The changes most didn’t see coming

Based in Des Moines, Iowa, and founded in 1879, Principal is a venerable US asset manager with more than $US625 billion in assets, including more than $US400 billion managed by its investment division Principal Global Investors.

The firm’s chief global economist Dr Bob Baur paid a visit to Australia this month to attend an economic conference, and while here he popped into several of our big super funds, including HESTA and Cbus, as well as the Federal Government’s Future Fund.

In my article series published in early January, including The key market challenges for 2019, Baur said the following: “2019 will likely be characterised by a continuation of the current dichotomy between the real economy, which is doing just fine, and financial markets, which remain in turmoil. In short: economies prosper; financial markets struggle.”

As always, things can and do change when it comes to economics and markets. So, I asked him if there had been any marked changes over recent times, and if there was still a dichotomy. The short answer was, yes. We also spoke of challenges and opportunities ahead, moving on to Australia and his expectation the Reserve Bank will cut interest rates.

Listen to the podcast or read the full interview transcript below.

Tony Kaye: Hello, I'm Tony Kaye. I'm, the Editor of InvestSMART. I'm joined today by Dr Bob Baur, who is the Chief Global Economist of Principal Global Investors based in Des Moines, USA. Welcome to Australia, Bob.

Bob Baur: Thank you very much. Appreciate the opportunity.

Tony Kaye: Bob, I wanted to talk to you obviously on the economic level about what's going on. But I wanted to ask you first off, has anything material changed over, say, the last six months or so in terms of the global economic scene, and has your advice to your investment management committee changed over that point in time?

Bob Baur: One big change has been what happened at the Federal Reserve. At the December meeting, Chairman Powell and other governors assumed they were going to continue to raise interest rates. I think some people had three or four times this year. The runoff of the balance sheet, the Fed balance sheet, the reversal, was on autopilot. Huge change in the January meeting. I think the Federal Reserve was kind of chastened by the big stock market decline in December, and so essentially everybody said, "Pause." We had been thinking for some time, six months, that the Fed could raise rates only once in 2019. We think that's fallen by the wayside, so I think the Fed is none and done for 2019. That's one thing that has changed. In terms of stock prices and interest rates, what I've been telling clients, employees, portfolio managers, has not really changed. I suggested six months ago people stay really cautious about the stock market. I thought we had a sizeable decline ahead and that the ideas that the Fed was going to keep raising rates were totally incorrect. I did think the interest rates would continue to rise, and they did. They hit three and a quarter, 10-year treasury yields in the US. They've moved back off of that now.

Our idea is, even with this huge rally post Christmas, I think the stock market, financial markets in general, are probably going to be hit by two things. One is a year ago we started the unwinding of a decade of central bank financial repression, where they kept interest rates suppressed. It's taken quite a while for the financial markets to adjust to that. That's why all the volatility we had last year. But I think now, with the world economy slowing somewhat, there's probably too much earnings optimism. I think financial markets are having to adjust to that.

Tony Kaye: Now, you actually contributed into an article that I wrote at the start of the year. You may or may not know that, but I asked a number of senior economists from Australia and overseas what they thought were the key challenges ahead for this year. At that point in time you spoke of the dichotomy between the real economy and the turmoil that's happening on markets. That turmoil has calmed down a bit, but do you still see that there's a dichotomy between the two?

Bob Baur: Yes, I do. That was certainly true last year. We had a really nice US economy and a really good global economy, but financial markets struggled that whole year. They struggled, as I mentioned, because we're unwinding this decade of suppressed interest rates. I do think that's going to continue. If we look at the US, the US economy, it's slowing somewhat, but I think it's still just fine. Household fundamentals are probably the best they've been in the decade. Business sentiment is kind of negative, and if business decides to hunker down and not hire and not invest, that could slow things down somewhat. But households are in great shape. The job market is wonderful. The wage growth is picking up, 4% for lower wage workers, production and non-supervisory workers, 3.2% for everybody. Retail sales are doing just fine. So, I think households are going to keep revenue and sales edging higher, so I think business won't stay as negative. I think the fears are overdone.

The world economy is slowing also, but I think it’s pretty good. Yet financial markets are continuing to struggle. You know? The US probably was one of the best major performers last year, but it was still off 6%. The only people that made any money last year were the people that owned gold, platinum, wheat, Mongolian starch, Russia, Brazil or India. About everybody else lost money. I think that turmoil is going to continue, because I believe there's too much optimism for earnings in the US, and I think with this slower growth, we get more downgrades of guidance. I think we could have another stock market downdraft similar to what we have in December.

Tony Kaye: Can investors afford to be passive in these conditions, or is it really a case of being much more active in their asset allocations and investments?

Bob Baur: Well, I think the current infatuation with passive investing is just about over. Passive investors who are in index funds, whether it was in bonds or stocks in 2018 did not do well. As I see stock markets, well, I think we're going to have a nice buying opportunity in March, April or May, and a recovery in the second half. So, this year could be positive. It's still not going to be great. The idea is that the big systematic influence by central banks that kept interest rates low for seven, eight, nine years, that allowed all stocks to be boosted higher, which made it very difficult for active managers to pick between stocks when this systematic influence was affecting everybody. Now that that influence is fading, I think active managers are going to have a better time, or it will be easier to pick between stocks that have some potential and stocks that don't. I think active management is going to come back to popularity.

Tony Kaye: Now, just looking in terms of opportunities, growth opportunities, where do you see on a global level would be some prime areas an investor should be looking into?

Bob Baur: Well, I think with the dollar weakening, which we have been expecting most of, or for the second half of last year looking for a peak in the dollar, this suggests that emerging markets might outperform the US. I think that they have been in recent months and I think that will continue this year. India in particular I think has got a fair amount of potential. The Modi administration has done several short term not good but long term good things over the last couple of years, and I think that's coming to fruition. I happen to like real estate. If you believe this, as I mentioned, a dichotomy between the real economy and financial markets, then real estate, which has income from the real economy with a little inflation and a decent economy, rents could still rise, so I kind of like real estate. I also like real assets in the situation with a little more inflation and central banks that are not going to be as aggressive as they were, and a weaker dollar.

Tony Kaye: Where are the areas that investors maybe should be avoiding in this climate?

Bob Baur: Well, I think frankly the US has outperformed ... its stock market has outperformed fairly dramatically over the least really several years until the last few months. So, I would guess the US dollar is probably still over owned, and because of the huge out performance in US tech stocks in recent years, I'm guessing the US stocks are probably over owned somewhat. So, I would look for places outside the US, although I do like US real estate at least in certain places, and I think there's real estate in Europe and maybe commercial real estate, I'm not sure about Australia, but other places in the world where commercial real estate could do well.

Tony Kaye: Now, I wanted to move onto Australia actually, especially while I've got you in the studio here. The Australian economy, similar to the US in a way, although we're in a different point in the cycle, but low unemployment, low interest rates. Our housing market is taking a big hit, which has already happened in the US a while ago now. So, we've got a bit of a mix of conditions. We've got a looming federal election coming up this year, which is causing uncertainty. But what are some of the things that you're seeing about the Australian economy?

Bob Baur: You know, what's the motto where something, Australia the lucky country?

Tony Kaye: Ah yes, the lucky country.

Bob Baur: Well, it really has been. I mean, it's been, what, 26 years or something without a recession? I mean, one of the unique things about Australia is not the volatility, but its currency is extremely flexible, and that has been very helpful during tough times when China has slowed and commodity prices have fallen, particularly in 2015 and '16. You know, I can remember when it took 107 US cents to get an Aussie dollar, and now it only takes 76 US cents.

Tony Kaye: Or less.

Bob Baur: Or less.

Tony Kaye: It's about 73.

Bob Baur: So, that flexibility has been really positive for your economy. As a result, even with the big collapse in commodity prices, your country has done extremely well. In part I think services have picked up some of the slack from the decline in the commodity business in the ... was it North West territories, North West Australia?

Tony Kaye: North West Australia, yes.

Bob Baur: I remember I was in Perth kind of at the peak, and gosh, Perth was just booming with all of the commodity exports. But the problems here are, in some sense, like the US in that you had this incredible run of house prices increases for a long time. In the US, for example, house prices did not go down all that much at any time between the Summer of '32 and the Summer of 2005. Now, that's a trend that anybody can extrapolate. There has been, not so long, but a similar kind of trend here in Australia. When you have a trend like that, similar things happen. People assume the trend will continue so they take bigger gambles. The loans they take out are less protected, and so the downturn in housing will likely continue for a little bit. But I think there are a lot of advantages to Australia, its flexible currency being one of the big ones. Your labour market is strong, and I think probably the RBA, its next move will probably be to cut interest rates at some point. So, while there are some problems here and the exports to China is slowing, that's a problem for Australia, I think the fundamentals are better than people might think.

Tony Kaye: Yeah. We're obviously very heavily dependent on China as our major trading partner on commodities. I actually wanted to come back to the lucky country briefly, because the book The Lucky Country which was written in the 1960s was really talking about how Australia had been, for so long, riding on the, they call it the sheep’s back in terms of our commodities, and really almost being like a lazy country because we didn't have to do anything apart from dig stuff out of the ground or shear sheep, send it off and make money. So, it was almost like a bit of a paradox, the term the lucky country. Obviously, to a large extent, we're still in that position of being very heavily dependent on our commodity exports.

Bob Baur: Which is why a flexible currency is a wonderful thing.

Tony Kaye: Bob, you've just mentioned that you believe the Reserve Bank may cut rather than raise rates, which others have said, but not many. Why are you taking that particular view?

Bob Baur: Well, I'd mentioned already that we are unwinding really a decade of financial repression and suppressed interest rates, but that's kind of on pause now. The Federal Reserve has said, "We're not going to raise rates," and if we do get another down draft, I think the fed might actually lower rates a bit. With house prices falling here in Australia, and with growth in China slowing, a lot of the stuff that has driven the Australian economy is weakening a little bit. So, with inflation not really a problem here or anywhere in the world, it just makes sense to me that the Reserve Bank might see a struggling housing market slowing growth in China as something to which they should react by making loans a little easier and making financial conditions a little less tight.

Tony Kaye: Interestingly, what you've got going on here is that the major banks, being the majority lenders for mortgages, have been doing out of a cycle rate rises. In fact, one of the smaller lenders did an out of cycle rate rise this week. So, that's been going on, and the reasoning behind that is that the cost of funding in financial markets has increased for them. So, obviously if the Reserve Bank did do a cut, then there's going to be even more of a gap between official rates and retail rates in the market here.

Bob Baur: Well, that's true, and that might be an incentive for some of those rates to decline. On the other hand, the banks may simply be reacting to what they see as loans that are maybe being stretched beyond what lending should be, so maybe that's what they're reacting to, and a little higher risk that they see in the market, which if housing markets are coming down somewhat, that's not an illogical thing for them to do.

Tony Kaye: Well, we'll just have to wait and see what happens on that front.

Bob Baur: Yes, we will.

Tony Kaye: Thanks for joining me again in the studio. Dr Bob Baur, Chief Global Economist of Principal Global Investors.

Bob Baur: Thanks Tony.