Six events you may have missed

by Michael Collins, Investment Commentator at Fidelity

February 2016

In 2011, the US suffered the embarrassment of losing its triple-A debt rating for the first time when Republicans abandoned the formality of renewing Washington’s debt limit in an attempt to blackmail Democrats into agreeing to spending cuts. The showdown went within days of sending Washington into default. That was too close for Standard & Poor’s. It was too much for investors who fled stocks.

In 2013, again to the angst of investors, Republicans renewed their extortion when the expiry of the compromise tax deal of 2011 was set to propel the economy over a “fiscal cliff” of spending cuts. About nine months of squabbling over the appropriate levels of Washington’s spending and debt ensued. Short-term fixes were passed to keep government functioning until October 1 when the US government went into a partial shutdown. Over most of those months, Treasury manipulated payments to stay within the country’s debt limit, while warning of impending default. Finally, on October 16 of that year, Congress passed a resolution to fund the government into 2014, a year when more fixes were needed to keep Washington financial.

Well, investor anxiety over the passing of a budget in Washington is done for a while. On December 18 just gone, for the first time since Republicans gained control of the House of Representatives in 2010, Congress agreed on a budget about as easily as any compromise could be approved, even allowing for a few rumblings in October and some last-minute drama on whether House Democrats would support a key bill.[1] No doubt, the dire polling for Republicans during the 2013 showdown helped the budget’s passage. Republicans nowadays obviously don’t want to jeopardise their party’s chances in this year’s elections. Whatever the motive, the budget’s passing was a welcome, even if unheralded, event that has ushered in fiscal harmony in Congress for 2016.

Amid all the turmoil of recent months, other pleasing events have occurred that investors may have overlooked amid all the pessimistic tidings. They counterbalance to some extent the concerns tugging at investors such as China’s slowing, tensions in the Middle East and the rise of populists in Europe and the US.

Even sought-after events aren’t without qualification, of course. The US budget compromise ducked a proper debate on what services the government should provide and how to pay for them. Thus, it does little to solidify the US government’s long-term financial position (Washington’s debt equates to 80% of GDP) because it fails to curb soaring welfare and healthcare costs. Even if beneficial events for the world economy take place, menacing ones can always overwhelm them, as happened in 2008. There are plenty of threats today that could do just that. Still, the world economy expands most years because lots of unheralded advancements trump well-publicised setbacks and concerns.

China contributions

Near the top of recent welcome events is another unexpected decision by US Congress. This one was to break a five-year stalemate to restore US support for the IMF. In the US$1.1 government-spending bill that formed the bulk of the budget compromise, Congress signed off on an IMF plan to increase the voting share of emerging economies such as Brazil, China and India and double the amount of permanent funding available to the 188-member body.[2]

The US ratification of the IMF plan was welcome firstly because years of Congressional inaction on the IMF changes weakened the global economic leadership of the US at a time it was needed. In essence, inaction by US Congress was weakening the global finance system Washington helped design when the IMF was created in 1945. Another benefit is that the greater say for emerging powerhouses in the IMF boosts the body’s legitimacy as an avenue for compromise between countries on issues related to global stability. For all its defects, the world needs a credible IMF because without it there is no valid lender of last resort for governments. Deprived of a well-functioning IMF, broke countries would end up as fiefdoms for a richer power or they would need to turn to private finance to survive. Global contagion would be a greater possibility.

The IMF, in turn, did the world a favour in November when it said that from October 1 this year it will include the yuan as the fifth currency in its special drawing rights or SDRs, a basket of currencies that are the IMF’s units of account.[3] The yuan’s inclusion with the euro, UK pound, US dollar and yen is largely symbolic because few goods and services are priced in IMF SDRs. The symbolism is that the IMF is acknowledging that the yuan deserves to be regarded as a reserve currency, one that governments and official bodies are willing to hold because it is seen as a store of value. (Much more needs to happen before the yuan is a true reserve currency, even if it is gaining wider use.)

For a currency to be included in the SDR basket, the IMF demands that a currency’s issuing country be a major exporter (pass for China) and that the currency be freely usable, which means easily convertible (fail for China). In a somewhat political decision, the IMF approved the yuan’s inclusion anyway. While the politics nips at the credibility of the decision and the yuan’s inclusion does little for its short-term value, the outcome is one that will bring economic benefits for the world because it will help open China’s economy over time.

The yuan’s SDR inclusion will help liberalise China in at least three ways. Firstly, the yuan’s inclusion promotes the uses of the currency in trade because it enhances its acceptance by governments and the private sector. Another benefit is that it cements China to the global financial system, which is to say it gives Beijing an incentive to take account of global stability when setting domestic policy. Lastly, it supports liberal policymakers in their debates on policy within China. It will help those with an international bent such as those at the top of the People’s Bank of China who want to open China’s capital account and let the yuan’s value be market set.

Speaking of China, did you hear that the number of Chinese visitors to Australia just exceeded one million for the first time over a 12-month period? In the year to November, short-term visitors from China reached 1.0 million, up 22% on a year earlier and about 50% higher than five year’s previously.[4] While the Chinese are still second to New Zealanders in terms of visitors, Tourism Australia forecasts that Chinese visitors will grow to such an extent they will spend up to $9 billion a year in Australia by 2020, up from $4.8 billion in 2013.[5]

China has been Australia’s biggest export services market since 2010[6] thanks to education, travel and business services worth $8.2 billion in 2014, about the value of coal exports that year.[7] The welcome symbolism of Chinese tourist numbers breaking above one million adds to the argument that Australia benefits from China’s rise in many ways. The good news displays how the China-inspired downturn in commodities is being cushioned to some extent by the pick-up in consumption in the world’s second-biggest economy.

Good news equates to …

Back to the US, the Federal Reserve’s decision on December 16 to raise the cash rate for the first time in nearly 10 years in still debated. Some say higher interest rates will wreck the US recovery, others reckon that the Fed should have raised rates earlier to curtail asset bubbles. It’s still too early to judge the Fed’s decision – that no one missed. But perhaps many failed to notice how seamlessly the US cash rate was raised from zero to 0.25% and how smoothly bond and stock investors accepted the future anticipated path of the US cash rate, even allowing for how much of this was already priced into asset prices and the chance that the rate increase could be view as a mistake in due course. The absence of trauma at the time of the rate increase was a credit to the Fed’s communication skills and classes as a welcome event. Think of how much coverage a panicked investor response would have received and how loud doomsdayers would have hollered.

As usual, the hassle-free US rate rise showed that good news is no news. Even worse, though, is when good news is made out to be bad news. A welcome event for the world economy that falls in this category is that austerity across the developed world has been overturned in many countries recently. Even though austerity is self-defeating in that the withdrawal of stimulus shrinks economies faster than government debt loads, it’s often written up as governments lacking the courage to fix their finances.  

Voters appear to have cottoned on to the fact that government budgets don’t operate like household ones (as has the austerity-recanting IMF). In October, for instance, Canadian voters tossed out the pro-austerity Conservative Party of Canada and installed the centre-left Liberal Party of Canada, which has promised to use fiscal stimulus to rev up Canada’s economy. Across the border, the US budget deal of December represents an easing of austerity because spending limits were eased and tax cuts made permanent. This year, US governments at all levels are poised to make their biggest contribution to growth since the fiscal packages saved the US economy in 2009 and 2010.

In Europe, electorates, economic hardship and events have teamed together to force an easing of austerity – or, to put in another way, they are allowing governments to flaunt the Stability and Growth Pact that legally enforces a fiscal straightjacket on countries no matter the state of the economy. In Portugal, a voter backlash against austerity in October resulted in a (shaky) Leftist coalition that has pledged to take its time to meet EU deficit targets. Austria, France, Italy, Lithuania and Spain, a list that includes three of the eurozone’s four largest economies, are others “at risk of non-compliance” with EU budget targets, to use EC speak. In fact, only five of 19 eurozone countries (Estonia, Germany, Luxembourg, the Netherlands and Slovakia) are unambiguously meeting EU deficit targets.[8] On top of that, the EU is allowing money spent to handle Europe’s refugee crisis to sit outside its budget rules that enforce a headline budget deficit of below 3%.

In Australia, it may have escaped attention amid fright about Canberra’s ballooning deficits that the Coalition is refusing to impose austerity. Canberra said in its mid-year budget review in December that it has postponed a budget return to surplus to 2021-22 and it will allow bigger deficits in the meantime.[9] While that postpones some tough tax and spending decisions, such a stance will help Australia’s economy cope with China’s slowdown. That was heartening news for investors during the same week in December that US Congress approved a budget, the Fed raised rates and few panicked, more Chinese arrived here and fiscal stimulus poured into economies. Just remember amid the gloom that more weeks like that happen than most investors realise.

Financial information comes from Bloomberg unless stated otherwise.

[1] A House majority of 316 to 113 passed US$1.1 trillion in spending measures on December 18 that formed the bulk of the budget while the Senate approved 65 to 33.

[2] Under the plan that was formulated in 2010, Brazil’s voting power ascends from 14th to 10th, China’s goes from sixth to third, India’s jumps from 11th to eighth, while the power of European and Persian gulf countries is reduced.Bloomberg News. “Congress approves IMF change in favour of emerging markets.” 19 December 2015.

[3] IMF. “IMF’s executive board completes review of SDR basket, includes Chinese renminbi.” 30 November 2015.”

[4] Australian Bureau of Statistics. “3401.0 – Overseas arrivals and departures, Australia, Nov 2015. Table 5: short-term movement, visitor arrivals – Selected countries of residence: Original.”

[5] Tourism Australia. “China. Market profile 2014.”

[6] Department of Foreign Affairs and Trade. Trade in Services, Australia 2003.79-10.

[7] Department of Foreign Affairs and Trade. “China profile.”

[8] European Commission. “Commission adopts opinions on the 2016 draft budgetary plans (DBPs) for 2016 that euro area member states submitted by 15 October.” 17 November 2015.

[9] Australian government. “Mid-year economic and fiscal outlook.” 15 December 2015.