy-makers began worrying about deflation – that is, prices getting lower over time. This phenomenon was not unknown to the modern world. Japan had struggled with deflation throughout the 1990s and 2000s. Now, however, observers were seeing important European economies like Italy and Spain flirt with sustained deflation (see graph right).

Even powerhouse economies like the US, the UK and Germany began to flirt with deflation. This presented a serious risk to the world. Whilst progressively lower prices might seem welcome, they present some signficant challenges to economies that are generally not equipped to deal with them. Prolonged deflation can lead to or entrench economic stagnation and unemployment, as people defer spending on the basis that things will be cheaper in the future. What’s more, deflation means that real debt burdens increase. Consumers and firms with debt can be locked into a ‘death spiral’, in which they are unable to repay their debt.

So a lingering after-effect of the GFC was entrenched low inflation, bordering on deflation, across the developed world. Central banks had few levers that they could pull to respond, so dropped official rates as low as possible (even turning negative, in some cases) and adopted ‘unconventional monetary policy’. And that is where we remain today. In Australia, inflation has not dropped as severely as in many other economies, but is still persistently below the mandated 2-3% p.a. target range. The Reserve Bank has dropped interest rates to record lows in response, but many fear that low rates across the world could be artificicially inflating asset prices.

With the close link between price stability, economic growth and unemployment, there is little doubt that policy makers across the world would prefer to see more inflation in the system. The question is how the developed world will generate it.

Conclusion

There are many other issues we could have considered in reflecting on the effects of the GFC. The banking system has been subject to a searching review and bank capital requirements continue to be increased. Perversely, global debt levels – one of the causes of the GFC in the first place – have continued to increase on the back of unconventional monetary policy and record low interest rates.

In Australia, the sharemarket remains stubbornly 20% below pre-GFC peaks. This partly reflects the bursting of the worst excesses of the resources boom, but also shows a domestic market that has yet to recover.

The months ahead will see a number of reflections published around the ten year anniversary of the global financial crisis. Perhaps the most important lesson for investors is that it was not a one-off, historical event. History instead tells us that economic crises occur regularly, even in sophisticated, developed economies. Their effects are long-lasting and can be disastrous for investors, particularly those who are at or near retirement. For this reason, it is imperative that investors remember the fundamental rules of investment –

  1. Keep it Simple, Silly – The GFC saw massive losses incurred by investors who were investing in complex products, which they could not fully assess or understand. If you don’t understand it, don’t invest in it!

  2. Don’t put all your eggs in one basket – Diversify, diversify, diversify. For most investors, this is still the best protection against most crises. An Australian shares portfolio remains 20% down on pre-GFC capital value levels even ten years after the event.

  3. Getting rich slowly never goes out of fashion – Any telling of the GFC will not miss the losses incurred by institutions and individuals who were taking excessive risk to ‘outperform the market’. Fortunes are made on the back of steady, sensible, conservative investment over time. Save your betting for the casino!


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Dateline: Paris, 9 August 2007The French bank BNP Paribas suspended operations of three of its funds and the European Central Bank injected cash into the financial system...


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This publication does not constitute financial advice and should not be relied upon as such. It is intended only to provide a summary and a general overview on matters of interest and it is not intended to be comprehensive. You should seek your own financial or other professional advice before acting or relying on any of the content.